Mutual Funds: Assessment of Regulatory Reforms to Improve the Management and Sale of Mutual Funds
Published: 2004-03-10T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Since September 2003, widespread allegations of abusive practices involving mutual funds have come to light. An abuse called late trading allowed some investors, at times in collusion with pension plan intermediary, broker-dealer, or fund adviser staff, to profit at other investors' expense by submitting orders for fund shares to receive that day's price after the legal cutoff. Other investors were allowed to conduct market timing trades to take advantage of stale prices used by funds to calculate their net asset values at funds with stated policies against such trading. SEC and other regulators have responded with numerous proposals for new or revised practices. Based on a body of work that GAO has conducted involving mutual funds, GAO analyzed and provides views on proposed and final rules involving (1) fund pricing and compliance practices intended to address various mutual fund trading abuses that have come to light recently, (2) fund boards' independence and effectiveness, (3) fund adviser compensation of broker-dealers that sell fund shares, and (4) additional actions regulators could take to further improve transparency and investor understanding of the fees they pay.
section_title: What GAO Found
paragraphs: GAO commends SEC and other regulators for their swift regulatory response to recently revealed abusive mutual fund practices. However, some proposed actions need to be thoroughly assessed to ensure equitable treatment for all investors and others will need to be reinforced with enhanced compliance, enforcement, and investor education programs to be truly effective. In particular, to prevent further late trading, SEC has proposed that all mutual fund orders be received by funds or designated processors by 4:00 p.m. Eastern Time, but this action may unfairly impact some retail investors that place orders through financial intermediaries. Although GAO supports in the short run the proposed hard 4:00 p.m. close as a way of increasing the certainty that all orders have been legitimately received, GAO believes that SEC should continue to work with industry participants, including pension plan intermediaries, to address concerns that the hard close would adversely affect investors that use such intermediaries. To address market timing, SEC is proposing that funds make greater disclosure of market timing, securities pricing, and portfolio disclosure policies. GAO supports these steps and encourages regulators to educate investors about the importance of such disclosures. To improve mutual fund corporate governance and oversight, SEC has also proposed increasing the proportion of independent directors to 75 percent and to require independent chairs. SEC is also proposing that fund advisers appoint compliance officers that report to fund boards. GAO sees these actions as giving increased prominence to independent members on fund boards of directors and providing them with additional tools to effectively oversee fund practices. However, additional actions may be needed to ensure that independent directors have no relationships with the fund adviser or its personnel that could impair their independence. SEC and other regulators have also proposed that the broker-dealers that sell fund shares make more extensive disclosures about payments they receive from fund advisers. SEC is also seeking comments on how to revise the fees they charge investors that also compensate broker-dealers for selling fund shares. GAO supports these actions as increasing the transparency of these costs to investors but recognizes that the effectiveness of these proposals could be enhanced by expanded compliance and investor education programs. SEC is also seeking information on how fund advisers use investor dollars to obtain research under a practice called soft dollars. Given the increased spotlight that Congress and regulators are placing on the mutual fund industry, GAO believes the time is right to more effectively address the conflicts of interest created by soft-dollar arrangements. In addition, GAO identifies further actions that could be taken to improve disclosure of mutual fund fees to enhance competition among funds on the basis of the fees that are charged to shareholders.

section_title: Letter
paragraphs: I am pleased to be here today to discuss GAO’s work assessing the  transparency of mutual fund fees and other fund practices and to discuss  the various proposed or anticipated regulatory reforms designed to  improve the management and sale of mutual funds. In the last 20 years,  mutual funds have grown from under $400 billion to over $7.5 trillion in  assets and have become a vital component of the financial security of the  more than 95 million American investors estimated to own mutual funds.  These funds have also grown to represent a significant portion of  American’s retirement wealth with 21 percent of the more than $10 trillion  in pension plan assets now invested in mutual funds. As a result, ensuring  that mutual funds have sound governance and trading practices has never  been more important. Recent actions by the Securities and Exchange  Commission (SEC) and NASD would establish new procedures to protect  shareholders against recently disclosed abusive trading practices, revise  the structure and duties of the boards of directors that oversee funds, and  place new responsibilities on the mutual fund and brokerage industries.
