a

GAO

United States General Accounting Office

Report to Congressional Requesters

June 2003 MUTUAL FUNDS

Greater Transparency 

Needed in Disclosures 

to Investors

GAO-03-763
Although mutual funds disclose considerable information about their 

costs to investors, the amount of fees and expenses that each investor 

specifically pays on their mutual fund shares are currently disclosed as 

percentages of fund assets, whereas most other financial services 

disclose the actual costs to the purchaser in dollar terms. SEC staff has 

proposed requiring funds to disclose additional information that could be 

used to compare fees across funds. However, other disclosures could 

also increase the transparency of these fees, such as by providing 

existing investors with the specific dollar amounts of the expenses paid 

or by placing fee-related disclosures in the quarterly account statements 

that investors receive. Although some of these additional disclosures 

could be costly and data on their benefits to investors was not generally 

available, less costly alternatives exist that could increase the 

transparency and investor awareness of mutual funds fees that make 

consideration of additional fee disclosures worthwhile. 

Changes in how mutual funds pay intermediaries to sell fund shares have 

benefited investors but have also raised concerns. Since 1980, mutual 

funds, under SEC Rule 12b-1 have been allowed to use fund assets to pay 

for certain marketing expenses. Since then, funds have developed ways 

to apply Rule 12b-1 fees to provide investors greater flexibility in 

choosing how to pay for the services of individual financial professionals 

that advise them on fund purchases. Another increasingly common 

marketing practice called revenue sharing involves fund investment 

advisers making additional payments to the broker-dealers that distribute 

their funds’ shares. However, receiving these payments can limit fund 

choices offered to investors and conflict with the broker-dealer’s 

obligation to recommend the most suitable funds. Regulators 

acknowledged that the current disclosure regulations might not always 

result in complete information about these payments being disclosed to 

investors. 

Under soft dollar arrangements, mutual fund investment advisers use 

part of the brokerage commissions they pay to broker-dealers for 

executing trades to obtain research and other services. Although 

industry participants said that soft dollars allow fund advisers access to a 

wider range of research than may otherwise be available and provide 

other benefits, these arrangements also can create incentives for 

investment advisers to trade excessively to obtain more soft dollar 

services, thereby increasing fund shareholders’ costs. SEC staff has 

recommended various changes that would increase transparency by 

expanding advisers’ disclosure of their use of soft dollars. By acting on 

the staff’s recommendations SEC would provide fund investors and 

directors with needed information about how their funds’ advisers are 

using soft dollars. 

The fees and other costs that 

investors pay as part of owning 

mutual fund shares can 

significantly affect their investment

returns. As a result, questions have 

been raised as to whether the 

disclosures of mutual fund fees and 

other practices are sufficiently 

transparent. GAO reviewed (1) 

how mutual funds disclose their 

fees and related trading costs and 

options for improving these 

disclosures, (2) changes in how 

mutual funds pay for the sale of 

fund shares and how the changes in 

these practices are affecting 

investors, and (3) the benefits of 

and the concerns over mutual 

funds’ use of soft dollars. 

GAO recommends that SEC 

consider the benefits of requiring 

additional disclosure relating to 

mutual fund fees and evaluate ways 

to provide more information that 

investors could use to evaluate the 

conflicts of interest arising from 

payments funds make to brokerdealers and fund advisers’ use of 

soft dollars. SEC agreed with the 

contents of this report and 

indicated that it will consider the 

recommendations in this report 

carefully in determining how best 

to inform investors about the 

importance of fees. It also 

indicated that it will be considering 

ways to expand disclosure and 

improve other regulatory aspects of

fund distribution and soft dollar 

practices. 

www.gao.gov/cgi-bin/getrpt?GAO-03-763.

To view the full report, including the scope 

and methodology, click on the link above. 

For more information, contact Richard Hillman 

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

Highlights of GAO-03-763, a report to the 

Chairman, House Committee on Financial 

Services and Chairman, Subcommittee on 

Capital Markets, Insurance and 

Government Sponsored Enterprises, 

House Committee on Financial Services 

June 2003

MUTUAL FUNDS 

Greater Transparency Needed in 

Disclosures to Investors 
Page i GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Contents

Letter 1

Results in Brief 2

Background 6

Additional Disclosure of Mutual Fund Costs May Benefit 

Investors 8

Independent Directors Play a Critical Role in Protecting Mutual 

Fund Investors 20

Changes in Mutual Fund Distribution Practices Have Increased 

Choices for Investors, but Have Raised Potential Concerns 29

Soft Dollar Arrangements Provide Benefits, but Could Also Have an 

Adverse Impact on Investors 42

Conclusions 54

Recommendations 56

Agency Comments and Our Evaluation 57

Appendixes

Appendix I: Scope and Methodology 60

Appendix II: Comments from the Securities and Exchange Commission 61

Appendix III: Comments from the Investment Company Institute 64

Appendix IV: GAO Contacts and Staff Acknowledgments 67

GAO Contacts 67

Acknowledgments 67

Tables Table 1: Fee Disclosure Practices for Selected Financial Services or 

Products 10

Table 2: Current and Proposed NYSE and NASDAQ Corporate 

Governance Listing Standards Compared to those 

Currently Required or Recommended for Mutual Fund 

Boards 28

Figure Figure 1: Factors Fund Directors Are to Consider in Voting to 

Approve or Continue 12b-1 Plans 31
Contents

Page ii GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Abbreviations

ECN electronic communications network

FSA Financial Services Authority

ICI Investment Company Institute

NAV net asset value

NYSE New York Stock Exchange

SAI Statement of Additional Information

SEC Securities and Exchange Commission

SRO self-regulatory organization

This is a work of the U.S. Government and is not subject to copyright protection in the 

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Permission from the copyright holder may be necessary should you wish to reproduce 

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Page 1 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

United States General Accounting Office

Washington, D.C. 20548

A

June 9, 2003 Lret

The Honorable Michael G. Oxley

Chairman, Committee on Financial Services

House of Representatives

The Honorable Richard H. Baker

Chairman, Subcommittee on Capital Markets,

 Insurance, and Government Sponsored Enterprises

Committee on Financial Services

House of Representatives

Millions of U.S. households have invested in mutual funds with assets 

exceeding $6 trillion by year-end 2002. The fees and other costs that these 

investors pay as part of owning mutual fund shares can significantly affect 

their investment returns. As a result, questions have been raised as to 

whether the disclosures of mutual fund fees and others costs, including the 

trading costs that mutual funds incur when they buy or sell securities, are 

sufficiently transparent. Some have also questioned the effectiveness of 

mutual fund boards of directors in protecting shareholder interests and 

overseeing the fees funds pay to investment advisers. Many mutual funds 

market their shares to investors through broker-dealers or other financial 

professionals, such as financial planners. However, concerns have been 

raised over how the payments that fund advisers make to the entities that 

sell fund shares affect investors. When mutual fund investment advisers 

use broker-dealers to buy or sell securities for the fund, they generally pay 

these broker-dealers a commission for executing the trade. Under 

arrangements known as soft dollars, part of these brokerage commissions 

may pay for research and brokerage services that the executing brokerdealer or third parties provide to the fund’s investment adviser. Because 

the amount of brokerage commissions a fund adviser pays directly reduces 

the ultimate return earned by investors in its funds, questions exist over the 

extent to which investors benefit from or are harmed by these soft dollar 

arrangements. 

To address these concerns, this report responds to your January 14, 2003, 

request that we review issues relating to the transparency and 

appropriateness of certain fees and practices among mutual funds. 

Specifically, our objectives were to review (1) how mutual funds and their 

advisers disclose their fees and related trading costs and options for 

improving these disclosures, (2) mutual fund directors' role in overseeing 

fees and various proposals for improving their effectiveness, (3) changes in 
Page 2 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

how mutual funds and their advisers pay for the sale of fund shares and 

how the changes in these practices are affecting investors, and (4) the 

benefits of and the concerns over mutual funds' use of soft dollars and 

options for addressing these concerns.

To determine how mutual funds currently disclose their fees and other 

costs, we reviewed regulatory requirements and disclosures made by a 

selection of mutual funds. We discussed various proposals to increase 

disclosure with staff from regulators that oversee mutual funds, including 

the Securities and Exchange Commission (SEC) and NASD, and staff from 

mutual fund companies, industry groups and researchers. We also 

interviewed officials of 10 mutual fund companies that sell their funds 

through broker-dealers and a judgmental sample of 15 certified financial 

planners. To identify the activities that mutual fund directors perform, we 

reviewed federal laws and regulations, interviewed staff from an 

association representing independent directors and used a structured 

questionnaire to interview a judgmental sample of six independent director 

members of this association. To determine how mutual funds and their 

advisers pay for distribution, we interviewed various regulatory staff, 

industry associations and researchers, fund companies, and two brokerdealers that sell fund shares. We also reviewed and analyzed various 

documents and studies of mutual fund distribution practices. To describe 

the benefits and potential conflicts of interest raised by mutual funds’ use 

of soft dollars, we spoke with SEC, NASD, and regulators in the United 

Kingdom and reviewed studies by regulators and industry experts on soft 

dollar arrangements. We conducted our work in accordance with generally 

accepted government auditing standards in Boston, MA; Kansas City, MO; 

Los Angeles and San Francisco, CA; New York, NY; and Washington, DC 

from February to June 2003. Our scope and methodology is described in 

detail in appendix I.

Results in Brief Although mutual funds already disclose considerable information about the 

fees they charge, regulators and others have proposed additional 

disclosures that could increase the transparency and investor awareness of 

the costs of investing in mutual funds. Currently, mutual funds disclose 

information about the fees and expenses that each investor specifically 

pays on their mutual fund shares as percentages of fund assets, whereas 

most other financial services disclose the actual costs to the purchaser in 

dollar terms. Mutual funds also incur brokerage commissions and other 

trading costs when they buy or sell securities, but these costs are not 

prominently disclosed to investors. To provide more information about the 
Page 3 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

fees investors pay, SEC has proposed requiring mutual funds to disclose 

additional fee-related information, but these would not provide investors 

with the specific dollar amount of fees paid on their shares as others have 

proposed, nor would these disclosures be provided in the document 

generally considered to be of the most interest to investors—the quarterly 

statement that shows the number and value of an investor’s mutual fund 

shares. Although continuing to consider the need for additional 

disclosures, SEC staff and industry participants noted that data on the 

extent to which additional fee information would benefit investors is 

generally lacking. However, continued consideration of the costs and 

benefits of providing additional disclosure appears worthwhile because 

some alternatives for providing fee information to mutual fund investors in 

quarterly statement could provide some benefit and may cost very little. 

Some industry participants have also called for more disclosure of 

information about the brokerage commissions and other costs that mutual 

funds incur when trading, but standard methodologies for determining 

some of these amounts do not exist and regulators and others raised 

concerns that such disclosures could be misleading. 

Mutual funds also have boards of directors that are tasked with reviewing 

the fees that fund investors are charged, but some industry participants 

questioned whether directors have been effective in overseeing these fees. 

In general, SEC rules require mutual fund boards to have a majority of 

independent directors, who are individuals not employed by or affiliated 

with the fund’s investment adviser. Among their many duties, these 

directors are specifically tasked with overseeing the fees their funds 

charge. However, some industry observers say that the process that fund 

directors are required to follow under the law fails to produce sufficient 

actions to minimize fees. To further reduce fees, some have suggested that 

fund directors should be required to seek competitive bids from other 

investment advisers. However, industry participants indicated that this 

may not result in lower costs and fees for investors and noted that directors 

seek to lower fund fees in other ways, such as by requiring the investment 

adviser to charge progressively lower fees as the assets of the fund grow. 

Regulators and industry bodies have also recommended various changes to 

the composition and structure of mutual fund boards as a means of 

increasing directors’ effectiveness that many funds have already adopted. 

Many reforms being proposed as a result of the recent corporate scandals, 

such as Enron, also seek to enhance board of director oversight of public 

companies. Such reforms could serve to further improve corporate 

governance of mutual funds, but industry participants report that, although 
Page 4 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

not all of these proposed practices are currently required for mutual funds, 

most fund boards are already following many of them. 

Changes in the ways that investors pay for mutual fund shares have 

produced benefits for investors but also raise concerns over their 

transparency. In 1980, an SEC rule was adopted to allow mutual funds to 

begin using fund assets to pay the distribution expenses, which included 

marketing expenses and compensation for the financial professionals who 

sell fund shares. Although rule 12b-1 was originally envisioned as 

providing funds a temporary means of increasing fund assets, the fees 

charged under this rule have instead evolved into an alternative way for 

investors to pay for the services of broker-dealers and other financial 

intermediaries from whom they purchase fund shares. Concerns exist over 

whether funds with 12b-1 fees are more costly to investors and whether 

current disclosures are sufficiently transparent to allow investors to 

determine the extent to which their particular broker-dealer representative 

or other financial professionals they use receive these payments. In a 

December 2000 report, SEC staff recommended that rule 12b-1 be modified 

to reflect changes in how funds are being marketed, but SEC has yet to 

develop a proposal to amend the requirements relating to this rule. 

Another distribution practice—called revenue sharing—that has become 

increasingly common involves investment advisers making additional 

payments to broker-dealers that distribute fund shares. Although little data 

on the extent of these payments exists, industry researchers say that such 

payments have been increasing and have raised concerns about how these 

payments may affect the overall expenses charged to fund investors. 

Concerns also exist over whether broker-dealers receiving payments to 

promote certain funds creates a conflict of interest for their sales 

representatives, who are responsible for recommending only investments 

that are suitable to their clients’ objectives and financial situation, or 

whether this also limits the choices that investors are offered. Under 

current disclosure requirements, an investor might not be explicitly told 

that the adviser of the fund their broker-dealer is recommending made 

payments to that broker-dealer, and some industry participants have called 

for additional disclosures to address these potential conflicts.

Soft dollar arrangements allow investment advisers of mutual funds to use 

part of the brokerage commissions paid to broker-dealers that execute 

trades on the fund’s behalf to obtain research and brokerage services that 

can potentially benefit fund investors but could increase the costs borne by 

their funds. Industry participants said that soft dollars allow fund advisers 

access to a wider range of research than may otherwise be available and 
Page 5 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

can also be used to reduce fund expenses. However, others were 

concerned that these arrangements can create conflicts of interest between 

investment advisers and investors that could increase investors’ costs. For 

example, fund advisers might use some broker-dealers solely because of 

the soft dollar services they offer rather than because of their ability to 

execute the fund’s trades in the most advantageous way. Concerns were 

raised that investment advisers might trade excessively to obtain additional 

services using soft dollars, which would increase fund investors’ costs. In a 

series of regulatory examinations performed in 1998, SEC staff found 

examples of problems relating to investment advisers’ use of soft dollars, 

although far fewer problems were attributable to the advisers for mutual 

funds. In response, the SEC staff issued a report that included various 

proposals to address the potential conflicts created by these arrangements, 

including recommending that investment advisers keep better records and 

disclose more information about their use of soft dollars. Although this 

could increase the transparency of these arrangements and help fund 

directors and investors better evaluate their fund advisers’ use of soft 

dollars, SEC has yet to take action on these proposed recommendations. 

This report contains recommendations to SEC designed to increase the 

transparency of mutual fund fees and of certain distribution and trading 

practices. Since both the extensiveness and the placement of mutual fund 

disclosures can affect their transparency and how effectively they increase 

investor awareness of the costs of investing in mutual funds, we 

recommend that SEC consider the benefits of additional disclosure relating 

to mutual fund fees, including requiring the account statements that mutual 

fund investors receive provide more information about the fees being paid. 

