Testimony 

Before the Committee on Banking, 

Housing and Urban Affairs, U.S. Senate 

United States General Accounting Office 

GAO

For Release on Delivery 

Expected at 10:00 a.m. EST 

Wednesday, March 10, 2004 MUTUAL FUNDS 

Assessment of Regulatory 

Reforms to Improve the 

Management and Sale of 

Mutual Funds 

Statement of David M. Walker 

Comptroller General of the United States 

GAO-04-533T 
www.gao.gov/cgi-bin/getrpt?GAO-04-533T.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact Richard J. 

Hillman (202) 512-8678 or hillmanr@gao.gov. 

Highlights of GAO-04-533T, a report to 

Chairman, Senate Committee on Banking, 

Housing and Urban Affairs 

March 10, 2004 

MUTUAL FUNDS 

Assessment of Regulatory Reforms to 

Improve the Management and Sale of 

Mutual Funds 

GAO commends SEC and other regulators for their swift regulatory response 

to recently revealed abusive mutual fund practices. However, some 

proposed actions need to be thoroughly assessed to ensure equitable 

treatment for all investors and others will need to be reinforced with 

enhanced compliance, enforcement, and investor education programs to be 

truly effective. In particular, to prevent further late trading, SEC has 

proposed that all mutual fund orders be received by funds or designated 

processors by 4:00 p.m. Eastern Time, but this action may unfairly impact 

some retail investors that place orders through financial intermediaries. 

Although GAO supports in the short run the proposed hard 4:00 p.m. close as 

a way of increasing the certainty that all orders have been legitimately 

received, GAO believes that SEC should continue to work with industry 

participants, including pension plan intermediaries, to address concerns that 

the hard close would adversely affect investors that use such intermediaries. 

To address market timing, SEC is proposing that funds make greater 

disclosure of market timing, securities pricing, and portfolio disclosure 

policies. GAO supports these steps and encourages regulators to educate 

investors about the importance of such disclosures. 

To improve mutual fund corporate governance and oversight, SEC has also 

proposed increasing the proportion of independent directors to 75 percent 

and to require independent chairs. SEC is also proposing that fund advisers 

appoint compliance officers that report to fund boards. GAO sees these 

actions as giving increased prominence to independent members on fund 

boards of directors and providing them with additional tools to effectively 

oversee fund practices. However, additional actions may be needed to 

ensure that independent directors have no relationships with the fund 

adviser or its personnel that could impair their independence. SEC and 

other regulators have also proposed that the broker-dealers that sell fund 

shares make more extensive disclosures about payments they receive from 

fund advisers. SEC is also seeking comments on how to revise the fees they 

charge investors that also compensate broker-dealers for selling fund shares. 

GAO supports these actions as increasing the transparency of these costs to 

investors but recognizes that the effectiveness of these proposals could be 

enhanced by expanded compliance and investor education programs. 

SEC is also seeking information on how fund advisers use investor dollars to 

obtain research under a practice called soft dollars. Given the increased 

spotlight that Congress and regulators are placing on the mutual fund 

industry, GAO believes the time is right to more effectively address the 

conflicts of interest created by soft-dollar arrangements. In addition, GAO 

identifies further actions that could be taken to improve disclosure of mutual 

fund fees to enhance competition among funds on the basis of the fees that 

are charged to shareholders. 

Since September 2003, widespread 

allegations of abusive practices 

involving mutual funds have come 

to light. An abuse called late 

trading allowed some investors, at 

times in collusion with pension 

plan intermediary, broker-dealer, 

or fund adviser staff, to profit at 

other investors’ expense by 

submitting orders for fund shares 

to receive that day’s price after the 

legal cutoff. Other investors were 

allowed to conduct market timing 

trades to take advantage of stale 

prices used by funds to calculate 

their net asset values at funds with 

stated policies against such trading. 

SEC and other regulators have 

responded with numerous 

proposals for new or revised 

practices. Based on a body of work 

that GAO has conducted involving 

mutual funds, GAO analyzed and 

provides views on proposed and 

final rules involving (1) fund 

pricing and compliance practices 

intended to address various mutual 

fund trading abuses that have come 

to light recently, (2) fund boards’ 

independence and effectiveness, 

(3) fund adviser compensation of 

broker-dealers that sell fund 

shares, and (4) additional actions 

regulators could take to further 

improve transparency and investor 

understanding of the fees they pay. 

In this statement, GAO raises a 

number of issues for regulators to 

consider that could enhance the 

effectiveness of proposed rule 

changes. 
Page 1 GAO-04-533T Mutual Fund Reforms 

Mr. Chairman and Members of the Committee: 

I am pleased to be here today to discuss GAO’s work assessing the 

transparency of mutual fund fees and other fund practices and to discuss 

the various proposed or anticipated regulatory reforms designed to 

improve the management and sale of mutual funds. In the last 20 years, 

mutual funds have grown from under $400 billion to over $7.5 trillion in 

assets and have become a vital component of the financial security of the 

more than 95 million American investors estimated to own mutual funds. 

These funds have also grown to represent a significant portion of 

American’s retirement wealth with 21 percent of the more than $10 trillion 

in pension plan assets now invested in mutual funds.1

 As a result, ensuring 

that mutual funds have sound governance and trading practices has never 

been more important. Recent actions by the Securities and Exchange 

Commission (SEC) and NASD would establish new procedures to protect 

shareholders against recently disclosed abusive trading practices, revise 

the structure and duties of the boards of directors that oversee funds, and 

place new responsibilities on the mutual fund and brokerage industries.2

Based on the work that we have performed over the last year, I will 

discuss problems we have seen within the mutual fund and brokerage 

industries and provide our views on the various SEC and NASD-proposed 

regulatory reforms.3

 Specifically, I will discuss proposed and final rules 

involving (1) fund pricing and compliance practices intended to address 

various mutual fund trading abuses that have come to light recently, (2) 

fund boards’ independence and effectiveness, and (3) fund advisers 

compensation of broker-dealers that sell fund shares. In addition I will 

discuss additional actions regulators could take to further improve 

transparency and investor understanding of the fees they pay. 

 1

These statistics were reported by the Investment Company Institute and the Federal 

Reserve Board. 

2

NASD oversees broker-dealers that sell mutual funds and other securities to their 

customers. 

3

See U.S. General Accounting Office, Mutual Funds: Information on Trends in Fees and 

Their Related Disclosure, GAO-03-551T (Washington, D.C.: Mar. 12, 2003); Mutual Funds: 

Greater Transparency Needed in Disclosures to Investors, GAO-03-763 (Washington, D.C.: 

June 9, 2003); Mutual Funds: Additional Disclosures Could Increase Transparency of 

Fees and Other Practices, GAO-03-909T (Washington, D.C.: June 18, 2003); and Mutual 

Funds: Additional Disclosures Could Increase Transparency of Fees and Other Practices, 

GAO-04-317T (Washington, D.C.: Jan. 27, 2004). 
Page 2 GAO-04-533T Mutual Fund Reforms 

In summary, we commend SEC and other regulators for their swift 

regulatory response to recent revelations of abusive mutual fund trading 

practices. We believe that many of the actions taken will provide the 

proper incentives to industry participants to follow sound practices and 

also provide regulators with additional compliance and enforcement tools 

to ensure that participants are held accountable for their behavior. 

However, some proposed actions need to be thoroughly assessed to 

ensure equitable treatment for all investors. In particular, while we agree 

that SEC’s proposal to address late trading abuses with a hard 4:00 p.m. 

close provides increased certainty of the legitimacy of orders, we also 

recognize that there are wide-ranging and divergent interests in today’s 

marketplace that must be accommodated to ensure that all retail and 

institutional investors are treated fairly. As such, while we agree with 

SEC’s proposal for addressing unlawful late trading in the short run, we 

believe that SEC should continue to work with the retirement plan 

community and cognizant federal agencies to address concerns that this 

proposed rule may have certain adverse implications for certain 

participants in retirement savings plans. 

We also firmly agree with SEC’s proposals to enhance the independence 

and effectiveness of mutual fund boards. Giving increased prominence to 

independent members on fund boards of directors and providing them 

with additional tools to effectively oversee fund practices should go a long 

way to improve the system of checks and balances needed to avoid future 

trading abuses. However, additional attention could be afforded to 

ensuring the adequacy of the definition of an “interested person” to ensure 

that directors designated as independent directors are truly independent. 

