U.S. GOVERNMENT PRINTING OFFICE

61–039CC WASHINGTON : 1999

INCREASING DISCLOSURE TO BENEFIT INVESTORS

HEARING

BEFORE THE

SUBCOMMITTEE ON

FINANCE AND HAZARDOUS MATERIALS

OF THE

COMMITTEE ON COMMERCE

HOUSE OF REPRESENTATIVES

ONE HUNDRED SIXTH CONGRESS

FIRST SESSION

ON

H.R. 887 and H.R. 1089

OCTOBER 29, 1999

Serial No. 106–70

Printed for the use of the Committee on Commerce

(

2

COMMITTEE ON COMMERCE

TOM BLILEY, Virginia, Chairman

W.J. ‘‘BILLY’’ TAUZIN, Louisiana

MICHAEL G. OXLEY, Ohio

MICHAEL BILIRAKIS, Florida

JOE BARTON, Texas

FRED UPTON, Michigan

CLIFF STEARNS, Florida

PAUL E. GILLMOR, Ohio

Vice Chairman

JAMES C. GREENWOOD, Pennsylvania

CHRISTOPHER COX, California

NATHAN DEAL, Georgia

STEVE LARGENT, Oklahoma

RICHARD BURR, North Carolina

BRIAN P. BILBRAY, California

ED WHITFIELD, Kentucky

GREG GANSKE, Iowa

CHARLIE NORWOOD, Georgia

TOM A. COBURN, Oklahoma

RICK LAZIO, New York

BARBARA CUBIN, Wyoming

JAMES E. ROGAN, California

JOHN SHIMKUS, Illinois

HEATHER WILSON, New Mexico

JOHN B. SHADEGG, Arizona

CHARLES W. ‘‘CHIP’’ PICKERING,

Mississippi

VITO FOSSELLA, New York

ROY BLUNT, Missouri

ED BRYANT, Tennessee

ROBERT L. EHRLICH, Jr., Maryland

JOHN D. DINGELL, Michigan

HENRY A. WAXMAN, California

EDWARD J. MARKEY, Massachusetts

RALPH M. HALL, Texas

RICK BOUCHER, Virginia

EDOLPHUS TOWNS, New York

FRANK PALLONE, Jr., New Jersey

SHERROD BROWN, Ohio

BART GORDON, Tennessee

PETER DEUTSCH, Florida

BOBBY L. RUSH, Illinois

ANNA G. ESHOO, California

RON KLINK, Pennsylvania

BART STUPAK, Michigan

ELIOT L. ENGEL, New York

THOMAS C. SAWYER, Ohio

ALBERT R. WYNN, Maryland

GENE GREEN, Texas

KAREN MCCARTHY, Missouri

TED STRICKLAND, Ohio

DIANA DEGETTE, Colorado

THOMAS M. BARRETT, Wisconsin

BILL LUTHER, Minnesota

LOIS CAPPS, California

JAMES E. DERDERIAN, Chief of Staff

JAMES D. BARNETTE, General Counsel

REID P.F. STUNTZ, Minority Staff Director and Chief Counsel

SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS

MICHAEL G. OXLEY, Ohio, Chairman

W.J. ‘‘BILLY’’ TAUZIN, Louisiana

Vice Chairman

PAUL E. GILLMOR, Ohio

JAMES C. GREENWOOD, Pennsylvania

CHRISTOPHER COX, California

STEVE LARGENT, Oklahoma

BRIAN P. BILBRAY, California

GREG GANSKE, Iowa

RICK LAZIO, New York

JOHN SHIMKUS, Illinois

HEATHER WILSON, New Mexico

JOHN B. SHADEGG, Arizona

VITO FOSSELLA, New York

ROY BLUNT, Missouri

ROBERT L. EHRLICH, Jr., Maryland

TOM BLILEY, Virginia,

(Ex Officio)

EDOLPHUS TOWNS, New York

PETER DEUTSCH, Florida

BART STUPAK, Michigan

ELIOT L. ENGEL, New York

DIANA DEGETTE, Colorado

THOMAS M. BARRETT, Wisconsin

BILL LUTHER, Minnesota

LOIS CAPPS, California

EDWARD J. MARKEY, Massachusetts

RALPH M. HALL, Texas

FRANK PALLONE, Jr., New Jersey

BOBBY L. RUSH, Illinois

JOHN D. DINGELL, Michigan,

(Ex Officio)

(II)

3

C O N T E N T S

Page

Testimony of:

Dickson, Joel M., Senior Investment Analyst, Vanguard Group .................. 17

Fink, Matthew P., President, Investment Company Institute ..................... 29

Jones, David B., Vice President, FMR Co ...................................................... 22

Mason, James L., Director of Public and Community Affairs, Eaton Corporation .......................................................................................................... 8

Thompson, Robert B., George Alexander Madill Professor of Law, Washington University .......................................................................................... 4

Material submitted for the record by:

American Society of Corporate Secretaries, letter dated October 27, 1999,

to Hon. Tom Bliley and Hon. Michael G. Oxley ......................................... 98

Association of Publicly Traded Companies, letter dated October 28, 1999,

to Hon. Tom Bliley and Hon. Michael G. Oxley ......................................... 41

Business Roundtable, The, letter dated July 23, 1999 .................................. 42

Dingell, Hon. John D., a Representative in Congress from the State

of Michigan, prepared statement with attachments .................................. 50

OMB Watch, letter dated November 3, 1999, to Hon. Michael G. Oxley .... 48

Ridings, Dorothy S., President and CEO, Council on Foundations, prepared statement of ........................................................................................ 44

Securities and Exchange Commission, prepared statement of ..................... 46

(III)

(1)

INCREASING DISCLOSURE TO BENEFIT

INVESTORS

FRIDAY, OCTOBER 29, 1999

HOUSE OF REPRESENTATIVES, COMMITTEE ON COMMERCE, SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS, Washington, DC.

The subcommittee met, pursuant to notice, at 10 a.m., in room

2123, Rayburn House Office Building, Hon. Paul E. Gillmor presiding.

Members present: Representatives Gillmor, Markey, and Cox.

Staff present: Brent DelMonte, majority counsel; David Cavicke,

majority counsel; Brian McCullough, majority professional staff;

Robert Simison, legislative clerk; and Consuela Washington, minority counsel.

Mr. GILLMOR. The committee will come to order and we will proceed with the first bill. We have two bills up today and two panels,

and we will do opening statements on the first bill, and then do the

panel and then the same procedure on the second bill.

I might tell those that are here that attendance is a little weak

today because Congress is not in session. We were scheduled to be

recessed, and when that happens, members leave town.

I want to thank members on both panels for coming. I know that

a number of you have come from some distance and we very much

appreciate your lending us your time and your expertise.

The first bill is H.R. 887, improved disclosure of charitable contributions by corporations, and I want to thank both Chairman

Mike Oxley and ranking member Ed Towns who have cosponsored

this legislation which I have introduced.

Over 60 years ago, we determined as part of national policy that

shareholders are entitled to receive relevant information from corporate management. Corporations give more than $8.5 billion per

year in charity, and there is no reason why shareholders should be

denied knowledge of that information.

Under current law if a corporation donates money to a charitable

organization, the corporation is under no obligation to reveal anything about those gifts. Because those gifts are donated from shareholder earnings, a reasonable disclosure requirement is a matter of

accountability. Now some corporations voluntarily disclose this type

of information, including Eaton Corporation which is testifying

today, and I want to commend those who voluntarily do disclose.

This is not an issue about which groups receive charitable contributions from corporations, it is an issue of shareholder rights.

Shareholders are the owners of a company’s assets, and nothing in

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my legislation questions a company’s commitment to social responsibility. Likewise, nothing in the legislation prohibits or restricts

management’s right to make donations or assess to whom or how

much. I simply believe that shareholders have a right to review

management’s decisions and rationale.

I have heard all of the arguments from companies and charities

that feel threatened by this legislation. It is too costly, too burdensome. Shareholders are not interested. The amount of contributions

is insignificant, given out to local companies, and more.

Of the Fortune 100 companies which have provided SEC information about charitable giving, 53 percent of the number of cash

contributions were $2,500 or less. A threshold of just $2,500 would

require those companies to report less than half their contributions,

and I would imagine that smaller companies would have to report

less than that. Contributions of $2,500 or less, however, accounted

for less than 4 percent of the total dollar amount. Less than 2 percent of the contributions exceed $100,000, but those contributions

represent 46 percent of the total amount contributed.

We are not talking about disclosing checks to the local boys’ and

girls’ clubs, we are talking about significant contributions from

shareholder earnings, and I have spent a lot of time working with

both business and charity groups to find a workable disclosure requirement.

The subcommittee did extend an invitation to the Business

Roundtable to be with us today. I regret that they and a member

company were not able to be here today, but we have met with

them in the past and their views are certainly welcome at any time

in the future as well.

The fact is companies that do voluntarily disclose their giving

haven’t had those problems. Arguments raised from companies

against the bill come mostly from managers who don’t want to tell

shareholders where they are giving the money away and use those

arguments as excuses. If a CEO’s spouse is the president of the

Hula Hoop Foundation and the company gives $1,000 dollars to the

Hula Hoop Foundation, and the company doesn’t manufacture, sell,

promote or have anything to do with Hula Hoops, then shareholders derive absolutely no benefit from those donations. Of course

there is a natural self-interest in that case for the CEO to keep the

donation out of the public eye. Transparency and integrity are the

foundations upon which shareholders take a stake in our equity

markets.

Today over one-half of American families are invested in the

stock market in one form or another. Millions of Americans are

owners of our publicly held companies, and as more and more

Americans take advantage of corporate ownership to secure their

financial future, they assume a greater role in responsible and judicious charitable giving. Shareholders cannot participate in this

great tradition unless they have access to this information.

I requested that the SEC do a study on the feasibility of this bill,

and the SEC did report back earlier this year and concluded, ‘‘The

corporate charitable disclosure requirements in H.R. 887 would be

feasible in that companies are capable of tracking and disclosing

this information to investors.’’

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I would also like to note a small utterance by the SEC Chairman

in a 1995 speech on disclosure. Chairman Levitt began by quoting

Samuel Johnson saying, ‘‘Where secrecy or mystery begins, vice or

roguery is not far off.’’

I turn to the distinguished gentleman from Massachusetts, Mr.

Markey.

Mr. MARKEY. Thank you very much, Mr. Chairman. And I thank

you very much for ensuring that we would have this very important hearing this morning which I hope can ultimately lead to legislative action.

I am a cosponsor with you, Mr. Chairman, of H.R. 1089, The Mutual Fund Tax Awareness Act. This bill would direct the SEC to

issue rules to ensure that mutual fund investors receive disclosure

regarding the after-tax performance of their mutual funds. This

type of information can be very useful to investors in combination

with other types of disclosures required under existing rules in

making an informed investment decision regarding the impact of

capital gains on the overall performance of a mutual fund.

While such disclosures, like all historical data regarding the past

performances of a fund, does not have precise predictive value, it

is nevertheless useful and important for investors to receive that

type of information.

The fact is because this industry is so competitive and because

there are so many funds out there, factors such as fees and taxadjusted performance can be a significant and material factor to an

investor in choosing which fund to invest their money. The more

information an investor has, the more likely they are going to make

an informed decision. That is ultimately the only goal of this legislation. To put the information in the hands of the investor to as

a result make them even more knowledgeable and then with the

guarantee that nothing is guaranteed, they can make their investments in the mutual funds of their choice.

So I hope, Mr. Chairman, that we can move forward on that legislation. I look forward to hearing from expert witnesses and I yield

back the balance of my time.

Mr. GILLMOR. Thank you, Mr. Markey.

[Additional statements submitted for the record follow:]

PREPARED STATEMENT OF HON. MICHAEL G. OXLEY, CHAIRMAN, SUBCOMMITTEE ON

FINANCE AND HAZARDOUS MATERIALS

Today this Subcommittee will focus on two bills drafted by my colleague, Congressman Gillmor. Both of these bills, which I cosponsor, would provide investors

with better investment information by mandating certain disclosures. Because educated investors make better decisions than those without reliable information, these

bills will benefit investors in our country and throughout the world.

The first bill we’ll consider, H.R. 887, would require corporations to provide their

shareholders with certain information about corporate giving. Responsible corporations play a major role in funding not-for-profit organizations, and no one in the

Congress wants to see corporations stop these beneficial activities. At the same

time, corporations are under no obligation to disclose to their shareholders where

shareholder money is being donated, even if the money is being funneled to a notfor-profit on which a director or a director’s spouse serves, or to groups opposed by

the majority of shareholders. While many corporations have taken it upon themselves to provide their shareholders with information about their charitable giving,

most corporations still do not. Since corporate gifts are donated out of shareholder

earnings, it is only reasonable to provide shareholders with information about where

the money, which would otherwise be returned to them in the form of a dividend,

is being spent.

4

In our second panel we’ll consider H.R. 1089, the Mutual Fund Tax Awareness

Act, a bill which would provide mutual fund shareholders with better information

about their funds’ rates of return. According to Morningstar, 180 of the 756 all

funds, or nearly one in four funds, which have been in existence for the past ten

years have lost more than three percentage points per year on their claimed rates

of return to taxes. The funds most likely to lose percentage points are those with

high portfolio turnover, because if the fund manager is frequently turning over

short-term gains in searching for better investments, the investors will have to pay

taxes on this turnover on a yearly basis. Despite this fact, the overwhelming majority of funds still do not list performance figures on an adjusted, after-tax basis, even

though they do list performance rates net of fees and expenses. This means that if

an investor buys into a fund which claims a rate of return of 15%, but the investor

isn’t provided with information showing that the adjusted rate of return for the fund

was only 10% after the investors paid their taxes, then that investor may have

missed out on the opportunity of buying into a fund which better takes into account

investor tax consequences when managing the fund.

I want to commend Congressman Gillmor on his hard work in drafting these bills.

They reflect a reasonable compromise between competing interests. I look forward

to working with the members of this Subcommittee to ensure that investors are provided better information about their investments.

PREPARED STATEMENT OF HON. TOM BLILEY, CHAIRMAN, COMMITTEE ON COMMERCE

Mr. Chairman: It goes without saying that investors, and potential investors, benefit from reliable investment information. This investment information takes many

forms. Today’s hearing will focus on one form of this information: mandated corporate disclosure. Specifically, this hearing will consider two bills drafted by my colleague, Congressman Gillmor.

The first bill upon which the Subcommittee will focus, H.R. 887, would amend the

Securities and Exchange Act to require that corporations disclose certain information concerning their charitable giving. While there is no doubt that corporate giving

is essential to the missions of many not-for-profits, at the same time it must be remembered that the money being given to these groups belongs to the shareholders,

not the corporate board. It is important to give these shareholders more information

about where their money is being spent, so we need to learn whether this bill would

effectively accomplish that objective.

The second bill, H.R. 1089, would require that the S.E.C. amend their regulations

to require improved disclosure of mutual fund returns. It is a common industry

practice to report mutual fund performance figures net of expenses and fees, but not

net of taxes. Given that many non-index funds experience a high rate of turnover

in their portfolios yearly, because investors must pay taxes on this turnover the actual rate of return investors enjoy frequently is less than what is reported by the

funds. Providing investors, and potential investors, with information about the

after-tax effects of portfolio turnover will better enable investors to properly choose

the mutual fund which best suits their investment needs.

Mr. Chairman, I commend Congressman Gillmor for his work on these bills, and

you for scheduling this hearing. I look forward to hearing from our witnesses.

Mr. GILLMOR. We will proceed with Robert Thompson, who is

from the University of Washington School of Law in St. Louis. Mr.

Thompson.

STATEMENTS OF ROBERT B. THOMPSON, GEORGE ALEXANDER MADILL PROFESSOR OF LAW, WASHINGTON UNIVERSITY; AND JAMES L. MASON, DIRECTOR OF PUBLIC AND

COMMUNITY AFFAIRS, EATON CORPORATION

Mr. THOMPSON. Thank you, Mr. Chairman. I am Robert Thompson of St. Louis, Missouri. I am a law faculty member at Washington University and Director of the Center for Interdisciplinary

Studies at the Washington University School of Law. My statement

is on behalf of myself and Professor Charles Elson who is a professor at Stetson University, a frequent writer about corporate governance and in fact a director to American corporations.

5

I speak this morning about H.R. 887 which would require corporate disclosure of charitable contributions. We believe that would

be a vital and welcome addition to a well-functioning corporate system and could help ensure confidence and encourage participation

in our Nation’s capital markets.

The corporate forum permits a specialization of function between

managers and shareholders. It is one of the most distinctive parts

of corporate law that separates and facilitates an efficient management structure and it permits the corporation to adapt to changed

circumstances which is essential in our modern economy.

At the same time, separation creates possible agency problems in

that directors are given control over large pools of funds invested

by the shareholders. Disclosure is the central mechanism used by

Federal law to enable shareholders to effectively exercise their voting and other rights available to them under State corporate law.

Disclosure of material charitable contributions, as would be required by H.R. 887, is consistent with the disclosure currently required under the Federal securities law. The more specific disclosure that would be required by this bill where there is a possibility

of a conflict of interest as to the corporate insiders and the beneficiary of the corporate charitable contribution is consistent with

the focus in Regulation S-K on disclosure relating to comment of

interest generally.

As with other expenditures of corporate money, shareholders desire that charitable contributions reflect a corporate purpose and do

not simply become a gift of corporate assets to benefit the managers who direct the funds, but with no financial or emotional benefit to the shareholders themselves and to their collective enterprise.

Today’s corporate philanthropy sometimes functions to promote

and aggrandize corporate managers with the benefit and the credit

for the donations flowing to the individuals without any corresponding benefit to the entity and its owners.

Consider the well-publicized case of Occidental Petroleum. When

its long-time CEO, Armand Hammer, was unable to obtain satisfactory terms as to the donation of his art collection to the Los Angeles County Museum of Art, he turned to the company, Occidental, to build a museum to house the collection. The cost of the

new building, the renovation of space for the museum’s use in Occidental’s headquarters next door, and property taxes and annuities

to help fund the museum’s initial operations approached $100 million. The company received some public recognition in the form of

the right to name and use certain space in the building and certain

sponsorship rights. Many believe the gift did little for the corporation’s financial prospects or its shareholders but did a great deal

for Mr. Hammer’s standing in the art community.

A challenge to this action under traditional State law corporate

rules led to a settlement limiting the company’s contributions. As

required by appropriate corporate law procedures, the Delaware

chancery court was asked to approve the settlement, but its language in doing so provides little reassurance as to the ability for

the current legal structure to actively address the problem that you

have mentioned this morning. The chancery said and I quote, ‘‘If

the court was a stockholder in Occidental it might vote for new diVerDate 20-MAR-2000 14:09 Mar 22, 2000 Jkt 010199 PO 00000 Frm 00008 Fmt 6633 Sfmt 6602 E:\HEARINGS\61039.TXT pfrm02 PsN: 61039
6

1George Alexander Madill Professor of Law and Director, Center for Interdisciplinary Studies,

Washington University School of Law, St. Louis, Missouri. Professor Thompson has taught corporations and securities law for more than 20 years. He is co-author of a corporations casebook

widely used in American law schools and is a former chair of the Section of Business Associations of the Association of American Law Schools. 2Professor of Law, Stetson University School of Law, St. Petersburg, Florida. Professor Elson

specializes in corporate governance research and is a director of two publicly held American

companies. He is a member of the Advisory Council of the National Association of Corporate

Directors; he organized a national working group of lawyers, investors, and law professors to

discuss possible language and approach for this bill in 1998 and a seminar on corporate

philantrophy in 1997.

rectors. If it was on the board, it might vote for new management.

And if it was a member of the special committee, it might vote

against a museum property.’’ But, the court continued, its options

are limited in reviewing the proposed settlement and in fact the

settlement was approved.