We also recommend that SEC consider developing disclosure requirements 

about revenue sharing arrangements so investors may be better able to 

evaluate potential conflicts arising from revenue sharing payments. 

Finally, we also recommend that SEC evaluate ways to provide more 

information that fund investors and directors could use to better evaluate 

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

dollars, including considering and implementing the recommendations 

from its 1998 soft dollar examinations report. 

We obtained comments from SEC and ICI, who generally agreed with the 

contents of this report. The letter from the SEC staff indicated that as part 

of their responsibilities in regulating mutual funds, they will consider the 

recommendations in this report very carefully in determining how best to 

inform investors about the importance of fees. The letter from the ICI staff 

noted that our report presented a generally balanced and well-informed 
Page 6 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

discussion of mutual fund regulatory requirements. However, the ICI staff 

were concerned over how we compare the disclosures made by mutual 

fund fees to those made by other financial products, and noted that mutual 

fund fee disclosures, which in some ways exceed the information disclosed 

by other products, allow individuals to make much more informed and 

accurate decisions about the costs of their funds than do the disclosures 

made by other financial service firms. We agree with ICI that mutual funds 

are required to make considerable disclosures that are useful to investors 

for comparing the level of fees across funds. However, we also believe that 

supplementing the existing mutual fund disclosures with additional 

information, particularly in the account statements that provide investors 

with the exact number and value of their mutual fund shares, could also 

prove beneficial for increasing awareness of fees and prompting additional 

fee-based competition among funds. 

Background Mutual funds are distinct legal entities owned by the shareholders of the 

fund. Each fund contracts separately with an investment adviser, who 

provides portfolio selection and administrative services to the fund. The 

costs of operating a mutual fund are accrued daily and periodically 

deducted from the fund’s assets. These costs include the fee paid to the 

fund’s investment adviser for managing the fund and the expenses 

associated with operating the fund, such as the costs for accounting and 

preparing fund documents. Each mutual fund has a board of directors, 

which is responsible for reviewing fund operations and overseeing the 

interests of the fund’s shareholders, including monitoring for conflicts of 

interest between the fund and its adviser.1

1

Although the Investment Company Act of 1940, which regulates mutual fund operations, 

does not dictate a specific form of organization for mutual funds, most funds are organized 

either as corporations governed by a board of directors or as business trusts governed by 

trustees. When establishing requirements relating to the officials overseeing a fund, the act 

uses the term “directors” to refer to such persons, and this report will also follow that 

convention.
Page 7 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

The incredible growth of mutual fund assets and in the number of investors 

that hold funds has raised concerns within Congress and elsewhere over 

the fees funds charge investors. In a report issued in June 2000, we found 

that the average fees charged by 77 of the largest stock and bond mutual 

funds had declined between 1990 and 1998.2 In our report, we also 

concluded that although many mutual funds exist that compete for investor 

dollars, they conduct this competition primarily on the basis of their 

performance rather than on the basis of the price of their service, that is, 

the fees they charge. In updating the results of the analysis from our June 

2000 report for a hearing on mutual funds in March 2003, we found that the 

average fees for this group of funds had increased slightly, due in part to 

some funds paying higher management fees to their investment advisers 

because of the effect of performance fees.3

Mutual funds are sold through a variety of distribution channels. For 

instance, investors can buy them directly by telephone or mail or they can 

be sold by a sales staff employed by the adviser or by third parties, such as 

broker-dealer account representatives. To compensate financial 

professionals not affiliated with the adviser for distributing or selling a 

fund’s shares, funds may levy a sales charge which is based on a percentage 

of the amount being invested—called a load—that the investor can either 

pay at the time the investment is made (a front-end load) or later when 

selling or redeeming the fund shares (a back-end load).4

 Many funds that 

use broker-dealers or other financial professionals to sell their fund shares 

may also charge investors ongoing fees, called 12b-1 fees that are used by 

funds to pay these distributors for recommending the fund or for servicing 

the investor’s account after purchases have been made. Mutual fund shares 

are also available for investors to purchase through mutual fund 

supermarkets. These are offered by broker-dealers, including those 

affiliated with a fund adviser, that allow their customers to purchase and 

redeem the shares of mutual funds from a wide range of fund companies 

through their accounts at the broker-dealer operating the supermarket.

2

U.S. General Accounting Office, Mutual Fund Fees: Additional Disclosure Could 

Encourage Price Competition, GAO/GGD-00-126 (Washington, D.C.: June 7, 2000).

3

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).

4

Some funds charge what is known as a contingent deferred sales load, which is a charge 

that is a percent of the amount invested that declines the longer the investment is held and 

usually becomes zero after a certain period.
Page 8 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

SEC is the federal regulatory agency with responsibility for overseeing the 

U.S. securities markets and protecting investors. Various self-regulatory 

organizations (SRO) also oversee the activities of securities industry 

participants. NASD is the SRO with primary responsibility for overseeing 

broker-dealers. SEC is responsible for oversight of the SROs and it also 

oversees and regulates the investment management industry. 

Additional Disclosure 

of Mutual Fund Costs 

May Benefit Investors 

Various alternatives with different advantages and disadvantages exist that 

could increase the amount of information that investors are provided about 

mutual fund fees and other costs. Currently, mutual funds disclose 

information about their fees as percentages of their assets whereas most 

other financial services disclose their costs in dollar terms. SEC and others 

have proposed various alternatives to disclose more information about 

mutual fund fees, but industry participants noted these alternatives could 

also involve costs to implement and data on the benefits associated with 

additional disclosures is not generally available. Mutual funds also incur 

brokerage commissions and other costs when they buy or sell securities 

and currently these costs are not routinely or explicitly disclosed to 

investors and there have been increasing calls for disclosure as well as 

debate on the benefits and costs of added transparency. 

Unlike Other Financial 

Products, Mutual Funds Do 

Not Disclose the Actual 

Dollar Amount of Fees Paid 

by Individual Investors 

Mutual funds provide various disclosures to their shareholders about fees. 

Presently, all funds must provide investors with disclosures about the fund 

in a written prospectus that must be provided to investors when they first 

purchase shares. SEC rules require that the prospectus include a fee table 

containing information about the sales charges, operating expenses, and 

other fees that investors pay as part of investing in the fund. Specifically, 

the table that mutual funds must provide presents (1) charges paid directly 

by shareholders out of their investment such as front or back-end sales 

loads and (2) recurring charges deducted from fund assets such as 

management fees, distribution fees, and other expenses charged to 

shareholder accounts. The fees deducted from the fund’s assets on an 

ongoing basis are reported to investors as a percentage of fund assets and 

are called the fund’s operating expense ratio. The fee table also contains a 

hypothetical example that shows the estimated dollar amount of expenses 

that an investor could expect to pay on a $10,000 investment if the investor 

received a 5-percent annual return and remained in the fund for 1, 3, 5, and 

10 years. The examples do not reflect costs incurred as a result of the 
Page 9 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

fund’s trading activity, including brokerage commissions that funds pay to 

broker-dealers when they trade securities on a fund’s behalf. 

Unlike many other financial products, mutual funds do not provide the 

exact dollar amounts of fees that individual investors pay while they hold 

the investment. Although mutual funds provide information about their 

fees in percentage terms and in dollar terms using hypothetical examples, 

they do not provide investors with information about the specific dollar 

amounts of the fees that have been deducted from the value of their shares. 

In contrast, most other financial products and services do provide specific 

dollar disclosures. For example, when a borrower obtains a mortgage loan 

the lender is required to provide a uniform mortgage costs disclosure 

statement. This disclosure must show both the interest rate in percentage 

terms that the borrow will be charged for the loan and also the costs of the 

loan in dollar terms. Under the law, the lender must provide a truth in 

lending statement, which shows the dollar amount of any finance charges, 

the dollar amount being financed, and the total dollar amount of all 

principal and interest payments that the borrower will make under the 

terms of the loan.5

 As shown in table 1, investors in other financial 

products or users of other financial services also generally receive 

information that discloses the specific dollar amounts for fees or other 

charges they pay.

5

The Real Estate Settlement Procedures Act, 12 U.S.C. § 2601-17.
Page 10 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Table 1: Fee Disclosure Practices for Selected Financial Services or Products

Source: GAO analysis of applicable disclosure regulations, rules, and industry practices.

a

In a wrap account, a customer receives investment advisory and brokerage execution services from a 

broker-dealer or other financial intermediary for a “wrapped” fee that is not based on transactions in 

the customer’s account.

Although mutual funds are not required to disclose specific dollar amounts 

of fees paid by individual investors, the amount of information that they do 

provide does exceed that provided by some investment products. For 

example, fixed-rate annuities or deposit accounts that provide investors a 

guaranteed return on their principal at a fixed rate do not specifically 

disclose to the purchasers of these products the provider’s operating 

expenses. The financial institutions offering these products generate their 

profits on these products by attempting to invest their customers’ funds in 

other investment vehicles earning higher rates of return than they are 

obligated to pay to the purchasers of the annuities. However, the returns 

Type of product or service Disclosure requirement

Mutual funds Mutual funds show the operating expenses as 

percentages of fund assets and dollar amounts for 

hypothetical investment amounts based on estimated 

future expenses in the prospectus. 

Deposit accounts Depository institutions are required to disclose itemized 

fees, in dollar amounts, on periodic statements.

Bank trust services Although covered by varying state laws, regulatory and 

association officials for banks indicated that trust service 

charges are generally shown as specific dollar amounts.

Investment services provided 

to individual investment 

accounts (such as those 

managed by a financial 

planner) 

When the provider has the right to deduct fees and other 

charges directly from the investor’s account, the dollar 

amounts of such charges are required to be disclosed to 

the investor.

Wrap accountsa Provider is required to disclose dollar amount of fees on 

investors’ statements.

Stock purchases Broker-dealers are required to report specific dollar 

amounts charged as commissions to investors.

Mortgage financing Mortgage lenders are required to provide at time of 

settlement a statement containing information on the 

annual percentage rate paid on the outstanding balance, 

and the total dollar amount of any finance charges, the 

amount financed, and the total of all payments required.

Credit cards Lenders are required to disclose the annual percentage 

rate paid for purchases and cash advances, and the dollar 

amounts of these charges appear on cardholder 

statements.
Page 11 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

they earn on customer funds and the costs they incur to generate those 

returns are not required to be disclosed as operating expenses to their 

customers.

Various Alternatives Could 

Improve Fee Disclosure, but 

the Benefits Have Not Been 

Quantified

In recent years, a number of alternatives have been proposed for improving 

the disclosure of mutual fund fees, which could provide additional 

information to fund investors. In response to a recommendation in our 

June 2000 report that SEC consider additional disclosures regarding fees, 

SEC has introduced a proposal to improve mutual fund fee disclosure.6

 In 

December 2002, SEC released proposed rule amendments, which include a 

requirement that mutual funds make additional disclosures about their 

expenses.7

 This information would be presented to investors in the annual 

and semiannual reports prepared by mutual funds. Specifically, mutual 

funds would be required to disclose the cost in dollars associated with an 

investment of $10,000 that earned the fund’s actual return and incurred the 

fund’s actual expenses paid during the period. In addition, the staff also 

proposed that mutual funds be required to disclose the cost in dollars, 

based on the fund’s actual expenses, of a $10,000 investment that earned a 

standardized return of 5 percent. 

The SEC’s proposed disclosures have various advantages and 

disadvantages. If adopted, this proposal would provide additional 

information to investors about the fees they pay when investing in mutual 

funds. In addition, these disclosures would be presented in a format that 

would allow investors to compare fees directly across funds. However, the 

disclosures would not be investor specific because they would not use an 

investor’s individual account balance or number of shares owned. In 

addition, SEC is proposing to place these new disclosures in the 

semiannual shareholder reports, instead of in quarterly statements. 

Quarterly statements, which show investors the number of shares owned 

and value of their fund holdings, are generally considered to be of most 

interest and utility to investors. As a result, SEC’s proposal may be less 

likely to increase investor awareness and improve price competition 

among mutual funds. According to SEC staff, they are open to consider 

6

GAO/GGD-00-126.

7

Shareholder Reports and Quarterly Portfolio Disclosure of Registered Management 

Investment Companies, Securities and Exchange Commission Release Nos. 33-8164; 34-

47023; IC-2587068 (Dec. 18, 2002).
Page 12 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

additional disclosures if the benefits to investors appear clear, but have 

decided to continue pursuing approval of the proposed disclosure format 

from their December 2002 rule proposal. This proposal has received a wide 

range of comments. Most comments were in support of SEC’s proposed 

requirement to include the dollar cost associated with a $10,000 

investment. For example, one investment advisory firm commented in its 

letter that the new disclosures SEC is proposing would benefit investors by 

allowing them to estimate actual expenses and compare costs between 

different funds in a meaningful way. 

Another alternative for disclosing mutual funds fees would involve funds 

specifically disclosing the actual dollar amount of fees paid by each 

investor. In our June 2000 report, we noted that such disclosure would 

make mutual funds comparable to other financial products and services 

such as bank checking accounts or stock transactions through brokerdealers. As our report noted, such services actively compete on the basis of 

price. If mutual funds made similar specific dollar disclosures, investors 

would be clearly reminded that they pay fees for investing in mutual funds 

and we stated that additional competition among funds on the basis of 

price could likely result among funds. An attorney specializing in mutual 

fund law told us that requiring funds to disclose the dollar amount of fees in 

investor account statements would likely encourage investment advisers to 

compete on the basis of fees. He believed that this could spur new entrants 

to the mutual fund industry and that the new entrants would promote their 

funds on the basis of their low costs, in much the same way that low-cost 

discount broker-dealers entered the securities industry. 

Although some financial planners, who directly assist investors in choosing 

among mutual funds, thought that requiring mutual funds to provide 

investors with the specific dollar amounts of fees paid would be useful, 

most indicated that other information was more important. We spoke to a 

judgmental sample of 15 certified financial planners whose names were 

provided by the Certified Financial Planner Board of Standards, a nonprofit professional regulatory organization that administers the certified 

financial planner examination. Of the 15 financial planners with whom we 

spoke, 6 believed specific dollar disclosure of mutual fund fees would 

provide additional benefit to investors. For example, one said that 

providing exact dollar amounts for expenses would be useful because 

investors don’t take the next step to calculate the actual costs they bear by 

multiplying their account value by the fund’s expense ratio. In contrast, the 

other 9 financial planners we interviewed said that the factor most 

investors consider more than others is the overall net performance of the 
Page 13 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

fund and thus did not think that specific dollar disclosures of fees would 

provide much additional benefit. 

Industry officials raised concerns about requiring specific dollar fee 

disclosures. For example, one investment company official stated that the 

costs of making specific dollar disclosures would not justify any benefit 

that might arise from providing such information, particularly because a 

majority of investors make their investment decisions through 

intermediaries, such as financial planners, and not on their own. Some 

industry officials stated that additional disclosure could confuse investors 

and create unintended consequences. For example, one official noted that 

specific dollar disclosure might lead investors to think that they could 

deduct those expenses from their taxes. Others noted that this type of 

disclosure would tell current mutual fund investors what they were paying 

in fees, but would not provide the proper context for evaluating how much 

other funds would charge, and thus would be unlikely to increase 

competition. Another official stated that disclosing fees paid in dollars in 

account statements would not be beneficial to prospective investors. 