We also recognize that other proposals for improving disclosures of 

mutual fund and brokerage trading practices will need to be reinforced 

with enhanced compliance, enforcement, and investor education programs 

if they are to be truly effective. 

There are also other areas that warrant SEC’s continued attention. SEC is 

seeking information on how mutual fund investors pay for advice from 

broker-dealers and how fund advisers use investor’s dollars to obtain 

research. However, given the increased spotlight Congress and regulators 

are placing on the mutual fund industry, in our view, the time is right to 

address various conflicts of interest created by soft-dollar arrangements. 

In addition, further actions could be taken to improve disclosure of mutual 

fund fees to enhance competition among funds on the basis of the fees 

that are charged to shareholders. 
Page 3 GAO-04-533T Mutual Fund Reforms 

In addition to the work I am discussing today, we are currently studying 

other issues related to the security of workers’ retirement benefits. 

Pensions and retirement savings plans are an important source of income 

for millions of retirees. As such, we are reviewing how retirement savings 

plans, such as 401(k) plans, have been affected by the mutual fund late 

trading and market timing scandals, and how SEC’s proposed rules to 

address these practices might affect plan participants and plan 

administration. On the broader issue of corporate governance, we also are 

currently studying what actions pension plan fiduciaries take to address 

conflicts of interest in connection with proxy voting issues. As large 

institutional shareholders, pension plans have the opportunity to influence 

governance of funds and hold company managers accountable for the 

business decisions they make. 

In reaction to allegations of widespread misconduct and abusive practices 

involving mutual funds, regulators have responded with various proposals. 

In early September 2003, the Attorney General of the State of New York 

filed charges against a hedge fund manager for arranging with several 

mutual fund companies to improperly trade in fund shares and profit at 

the expense of other fund shareholders.4

 Since then, widening federal and 

state investigations of illegal late trading and improper timing of fund 

trades have involved a growing number of prominent mutual fund 

companies and brokerage firms. 

One of the abuses that has come to light recently is late trading. Under 

current rules, funds accept orders to sell and redeem fund shares at a price 

based on the current net asset value, which most funds calculate once a 

day at 4:00 p.m. Eastern Time.5

 Many investors, however, purchase mutual 

fund shares through other intermediaries such as broker-dealers, banks, 

and retirement savings plans. Instead of submitting hundreds or even 

thousands of individual purchase and redemption orders each day, these 

 4

The term “hedge fund” generally identifies an entity that holds a pool of securities and 

perhaps other assets that does not register its securities offerings under the Securities Act 

and which is not registered as an investment company under the Investment Company Act 

of 1940. Hedge funds are also characterized by their fee structure, which compensates the 

adviser based upon a percentage of the hedge fund’s capital gains and capital appreciation. 

5

SEC rule 22c-1, promulgated under the Investment Company Act of 1940, prohibits the 

purchase or sale of mutual fund shares except at a price based on current net asset value of 

such shares that is next calculated after receipt of a buy or sell order. 

Regulators Are Taking 

Actions to Address 

Abusive Mutual Fund 

Practices 

Late Trading and Market 

Timing Are Detrimental to 

Fund Long-Term 

Shareholders 
Page 4 GAO-04-533T Mutual Fund Reforms 

intermediaries typically aggregate orders received from investors and 

submit a single purchase or redemption order that nets all the individual 

shares their customers are seeking to buy or sell. Because this processing 

takes time, SEC rules permit these intermediaries to forward the order 

information to funds after 4:00 p.m. 

However, late trading occurs when some investors are able to illegally 

purchase or sell mutual fund shares after the 4:00 p.m. Eastern Time close 

of U.S. securities markets, the time at which funds typically price their 

shares. An investor permitted to engage in late trading could be buying or 

selling shares at the current day’s 4:00 p.m. price with knowledge of 

developments in the financial markets that occurred after 4:00 p.m. Such 

investors thus have unfair access to opportunities for profit that are not 

provided to other fund shareholders. 

The extent to which some investors were allowed to submit late trading 

orders may have been significant. In September 2003, SEC sought 

information from fund advisers and broker-dealers about their pricing of 

mutual fund orders and late trading policies. SEC’s preliminary analysis of 

this information showed that more than 25 percent of the 34 major brokerdealers that responded had customers that still received that day’s price 

for orders they had placed or confirmed after 4:00 p.m. As of March 1, 

2004, SEC had formally announced seven enforcement cases involving 

broker-dealers and other firms that were allegedly involved in late trading 

schemes; other cases may be forthcoming. We will be initiating a review of 

the adequacy of SEC’s enforcement efforts and the sanctions that it can 

and has applied in these cases and will be reporting separately on these 

issues later this year. In addition, legislation is under consideration in the 

House of Representatives that will expand SEC’s enforcement capabilities 

by raising the civil penalties for securities law violations, enhance the 

investigative procedures available to SEC, and streamline the process by 

which fines are disbursed among injured parties.6

Another abuse that has come to light is known as market timing. Market 

timing occurs when certain fund investors place orders to take advantage 

of temporary disparities between the share value of a fund and the values 

of the underlying assets in the fund’s portfolio. For example, U.S. mutual 

funds that use the last traded price for foreign securities (whose markets 

close hours before the U.S. markets) to value their portfolio when the U.S. 

 6

See H.R. 2179, Securities Fraud Deterrence and Investor Restitution Act of 2003. 
Page 5 GAO-04-533T Mutual Fund Reforms 

markets close could create opportunities for market timing if events that 

subsequently occurred were likely to cause significant movements in the 

prices of those foreign securities when their home markets reopen. 

Market timing, although not currently illegal, can be unfair to long-term 

fund investors because it provides the opportunity for selected fund 

investors to profit from fund assets at the expense of long-term investors. 

The following example illustrates how market timing transactions can 

reduce the return to long-term shareholders of a fund. 

Figure 1: Impact on Fund Net Asset Value (NAV) With and Without an Investment By 

a Market Timer 

Note: The figure shows how a hypothetical mutual fund is affected by an increase in its portfolio 

assets with and without a market timer transaction. In this example, a market timer invests $1,000 in 

the fund on day 1 before a 10 percent rise in the value of the securities held by the fund. On day 2 the 

market timer redeems the shares yielding a reduction in the fund’s net asset value compared to its 

value without a market timer transaction. The example assumes that the portfolio manager is unable 

to invest the market timer’s cash and thus that amount does not help increase the fund’s gain when 

the market rises. 

As shown in the figure, the loss to long-term holders of the fund in this 

case is only $.01 per share. Although the amount by which a single market 

timing transaction reduces a fund’s overall return can be small, repeated 

and large transactions over long periods of time can have a greater 

$1,000

Portfolio securities

Cash

Total assets

Shares

Net asset value

$90,000

$10,000

$100,000

10,000

$10.00

$90,000

$11,000

$101,000

10,100

$10.00

$99,000

$11,000

$110,000

10,100

$10.89

$99,000

$10,000

$109,000

10,000

$10.90

$99,000

$9,911

$108,911

10,000

$10.89

Market timer

buys 100 shares

$1,089

Day

1

Day

2

With

market

timing

With no

market

timing

With

market

timing

With no

market

timing

10% rise in

price of securities

Holdings of fund

at end of day 2

Calculation of net asset 

value after 10% rise and 

$1,000 investment by 

market timer

+

=

=

÷

Source: GAO.

Fund redeems market

timer's 100 shares at day 2

net asset value
Page 6 GAO-04-533T Mutual Fund Reforms 

cumulative effect. For example, one fund company whose staff were 

accommodating market timing transactions by 10 different investors 

estimated that these investors earned $22.8 million through their trading 

and that these activities costs its funds $2.7 million over a period of several 

years. In addition, the redemption fees that these investors should have 

paid but did not, amounted to another $5 million. 