This story is sadly not alone in our corporate landscape. Generally if a manager directs substantial contributions out of corporate funds to a charity with whom he or she is personally involved, there is the potential of a conflict of interest. If the charity

has no relationship with the entity’s business but provides the

manager some form of personal benefit within the community, the

possibility of self-dealing is real. Such a manager may not be the

best steward of the shareholders’s resources. Knowledge of those

facts would clearly be material to shareholders in evaluating the

performance of directors and directly relevant to their providing

proxies to the election of directors. Current Federal regulation provides for direct conflict transactions, but does not provide for disclosure of charitable donations. Shareholders, therefore, cannot readily ascertain the existence of such a conflict. The House bill will

provide the facts necessary for determining either the existence of

such conflict or even the simple misapplication of shareholders’ investment.

While the benefit of such disclosure is substantial, the corresponding cost is not. Every public company that makes such

charitable contributions annually collects information regarding

those donations for reporting to the appropriate State and Federal

taxation authorities. Requiring the disclosure of charitable contributions over a threshold amount will require no more than the

repetition of information already collected and transmitted to government agencies. The disclosure contemplated by the proposed

legislation greatly benefits the shareholding public at very little potential cost to the reporting companies. The proposed legislation is

a focused and targeted effort that can be implemented consistent

with existing Federal approach to securities disclosures. We urge

you to make them part of our Federal securities laws.

[The prepared statement of Robert B. Thompson follows:]

PREPARED STATEMENT OF ROBERT B. THOMPSON 1 AND CHARLES M. ELSON 2

REGARDING H.R. 887

H.R. 887 requiring corporate disclosure of material charitable contributions is a

vital and welcome part of a well-functioning corporate governance system that can

insure investor confidence and encourages active participation in the national capital markets. It makes necessary changes that can be implemented at a minimal

cost.

The corporate form permits a specialization of function between directors and

shareholders, for example, that facilitates an efficient management structure and

permits the corporation to adapt to changed circumstances. At the same time, this

7

3See Kahn v. Sullivan, 594 A.2d 48 (Del. 1991); see also Nell Minnow, What’s Wrong with

These Pictures? The Story of the Hammer Museum Litigation, in Law Stories 101 (Gary Bellow

& Martha Minnow, Eds. 1996). 4Sullivan v. Hammer, No. 10823, 1990 Del. Ch. LEXIS 119, at *12 (Del. Ch. Aug. 7, 1990)

aff’d sub nom., Kahn v. Sullivan, 594 A.2d 48 (Del. 1991). 5See also Jayne W. Barnard, Corporate Philanthropy, Executives’ Pet Charities and the Agency Problem, 41 N.Y.L.S. L. Rev. 1147, 1160-64 (1997) (examples of sizeable corporate contributions connected to CEO preferences). 6See Faith Stevelman Kahn, Legislatures, Courts and the SEC: Reflections on Silence and

Power in Corporate and Securities Law, 41 N.Y.L.S. L. Rev. 1107 (1997).

separation creates possible agency problems in that directors are given control over

large pools of funds invested by the shareholders. Disclosure is the central mechanism used by federal law to enable shareholders to effectively exercise their voting

and other rights available to them under state corporate law.

Disclosure of material charitable contributions as would be required by H.R. 887

is consistent with disclosure currently required under federal securities laws. The

more specific disclosure that would be required when there is the possibility of a

conflict of interest as to a corporate insider and the beneficiary of the corporate

charitable contribution is consistent with the focus in Regulation S-K, for example,

on disclosure relating to possible conflicts of interest.

As with other expenditures of corporate money, the shareholders desire that charitable contributions reflect a corporate purpose and do not become simply a gift of

corporate assets that benefits the manager who directs the corporate funds with no

financial or emotional benefit to the shareholders themselves and their collective enterprise. Today’s corporate philantrophy sometimes functions to promote and aggrandize corporate managers, with benefit and credit for the donations flowing to

the individuals without any corresponding benefit to the entity and its owners. Consider the well-publicized case of Occidental Petroleum Corporation. 3 When its longtime CEO Armand Hammer was unable to obtain satisfactory terms as to the donation of his art collection to the Los Angeles County Museum of Art he turned to Occidental to build a museum to house his collection. The costs of the new building,

renovation of space for the Museum’s use in Occidental’s headquarters next door,

property taxes and an annuity to help fund the museum’s initial operations exceeded $100 million. The company received some public recognition in the form of the

right to name and use certain spaces and certain sponsorship rights. Many believe

that the gift did little for the corporation’s financial prospects or its shareholders

but did a great deal for Mr. Hammer’s standing in the art community.

A challenge to this action under traditional state law corporate rules led to a settlement limiting the company’s contributions. As required by appropriate corporate

law procedures, the Delaware Chancery Court approved the settlement but in language that provides little reassurance for the ability of the current legal structures

to adequately address this problem: ‘‘If the Court was a stockholder of Occidental,

it might vote for new directors, if it was on the Board it might vote for new management and if it was a member of the Special Committee, it might vote against the

Museum project. But its options are limited in reviewing a proposed settlement . . .’’ 4

This story is sadly not alone in our corporate landscape. 5

Generally, if a manager directs substantial contributions out of corporate funds

to a charity with whom he or she is personally involved there is the potential of

a conflict of interest. If the charity has no relationship with the entity’s business,

but provides the manager some form of personal benefit within the community, the

possibility of self-dealing is real. Such a manager may not be the best steward of

the shareholders’ resources. Knowledge of those facts would clearly be material to

shareholders in evaluating the performance of directors, and directly relevant to

their providing proxies for the election of directors. Current federal regulations provide disclosure for direct conflict transactions, but do not provide for disclosure of

such charitable donations. 6 Shareholders therefore cannot readily ascertain the existence of such conduct, either malignant or benign. The House Bill will provide the

facts necessary for determining either the existence of such conflicts of interest or

even the simple misapplication of shareholders’ investment. Information such as

this is necessary to the shareholder’s informed evaluation of company management

which in turn is vital to a properly functioning capital market.

While the benefit of such disclosure is substantial, the corresponding cost is not.

Every public company that makes such charitable contributions annually collects information regarding such donations for reporting to the appropriate state and federal taxation authorities. Requiring the disclosure of charitable contributions over

a threshold amount will require no more than the repetition of information already

collected and transmitted to governmental agencies. The disclosure contemplated by

8

7See Melvin Aron Eisenberg, Corporate Conduct That Does Not Maximize Shareholder Gain:

Legal Conduct, Ethical Conduct, The Penumbra Effect, Reciprocity, The Prisoner’s Dilemma,

Sheep’s Clothing, Social Conduct and Disclosure, 28 Stetson L. Rev. 1, 25 (1998).

the proposed legislation greatly benefits the shareholding public at very little potential cost to the reporting companies.

The proposed legislation is a focused and targeted effort that can be implemented

consistent with the existing federal approach to securities disclosure. It applies only

to reporting companies (and similar companies regulated under the Investment

Company Act.) Subsection 1 requires disclosure of contributions to nonprofits when

an issuer’s director officer or control person (or a spouse of one of those) is a director

or trustee of the nonprofit. It will require disclosure of contributions only above a

threshold amount as designated by the Securities and Exchange Commission

(‘‘SEC’’). Subsection 2 requires additional disclosure of the total value of contributions made by a corporation and individual disclosure above a threshold that will

be designated by the SEC. Unlike the disclosure in the previous section, this disclosure would appear not in the proxy report sent to all shareholders but in a filing

as designated by the SEC. Because the reason for such disclosures differ from the

reasons for conflict of interest disclosure, the nature of the disclosure may also differ. 7

These disclosures are consistent with, and considerably less complex than, existing disclosure as to conflict transactions as found, for example, in Item 404 of Regulation S-K. They reflect disclosure priorities found generally in Regulation S-K and

other parts of the federal securities laws. We urge you to make them part of our

federal securities law.

Mr. GILLMOR. Thank you very much, Mr. Thompson, and I want

to announce that the record will remain open for others members

to submit in writing their opening statements. James Mason from

Eaton Corporation in Cleveland, Ohio.

STATEMENT OF JAMES L. MASON

Mr. MASON. Good morning, Mr. Chairman. Thank you very much

for the opportunity to appear this morning and talk a little bit

about H.R. 887.

I am Director of Public and Community affairs for Eaton Corporation, a global manufacturer headquartered in Cleveland, Ohio.

It employs about 65,000 men and women worldwide at about 215

manufacturing sites.

Let me tell you about our overall contributions and community

relations philosophy. As a global company, Eaton Corporation transcends national borders, crosses State lines and bridges cultural

differences by providing jobs and economic stability. The company

invests in itself and in the future with little fanfare. As background, we provided about $5 million last year to deserving nonprofit organizations and communities.

Each year we look at the many causes called to our attention by

our employees and apply our knowledge and skills to determine

where we can provide the most benefit to those in need. Our first

commitment is in those cities and towns and communities where

our employees live and work. We support programs that aid education and strengthen the community as well as help those with

limited opportunities and few resources.

No less important than the dollars provided are the many hours

that volunteers devote to making a difference in people’s lives. This

is part of the Eaton of which I am most proud. Across the company

there are many unsung heroes who take the time to engage in

these volunteer activities. Each year we honor those individuals

with an award for community service named after one of our

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former chairmen, who like many in our company have had a tradition of volunteerism.

It is clear as we approach the new millennium, technological advances have not provided the solutions to the human and social

issues of our times. We have an opportunity and an obligation to

strengthen the communities where we live and work and to help

those less fortunate. To do less would be to deny that corporations

have a mission beyond providing jobs and creating wealth. We believe otherwise, and we act on that belief.

Our employees consistently give of their time, talent, and finances to support a variety of noteworthy programs and organizations. Grants are frequently awarded to organizations recommended by our employees who are involved in leadership roles

and who are in a position to ensure the effective use of the company’s investment.

It has been our philosophy at Eaton to be open and candid in disclosing to whom our charitable contributions are made and the

amount of our philanthropy. We do this in a volunteer manner and

share this information with our board of directors, our employees

and grant seekers. I have reports of our contributions, Mr. Chairman, with my testimony on our total philanthropy.

In addition to our voluntary disclosure, we also meet with our

board of directors on an annual basis, a committee of our board of

public policy and social responsibility; it is a chance to view firsthand the projects and priorities that we are funding.

But I am not sure, Mr. Chairman, that one size fits all. This

works for a company such as Eaton. It has been in our history. We

don’t make that much in the way of corporate philanthropy that it

is going to make a difference on the margin. We try to be supportive of the involvement of our people. That is where our money

flows. I know that you have run some statistics as to whether this

would have an impact on philanthropy. I am not sure, but I think

anything that could have a possible chilling effect is something that

we would not want to advocate.

I know in talking to colleagues within the philanthropic community, Mr. Chairman, we have a very different opinion on this issue.

Disclosure, as it indicates, I think is good for the process. I think

mandating the types of elements may not be, and I would not advocate that.

Thank you very much, Mr. Chairman.

[The prepared statement of James L. Mason follows:]

PREPARED STATEMENT OF JAMES L. MASON, DIRECTOR, PUBLIC & COMMUNITY

AFFAIRS, EATON CORPORATION

INTRODUCTION

My name is Jim Mason and I am Director of Public & Community Affairs for

Eaton Corporation. My company is a global manufacturer of highly engineered products that serve industrial, vehicle, construction, commercial, aerospace and semiconductor markets. Principal products include hydraulic products and fluid connectors,

electrical power distribution and control equipment, truck drivetrain systems, ion

implanters and a wide variety of controls. We are headquartered in Cleveland,

Ohio—and employ 65,000 men and women at 215 manufacturing sites in 25 countries around the world. Our 1999 sales are expected to be nearly $9 billion.

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BACKGROUND

I am providing testimony in regards to H.R.887 regarding disclosure of corporate

charitable contributions sponsored by Congressman Paul Gillmor. Let me begin by

telling you about Eaton and its overall contributions and community relations’ philosophy.

As a global company, Eaton Corporation transcends national borders, crosses

state lines and bridges cultural differences. By providing jobs and economic stability, the company invests in itself, in society and in the future. With little fanfare,

Eaton provided nearly $5 million last year to deserving non-profit organizations and

communities.

Each year we look at the many causes called to our attention by our employees

and apply our knowledge and skills to determine where we can provide the most

benefit to those in need. Our first commitment is to the cities, towns, and villages

where our employees live and work. We support programs that aid education and

strengthen the community as well as help those with limited opportunities and few

resources.

Of no less importance than the dollars provided are the many hours that volunteers devote to making a difference in people’s lives. This is the part of Eaton of

which I am most proud. Across the company there are many unsung heroes who

take the time to teach reading to the illiterate, coach little league softball, organize

a school aid program or reach out in other ways to those in need. Each year we

honor several of these volunteer leaders with the James R. Stover Awards for Community Service, named after one of our former chairmen, but there are many, many

others who uphold this Eaton tradition of volunteerism.

As we approach a new millennium, it is clear that technological advances have

not provided solutions to the human and social issues that trouble our times. We

have an opportunity and an obligation to strengthen the communities where we live

and work and to help those less fortunate. To do less would be to deny that corporations have a mission beyond providing jobs and creating wealth. We believe otherwise and we act on that belief.

Eaton employees consistently give of their time, talent and finances to support a

variety of noteworthy programs and organizations. Grants are frequently awarded

to organizations recommended by employees who are involved in leadership roles

and who are in a position to ensure the effective use of the company’s investment.

It’s been Eaton’s philosophy to be open and candid in disclosing to whom our charitable contributions are made and the amount of our philanthropy—we do this voluntarily and share the information with our board of directors, employees and grant

seekers. Enclosed with this commentary are reports of contributions that reflect our

total philanthropy.

What Congressman Gillmor is suggesting with H.R.887 is improved disclosure,

openness and accountability—all very worthwhile goals. However, what is disturbing, in my opinion, is the provision that publicly held companies such as Eaton,

would be required to list in our proxy statement, all contributions (amount to be

determined by the SEC) to non-profit organizations that had a board member who

is an executive of the corporation, or is an executive’s spouse. Also, disclosure is required of the total amount of contributions in a year, along with the name of any

non-profit receiving contributions exceeding a certain amount specified again by the

SEC.

I can understand that possibly these provisions were intended to prevent some individuals from becoming too directly involved on certain ‘‘pet projects’’, but we want

our executives and our associates actively involved with organizations and witnessing first-hand the delivery of services and providing oversight on governing

boards. If the aforementioned provision is enacted, it is possible that a chilling affect

will occur, not only would the non-profit experience some funding dilemmas, but active involvement would be lost as well.

Although we choose to disclose our philanthropy voluntarily (not in a proxy statement), many other businesses for a variety of reasons choose not to disclose in the

same manner as Eaton. It’s been suggested that added cost would result from the

proposed mandates, I am not certain as to the amount, but it would have an adverse

impact on corporate philanthropy. And, that is what we don’t need today—in the

era of unprecedented economic growth, more corporate philanthropy by new small

and medium sized businesses should be encouraged to do more for others in need

in our society.

Mr. GILLMOR. Thank you very much, Mr. Mason.

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Let me ask both of you what would be, if any, the compelling

public policy reason for shareholders not to know this information?

Is there any?

Mr. THOMPSON. Shareholders care about how the corporate

money is spent, and there is a question of materiality in terms of

at what level they would be concerned, but the bill seeks to address

that by not requiring every disclosure but only that over a threshold. That is in response to the main argument, obviously.

Mr. MASON. I think on that point, Mr. Chairman, our shareholders, at least through our board of directors, are fully informed

and the report of contributions that we make available to the various public is open to shareholders. Do I send that to every shareholder of Eaton Corporation? I certainly do not. But it is available,

Mr. Chairman, for them to review.

Mr. GILLMOR. One potential concern that you have raised is that

it might have a chilling effect on contributions. Now there are

other companies that publicly disclose, including some very big

ones. Chevron is an example. But in your case, because you have

been disclosing for years—and in fact I have seen your report,

which is very good, and your disclosure goes far beyond anything

that would be called for in this legislation—does the fact that

Eaton discloses have a chilling effect on what you give?

Mr. MASON. No, I don’t think it has a chilling effect. I guess I

am a little concerned that the implication drawn in the legislation

of either the chairman or a member of the board or spouse would—

that there would be something sinister, and maybe that is not the

intended consequence.

We do link a lot of our philanthropy, as you know, Mr. Chairman, with the involvement. We think that it is important that our

people are not only giving of their own personal finances, but they

are taking the time to have some oversight and governance on

these organizations. I don’t see anything wrong with that. I get

concerned that if in the spirit of volunteerism we lose that pull by

mandating certain types of openness beyond where we are open

now.

I think I would rather present this material in this fashion than

include it in a proxy statement, for example, is what I am saying.

I think for every example that Professor Thompson gave relative to

the situation about Mr. Hammer, I don’t think that we see that in

corporate America. I can’t speak to that end of it, certainly.

Mr. GILLMOR. Let me ask Mr. Thompson, because you have been

involved in this type of legislation and you have heard the arguments against the disclosure requirement. You have reviewed the

previous bill that I have introduced, and I think many companies

were surprised at how small a disclosure requirement we actually

have in H.R. 887. But from your looking at the changes which have

been made in this bill, do you think any of those cost or burden

arguments have been alleviated in the current legislation?

Mr. THOMPSON. Yes, I think the changes from the prior legislation to this proposal speak to a number of concerns that were

raised about cost and regulation.

This bill is disclosure which is common in lots of areas of corporate America. Companies do it all of the time. It only applies to

specific disclosures when there is a specific conflict. There will be

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a threshold which can speak to the numbers that you made in your

opening statement. If you eliminate all the small ones, it is not a

large number. With those changes, the burden has been made

much smaller.

Remember, the costs generally are not very great because the information is being collected to be given to the tax authorities relevant to tax returns. So I think that the changes have been very

responsive to the concerns raised about the cost and impact.

Mr. GILLMOR. Thank you very much.

The gentleman from California, Mr. Cox.

Mr. COX. Thank you, Mr. Chairman.

I would like to thank our witnesses for being with us this morning, and I would like to thank Eaton for its enlightened policy. I

think the reason that we are here this morning is to see whether

or not Eaton’s enlightened policy ought not to be the policy generally in a marketplace that is characterized by full disclosure.

Mr. Mason, I think I share your concern about anything that

would have a chilling effect. I think the chairman’s question about

whether your enlightened policy and disclosure causes any chilling

effect gets right to the heart of it. In your view it does not, but

there are certain kinds of transfers of shareholder wealth for no

value—which is what a gift is, it has to be in return for nothing—

that obviously could violate the fiduciary duty of the officer or director, that obviously could work to the personal benefit of the person making the transfer and so on.

There are a number of reasons that I can think of that shareholders at least ought to have access to that information. And insofar as the link between officers and directors of the contributing

corporation and directors of the nonprofit, it seems to me that is

exactly the kind of information that shareholders are already entrusted with when it comes to other benefits to the directors and

the officers of the company in which they invest.

For example, I think I would make the same argument that you

just made about the value of getting your officers or your board

members involved in a charity that you are contributing to when

it comes to stock options. You know, we give officers and directors

stock options all of the time. There is a potential conflict of interest

there, of course, but for the most part I think companies and management believe, and generally investors go along with this, that

giving people who work there a stake in the outcome is a good idea.

Yet our disclosure rules require us to disclose the hell out of this

area to make sure that there is not a conflict of interest. That

didn’t stop companies from—do you have stock options?

Mr. MASON. Yes, sir.

Mr. COX. You bet, and so do most corporate insiders. The fact

that there is disclosure doesn’t in any way chill the use. Why

doesn’t it chill the use of stock options?

Mr. MASON. Well, Mr. Cox, I am not certain where we are going

on this. We offer stock options to a lot of men and women within

my company, not just the senior officers.