Based on the work that we have performed over the last year, I will  discuss problems we have seen within the mutual fund and brokerage  industries and provide our views on the various SEC and NASD-proposed  regulatory reforms. Specifically, I will discuss proposed and final rules  involving (1) fund pricing and compliance practices intended to address  various mutual fund trading abuses that have come to light recently, (2)  fund boards’ independence and effectiveness, and (3) fund advisers  compensation of broker-dealers that sell fund shares. In addition I will  discuss additional actions regulators could take to further improve  transparency and investor understanding of the fees they pay.
In summary, we commend SEC and other regulators for their swift  regulatory response to recent revelations of abusive mutual fund trading  practices. We believe that many of the actions taken will provide the  proper incentives to industry participants to follow sound practices and  also provide regulators with additional compliance and enforcement tools  to ensure that participants are held accountable for their behavior.  However, some proposed actions need to be thoroughly assessed to  ensure equitable treatment for all investors. In particular, while we agree  that SEC’s proposal to address late trading abuses with a hard 4:00 p.m.  close provides increased certainty of the legitimacy of orders, we also  recognize that there are wide-ranging and divergent interests in today’s  marketplace that must be accommodated to ensure that all retail and  institutional investors are treated fairly. As such, while we agree with  SEC’s proposal for addressing unlawful late trading in the short run, we  believe that SEC should continue to work with the retirement plan  community and cognizant federal agencies to address concerns that this  proposed rule may have certain adverse implications for certain  participants in retirement savings plans.
We also firmly agree with SEC’s proposals to enhance the independence  and effectiveness of mutual fund boards. Giving increased prominence to  independent members on fund boards of directors and providing them  with additional tools to effectively oversee fund practices should go a long  way to improve the system of checks and balances needed to avoid future  trading abuses. However, additional attention could be afforded to  ensuring the adequacy of the definition of an “interested person” to ensure  that directors designated as independent directors are truly independent.  We also recognize that other proposals for improving disclosures of  mutual fund and brokerage trading practices will need to be reinforced  with enhanced compliance, enforcement, and investor education programs  if they are to be truly effective.
There are also other areas that warrant SEC’s continued attention. SEC is  seeking information on how mutual fund investors pay for advice from  broker-dealers and how fund advisers use investor’s dollars to obtain  research. However, given the increased spotlight Congress and regulators  are placing on the mutual fund industry, in our view, the time is right to  address various conflicts of interest created by soft-dollar arrangements.  In addition, further actions could be taken to improve disclosure of mutual  fund fees to enhance competition among funds on the basis of the fees  that are charged to shareholders.
In addition to the work I am discussing today, we are currently studying  other issues related to the security of workers’ retirement benefits.  Pensions and retirement savings plans are an important source of income  for millions of retirees. As such, we are reviewing how retirement savings  plans, such as 401(k) plans, have been affected by the mutual fund late  trading and market timing scandals, and how SEC’s proposed rules to  address these practices might affect plan participants and plan  administration. On the broader issue of corporate governance, we also are  currently studying what actions pension plan fiduciaries take to address  conflicts of interest in connection with proxy voting issues. As large  institutional shareholders, pension plans have the opportunity to influence  governance of funds and hold company managers accountable for the  business decisions they make.
subsections: section_title: Regulators Are Taking Actions to Address Abusive Mutual Fund Practices
paragraphs: In reaction to allegations of widespread misconduct and abusive practices  involving mutual funds, regulators have responded with various proposals.  In early September 2003, the Attorney General of the State of New York  filed charges against a hedge fund manager for arranging with several  mutual fund companies to improperly trade in fund shares and profit at  the expense of other fund shareholders. Since then, widening federal and  state investigations of illegal late trading and improper timing of fund  trades have involved a growing number of prominent mutual fund  companies and brokerage firms.
subsections: section_title: Late Trading and Market Timing Are Detrimental to Fund Long-Term Shareholders
paragraphs: One of the abuses that has come to light recently is late trading. Under  current rules, funds accept orders to sell and redeem fund shares at a price  based on the current net asset value, which most funds calculate once a  day at 4:00 p.m. Eastern Time. Many investors, however, purchase mutual  fund shares through other intermediaries such as broker-dealers, banks,  and retirement savings plans. Instead of submitting hundreds or even  thousands of individual purchase and redemption orders each day, these  intermediaries typically aggregate orders received from investors and  submit a single purchase or redemption order that nets all the individual  shares their customers are seeking to buy or sell. Because this processing  takes time, SEC rules permit these intermediaries to forward the order  information to funds after 4:00 p.m.