Market timing may also have been widespread. According to testimony by 

SEC’s Director of Enforcement, although most mutual funds have policies 

that discourage market timing, this strategy was popular among some 

individuals and institutional traders who attempted to conceal their 

identities from fund companies. He also stated that 30 percent of the 

broker-dealers responding to an SEC information request reported 

assisting customers in attempting to conduct market timing trades, by 

using methods, such as breaking their orders into smaller sizes to avoid 

detection by the fund companies. Of the twelve cases SEC formally 

opened that involved market timing activities, including five cases that 

also involved late trading, two have been settled. In the settlement for one 

case that involved both late trading and market timing, SEC ordered the 

firm to pay fines and disgorgements of $225 million. In the other case, SEC 

ordered the firm to pay $250 million in fines and disgorgements. NASD 

also has taken various enforcement cases against broker-dealers involving 

late trading and market timing, including one in which a broker-dealer was 

fined $1 million and ordered to provide restitution of more than $500,000 

for failing to prevent market timing of an affiliated firm’s mutual funds. 

Additional abusive practices associated with mutual funds have also come 

to light. To facilitate late trading and market timing arrangements, some 

fund advisers selectively disclosed information about their funds’ portfolio 

holdings to outsiders. They also allowed these parties to late trade or 

conduct market timing in their funds. For example, in one SEC case a fund 

manager allowed a hedge fund to engage in market timing in a fund that he 

managed. The fund manager also disclosed portfolio information to a 

broker that enabled brokerage customers to conduct market timing 

transactions in the funds. In another state-administered case, a hedge fund 

executive obtained special trading privileges from several mutual fund 

companies that allowed him to engage in late trading and market timing in 

those funds. 
Page 7 GAO-04-533T Mutual Fund Reforms 

In addition to enforcement actions, SEC has also proposed amending 

regulatory rules to address late trading, market timing, and selective 

disclosure abuses. In December 2003, SEC proposed amending the rule 

that governs how mutual funds price their shares and receive orders for 

share purchases or sales. 7

 Since many of the cases of late trading involved 

orders submitted through intermediaries, including banks and pension 

plans not regulated by SEC, the proposed amendments to its rules would 

require that orders to purchase or redeem mutual fund shares be received 

by a fund, its transfer agent, or a registered clearing agency before the 

time of pricing (that is, 4:00 p.m. Eastern Time).8

Many organizations that purchase mutual fund shares, particularly those 

that administer retirement savings plans, have expressed concerns that 

such a “hard close” would unfairly prohibit some of their participants from 

receiving the same day’s price on share purchases. Because intermediaries 

generally combine individual investor orders and submit single orders to 

funds to buy or sell, many officials at such firms are concerned that the 

time required to complete this processing will not allow them to meet the 

4:00 p.m. deadline. In such cases, investors purchasing shares from 

Western states or through intermediaries would either have to submit their 

trades earlier than other investors in order to receive the current day’s 

price or receive the next day’s price. A letter commenting on SEC’s 

proposal from two investor advocacy groups indicated that implementing 

the hard close would relegate some retail investors to the status of 

“second-class shareholders.” Some plan sponsor organizations and plan 

record keepers have also raised concerns about the potential significant 

administrative costs associated with adopting systems to accommodate 

the 4:00 p.m. hard close and other proposed rules. 

Because the hard close could affect some investors’ ability to trade at the 

current day’s price, some groups have called on SEC to allow industry 

participants to develop systems of internal controls that would serve to 

ensure that intermediaries receive individual orders before 4:00 p.m. With 

such controls in place, these orders could continue to be processed after 

 7

Securities and Exchange Commission, Proposed Rule: Amendments to Rules Governing 

Pricing of Mutual Fund Shares, Release No. IC-26288 (Dec. 11, 2003). 

8

A fund’s transfer agent maintains records of fund owners. Currently, the National 

Securities Clearing Corporation, which is the clearing organization for securities trades in 

the United States, also operates a system used by broker-dealers and others to transmit 

mutual fund orders to fund companies. 

Rule Changes Could Prevent 

Late Trading and Discourage 

Market Timing, but Some 

Investors Might Be 

Disadvantaged 
Page 8 GAO-04-533T Mutual Fund Reforms 

this time. However, SEC officials told us that they were skeptical that any 

system that relies on internal controls could not provide certainty that late 

trading was not occurring because many of the late trading abuses 

happened at firms that purportedly had such controls in place. However, 

SEC remains open to the possibility of the development of systems that 

could reasonably detect and deter late trading. In its proposals, SEC 

requests comments on various approaches designed to prevent late 

trading. Such protections could include a system that provides an 

electronic or physical time-stamp on orders. Other possible controls could 

include certifications that the intermediary had policies and procedures in 

place designed to prevent late trades, or audits by independent public 

accountants. Because multiple regulators oversee the operations of these 

financial intermediaries, any assessment of the reasonableness of 

recommended systems or controls would likely require effective 

coordination. 

SEC is also proposing to take actions to address market timing. On 

December 11, 2003, SEC released a rule proposal to provide greater 

transparency to funds’ market timing policies. Specifically, SEC would 

require mutual funds to disclose in their prospectuses the risks to 

shareholders of the frequent purchase and redemption of investment 

company shares, and fund policies and procedures pertaining to frequent 

purchases and redemptions. The proposal also would require funds to 

explain both the circumstances under which they would use fair value 

pricing and the effects of using fair value pricing.9

 Another rule will require 

funds to adopt fair value pricing policies that require funds among other 

things, to monitor for circumstances that may necessitate the use of fair 

value pricing, establish criteria for determining when market quotations 

are no longer reliable for a particular portfolio security, and provide a 

methodology or methodologies by which the funds determine the current 

fair value of portfolio securities. Also, SEC is seeking comment in one of 

its proposals for additional ways to improve the implementation of fair 

value pricing. In addition, the proposal would require funds to disclose 

policies and procedures pertaining to their disclosing information on the 

funds’ portfolio holdings, and any ongoing arrangements to make available 

information about their portfolio securities. These additional disclosures 

would enable investors to better assess risks, policies, and procedures, 

 9

Fair value pricing is a process that mutual funds use to value fund shares (such as for 

assets traded in foreign markets) in the absence of current market values. The Investment 

Company Act of 1940 requires that when market quotations for a portfolio security are not 

readily available, a fund must calculate its fair value. 
Page 9 GAO-04-533T Mutual Fund Reforms 

and determine if a fund’s policies and procedures were in line with their 

expectations. Disclosure of a fund’s procedures in these areas would also 

allow SEC to better examine a fund’s compliance with its stated 

procedures and hold fund managers accountable for their actions. 

To further stem market timing, on March 3, 2004, SEC issued a proposed 

new rule to require mutual funds to impose a 2-percent redemption fee on 

the proceeds of shares redeemed within 5 business days of purchase. 

According to the proposal, the proceeds from the redemption fees would 

be retained by the fund, becoming a part of fund assets. In addition, the 

proposal addresses the pass thru of information from omnibus accounts 

maintained by intermediaries. Specifically, the proposal identifies three 

alternatives for funds to ensure that redemption fees are imposed on the 

appropriate market timers through the use of Taxpayer Identification 

Numbers. On at least a weekly basis intermediaries would be required to 

provide to the fund, purchase and redemption information for each 

shareholder within an omnibus account to enable the fund to detect 

market timers and properly assess redemption fees. The rule is designed to 

require short-term shareholders to reimburse funds for costs incurred as a 

result of investors using short-term trading strategies, such as market 

timing. The proposal would also include an emergency exception that 

would allow an investor not to pay a redemption fee in the event of an 

unanticipated financial emergency. 

Unlawful late trading and certain market timing activities, which are not 

currently illegal, can be unfair to long-term investors because these 

activities provide the opportunity for selected fund investors to profit from 

fund assets at the expense of fund long-term investors. SEC’s proposal to 

address late trading with a hard 4:00 p.m. close appears, in the short-term, 

to be the solution that provides the most certainty that all orders being 

submitted to the funds legitimately deserve that day’s price. However, we 

also recognize that this action could have a significant impact on many 

investors, particularly those in employer-based retirement savings plans, 

who own fund shares through financial intermediaries. As a result, we 

urge the Commission to, as a supplement to their planned action, explore 

alternatives to the hard 4:00 p.m. close more fully and to revisit formally 

the question of how best to prevent late trading. Since some of the 

financial intermediaries involved are either overseen by other regulators 

or, in the case of third-party pension plan administrators, not overseen by 

any regulator, any such assessment should include the development of a 

strategy for overseeing the intermediary processing of mutual fund trades. 