Mr. COX. But specifically, why does the fact that you have to disclose the details as an insider transaction, as it were, not deter you

from doing it?

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Mr. MASON. It is a good point. We certainly do disclose that candidly in our proxy statement.

Mr. COX. By law?

Mr. MASON. By law, on an aggregated basis. There are certain

individuals with their compensation that are outlined.

I think philanthropy and what we are talking about on stock options, although—I am not arguing with you. We chose to disclose.

We choose to do that on a voluntary basis. I can understand some

organizations not being particularly enamored with doing that, and

I think you and I would know those types of organizations. I think

if you can’t stand the heat in this, you ought not to show your philanthropy.

We are not going to make a major difference with our corporate

philanthropy in health and human services across this country of

ours. We think that we are trying to do those things, Mr. Cox, on

the margin that might make a difference.

Mr. COX. You want to do your part?

Mr. MASON. Yes, sir. And we would like to have those men and

women who are employees of ours step up to that both from a volunteer standpoint, giving of their time and talent as well as some

resources, as well as the company matching that activity. I think

the centerpiece for our philanthropy has been our support of the

United Way. For every dollar a man and woman who works for

Eaton contributes, we put in 50 cents. And that doesn’t sound like

much until you start aggregating that pot and it is about $2.5 million that our employees give and we are doing about 50 percent of

that. So aggregating, you are getting close to $4 million.

Mr. COX. I think it is going to be very hard for the four of us

to disagree on most of these things because it is rather obvious that

corporate contributions are made for the purpose of benefiting the

general community of which business organizations find themselves a part. It is well understood that encouraging employees,

management, directors, to participate in their communities is a

good thing, makes them better workers, makes the community a

better place. And it is all benign.

The very reason that corporations make charitable contributions

is that they wish to show themselves to be good corporate citizens,

and they wish to be good corporate citizens. For that very reason,

many corporations go out of their way to advertise their charitable

involvements. The disclosure of those charitable contributions

would as a result only further advertise what they already are

proud of and what they want to take credit for and encourage more

of.

So what we are talking about here, if there is a chill at all, is

chilling things that for some reason somebody that is part of the

transaction would rather cover up, would rather keep a secret. And

I wonder if I could ask, Mr. Thompson, what kinds of transactions

are those?

Mr. THOMPSON. They are basically conflict-of-interest transactions. Your point about not many companies not disclosing stock

options is a strong one. Probably a few more disclose their charitable contributions because of the benefit that you just described of

being a good corporate citizen, but not many do.

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The SEC study done at the request of the committee has a survey of the largest 100 corporations, and they tried to get the information from those companies about their charitable contributions

and it was pretty hard to get the information. So there was some

resistance to that. Where the resistance will be the most is where

there is a specific conflict, a potential for embarrassment, and they

don’t want the embarrassment.

Mr. COX. Let us say that a company has a union and let us say

that the company does not—at least its management does not wish

to antagonize the union, but the company wants to influence legislation in Washington. Could the company make a contribution to

a nonprofit organization which would then advertise against the

union’s position at arm’s length and not disclose that to anybody?

Mr. THOMPSON. The line between charity and business expenses

is sometimes gray and hard to define, and your example might well

fall into that gray area.

Most of the stories and concerns which have been raised by charitable contributions have been more directly related to charity, but

it would not exclude the example that you raised.

Mr. COX. Your concern is officers and directors using corporate

assets to benefit themselves personally; is that what you think is

the garden-variety abuse?

Mr. THOMPSON. They are given the right how to decide to use

other people’s money, and that is done for corporate purposes. That

discretion is sometimes used for charitable contributions which can

be good. But when they get a personal benefit from that, we have

crossed the line from the beneficial use to the use that should concern us. This legislation tries to disclose those examples.

Mr. COX. I take it because the character of the personal benefit

is always going to be in the eye of the beholder—these are subjective judgments—that you would recommend that Congress make

no attempt to actually regulate corporate gifts themselves, but

rather simply use the disclosure model to let the market handle it?

Mr. THOMPSON. Disclosure is the best police officer, and the market can decide for itself. I would expect that many corporations

would present their charitable contributions the way that Mr.

Mason has described what Eaton does; showing its commitment to

volunteerism. But within that context, there will be the information for shareholders to evaluate whether or not directors are getting too close to the line.

Mr. COX. There is an unchallenged assumption here that it is the

business of corporations in part to contribute money to their communities. There is another point of view. Milton Friedman once

wrote, ‘‘Few trends could so thoroughly undermine the foundation

of our society as the acceptance by corporate officials of a social responsibility other than to make as much money for their stockholders as possible.’’ Of course he fleshed out his reasons for saying

that, and they are not trivial. We are not asking that question here

this morning with the consideration of this bill because the bill essentially would state in law that this is an acceptable practice; but

should we be concerned in any way at the margin about the license

that this bill would give for corporate philanthropy which presently

appears nowhere in the securities laws?

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Mr. THOMPSON. For much of this century which is now closing,

the law has not permitted those kinds of charitable contributions

by corporations. It has been an evolution over the last few decades

of this century to where that has been permissible. There is an argument against that which you have identified and addressed.

The Congress could if it wished take up that point. That is more

likely a question for state corporate law than Federal securities

laws. The reason that it is relevant for Federal securities laws is

that disclosure is the main focus of Federal law and this bill picks

up on that disclosure aspect and says disclose what you are doing

within the bounds of State law.

Mr. COX. But you are the law professor and I am not. It is my

understanding that there is nothing in the 1933 act or the 1934 act

or the Investment Company Act today that in any way acknowledges that it is an appropriate mission of the corporation to give

away money for no value?

Mr. THOMPSON. No.

Mr. COX. So this would be the first time that we are stating in

statute that is okay?

Mr. THOMPSON. It is saying that if it happens, it needs to be disclosed.

Mr. COX. I don’t think that you would task the SEC with the

business of drafting regulations to determine at what threshold corporate contributions are being made if it were verboten.

Mr. THOMPSON. I think that is a fair statement, yes, sir.

Mr. COX. I just observe, Mr. Chairman, that ought to at least

counterbalance, or more, concerns about chilling effects because

this is the first time that Congress would be saying that this is an

acceptable use of corporate funds and there are arguments that it

is not.

I thank the chairman.

Mr. GILLMOR. Thank you very much, Mr. Cox. That will conclude

our first panel and the hearing on H.R. 887. We will ask—I want

to thank both of you, Mr. Thompson and Mr. Mason, for coming

and helping us out.

We will ask our second panel to come forward.

Let us begin with opening statements. Congressman Markey who

is a cosponsor of this bill, H.R. 1089, has made an opening statement.

Let me say that similar to mutual fund costs, most investors in

nontax-deferred accounts do not understand how taxes impact total

return, and most fund shareholders probably don’t give much

weight to tax considerations.

I would like to thank the chairman of the subcommittee, Chairman Oxley, and the ranking member, Ed Towns, for joining me in

cosponsoring the legislation I have introduced, as has Mr. Markey.

This is an effort to provide millions of American shareholders relevant information regarding their financial objectives. I want to applaud the mutual fund industry for giving Americans an easy way

to participate in American capitalism and for the enlightened view

that they have by and large taken toward more disclosure of preand after-tax returns. If you look at the chart, you can see the impact that taxes have had on mutual fund returns. We have heard

about the magic of compounding, but the magic of compounding

16

doesn’t discriminate. It works equally well with costs and taxes as

it does with return.

The yellow bar shows a rate of return before taxes of the average

mutual fund over the 15-year period ending June 30, 1998 and that

was 13.6 percent.

The subcommittee held a hearing last fall on mutual fund fees

and expenses, and the red bar represents the return of the average

mutual fund after fees and expenses. And that is a return that is

disclosed to fund shareholders. The majority of fund assets are in

nontax-deferred accounts, and investors owe taxes on the distribution a fund makes.

The blue bar represents the total return shareholders get after

they pay taxes, and based on the market return over a 15-year period, the average tax return or the average mutual fund represents

only 67 percent of the pretax return that is disclosed to fund shareholders.

If the average annual return continues for another 5 years, a

$10,000 initial investment in the market would have grown to

$208,000. After costs and expenses, that $208,000 is reduced to

$128,000. Finally, after taxes, the shareholder is left with just

$75,000 or just 36 percent of the total market return. In other

words, over 20 years the investor loses $133,000 to costs and taxes.

So after taxes, the rate of return for the average mutual fund fell

to 10.8 percent. And at the end of the 15-year period, the after-tax

return is only 69 percent of the pretax return.

It is clear that many mutual fund investors and managers focus

only on investment performance before costs and taxes. As taxes

are just an added cost to investors, fund shareholders should have

an opportunity to judge a fund manager’s trading activities to see

how it impacts taxes.

Since we are talking here about taxes primarily derived from the

stock market, here is what I think is an interesting figure. The

Federal Government collected over $23 billion in taxes off mutual

fund trading last year. Now if that were the only source of income

for the U.S. Government, the United States would rank 150th on

the Fortune 500 list based on revenues and we would be just ahead

of Walt Disney and Coca-Cola.

Are some mutual fund income and capital gains distributions inevitable? Of course they are. Likewise, many are preventable as

well. If minimizing taxable income is not important to the fund

manager, it certainly is to the shareholder. A tax is a cost, and to

the extent that taxes can represent as much or more than the cost

of managing the mutual fund, I think investors should be provided

this information in a form that is easily understood. Shareholders

incur taxes when a fund makes income or capital gains distributions. When it sells securities, realizes a profit, capital gains are incurred and distributed, and the selling of those securities is a result of portfolio management decisions. And fund shareholders

should be afforded the opportunity to review what the tax liability

is that is going to be imposed on them.

Now, this bill does not in any way tell a fund manager when,

what, or how frequently to buy or sell. It simply discloses the tax

consequence of those actions.

17

I am encouraged by the efforts of the members of this panel and

by the mutual fund industry to improve after-tax disclosure to

shareholders. The Investment Company Institute has stated its

support for the bill’s objectives, and I am confident that we will

continue to work together in the best interest of shareholders.

Our panel consists of Joel Dickson, Senior Investment Analyst of

Vanguard Group; Mr. David Jones, Vice President, FMR Company,

the Fidelity Mutual Fund Group; and Matthew Fink, the President

of the Investment Company Institute, and we will begin with Mr.

Dickson.

First, I want to ask Mr. Cox if he has an opening statement on

this legislation.

Mr. COX. I do not. I am anxious to hear from the witnesses.

Mr. GILLMOR. You may proceed, Mr. Dickson.

STATEMENTS OF JOEL M. DICKSON, SENIOR INVESTMENT ANALYST, VANGUARD GROUP; DAVID B. JONES, VICE PRESIDENT, FMR CO.; AND MATTHEW P. FINK, PRESIDENT, INVESTMENT COMPANY INSTITUTE

Mr. DICKSON. Thank you, Mr. Chairman and members of the

subcommittee. I welcome the opportunity to testify today on the

Mutual Fund Tax Awareness Act of 1999. The Vanguard Group

strongly supports the bill’s objective of providing better information

on the actual return of mutual funds for taxable investors. To date,

most investors have little or no idea about how taxes reduce their

returns because the industry generally has not discussed the tax

implications of mutual fund management.

Taxes are the largest cost of mutual fund investment for most investors. Based on calculations from Morningstar, the average domestic equity fund returned about 13.5 percent annually on a

pretax basis over the last 10 years. However, these funds returned

about 11 percent on an after-tax basis, a difference of 2.5 percentage points per year.

In fact, two funds with identical pretax returns can have very

different after-tax returns. For example, a $10,000 investment in

Vanguard Growth and Income Fund would have grown to about

$47,700 over the last decade, about $1,000 more than in the Vanguard 500 Index Fund. However, on an after-tax basis, the index

fund’s total of $42,100 was some $4,600 higher. Vanguard has long

encouraged investors to become more knowledgeable about the tax

costs of investing. Most recently we began publishing after-tax mutual fund returns. We are the first mutual fund company to report

after-tax returns for funds other than those that present themselves as tax managed. This is an important step because tax-managed funds represent less than 1 percent of industry assets. We believe that our new disclosure is in lockstep with the objectives of

the bill being discussed today.

I would like to highlight one important aspect of our calculation.

We calculate the return by accounting for the taxes paid on distributions made by the fund to its shareholders. The primary advantage of this approach is that it isolates the tax effects on all

shareholders resulting from the portfolio manager’s decisions.

An alternative would be to assume a shareholder sells his or her

fund shares and pays all the taxes. Because this is an individual

18

decision affecting a particular shareholder, it does not help investors understand how the manager’s decisions affect performance.

Vanguard believes that our calculation allows for a clear-cut discussion of after-tax returns without potentially confusing shareholders.

It is important to note that our after-tax calculation or any aftertax calculation for that matter, is not intended to represent the

exact investment return for any particular investors. Every individual’s return will differ based on his or her unique tax situation.

Rather, our intent is to allow for relevant comparisons of tax effects

across mutual funds with similar objectives.

Although certain assumptions must be made to compute an aftertax return, Vanguard believes that we have developed a presentation that gives relevant, useful information that the average investor can understand. Our annual report disclosure closes an important gap in the assessment of a fund’s return and speaks directly to the goals of The Mutual Fund Tax Awareness Act of 1999.

To the extent that others think that our methodology or presentation can be improved, we would welcome their input. Thank you

very much.

[The prepared statement of Joel M. Dickson follows:]

PREPARED STATEMENT OF JOEL M. DICKSON, PRINCIPAL, THE VANGUARD GROUP, INC.

I welcome the opportunity to testify today on the Mutual Fund Tax Awareness

Act of 1999 and appreciate your invitation for me to address this topic. Vanguard

strongly supports the bill’s objective of providing to mutual fund shareholders better

information on the actual return of their funds.

THE TAX COST OF MUTUAL FUND MANAGEMENT

Taxes are the largest cost of mutual fund investment for most investors. Based

on calculations using data from Morningstar, the average domestic equity mutual

fund has lost nearly 2.5 percentage points per year to taxes on distributions of dividends and capital gains made to the fund’s shareholders. Unfortunately, most investors have little or no idea about how taxes reduce their returns because the industry

generally does not discuss the tax implications of mutual fund management.

If every fund lost the same amount to taxes each year, then little useful information would be gained by reporting after-tax returns. However, funds vary tremendously in the tax burdens they place on their shareholders. For this reason, pretax

returns can be misleading for shareholders subject to taxes on the distributions they

receive. Although the average annual tax bite was 2.5 percentage points, the

19

amount lost to taxes for an individual fund ranged from zero (that is, the pretax

and after-tax returns were equal) to 7.35 percentage points per year.

Rankings of funds’ returns also differed greatly depending on whether pretax or

after-tax returns are used. Of the 547 domestic equity funds with 10 years of returns, 118 (22%) would have their rankings change by more than 10 percentile

points—i.e., they moved up or down by at least 55 spots in the rankings—depending

on whether they were being evaluated on pretax or after-tax returns. The differences can be startling. The fund that lost the most to taxes each year ranked

28th on a pretax basis, yet fell to 272nd out of 547 funds on an after-tax basis.

Similarly, two funds that may appear identical on a pretax basis can have very

different after-tax returns. As shown in the chart below, Vanguard Growth and Income Fund outperformed Vanguard 500 Index by a slight margin over the past ten

years on a pretax basis. However, after considering taxes, the 500 Index Fund would

have generated a substantially higher return. In other words, an investor in a taxdeferred vehicle—e.g., a 401(k) or Individual Retirement Arrangement—would have

been better off with the Growth and Income Fund. The taxable investor, on the

other hand, would have accumulated greater wealth with the 500 Index Fund.

Performance reporting that considers only pretax returns could lead taxable investors to believe that the past performance of a particular fund was much better than

it actually was for a taxable shareholder. Because of these substantial differences

in pretax and after-tax returns, we believe that after-tax returns should be reported

in prospectuses or shareholder reports.

VANGUARD’S EFFORTS TO EDUCATE SHAREHOLDERS ON MUTUAL FUND TAXATION

Vanguard has long encouraged investors to become more knowledgeable about the

tax costs of investing. Most recently, we began publishing after-tax returns in the

annual reports of our equity and balanced mutual funds. In total, these initiatives

represent a natural evolution of Vanguard’s long-standing leadership position in

providing clear and candid disclosure on issues that investors should understand

when evaluating funds’ performance. Some other examples of Vanguard’s efforts to

communicate the importance of taxes on mutual funds’ returns include:

• developing a free, educational booklet, ‘‘Taxes and Mutual Funds,’’ that describes

the tax consequences of mutual fund investment;

• adding voluntary disclosure to our prospectuses regarding the portfolio manager’s

sensitivity to tax implications when making trading decisions. In most cases,

our actively managed equity funds are managed for pretax return. In these

cases, our prospectuses state that ‘‘this fund is generally not managed with respect to tax ramifications’’;

• launching five ‘‘tax-managed’’ funds that are offered only to taxable shareholders

and publishing after-tax returns for these funds in the 1998 annual report to

shareholders; and

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• reporting estimated dividend and capital gain distributions well in advance of distribution dates so that shareholders can assess the impact of purchasing shares

before the distribution, which might accelerate their tax liability.

VANGUARD’S INITIATIVE TO REPORT AFTER-TAX RETURNS

Earlier this month, Vanguard announced that we would start reporting after-tax

returns in the annual reports of all of our balanced and equity mutual funds. Vanguard decided to publish after-tax returns for a broad range of funds after considering a number of options. Calculating and presenting after-tax returns raise a

number of challenges, including what methodology to use and how to explain the

returns to shareholders in a clear and concise manner. Ultimately, we believe that

we succeeded in developing disclosure that meets the objectives of providing relevant, useful information that the average investor can understand. An example of

our disclosure is presented on the following page.

21

We believe our new disclosure is in lockstep with the objectives of the bill being

discussed today, and I would like to highlight a few key points of our presentation.

We made a conscious decision to publish after-tax returns in the annual reports only

for balanced and equity funds and not for bond and money market funds. We view

the annual report as the appropriate venue to discuss the impact of the investment

adviser’s decisions on investment returns. As previously documented, tax realizations vary greatly among equity funds because capital gain realizations resulting

from the sale of stocks are largely at the discretion of the portfolio manager. On

the other hand, there is little ability for bond fund managers to affect the relative

after-tax returns of their funds because interest income received from a bond investment is not an event that can generally be controlled by the manager. Although we

feel that a discussion of bond funds’ after-tax returns does not warrant discussion

in the annual reports, we do make these returns available through other media

(e.g., over the phone or on our website) for shareholders seeking such information.

Overview of Vanguard’s After-Tax Calculation Methodology

Our calculation of after-tax returns makes the following key assumptions:

• After-tax returns are calculated by reinvesting all of the fund’s distributions made

to shareholders, less any taxes owed on such distributions. (Pretax returns are

computed by reinvesting the entire distribution.) In other words, taxes are owed

at the time of the distribution. • We use historical tax rates in the computations. Specifically, we use the highest

individual federal income tax rates in effect at the time of the distribution (currently 39.6% for dividends and short-term capital gain distributions and 20%

for long-term capital gain distributions). We make no adjustments for state or

local income taxes. • We assume that the fund shares were retained—not sold—at the end of the periods shown.

Pre-Liquidation vs. Post-Liquidation Returns

The most important assumption is that we assume no liquidation of the fund’s

shares at the end of the measurement period. This approach may understate the

total taxes due for a shareholder who may ultimately redeem his or her investment

and pay additional taxes upon such a sale. The primary advantage of the

preliquidation figure is that it isolates the effects on all shareholders of the taxes

resulting from the portfolio manager’s investment decisions. That is, distribution of

dividends and capital gains result from the fund’s portfolio management activity

and are given to all shareholders based on their pro-rata share of the fund’s holdings.