Although the total cost of providing specific dollar fee disclosures might be 

significant, the cost might not represent a large outlay on a per investor 

basis. As we reported in our March 2003 statement, the Investment 

Company Institute (ICI), the industry association representing mutual 

funds, commissioned a study by a large accounting firm to survey mutual 

fund companies about the costs of producing such disclosures.8

 The study 

concluded that the aggregated estimated costs for the survey respondents 

to implement specific dollar disclosures in shareholder account statements 

would exceed $200 million, and the annual costs of compliance would be 

about $66 million.9

 Although these are significant costs, when spread over 

the accounts of many investors, the amounts are less sizeable. For 

example, ICI reported that at the end of 2001, a total of about 248 million 

shareholder accounts existed. If the fund companies represented in ICI’s 

study, which represent 77 percent of industry assets, also maintain about 

the same percentage of customer accounts, then the companies would hold 

about 191 million accounts. As a result, apportioning the estimated $200 

million in initial costs to these accounts would amount to about $1 per 

8

GAO-03-551T. 

9

However, this estimate did not include the reportedly significant costs that would be borne 

by third-party financial institutions, which maintain accounts on behalf of individual mutual 

fund shareholders.
Page 14 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

account. Apportioning the estimated $66 million in annual costs to these 

accounts would amount to about $0.35 per account.

We also spoke with a full-service transfer agent that provides services for 

about one third of the total 240 million accounts industrywide.10 Staff from 

this organization prepared estimates of the costs to their organization of 

producing specific dollar fee disclosures for fund investors. They 

estimated that to produce this information, they would incur one-time 

development costs between $1.5 and $3 million to revise their systems to 

accept and maintain individual investor account expense data, and ongoing 

data processing expenses of about $0.15 to $0.30 per fund/account per year. 

These ongoing expenses would reflect about 1 percent of the estimated $18 

to $23 per year of administrative costs per account already incurred. The 

officials also estimated that shareholder servicing costs would increase as 

investors would call in to try to understand the new disclosures or offer to 

send payments under the mistaken impression that this was a new charge 

that they had to explicitly pay. Funds would also incur costs to update and 

modify their Web sites so that investors could find this specific expense 

information there as well. 

Another concern raised regarding requiring mutual funds to disclose the 

specific dollar amount of fees was that information on the extent to which 

such disclosures would benefit investors is not generally available. For our 

work on this report, we attempted to identify studies or analyses on the 

impact of disclosing prices in dollars versus percentage terms, but no 

available information was found to exist. We also reviewed surveys done 

of investor preferences relative to mutual funds but none of the surveys we 

identified discussed disclosure of mutual fund fees in dollar terms. In our 

June 2000 report, we presented information from a survey of over 500 

investors that was administered by a broker-dealer to its clients.11 As we 

reported, this survey found that almost 90 percent of these investors 

indicated that specific dollar disclosures would be useful or very useful. 

However, only 14 percent of these investors were very or somewhat likely 

to be willing to pay for this information. SEC and industry participants 

noted that having more definitive data on the extent to which investors 

want and would benefit from receiving information on the specific dollar 

10A mutual fund transfer agent maintains shareholder account records and processes share 

purchases and redemptions. 

11See GAO/GGD-00-126, p. 78.
Page 15 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

amount of fees they paid would be necessary before requiring mutual 

funds, broker-dealers, and other intermediaries to undertake the costly 

revisions to their systems necessary to capture such information. 

Another option for disclosure was proposed by an industry official that 

may not impose significant costs on the industry. The official said that fund 

companies could include a notice in account statements to remind 

investors that they pay fees as part of investing in mutual funds. The 

notice, the official said could remind investors that, “Mutual funds, like all 

investments, do have fees and ongoing expenses and such fees and 

expenses can vary considerably and can affect your overall return. Check 

your prospectus and with your financial adviser for more information.” By 

providing this notice in the quarterly account statements that mutual fund 

investors receive, mutual fund investors would be reminded about fees in a 

document that, because it contains information about their particular 

account and its holdings, is more likely to be read. 

Trading and Other Costs 

Impact Mutual Fund 

Investor Returns, but Are 

Not Prominently Disclosed

In addition to the expenses reflected in a mutual fund’s expense ratio—the 

fund’s total annual operating expenses as a percentage of fund assets—

mutual funds incur trading costs that also affect investors’ returns. Among 

these costs are brokerage commissions that funds pay to broker-dealers 

when they trade securities on a fund’s behalf. When mutual funds buy or 

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

execute these trades a commission. In other cases, trades are not subject to 

explicit brokerage commissions but rather to “markups,” which is an 

amount a broker-dealer may add to the price of security before selling it to 

another party. Trades involving bonds are often subject to markups. 

Commissions have also not traditionally been charged on trades involving 

the stocks traded on NASDAQ because the broker-dealers offering these 

stocks are compensated by the spread between the buying and selling 

prices of the securities they offer.12

Other trading-related costs that can also affect investor returns include 

potential market impact costs that can arise when funds seek to trade large 

amounts of particular securities. For example, a fund seeking to buy a large 

block of a particular company’s stock may end up paying higher prices to 

12These different prices are called the bid price, which is the price the broker-dealer is 

willing to pay for shares and the ask price, which is the price at which the broker-dealer is 

willing to sell shares.
Page 16 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

acquire all the shares it seeks because its transaction volume causes the 

stock price to rise while its trades are being executed. Various 

methodologies exist for estimating these types of trading costs, however, 

no generally agreed upon approach exists for accurately calculating these 

costs. 

Although trading costs affect investor returns, these costs are not currently 

required to be disclosed in documents routinely provided to investors. ICI 

staff and others told us that the costs of trading, including brokerage 

commissions, are required under current accounting practices and tax 

regulations to be included as part of the initial value of the security 

purchased. As a result, this amount is used to compute the gain or loss 

when the security is eventually sold and thus the amount of any 

commissions or other trading costs are already implicitly included in fund 

performance returns.13 Investors do receive some information relating to a 

fund’s trading activities because funds are required to disclose their 

portfolio turnover, (the frequency with which funds conduct portfolio 

trading) in their prospectuses, which are routinely sent to new and existing 

investors. However, the frequency with which individual mutual funds 

conduct portfolio trading and incur brokerage commissions can vary 

greatly and the amount of brokerage commissions a fund pays are not 

disclosed in documents routinely sent to investors. Instead, SEC requires 

mutual funds to disclose the amount of brokerage commissions paid in the 

statement of additional information (SAI), which also includes disclosures 

relating to a fund’s policies, its officers and directors, and various tax 

matters. Regarding their trading activities, funds are required to disclose in 

their SAI how transactions in portfolio securities are conducted, how 

brokers are selected, and how the fund determines the overall 

reasonableness of brokerage commissions paid. The amount disclosed in 

the SAI does not include other trading costs borne by mutual funds such as 

spreads or the market impact cost of the fund’s trading. Unlike fund 

prospectuses or annual reports, SAIs do not have to be sent periodically to 

a fund’s shareholders, but instead are filed with SEC annually and are sent 

to investors upon request. 

13For example, if a fund buys a security for $10 a share and pays a $.05 commission on each 

share, its basis in the security is $10.05, and this is the amount that will be used to calculate 

any subsequent gain or loss when the shares are sold.
Page 17 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Academics and Others Have 

Also Called for Increased 

Disclosure of Mutual Fund 

Trading Costs, but Others 

Noted that Producing Such 

Disclosures Would be 

Difficult 

Academics and other industry observers have also called for increased 

disclosure of mutual fund brokerage commissions and other trading costs 

that are not currently included in fund expense ratios. In an academic 

study we reviewed that looked at brokerage commission costs, the authors 

urged that investors pay increased attention to such costs.14 For example, 

the study noted that investors seeking to choose their funds on the basis of 

expenses should also consider reviewing trading costs as relevant 

information because the impact of these unobservable trading costs is 

comparable to the more observable expense ratio. The authors of another 

study noted that research shows that all expenses can reduce returns so 

attention should be paid to fund trading costs, including brokerage 

commissions, and that these costs should not be relegated to being 

disclosed only in mutual funds’ SAIs.15

Others who advocated additional disclosure of brokerage commissions 

cited other benefits. Some officials have called for mutual funds to be 

required to include their trading costs, including brokerage commissions, 

in their expense ratios or as separate disclosures in the same place their 

expense ratios are disclosed. For example, one investor advocate noted 

that if funds were required to disclose brokerage commissions in these 

ways, funds would likely seek to reduce such expenses and investors 

would be better off because the costs of such funds would be similarly 

reduced. He explained that this could result in funds experiencing less 

turnover, which could also benefit investors as some studies have found 

that high-turnover funds tend to have lower returns than low-turnover 

funds. 

The majority of certified financial planners we interviewed also indicated 

that disclosing transaction costs would benefit investors. Of the 15 with 

whom we spoke, 9 stated that investors would benefit from having more 

cost information such as portfolio transaction costs. For example, one said 

that investors should know the costs of transactions paid by the fund and 

that this information should be disclosed in a document more prominent 

than the SAI. Another stated that brokerage commissions should be 

14J.M.R. Chalmers, R.M. Edelen, and G.B. Kadlec, “Mutual Fund Trading Costs,” Rodney L. 

White Center for Financial Research, The Wharton School, University of Pennsylvania (Nov. 

2, 1999).

15M. Livingston and E.S. O’Neal, “Mutual Fund Brokerage Commissions,” Journal of 

Financial Research (Summer 1996).
Page 18 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

reported as a percentage of average net assets. Overall they felt that more 

information would help investors compare costs across funds, which could 

likely result in more competition based on costs, but they also varied in 

opinion on the most appropriate format and place to present these 

disclosures. The planners who did not think transaction costs should be 

disclosed generally believed that investors would not benefit from this type 

of additional information because they would not understand it. 

Some industry observers and financial planners we interviewed indicated 

that investors should be provided all the information that affects a fund’s 

returns in one place. This information could include the current disclosed 

costs such as the total expense ratio, the impact of taxes, and undisclosed 

trading costs. Some financial planners and an industry consultant 

suggested disclosing all such expenses in percentages. They also 

expressed the importance of including after-tax performance returns. SEC 

adopted a rule in January 2001 requiring all funds to disclose their after-tax 

returns in their prospectus. A mutual fund industry analyst noted that 

when an item is disclosed, investment advisers will likely attempt to 

compete with one another to maximize their performance in the activity 

subject to disclosure. Therefore, presenting investors with information on 

the factors that affect their return and that are within the investment 

adviser’s control could spur additional competition and produce benefits 

for investors. A financial planner we interviewed also agreed that having 

mutual funds disclose information about expenses, tax impacts, and 

trading costs, particularly brokerage commissions all in one place would 

increase investor awareness of the costs incurred for owning mutual fund 

shares and could increase competition among funds based on costs and 

lead to lower expenses for investors. 

Although additional disclosures in this format could possibly benefit 

investors, developing the information needed to provide a disclosure of this 

type could pose difficulties. SEC officials said that, if funds were required 

to separately disclose brokerage commission costs as a percentage of fund 

assets, fund advisers would also likely want to present their fund’s gross 

return before trading costs were included so that the information does not 

appear to be counted twice. However, the SEC staff noted that determining 

a fund’s gross return before trading costs could be challenging because it 

could involve having to estimate markups and spread costs. ICI officials 

also stated that disclosing gross returns could create the idea of cost free 

investing, which is not a realistic expectation for investors. They also 

worried that mutual funds could try and market their gross return figures, 

which would be misleading.
Page 19 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Mutual fund officials also raised various concerns about expanding the 

disclosure of brokerage commissions and trading costs in general. Some 

officials said that requiring funds to present additional information about 

brokerage commissions by including such costs in the fund’s operating 

expense ratios would not present information to investors that could be 

easily compared across funds. For example, funds that invest in securities 

on the New York Stock Exchange (NYSE), for which commissions are 

usually paid, would pay more in total commissions than would funds that 

invest primarily in securities listed on NASDAQ because the broker-dealers 

offering such securities are usually compensated by spreads rather than 

explicit commissions. Similarly, most bond fund transactions are subject 

to markups rather than explicit commissions. If funds were required to 

disclose the costs of trades that involve spreads, officials noted that such 

amounts would be subject to estimation errors. As discussed earlier, ICI 

staff and others said that separate disclosure of these costs is not needed 

because the costs of trading are already included in the performance return 

percentages that mutual funds report. Officials at one fund company told 

us that it would be difficult for fund companies to produce a percentage 

figure for other trading costs outside of commissions because no agreedupon methodology for quantifying market impact costs, spreads, and 

markup costs exists within the industry. Other industry participants told us 

that due to the complexity of calculating such figures, trading cost 

disclosure is likely to confuse investors. For example funds that attempt to 

mimic the performance of certain stock indexes, such as the Standard & 

Poors 500 stock index, and thus limit their investments to just these 

securities have lower brokerage commissions because they trade less. In 

contrast, other funds may employ a strategy that requires them to trade 

frequently and thus would have higher brokerage commissions. However, 

choosing among these funds on the basis of their relative trading costs may 

not be the best approach for an investor because of the differences in these 

two types of strategies. 

Finally, some financial planners and an industry expert stated that 

additional disclosure of mutual fund costs would be monitored not by 

investors but more so by financial professionals, such as financial planners, 

and the financial media. These groups serve as intermediaries between 

fund companies and investors, and are the primary channel through which 

information on the performance and costs across mutual funds is 

distributed. The financial planners and the industry expert believed that 

increased disclosures of trading costs could prove beneficial to the 

financial professionals that help select mutual funds for their investor 

clients. 
Page 20 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Independent Directors 

Play a Critical Role in 

Protecting Mutual 

Fund Investors

Mutual fund boards of directors have a responsibility to protect 

shareholder interests. Independent directors, who are not affiliated with 

the investment adviser, play a critical role in protecting mutual fund 

investors. Specifically, independent directors have certain statutory 

responsibilities to approve investment advisory contracts and monitor 

mutual fund fees. However, some industry observers believe that 

independent directors could do more to assert their influence to reduce 

fees charged by fund advisers. Alternatives are being considered to 

improve public company governance such as changing board composition 

and structure, however many practices are already in place within the 

mutual fund industry.

Mutual Fund Boards of 

Directors Are Responsible 

for Protecting Shareholder 

Interests 

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 interest 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 level of the 

management fee representing its revenue from the fund, the adviser’s 

desire to maximize its revenues could conflict with shareholders’ goal 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’s interests. 

These boards must also 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 

addition to approval by the full board, the Investment Company Act 

requires that a majority of the independent directors separately approve 

the contracts with the investment adviser that will manage the fund’s 

portfolio and the entity that will act as distributor of the fund’s shares. A 

mutual fund’s board, including a majority of the independent directors, are 

also required to review other service arrangements such as transfer agency, 

custodial, or bookkeeping services. 
Page 21 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

If the services to the fund are provided by an affiliate of the adviser, the 

independent directors also generally consider several items before 

approving the arrangement. Specifically they determine that the service 

contract is in the best interest of the fund and its shareholders, the services 

are required for the operation of the fund, the services are of a nature and 

quality at least equal to the same or similar services provided by 

independent third parties, and the fees for such services are fair and 

reasonable in comparison to the usual and customary fees charged for 

services of the same nature and quality. 

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 the annual approval of an advisory contract by a 

fund’s full board of directors as well as by a majority of its independent 

directors, acting separately and in person, at a meeting called for that 

purpose. 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 the 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.16 In addition to potentially considering how a fund’s fee 

compared to those of other funds, this court indicated that directors may 

find other factors more important, including

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

• the adviser’s costs to provide those services,

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

economies of scale as the fund grows,

16Gartenberg 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 22 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

• 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.