Having a sound strategy for oversight of the varied participants in the 
Page 10 GAO-04-533T Mutual Fund Reforms 

mutual fund industry would ensure that all relevant entities are held 

equally accountable for compliance with all appropriate laws. 

We also commend SEC for proposing to require that mutual funds more 

fully disclose their market timing and portfolio disclosure policies. By 

increasing the transparency of these policies, industry participants will 

have the incentive to ensure that their policies are sound and will provide 

investors with information that they can use to distinguish between funds 

on the basis of these policies. The disclosures will also provide regulators 

and others with information to hold these firms accountable for their 

actions. However, such disclosures would likely also require improving 

related investor education programs to better ensure that investors 

understand the importance of these new disclosures. We also support 

SEC’s redemption fee proposal as a means of discouraging market timing. 

Placing the proceeds of the fee back in the fund itself helps to ensure that 

the actions of short-term traders do not financially harm long-term 

investors, including pension plan participants who hold such funds. 

Mutual fund boards of directors have a responsibility to protect 

shareholder interests and SEC has issued various proposals to increase 

the effectiveness of these bodies. In particular, independent directors, who 

are not affiliated with the investment adviser, play a critical role in 

protecting mutual fund investors. To improve the independence of fund 

boards, SEC has issued various proposals to alter the structure of these 

boards and task them with additional duties. 

Because the organizational structure of a mutual fund can create conflicts 

of interest between the fund’s investment adviser and its shareholders, the 

law governing U.S. mutual funds requires funds to have a board of 

directors to protect the interests of the fund’s shareholders. A fund is 

usually organized by an investment management company or adviser, 

which is responsible for providing portfolio management, administrative, 

distribution, and other operational services. In addition, the fund’s officers 

are usually provided, employed, and compensated by the investment 

adviser. The adviser charges a management fee, which is paid with fund 

assets, to cover the costs of these services. With the management fee 

representing its revenue from the fund, the adviser’s desire to maximize its 

revenues could conflict with shareholder goals of reducing fees. As one 

safeguard against this potential conflict, the Investment Company Act of 

1940 (the Investment Company Act) requires mutual funds to have boards 

of directors to oversee shareholder interests. These boards must also 

Regulators Are Taking 

Actions to Improve 

the Effectiveness of 

Mutual Fund Boards 

of Directors 

Directors Have a Role in 

Overseeing Fees 
Page 11 GAO-04-533T Mutual Fund Reforms 

include independent directors who are not employed by or affiliated with 

the investment adviser. 

As a group, the directors of a mutual fund have various responsibilities 

and in some cases, the independent directors have additional duties. In 

particular, the independent directors also have specific duties to approve 

the investment advisory contract between the fund and the investment 

adviser and the fees that will be charged. Specifically, section 15 of the 

Investment Company Act requires that the terms of any advisory contracts 

and renewals of advisory contracts be approved by a vote of the majority 

of the independent directors. 

Under section 36(b) of the Investment Company Act, investment advisers 

have a fiduciary duty to the fund with respect to the fees they receive, 

which under state common law typically means that the adviser must act 

with the same degree of care and skill that a reasonably prudent person 

would use in connection with his or her own affairs. Section 36(b) also 

authorizes actions by shareholders and SEC against an adviser for breach 

of this duty. Courts have developed a framework for determining whether 

an adviser has breached its duty under section 36(b), and directors 

typically use this framework in evaluating advisory fees. This framework 

finds its origin in a Second Circuit Court of Appeals decision, in which the 

court set forth the factors relevant to determining whether an adviser’s fee 

is excessive.10 The court in this case stated that to be guilty of a breach 

under section 36 (b), the fee must be “so disproportionately large that it 

bears no reasonable relationship to the services rendered and could not 

have been the product of arms-length bargaining.” The standards 

developed in this case, and in cases that followed, served to establish 

current expectations for fund directors with respect to fees. In addition to 

potentially considering how a fund’s fee compared to those of other funds, 

this court indicated that directors might find other factors more important, 

including 

• the nature and quality of the adviser’s services, 

• the adviser’s costs to provide those services, 

 10Gartenberg v. Merrill Lynch Asset Management Inc., 528 F. Supp. 1038 (S.D.N.Y. 1981), 

aff’d, 694 F. 2d 923 (2d Cir. 1982), cert. denied, 461 U.S. 906(1983).
Page 12 GAO-04-533T Mutual Fund Reforms 

• the extent to which the adviser realizes and shares with the fund 

economies of scale as the fund grows, 

• the volume of orders that the manager must process, 

• indirect benefits to the adviser as the result of operating the fund, and 

• the independence and conscientiousness of the directors. 

Some industry experts have criticized independent directors for not 

exercising their authority to reduce fees. For example, in a speech to 

shareholders, one industry expert stated that mutual fund directors have 

failed in negotiating management fees. The criticism arises in part from the 

annual contract renewal process, in which boards compare fees of similar 

funds. However, the directors compare fees with the industry averages, 

which the experts claim provides no incentive for directors to seek to 

lower fees. Another industry expert complained that fund directors are not 

required to ensure that fund fees are reasonable, much less as low as 

possible, but instead are only expected to ensure that fees fall within a 

certain range of reasonableness. 

In contrast, an academic study we reviewed criticized the court cases that 

have shaped directors’ roles in overseeing mutual fund fees. The authors 

noted that these cases generally found that comparing a fund’s fees to 

other similar investment management services, such as pension plans, was 

inappropriate as fund advisers do not compete with each other to manage 

a particular fund. Without being able to compare fund fees to these other 

products, the study’s authors say that investors bringing these cases 

lacked sufficient data to show that a fund’s fees were excessive.11

In light of concerns over director roles and effectiveness, including 

concerns arising from the recently alleged abusive practices, SEC has 

taken various actions to improve board governance and strengthen the 

compliance programs of fund advisers. To strengthen the hand of 

independent directors when dealing with fund management, SEC issued a 

proposal in January 2004 to amend rules under the Investment Company 

 11J.P. Freeman and S.L. Brown, “Mutual Fund Advisory Fees: The Cost of Conflicts of 

Interest,” 26 Journal of Corporation Law 609 (2001). 

Concerns Over Directors’ 

Roles Exist 

Various Actions Taken or 

Proposed to Increase 

Board Effectiveness and 

Mutual Fund Oversight 
Page 13 GAO-04-533T Mutual Fund Reforms 

Act to alter the composition and duties of many fund boards.12 These 

reforms include 

• requiring an independent chairman for fund boards of directors; 

• increasing the percentage of independent directors from a majority to 

at least seventy-five percent of a fund’s board; 

• requiring fund independent directors to meet at least quarterly in a 

separate session; and 

• providing the independent directors with authority to hire employees 

and others to help the independent directors fulfill their fiduciary 

duties. 

Under the Investment Company Act, only individuals who are not 

“interested” can serve as independent directors. Section 2(a)(19) of the 

Investment Company Act defines the term “interested person” to include 

the fund’s investment adviser, principal underwriter, and certain other 

persons (including their employees, officers or directors) who have a 

significant relationship with the fund, its investment adviser or principal 

underwriter. Broker-dealers that distribute the fund’s shares or persons 

who have served as counsel to the fund would also be considered 

interested. However, SEC has suggested that Congress give it authority to 

fill gaps in the statute that have permitted persons to serve as independent 

directors who do not appear to be sufficiently independent of fund 

management. For example, the statute permits a former executive of the 

fund’s adviser to serve as an independent director two years after the 

person has retired from his position. This permits an adviser to use board 

positions as a retirement benefit for its employees. The statute also 

permits relatives of fund managers to serve as independent directors as 

long as they are not members of the “immediate family” or affiliated 

persons of the fund. In one case, SEC found that an uncle of the funds 

portfolio manager served as an independent director of the fund. Giving 

SEC additional rulemaking authority to define the term “interested person” 

clearly seems appropriate. 