However, late trading occurs when some investors are able to illegally  purchase or sell mutual fund shares after the 4:00 p.m. Eastern Time close  of U.S. securities markets, the time at which funds typically price their  shares. An investor permitted to engage in late trading could be buying or  selling shares at the current day’s 4:00 p.m. price with knowledge of  developments in the financial markets that occurred after 4:00 p.m. Such  investors thus have unfair access to opportunities for profit that are not  provided to other fund shareholders.
The extent to which some investors were allowed to submit late trading  orders may have been significant. In September 2003, SEC sought  information from fund advisers and broker-dealers about their pricing of  mutual fund orders and late trading policies. SEC’s preliminary analysis of  this information showed that more than 25 percent of the 34 major broker- dealers that responded had customers that still received that day’s price  for orders they had placed or confirmed after 4:00 p.m. As of March 1,  2004, SEC had formally announced seven enforcement cases involving  broker-dealers and other firms that were allegedly involved in late trading  schemes; other cases may be forthcoming. We will be initiating a review of  the adequacy of SEC’s enforcement efforts and the sanctions that it can  and has applied in these cases and will be reporting separately on these  issues later this year. In addition, legislation is under consideration in the  House of Representatives that will expand SEC’s enforcement capabilities  by raising the civil penalties for securities law violations, enhance the  investigative procedures available to SEC, and streamline the process by  which fines are disbursed among injured parties.
Another abuse that has come to light is known as market timing. Market  timing occurs when certain fund investors place orders to take advantage  of temporary disparities between the share value of a fund and the values  of the underlying assets in the fund’s portfolio. For example, U.S. mutual  funds that use the last traded price for foreign securities (whose markets  close hours before the U.S. markets) to value their portfolio when the U.S.  markets close could create opportunities for market timing if events that  subsequently occurred were likely to cause significant movements in the  prices of those foreign securities when their home markets reopen.
Market timing, although not currently illegal, can be unfair to long-term  fund investors because it provides the opportunity for selected fund  investors to profit from fund assets at the expense of long-term investors.  The following example illustrates how market timing transactions can  reduce the return to long-term shareholders of a fund.
As shown in the figure, the loss to long-term holders of the fund in this  case is only $.01 per share. Although the amount by which a single market  timing transaction reduces a fund’s overall return can be small, repeated  and large transactions over long periods of time can have a greater  cumulative effect. For example, one fund company whose staff were  accommodating market timing transactions by 10 different investors  estimated that these investors earned $22.8 million through their trading  and that these activities costs its funds $2.7 million over a period of several  years. In addition, the redemption fees that these investors should have  paid but did not, amounted to another $5 million.
Market timing may also have been widespread. According to testimony by  SEC’s Director of Enforcement, although most mutual funds have policies  that discourage market timing, this strategy was popular among some  individuals and institutional traders who attempted to conceal their  identities from fund companies. He also stated that 30 percent of the  broker-dealers responding to an SEC information request reported  assisting customers in attempting to conduct market timing trades, by  using methods, such as breaking their orders into smaller sizes to avoid  detection by the fund companies. Of the twelve cases SEC formally  opened that involved market timing activities, including five cases that  also involved late trading, two have been settled. In the settlement for one  case that involved both late trading and market timing, SEC ordered the  firm to pay fines and disgorgements of $225 million. In the other case, SEC  ordered the firm to pay $250 million in fines and disgorgements. NASD  also has taken various enforcement cases against broker-dealers involving  late trading and market timing, including one in which a broker-dealer was  fined $1 million and ordered to provide restitution of more than $500,000  for failing to prevent market timing of an affiliated firm’s mutual funds.