Fund company officials and independent directors with whom we spoke 

said their boards review extensive amounts of information during the 

annual contract renewal process to help them evaluate the fees and 

expenses paid by the fund. For example, they stated that they hire a thirdparty research organization, such as Lipper, Inc., to provide data on their 

funds investment performance, management fee rates, and expense ratios 

as they compare to funds of similar size, objective, and style. They also 

compare performance to established benchmarks, such as the Standard & 

Poors 500 Stock Index. For example, officials at one fund company told us 

that, for each of their funds, their board reviews information on the 

performance and fees charged by 20 funds with a similar investment 

objective, including the 10 funds closest in size with more assets than their 

fund and the 10 funds closest in size with fewer assets. In addition to 

comparing themselves to peers, they explained that their board reviews the 

profitability of the adviser, stability of fund personnel or staff turnover, and 

quality of adviser services. Fund officials stated that their boards receive a 

large package of information that includes all of the necessary information 

to be reviewed for the contract renewal process in advance of board 

meetings. 

SEC oversight of mutual funds indicates that fund directors generally 

conduct their activities in accordance with the law. Staff from SEC’s Office 

of Compliance Inspections and Examinations, which conducts 

examinations of mutual funds and their investment advisers, told us that as 

part of their examinations they review the minutes of past board meetings 

to ensure that the directors were told and discussed the relevant 

information as part of the board’s decision-making process. The SEC staff 

also told us they review the information provided to the board by the 

investment adviser to ensure its completeness and accuracy. Based on 

their review, SEC staff said that they have not generally found problems 

with mutual fund board proceedings. SEC has brought cases against 

mutual fund directors but these involved other activities. For example, 

SEC settled a case involving a mutual fund’s board of directors that had 

knowingly filed misleading information in the fund's prospectus and other 

fund disclosures regarding the liquidity and value of the shares of their 

money market fund. 
Page 23 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Critics Suggest Independent 

Directors Could Do More to 

Assert Their Influence and 

Reduce Fees 

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. Part of the criticism arises from the 

fact that during the annual contract renewal process, when boards 

compare fees of similar funds, the process maintains the status quo by 

comparing fees with the industry averages thus keeping fees at their 

current level. However, 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. An academic study we 

reviewed criticized the court cases that have shaped director’s roles in 

overseeing mutual fund fees because these cases generally found that 

comparing a fund’s fees to other similar investment management services, 

such as pension funds 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 have lacked sufficient data to show that a 

fund’s fees are excessive.17

One method offered by some industry critics for improving the 

effectiveness of boards in lowering fees for investors was to have fund 

directors seek competitive bids for their fund’s investment advisory 

contracts. Advocates of having boards take this action said that pension 

funds more routinely seek competitive bids from investment advisers for 

pension fund assets. A former Treasury Department official said that 

pension funds commonly seek new investment advisers every 2 to 3 years, 

and, as a result, pension fund investors pay two to three times less in fees 

than the average mutual fund investors. One academic study we reviewed 

that compared advisory fees for similarly-sized pension funds and mutual 

funds found that the average mutual fund advisory fee is twice as large as a 

pension fund advisory fee.18 The study showed that the average pension 

fund pays 28 basis points for its advisory fee compared to 56 basis points 

for mutual funds. The study concluded that the main reason for differences 

between pension funds and mutual funds was that advisory fees for 

17J.P. Freeman and S.L. Brown, “Mutual Fund Advisory Fees: The Cost of Conflicts of 

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

18J.P. Freeman and S.L. Brown.
Page 24 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

pension funds are set in a marketplace in which arm’s-length bargaining 

occurs because of the separation of the fund and the investment advisers.

Regulators and industry participants indicated that differences in the costs 

and services provided by mutual funds can explain why mutual funds 

charge more than pension funds. According to staff of SEC and ICI with 

whom we spoke, investment advisers usually perform many other services 

for their mutual funds than does the adviser of a pension fund and that their 

advisory fee compensates them for these additional services. Among the 

services that advisers of mutual funds would provide that a pension fund 

adviser would not include around the clock telephone customer service, 

preparing periodic account statements and shareholder communications, 

and compiling annual tax information for fund investors. Some industry 

officials also noted the difference in cost structure between pension and 

mutual funds. One official stated that pension funds have one institutional 

account, whereas mutual funds have thousands of smaller accounts, which 

requires substantial record keeping and customer service expenses. 

Mutual fund advisers would also have increased costs because they have to 

manage their fund’s daily inflows and outflows, whereas pool of assets that 

a pension fund adviser manages are not subject to such frequent 

fluctuations. 

Based on information we collected, very few mutual funds change their 

investment advisers. According to research organizations that monitor 

developments in the mutual fund industry, less than 10 funds have changed 

their primary investment adviser within the last 15 years. The process of 

changing investment adviser is not solely dependent upon the board of 

directors. If the fund board of directors made a decision to change an 

investment adviser, the board would need to file a proxy statement and 

have the shareholders of the fund vote to approve the change. 

Industry participants also said that having mutual fund boards put out their 

advisory service contracts for bid may not produce expected savings and 

could increase fund shareholders’ costs. According to staff at one fund 

company, they would not likely bid on contracts to manage mutual fund 

assets at the same rate that they bid for pension fund assets because their 

costs to manage and administer mutual fund assets are higher. They said 

that pension fund assets are offered to investment advisers in a large preexisting pool. In contrast, mutual fund assets must be accumulated over 

time from many investors. Each time a fund’s board hired a new 

investment adviser, the fund’s shareholders costs would also likely go up 

because all the accounts would have to be transferred to the new adviser 
Page 25 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

and the fund would likely incur additional document preparation, legal, and 

customer service costs. For example, we identified a case in which a small 

fund had removed its investment adviser, which resulted in a significant 

increase of fund expenses. In this case, the fund’s investment adviser 

resigned and a majority of the fund’s board of directors voted to take over 

the fund’s management. The decision was submitted to the shareholders 

for a proxy vote and passed. As a result the fund’s expense ratio went from 

1.8 percent in 2001 to 3.4 percent in 2002. The fund attributed this 

significant increase to a number of one-time items, which consisted 

primarily of legal expenses associated with the removal of the investment 

adviser and the management of the fund’s portfolio. 

Finally, industry participants indicated that mutual fund shareholders likely 

do not expect their fund’s board to change the fund’s investment adviser. 

They said that mutual fund shareholders often choose their funds because 

of the reputation or services offered by a particular investment adviser and 

having their fund’s board seek to move their fund to another company 

would not likely be supported by the shareholders. Furthermore, having 

fund boards seek new investment advisers is unnecessary because mutual 

fund shareholders can choose to redeem their shares of a particular 

adviser’s fund and invest them in the funds of other advisers if they are 

unhappy with their existing fund or its adviser. In contrast, pension fund 

participants cannot move their pension fund investments if they are 

unhappy with their fund’s investment adviser or its performance. Instead, 

the decisions about which advisers are hired to manage pension fund’s 

assets are made by their fund administrators. ICI officials also questioned 

whether pension funds actually change investment advisers that frequently. 

They said that pension funds often seek long-term relationships with 

investment advisers. 

Although they do not frequently change advisers, mutual fund directors 

engage in other activities to lower fees. Industry officials said that advisers 

typically institute management fee “breakpoints” based on the level of fund 

assets or performance. These breakpoints reduce the level of management 

fees when funds exceed certain asset levels, thus as a fund’s assets grow, 

the investment adviser’s fee is reduced for those additional assets above 

the levels set in the breakpoint. Directors could also approve performance 

fees as a part of an investment adviser’s compensation that would reduce 

the fee the adviser was able to charge if the fund’s performance fails to 

meet or exceed a specified performance benchmark, such as the Standard 

& Poors 500 Stock Index. Industry officials also stated that advisers will at 

times offer to waive management fees, and may also waive or cap certain 
Page 26 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

expenses such as certain transfer agency fees. Noting that the fees for 

mutual funds in the United States are lower compared to those of other 

countries, SEC and ICI officials attributed this to the role and influence of 

U.S. funds’ board of directors because such independent oversight is not 

always required in other countries. 

Mutual Funds Already 

Employ Many Practices 

Being Suggested to Improve 

Public Company 

Governance

Changes in the structure of mutual fund boards of directors have been 

proposed and adopted in recent years and recent corporate scandals have 

prompted consideration of additional reforms but industry participants 

note that most funds have already adopted such practices. In February 

1999, SEC held a forum on the role of independent mutual fund directors to 

consider ways to improve mutual fund governance. At the forum, the SEC 

Chairman at that time requested proposals for improving fund governance. 

At the same time, ICI created the Advisory Group on Best Practices for 

Fund Directors. This advisory group identified 15 best practices used by 

fund boards to enhance the independence and effectiveness of mutual fund 

directors and recommended that all fund boards adopt them. The ICI 

recommendations included having 

• independent directors constitute at least two thirds of the fund’s board,

• independent directors select and nominate other independent directors, 

and 

• independent counsel for the independent directors. 

After evaluating the ideas and suggestions of the forum participants, SEC 

proposed various rule and form amendments designed to reaffirm the 

important role that independent directors play in protecting fund investors. 

These amendments were adopted in January 2001. They included requiring 

funds relying on certain exemptive rules—which includes almost all funds 

according to SEC staff—to have a majority of independent directors on 

their boards and to have their independent directors select and nominate 

other independent directors. SEC also required that any legal counsel for 

the independent directors also be independent.19 

19Role of Independent Directors of Investment Companies, Securities and Exchange 

Commission Release Nos. 33-7932; 34-43786; IC-24816 (Jan. 2, 2001).
Page 27 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

As a result of recent scandals such as Enron and Worldcom, various new 

reforms have been proposed to increase the effectiveness and 

accountability of public companies’ boards of directors. In July 2002, the 

Sarbanes-Oxley Act (Sarbanes-Oxley) was enacted to address concerns 

related to corporate responsibility.20 In addition to enhancing the financial 

reporting regulatory structure, Sarbanes-Oxley sought to increase 

corporate accountability by reforming the structure of corporate boards 

audit committees. Section 301 of Sarbanes-Oxley requires that directors 

who serve on a public company’s audit committee also be “independent” 

and be responsible for selecting and overseeing outside auditors. In 

response to the scandals at public companies, officials at the two primary 

venues where public companies are traded—the NYSE and NASDAQ—

have also proposed changes to the corporate governance standards that 

public companies seeking to be listed on their markets must meet. 

However, many of the corporate governance reforms being proposed for 

public companies are already either required or have been recommended 

as best practices for mutual fund boards. Table 2 presents how the 

corporate governance practices that are currently required by mutual fund 

law or rules or recommended by ICI’s best practices for mutual fund boards 

compare to the current and proposed NYSE and NASDAQ listing standards 

applicable to public company boards. As the table shows, the mutual funds 

boards are already recommended to have in place all of the proposed 

corporate listing standards.

20Pub. L. No. 107-204, 116 Stat. 745 (codified in scattered sections of 11, 15, 18, 28, and 29 

U.S.C.A.).
Page 28 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Table 2: Current and Proposed NYSE and NASDAQ Corporate Governance Listing 

Standards Compared to those Currently Required or Recommended for Mutual Fund 

Boards

Source: GAO analysis of ICI Best Practices, statutes, SEC rules, and NYSE and NASDAQ rule proposals.

a

SEC requires the board of directors of any fund that takes advantage of various exemptive rules to 

meet these requirements and SEC staff indicated that, as a result, almost all funds must comply.

b

Although fully independent audit committees is not a requirement for funds, SEC has adopted a rule 

to encourage fund boards to have audit committees consisting exclusively of independent directors by 

exempting such committees from having to seek shareholder approval of the fund’s auditor. 

c

Both the NYSE and NASDAQ definitions of director independence currently apply only to members of 

the audit committee, but their rule proposals would extend this definition to the full board. 

According to industry participants, most mutual fund boards already have 

the corporate governance practices recommended by these various 

standards in place. Officials of the fund companies and the independent 

directors that we interviewed told us that the majority of their boards 

consisted of independent directors, and, in many cases, had only one 

interested director. For public companies, some commenters have called 

for boards of directors to have supermajorities of independent directors as 

a means of ensuring that the voices of the independent directors are heard. 

As noted above, this practice has already been advocated by ICI’s best 

practice recommendations and one fund governance consulting official 

NYSE/NASDAQ listing 

standards Mutual funds

Governance 

requirement

Currently 

required

Proposed 

requirement

Required by 

statute or 

SEC rulea

ICI 

recommended 

best practice

Board must have a 

majority of independent 

directors

X X X

Independent directors 

must be responsible for 

nominating new 

independent directors 

X X X

Audit committee must 

consist of only 

independent directorsb

X X X

Standards that define 

who qualifies as an 

independent directorc

X X X X

Independent directors 

required to meet 

separately in executive 

sessions 

X X
Page 29 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

said that a 2002 survey conducted by his firm found that, in 75 percent of 

the mutual fund complexes they surveyed, over 70 percent of the directors 

were independent. An academic study we reviewed also found that funds’ 

independent directors already comprised funds’ nominating committees 

and most funds have self-nominating independent directors. 

Another change related to board composition that has been proposed for 

mutual funds would be to have an independent director serving as the 

board’s chair, but industry participants did not see this as a beneficial 

change. Some industry critics have stated that the lack of an independent 

chair allows the board’s activities during the meeting to be controlled by 

fund management, as the fund’s board chair is typically the chairman or 

other senior official of the investment adviser. A number of fund 

companies and independent directors we spoke with indicated that their 

board did have an independent chair. For the fund companies that did not 

have an independent chair, they had instead a lead independent director. 

An official from the Mutual Fund Directors Forum, an independent 

directors association which provides continuing education and outreach on 

mutual fund governance, said that the most important factor is the 

initiative demonstrated by the independent director, whether the individual 

is the lead or chair. He stated that if the lead independent director is 

motivated, it doesn’t matter who the chair is, because the lead director will 

be proactive and effective on behalf of fund shareholders. Other fund 

company officials indicated that an independent chair could be harmful to 

the board. One stated that investors are better served by having a fund 

company executive chair the fund’s board because such an official is better 

positioned to ensure that all of the information that the adviser needs to 

share with the independent directors is provided efficiently. 

Changes in Mutual 

Fund Distribution 

Practices Have 

Increased Choices for 

Investors, but Have 

Raised Potential 

Concerns

Concerns have been raised over changes in how mutual funds pay for the 

distribution of their shares to investors. SEC Rule 12b-1 allows mutual 

fund companies to use fund assets to pay expenses for distributing their 

funds through broker-dealers, and has evolved into a means for fund 

companies to offer investors a variety of ways to pay for the services of 

financial professionals, such as broker-dealer staff or financial planners. 

However, 12b-1 fees remain controversial among mutual fund researchers 

because, in addition to increasing a fund’s overall expense ratio, funds with 

12b-1 fees may be more costly to own in other ways. In a recent study, SEC 

staff recommended rule 12b-1 modifications to reflect changes in how 

funds are being marketed, but as of May 2003, SEC had not proposed any 

amendments. Concerns also have been raised as to whether the disclosure 
Page 30 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

of 12b-1 fees is sufficient and whether, another distribution practice—

referred to as revenue sharing, in which investment advisers make 

payments to broker-dealers for selling and marketing their funds—could 

limit the number of mutual fund choices offered to investors. Revenue 

sharing also may result in a broker-dealer’s failure to recommend funds 

from which the brokerage firm is not being compensated by the funds’ 

advisers, which some suggest could conflict with broker-dealers’ 

responsibilities to recommend suitable investments. 