As part of their proposal to alter the structure of fund boards, SEC is also 

proposing that fund directors perform at least once annually an evaluation 

 12Securities and Exchange Commission, Proposed Rule: Investment Company Governance,

Release No. IC-26323 (Jan.15, 2004). 
Page 14 GAO-04-533T Mutual Fund Reforms 

of the effectiveness of the board and its committees. This evaluation is to 

consider the effectiveness of the board’s committee structure and whether 

the directors have taken on the responsibility for overseeing too many 

funds. The proposal also seeks to amend the fund recordkeeping rule (rule 

31a-2) to require that funds retain copies of the written materials that 

directors consider in approving an advisory contract under section 15 of 

the Investment Company Act. 

According to the SEC proposal, the changes to board structure and 

authority are designed to enhance the independence and effectiveness of 

fund boards and to improve their ability to protect the interests of the 

funds and fund shareholders they serve. Specifically, SEC noted that 

commenters on a 2001 amendment believed that a supermajority of 

independent directors would help to strengthen the hand of independent 

directors when dealing with fund management, and help assure that 

independent directors maintain control of the board in the event of illness 

or absence of other independent directors. Also, SEC concluded that (1) a 

boardroom culture favoring the long-term interests of fund shareholders 

might be more likely to prevail if the board chairman does not have the 

conflicts of interest inherent in his role as an executive of the fund adviser, 

and (2) a fund board may be more effective when negotiating with the 

fund adviser over matters such as the advisory fee if it were not led by an 

executive of the adviser with whom it was negotiating. SEC also noted that 

separate meetings of the independent directors would afford independent 

directors the opportunity for frank and candid discussion among 

themselves regarding the management of the fund. In addition, it saw the 

use of staff and experts as important to help independent directors deal 

with matters beyond their level of expertise and give them an 

understanding of better practices among mutual funds. 

According to SEC’s proposal, having fund directors perform selfevaluations of the boards’ effectiveness could improve fund performance 

by strengthening the directors’ understanding of their role and fostering 

better communication and greater cohesiveness. This would focus the 

board’s attention on the need to create, consolidate, or revise various 

board committees such as the audit, nominating, or pricing committees. 

Finally, according to SEC staff, the proposed additional recordkeeping 

rule would allow compliance examiners to review the quality of the 

materials that boards considered in approving advisory contracts. 

In response to concerns regarding the adequacy of fund board review of 

advisory contracts and management fees, on February 11, 2004, SEC also 

released proposed rule amendments to require that funds disclose in 
Page 15 GAO-04-533T Mutual Fund Reforms 

shareholders reports how boards of directors evaluate and approve, and 

recommend shareholder approval of investment, advisory contracts. The 

proposed amendments would require a fund to disclose in its reports to 

shareholders the material factors and the conclusions with respect to 

those factors that formed the basis for the board’s approval of advisory 

contracts during the reporting period. The proposals also are designed to 

encourage improved disclosure in the registration statement of the basis 

for the board’s approval of existing advisory contracts, and in proxy 

statements of the basis for the board’s recommendation that shareholders 

approve an advisory contract. 

In addition, to facilitate better board governance and oversight, SEC 

adopted requirements to ensure that mutual funds and advisers have 

internal programs to enhance compliance with federal securities laws and 

regulations. On December 17, 2003, SEC adopted a new rule that requires 

each investment company and investment adviser registered with the 

Commission to 

• adopt and implement written policies and procedures reasonably 

designed to prevent violation of the federal securities laws, 

• review those policies and procedures annually for their adequacy and 

the effectiveness of their implementation, and 

• designate a chief compliance officer to be responsible for 

administering the policies and procedures. 

In the case of an investment company, the chief compliance officer would 

report directly to the fund board. These rules are designed to protect 

investors by ensuring that all funds and advisers have internal programs to 

enhance compliance with federal securities laws. 

To ensure that fund investment adviser officials and employees are aware 

of and held accountable for their fiduciary responsibilities to their fund 

shareholders, SEC also released a rule proposal in January 2004 that 

would require registered investment adviser firms to adopt codes of ethics. 

According to the proposal, the rule was designed to prevent fraud by 

reinforcing fiduciary principles that must govern the conduct of advisory 

firms and their personnel. The proposal states that codes of ethics remind 

employees that they are in a position of trust and must act with integrity at 

all times. The codes would also direct investment advisers to establish 

procedures for employees, so that the adviser would be able to determine 

whether the employee was complying with the firm’s principles. 
Page 16 GAO-04-533T Mutual Fund Reforms 

In addition to these actions, SEC had previously adopted rules that 

became effective in April 2003 that require funds to disclose on a quarterly 

basis how they voted their proxies for the portfolio securities they hold. 

SEC also required client proxies to adopt policies and procedures 

reasonably designed to ensure that the adviser votes proxies in the best 

interests of clients, to disclose to clients information about those policies 

and procedures, to disclose to clients how they may obtain information on 

how the adviser voted their proxies, and to maintain certain records 

relating to proxy voting. In adopting these requirements, SEC noted that 

this increased transparency would enable fund shareholders to monitor 

their funds’ involvement in the governance activities of portfolio 

companies, which may have a dramatic impact on shareholder value. We 

are currently reviewing whether pension plans have similar requirements 

to disclose their proxy voting activities to their participants and will be 

reporting separately on these issues later this year. 

In our view, these SEC proposals should help ensure that mutual fund 

boards of directors are independent and take an active role in ensuring 

that their funds are managed in the interests of their shareholders. Many 

fund boards already meet some of these requirements, but SEC’s proposal 

will better ensure that such practices are the norm across the industry. 

Although such practices do not guarantee that funds will be well managed 

and will avoid illegal or abusive behavior, greater board independence 

could promote board decision making that is aligned with shareholders’ 

interests and thereby enhance board accountability. While board 

independence does not require eliminating all nonindependent directors, 

we have taken the position in previous work that it should call for a 

supermajority of independent directors.13 Our prior work also recognized 

that independent leadership of the board is preferable to ensure some 

degree of control over the flow of information from management to the 

board, scheduling of meetings, setting of board agendas, and holding top 

management accountable. To further ensure that board members are truly 

independent, we would support the Congress giving SEC rulemaking 

authority to specify the types of persons who qualify as “interested 

persons.” Having compliance officers report to fund boards and having 

advisers implement codes of ethics should also provide additional tools to 

hold fund advisers and boards accountable for ensuring that all fund 

 13U.S. Comptroller General David M. Walker, Integrity: Restoring Trust in American 

Business and the Accounting Profession (document based on author’s speech to the 

American Institute of Certified Public Accountants), Nov. 2002. 
Page 17 GAO-04-533T Mutual Fund Reforms 

activities are conducted in compliance with legal requirements and with 

integrity. 

In addition to addressing alleged abusive practices, securities regulators 

are also introducing proposals that respond to concerns over how brokerdealers are compensated for selling mutual funds. Specifically, SEC is 

seeking comments on how to revise a rule that allows mutual funds to 

deduct fees to pay for the marketing and sale of fund shares. In addition, 

to address a practice that raises potential conflicts of interest between 

broker-dealers and their customers, SEC and NASD have also proposed 

rules that would require broker-dealers to disclose revenue sharing 

payments that fund advisers make to broker-dealers to compensate them 

for selling fund shares. SEC has also recently proposed banning a practice 

called directed brokerage that, if adopted, would prohibit funds from using 

trading commissions as an additional means of compensating brokerdealers for selling their funds. 

Approximately 80 percent of mutual fund purchases are made through 

broker-dealers or other financial professionals, such as financial planners 

and pension plan administrators. Prior to 1980, the compensation that 

these financial professionals received for assisting investors with mutual 

fund purchases was paid either by charging investors a sales charge or 

load or paying for such expenses out of the investment adviser’s own 

profits. However, in 1980, SEC adopted rule 12b-1 under the Investment 

Company Act to help funds counter a period of net redemptions by 

allowing them to use fund assets to pay the expenses associated with the 

distribution of fund shares. Under NASD rules, 12b-1 fees are limited to a 

maximum of 1 percent of a fund’s average net assets per year.14

Although originally envisioned as a temporary measure to be used during 

periods when fund assets were declining, the use of 12b-1 fees has evolved 

to provide investors with flexibility in paying for investment advice and 

purchases of fund shares. Instead of being offered only funds that charge a 

front-end load, investors using broker-dealers to assist them with their 

 14Specifically, NASD rules limits the amount of 12b-1 fees that may be paid to brokerdealers to no more than 0.75 percent of a fund’s average net assets per year. Funds are also 

allowed to include an additional service fee of up to 0.25 percent of average net assets each 

year to compensate sales professionals for providing ongoing services to investors or for 

maintaining their accounts. 