An alternative methodology would be to assume a liquidation of the fund’s shares

at the end of the period, whether or not a shareholder would actually redeem his

or her investment. In contrast to the preliquidation figure, this method tends to

overstate the tax impact of mutual fund investments because it accelerates the tax

liability for the buy-and-hold investor. More importantly, the sale of fund shares is

an individual investment decision that results in a taxable event for a particular

shareholder. It does not help investors understand how the manager’s decisions affected the tax liability of all shareholders in the fund. Given these considerations,

Vanguard believes that a pre-liquidation calculation is the best approach to assess

how a manager’s actions affect the after-tax returns received by shareholders.

Using the Highest Federal Marginal Tax Rates

By incorporating the highest individual federal income tax rate in effect at the

time of the distribution, we are taking the most conservative approach by illustrating the greatest potential tax impact to total return. While this methodology will

not incorporate the marginal tax brackets of all our taxable shareholders, it will enVerDate 20-MAR-2000 14:09 Mar 22, 2000 Jkt 010199 PO 00000 Frm 00024 Fmt 6633 Sfmt 6621 E:\HEARINGS\61039.TXT pfrm02 PsN: 61039
22

1This relatively small difference in after-tax returns between the 28% and 39.6% tax rates

occurs because the tax rate difference applies only to dividends and short-term capital gains.

Over the past ten years, long-term capital gains have been taxed at the same rate (28% prior

to the spring of 1997 and currently 20%) for all taxpayers outside of the lowest federal tax

bracket. Among Vanguard’s equity funds, long-term capital gains have generally represented the

bulk of the taxable distributions.

sure that the impact of taxes is not understated for an individual taxable investor.

(We do not incorporate state and local taxes because of the significant complexity

in calculation and presentation that would result in presenting returns for all 50

states and the District of Columbia.)

It is important to note that our after-tax calculation is not intended to represent

the exact investment return for any particular investor because every individual’s

return will differ based on his or her unique tax situation. Rather, our intent is to

allow for relevant comparisons of tax effects across mutual funds with similar objectives. Vanguard’s methodology is the same used by Morningstar in their after-tax

return calculations, which allows investors to make an ‘‘apples-to-apples’’ comparison between a Vanguard fund’s after-tax returns and an appropriate peer-group average after-tax return.

That said, we realize that most shareholders do not fall within the highest federal

marginal tax rate bracket—currently 39.6%. However, the difference between aftertax returns using the highest rate versus a more-common rate of 28% would be less

than 0.4 percentage points annually for most of Vanguard’s equity funds over the

last ten years.1

Given this modest difference in returns, we decided to use the ‘‘highest rate’’

methodology because it is the most conservative approach and because it is much

simpler to track the ‘‘highest rate’’ over time, rather than trying to determine what

historical tax rates would correspond to today’s tax brackets. We believe that it is

extremely important to use historical tax rates in the calculation in order to capture

any tax-related portfolio management decisions made as a result of anticipated tax

rate changes.

SUMMARY

You will undoubtedly hear arguments that computing after-tax returns is a complicated endeavor that may lead to such confusion among investors that the information could do more harm than good. Although certain assumptions must be made

to compute an after-tax return, we think these issues can be addressed without sacrificing either the relevance of the calculation or the clarity of the presentation. In

fact, Vanguard has taken up this challenge, and we believe that we have developed

clear, concise disclosure on the after-tax performance of our balanced and equity

mutual funds. Our annual report disclosure closes an important gap in the assessment of a fund’s return and speaks directly to the goals of the Mutual Fund Tax

Awareness Act of 1999. To the extent that others think that our methodology or

presentation can be improved, we would welcome their input.

Mr. GILLMOR. Thank you, Mr. Dickson.

Mr. Jones.

STATEMENT OF DAVID B. JONES

Mr. JONES. Thank you, Mr. Chairman and members of the subcommittee. I appreciate the opportunity to testify before you today

regarding H.R. 1089, the Mutual Fund Tax Awareness Act of 1999.

Fidelity Investments supports the bill’s goal of providing investors

with access to better after-tax return information for their funds.

We believe investors would benefit from having a better understanding of the impact of taxes on their investments and from the

development of an industry standard calculation which would allow

relevant comparisons across different mutual funds.

We note in this respect that mutual funds as a group are relatively tax efficient investments compared to many other alternatives available to investors because in contrast to an investment

such as a certificate of deposit or a Treasury bill which bears interest, mutual funds are allowed to provide investors with returns

23

taxable at more favorable long-term capital gain rates and not all

of this necessarily is taxable in any given year.

Now, Fidelity first published after-tax returns for one of its funds

in 1993, and we have developed an approach to calculating aftertax returns that we believe presents the impact of taxes fairly and

accurately to investors. We have shared that approach with the

SEC and have met with them on several occasions at their request

to discuss some of the issues associated with this, and some of the

very detailed matters of how the calculation works. But overall, the

approach that we have developed is very similar to the approach

developed by other industry members and analysts of the investment company community.

Nevertheless, there are some important details and differences

that remain to be resolved.

Now any standardized return calculation does require a number

of assumptions because investors have so many different tax positions individually. Possibly the most useful figure is to assume an

individual investor in the highest tax bracket since that maximizes

the tax impact, but inevitably this will be an inaccurate number for

those investors in lower brackets, and importantly, for the very

large number of investors who invest through retirement plans and

are subject to completely different tax regimes.

After-tax returns also vary depending on whether you have presumed the investor continues to hold the account, so-called

preliquidation return, or if you assume that the investor redeems

their shares and uses the money for some purpose, a postliquidation return.

Preliquidation returns will highlight the impact of dividends and

distributions that an investor receives during the course of their

holding period, but doesn’t take all tax liabilities into account because some capital gain liability remains upon redemption.

As a result, preliquidation returns will tend to be higher. Postliquidation returns are, after all, taxes, including anything due

when the shares are redeemed, and including any exit fees that

may be imposed by the fund company. This is consistent with the

approach currently required by the SEC for pretax total returns.

We feel that this gives a more realistic impression of tax impact

for investors, particularly over longer time periods.

Now since 1993 our approach has been to show both of these

numbers to investors because we believe that it is essential to see

the two of them to truly understand the tax impact. Relative results can differ. A fund that appears to be have a superior return

on a preliquidation basis may have an inferior return on a

postliquidation basis, and vice versa. That is an important point.

There are some examples of that in my written testimony.

So finally, I conclude by noting that the competing methods that

we have of after-tax return calculation in the industry are very

similar to each other, and this suggests that this forms a very

sound basis for developing an industry standard. The next step is

to hammer out some very important details and some philosophical

questions ultimately to be arbitrated by the SEC so that we can

have a consistent industry standard that is efficient for mutual

fund companies to produce an effective tool for communicating to

investors.

24

1Fidelity Investments manages more than 280 funds with more than 15 million shareholders. With total assets under management of more than $833 billion, Fidelity is the largest mutual

fund manager in the United States. Fidelity also makes more than 4,000 non-Fidelity funds

available to investors through its FundsNetwork program. 2The tax benefits of mutual funds compared to other investments can be dramatic. An investor who bought our Fidelity OTC Portfolio on September 30, 1998 would have earned a 52.10%

pretax return through September 30, 1999. After paying taxes on fund distributions, an individual investor in the top tax bracket would still have had a 48.86% return, which represents

94% of the pretax result. And after liquidating the investment and paying all remaining capital

gains taxes (assuming long-term gain rates), the investor would have had an after-tax return

of 40.87%, or 78% of the pretax return. (Source for returns: Morningstar Inc.) If that 52.10%

return had been earned from another type of investment in the form of interest, the investor’s

after-tax return would have been 31.47%, or only 60% of the pretax result, because 39.6% of

the return would have gone to pay federal taxes.

Thank you.

[The prepared statement of David B. Jones follows:]

PREPARED STATEMENT OF DAVID B. JONES, VICE PRESIDENT, FIDELITY MANAGEMENT

& RESEARCH COMPANY

I. INTRODUCTION

My name is David B. Jones. I am Vice President of Fidelity Management & Research Company, the investment advisor to the Fidelity Investments group of mutual funds.1

I appreciate the opportunity to testify today on H.R. 1089, the ‘‘Mutual Fund Tax

Awareness Act of 1999’’. This bill, which has been introduced by Representatives

Gillmor, Markey and nine cosponsors, would direct the Securities and Exchange

Commission (‘‘SEC’’) to develop a requirement pursuant to which mutual funds

would disclose the effects of taxes on returns to fund investors.

Fidelity Investments supports the bill’s goals. We believe that investors would

benefit from having access to after-tax return information for the funds they invest

in; that the fund industry would benefit from having an industry-standard formula

for after-tax returns, so that investors can compare funds on an equivalent basis;

and that ultimately all would benefit from having better information available about

the impact of taxes on fund returns. The mutual fund industry has built its success

on providing investors with the education and the tools they need to invest responsibly. After-tax returns are one more tool that investors can use to gain a better

understanding of the investment world and of their financial future.

In addition, we are mindful of the fact that mutual funds as a group are relatively

tax-efficient investments compared to many other investment and savings alternatives. For example, savings accounts, certificates of deposit and even U.S. Treasury bills all generate returns that are 100% taxable, at ordinary income rates, in

each year as the returns are earned. Mutual funds, by contrast, may generate returns that are wholly or partly taxable at more favorable long-term capital gain

rates, and may allow investors to defer taxes on part of their returns until they liquidate (redeem) their investments. 2

Fidelity Investments first published after-tax returns in 1993, in annual and

semiannual reports for a Fidelity bond fund managed for after-tax results. Although

that fund has since been liquidated, today we continue to publish after-tax returns

for Fidelity Tax-Managed Stock Fund, which also is managed with after-tax results

as an explicit goal.

In the years since 1993 we have developed a methodology for calculating aftertax returns that we believe fairly communicates the impact of taxes on a shareholder’s investment. Other fund complexes, working independently, have developed

competing methodologies, as has Morningstar, Inc. the well-known third-party analysis firm. While the methodologies developed by Fidelity, Morningstar and other

firms are remarkably similar in many respects, important differences of opinion remain. There are still essential details and complex technical questions that will fall

to the SEC to resolve.

Fidelity is prepared to do its part to help arrive at an industry standard for aftertax returns. We have met with the staff of the SEC on two occasions in 1999 to

share our experiences on this subject, and have submitted to the staff, at their request, a letter outlining potential methodologies for calculating standardized aftertax returns for mutual funds.

The remainder of my testimony discusses aspects of the after-tax return calculation methodology that Fidelity employs. Some of the more detailed aspects of that

25

methodology, and some of the remaining open issues, are discussed in our letter to

the SEC staff, a copy of which is attached as Exhibit 1.

II. MAJOR ASSUMPTIONS NEEDED TO CALCULATE AFTER-TAX RETURNS

After-tax returns are inherently more complicated than pre-tax returns, because

each investor has a different tax situation. Some may be in high tax brackets and

be very sensitive to taxes, while some may be in lower brackets and be relatively

unconcerned. Some investors are not subject to individual tax rates at all: corporations, for example, or offshore investors. Most importantly, many investors buy

shares through tax-deferred retirement plans, and will not be subject to any taxes

on their investments until some time in the future. Tax-deferred retirement accounts represent more than 50% of most Fidelity funds’ shareholder base by assets.

No one method can give the right after-tax result for all of these investors. As

with any standardized calculation, inevitably the results will highlight one set of circumstances at the expense of others.

In providing after-tax returns for our tax-managed funds, we have chosen to calculate results for an individual investor in the highest marginal tax bracket. This

choice implies several limitations: among other things, it will overstate the impact

of taxes for many investors, because most are not in the highest tax bracket, and

it will produce an inaccurate result for retirement investors, because they are subject to a different tax regime. However, this choice of tax rates is useful as a way

of highlighting the impact of taxes for the most tax-sensitive investors.

Other assumptions and choices that must be made in developing a standard return include: whether to reflect state taxes (we do not), whether to use current tax

rates or historical tax rates for historical periods (we prefer historical rates), when

to assume that taxes are paid (we reflect them at the time that distributions are

made, though others have suggested December 31 or April 15 of each year as an

alternative), and how to handle special kinds of mutual fund distributions, such as

returns of capital or distributions derived from real estate investment trusts. These

assumptions will have a less material effect than the choice of a tax bracket, but

they must still be resolved in a standard way for returns to be comparable across

different funds.

III. PRE-LIQUIDATION AND POST-LIQUIDATION RETURNS

‘‘Pre-liquidation’’ returns are adjusted for taxes resulting from fund distributions—dividends, capital gains distributions, and other payments that funds make

to their shareholders. Pre-liquidation returns do not reflect any taxes that may be

due when an investor redeems his or her investment. We sometimes describe them

as ‘‘your after-tax return if you continued to hold your shares.’’

We quote pre-liquidation returns for our tax-managed fund because current income is of great concern to tax-sensitive investors, and pre-liquidation returns highlight this aspect of mutual funds best. But because pre-liquidation returns do not

reflect the taxes due upon redeeming shares, they can give a false picture of the

impact of taxes on mutual fund investments: they are ‘‘after-tax’’ in a sense, but not

after all taxes.

At current federal tax rates, at least 20% of an investor’s gains—the most favorable tax rate available to investors in the maximum bracket—will ultimately go to

taxes (unless the investor dies before touching the money, or donates his or her

shares before death). Pre-liquidation returns risk fostering the impression that taxes

can be deferred indefinitely, which is not the case for most investors, and tend to

exaggerate the benefits of tax deferral. As a result, we use them only in conjunction

with ‘‘post-liquidation’’ returns, which reflect taxes due when the investment is reduced to cash that an investor can use. We sometimes describe post-liquidation returns as ‘‘your after-tax return if you closed your account.’’

Post-liquidation returns address other important disclosure concerns as well.

Under current SEC requirements for pre-tax returns, funds must quote performance

net of all exit fees or other charges (if any) that apply when a shareholder liquidates

his or her investment. Pre-liquidation returns would not ordinarily reflect such

charges, and thus could overstate performance. In addition, current SEC standards

require funds to quote pre-tax returns for 1, 5 and 10-year holding periods. While

a one-year period is relatively short, most mutual fund investors are likely to sell

at least some of their shares before ten years are up, suggesting that a post-liquidation return may be the more relevant number.

For all these reasons, we feel compelled to quote post-liquidation returns as well

as pre-liquidation returns, even though post-liquidation returns are normally lower

numbers. However, this is a question on which reasonable parties may disagree, and

26

3Source: Morningstar Inc., assuming maximum individual tax rates. For these funds

Morningstar’s calculation methodology is essentially the same as that used by Fidelity currently,

except that their one-year post-liquidation returns assume long-term rather than short-term

capital gain tax rates apply.

it represents one of the areas where we expect further debate as the SEC decides

on specific requirements.

IV. EXAMPLE OF AFTER-TAX RETURNS

To illustrate the impact of after-tax return calculations, the following table compares the returns of Fidelity OTC Portfolio, an aggressive, actively managed stock

fund focused on the over-the-counter market, and Fidelity’s Spartan U.S. Equity

Index Fund, a fund managed to track the S&P 500 index, for periods ended September 30, 1999. The index fund has generally had lower taxable distributions, because of its less active management style. However, the relative after-tax result depends both on the time period chosen and on whether returns are viewed before or

after liquidation (the higher result in each case is in bold) 3.

[In percent]

Index

Fund

OTC

Fund

One-year results:

Pretax ............................................................................................................................................................... 27.54 52.10

Pre-liquidation ................................................................................................................................................. 26.87 48.86

Post-liquidation ............................................................................................................................................... 21.74 40.87

Five-year results (annualized):

Pretax ............................................................................................................................................................... 24.76 25.40

Pre-liquidation ................................................................................................................................................. 23.65 22.30

Post-liquidation ............................................................................................................................................... 20.50 20.08

Ten-year results (annualized):

Pretax ............................................................................................................................................................... 16.51 18.06

Pre-liquidation ................................................................................................................................................. 15.26 14.84

Post-liquidation ............................................................................................................................................... 13.61 13.75

This example highlights the importance of considering both pre-liquidation and

post-liquidation results when considering historical after-tax returns. The example

demonstrates that after-tax returns tend to be lower than pre-tax returns, and that

post-liquidation returns tend to be lower than pre-liquidation returns. The 5-year

results exemplify how a fund may have a superior pre-tax performance but an inferior after-tax return. And the 10-year results show how a fund may have a return

that appears superior when viewed on a pre-liquidation basis, but inferior when

viewed in terms of post-liquidation results.

V. CONCLUSION

The mutual fund industry has a long history of working with its regulators in developing standards for disclosure to investors. When the SEC developed standard

calculations for mutual fund yields and total returns in the 1980s, they received

substantial input from the industry and others, and took this input into account in

designing final rules. As a result of this thorough, detailed process, the standard calculations promulgated in the 1980s still work well today.

After-tax return calculations present a similar challenge. Industry members,

working independently, have developed calculation methodologies that are similar

in approach, suggesting that a standard calculation may be within reach. But important details remain to be resolved in order to assure that after-tax return calculations will be efficient for funds to produce and effective in communicating to investors. We look forward to working with other industry members and the SEC to

develop effective standards.

Fidelity Investments appreciates the opportunity to testify before the Subcommittee. We support the objectives of the ‘‘Mutual Fund Awareness Act of 1999’’.

We will continue to work with the Congress and the SEC in order to achieve aftertax measurements that will be most useful to our shareholders.

27

EXHIBIT 1

4 August 1999

SUSAN NASH, Esq., Senior Assistant Director

Division of Investment Management

Securities and Exchange Commission

450 5th Street, N.W.

Washington, DC 20549

Re: Sample Calculation Methodology for Mutual Fund After-Tax Total Returns

DEAR MS. NASH: As you requested by phone, we have drafted a set of sample instructions for calculating mutual fund after-tax returns. The instructions are based

on the calculation methodology we used in calculating after-tax returns for two of

our funds that have tax management as an explicit investment goal: Spartan Bond

Strategist, which operated from 1993 through 1996, and Fidelity Tax-Managed

Stock Fund, which commenced operations in November 1998.

The sample instructions (enclosed) are designed to produce after-tax returns that

would complement standard pre-tax returns calculated under Item 21(b)(1) of Form

N-1A. As a result, they follow the same basic assumptions as those standard return

calculations, including the assumption of a hypothetical $1,000 one-time initial investment and deduction of all sales loads and other charges, and assume that aftertax returns would be calculated on an annualized basis for 1-, 5- and 10-year periods. Similar tax adjustments could also be applied to other kinds of total returns

(such as no-load returns, returns assuming a series of periodic investments, or returns for alternative time periods) with equal validity. As you requested, we have

supplied instructions for pre-liquidation and post-liquidation after-tax returns.

As we have discussed, there is no one after-tax calculation that will be meaningful

for all investors, because their tax situations can differ so dramatically. Therefore,

we necessarily made a number of assumptions in calculating after-tax returns for

our tax-managed funds, which are reflected in our sample instructions. They include

the following:

1. Individual Tax Rates. We assumed tax rates for individuals, and assumed

shares were held outside a tax-deferred account. A corporate investor, or an individual buying through a retirement plan, would have significantly different results:

our calculation would not produce an after-tax return that would apply to them.

2. Historical Tax Rates. We believe that historical tax rates produce a more accurate result than current tax rates, although this method requires a rule for selecting

historical tax brackets (we have supplied one possible rule, based on assuming a

constant wage adjusted for inflation). We have not specified a particular tax bracket

in the instructions; for our tax-managed funds, which were designed for higherbracket investors, we used the maximum tax bracket, but this may be too high a

rate for the more typical fund investor. We have also assumed deduction of federal

taxes only, in order to produce a number that could be useful for investors in multiple states, and have not attempted to include the impact of the federal alternative

minimum tax, which only applies to some taxpayers.