12b-1 Plans Provide 

Alternative Means for 

Compensating Financial 

Professionals but Also Raise 

Concerns Over Costs

Previously, mutual funds distribution expenses were paid for either by 

charging investors a sales charge or load or by 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. Rule 

12b-1 plans were envisioned as temporary measures to be used during 

periods of declining assets. Any activity that is primarily intended to result 

in the sale of mutual fund shares must be included as a 12b-1 expense and 

can include advertising; compensation of underwriters, dealers, and sales 

personnel; printing and mailing prospectuses to persons other than current 

shareholders; and printing and mailing sales literature. 

To be allowed to use fund assets for marketing purposes, funds are 

required to adopt 12b-1 plans that outline how they intend to use these 

payments. A fund’s written 12b-1 plan must describe all material aspects of 

the proposed financing of distribution and related agreements with 

distributors about how the plan is to be implemented. Before 

implementing a plan that will allow a fund to begin charging 12b-1 fees, rule 

12b-1 requires fund shareholders and directors to approve 12b-1 plans and 

places other requirements on plan adoption. The plans must also be 

approved by a vote of a majority of outstanding shareholders and by a 

majority of funds’ directors, including a majority of the fund’s independent 

directors. Because such plans were envisioned to be of a limited duration, 

a majority of funds’ directors, including a majority of the fund’s 

independent directors, must also make various approvals on an ongoing 

basis, including approving the 12b-1 plans annually. They must also 

approve any amendment to the plan and approve on at least a quarterly 

basis the reports of plan expenditures and the purposes of the 

expenditures. 12b-1 plans must also provide for plan termination upon the 

vote of a majority of independent directors or a majority of shareholders. 
Page 31 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

In the adopting release for the rule, SEC presented various factors that 

directors should consider when approving a fund’s 12b-1 plan. These 

factors were offered to provide guidance to directors in determining 

whether to use fund assets to bear expenses for fund distribution. The nine 

factors are shown in figure 1. 

Figure 1: Factors Fund Directors Are to Consider in Voting to Approve or Continue 

12b-1 Plans

The need for independent counsel or experts to assist the 

directors in reaching a determination.

The nature of the problems or circumstances which purportedly make 

implementation or continuation of such a plan necessary or appropriate.

The causes of such problems or circumstances.

The way in which the plan would address these problems or circumstances and 

how it would be expected to resolve or alleviate them, including the nature and 

approximate amount of the expenditures; the relationship of such expenditures to 

the overall cost structure of the fund; the nature of the anticipated benefits, and the 

time it would take for those benefits to be achieved.

The merits of possible alternative plans.

The interrelationship between the plan and the activities of any other person who 

finances or has financed distribution of the company's shares, including whether 

any payments by the company to such other person are made in such a manner as 

to constitute the indirect financing of distribution by the company.

The possible benefits of the plan to any other person relative to those expected 

to inure to the company.

The effect of the plan on existing shareholders.

In the case of a decision on whether to continue a plan, whether the plan has 

in fact produced the anticipated benefits for the company and its shareholders.

1.

2.

9.

8.

7.

6.

5.

4.

3.

Source: SEC Release Nos. 33-6254 and IC-11414. 
Page 32 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

The 12b-1 fees that are used to pay marketing and distribution expenses are 

deducted directly from fund assets and are reported as a separate line item 

in the fund’s fee table and included in funds’ expense ratios. NASD, whose 

rules govern the distribution of fund shares by broker-dealers, limits the 

annual rate at which 12b-1 fees may be paid to broker-dealers to no more 

than 0.75 percent of a fund’s average net assets per year.21 Funds are 

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. Therefore, 

12b-1 fees included in a fund’s total expense ratio are limited to a maximum 

of 1 percent per year. The actual dollar amount of distribution and service 

expenses paid under a fund’s 12b-1 plan must be disclosed in an SAI, which 

supplements the prospectus, and in the fund’s annual report.

As part of its oversight, SEC staff periodically examines mutual funds and 

their advisers for compliance with securities laws and rules and generally 

find that mutual fund boards adequately oversee their fund’s 12b-1 plan. An 

SEC official told us that SEC examiners check to see that the directors and 

shareholders have approved 12b-1 plans and whether the funds have 

controls in place to ensure that relationships with distributors are 

reasonable, such as having the directors review 12b-1 fees. The official said 

that some examinations have found that funds lack adequate control 

procedures, but the SEC staff rarely have found serious material 

deficiencies.

12b-1 Plans Provide Additional 

Ways for Investors to Pay for 

Investment Advice and Fund 

Companies to Market Fund 

Shares 

Rule 12b-1 provides investors an alternative way of paying for investment 

advice and purchases of fund shares. Funds can be sold directly to 

investors by a fund company or through financial intermediaries such as 

broker-dealers or financial advisers. According to ICI, approximately 80 

percent of investors’ mutual fund purchases are made through brokers, 

financial advisers, and other intermediaries, including employer-sponsored 

pension plans. Apart from 12b-1 fees, brokers can be paid with sales 

charges called “loads”; “front-end” loads are applied when shares in a fund 

are purchased and “back-end” loads when shares are redeemed. With a 12b1 plan, the fund can finance the broker’s compensation with installments 

deducted from fund assets over a period of several years. Thus, 12b-1 plans 

allow investors to consider the time-related objectives of their investment 

and possibly earn returns on the full amount of the money they have to 

21NASD Conduct Rule 2830(d).
Page 33 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

invest, rather than have a portion of their investment immediately deducted 

to pay their broker. 

Rule 12b-1 has also made it possible for fund companies to market fund 

shares through a variety of share classes designed to help meet the 

different objectives of investors. For example, Class A shares might charge 

front-end loads to compensate brokers and may offer discounts called 

breakpoints for larger purchases of fund shares. Class B shares, 

alternatively, might not have front-end loads, but would impose asset-based 

12b-1 fees to finance broker compensation over several years. Class B 

shares also might have deferred back-end loads if shares are redeemed 

within a certain number of years and might convert to Class A shares if held 

a certain number of years, such as 7 or 8 years. Class C shares might have a 

higher 12b-1 fee, but generally would not impose any front-end or back-end 

loads. While Class A shares might be more attractive to larger, more 

sophisticated investors who wanted to take advantage of the breakpoints, 

smaller investors, depending on how long they plan to hold the shares, 

might prefer Class B or C shares because no sales charges would be 

deducted from their initial investments. 

Industry officials and analysts generally viewed the alternative marketing 

arrangements fostered by rule 12b-1 favorably. ICI and fund company 

officials generally agreed that rule 12b-1 plans gave fund distributors more 

options for offering investors multiple ways to pay for fund investments. 

For example, one company official said that 12b-1 plans have allowed 

investors to choose the type of fund in which they want to invest and have 

helped stabilize fund assets. Another official said that rule 12b-1 has 

provided investors choices on how to pay their broker, which investors 

have grown to like. He said that in his fund complex, 50 percent of shares 

are now held in Class B shares that charge 12b-1 fees as opposed to other 

share classes. A broker-dealer official that distributes funds said that 12b-1 

plans are beneficial because the fees provide a revenue stream that 

encourages financial advisers to plan for the long-term. A mutual fund 

shareholders advocate said that this incentive is good because it would 

cause the financial advisers to recommend funds that will work out well for 

investors over time, rather than focus on earning front-end loads.
Page 34 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

12b-1 Fees Raise Some Concerns 

Over Cost of Funds 

Although providing alternative means for investors to pay for the advice of 

financial professionals, some concerns exist over the impact of 12b-1 fees 

on investors’ costs. For example, an academic study of 3,861 multiple share 

class funds available at the end of 1997 found that funds with multiple 

share classes and 12b-1 fees also had higher management fees than those 

charged by funds with only a single share class, and, therefore, were more 

costly to investors before considering the additional expenses used to 

compensate their financial professional.22 However, another study found 

that funds with 12b-1 fees might provide investors with greater 

performance. This study, which reviewed the risk-adjusted performance of 

a sample of 568 mutual funds for the period 1987-1992, found that 12b-1 

plans increased fund expenses but on average generated higher riskadjusted performance than funds with front-end loads. For this reason, the 

study concluded that investors should not avoid funds with 12b-1 plans.23

Questions involving funds with 12b-1 fees have also been raised over 

whether some investors are paying too much for their funds depending on 

which share class they purchase. Earlier in 2003, in federal court in 

Nashville, Tennessee, investors filed lawsuits against a brokerage firm 

alleging that the firms’ brokers placed the investors’ funds into share 

classes with higher 12b-1 fees when other share classes with different fee 

structures would have been more appropriate for the investors. A 1999 

academic study also found that differing distribution arrangements cause 

broker-dealer sales representatives to be compensated differently 

depending on the class of shares they sell. These individuals, the study 

found, have monetary incentives to steer long-term investors to low load, 

high 12b-1 fee share classes and to steer short-term investors to high load, 

12b-1 fee share classes.24 However, depending on the time that they are 

likely to hold the investment, some investors would be better off investing 

in funds that charge a front-end load and have smaller 12b-1 fees than by 

purchasing shares in funds without loads but higher 12b-1 fees. The study 

noted that this conflict of interest between investors and brokers is most 

22Lesseig, Vance P.; Long, D. Michael; and Smythe, Thomas I. “Gains to Mutual Fund 

Sponsors Offering Multiple Share Class Funds,” Journal of Financial Research (March 

1990).

23Dellva, Wilfred L. and Olson, Gerard T. “The Relationship Between Mutual Fund Fees and 

Expenses and Their Effects on Performance,” The Financial Review (February 1998).

24O’Neal, Edward S., “Mutual Fund Share Classes and Broker Incentives,” Financial 

Analysts Journal (September/October 1999).
Page 35 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

serious when broker-dealer representatives advise relatively uninformed 

investors, who are more likely to seek advice on mutual fund investing.

In addition to concerns over 12b-1 fees, regulators have recently begun 

investigations of whether investors are receiving the appropriate discounts 

in mutual fund sales loads. In March 2003, NASD, NYSE, and SEC staff 

reported on the results of jointly administered examinations of 43 

registered broker-dealers that sell mutual funds with a front-end load. The 

purpose of the examinations was to determine whether investors were 

receiving the benefit of available breakpoint discounts on front-end loads 

in mutual fund transactions. The examinations found that most of the 

brokerage firms examined, in some instances, did not provide customers 

with breakpoint discounts for which they appeared to have been eligible. In 

instances where investors were not afforded the benefit of a breakpoint 

discount, the average discount not provided was $364 per transaction. The 

most frequent causes for the broker-dealers not providing a breakpoint 

discount were not linking a customer’s ownership of different funds within 

the same mutual fund family, not linking shares owned in a fund or fund 

family in all of a customer’s accounts at the firm, and not linking shares 

owned in the same fund or fund family by persons related to the customer 

in accounts at the firm. The regulators concluded that many of the 

problems did not appear to have been intentional failures to charge correct 

loads. Among other things, the report noted that, although most of the 

firms had written supervisory procedures addressing breakpoints, the 

procedures often were not comprehensive.

SEC Report Recommended That 

Rule 12b-1 Be Updated to Reflect 

Changes in Fund Marketing

In a December 2000 report on mutual fund fees and expenses, staff in SEC’s 

Division of Investment Management recommended that SEC consider 

reviewing the requirements of rule 12b-1 that govern how funds adopt and 

renew their 12b-1 plans.25 The division’s staff noted that modifications 

might be needed to reflect changes in the manner in which funds are 

marketed and distributed and the experience gained from observing how 

rule 12b-1 has operated since its adoption in 1980. The report noted that 

the development of multiple fund share classes permit investors to choose 

how distribution expenses are to be paid—for example, up front, in 

installments over time, or at redemption. Many funds that offer shares 

through broker-dealer fund supermarkets also adopt 12b-1 plans to pay for 

the fees that the sponsoring broker-dealer charges the funds sold through 

25U.S. Securities and Exchange Commission, Division of Investment Management: Report 

on Mutual Fund Fees and Expenses (Washington, D.C.: December 2000).
Page 36 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

their supermarket. The division’s report noted that because these 12b-1 

plans are essential to the funds’ participation in these supermarkets, such 

plans could be viewed as indefinite commitments. Also since 1980, some 

fund distributors have been using 12b-1 receivable revenues as collateral to 

obtain loans to finance their distribution efforts. The SEC staff noted that 

such changes illustrate that 12b-1 fees have come to be used in different 

ways than were originally envisioned under the rule and that changes may 

be needed to reflect current practices. Because of these changes, the 

report noted that SEC should consider whether it needed to give additional 

or different guidance to fund directors with respect to their review of rule 

12b-1 plans, including whether the nine factors published in the 1980 

release of rule 12b-1 were still valid (shown in fig. 1 of this report).

Although SEC has not yet provided additional guidance on or updated rule 

12b-1 to reflect market changes, SEC staff told us that any amendment of 

rule 12b-1 could also involve changes to how distribution fees and 

expenses are disclosed. One fund independent director with whom we 

spoke said that rule 12b-1 should be amended to allow payment only to 

broker-dealers with net sales of fund shares and broker-dealers with net 

redemptions would not be paid. He said that this change would make sense 

for rule 12b-1 to fulfill its original purpose of increasing fund assets.

Concerns Raised over Adequacy 

of 12b-1 Fee Disclosure 

Some concerns have been raised over the adequacy of 12b-1 fee 

disclosures. A mutual fund shareholder advocacy organization has called 

for reform in the disclosure of fund distribution expenses to better inform 

investors of possible conflicts of interest that could compromise the 

adviser’s responsibility to control fund costs and provide investors a 

satisfactory return. For example, this group notes that 12b-1 fee disclosure 

is misleading to investors because a fund’s money can be paying for 

distribution expenses either through a 12b-1 fee or the adviser’s 

management fee. However, the group asserts, the fee table in the 

prospectus could give the investor the impression all distribution expenses 

are covered by 12b-1 fees, while the fund adviser benefits from all of the 

expenses paid from fund assets, the group noted. The group also noted that 

12b-1 disclosures do not inform investors of potential conflicts of interest 

affecting brokers because, based on the fee disclosures in the prospectus, 

an investor cannot determine whether his broker received compensation 

from the 12b-1 fees.
Page 37 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Revenue Sharing 

Arrangements Provide 

Additional Distribution 

Options and Are 

Increasingly Used to 

Compensate Fund 

Distributors

Revenue sharing payments are compensation that investment advisers pay 

from their profits to the broker-dealers that distribute their funds. Some 

broker-dealers whose sales representatives market mutual funds have 

narrowed their offerings of funds or created preferred lists of funds, which 

then become the funds that receive the most marketing by these brokerdealer sales representatives. 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. According to one research 

organization official, there are significantly fewer distributing brokerdealers than there are mutual fund investment advisers. As a result, the 

mutual fund distributors have the clout to require advisers to pay more to 

have their funds sold by the distributing broker-dealers staff. For example, 

distributors sometimes require investment advisers to share their profits 

and pay for expenses incurred by the distributing broker-dealers, such as 

advertising or marketing materials that are used by the distributing brokerdealers. 