Regulators Have 

Responded to BrokerDealer Compensation 

Issues 

12b-1 Fees Have Increased 

Investor Choice but 

Alternatives Could Provide 

Additional Benefits 
Page 18 GAO-04-533T Mutual Fund Reforms 

purchases can now choose from different classes of fund shares that vary 

by how the broker-dealer is compensated. In addition to shares that 

involve front-end loads with low or no 12b-1 fee—typically called Class A 

shares, investors can also invest in Class B shares that have no front-end 

load but instead charge an annual 1 percent 12b-1 fee paid a certain 

number of years, such as 7 or 8 years, after which the Class B shares 

would convert to Class A shares. Other share classes may have lower 12b1 fees but charge investors a redemption fee—called a back-end load—if 

shares are not held for a certain minimum period. Having classes of shares 

allows investors to choose the share class that is most advantageous 

depending on how long they plan to hold the investment.15

Because 12b-1 fees are used in ways different than originally envisioned, 

SEC is seeking public comment on whether changes to rule 12b-1 are 

necessary. In a proposal issued on February 24, 2004, SEC staff noted that 

modifications might be needed to reflect changes in the manner in which 

funds are marketed and distributed. For example, SEC staff told us that 

rule 12b-1 requires fund boards when annually re-approving a fund’s 12b-1 

plan, to consider a set of factors that likely are not relevant in today’s 

environment. 

In the proposal, SEC also seeks comments on whether alternatives to 12b1 fees would be beneficial. One such alternative would have distributionrelated costs deducted directly from individual customer accounts rather 

than having fund advisers deduct fees from the entire fund’s assets for 

eventual payment to selling broker-dealers. The amount due the brokerdealer could be deducted over time, say once a quarter until the total 

amount is collected.16 According to the SEC proposal, this alternative 

would be beneficial because the amounts charged and their effect on 

shareholder value would be completely transparent to the shareholder 

because the amounts would appear on the shareholder’s account 

 15Concerns over whether broker-dealers are helping investors choose the best type of fund 

shares for their needs have been raised recently. For example, in May 2003, SEC took an 

enforcement action against a major broker dealer that it accused of inappropriately selling 

mutual fund B shares to investors who would have been better off buying another class of 

shares. 

16SEC’s proposal provides an example where a shareholder purchasing $10,000 of fund 

shares with a 5-percent sales load could pay a $500 sales load at the time of purchase, or 

could pay an amount equal to some percentage of the value of his or her account each 

month until the $500 amount was fully paid (plus carrying interest). If the shareholder 

redeemed the shares before the amount was fully paid, the proceeds of the redemption 

would be reduced by the unpaid amount. 
Page 19 GAO-04-533T Mutual Fund Reforms 

statements. According to a fund official and an industry analyst, having 

fund shareholders see the amount of compensation that their broker is 

receiving would increase investor awareness of such costs and could spur 

greater competition among firms over such costs. 

We commend SEC for seeking comments on potentially revising rule 

12b-1. Such fees are now being used in ways SEC did not intend when it 

adopted the rule in 1980. We believe providing alternative means for 

investors to compensate broker-dealers, like the one SEC’s proposal 

describes, would preserve the beneficial flexibility that investors currently 

enjoy while also increasing the transparency of these fees. An approach 

like the one SEC describes would also likely increase competition among 

broker-dealers over these charges, which could lower the costs of 

investing in fund shares further. 

Regulators have also acted to address concerns arising from another 

common mutual fund distribution practice called revenue sharing. 

Revenue sharing occurs when mutual fund advisers make payments out of 

their own revenue to broker-dealers to compensate them for selling that 

adviser’s fund shares. Broker-dealers that have extensive distribution 

networks and large staffs of financial professionals who work directly 

with and make investment recommendations to investors, increasingly 

demand that fund advisers make these payments in addition to the sales 

loads and 12b-1 fees that they earn when their customers purchase fund 

shares. For example, some broker-dealers have narrowed their offerings of 

funds or created preferred lists that include the funds of just six or seven 

fund companies that then become the funds that receive the most 

marketing by these broker-dealers. In order to be selected as one of the 

preferred fund families on these lists, the mutual fund adviser often is 

required to compensate the broker-dealer firms with revenue sharing 

payments. According to an article in one trade journal, revenue sharing 

payments made by major fund companies to broker-dealers may total as 

much as $2 billion per year. According to the officials of a mutual fund 

research organization, about 80 percent of fund companies that partner 

with major broker-dealers make cash revenue sharing payments. 

However, revenue sharing payments may create conflicts of interest 

between broker-dealers and their customers. By receiving compensation 

to emphasize the marketing of particular funds, broker-dealers and their 

sales representatives may have incentives to offer funds for reasons other 

than the needs of the investor. For example, revenue sharing arrangements 

might unduly focus the attention of broker-dealers on particular mutual 

Regulators Respond to 

Revenue Sharing Payment 

Concerns 
Page 20 GAO-04-533T Mutual Fund Reforms 

funds, reducing the number of funds considered as part of an investment 

decision—potentially leading to inferior investment choices and 

potentially reducing fee competition among funds. Finally, concerns have 

been raised that revenue sharing arrangements might conflict with 

securities self-regulatory organization rules requiring that brokers 

recommend purchasing a security only after ensuring that the investment 

is suitable for the investor’s financial situation and risk profile. 

Our June 2003 report recommended that SEC consider requiring that more 

information be provided to investors to evaluate these conflicts of interest; 

SEC and NASD have recently issued proposals to require such disclosure. 

Although broker-dealers are currently required to inform their customers 

about the third-party compensation the firm is receiving, they have 

generally been complying with this requirement by providing their 

customers with the mutual fund’s prospectus, which discloses such 

compensation in general terms. On January 14, 2004, SEC proposed rule 

changes that would require broker-dealers to disclose to investors prior to 

purchasing a mutual fund whether the broker-dealer receives revenue 

sharing payments or portfolio commissions from that fund adviser as well 

as other cost-related information. Similarly, NASD has proposed a change 

to its rules that would require broker-dealers to provide written 

disclosures to a customer when an account is first opened or when mutual 

fund shares are purchased that describe any compensation that they 

receive from fund advisers for providing their funds “shelf space” or 

preference over other funds. SEC is also proposing that broker-dealers be 

required to provide additional specific information about the revenue 

sharing payments they receive in the confirmation documents they provide 

to their customers to acknowledge a purchase. This additional information 

would include the total dollar amount earned from a fund’s adviser and the 

percentage that this amount represented of the total sales by the brokerdealer of that advisers’ fund shares over the 4 most recent quarters. 

We commend SEC and NASD for taking these actions. The disclosures 

being proposed by SEC and NASD are intended to ensure that investors 

have information that they can use to evaluate the potential conflicts their 

broker-dealer may have when recommending particular fund shares to 

investors. However, such disclosures would likely also require improving 

related investor education programs to better ensure that investors 

understand the importance of these new disclosures. 
Page 21 GAO-04-533T Mutual Fund Reforms 

SEC has also taken another action to address a practice that creates 

conflicts of interest between fund shareholders and broker-dealers or fund 

advisers. On February 11, 2004, SEC proposed prohibiting fund advisers 

from using trading commissions as compensation to broker-dealers that 

sell their funds. Such arrangements are called “directed brokerage,” in 

which fund advisers choose broker-dealers to conduct trades in their 

funds’ portfolio securities as an additional way of compensating those 

brokers for selling fund shares. These arrangements represent a hidden 

expense to fund shareholders because brokerage commissions are paid 

out of fund assets, unlike revenue sharing, which is paid out of advisers’ 

revenues. We support this action as a means of better ensuring that fund 

advisers choose broker-dealers based on their ability to effectively execute 

trades and not for other reasons. 

SEC is considering actions to address conflicts of interests created by 

“soft-dollar arrangements” and has taken actions to enhance disclosures 

related to the costs of owning mutual funds, including considering making 

more transparent costs included in brokerage transactions. Although SEC 

has taken some actions, we believe that additional steps could be taken to 

provide further benefits to investors by increasing the transparency of 

certain mutual fund practices and enhancing competition among funds on 

the basis of the fees that are charged to shareholders. 