3. Time of Deemed Tax Payment. We have assumed that taxes on distributions

are paid at the time of the distribution, as if they were withheld from the distributions before reinvestment. Although other methods could be imagined (redeeming

shares from the account to pay taxes on December 31 or April 15, for example, or

assuming taxes are paid from some separate cash account), we believe this method

is the simplest and involves the fewest assumptions.

4. Special Distribution Characteristics. In addition to ordinary income dividends

and capital gain distributions, funds may have distributions or other features with

more complicated tax consequences. These may include distributions taxable as returns of capital, distributions that are partially derived from municipal interest and

therefore are partially tax-free, distributions derived from REIT income (i.e., recaptured depreciation) taxable at a special 25% rate, distributions derived from commodities gains taxable at 28%, retained capital gains taxable at the fund level, and

foreign tax credits or deductions that pass through with respect to foreign source

income. Rather than enumerate how each of these should be handled in an aftertax return calculation, we have tried to describe more general principles under

which these events would be taken into account based on their impact on an individual taxpayer.

5. Gains or Losses on Redemption. Taxes on capital gains are assumed to reduce

ending value (and after-tax return), while losses on redemption are treated as a tax

benefit that increases after-tax return. In effect, the calculation assumes that capital losses can be used to offset capital gains of the same character (long-term or

short-term), giving rise to a benefit equal to the amount of taxes avoided as a result.

28

In addition, one essential simplifying assumption has been made: we recommend

that shares acquired through reinvestment be treated as having the same holding

period as the initial investment, so that gain or loss on shares reinvested in the last

year could be treated as long-term rather than short-term. This greatly simplifies

the recordkeeping required to calculate post-liquidation return, with only a minor

impact on the result.

As you requested, our sample calculations do not include any provisions regarding

whether the calculation methodology should be permissive (like a non-standard total

return, which may be calculated many different ways) or mandatory (like a money

market fund yield, which may only be calculated according to SEC guidelines). Nor

do they address whether funds would be required to disclose after-tax returns in a

specific document or permitted to disclose them according to a standard formula if

desired. We note, however, that standardization is especially problematic where

taxes are concerned, because investors are subject to such widely divergent tax regimes. And although the after-tax calculations we describe have worked well as voluntary disclosure for our tax-managed products in the past, we have never published after-tax returns for our other funds and do not have experience as to how

other investors would react to them.

We appreciate the opportunity to assist the Division by describing our approach

to after-tax returns, and look forward to additional discussions as your proposals

progress. If you have any questions, please contact the undersigned at 617-563-6292

or Deborah Pege at 617-563-6379.

Sincerely yours,

DAVID B. JONES

cc: Craig S. Tyle, Investment Company Institute

Heidi Stam, The Vanguard Group

enclosure

METHODOLOGY FOR CALCULATION OF MUTUAL FUND AFTER-TAX RETURNS

FIDELITY MANAGEMENT & RESEARCH COMPANY DRAFT—AUGUST 4, 1999

A. General. After-tax returns should be calculated using the same assumptions

and instructions as for average annual returns under Item 21(b)(1) of Form N-1A,

with the exceptions noted below.

B. After-Tax Return (Before Redemption). For purposes of Instruction 2 to Item

21(b)(1), assume all taxable dividends or other distributions are reinvested after adjusting the distribution by an amount equal to the taxes applicable to the distribution. Do not assume complete redemption of shares as required by Instruction 4 to

Item 21(b)(1).

C. After-Tax Return (After Redemption). Assume complete redemption as provided

by Instruction 4 to Item 21(b)(1). In addition to the adjustments provided in Paragraph B above, adjust Ending Redeemable Value (ERV) by an amount equal to the

capital gains taxes applicable to the redemption.

Instructions.

1. Historical Tax Rates. Use the federal tax rates applicable to individual taxpayers as of the historical date of each distribution or redemption. In determining

the historical tax bracket applicable to each taxable transaction, assume the investor had a constant level of income (adjusted for inflation) over the period.

2. Distributions. Adjust each distribution before reinvestment by multiplying the

amount of the distribution taxable at a given rate by one minus that rate. For example, adjust a distribution taxable as long-term capital gains by multiplying it by one

minus the applicable tax rate for long-term capital gains.

a. The taxable amount and tax character of each distribution should be as specified by the fund on the dividend declaration date, but may be adjusted to reflect

subsequent recharacterizations of distributions.

b. In general, distributions should be adjusted to reflect the federal tax impact

on an individual taxpayer. Distributions that would not be federally taxable to

an individual (e.g., those taxable as tax-exempt interest or as returns of capital)

should not be reduced before reinvestment.

3. Redemption. Adjust redemption proceeds by multiplying the capital gain or loss

upon redemption by the applicable tax rate and subtracting the result from ERV.

a. Calculate capital gain or loss upon redemption by subtracting the total tax basis

of the hypothetical $1,000 payment from the redemption proceeds (after deduction of any non-recurring charges as specified by Instruction 4 to Item 21(b)).

State a capital gain as a positive number and a capital loss as a negative numVerDate 20-MAR-2000 14:09 Mar 22, 2000 Jkt 010199 PO 00000 Frm 00031 Fmt 6633 Sfmt 6621 E:\HEARINGS\61039.TXT pfrm02 PsN: 61039
29

ber, so that ERV will be adjusted downward in case of a capital gain and upward in case of a capital loss.

b. In calculating the total tax basis of the hypothetical $1,000 payment, include the

cost basis attributable to reinvested distributions and any other costs basis adjustments that would apply to an individual investor.

c. When determining the character of capital gain or loss upon redemption, the fund

may assume that shares acquired through reinvestment of distributions have

the same holding period as the initial $1,000 investment.

Mr. GILLMOR. Thank you very much, Mr. Jones.

Mr. Fink.

STATEMENT OF MATTHEW P. FINK

Mr. FINK. Thank you very much, Mr. Chairman. I am pleased to

say that the Investment Company Institute, the trade association

for the mutual fund industry, strongly supports the bill’s objective

of improving disclosure to shareholders about the effect of taxes on

mutual fund performance. As a witness on the previous panel on

charitable contributions stated, disclosure has proved to be the best

police officer in a lot of areas, and it certainly will be in this one.

Mutual fund shareholders who have taxable accounts need to understand the important impact that taxes can have on their returns.

We have been discussing the relevant issues with both the bill’s

sponsors on this subcommittee and with the Securities and Exchange Commission. I have to say some of the issues are much

more complex than it first appears on the surface, but I am hopeful

that the SEC will come out with a proposal in the near future. We

look forward to working with the SEC to resolve swiftly these various issues, and to get a final rule in place, as the prior witnesses

said, to set an industry standard. Once there is a final rule, we

hope that rule will meet the needs of investors, meet the expectations of the sponsors on this subcommittee, and I think it will enjoy

the very strong support of the fund industry.

To name some of the issues that have to be resolved as a threshold matter, the SEC will have to decide whether it is best to expand upon existing disclosure requirements in prospectuses and

annual reports, or to require funds to calculate one or more aftertax numbers as the other two witnesses have suggested.

If in fact an after-tax number is used, perhaps in a series of difficult computational issues, the most significant one is the one that

the two witnesses before me highlighted: whether the return

should simply be based on a preliquidation basis, which assumes

that the investor receives dividends and capital gain distributions

but holds his or her shares after the end of the period, or instead

on a postliquidation basis, which assumes again that the investor

receives distributions, but also that he or she redeems his or her

shares at the end of the period.

As you just heard, there are different views in the industry, and

this will be probably one of the most important issues the SEC will

have to hammer out. There are other issues. Just to give you the

obvious one that Mr. Jones just mentioned, which tax rate do we

assume?

Both Vanguard and Fidelity have been urging using the highest

taxable rate, which I think is 39.6 percent, but that applies only

30

1The Investment Company Institute is the national association of the American investment

company industry. Its membership includes 7,729 open-end investment companies (‘‘mutual

funds’’), 485 closed-end investment companies and 8 sponsors of unit investment trusts. Its mutual fund members have assets of about $6.010 trillion, accounting for approximately 95% of

total industry assets, and over 78.7 million individual shareholders.

to a very small number of fund shareholders. Most are in far lower

tax brackets, so you have an issue of which tax bracket to use.

But if I had to conclude with one final point, I want to emphasize

how important it is going to be if an after-tax number or numbers

are used. There has to be very careful textual disclosure of the inherent limitations in the numbers and of how one should look at

them. Otherwise we could all easily inadvertently mislead investors.

Let me give three possible areas that we have to worry about.

First, investors have to be told that after-tax returns will vary from

investor to investor depending on their Federal tax rate and their

State situation. And of course we have to make clear to the 50 percent of shareholders who are in tax-exempt accounts, IRAs, 401(k)

plans, that none of this makes any difference to them.

Second, we have to again tell investors that while taxes are very

important, as indicated by Mr. Gillmor’s chart, taxes are only one

important factor to consider. It is not the only factor.

And third, if I had to stress one point, and as Mr. Markey stated

in his opening statement, it has to be made very clear to investors

that these numbers are in no way predictive of what is going to

happen in the future. You could very easily have a fund which has

been very tax efficient in the past, and in the new year ahead of

us it could have substantial taxable distributions, in part because

the size, scale, and timing of the distributions often are out of the

control of the portfolio manager of the fund. So we really have to

warn investors that this is not predictive.

I am confident, based on working with people like those on this

panel and with the SEC over the last 28 years, that all of this can

be resolved in SEC rulemaking.

I would like to thank the chairman and the other members of the

committee for their leadership in this area, and we are hopeful and

confident that it will all soon be resolved. Thank you.

[The prepared statement of Matthew P. Fink follows:]

PREPARED STATEMENT OF MATTHEW P. FINK, PRESIDENT, INVESTMENT COMPANY

INSTITUTE

I. INTRODUCTION

My name is Matthew P. Fink. I am the President of the Investment Company Institute, the national association of the American investment company industry.1

I appreciate the opportunity to testify today on H.R. 1089, the ‘‘Mutual Fund Tax

Awareness Act of 1999.’’ This bill, introduced by Representatives Gillmor, Markey

and nine co-sponsors, would direct the Securities and Exchange Commission (‘‘SEC’’)

to develop a rule to require mutual funds to disclose the effects of taxes on returns

to fund investors.

The Institute thanks you for giving us the opportunity to work with you on this

legislation. Ensuring that mutual fund investors understand the impact that taxes

can have on returns generated in their taxable accounts is entirely consistent with

the Institute’s long-standing, strong support for initiatives to improve disclosure to

investors.

The industry has taken several steps to promote the disclosure improvements

sought by the legislation. Following the introduction last year of similar legislation,

the Institute formed a task force of its members to develop approaches for identiVerDate 20-MAR-2000 14:09 Mar 22, 2000 Jkt 010199 PO 00000 Frm 00033 Fmt 6633 Sfmt 6621 E:\HEARINGS\61039.TXT pfrm02 PsN: 61039
31

2For example, consider two funds (A & B) each of which has a $10.00 net asset value (‘‘NAV’’) at the beginning of the measurement period and an $11.00 NAV at the end of the period (before

distributions). The $1 increase in NAV represents a 10% return for the measurement period.

Further assume that Fund A distributes $0.20 per share and Fund B distributes $0.40 per share

on the last day of the measurement period. An investor in Fund A receives 20% of the return

in the form of a $0.20 per-share taxable distribution, with the remaining 80% of the return presently untaxed in the form of an $0.80 increase from the original $10.00 NAV. An investor in

Fund B, in contrast, receives 40% of the return in the form of a $0.40 per-share taxable distribution, with the remaining 60% of the return presently untaxed in the form of a $0.60 increase

from the original $10.00 NAV. 3Source: ICI data used in publishing 1999 Mutual Fund Fact Book (39th ed.).

fying and resolving the complex issues associated with disclosing after-tax returns.

The industry has had discussions with Mr. Gillmor, Mr. Markey, others of you, and

the SEC regarding after-tax return disclosure issues. We submitted materials to the

SEC in July regarding possible methodologies for calculating after-tax returns.

We understand that the SEC staff is actively considering this matter. The Institute is committed to working with the Congress and the SEC as this process moves

forward toward completion.

The remainder of my testimony provides background on the tax aspects of investing in mutual funds, a summary of current disclosure requirements and finally a

discussion of approaches to after-tax disclosure and issues raised by these approaches.

II. TAX ASPECTS OF MUTUAL FUND INVESTING

A mutual fund shareholder invested in a taxable account may be taxed on his investment in two ways: first, when the fund distributes its income and net realized

gains (whether received in cash or reinvested in additional shares); second, when

the investor redeems fund shares at a gain (whether received in cash or exchanged

for shares in another fund).

A. Distributions to Shareholders

The timing and character of mutual fund distributions is governed by the Internal

Revenue Code. The Code effectively requires a mutual fund to distribute all of the

income and net gains from its portfolio investments annually. A fund’s distributions

may be taxable to the shareholder in two different ways: (1) as ordinary income

(e.g., dividends, taxable interest and net short-term capital gains) or (2) as longterm capital gains (i.e., capital gain dividends attributable to net long-term capital

gains). This is the case whether the shareholder takes his distributions or reinvests

them. Distributions also may be exempt from tax (e.g., exempt-interest dividends attributable to tax-exempt interest).

The amount of mutual fund distributions can be affected by a fund’s investment

policies and strategies (e.g., depending on whether it has a policy of actively trading

its portfolio) and by factors outside the control of the fund’s investment adviser. For

example, a fund that experiences net redemptions can be forced to sell portfolio securities to meet redemptions and thereby realize gains that it otherwise would not.

B. Redemptions by Shareholders

Redemptions (sales) of mutual fund shares result in taxable gain (or loss) to the

redeeming investor (whether the proceeds are received in cash or exchanged for

shares of another fund). This gain or loss is based upon the difference between what

the investor paid for the shares (including the value of shares purchased with reinvested dividends) and the price at which he sold them.

All of a fund investor’s economic return ultimately is received either as a distribution or as redemption gain. Consequently, there is a clear inverse relationship between these two tax consequences. If a fund makes relatively lower distributions because it does not realize its gains, gains build up in the fund. Consequently, a redeeming shareholder will have larger capital gains upon redemption than he otherwise would have had if the fund had realized and distributed the gains.2

C. Nontaxable Accounts

It is important to note that the tax impact discussed above is not applicable in

the case of investors that hold their mutual fund shares in a tax-deferred account,

such as a qualified employer-sponsored retirement plan (e.g., a 401(k) plan), or an

Individual Retirement Account. As of year-end 1998, 45% of all mutual fund assets

(other than money market funds), and 50% of all equity fund assets, were held in

a tax-deferred account.3

32

4See Item 7(e) of Form N-1A. There are also special disclosures required of tax-exempt funds.

5See Instruction 7 to Item 4(b)(1) of Form N-1A.

6Portfolio turnover rate is included in the fund’s financial highlights table (see Item 9(a) of

Form N-1A); net unrealized gains are reported in the fund’s financial statements (see Rule 6-

05 of Regulation S-X).

As was noted recently in Morningstar FundInvestor, however, a fund’s portfolio turnover and

potential capital gains exposure are at best only loosely correlated with the level of a fund’s taxable distributions. See Morningstar FundInvestor, Vol. 8 No. 1, September 1999. 7See Item 9(a) of Form N-1A.

8The SEC may decide to require some funds, but not all, to disclose their after-tax returns.

The SEC could either exempt some funds, such as money market funds or funds sold principally

to tax-deferred accounts, or only apply the requirement to certain types of funds, such as funds

that hold themselves out as ‘‘tax managed’’.

III. CURRENT DISCLOSURE REQUIREMENTS

The SEC currently requires that the general tax effect of investing in mutual

funds be disclosed to investors in a plain English narrative in a fund’s prospectus.

Mutual funds are required to describe ‘‘the tax consequences to shareholders of buying, holding, exchanging and selling the Fund’s shares,’’ including, as applicable,

specific disclosures that distributions from the fund may be taxed as ordinary income or capital gains, that distributions may be subject to tax whether they are received in cash or reinvested, and that exchanges for shares of another fund will be

treated as a sale of the fund’s shares and subject to tax.4 Any fund that may engage

in active and frequent trading of portfolio securities also is required to explain the

tax consequences of increased portfolio turnover, and how this may affect the fund’s

performance.5

All funds are required to provide investors with other information that may reflect

the tax consequences of investing, including the fund’s portfolio turnover rate and

the amount of its net unrealized gains.6 The financial highlights table, which is required to be included in fund prospectuses and annual reports, also contains information on a fund’s distributions, including distributions attributable to income and

to realized gains.7

IV. ISSUES FOR SEC CONSIDERATION

The Institute agrees with the intent of H.R. 1089 and supports the approach

taken under H.R. 1089, which leaves after-tax disclosure to SEC rulemaking. Development of this disclosure will require the consideration of several surprisingly complex issues, some of which may not be immediately apparent. Thus, this issue is a

good candidate for the rulemaking notice and comment process, where especially

complex issues can be resolved.

A. Improved Narrative Disclosure vs. Providing One or More After-Tax Return Numbers

A threshold matter that the SEC will have to consider is whether to expand upon

the existing required disclosures, or to require funds to calculate one or more aftertax return numbers. On the one hand, an after-tax number might appear more

straightforward, as it would not require a shareholder to review financial statements and apply the correct tax rates in order to determine the effects of taxes upon

his return. In this way, it also might facilitate the ability of shareholders to compare

different funds.

On the other hand, an after-tax number could have inherent limitations. As described more fully below, in order to compute an after-tax number, funds will have

to make a series of assumptions, many of which may not be applicable to any particular shareholder. This runs the risk of inadvertently misleading investors. It also

should be noted that other financial products, including ones that compete with mutual funds, are not required to disclose their after-tax returns and thus comparisons

between competing products will not be possible.8

Assuming the SEC determines that it is appropriate to require funds to disclose

an after-tax return number, two types of issues will have to be addressed. The first

relates to the actual computation of after-tax return(s). The second relates to the

need to ensure investor understanding of this information.

B. COMPUTATIONAL CONSIDERATIONS

1. After-Tax Calculations on a Pre-Liquidation and/or Post-Liquidation Basis—

Perhaps the most significant computation issue is whether any after-tax return formula should assume that the investor continues to hold, or instead redeems, his

shares at the end of the period for which the return is being calculated. If the formula assumes that he holds the shares (the ‘‘pre-liquidation calculation’’), the afterVerDate 20-MAR-2000 14:09 Mar 22, 2000 Jkt 010199 PO 00000 Frm 00035 Fmt 6633 Sfmt 6621 E:\HEARINGS\61039.TXT pfrm02 PsN: 61039
33

9Source: ICI 1999 Mutual Fund Fact Book (39th ed.) 45.

10Other computational issues are noted in the attached Institute letter to the SEC. 11 Under the SEC’s methodology for calculating pre-tax total return, which assumes a hypothetical $1,000 investment and the reinvestment of all fund distributions, all investors in the

fund throughout the measurement period will have the same return (provided they have the

same account transactions—e.g., all dividends are reinvested, no other share purchases occur

and no shares are redeemed).

tax return would be calculated by reducing the fund’s total return by the tax due

on distributions made during the measurement period. If the formula assumes that

he redeems the shares (the ‘‘post-liquidation calculation’’), the return would be further adjusted to reflect capital gains (or possibly capital losses) that would be realized upon redemption.

The first (pre-liquidation) alternative is intended to disclose the tax effects only

of actions taken by the fund, by reflecting the tax impact of distributions made by

the fund during the measurement period(s). The second (post-liquidation) alternative, in contrast, also reflects the potential impact of taxes on (1) unrealized appreciation in the fund’s portfolio and (2) realized but undistributed capital gains. It

thus better discloses an investor’s total potential tax exposure but, in order to do

so, assumes that the investor will redeem his shares at the end of the measurement

period, which will probably not be the case.