The revenue sharing payments that come from the adviser’s profits may 

supplement distribution-related payments out of fund assets. As noted, 

funds may annually pay up to one percent of fund assets to distributors 

pursuant to 12b-1 plans. However, SEC officials state that revenue sharing 

arrangements, paid out of the adviser’s management fee, can permit brokerdealer distributors to receive payments outside of the 12b-1 limits. Further, 

broker-dealers have discretion as to how to use these payments, including 

using them to defray expenses incurred in marketing funds or to invest 

them in other areas of the broker-dealer’s business.

Mutual funds and their investment advisers also may make distribution 

payments or incur revenue sharing costs when they offer funds through 

mutual fund supermarkets. Various broker-dealers, including those 

affiliated with a mutual fund adviser, allow their customers to purchase 

through their brokerage accounts the shares of funds operated by a wide 

range of investment advisers. Although these fund supermarkets provide 

the advisers of participating funds with an additional means of acquiring 

investor dollars, the firms that provide such supermarkets generally require 

investment advisers or funds themselves to pay a certain percentage on the 

dollars attracted from purchases by customers of the firm’s supermarket. 

For example, funds or advisers for the funds participating in the Charles 

Schwab One Source supermarket pay that broker-dealer firm up to 0.40 

percent of the amount invested by that firm’s customers. While some 

portion of those payments may be paid out of fund assets pursuant to 12b-1 

plans, those payments also may represent sharing of advisory fees. Some 
Page 38 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

or all of these payments may be for transfer agency and shareholder 

services.

According to SEC officials, revenue sharing is legitimate and consistent 

with provisions of rule 12b-1. SEC’s adopting release of Rule 12b-1 states 

that the rule should apply to both direct and indirect distribution expenses. 

However, because there can be no precise definition of what expenses are 

indirect, SEC decided that fund directors, particularly independent 

directors, would bear the responsibility for determining on a case-by-case 

basis whether the use of fund assets for distribution is in compliance with 

the rule. SEC further noted that fund advisers can use the revenues they 

receive from their management fee to pay for distribution expenses as long 

as the adviser’s profits are legitimate and not excessive. 

Actual Amount of Revenue 

Sharing Occurring Is Unknown 

Mutual funds are not required to disclose the revenue sharing payments 

made by their advisers as they are other distribution expenses paid by the 

funds. As noted above, any sales loads or 12b-1 fees that funds charge are 

disclosed in funds’ prospectuses and annual reports. However, the amount 

of revenue sharing payments, which are paid out of the fund adviser’s 

profits earned from the management fee or income from other sources, are 

not typically disclosed to investors, except for possible general disclosure 

in a fund’s prospectus or SAI. Funds do disclose 12b-1 payments and may 

disclose that they may make other distribution-related payments but do not 

have to disclose the total amount paid or identify the recipients of those 

payments. As a result, complete data are not available on the extent to 

which mutual fund advisers are making revenue sharing payments. An 

industry researcher said that the cost of revenue sharing does not show up 

in advisers’ financial reports because there is no line item for it and costs 

that fund advisers may incur to pay for sales meetings attended by brokerdealer staff or other promotion efforts are not specifically shown in fund 

adviser income statements. According to an article in one trade journal, 

revenue sharing payments made by major fund companies to brokerdealers may total as much as $2 billion per year. These amounts have been 

growing. According to the officials of a mutual fund research organization, 

revenue sharing costs are hard to quantify but are rising. For example, the 

organization reports that about 80 percent of fund companies that partner 

with major broker-dealers make cash revenue sharing payments.

Some Industry Participants Are 

Concerned that Revenue Sharing 

Could Negatively Impact 

Investors 

The increased use of revenue sharing payments is raising concerns among 

some industry participants. Although revenue sharing payments are 

becoming a major expense for fund advisers, industry research 

organization officials told us that most fund advisers are not willing to 
Page 39 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

publicly discuss the extent to which they are making such payments. A 

2001 report on fund distribution practices states that “the details and levels 

of revenue sharing vary widely across the industry and are seldom codified 

in written contracts.” In one industry magazine article, a mutual fund 

industry researcher referred to revenue sharing as “the dirty little secret of 

the mutual fund industry.” 

One of the concerns raised about revenue sharing payments is the effect on 

overall fund expenses. The 2001 research organization report on fund 

distribution practices noted that the extent to which revenue sharing may 

affect other fees that funds charge, such as 12b-1 fees or management fees, 

is uncertain. For example, the report noted that it was not clear whether 

the increase in revenue sharing payments had increased any fund’s fees but 

noted that by reducing fund adviser profits, revenue sharing would likely 

prevent advisers from lowering their fees. In addition, fund directors 

normally would not question revenue sharing arrangements because they 

are paid from the adviser’s profits, unless the payments are financed 

directly from fund assets as part of the adviser’s management fee or a 12b-1 

plan. Fund directors, however, in the course of their review of the advisory 

contract, consider the adviser’s profits before marketing and distribution 

expenses, which also may limit the ability of advisers to shift these costs to 

the fund.

Revenue sharing payments may also 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, these revenue sharing 

arrangements may have the effect of unduly focusing the attention of 

investors and their broker-dealers on particular mutual fund choices, which 

can reduce the number of funds they consider as part of the investment 

decision. That not only may lead to inferior investment choices, but may 

also reduce fee competition among funds. Finally, concerns have been 

raised that revenue sharing arrangements may conflict with securities selfregulatory organization rules requiring that brokers recommend 

purchasing a security only after ensuring that the investment is suitable 

given the investor’s financial situation and risk profile. 

Mutual fund officials’ opinions about revenue sharing were mixed. Some of 

the fund officials with whom we spoke viewed revenue sharing as a cost of 

doing business, which enabled them to obtain “shelf space” for their funds 

with major broker-dealers and did not regard these arrangements as 
Page 40 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

potentially conflicting with investors’ interests. They explained that the 

payments are made directly to the brokerage firm and not to individual 

staff financial advisers. One fund official said that there would be no 

incentive for broker-dealers’ sales staff to push certain funds, unless 

managers exerted pressure on sales staff to sell those funds. Officials of 

one large broker-dealer with whom we spoke said that their fund sales 

platform has an “open architecture” through which all participating funds’ 

agreements and payments are the same, which creates a level playing field 

on which no funds are given priority. One fund official commented that 

NASD rules require that broker-dealers sales staff recommend funds that 

are most suitable to the individual investor’s financial situation. However, 

in letters commenting on certain compensation arrangements among 

broker-dealers, ICI has stated that cash compensation creates potential 

conflicts of interest between the broker-dealer receiving the compensation 

and the customer because the sale of a recommended security could 

increase the compensation paid to the broker-dealer’s sales representative.

Although the extent to which revenue sharing payments are affecting the 

appropriateness of the fund recommendations that broker-dealers make is 

not known, investor’s complaints regarding mutual fund shares they 

purchased have recently increased dramatically. According to NASD 

statistics, the number of NASD-administered arbitration cases involving 

mutual funds have increased by over 900 percent from 121 cases in 1999 to 

1,249 cases in 2002. According to NASD staff, about 34 percent of the 2002 

cases involved complaints of unsuitable mutual fund purchases. The 

extent to which revenue sharing payments are involved with these cases is 

unknown and NASD staff said the likely reason behind the increase in 

arbitrations involving mutual funds is the decline in the stock market and 

the associated declines in mutual fund performance. 

Extent to Which Investors Are 

Told About the Potential Conflict 

That Revenue Sharing Creates Is 

Unclear

Although revenue sharing payments can create conflicts of interest 

between broker-dealers and their clients, the extent to which brokerdealers disclose to their clients that their firms receive such payments from 

fund advisers is not clear. Rule 10b-10 under the Securities Exchange Act 

of 1934 requires, among other things, that broker-dealers provide 

customers with information about third-party compensation that brokerdealers receive in connection with securities transactions. While brokerdealers generally satisfy the requirements of rule 10b-10 by providing 

customers with written “confirmations,” the rule does not specifically 

require broker-dealers to provide the required information about thirdparty compensation related to mutual fund purchases in any particular 

document. SEC staff told us that they interpret rule 10b-10 to permit 
Page 41 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

broker-dealers to disclose third-party compensation related to mutual fund 

purchases through delivery of a fund prospectus that discusses the 

compensation. However, investors will not receive a confirmation, and may 

not view a prospectus, until after purchasing mutual fund shares. 

According to SEC staff, the compensation-disclosure requirements of rule 

10b-10 in large part are geared toward providing investors with information 

that is useful over a course of dealing with a broker-dealer, rather than just 

one transaction. Information disclosed following the first transaction in a 

security can help the investor determine whether to continue to use that 

broker-dealer for future transactions. That is particularly applicable in the 

context of mutual funds, given that investors often purchase fund shares 

over time in a series of transactions. 

Regulators and others acknowledged that additional disclosures may be 

necessary to better help investors assess the potential conflicts of interest 

associated with mutual fund transactions when distributing broker-dealers 

receive revenue sharing payments. According to SEC staff, additional 

disclosure is consistent with the principle that investors should be 

informed about the financial interest that their broker-dealers have with 

respect to mutual fund transactions. Additional disclosure about revenue 

sharing also may help investors be more sensitive to the question of 

whether they are being presented with an adequate range of investment 

choices within a fund class. SEC officials also told us that additional 

disclosure of revenue sharing payments may be justified so that investors 

can better assess whether the fund’s advisory fees are excessive. SEC 

officials, in addition, noted that additional disclosure also might help 

promote fee competition among funds. 

NASD officials said that mutual funds’ revenue sharing arrangements with 

broker-dealers could present a conflict of interest for the broker-dealer. 

However, NASD looked at this issue in the past and found no hard evidence 

of sales representatives recommending unsuitable funds, but they 

acknowledged that making such a determination would be difficult. The 

NASD officials told us that it may be time to reexamine this issue. They said 

that NASD Rule 2830 prohibits member brokers from accepting 

compensation from fund advisers unless the funds disclose these payments 

in fund prospectuses. ICI has also endorsed regulatory rule changes that 

would require broker-dealers to disclose if they are receiving compensation 

from fund advisers, in addition to requiring disclosure of these payments in 

fund prospectuses. However, an official at one mutual fund adviser with 

whom we spoke said that disclosure of funds’ revenue sharing agreements 

would not be helpful because it would include only their largest 
Page 42 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

distributors and might mislead investors about the extent of revenue 

sharing.

Soft Dollar 

Arrangements Provide 

Benefits, but Could 

Also Have an Adverse 

Impact on Investors 

Soft dollar arrangements allow investment advisers of mutual funds and 

other clients to use part of the brokerage commissions paid to brokerdealers that execute trades on the fund's behalf to obtain research and 

brokerage services that can potentially benefit fund investors but could 

increase the costs borne by their funds. The research and brokerage 

services that fund advisers obtain through the use of soft dollars can 

benefit a mutual fund investor by increasing the availability of research. 

This practice also creates potential conflicts of interest that could harm 

fund investors. Some industry participants argued that when mutual fund 

investment advisers use fund assets to pay brokerage commissions and 

receive research or brokerage services as part of soft dollar arrangements, 

such services improve the investment advisers’ management of the fund. 

However, others expressed concerns that such arrangements create 

conflicts of interest that could result in fund advisers paying higher 

brokerage commissions than necessary, which increases costs to fund 

investors. Investors’ expenses also could be higher if investment advisers 

use brokerage commissions to pay for research and brokerage services that 

they do not need or would otherwise pay for out of their own profits. 

Expenses to investors would also be higher if investment advisers traded 

more to generate and receive more soft dollar services. According to SEC, 

soft dollar arrangements could also compromise advisers’ fiduciary 

responsibility to seek brokers capable of providing the best execution on 

fund trades by choosing broker-dealers on the basis of their soft dollar 

offerings. With these potential conflicts of interest in mind, several 

interested parties in the United States and abroad have made suggestions 

for how potential soft dollar abuses could be mitigated, although some of 

these actions could have other negative consequences. 
Page 43 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Soft Dollars Pay for 

Research and Brokerage 

Services

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.26 In return for 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 refer to the exchange of research and brokerage services 

from broker-dealers to fund advisers in return for brokerage commissions.

For example, many full-service broker-dealers offer trade execution 

services, and in exchange for paying their stated institutional commission 

rate, advisers conducting trades through them could be entitled to research 

produced by the broker-dealers’ analysts or receive priority notification of 

market or company-specific news. In addition to providing this proprietary 

research, these broker-dealers may also allow the fund adviser to generate 

soft dollar credits with a portion of the brokerage commissions paid that 

the fund adviser can then use to purchase other research from third parties. 

These third parties can be other broker-dealers, independent research or 

analytical firms, or service providers such as market data or trading 

systems software and hardware vendors. In a 1998 inspection report that 

documented reviews of soft dollar practices at 75 broker-dealers and 280 

investment advisers and investment companies, SEC reported for every 

$1.70 in commissions paid to a broker-dealer, the adviser would receive 

$1.00 worth of soft dollar products and services. 27

Soft dollar arrangements are not unique to the mutual fund industry. They 

are widely used by investment advisers who manage portfolios for other 

clients besides mutual funds, including pension funds, hedge funds, and 

individual retail clients.

Soft Dollar Arrangements 

Have Evolved Over Time

Many of the features of soft dollar arrangements that exist today 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 

26As noted previously, instead of commissions, broker-dealers executing trades also could 

be compensated through markups or spreads.

27U.S. Securities and Exchange Commission, Inspection Report on the Soft Dollar Practices 

of Broker-Dealers, Investment Advisers and Mutual Funds (Washington, D.C.: Sept. 22, 

1998).
Page 44 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

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 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 

and not be in breach of their fiduciary duty. In order to be protected 

against a claim of breach of fiduciary duty under this safe harbor, the 

adviser must make a good faith determination that the amount of 

commission paid is reasonable in relation to the value of the brokerage and 

research services provided by the broker-dealer. 

The definition of what research and brokerage services can be obtained 

through soft dollar arrangements has evolved over time. In a 1976 release, 

SEC issued guidelines for determining when a product or service is within 

the meaning of brokerage and research services and available for the safe 

harbor under section 28(e). The 1976 guidelines provided the product or 

service must not be “readily and customarily available and offered to the 

general public on a commercial basis.” In 1986, noting that this standard 

was difficult to apply and unduly restrictive in certain instances, SEC 

reinterpreted the safe harbor as permitting soft dollar arrangements to 

purchase products and services that “provide lawful and appropriate 

assistance to the money manager in the performance of his investment 

decision-making responsibilities,” which could then include those 

commercially available to the public.28 Under the revised interpretation, the 

cost of products and services that provide lawful and appropriate 

assistance, such as computer hardware and seminars, may be paid for with 

soft dollars.

28Securities; Brokerage and Research Services, Securities and Exchange Commission 

Release No. 34-23170, 51 F.R. 16004 (Apr. 23, 1986). 
Page 45 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Although the Complete 

Extent of Soft Dollar Use Is 

Unknown, Soft Dollars 

Could Represent a 

Significant Portion of 

Trading Commissions 

Because soft dollar research is often bundled, only aggregate value 

estimates of soft dollar arrangements are available. According to one 

industry research organization, the total amount paid in brokerage 

commissions for U.S. stocks totaled $8.6 billion in 2001, up from $7.7 billion 

in 2000.29 Of this amount, industry participants estimate that 15 percent of 

total annual brokerage commissions, or roughly $1 billion, is used to obtain 

third-party research. However, this figure does not include the value of 

proprietary research, which cannot be unbundled as easily as third-party 

research. Moreover, in light of recent declines in fund assets, concern has 

been raised that advisers are under increased pressure to use soft dollars to 

pay for research rather than incur additional fund expenses. 