Soft dollar arrangements allow fund investment advisers to obtain 

research and brokerage services that could potentially benefit fund 

investors but also increase investor costs. When investment advisers buy 

or sell securities for a fund, they may have to pay the broker-dealers that 

execute these trades a commission using fund assets. In return for these 

brokerage commissions, many broker-dealers provide advisers with a 

bundle of services, including trade execution, access to analysts and 

traders, and research products. 

Soft dollar arrangements are the result of regulatory changes in the 1970s. 

Until the mid-1970s, the commissions charged by all brokers were fixed at 

one equal price. To compete for commissions, broker-dealers 

differentiated themselves by offering research-related products and 

services to advisers. In 1975, to increase competition, SEC abolished fixed 

brokerage commission rates. However, investment advisers were 

concerned that they could be held in breach of their fiduciary duty to their 

clients to obtain best execution on trades if they paid anything but the 

lowest commission rate available to obtain research and brokerage 

SEC Has Also Proposed 

Eliminating Another 

Potential Mutual Fund 

Conflict 

Other Areas Requiring 

Continued SEC 

Attention 

Soft Dollar Arrangements 

Provide Benefits, but 

Could Adversely Impact 

Investors 
Page 22 GAO-04-533T Mutual Fund Reforms 

services. In response, Congress created a “safe harbor” under Section 

28(e) of the Securities Exchange Act of 1934 that allowed advisers to pay 

more than the lowest available commission rate for security transactions 

in return for research and brokerage services. Although legislation 

provides a safe harbor for investment advisers to use soft-dollars, SEC is 

responsible for defining what types of products and services are 

considered lawful under the safe harbor. Since 1986, the SEC has 

interpreted Section 28(e) as applying to a broad range of products and 

services, as long as they provide ‘lawful and appropriate assistance to the 

money manager in carrying out investment decision-making 

responsibilities.’ 

Some industry participants argue that the use of soft dollars benefits 

investors in various ways. The research that the fund adviser obtains can 

directly benefit fund investors if the adviser uses it to select securities for 

purchase or sale by the fund. The prevalence of soft dollar arrangements 

also allows specialized, independent research to flourish, thereby 

providing money managers a wider choice of investment ideas. As a result, 

this research could contribute to better fund performance. The 

proliferation of research available as a result of soft dollars might also 

have other benefits. For example, an investment adviser official told us 

that the research on smaller companies helps create a more efficient 

market for securities of those companies, resulting in greater market 

liquidity and lower spreads, which would benefit all investors including 

those in mutual funds. 

Although the research and brokerage services that fund advisers obtain 

through the use of soft dollars could benefit a mutual fund investor, this 

practice also could increase investors’ costs and create potential conflicts 

of interest that could harm fund investors. For example, soft dollars could 

cause investors to pay higher brokerage commissions than they otherwise 

would, because advisers might choose broker-dealers on the basis of soft 

dollar products and services, not trade execution quality. Soft dollar 

arrangements could also encourage advisers to trade more in order to pay 

for more soft dollar products and services. Overtrading would cause 

investors to pay more in brokerage commissions than they otherwise 

would. These arrangements might also tempt advisers to “over-consume” 

research because they would not be paying for it directly. In turn, advisers 

might have less incentive to negotiate lower commissions, resulting in 

investors paying more for trades. 

Regulators also have raised concerns over soft dollar practices. In 1996 

and 1997, SEC examiners conducted an examination sweep into the soft 
Page 23 GAO-04-533T Mutual Fund Reforms 

dollar practices of broker-dealers, investment advisers, and mutual funds. 

In the resulting 1998 inspection report, SEC staff documented instances of 

soft dollars being used for products and services outside the safe harbor, 

as well as inadequate disclosure and bookkeeping of soft dollar 

arrangements. SEC staff told us that their review found that mutual fund 

advisers engaged in far fewer soft dollar abuses than other types of 

advisers. To address the concerns identified, the SEC staff report 

proposed recommending that investment advisers keep better records and 

make greater disclosure about their use of soft dollars. A working group 

formed in 1997 by the Department of Labor (DOL) to study the need for 

regulatory changes and additional disclosures to pension plan sponsors 

and fiduciaries on soft dollar arrangements recommended that SEC act to 

narrow the definition of products and services that are considered 

research and allowable under the safe harbor.17 The working group also 

recommended that SEC prepare a specific list of acceptable purchases 

with soft dollars that included brokerage and research services. 

Although SEC has acknowledged the concerns involved with soft-dollar 

arrangements, it has taken limited actions to date. SEC staff told us that 

the press of other business prevented them from addressing the issues 

raised by other regulators and their own 1998 staff report. However, in a 

December 2003 concept release on portfolio transaction costs staff 

requested comments on what types of information investment advisers 

should be required to provide to mutual fund boards regarding the 

allocation of brokerage commissions for execution purposes and soft 

dollar benefits.18 In addition, SEC staff told us that they have formed a 

study group with representatives of the relevant SEC divisions, including 

Investment Management, Market Regulation, and the Office of Compliance 

Inspections and Examinations, to review soft dollar issues. This group also 

is collecting information from industry and foreign regulators. 

Regulators in other countries and other industries have acted to address 

the conflicts created by soft dollars. In the United Kingdom, the Financial 

Services Authority (FSA), which regulates the financial services industry 

 17U.S. Department of Labor, Report of the Working Group on Soft Dollars/Commission 

Recapture (Nov. 13, 1997) available at http://www.dol.gov/ebsa/publications/softdolr.htm. 

DOL oversees pension plans. 

18SEC’s concept release “Measures to Improve Disclosure of Mutual Fund Transaction 

Costs” specifically requests comments on ways to improve the qualification and disclosure 

of commission costs as well as other transaction related costs. 

Additional Actions to Address 

Conflicts Raised by Soft Dollars 

Could be Beneficial 
Page 24 GAO-04-533T Mutual Fund Reforms 

in that country, has issued a consultation paper that argues that these 

arrangements create incentives for advisers to route trades to brokerdealers on the basis of soft dollar arrangements and that these practices 

represented an unacceptable market distortion.19 As a result of 

recommendations from a government-commissioned review of 

institutional investment, FSA has proposed banning soft dollars for market 

pricing and information services, as well as various other products.20 FSA 

notes that their proposal would limit the ability of fund managers to pass 

management costs through their customers’ funds in the form of 

commissions and would provide more incentive to consider what services 

are necessary for efficient funds management, both of which could lower 

investor costs. However, FSA staff has acknowledged that restricting soft 

dollar arrangements in the United Kingdom could hurt the international 

competitiveness of their fund industry because fund advisers outside their 

country would not have to comply with these restrictions. 

In addition, DOL has placed more restrictions on pension plan 

administrators use of soft dollars than apply to mutual fund advisers. SEC 

requires mutual fund boards of directors to review fund trading activities 

to ensure that the adviser is obtaining best execution and to monitor any 

conflicts of interest involving soft dollars. However, section 28(e) allows 

fund advisers to use soft dollars generated by trading in one fund’s 

portfolio to obtain research that does not benefit that particular fund but 

instead benefits other funds managed by that adviser. In contrast, DOL 

requires plan fiduciaries to monitor the plan’s investment managers to 

ensure that the soft dollar research obtained from trading commissions 

paid out of plan assets benefits the plan and that the benefits to the plan 

are reasonable in relation to the value of the brokerage and research 

services provided to the plan. 

Some industry participants have also called on SEC to restrict soft dollar 

usage. For example, the board of the Investment Company Institute (ICI), 

which is the industry association for mutual funds, recently recommended 

that SEC consider narrowing the definition of allowable research under 

Section 28(e) and eliminate the purchase of third-party research with softdollars. According to statements released by ICI, SEC’s definition of 

permitted research is overly expansive and has been susceptible to abuse. 

 19Financial Services Authority, Bundled Brokerage and Soft Commission Arrangements

(April 2003). 