2. Federal and State Tax Rate Assumptions—Other significant issues involve the

assumptions regarding applicable federal and state income tax rates to be used (or

not used) in calculating after-tax returns. For example, which federal tax rate

should be applied to income distributions? As a preliminary matter, the Institute

believes that it may not be appropriate to apply the top federal tax rate (currently

39.6%) to fund distributions, since this rate currently applies to individuals with a

taxable income of more than $283,150, while the median income of mutual fund

shareholders is approximately $55,000.9 Another issue is whether current or historical rates should be used. For example, if a fund were computing its 10-year aftertax return, should it apply the 1990 income tax rates to distributions made in 1990,

or the present day rates? Finally, the SEC will have to consider whether other

taxes, such as state tax, should be reflected; because of the complexity, the Institute

believes that they should not.10

C. Ensuring Investor Understanding of the Information

The after-tax return numbers must be accompanied by disclosure that informs investors of their appropriate use and inherent limitations. Otherwise, investors could

misunderstand them, and be inadvertently misled as to the impact of taxes on their

returns.

1. After-Tax Returns Vary From Investor to Investor—It must be clearly disclosed

to fund investors that after-tax returns will vary significantly from investor to investor (unlike pre-tax total returns, which are equally relevant for all investors in a

fund for the measurement period).11 Thus, any after-tax return disclosed by a fund

may not, and probably will not, reflect a fund shareholder’s own individual circumstances. There are as many after-tax returns for a given pre-tax return as there

are possible combinations of potentially applicable federal and state tax rates. In addition, different investors in the same fund may be more or less tax-sensitive depending, for example, on an investor’s ability to offset distributed capital gains

against unrelated, realized losses. And, for some investors—such as those who hold

fund shares in IRAs or 401(k) plans—after-tax returns will have no relevance.

2. After-Tax Return Numbers Are Not Predictive—There are ‘‘predictive’’ limitations to an after-tax return number. As noted above, the future behavior of some

fund shareholders (e.g., redemption activity) can have a significant impact on other

shareholders’ after-tax returns. In addition, ‘‘good’’ past after-tax returns could

mean that the shareholder has more potential tax exposure in the future. If most

of a fund’s gains were unrealized, those gains could lead to greater distributions in

the coming years.

Thus, the Institute would recommend inclusion of a cautionary legend, similar to

that required for total pre-tax return data, disclosing that an after-tax return number reflects past tax effects and is not predictive of future tax effects.

3. Taxes Are One of Many Important Factors When Making Investment Decisions—

While taxes are an important consideration for investors purchasing fund shares in

their taxable accounts, other factors also are important. For example, investors purchase bond funds to receive current distributions of interest income, taxable at federal tax rates up to 39.6% (except in the case of municipal bond funds). A taxable

investor’s goal should be, consistent with his investment objectives, to maximize

after-tax returns rather than to minimize taxes.

34

V. CONCLUSION

The Institute appreciates the opportunity to testify before the Subcommittee. We

support the objectives of the ‘‘Mutual Fund Tax Awareness Act of 1999’’ to improve

disclosure to investors of tax effects on mutual fund total returns. We will continue

to work with the Congress and the SEC in order to achieve a result that will be

most useful for our 77 million shareholders.

Mr. GILLMOR. Thank you very much, Mr. Fink.

I might say that I agree that it isn’t as simple as it might first

appear. You have the pre- and postredemption problem, and you

have the problem that it is not going to treat all taxpayers the

same, but it is a guide and information that they don’t have now.

In that sense I think we at least would have less confusion.

But let me ask you, Mr. Fink, or any other members of the panel,

do you have any idea at this point how many of those thousands

of mutual funds out there do some kind of after-tax disclosure?

Mr. FINK. I believe there are now 30 tax-managed funds that do

that, and I think there are something like 200 index funds which

probably also talk about the area.

Mr. DICKSON. In terms of actually disclosing an after-tax return,

to my knowledge some tax-managed funds do it, the numbers that

Mr. Fink cited. And to this point, Vanguard just recently announced that we will be doing it for 47 of our funds, and also providing the information. Although not in shareholder reports, for

most of the remainder of our funds through Web site or over the

phone.

Other than that, I am not aware of any widespread after-tax disclosure of returns within the industry.

Mr. GILLMOR. All of that is a very small percentage. I would

guess that it is probably a significant improvement over 5 years

ago, when I doubt if anybody did it.

Let me ask, Mr. Jones, Fidelity’s after-tax returns of Fidelity’s

tax-managed fund, what is your evaluation of how shareholders

have received and reviewed that information and have you given

any thought of publishing those kind of returns on other equity

funds?

Mr. JONES. The tax-managed fund shareholders that we have

communicated this sort of return to have, I think, found it useful

generally. I think I take it as a favorable reaction that we haven’t

had too many questions. One of our concerns early on was will people just say, ‘‘What the heck does this number mean?’’ But it seems

it has been effective in communicating to the investors in that category who are interested in tax impact before they invest in the

fund at all.

For our other funds we don’t presently calculate the number.

Like most fund groups, we have a lot of information on tax impact

available but most of it is narrative or it is information like how

much distributions have been paid. It isn’t pulled together to a return number. Looking at the future, I think regardless almost of

action by the Securities and Exchange Commission, I think customer demand will require us to make that information available

on more funds.

Mr. GILLMOR. It would seem to me because of the different ways

this can be disclosed, one of the advantages of the legislation is

35

that we get a uniform disclosure so that shareholders can really be

comparing apples and apples. I will yield back.

Mr. Markey?

Mr. MARKEY. Thank you, Mr. Chairman, very much. This is a

very interesting chart that is up in the room today. The numbers

we have before them, that would probably surprise a lot of investors to see the huge differential that exists between what they

might see in the newspaper and then what ultimately winds up

going to them and the role which taxes plays in reducing that total.

I think what Mr. Gillmor and I have as our intent is just that

the investor can see this, understand it, and then make marketplace judgments. And the logical differential, of course, is the greater the likelihood that an investor will move over to another fund.

My entire investment is relatively modest in a Fidelity Spartan

Index 500 Fund, and while the fees are slightly higher, almost infinitesimally higher than Vanguard, Fidelity is in Boston so I stick

with Fidelity. They are the hometown team. But if combined with

the tax management, combined with other things, the number just

kept getting larger and larger, then I think there would be some

reason to reconsider and it is just, I think, a matter of information

that will ultimately determine the extent to which people are loyal

for secondary considerations and how much the primary considerations are just overwhelming.

And that is what I think we are trying to achieve here. So for

all of you, I understand that the average portfolio turnover rate for

an actively managed non-index mutual fund has increased from 30

percent 20 years ago to 90 percent today, managers who turn over

their portfolios without considering the tax consequences of their

decisions on fund investors might sell stocks in which the fund has

made short-term gains, and other long-term gains without offsets,

resulting in higher yearly taxes for investors.

Again, you do agree, according to your testimony, that the investors should get the right to the disclosure of the tax-adjusted performance for that fund. Do you agree with that? Both of you?

Mr. DICKSON. That’s correct.

Mr. JONES. Yes.

Mr. MARKEY. Mr. Fink, you indicated that one of the key issues

for the FCC to make is a decision in the rulemaking mandated by

the Gillmor-Markey bill which would be to determine what type of

after-tax number should be disclosed. The two options you mention

are, No. 1, a preliquidation after-tax return and two, a

postliquidation after-tax return. Does the ICI have a position at

this time as to which of these two options is preferable?

Mr. FINK. No, particularly because I have my two biggest members sitting next to me who disagree on this. It has been talked

about with other members but I think it really shows why you

need—not to dodge the question—you really need an SEC public

hearing to hear not only from people in the industry but the consumer groups, the Consumer Federation, the Association of Individual Investors. There are very good arguments for both. And I

think you really need a public hearing and an open dialog, and I

personally do not have a view at this point.

Mr. MARKEY. Thank you, Mr. Fink, for setting up the discussion.

I appreciate it. So, Mr. Dickson, your firm, Vanguard, has recently

36

begun disclosing after-tax returns. And I see from your testimony

that you favor disclosure of preliquidation returns. Can you tell us

why and why it is preferable to postliquidation?

Mr. DICKSON. Sure. There are a number of considerations. First

of all let me say, and I certainly think I share this view with Mr.

Jones, that we see value in both numbers. It is a question of presentation and a question of what is in the best interest to convey

the information that we are trying to make. In the case of Vanguard and our decision to make preliquidation returns available

through shareholder reports, we feel that the shareholder report

talks about the actions of the portfolio manager that affect all

shareholders in the fund. That is, the distributions of dividends

and capital gains that are given to all shareholders in the fund.

That is a preliquidation calculation.

It is certainly the case, and we have disclosure to this effect in

our presentation, that additional taxes may be owed if you sell the

fund’s shares. However, just from one sort of level, annual reports

only go to shareholders that are currently in the funds, so if you

sell your fund’s shares, you are not getting an annual report. Second, we do feel this is important information, but we feel it doesn’t

rise to the level of disclosure in the annual report. Instead, we

would plan to make it available through other vehicles that are

customized ways of showing an individual shareholder return, like

through the Web or over the phone, where people can input, especially over the Web, different tax rates, different tax treatments, to

be able to calculate their specific tax-adjusted return. For that

level. To keep the clarity brief and to not overwhelm shareholders

with a whole slew of different numbers for different time periods

and different methodologies, we chose the preliquidation return as

the best approach.

Mr. MARKEY. Mr. Jones, Fidelity favors postliquidation returns.

Could you explain from your perspective the case for that kind of

disclosure as opposed to the Vanguard preliquidation approach?

Mr. JONES. Absolutely. Just to clarify, our preference of what we

have done in calculating and presenting these figures in the past

has not been to show postliquidation only. It has been to show

preliquidation and postliquidation. So the differences between Vanguard’s approach and ours are actually perhaps smaller than they

might appear. It is truly best seen as the difference between showing a preliquidation return and putting in the footnote,

‘‘postliquidation returns may be lower,’’ which is more or less the

Vanguard approach, noting that there may be other taxes due. Or,

what we feel is necessary, saying preliquidation return is X, the

postliquidation return is Y, and actually giving the actual amount

of the difference.

Now, I think we felt that that is necessary in part to make sure

that all taxes are taken into account so that you have a truly aftertax number and to make sure that any exit fees or other charges

are taken into account as currently required by other SEC regulations.

Mr. MARKEY. But in your testimony, just so I can focus in on this

pre- and post- issue, whichever one is going to lead, in other words,

and then have the footnote after the lead number—what Mr.

Dickson is saying in his testimony is that disclosing postliquidation

37

tax-adjusted returns hinges the disclosure to the investor’s decision

to sell the fund rather than the fund manager’s skill of performance in taking account of the tax consequences of the manager’s

buy or sell decisions. What is your response to that argument?

Mr. JONES. I would say it is true that the preliquidation and

postliquidation returns are both based on a hypothetical investor.

Both of them are hypothetical numbers saying let’s assume that

$1,000 is put into a fund at a given time, whether it is pre- or

after-tax, in fact. The charges applicable to an account of that size

are taken into account and then in the case of a preliquidation return, there is an assumption that the investor hasn’t sold any

shares and so there is an embedded tax liability that is unpaid. In

postliquidation, there is an assumption that the investor did liquidate his or her shares. We feel that is a perfectly reasonable assumption, especially given the fact that standardized returns are

required for periods up to 10 years. A tax-sensitive investor isn’t

really likely to trade out of their fund in 1 year if they are at a

gain because they are a tax-sensitive investor and they would probably be reluctant to take a short-term gain. But quite a few investors in mutual funds, although we would like them to stay with us

indefinitely, would have sold some of their shares by the time 10

years is up.

Mr. MARKEY. And, Mr. Dickson, Mr. Jones’ testimony suggests

that failing to disclose postliquidation returns gives a false picture

of the impact of taxes on mutual fund investors because they foster

the impression that taxes can be deferred indefinitely, when in fact

they can’t. How do you respond to that?

Mr. DICKSON. I completely agree with that approach. It is a question of whether—and, in fact, we address that in our disclosure by

saying that in fact you may very well owe additional taxes at the

time that you sell your fund shares. We just don’t want to deem

that redemption on the shareholder, which is a shareholder-specific

action as opposed to a portfolio management action, and that deeming of redemption may or may not have actually occurred by the

shareholder.

Certainly there is some unrealized potential tax liability, but to

a certain extent you could even construct situations where you do

get out of that tax liability the postliquidation scenario if the mutual fund shares passed through an estate or are given away as a

charitable contribution. So it is really focusing on what the manager is effecting in terms of the performance for all shareholders

in the fund as opposed to any particular shareholder.

Mr. MARKEY. Thank you, Mr. Dickson. I thank you, Mr. Chairman, for the extra time. Thank you.

Mr. GILLMOR. Before I go to Mr. Cox, I just thought of an advantage for this bill that I hadn’t before and I don’t know if Mr. Markey will agree with this result, but the more that people know—

there are half the families in the country that own stock—how

much their taxes are, we might get a lot more support for tax cuts

here.

Mr. Cox.

Mr. COX. That is very true.

Mr. Dickson, you mentioned something a moment ago that I

think this whole discussion is pregnant with, and the Web, and

38

what your firm might do with it. I wonder if I could ask you what

you consider the SEC might do with it, specifically? Should we

imagine a future in which you all provide standardized inputs to

the SEC, they put a calculator up on the Web as a potential investor and answer a few simple questions on the SEC’s Web site, such

as whether I have got any offsetting capital losses myself, what my

tax bracket is and what State I live in, and let it rip?

Mr. DICKSON. Certainly that is possible. We view it—and certainly the SEC has actually done quite a nice service with putting

up a cost comparison calculator on their Web site. However, at the

end of the day, Vanguard wants to serve Vanguard shareholders,

and to the extent there is a standardized calculation which this bill

would address, then we can get those same results from doing individualized work on our own Web site as opposed to sending everything to the SEC.

Mr. COX. So the advantage would be simply that we would have

the same measures, the same calculator across the industry rather

than boutique calculator here and there and all slightly different?

Mr. DICKSON. Well, the one thing that I would say is there is certainly a lot more information that you might be able to pull of

shareholders than just some specific items that you would send, as

you were saying. You might be able to customize it based on information that only—that Vanguard might have for its shareholders

or that the shareholder might have when logging on. We would just

view—in terms of the presentation ourselves, we would love to do

it and in fact we are planning to do it, to provide customized aftertax return calculations for shareholders on our Web site.

Mr. COX. I am not sure whether you think it would be appropriate for the SEC to do this.

Mr. DICKSON. I would say we would prefer to do it ourselves.

Mr. COX. Do our other witnesses have a view?

Mr. JONES. I think there are commercial services at present that

are in the business of providing hypothetical performance information on a pretax basis. The data collection involved is actually fairly significant as is the data maintenance. It would be a new role

for the SEC to move into that business and say that they will provide hypothetical return calculations. I think it is a question for

gentlemen like yourselves as to whether that is an appropriate

role. I would expect the same sort of third-party hypothetical performance providers would adopt an after-tax calculation, as they

have in the past with other standard return calculations, once they

have been standardized by the SEC.

Mr. COX. Having heard what your members think, Mr. Fink,

what do you think?

Mr. FINK. I would guess that they wouldn’t see anything wrong

with the SEC doing it, but I think they would say better to have

the marketplace do it; and given all the SEC’s other responsibilities, they probably would say have individual firms do it. That is

why I think the industry would come out.

Mr. Cox, I have an add-on which may sound disconnective but

I want to make the point we are talking to two fund groups that

sell directly to consumers basically. That is almost their entire

business. That is a minority. Eighty percent of fund investors buy

through third parties. Now, some of them may use the Web, but

39

their biggest inclination is probably go to their broker, financial

planner, bank, or employer because they are buying through third

parties. It just changes when you look at the industry where people

get information from. Their shareholders would go to them. If you

are investing in the other 80 percent, you probably would not go

to the web site of your fund. You would go——

Mr. COX. If I am buying through a broker, my broker could do

it.

Mr. FINK. I’m sorry?

Mr. COX. I am sorry, too. I am a little hoarse today. If I am buying through a broker, my broker could use the SEC site?

Mr. FINK. Yes.

Mr. COX. It amounts to the same thing?

Mr. FINK. Yes.

Mr. COX. I have to say I’m a little bit surprised to hear a discussion about whether we should be doing pre- or postliquidation returns. Why in the world would we do both? Mutual funds are supposed to be liquid assets and therefore the idea of liquidating them

shouldn’t come as a shock. It is the very purpose that one would

put funds there as opposed to something less liquid, and I think

you ought to be able to get both answers.

In this era of cheap computing, it is not a great deal of trouble.

It is amazingly routinized. Once you have got the information, the

computer can crank out that data all day long and customize it for

every individual investor at essentially zero cost. I think the greater concern here is all the assumptions that have to be made that

haven’t anything to do with the complexities of tax law but, rather,

there is a built-in major league assumption up front that the past

is prologue, as Shakespeare would put it, that these are in any way

predictive measures.

And yet because we haven’t anything else to go by, I think we

all sort of swallow hard and look at what happened in the past and

make our best guess about the future. We are also assuming that

the taxpayer’s current situation, which is all the taxpayer knows,

is going to be the taxpayer’s situation in the future. So you have

got a double probabilistic variable here, that you not only need to

concern yourself with whether the fund is going to be the same as

the fund was in the past, but whether you and your tax situation

are the same in the future. Then you have got us to worry about

up here. Is Congress going to keep the same tax laws in place in

the future that we have had in the past, and we haven’t had any

discussion whatsoever about States, but of course that is another

layer of uncertainty. And in all of these sorts of things are what

the market can do.

That is why we despair, ourselves, of trying to provide direction

or guidance to investors on these funds and rather say, ‘‘Here is

the information, you do with it what you will.’’ What we are talking

about here today is simply getting them the basic information that

they can then evaluate and put in the Cuisinart with all these variables and uncertainties. I would hope we would strive to put as

much hard data that we know is available in front of people rather

than keep that back, because even once you have all the hard data,

you are still out there in the middle of guess land. Otherwise, we

would all be wealthy.

40

Mr. GILLMOR. Thank you very much, Mr. Cox. I want to thank

the members of our panel and also the previous panel.

Mr. MARKEY. Mr. Chairman?

Mr. GILLMOR. Yes, Mr. Markey.

Mr. MARKEY. I thank you very much. First of all, I would like

to follow up on Mr. Cox’s line of questioning which I think focuses

on the issue of whether or not the compromise between the two positions might not be disclosure of both, which is I think very much

an interesting—again, something we can’t determine, but I think

that is an interesting approach that has to be considered, given the

technological capacity of the SEC or any of these firms.

And I would also like to endorse the proposal by the gentleman

from California that the SEC’s Web site put data up mainly because, to be honest with you, that Web site would be subject to the

Privacy Act which governs the retransfer of any of the information,

and as a result people are going to be putting all of their financial

data into a formula which would be on-line and in the hands of

some private-sector company that would not be secure under our

laws. Even the financial services modernization bill we are passing

right now provides no privacy protection if the information is in the

hands of the financial institution. So if we were going to do it and

the individual wanted to use this type of a service but didn’t want

to disclose their entire tax position to Vanguard or Fidelity, using

the SEC under the Privacy Act would probably be a good alternative.

Mr. COX. If the gentleman would yield, I think it is very important. People do feel a little bit more comfortable with the SEC than

they do with some firms, not all of them, Vanguard and Fidelity,

that they have never met before. On the other hand, I note that

there is a subset of the population that probably feels a lot more

comfortable providing their actual tax information to a private firm

than they would to the U.S. Government.

Mr. MARKEY. I agree with that. The reality is that the SEC is

probably the most respected agency in the Federal Government.