Soft dollar products and services appear to represent a substantial portion 

of the cost of brokerage commissions on individual trades. Industry 

participants estimate that on average broker-dealers charge commissions 

of between $.05 and $.06 per share traded. In contrast, one industry expert 

has noted that it costs less than $.01 per share to execute a trade through 

an electronic communications network (ECN). ECNs are registered 

broker-dealers that operate as electronic exchanges. Because ECNs do not 

offer as many of the services offered by full service broker-dealers and 

execute trades electronically, the cost of executing trades through these 

brokers is lower. However, the estimated costs of trading on an ECN may 

not be representative of trading in all securities because most activity on 

ECNs involves widely traded, liquid stocks. Other estimates of the portion 

of individual brokerage commissions represented by soft dollars and 

execution services varied. One academic study, for example, attributes 67 

percent of the cost of brokerage commissions on individual trades to soft 

dollars that pay for proprietary or third-party research.30 However, 

recognizing that a portion of brokerage commissions goes towards brokerdealer profits, a consulting firm that specializes in mutual funds estimates 

more conservatively that soft dollars constitute 33 percent of brokerage 

commission costs.

Advisers who offer mutual funds use soft dollar arrangements to varying 

degrees. According to one SEC official, many fund companies do their own 

29Greenwich Associates, Commission and Soft-Dollar Practices in U.S. Equities (May 3, 

2002).

30M. Livingston and E.S. O’Neal, “Mutual Fund Brokerage Commissions,” The Journal of 

Financial Research (Summer 1996).
Page 46 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

research and thus have less use for broker-dealer or third-party research. 

Fixed-income funds, because their trades largely do not involve paying 

commissions, may not generate many soft dollar credits that could be used 

to obtain third-party research. However, one adviser of fixed-income funds 

with whom we spoke said that his firm does receive proprietary research 

from the full-service broker-dealers with whom they trade. Nine of the ten 

fund companies with whom we spoke also used soft dollars to varying 

degrees. One of the fund companies indicated that they did not engage in 

any soft dollar arrangements. However, this company specializes in 

indexed funds, which do not require research, and therefore seeks 

execution-only trades when it engages in portfolio transactions. Officials 

from other firms indicated that they limited the items that they obtained 

with soft dollars to research reports and analysis. On the other hand, some 

fund companies with whom we spoke indicated that their funds engaged in 

greater use of soft dollar arrangements for a variety of research and 

brokerage services permissible under section 28(e), including computer 

monitors and analytical software. 

Disclosure of Soft Dollar 

Use to Mutual Fund 

Investors Is Limited 

Fund advisers and investment companies must make some disclosure of 

their soft dollar arrangements, but these disclosures are not specific and 

not required to be routinely provided to mutual fund investors. Under the 

Investment Advisers Act of 1940, advisers must disclose details of their soft 

dollar arrangements in Part II of Form ADV, which is the form that 

investment advisers use to register with SEC and are required to send to 

their advisory clients. Specifically, Form ADV requires advisers to describe 

the factors considered in selecting brokers and determining the 

reasonableness of their commissions when the adviser has discretion in 

choosing brokers. If the value of the products, research and services given 

to the adviser affects the choice of brokers or the brokerage commission 

paid, the adviser must also describe the products, research and services 

and whether clients may pay commissions higher than those obtainable 

from other brokers in return for those products. The adviser is also to 

disclose whether research is used to service all of the adviser’s accounts or 

just those accounts paying for it and any procedures the adviser used 

during the last fiscal year to direct client transactions to a particular broker 

in return for products and research services received. However, SEC staff 

told us that the Form ADV disclosures tend to use standardized language 

that is difficult for advisory clients to evaluate.
Page 47 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

The information that investment advisers disclose about their choice of 

broker-dealers and their use of soft dollars in their Form ADV is not 

required to be routinely provided to mutual fund investors. As noted 

above, investment advisers are required to provide their Form ADV to their 

advisory clients. However, in the case of mutual funds, the client is 

considered to be the legal entity that is registered as the investment 

company with SEC and not the individual shareholders of the mutual fund. 

SEC rules also require advisers to disclose the aggregate brokerage 

commissions paid by the investment adviser with fund assets, the criteria 

for broker selection, and the products and services obtained through soft 

dollar arrangements in their SAI. 31 However, SAIs are only sent to 

investors upon request, and industry officials noted that investors rarely 

request SAIs. As a result, mutual fund shareholders do not routinely 

receive information about the extent to which their funds’ advisers receives 

and uses soft dollar credits when making purchases or sales of the 

securities in the mutual funds that they own. 

In addition to oversight of fees and fund distribution expenses, mutual fund 

directors also have a responsibility to monitor advisers’ soft dollar 

arrangements to ensure best execution on portfolio trades. According to 

SEC, fund directors typically have access to more detailed information 

about an adviser’s soft dollar practices than described in the Form ADV, 

including a list of brokers used and the total commissions dollars paid to 

each broker, the average commission rate per share by broker, the list of 

brokers with which the fund adviser has soft dollar arrangements and a 

description of research and brokerages services received by the fund. 

Additionally, directors often receive the advice of independent counsel 

about an adviser’s soft dollar practices. Both SEC examiners and fund 

directors evaluate soft dollar arrangements in the context of whether 

advisers are getting best execution on portfolio transactions. Directors and 

31The information that investment advisers are required to file with SEC that comprises the 

SAI is contained in Form N-1A, which is the registration statement for open-ended 

management investment companies. Information about soft dollar arrangements are also 

contained in Form N-SAR, which is the form registered management investment companies 

file with SEC on a semi-annual basis. Disclosures regarding brokerage practices are found 

in items 20, 21, 22, and 26 of this form. In particular, item 26 requires the fund to answer yes 

or no as to various considerations that affected the participation of brokers or dealers in 

commissions or other compensation paid on portfolio transactions of the fund. These 

considerations include sales of the fund's shares; receipt of investment research and 

statistical information; receipt of quotations for portfolio valuations; ability to execute 

portfolio transactions to obtain best price and execution; receipt of telephone line and wire 

services; affiliated status of the broker or dealer; and arrangements to return or credit part 

or all of commissions or profits thereon to the fund and other affiliated persons of the fund. 
Page 48 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

industry participants with whom we spoke indicated that boards evaluate 

how advisers use soft dollars, whether these charges are reasonable, and 

whether these arrangements affect best execution of portfolio 

transactions.

Soft Dollars Benefit 

Investors in Various Ways, 

but Could Also Increase 

Investor Costs or Raise 

Conflicts of Interest

Some industry participants argue that the use of soft dollar benefits 

investors in various ways. They note that the prevalence of soft dollar 

arrangements allow 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 may also have 

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

research on smaller companies for which soft dollars pay helps create a 

more efficient market for such companies’ securities, resulting in greater 

market liquidity and lower spreads.

However, concerns have been raised about soft dollar arrangements 

because they could increase the costs that investors incur when investing 

in a mutual fund. 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. As a result, soft dollar trades 

might have both higher brokerage commissions and worse trade execution. 

One academic study, for example, shows that trades executed by brokerdealers that specialize in providing soft dollar products and services tend to 

be more expensive than those executed through other broker-dealers, 

including full-service broker-dealers.32 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 were 

not paying for it directly. In turn, advisers might have less incentive to 

negotiate lower commissions, resulting in investors paying more for trades. 

Some believe soft dollars are used to purchase research and brokerage 

services for which advisers should pay out of their own profits and not out 

of fund assets. As a result, the investor assumes the direct financial burden 

for the advisers’ costs. 

32J.S. Conrad, K.M Johnson, and S. Wahal, “Institutional Trading and Soft Dollars,” Journal 

of Finance (February 2001).
Page 49 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Concerns have also been expressed that the range of products and services 

that advisers are obtaining with client commissions might be too broad. 

Critics of soft dollar arrangements have argued that the 1986 principle has 

legitimized the use of investor dollars to pay for products and services with 

only marginal research applications, such as computer terminals, 

telephone bills, and magazine subscriptions. Using soft dollars for such 

services could harm investors because advisers have an incentive to freely 

obtain such services that they would otherwise have to pay for out of their 

profits. 

SEC noted that mutual fund advisers tend to abide by the spirit of section 

28(e) more diligently than other investment advisers. In 1996 and 1997, SEC 

examiners conducted an examination sweep into the soft dollar practices 

of broker-dealers, investment advisers and mutual funds. In their 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. 

However, SEC staff indicated that their review found that mutual fund 

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

advisers. They attributed mutual fund adviser compliance to the role that 

independent directors play in overseeing and approving advisers’ soft 

dollar arrangements. The SEC staff also indicated that active involvement 

by legal counsel in the affairs of mutual funds may contribute to the relative 

lack of soft dollar abuses among mutual fund advisers as well.

Investment advisers also receive services in exchange for part of the 

brokerage commissions they pay with fund assets that directly reduce the 

costs borne by mutual fund investors. In these cases, instead of the adviser 

receiving research or brokerage services, the adviser, at the request of the 

fund board, could direct the broker-dealer executing a trade to use a 

portion of the commission paid to pay an expense of the mutual fund. For 

example, the executing broker-dealer could mail a payment to the fund’s 

custodian for the services rendered to the mutual fund that could reduce 

the amount the fund itself would have to directly pay the custodian out of 

fund assets. Alternatively, the executing broker-dealer could rebate part of 

the brokerage commission to the fund in cash. Such directed brokerage 

arrangements do not fall under the section 28(e) safe harbor and do not 

present the same conflicts of interest as traditional soft dollar 

arrangements, because the investor, not the adviser, is directly benefiting 

from them. An industry participant has indicated that such arrangements 

are not very common in the mutual fund industry.
Page 50 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Regulators and Industry 

Participants Have Proposed 

Alternatives for Mitigating 

Potential Conflicts Involving 

Soft Dollar Use 

As a result of its 1998 inspection report on its soft dollar examination 

sweep, SEC staff made several proposals that could help investors better 

evaluate advisers’ use of soft dollars. In the examination sweep, SEC 

examiners found inconsistencies in how advisers and broker-dealers 

interpreted the section 28(e) safe harbor. Staff also found poor record 

keeping and internal controls for soft dollar arrangements and that advisers 

were not adequately disclosing their soft dollar usage. As a result, SEC 

staff recommended that Form ADV be modified to require more meaningful 

disclosure. To facilitate this disclosure, SEC staff also recommended that 

SEC publish the inspection report and issue additional guidance to clarify 

the scope of the safe harbor. SEC published the inspection report to 

reiterate guidance with respect to the scope of the safe harbor and to 

emphasize the obligations of broker-dealers, investment advisers, and 

investment companies that participate in soft dollar arrangements. This 

recommendation may help industry participants apply the standards 

articulated in the 1986 interpretive release more consistently and ensure 

that investor dollars only pay for research and brokerage services within 

the scope of section 28(e). Additionally, SEC staff recommended that SEC 

consider adopting a bookkeeping requirement. A bookkeeping requirement 

would enable advisers to disclose more easily to investors the products and 

services for which soft dollars are paying. It would also ensure that 

directors are able to receive information that fairly reflects the adviser’s 

soft dollar arrangements. SEC staff told us that if the expanded disclosure 

and other changes envisioned in their sweep report were implemented, 

clients of investment advisers also would have more specific information 

that could allow them to evaluate the appropriateness of their own 

adviser’s use of soft dollars. The Department of Labor, which oversees 

pension funds, and the Association for Investment Management and 

Research, which administers professional certification examinations for 

financial analysts, have also called for improved disclosure of soft dollar 

usage by investment advisers.33

33See Department of Labor Advisory Council on Employee Welfare and Benefit Plans, Report 

of the Working Group on Soft Dollars/Commission Recapture (Nov. 13, 1997); and 

Association for Investment Management and Research, AIMR Soft Dollar Standards (August 

1999).
Page 51 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

However, SEC has yet to implement some of these recommendations due 

to staff turnover and other high priority business. Except for publishing the 

inspection report and issuing interpretative guidance that classifies certain 

riskless principal transactions as falling under the section 28(e) safe 

harbor, SEC has not issued further guidance regarding soft dollars.34 A soft 

dollar bookkeeping requirement has been discussed as part of a larger SEC 

initiative on bookkeeping, but no formal proposal has been presented. 

Finally, the SEC issued a proposed rule on Form ADV modifications in 

April 2000, which solicited comments on several changes that could force 

advisers to make more meaningful disclosures of soft dollar arrangements. 

However, this rule has not been adopted.35 SEC staff told us that they have 

not taken further actions on these proposals due to staff turnover and the 

press of business in other areas. 

Some industry participants are not convinced that greater disclosure would 

benefit investors. Form ADV is sent to advisory clients, not fund investors. 

Thus, the proposed disclosure requirements do not address the needs of 

fund investors. Investors do have access to information on a fund’s soft 

dollar arrangements through the SAI, which is available upon request. 

However, representatives of one fund company with whom we spoke 

indicated that investors very rarely request SAIs. Industry participants also 

noted that it might be difficult for investors to evaluate an adviser’s best 

execution policies, which are not uniform across funds. Moreover, more 

disclosure might lead investors to infer that soft dollar arrangements are 

necessarily harmful and therefore adverse to their best interests.

34In SEC Interpretation: Commission Guidance on the Scope of Section 28(e) of the 

Exchange Act, Securities and Exchange Commission Release No. 34-45194 (12/27/2001), 

SEC clarified that the term “commission” for purposes of the Section 28(e) safe harbor 

encompasses, among other things, certain riskless principal transactions.

35Proposed Rule: Electronic Filing by Investment Advisers; Proposed Amendments to Form 

ADV, Securities and Exchange Commission, Release No. IA-1862; 34-42620 (Apr. 5, 2000).
Page 52 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Some proposals would seek to restrict or ban the use of soft dollars in 

order to encourage brokerage commissions to fall. As a result of 

recommendations from a government-commissioned review of 

institutional investment in the United Kingdom, the Financial Services 

Authority (FSA), which regulates the financial services industry in that 

country, issued a consultation paper that argued that soft dollar 

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

practices do not result in a good value for investors.36 As a result of these 

findings, the paper proposed banning soft dollars for market pricing and 

information services, as well as various other products. This 

recommendation would provide a more direct incentive for advisers to 

consider what services are necessary for efficient fund management, which 

could lower investors costs by reducing the extent to which advisers use 

client funds for services that the adviser does not need. The paper also 

recommended that advisers quantify, or unbundle, the cost of all other soft 

dollar products and services and rebate those costs to investors’ accounts 

with hard dollars, which would result in investors having lower trading 

costs in their funds. 

Whether implementing the actions envisioned by the FSA’s proposals is 

feasible is not certain. For example, FSA staff 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. 

Such restrictions could also encourage UK advisers to move their 

operations elsewhere. In addition, SEC staff told us that implementing the 

FSA proposal would be more difficult here without legislative change 

because the United States has the statutory safe harbor under Section 

28(e), whereas the United Kingdom does not. 