20P. Myners, Institutional Investment in the United Kingdom: A Review (Mar. 6, 2001).
Page 25 GAO-04-533T Mutual Fund Reforms 

ICI recommends that SEC prohibit advisers from using soft dollars to 

obtain any products and services that are otherwise publicly available in 

the marketplace, such as periodical subscriptions or electronic news 

services. In a letter to the SEC Chairman, ICI wrote that its proposal would 

reduce incentives for investment advisers to engage in unnecessary 

trading and would more closely reflect the original purpose of Section 

28(e), which was to allow investment advisers to take into account a 

broker-dealer’s research capabilities in addition to its ability to provide 

best execution. 

Beyond these proposals, some industry participants have called for a 

complete ban of soft dollars. If soft dollars were banned—which would 

require repeal of Section 28(e)—and bundled commission rates were 

required to be separately itemized, fund advisers would not be allowed to 

pay higher commissions in exchange for research. Advocates of banning 

soft dollars believe that this would spur broker-dealers to compete on the 

price of executing trades, which averages between $.05 and $.06 per share 

at large broker-dealers, whereas trades conducted through other venues 

can be done for $.01 or less. Critics fear that this ban would reduce the 

amount of independent research that advisers obtain, which would hurt 

investors and threaten the viability of some existing independent research 

firms. 

To address concerns over soft dollars, our June 2003 report recommends 

that SEC evaluate ways to provide additional information to fund directors 

and investors on their fund advisers’ use of soft dollars. Because SEC has 

not acted to more fully address soft dollar-related concerns, investors and 

mutual fund directors have less complete and transparent information 

with which to evaluate the benefits and potential disadvantages of fund 

advisers’ use of soft dollars. However, such disclosures could potentially 

increase the complexity of the information that investors are provided and 

require them to interpret and understand such information. As such, an 

enhanced investor education campaign would also likely be warranted. 

Although disclosure can improve transparency, it may not be sufficient for 

creating proper incentives and accountability. In our view, the time for 

SEC to take bolder actions regarding soft dollars is now. Allowing the 

advisers of mutual funds to use customer assets to obtain services that 

would otherwise have to be paid for using advisers’ revenues appears to 

create inappropriate incentives, and inadequate transparency and 

accountability. 
Page 26 GAO-04-533T Mutual Fund Reforms 

We commend SEC for initiating an internal study of soft dollar issues. As 

part of this evaluation, we believe that SEC should consider at a minimum 

the merits of narrowing the services that are considered acceptable under 

the safe harbor. Concerns that SEC’s current definition of permitted 

research is overly expansive and susceptible to abuse have been 

recognized for years. Acting to narrow the safe harbor could reduce 

opportunities for abusive practices. It could also lower investor costs by 

reducing adviser incentives to overtrade portfolio assets to obtain soft 

dollar research and services. We also believe that SEC’s study should 

consider the relative merits of eliminating soft dollar arrangements 

altogether. The elimination of soft dollars, which would require legislative 

action, could create greater incentives for broker-dealers to compete on 

the basis of execution cost and greater incentives for fund advisers to 

weigh the necessity of some of the research they now receive since they 

would have to pay for such items from their own revenues. 

SEC recently adopted rules and rule amendments aimed at increasing 

investor awareness by improving the disclosures of the fees and expenses 

paid for investing in mutual funds. In February 2004, SEC adopted rule 

amendments that require mutual funds to make additional disclosures 

about their expenses.21 This information will be presented to investors in 

the annual and semiannual reports prepared by mutual funds. Among 

other things, mutual funds will now be required to disclose the cost in 

dollars associated with an investment of $1,000 that earned the fund’s 

actual return and incurred the fund’s actual expenses paid during the 

period. In addition to allowing existing investors to compare fees across 

funds, SEC staff indicated that placing these disclosures in funds’ annual 

and semiannual reports will help prospective investors to compare funds’ 

expenses before making a purchase decision. 

In addition to this action, SEC amended fund advertising rules in 

September 2003 to require funds to state in advertisements that investors 

should consider a fund’s fees before investing and direct investors to 

consult the fund prospectus for more information.22 Additionally, in 

 21Securities and Exchange Commission, Final Rule: Shareholder Reports and Quarterly 

Portfolio Disclosure of Registered Management Investment Companies, Release Nos. 33-

8393; 34-49333; IC-26372 (Feb. 27, 2004). 

22Securities and Exchange Commission, Final Rule: Amendments to Investment Company 

Advertising Rules, Release Nos. 33-8294; 34-48558; IC-26195 (Sep. 29, 2003). 

New and Proposed Rules 

Could Provide Added 

Transparency of the Costs 

of Investing in Mutual 

Funds 
Page 27 GAO-04-533T Mutual Fund Reforms 

November 2003, NASD proposed amending rules to require that mutual 

funds advertising their performance present specific information about the 

fund’s expenses and performance in a more prominent format. These new 

requirements are aimed at improving investor awareness of the costs of 

buying and owning a mutual fund, facilitating comparison of fees among 

funds, and make presentation of standardized performance information 

more prominent. Specifically, NASD’s proposal would require that all 

performance advertising contain a text box that sets forth the fund’s 

standardized performance information, maximum sales charge, and annual 

expense ratio. In doing so NASD’s proposal would go beyond SEC 

requirements by requiring funds to include specific performance and 

expense information within advertising materials. 

Another cost-related rulemaking initiative by SEC staff seeks to improve 

the disclosure of breakpoint discounts for front-end sales loads. In March 

2003, SEC, NASD, and the New York Stock Exchange issued a report 

describing the failure of some broker-dealers to issue discounts on frontend charges paid to them by mutual fund investors. Mutual funds with 

front-end sales loads often offer investors discounts or “breakpoints” in 

these sales loads as the dollar value of the shares purchased by investors 

or members of their family increases, such as for purchases of $50,000 or 

more. To better ensure that investors receive these discounts when 

deserved, SEC is proposing to require funds to disclose in their 

prospectuses when shareholders are eligible for breakpoint discounts. 

According to the SEC proposal, such amendments are intended to provide 

greater prominence to breakpoint disclosure by requiring its inclusion in 

the prospectus rather than in the Statement of Additional Information, 

which is a document delivered to investors only upon request. 

However, these actions would not require mutual funds to disclose to each 

investor the specific amount of fees in dollars that are paid on the shares 

they own. As result, investors will not receive information on the costs of 

mutual fund investing in the same way they see the costs of many other 

financial products and services that they may use. In addition, these 

actions do not require that mutual funds provide information relating to 

fees in the document that is most relevant to investors—the quarterly 

account statement. In a 1997 survey of how investors obtain information 

about their funds, ICI indicated that, to shareholders, the account 

statement is probably the most important communication that they receive 

from a mutual fund company and that nearly all shareholders use such 

statements to monitor their mutual funds. 
Page 28 GAO-04-533T Mutual Fund Reforms 

Our June 2003 report recommends that SEC consider requiring mutual 

funds to make additional disclosures to investors, including considering 

requiring funds to specifically disclose fees in dollars to each investor in 

quarterly account statements. SEC has agreed to consider requiring such 

disclosures but was unsure that the benefits of implementing specific 

dollar disclosures outweighed the costs to produce such disclosures. 

However, we estimate that spreading these implementation costs across 

all investor accounts might not represent a large outlay on a per-investor 

basis. 

Our report also discusses less costly alternatives that could also prove 

beneficial to investors and spur increased competition among mutual 

funds on the basis of fees. For example, one less costly alternative would 

require quarterly statements to present the same information—the dollar 

amount of a fund’s fees based on a set investment amount—recently 

required for mutual fund semiannual reports. Doing so would place this 

additional fee disclosure in the document generally considered to be of the 

most interest to investors. An even less costly alternative would be to 

require that quarterly statements also include a notice that reminds 

investors that they pay fees and to check their prospectus and ask their 

financial adviser for more information. Disclosures such as these could be 

the incentive that some investors need to take action to compare their 

fund’s expenses to those of other funds and thus make more informed 

investment decisions. Such disclosures may also increasingly motivate 

fund companies to respond competitively by lowering fees. 

This concludes my prepared statement and I would be happy to respond to 

any questions at the appropriate time. 

For further information regarding this testimony, please contact Richard J. 

Hillman or Cody J. Goebel at (202) 512-8678. Individuals making key 

contributions to this testimony include Toayoa Aldridge, Barbara 

Roesmann, George Scott, and David Tarosky. 

Contacts and 

Acknowledgements 

(250187) 
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