They are in fact viewed as the cop on the beat, the guardian of the

investor. The greatness of this industry, of course, is that they

come to us with the most impeccable record of any part of the financial services community and that is to the credit of the mutual

fund industry that they have been so willing to accept the kinds

of regulations that we are even talking about today to ensure the

investor is king.

So hopefully, as a result of legislation, we will be able to move

it forward quickly, pass it in the House, have some response for the

Senate, so that perhaps by the end of next year investors across

this country could have this kind of information available to them

before they are making their end of year 2000 decisions as to how

they want to handle their investment portfolio.

I thank each of you for your excellent testimony. I yield back.

Mr. GILLMOR. Thank you very much. We stand adjourned.

[Whereupon, at 11:27 a.m., the subcommittee was adjourned.]

[Additional material submitted for the record follows:]

41

ASSOCIATION OF PUBLICLY TRADED COMPANIES

October 28, 1999

The Honorable TOM BLILEY

Chairman, Committee on Commerce

2125 Rayburn House Office Building

Washington, DC 20515-6115

The Honorable MICHAEL G. OXLEY

Chairman, Subcommittee on Finance and Hazardous Materials

2125 Rayburn House Office Building

Washington, DC 20515-6115

RE: Hearing on H.R. 887, Charitable Contributions Disclosure

DEAR CHAIRMAN BLILEY AND CHAIRMAN OXLEY: I am writing on behalf of the

Board of Directors of the Association of Publicly Traded Companies to express our

opposition to HR 887. While we have great respect for the sponsors of the legislation, we believe that new government regulation of this type will be counterproductive. I request that this letter be included in the record of the hearing.

INTRODUCTION

The Association of Publicly Traded Companies (‘‘APTC’’) represents a wide range

of public companies from the newest and smallest to larger, more established firms.

Many of the Association’s member companies are in the high-growth sector of the

nation’s economy. Our members are from the every American industry, representing

the breadth and diversity of the entire economy. Moreover, our members develop the

products and services upon which America’s long-term economic health depends. As

SEC registered public companies, all of our members would be required to make the

new disclosures that are contemplated in H.R. 887. For all of these reasons, APTC

believes that our comments deserve careful consideration.

THE ASSOCIATION’S POSITION IN OPPOSITION TO H.R. 887

Public companies are eager to communicate with investors on critical issues. In

order to understand their investments, shareholders need the right kind of information about the company—audited financial statements, description of the business

and the stated vision of the managers—in a clear concise document. APTC is concerned that too much of the information currently mandated by the SEC, especially

in the proxy statement, distracts shareholders from the core questions of sound investing. H.R. 887 would add more distracting information to the proxy.

Moreover, H.R. 887, if enacted, would continue a disturbing trend toward more

and more mandatory disclosure of non-material information. Investors should receive information that is material to investment decisions. Once this ‘‘materiality’’

rule gives way to a ‘‘for what it’s worth’’ rule, the scope of natural curiosity is the

only limit.

There is no need for the new disclosures that H.R. 887 would mandate.

We are mindful of Justice Louis Brandeis’ famous admonition that ‘‘[s]unlight is

said to be the best of disinfectant . . .’’ However, it is not clear that corporate philanthropy needs disinfecting. We see no evidence of corporate charitable profligacy. Nor

are corporate directors sacrificing their integrity and violating their fiduciary duties

in exchange for contributions to their favorite charities.

Requiring charitable contribution disclosure in the proxy will be counterproductive.

Governmentally mandated disclosure about extraneous matters distracts investors

from material information about the company. Specific information about charitable

contribution will send a confusing and erroneous message, i.e., ‘‘the SEC, your investor advocate, thinks that this information is important to you as an investor.’’ The

limited time that the investor has to study the potential long-term performance of

the company may well be squandered pondering the significance of the company’s

charitable contributions.

Unfortunately, the annual proxy materials are already replete with information

of marginal significance to the long-term performance of the company. In fact, proxy

statements are dominated by mandatory information about executive and board

compensation. More information regarding charitable contributions and their supposed links to officers and directors will serve to further clutter the proxy statement

42

The main consequence of the new disclosure will be the unintended ones.

The mandatory disclosure of charitable contributions could have negative, unintended consequence for both publicly traded companies and the charities and other

non-profit organizations they support.

The only contributions a company ought to make are those that benefit the business. While a relationship between an officer or director and the charity may exist,

the reasons for any given contribution are usually many and varied. It is the legal

duty of the managers and the board to insure that the corporate assets are not

wasted. This requirement provides adequate safeguards.

If all contributions must be disclosed, a new rule will likely be heard in many

companies: ‘‘you can’t get in trouble for contributions you don’t make.’’ Mandatory

disclosure of contributions will lead to the need to justify those contributions and

the requirement to be able to defend those contributions. In those circumstances,

a corporation may conclude that it is prudent to simply avoid making contributions

where the recipient has any relationship to an officer or director. That course may

be a disservice to the charity, and to the officers and directors. But it may be the

prudent course.

CONCLUSION

For the reasons stated here, the Association opposes H.R. 887. We are very interested in the issues raised by the legislation. We would be pleased to provide more

information should the Committee pursue this matter further.

Very Truly Yours,

BRIAN T. BORDERS

President

cc: Brent Delmonte

Committee Counsel

Committee on Commerce

Washington, DC 20515-6115

THE BUSINESS ROUNDTABLE

July 23, 1999

Securities and Exchange Commission

450 Fifth Street, N.W.

Washington D. D., 20509

Attn: Brian J. Lane, Director, Division of Corporate Finance

Re: Proposed Disclosure of Charitable Contributions (HR 887)

LADIES AND GENTLEMEN: Thank you for the opportunity to address the proposed

Bill introduced in the House of Representatives (HR 887), which would require disclosure of charitable contributions by issuers that have securities registered under

Section 12 of the Securities Exchange Act of 1934, as amended. The Business

Roundtable (BRT) includes the CEOs of many of the country’s largest corporations,

virtually all of which are significant contributors to the arts, civic projects, charities

and other worthwhile organizations and activities. Virtually all of the BRT members

and senior executives of many other major U.S. companies are actively involved in

charitable activities and, consequently, any legislation or regulations impacting such

activities are of concern to the BRT.

The BRT believes the proposed requirement of disclosure of charitable contributions is unnecessary. For the reasons set forth in this letter, we believe the proposed

disclosure is unnecessary for the protection of investors and is, at best, overbearing

and unnecessarily burdensome. Many of the companies whose CEOs are members

of the BRT already voluntarily make available reports of their charitable contributions to interested stockholders, and there has been no showing that there exists

any abuse of corporate-giving programs to warrant the increased burden associated

with the proposed legislative change. Moreover, if the Securities and Exchange Commission (‘‘Commission’’) were to determine that such disclosure was necessary, it

has ample authority to require it without legislative or regulatory changes.

1. There is no justification for the proposed disclosure requirement.

While some stockholders may have a special interest in knowing to which charities contributions have been made, no concern of general interest and materiality

to stockholders is raised unless the contributions are so disproportionately large to

the size of the reporting company as to amount to corporate waste or would otherwise reach the level where a director can be said to have failed to exercise his or

her fiduciary duties. Under state corporate law, companies and their directors have

43

a fiduciary duty to stockholders not to waste corporate assets. The decisions of a

corporation on its community relations and charitable giving programs are quintessential business decisions, and under state law are within the purview to the

board of directors and management. They involve considerations unique to each corporation, and its customer base and the communities in which it operates. Such decisions should not be made based on SEC disclosure policy or general stockholder

referenda, but should be regulated pursuant to state law corporate governance

standards. Further, state law provides sufficient ability for stockholders to regulate

charitable ‘‘gifts’’ by their companies through their right to review the books and

records of the company and their ability to present and advocate stockholder resolutions addressing such activities. SEC-mandated disclosure, as proposed, regarding

charitable contributions would be tantamount to substituting federal legislation for

a matter that is properly one for state law.

2. Contributions to charitable organizations should be disclosed only if there is a significant direct or indirect economic benefit to an insider and the amount of the

contribution is unusually large.

The proposed legislation would require disclosure in proxy statements and other

consent solicitation documents of charitable contributions in excess of an amount to

be determined by the SEC if a director, officer or controlling person of the donor

company, or their spouse serves as a director or trustee of the charity. While, for

the reasons stated above, we think a general disclosure requirement for charitable

contributions is both bad policy and an unwarranted intrusion on areas regulated

by state corporate governance laws, there may be a limited number of instances

where disclosure may be appropriate. We believe that if proxy disclosure is required,

it should only be required if an insider serves as a director or trustee of the charity

and there would be a significant direct economic benefit to the insider. For example,

a substantial donation to a ‘‘private foundation’’ controlled by the insiders would

generally be disclosable under the above described standard. This disclosure would

be appropriate because the insider would have discretionary power over the donated

funds after the donation. Similarly, a grant to a research institution or university

for the development of bio-tech products would be disclosable if the company had

a technology development agreement with the university and a director of the company received research funds from such contribution. The standard proposed for

proxy disclosure by the proposed legislation seems to imply that disclosure under

all circumstances is warranted because the insider is perceived as having received

a benefit as a result of, or in connection with, the company’s charitable donation.

When the insider is not receiving any significant direct economic benefit from the

contribution, no disclosure should be required. Under all circumstances, the threshold amount of contribution to a charity before disclosure is required should be substantial. No disclosure should be required if the aggregate amount of a company

contributions does not exceed 2.5% of consolidated revenues.

3. The proposed disclosure standards are unnecessarily complicated.

As proposed, the bill distinguishes between proxy disclosure, and information regarding charitable donations that must be made available to stockholders annually,

in a format to be prescribed by the SEC. Proxy disclosure is required only if the

value of the charitable contribution exceeds an amount to be determined by the

SEC, and then only if an insider serves as a director or trustee of the recipient charity. The bills proposed annual disclosure, however, would require an issuer to make

available the aggregate amount of charitable donations made by it in any given year

and, if any one particular charitable organization received donations in excess of an

amount to be determined by the SEC, the name of such charitable organization and

the value of the contribution made. As proposed, the annual disclosure is required

even if no insider of the donor company serves as a director or trustee of the recipient charity.

We do not believe that, absent a significant direct relationship between the charity and an insider of the reporting company, disclosure regarding charitable donations is necessary for the protection of investors, or consistent with the Commission’s charter and with the authority of the states to regulate corporate governance.

No evidence has been presented by the proponents of the bill to indicate that such

disclosure will cure a significant level of abuse or provide material disclosure necessary for the protection of investors. The additional regulatory burden imposed on

the issuer should be balanced against the benefit to be gained. Unless the amount

of contributions are material to the financial statements or business of the Company

we see no reason why the disclosure of charitable contribution needs to be bifurcated. We would suggest that any required disclosure be restricted to the proxy

statement and to instances when there is an insider involved with the charity in

44

the manner we have proposed in 2. above. Many, if not most, charitable organizations are subject to state and federal regulatory review (IRS) and substantial financial information is open for public scrutiny as a matter of law. The bifurcated disclosure standard is unnecessarily complicated and poses an unnecessary regulatory

burden on an issuer. Rather than imposing different requirements, one standard for

proxy statement and annual report disclosure should be devised and an issuer

should be allowed to incorporate by reference in its annual report the disclosure in

its proxy statement, as is currently permitted with respect to Items 11 through 13

of Form 10-K.

4. If disclosure is deemed necessary, stockholder proposals with respect to charitable

donations should be precluded.

If an issuer is required to make disclosure about charitable donations, such disclosure is likely to become the target of greater special interest group and political criticism regarding its choice of charities. Charities acceptable or even supported by one

stockholder may be entirely unacceptable to another stockholder. The outcome of

this could very well be a rash of stockholder proposals demanding that a particular

charity be declared ineligible to receive future donations or that a different charity

be the recipient of the company’s gifts. The time and resources required to deal with

such proposals alone would be a sufficient reason to limit the proposed disclosure.

If, however, the proposed bill is enacted, it should at a minimum afford protection

from stockholder proposals by declaring that charitable donations are ‘‘ordinary

business’’ under the standard of Rule 14a-8(i)(7) and thus not a proper subject for

action by an issuer’s stockholders unless the proponent clearly demonstrates that

the relationship to the charity is significant to the business of the company.

5. The proposed disclosure could have a stifling effect on corporate charitable donations and is not necessary for the protection of investors.

We believe that the bill’s proposed disclosure requirement could have a stifling

effect on corporate donations. To the extent that the gift programs of the companies

become the target of stockholder complaints that either disagree with corporate giving generally or the specific recipients, it is likely that companies will restrict contributions to avoid the burden of disclosure. The negative impact on corporate philanthropy will almost certainly exceed any disclosure gain intended by the proposed

statutory change. The central tenet of the securities laws is the protection of investors. What an investors needs to know to make an informed investment decision

should not be equated with what a few investors, who may have a special interest

or other non-corporate agenda, would like to know.

6. The legislation is unnecessary.

Finally, legislation on this subject is unnecessary. The Commission has ample authority under the Securities Act of 1933 and the Securities Exchange Act of 1934

to require any disclosure relating to charitable contributions that is actually material to investors.

We would welcome the opportunity for representatives of the BRT to meet with

you on this matter.

Very truly yours,

WILLIAM C. STEERE, JR.

PREPARED STATEMENT OF DOROTHY S. RIDINGS, PRESIDENT AND CEO, COUNCIL ON

FOUNDATIONS

The Council on Foundations and its more than 200 corporate grantmaking members continue to be concerned about the possible negative effects of H.R. 887 on

charitable giving. The bill would amend the Securities and Exchange Act to require

disclosures of contributions to nonprofit organizations. Although H.R. 887 is an improvement over similar bills introduced in the last Congress, and although the

Council strongly encourages grantmakers to issue periodic reports informing the

public about their gifts and grants, we question the need for federal legislation in

this area. Particular problems with the bill include the prospect that it may deter

volunteering and diminish giving. In addition, the measure delegates substantial

authority to the Securities and Exchange Commission without affording necessary

guidance on how the SEC is to exercise that authority. Finally, the bill fails to address serious issues with regard to the scope of required disclosure.

The Council on Foundations is a nonprofit association of more than 1800

grantmaking foundations and corporations. (A list of our corporate members is enclosed.) We estimate, based on market projections and other factors, that the 235

corporate grantmaker members of the Council will make more than $2.5 billion in

45

charitable gifts in 1999. In addition to their financial resources, corporations also

provide volunteer time, expertise, and visibility to the organizations they support.

They are a vital and integral part of the charitable private sector. We hope that you

will take our concerns into account as you consider H.R. 887.

Deterring volunteer activities. The first substantive provision of H.R. 887 would

require publicly traded companies to disclose all contributions (above an amount to

be set by the Securities and Exchange Commission) that the company makes to a

nonprofit organization if a director, officer, or controlling person of the company is

a director or trustee of the nonprofit. Disclosure also is required if a spouse of a

covered individual serves on the nonprofit’s board.

Many companies encourage their employees to become involved in community organizations, and many employees respond by generously donating their time to

serve on community boards. Many companies also like to direct their giving to charities with which their employees are involved. We are deeply concerned that the disclosure requirement will place a strongly negative cast on this practice, leading key

corporate employees and their spouses to resign their charity board positions lest

they be perceived as having done something wrong. There is much reason to believe

that volunteering by key corporate employees strengthens the social fabric of their

communities, but correspondingly little evidence that this practice harms shareholders.

Discouraging Giving. The second provision of H.R. 887 requires publicly traded

companies to disclose the names of nonprofits to which they made gifts and the

amount they gave. Again, disclosure would be required only for gifts that exceeded

a minimum amount to be established by the Securities and Exchange Commission.

Currently corporations can decide whether and how they wish to publicize their

gifts. H.R. 887 would remove this choice.

We are concerned that this Congressional action could have an adverse impact on

charitable giving by publicly traded companies. While the Council encourages companies to report their philanthropic efforts to the community, it would be naı ̈

ve not

to acknowledge that charitable giving can be a sensitive issue for many corporations, especially those that deal directly with the public. We fear that some corporations may choose to eliminate giving programs rather than make disclosure. Others

may decide to reduce the size of all contributions to a level below whatever minimum the SEC establishes. We urge you to keep in mind that corporate giving is

an entirely voluntary expenditure. Nothing prevents a corporation from deciding

that intrusive government regulation makes it undesirable to continue these gifts.

Promoting red tape. Many publicly traded corporations have numerous operating

divisions and subsidiaries, each of which may have its own budget for charitable

giving. If this legislation is enacted some of these companies likely will be required

to invest in new software and tracking capability to collect and centralize information about the identity of all recipients and the amount of each gift. This task would

be complicated by the need to accumulate gifts over the course of the year to determine whether the total exceeded the threshold established by the SEC. A further

difficulty is that the answer to the threshold question may depend on how the recipient is organized. For example, because chapters of the American Red Cross are

not separately incorporated, it would be necessary to accumulate all gifts to the various chapters. By contrast, local YMCAs and YWCAs are separate corporations (although often with multiple operating units), meaning that gifts to each corporate

entity would be separately tracked.

Absence of necessary guidance to the SEC. H.R. 887 requires the Securities and

Exchange Commission to establish a floor for both disclosure requirements. The only

guidance to the SEC is that the amount it sets must be one that is ‘‘consistent with

the public interest and the protection of investors.’’ The bill leaves the SEC to guess

what this level should be, since even total giving through corporate giving programs

rarely, if ever, rises to the level of materiality—the standard the SEC normally applies in determining the need for disclosure. The height of the floor will have a significant impact on the record keeping burden that H.R. 877 will impose.

A related problem is that H.R. 887 does not include even the flawed provisions

found in earlier versions of this legislation that attempted to reduce the size and

scope of the burden the legislation would place on corporate givers. Thus earlier

versions excluded from disclosure gifts of tangible property, gifts to public and private educational institutions, and gifts to local charities. The lack of similar provisions in this bill means that all gifts must be reported if they fall above the floor

to be established by the SEC. Many corporate commenters on previous versions of

this legislation also pointed out the burden involved if reportable gifts include all

those made by a corporation pursuant to an employee gift matching program. H.R.

887 does not give the SEC the discretion to adopt a rule excluding matching gifts,

46

except to the extent that matching gifts falling below the established floor will not

be required to be disclosed.

The legislation also is vague on the gifts that must be disclosed. While the section

heading is titled ‘‘Disclosure of Charitable Contributions,’’ the text of the legislation

mandates disclosure in connection with ‘‘contributions’’ to ‘‘any nonprofit organization.’’ Charitable institutions—those organized and operated for a charitable purpose

and exempt from tax under section 501(c)(3) of the Internal Revenue Code—are only

one type of nonprofit organization. Examples of non-charitable nonprofits include

trade and professional associations, civic leagues and social welfare organizations,

social clubs, fraternal organizations, and a host of entities created for various pension and employee welfare purposes. H.R. 887 requires that contributions to these

entities also would have to be tracked and disclosed.

Normal corporate checks and balances protect investors and the public. Corporate

management generally makes charitable contribution decisions. Corporate management is directly accountable to the directors who represent the shareholders. Shareholders who are unhappy about how their corporation is run have the option of voting to replace the directors. This system is not perfect. But it is far preferable to

micromanagement by the federal government, particularly in the absence of any

concrete evidence that corporate giving is harming investors or the public.

In sum, the Council on Foundations is concerned that the risks of H.R. 887 substantially outweigh its benefits. We urge the subcommittee to consider carefully the

need for injecting federal regulation into a system that currently works productively

to provide substantial private voluntary support for a wide range of charitable organizations in all parts of the United States.

PREPARED STATEMENT OF THE U.S. SECURITIES AND EXCHANGE COMMISSION

Thank you for giving the Securities and Exchange Commission (SEC or Commission) the opportunity to present this statement concerning the disclosure of tax consequences of mutual fund investments and charitable contributions. The Commission fully supports the important goal of full disclosure, and welcomes this dialogue

on these issues.