We learned of another proposal related to soft dollars and brokerage 

commissions from an industry participant who was concerned that the 

general practice of full-service broker-dealers charging about $0.05 to $0.06 

per share in commissions and then offering discounts in the form of soft 

dollars was serving to keep commissions artificially high. His first 

suggestion would be to ban soft dollar arrangements to obtain products 

36See P. Myners, Institutional Investment in the United Kingdom: A Review (Mar. 6, 2001); 

and Financial Services Authority, Bundled Brokerage and Soft Commission Arrangements

(April 2003).
Page 53 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

and services with marginal research applications, forcing advisers to pay 

for these products with their own profits rather than with fund assets and 

therefore reducing the trading costs borne by fund investors. Another 

suggestion he had would have broker-dealers quantify the execution-only 

portion of their brokerage commissions. If this information were collected 

by SEC and reported as industry averages, mutual fund directors would 

have more information to use to evaluate their fund’s trading activities. 

However, many industry participants are skeptical about whether soft 

dollar arrangements contribute to investors paying higher brokerage 

commissions. For example, according to SEC officials and an industry 

participant, many broker-dealers claim that they would not negotiate lower 

commission rates with investment advisers regardless of whether an 

adviser was willing to forfeit soft dollar products and services in return. 

One group with whom we spoke suggested that soft dollars might be more 

of a volume rebate for brokerage than a factor influencing commission 

rates. Moreover, surveys of investment advisers and broker-dealers 

conducted in the United Kingdom found that third-party soft dollar 

arrangements were a very minor factor on which broker-dealers competed 

for business and advisers selected broker-dealers. These results suggest 

that advisers’ incentive to compromise their fiduciary responsibility to seek 

best execution in return for generous soft dollar arrangements might be 

overstated. 

Concern has also been raised about how the value of some soft dollar 

products and services could be fairly determined. Because proprietary soft 

dollar products and services are bundled, their values as individually 

purchased items are difficult to estimate. For example, SEC officials noted 

that it is hard to put a meaningful value on the cost of information 

exchanged in a phone call between a fund adviser and a broker-dealer. 

Nevertheless, brokerage commissions pay for this type of informal access. 

Some industry experts, including SEC, have noted that attempts to require 

the industry to quantify the value of soft dollar services could have a 

disproportionate impact on third-party research. Third-party research is 

free from the potential conflicts of interest that have recently tainted some 

proprietary research from brokerage houses. Additionally, several fund 

companies have indicated that they find research provided by specialized 

research firms does provide valuable insights into investment decisions. 

Because broker-dealers use soft dollar credits to purchase third-party 

research, its value is more easily determined than proprietary research. As 

a result, some have expressed concern that this distinction could make 

third-party research more vulnerable if regulatory changes were enacted.
Page 54 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Some have suggested that limiting the products and services that could be 

obtained with soft dollars might have some unintended consequences. 

According to some fund officials, this option could shift a greater financial 

burden onto advisers, who might be tempted to raise management fees as a 

result. While having investment advisers pay directly for research and 

brokerage services rather than receive them through soft dollars could 

increase the transparency of these arrangements, the increased costs to the 

adviser could cause advisers to seek fee increases or at least prevent 

further reductions in the fees advisers do charge. 

Conclusions Although mutual funds disclose considerable information about their costs 

to investors, some industry participants urge that additional disclosures are 

needed to further increase the awareness of investors of the fees they pay 

as part of investing in mutual funds and to encourage greater competition 

among mutual funds on the basis of these fees. The SEC staff’s proposal to 

require funds to disclose the actual expenses in dollars based on an 

investment amount of $10,000 would provide investors with more 

information on fund fees and in a form that would allow for direct 

comparison across funds. If adopted, this will provide investors selecting 

among different funds with useful information prior to investing. However, 

additional disclosures could also improve investor awareness and the 

transparency of these fees. Providing existing investors with the specific 

dollar amounts of the fees paid on their shares and placing fee related 

disclosures in the quarterly account statements that investors receive 

would put mutual fund disclosures on comparable footing to many other 

financial services that already disclose specifically in dollars the cost of 

their services. Seeing the specific dollar amount paid on their shares could 

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

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

investment decisions on this basis. Such disclosures may also increasingly 

motivate fund companies to respond competitively by lowering fees. 

Given the cost of producing such disclosures and the lack of data on the 

additional benefits to investors, the SEC staff have indicated that they were 

not certain that specific dollar disclosures are warranted. However, we 

believe that actively weighing the costs and benefits of providing additional 

disclosure is worthwhile. In addition, other less costly alternatives are also 

available that could increase investor awareness of the fees they are paying 

on their mutual funds by providing them with information on the fees they 

pay in the quarterly statements that provide information on an investor’s 

share balance and account value. For example, one alternative that would 
Page 55 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

not likely be overly expensive would be to require these quarterly 

statements to present the information that SEC has proposed be added to 

mutual fund’s semiannual reports that would disclose the dollar amounts of 

a fund’s fees based on a set investment amount. 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 could be to 

require quarterly statements to also include a notice that reminds investors 

that they pay fees and to check their prospectus and with their financial 

adviser for more information. If additional fee disclosures such as these 

were used to supplement the existing information already provided in 

prospectuses and semiannual reports, both prospective and existing 

investors in mutual funds would have access to valuable information about 

the relative costs of investing in different funds.

Mutual fund directors play a critical role in overseeing fund advisers 

activities and have been credited with ensuring that U.S. mutual funds have 

lower fees than those charged in other countries. However, the popularity 

of mutual fund investing and the increasing importance of such 

investments to investors’ financial well being and ability to retire securely 

also increases the need for regulators and industry participants to 

continually seek to ensure that mutual fund corporate governance 

practices remain strong. The recent corporate scandals have resulted in 

various corporate governance reforms being proposed to improve the 

oversight of public companies by their boards of directors. We have 

supported regulatory and industry efforts to strengthen the corporate 

governance of public companies. Although many of the reforms being 

sought for public companies are already either embodied in regulatory 

requirements or recommended as best practices by the mutual fund 

industry group, additional improvements to mutual fund governance, such 

as mandating supermajorities of independent directors, are likely to 

continue to be considered by regulators and industry participants, which 

should further benefit mutual fund investors. 

Although the ways that funds use 12b-1 fees has changed over time, these 

fees appear to have provided investors with increased flexibility in 

choosing how to pay for the services of the individual financial 

professionals providing them with advice on fund purchases. As a result, 

they appear to provide benefits to the large number of investors that 

require assistance with their financial decisions. The revenue sharing 

payments that funds make to broker-dealers illustrate that mutual funds 

must compete to obtain access to the distribution networks that these 

firms provide. How and the extent to which these payments affect the 
Page 56 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

overall level of fees that fund investors pay is not clear. However, by 

compensating broker-dealers to market the funds of a particular company, 

they can introduce a conflict with the broker-dealer obligation to 

recommend the funds most suitable to the investor’s needs. Further, even 

if the payments do not conflict with this obligation, the payments can result 

in financial professionals providing investors with fewer investment 

choices. Regulators acknowledged that the currently required disclosures 

might not provide needed transparency to investors at the time that mutual 

fund shares are being recommended for purchase. Having additional 

disclosures made at the time that fund shares are recommended about the 

compensation that a broker-dealer receives from fund companies could 

provide investors with more complete information to consider when 

making their investment decision. 

Fund investors can benefit when their fund’s investment adviser uses soft 

dollars to obtain research and brokerage services that benefit the fund or to 

pay other fund expenses. However, investment advisers may also use soft 

dollars for services that may just reduce the adviser’s own expenses. The 

SEC staff has recommended various changes that would increase the 

transparency of soft dollar practices by clarifying the acceptable uses of 

soft dollars and providing fund investors and directors with more 

information about how their fund’s adviser is using soft dollars. However, 

the rule proposal to expand advisers’ disclosure of their use of soft dollars 

was issued about 3 years ago and has not yet been acted upon. In addition, 

the SEC staff have not developed and issued a formal rule proposal to 

implement its recommendation to require increased soft dollar 

recordkeeping by broker dealers and advisers that would increase the 

transparency of these arrangements. SEC relies on disclosure of 

information as a primary means of addressing potential conflicts between 

investors and financial professionals. However, by not acting on these soft 

dollar-related measures, investors and mutual fund directors have less 

complete and transparent information with which to evaluate the benefits 

and potential disadvantages of their fund adviser’s use of soft dollars.

Recommendations To promote greater investor awareness and competition among mutual 

funds on the basis of their fees, we recommend that the Chairman, SEC 

increase the transparency of the fees and practices that relate to mutual 

funds by
Page 57 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

• considering the benefits of additional disclosure relating to mutual fund 

fees, including requiring more information in mutual fund account 

statements about the fees investors pay; 

• evaluating ways to provide more information that investors could use to 

evaluate possible conflicts of interest resulting from any revenue 

sharing payments their broker-dealers receive; and 

• evaluating ways to provide more information that fund investors and 

directors could use to better evaluate the benefits and potential 

disadvantages of their fund adviser’s use of soft dollars, including 

considering and implementing the recommendations from its 1998 soft 

dollar examinations report.

Agency Comments and 

Our Evaluation 

SEC and ICI generally agreed with the contents of this report. Regarding 

our recommendation that SEC consider additional ways to provide fee 

information to investors in account statements, the letter from the director 

of the Division of Investment Management notes that the SEC staff agreed 

that mutual fund shareholders need to understand the amount of fees that 

mutual funds charge and indicated that they would consider whether some 

form of fee disclosure could be included in account statements as they 

continue to evaluate the comments they have received on their proposed 

disclosure changes. Regarding our recommendations on increasing the 

amount of information disclosed about revenue sharing and soft dollar 

arrangements, the SEC staff also indicated that they intend to consider 

ways in which additional information about these practices could be 

disclosed. 

The letter from the president of ICI notes that our report’s discussion of 

mutual fund regulatory requirements is generally balanced and well 

informed. However, his letter indicates concern over how we compare the 

disclosures made by mutual fund fees to those made by other financial 

products. According to the letter, ICI staff are convinced that current 

mutual fund fee disclosures allow individuals to make much more informed 

and accurate decisions about the costs of their funds than do the 

disclosures made by other financial service firms. In particular, they 

indicated that they are not aware of any other financial product that is 

legally required to provide standardized information that reveals the exact 

level of all of its fees and expenses and projects their impact in dollar terms 

over various time periods. 
Page 58 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

We agree with ICI that mutual funds are already required to make 

considerable disclosures that are useful to investors for comparing the 

level of fees across funds. Although our report notes that, unlike mutual 

funds, other financial products generally do disclose their costs in specific 

dollar terms, we do not make a judgment as to whether the overall 

disclosures provided by these products are superior to that provided for 

mutual funds. Instead, we believe that supplementing the existing mutual 

fund disclosures with additional information, particularly in the account 

statements that provide investors with the exact number and value of their 

mutual fund shares, could also prove beneficial for increasing awareness of 

fees and prompting additional fee-based competition among funds. 

The ICI’s staff’s letter also indicates that our report presents a thorough and 

useful discussion of the role played by independent directors in overseeing 

mutual fund fees. However, they expressed concern that mutual fund 

independent directors are not usually given sufficient credit for protecting 

fund shareholder interests. ICI noted that independent directors have 

helped keep the industry free of major scandal and that mutual fund 

governance standards, as set by the Investment Company Act of 1940, 

places strict requirements on funds that exceed the voluntary standards 

with which public companies are expected to adhere. We agree with ICI 

that independent directors have played important roles in overseeing funds 

and, in each of the issues addressed by our report, we discuss the actions 

taken by mutual fund directors to oversee the issues and that SEC reviews 

generally find that directors have fulfilled their duties in accordance with 

the law. However, given recent scandals and concerns related to corporate 

responsibility in the financial sector and the growing importance of fund 

investments to the financial health and retirement security of investors, 

continued debate by the Congress and among regulators and industry 

participants about the effectiveness of existing mutual fund corporate 

governance standards is appropriate. SEC’s and ICI’s written responses are 

shown in appendixes II and III.

As agreed with your offices, unless you publicly announce the contents of 

this report earlier, we plan no further distribution of this report until 30 

days from the report date. At that time, we will provide copies of this report 

to the Chairman and the Ranking Minority Member, Senate Committee on 

Banking, Housing, and Urban Affairs, and the Ranking Minority Members, 

House Committee on Financial Services and its Subcommittee on Capital 

Markets, Insurance, and Government Sponsored Enterprises. Copies also 

will be provided to the Chairman, SEC; the President, ICI; and other 
Page 59 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

interested parties. The report will also be available at no charge on GAO’s 

home page at http://www.gao.gov. 

If you or your staff have any questions regarding this report, please contact 

Mr. Cody Goebel or me at (202) 512-8678. GAO staff that made major 

contributions to this report are shown in appendix IV.

Richard J. Hillman

Director, Financial Markets

 and Community Investment
Page 60 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Appendix I

Scope and Methodology AAppenendxIdeisi

To describe mutual fund fee and trading cost disclosures and other 

financial product disclosures and the related costs we reviewed SEC rules 

and studies by academics and others, and various mutual fund company 

fund literature including prospectuses and SAIs, as well as prior GAO work. 

To evaluate the benefits of additional mutual fund cost disclosure we 

collected opinions from a judgmental sample of 15 certified financial 

planners with the use of a structured questionnaire. 

To describe the role of mutual fund independent directors we reviewed 

federal laws and regulations, academic studies, and prior GAO work. We 

collected opinions from officials representing an independent directors 

association and from a judgmental sample of independent directors with 

the use of a structured questionnaire. 

To obtain information on mutual fund distribution practices we 

interviewed officials of ten mutual fund companies, two broker-dealers, 

ICI, NASD, SEC, mutual fund research organizations, and investor 

advocacy organizations and individuals. We also reviewed and analyzed 

various documents and studies of mutual fund distribution practices. 

To address the benefits and potential conflicts of interest raised by mutual 

funds’ use of soft dollars, we spoke with the FSA and other industry 

experts on soft dollars. We also reviewed studies by regulators and industry 

experts on soft dollar arrangements. Some groups we spoke to had made 

specific recommendations for regulatory changes to soft dollar 

arrangements. To the extent possible, we discussed the potential 

advantages and disadvantages of these recommendations with officials of 

the ten mutual fund companies, two broker-dealers, ICI, NASD, SEC, 

mutual fund research organizations, and investor advocacy organizations 

and individuals.

For each of the topics we reviewed in this report we gathered views from 

staff at SEC, mutual fund company officials, broker-dealers, ICI, mutual 

fund research organizations, and investor advocacy organizations and 

individuals. We conducted our work in Washington, D.C.; Boston, MA; 

Kansas City, MO; Los Angeles, CA; New York, N.Y.; and San Francisco, CA, 

from February to June 2003, in accordance with generally accepted 

government auditing standards.
Page 61 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Appendix II

Comments from the Securities and Exchange 

Commission ApenIdxi
Appendix II

Comments from the Securities and Exchange 

Commission

Page 62 GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Appendix II

Comments from the Securities and Exchange 

Commission

Page 63 GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Page 64 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Appendix III

Comments from the Investment Company 

Institute ApenIdxi
Appendix III

Comments from the Investment Company 

Institute

Page 65 GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Appendix III

Comments from the Investment Company 

Institute

Page 66 GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Page 67 GAO-03-763 Greater Transparency Needed in Disclosures to Investors

Appendix IV

GAO Contacts and Staff Acknowledgments ApenVIdxi

GAO Contacts Richard J. Hillman (202) 512-8678

Cody J. Goebel (202) 512-7329

Acknowledgments In addition to the individuals named above, Toayoa Aldridge, Jonathan 

Altshul, Marc Molino, Robert Pollard, Barbara Roesmann, David Tarosky, 

and Sindy Udell made key contributions to this report.

(250132)
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