I. THE TAX CONSEQUENCES OF MUTUAL FUND INVESTMENTS

One of the Commission’s primary goals with respect to mutual fund disclosure is

ensuring that funds clearly present their performance and costs to investors. H.R.

1089, the Mutual Fund Tax Awareness Act of 1999, would address an important aspect of this issue, the effect of taxes on mutual fund performance. H.R. 1089 would

require the Commission to revise its regulations to improve methods of disclosing

to investors in mutual fund prospectuses and annual reports the after-tax effects of

portfolio turnover on mutual fund returns. In fact, as more fully described below,

the Commission staff is already working on improving disclosure in this area.

Current Disclosure Requirements

Mutual funds currently are required to disclose the following information about

taxes in their prospectuses and annual reports:

• Tax Consequences. A fund must disclose in its prospectus the tax consequences

to shareholders of buying, holding, exchanging, and selling the fund’s shares,

including the tax consequences of fund distributions.

• Portfolio Turnover. A fund must disclose in its prospectus whether the fund may

engage in active and frequent portfolio trading to achieve its principal investment strategies and, if so, the tax consequences to investors of increased portfolio turnover and how this may affect fund performance. A fund also must disclose in its prospectus and annual reports the portfolio turnover rate for each

of the last 5 fiscal years.

• Distributions. A fund must disclose dividends from net investment income and

capital gains distributions per share for each of the last 5 fiscal years in its prospectus and annual reports.

Staff Consideration of Mutual Fund Tax Disclosure

The Commission staff has been considering whether mutual fund disclosure requirements could be revised to provide investors with a better understanding of the

tax consequences of holding and disposing of a fund, the relative tax efficiencies of

different funds, and how much of a fund’s reported pre-tax return will be paid out

by an investor in taxes. There is no direct correlation between the portfolio turnover

rate, which currently is disclosed, and shareholder tax consequences. For example,

47

a fund with high portfolio turnover may produce relatively low taxable gain to investors if it offsets realized gains with realized losses.

The Commission staff is considering whether there are other measures that could

be used to convey mutual fund tax consequences that are understandable to investors and not unduly burdensome for funds to compute. Standardizing disclosure of

the tax consequences of a mutual fund investment is complicated because different

fund investors are in different tax situations and, therefore, may experience different tax consequences from the same fund investment.

The Commission staff’s considerations have focused on after-tax return, a measure

of a mutual fund’s performance, adjusted to illustrate how taxes could affect an investor. (The calculation of after-tax return requires a number of assumptions about

the investor’s tax situation, such as his or her tax bracket.) The staff is considering

two separate measures of after-tax return:

• Pre-Liquidation After-Tax Return. This measure assumes that an investor continues to hold the fund at the end of the period for which the return is computed. It measures only the taxes resulting to the investor from the portfolio

manager’s purchase and sale of portfolio securities. • Post-Liquidation After-Tax Return. This measure assumes that an investor sells

the fund at the end of the period for which the return is computed and pays

taxes on any appreciation (or realizes losses). It measures both the taxes resulting from the portfolio manager’s purchase and sale of portfolio securities and

the taxes incurred by shareholders on a sale of fund shares.

These measures of after-tax return could help investors compare the after-tax returns of different funds and gain an understanding of the impact of taxes on a

fund’s reported pre-tax return.

Anticipated Commission Action

The Commission staff currently is preparing a recommendation to the Commission that it issue proposed rule amendments intended to improve the disclosure of

the tax consequences of mutual fund investments. The proposed rule amendments,

if issued, would be promulgated pursuant to the Commission’s existing authority

and would be the subject of public notice and comment.

II. DISCLOSURE OF CHARITABLE CONTRIBUTIONS BY PUBLIC COMPANIES AND MUTUAL

FUNDS

H.R. 887 is a bill that would require public companies and mutual funds to disclose information about certain of their contributions to non-profit organizations

where an insider of the company, or a spouse, is a director or trustee of the organization. In addition, public companies would be required to make available disclosure

of the total value of contributions made and identify the donees and amounts contributed if they exceed a dollar threshold established by the Commission.

SEC Staff Study

At Representative Gillmor’s request, the Commission staff has studied H.R. 887

and previous versions of the legislation. In fact, the staff requested comment from

the public concerning the costs and benefits of the earlier legislation (H.R. 944 and

945). Nearly 200 persons commented. The vast majority of the commenters opposed

the previous legislation. The commenters supporting disclosure argued that improved disclosure would reduce abuse, improve accountability, reduce shareholder

distrust, provide another basis on which to assess the judgment of management, and

build goodwill with the companies’ customers and community. Opponents of disclosure argued that it would be costly to track small contributions, especially for large

companies. They believed that companies would reduce the amount of gifts to avoid

disclosure or avoid giving to controversial charities. There was concern this disclosure could be used for political or personal agendas.

After studying the issue, the Commission staff concluded that imposing the corporate charitable contributions disclosure requirements in H.R. 887 would be feasible in that public companies are capable of tracking and disclosing this information to investors. Many companies currently collect charitable contribution information for tax purposes, and a small number already voluntarily disclose this information to the public.

Current Disclosure Requirements

Currently, shareholders have a right to make proposals in the company’s proxy

statement to provide disclosure of charitable contributions. Those proposals have not

attracted substantial support from shareholders. The Business Roundtable has commented that few shareholders request information regarding charitable contributions from companies that provide this information voluntarily. This leads us to beVerDate 20-MAR-2000 14:09 Mar 22, 2000 Jkt 010199 PO 00000 Frm 00050 Fmt 6633 Sfmt 6621 E:\HEARINGS\61039.TXT pfrm02 PsN: 61039
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lieve that a significant majority of shareholders may not consider this information

to be important.

In recent years, the Commission has been focusing much of its efforts on streamlining disclosure and mandating plain English. Charitable contributions account for

a small portion of most companies’ financial activities. We are cautious about adding

disclosure that would add to the volume of detail given to investors without providing material information.

In the course of reviewing H.R. 887, the Commission staff identified additional

practical issues that may affect the implementation of disclosure requirements for

corporate charitable giving. Although companies already track the amount of their

charitable contributions and to whom they are made for tax purposes, they may not

have in place mechanisms to identify gifts to organizations affiliated with corporate

insiders and their spouses, in part because they are not currently required to do so.

Also, depending upon the dollar thresholds for disclosure, the amount of disclosure

and the corresponding cost burden will vary significantly. Finally, there are other

technical issues that the staff would be pleased to discuss.

III. CONCLUSION

The Commission supports the goals of H.R. 1089, the Mutual Fund Tax Awareness Act of 1999. Taxes have a significant effect on mutual fund performance, and

the Commission and its staff are already working hard to improve the disclosure

that funds make to investors in this area. The Commission remains concerned about

H.R. 887. The Commission looks forward to working with the Subcommittee on

these important issues.

OMB WATCH

November 2, 1999

Representative MICHAEL OXLEY

Chair, Finance and Hazardous Materials Subcommittee

House Commerce Committee

2125 Rayburn House Office Building

Washington, DC 20515

REPRESENTATIVE OXLEY: We are writing to ask that our statement be entered into

the record of the recent hearing on H.R. 887.

We strongly support the ideal of disclosure, and feel it is vital to a democratic society. A large part of our mission involves working for greater openness in government. While we realize that there can be some downsides to full disclosure, we feel

that the benefits far outweigh any of these. Therefore, we view H.R. 887 as a positive start for greater disclosure of corporate philanthropy, although clarification is

needed on several points.

First, will the two disclosure requirements apply only to cash contributions made

to nonprofits, or will they also include in-kind contributions? Many publicly held

companies donate products that they manufacture, or services that they provide, to

nonprofits. Also, many companies donate office equipment to nonprofits after making upgrades. It is important that these donations are also covered.

Second, clarification of the disclosure process in Section 2 is required. Currently

there is no indication of what the process will involve, as the legislation simply

states that the disclosure statement must be made ‘‘in a format designated by the

[Securities and Exchange] Commission.’’ We would strongly recommend that the

data be widely available to the public using the internet. Also, allowing publicly

held companies to submit the disclosure information electronically would ease any

burden caused by the new requirements, as well as allow easy posting on the internet.

Even though clarifications are still needed, we feel that this is an important piece

of legislation because it obliquely serves to codify the practice of corporate philanthropy. As Representative Cox pointed out at the hearing, by regulating disclosure

of donations by publicly held companies, this law indirectly states that corporate

philanthropy is allowed under SEC regulations.

Sincerely,

GARY D. BASS

Executive Director

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INCREASING CORPORATE ACCOUNTABILITY?

OMB WATCH ANALYSIS OF H.R. 887

(7/06/99)

Summary

A bill introduced by Representative Paul Gillmor (R-OH) would require stockissuing corporations that are registered with the Securities Exchange Commission

(SEC) to disclose the amount of money they have given to charities each year, as

well as the names of recipients of large grants, through two processes. The first

would require the disclosure of any contribution over a limit to be set by the SEC

to any nonprofit of which ‘‘a director, officer, or controlling person’’ of the corporation ‘‘or a spouse thereof was a director or trustee’’ to be included in the annual

proxy statement. This would include the name on the nonprofit, and the amount of

the contribution.

The second process requires all corporations to annually ‘‘make available’’ the

‘‘total value of contributions made by the issuer to nonprofit organizations during

its previous fiscal year.’’ This process would also require the name of the nonprofit

organization receiving the donation to be included in the report, as well as the

amount contributed, if the contribution is over an amount set by the SEC.

Background

Gillmor proposed a similar piece of legislation in the 105th Congress (H.R. 944).

That bill simply called for ‘‘disclosure of the issuer’s charitable contributions during

the preceding fiscal year, including the identity of and the amount provided to each

recipient.’’ The legislation was not as comprehensive as this year’s bill, H.R. 887,

as it allowed the SEC to grant several types of exemptions. It was also partnered

with another bill (H.R. 945) that would have required the approval of shareholders

for any charitable contributions. Taken together, these bills would have created substantial barriers to corporate giving, and would have made contributions far less attractive to companies.

Gillmor asked the SEC to evaluate the feasibility of requiring disclosure to shareholders in the spring of 1997, and the SEC finally released a report early this June.

While the report covers general principles of disclosure, it focuses on H.R. 887. The

report finds that the ‘‘corporate charitable disclosure requirements in H.R. 887

would be feasible in that companies are capable of tracking and disclosing this information to investors.’’ The report notes that many companies already track charitable contributions for tax purposes, and some already voluntarily disclose their contributions to the public. Gillmor also asked that the SEC perform a cost and benefit

analysis, but this was not included in the report.

Analysis

OMB Watch supports the ideals of accountability and disclosure in the nonprofit

sector. This bill is a good beginning for greater disclosure. Unlike foundations, public corporations are not now required to disclose information about their contributions or grants. Principles have been in place for some time regarding disclosure of

philanthropic endeavors. The Council on Foundations, for example encourages its

members to disclose information about contributions in annual reports. It should not

be difficult for a corporation to print a listing of contributions in its annual proxy

statement. Further, the SEC should allow for electronic submission of the disclosure

information for ease of submission, and post it on the internet for simple public access.

Disclosure of charitable contributions by corporations should not be a controversial issue, nor is it costly to implement. If the intent of the bill is to increase corporate accountability, it is interesting that it only applies to corporate contributions.

Why not include information disclosing lobbying expenditures, campaign contributions (both ‘‘hard’’ and ‘‘soft’’ money), expenditures for legislative, ballot and regulatory issue campaigns, as well as other information in annual reports? Disclosure

of contributions to charities is a good start, but is only a small part of corporate

accountability.

Another important piece of the legislation is a provision that requires the disclosure of any contributions over a limit to be determined by the SEC made by a company to any nonprofit organization ‘‘of which a director, officer, or controlling person’’ of the company, or the person’s spouse is a ‘‘director or trustee.’’ This provision

would allow the public to see contributions that may be made simply because of an

executive’s involvement with an organization. For example, under this bill a corporation which makes a contribution simply as a ‘‘fee’’ for an executive’s seat on a

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nonprofit board may be required to disclose this contribution if it is above the SEC

designated amount.

Potential Problems:

As drafted, this legislation does not apply to corporate foundations. This could impede full disclosure, because a company seeking to avoid disclosure could simply

make a large payment to its foundation, and then have the foundation make contributions. The company would only be obligated to disclose its contributions to its

foundation (assuming that the contribution exceeds the threshold that is to be determined by the SEC). There will be some level of disclosure, however, because private

foundations are required to disclose contributions in their IRS form 990-PF. While

these documents are available for public inspection, they are most likely not delivered to shareholders on a yearly basis, as an annual report is.

Another problem with this legislation is that contributions to charities where an

executive is a director or trustee are only disclosed to shareholders, and not necessarily the general public. This disclosure is to be included with the written information distributed to shareholders before the corporation’s annual meeting, which

usually is an annual report. While most corporations will give a copy of their annual

report to non-shareholders, they are under no obligation to do so. The general public

should have access to a corporation’s total charitable contributions as well as the

names of charities receiving contributions over the threshold that is to be set by the

SEC, preferably in an easily accessed electronic format. The legislation does state

that this information must be made available ‘‘in a format designated by the Commission,’’ but does not state who this information is to be made available to, nor

does it give any hint as to the format.

It is unclear if this legislation applies to contributions made by U.S. companies

to foreign nonprofit organizations. Donations made by U.S. corporations to foreign

nonprofits may not be disclosed, as they are not tax-deductible, and may not fall

under a final definition of ‘‘contribution.’’ The legislation also appears to apply to

contributions to U.S. charities made by foreign companies that are ‘‘registered’’ with

the SEC. These foreign companies may be subject to domestic laws that may conflict

with the purposes of this bill, and there may be difficulty enforcing this legislation

in foreign companies.

Conclusion

While disclosure of corporate charitable contributions is the right thing to do, is

unlikely to have a major impact on corporate accountability. Legislation is still

needed requiring corporations to disclose other types of contributions, such as ‘‘soft

money’’ campaign contributions. Further, because the reporting threshold has not

yet been set by the SEC, the impact of H.R. 887 cannot be fully measured.

PREPARED STATEMENT OF HON. JOHN D. DINGELL, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF MICHIGAN

The Subcommittee on Finance and Hazardous Materials held a hearing on H.R.

887, legislation to mandate the disclosure of certain corporate charitable contributions, and H.R. 1089, the Mutual Fund Tax Awareness Act of 1999, on Friday, October 29, 1999, when the House was not in session and only three Subcommittee

Members (Reps. Gillmor, Markey, and Cox) were able to attend.

The hearing was chaired by Rep. Gillmor, the lead sponsor of both bills. Rep.

Gillmor announced that the hearing record would be held open to allow other Members to insert their statements. I appreciate that courtesy and will avail myself of

the opportunity to clarify the record.

First, I note that both bills amend the federal securities laws to mandate that the

Securities and Exchange Commission (SEC) require certain disclosures. Yet, in a departure from usual subcommittee practice, the SEC was not invited to testify on the

legislation. I have subsequently learned that the Majority did ask the SEC to submit a written statement but that statement was not made available to Members either before or during the hearing. It appears that the SEC statement raises concerns with at least one of the bills. I am submitting the SEC statement for inclusion

in the record and circulating it to Democratic Members.

Similarly, in May 1997, six Members of the Subcommittee wrote to the SEC asking for a report on predecessor legislation to H.R. 887. The SEC staff report was

not distributed to Members with the briefing materials for this hearing or included

in the hearing record. The briefing memorandum mentions the SEC staff report’s

finding that ‘‘imposing the corporate charitable contributions disclosure requirements in H.R. 887 would be feasible in that public companies are capable of tracking and disclosing this information to investors.’’ However, it does not mention any

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of the concerns and problems that also were discussed. Therefore, I am submitting

copies of the May 1997 letter and the May 1999 SEC staff report for inclusion in

the hearing record as well.

No mention of a markup date was made at Friday’s hearing. At 5:30 p.m., after

most offices were closed for the weekend, the Majority sent out a notice that both

bills would be scheduled for Subcommittee markup on Tuesday, November 2, 1999.

The SEC was not notified of the markup. No meeting has been scheduled in advance

of the markup with the SEC to discuss and address their concerns.

With respect to the substance, H.R. 1089 would require the SEC to revise its regulations to improve the methods of disclosing to investors in mutual fund

prospectuses and annual reports the after-tax effects of portfolio turnover on mutual

fund returns. SEC staff currently is preparing a recommendation to the Commission

that the agency issue proposed rule amendments, under its existing statutory authority, with the intention of improving the disclosure of the tax consequences of

mutual fund investments. This issue is complex, as was noted by the witnesses.

Every investor’s tax situation differs and, short of person-by-person disclosure, it

will be difficult to craft meaningful disclosures. Any disclosure in this area will have

to be accompanied by clear cautionary narrative informing investors of the appropriate use and inherent limitations of any new tax information. This legislation is

not necessary, but may provide a beneficial prod, as long as the SEC is given sufficient flexibility in implementing the legislation’s goals. The SEC has submitted a

package of technical changes to H.R. 1089. These should be taken care of.

H.R. 887 requires all SEC-registered companies to annually make available, in a

format to be designated by the SEC, the total value of contributions made by the

issuer to nonprofit organizations during the previous fiscal year. The name of the

organization receiving the donation and the amount contributed also must be included in the report for any contributions over a threshold amount to be set by the

SEC. H.R. 887 also requires SEC-registered companies to disclose in their proxy

statements any contributions, over threshold to be set by the SEC, made by the

issuer during the previous year to any nonprofit organization of which a director,

officer, or controlling person of the issuer, or spouse thereof, was a director or trustee, including the name of the organization and the value of the contribution.

Concern has been raised that this disclosure could be used in furtherance of improper political or personal agendas. Moreover, if the intent of the bill is to increase

corporate accountability, it is curious that it only applies to corporate charitable contributions. Disclosure of contributions to charities is only a small part of corporate

accountability. Why not include information disclosing lobbying expenditures, campaign contributions (both ‘‘hard’’ and ‘‘soft’’ money), expenditures for legislative, ballot, and regulatory issue campaigns, as well as other significant information?

In addition, the SEC staff report on H.R. 887 raises the following specific con- cerns:

(1) There does not appear to be evidence of widespread (or even significant) abuse—

only a handful of examples or allegations have been provided.

(2) Information regarding charitable giving by corporations is currently available:

• Some companies voluntarily make available information regarding their charitable contributions to shareholders.

• Corporate private foundations are required, under IRS regulations, to make

a list of contributions available to the public, and apparently the IRS is

amending its regulations to improve public access.

(3) There does not appear to be evidence of widespread shareholder interest in obtaining this information:

• Companies that make such information available to shareholders have found

relatively low shareholder interest.

• Only a small number of shareholder proposals for disclosure of charitable contributions have been offered and voted upon, and none have been approved

by shareholders.

(4) The information may not be material to investors since it may not be considered

relevant to a reasonable person’s investment decision, particularly if the donations are not improper:

• Corporations donate an average of a mere one percent of their pretax income

to charity.

• The SEC generally requires disclosure of information that is is ‘‘material’’ so

that disclosure is meaningful and does not overwhelmshareholders. Only in

very rare instances, if at all, would corporate charitable contributions meet

any reasonable ‘‘materiality’’ standard.

(5) Companies may evade the disclosure required by the bill:

• By making contributions through their foundations;

• By making contributions below any threshold; and

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• By characterizing payments as business expenses instead of charitable contributions.

(6) The costs of compiling the information may not be as low as proponents anticipate because companies may not have centralized records of all types of contributions including cash, products, services, use of facilities and time of employees.

I intend to vote against H.R. 887 in its current form.

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