Additional abusive practices associated with mutual funds have also come  to light. To facilitate late trading and market timing arrangements, some  fund advisers selectively disclosed information about their funds’ portfolio  holdings to outsiders. They also allowed these parties to late trade or  conduct market timing in their funds. For example, in one SEC case a fund  manager allowed a hedge fund to engage in market timing in a fund that he  managed. The fund manager also disclosed portfolio information to a  broker that enabled brokerage customers to conduct market timing  transactions in the funds. In another state-administered case, a hedge fund  executive obtained special trading privileges from several mutual fund  companies that allowed him to engage in late trading and market timing in  those funds.
subsections: section_title: Rule Changes Could Prevent Late Trading and Discourage Market Timing, but Some Investors Might Be Disadvantaged
paragraphs: In addition to enforcement actions, SEC has also proposed amending  regulatory rules to address late trading, market timing, and selective  disclosure abuses. In December 2003, SEC proposed amending the rule  that governs how mutual funds price their shares and receive orders for  share purchases or sales.  Since many of the cases of late trading involved  orders submitted through intermediaries, including banks and pension  plans not regulated by SEC, the proposed amendments to its rules would  require that orders to purchase or redeem mutual fund shares be received  by a fund, its transfer agent, or a registered clearing agency before the  time of pricing (that is, 4:00 p.m. Eastern Time).
Many organizations that purchase mutual fund shares, particularly those  that administer retirement savings plans, have expressed concerns that  such a “hard close” would unfairly prohibit some of their participants from  receiving the same day’s price on share purchases. Because intermediaries  generally combine individual investor orders and submit single orders to  funds to buy or sell, many officials at such firms are concerned that the  time required to complete this processing will not allow them to meet the  4:00 p.m. deadline. In such cases, investors purchasing shares from  Western states or through intermediaries would either have to submit their  trades earlier than other investors in order to receive the current day’s  price or receive the next day’s price. A letter commenting on SEC’s  proposal from two investor advocacy groups indicated that implementing  the hard close would relegate some retail investors to the status of  “second-class shareholders.” Some plan sponsor organizations and plan  record keepers have also raised concerns about the potential significant  administrative costs associated with adopting systems to accommodate  the 4:00 p.m. hard close and other proposed rules.
Because the hard close could affect some investors’ ability to trade at the  current day’s price, some groups have called on SEC to allow industry  participants to develop systems of internal controls that would serve to  ensure that intermediaries receive individual orders before 4:00 p.m. With  such controls in place, these orders could continue to be processed after  this time. However, SEC officials told us that they were skeptical that any  system that relies on internal controls could not provide certainty that late  trading was not occurring because many of the late trading abuses  happened at firms that purportedly had such controls in place. However,  SEC remains open to the possibility of the development of systems that  could reasonably detect and deter late trading. In its proposals, SEC  requests comments on various approaches designed to prevent late  trading. Such protections could include a system that provides an  electronic or physical time-stamp on orders. Other possible controls could  include certifications that the intermediary had policies and procedures in  place designed to prevent late trades, or audits by independent public  accountants. Because multiple regulators oversee the operations of these  financial intermediaries, any assessment of the reasonableness of  recommended systems or controls would likely require effective  coordination.
SEC is also proposing to take actions to address market timing. On  December 11, 2003, SEC released a rule proposal to provide greater  transparency to funds’ market timing policies. Specifically, SEC would  require mutual funds to disclose in their prospectuses the risks to  shareholders of the frequent purchase and redemption of investment  company shares, and fund policies and procedures pertaining to frequent  purchases and redemptions. The proposal also would require funds to  explain both the circumstances under which they would use fair value  pricing and the effects of using fair value pricing. Another rule will require  funds to adopt fair value pricing policies that require funds among other  things, to monitor for circumstances that may necessitate the use of fair  value pricing, establish criteria for determining when market quotations  are no longer reliable for a particular portfolio security, and provide a  methodology or methodologies by which the funds determine the current  fair value of portfolio securities. Also, SEC is seeking comment in one of  its proposals for additional ways to improve the implementation of fair  value pricing. In addition, the proposal would require funds to disclose  policies and procedures pertaining to their disclosing information on the  funds’ portfolio holdings, and any ongoing arrangements to make available  information about their portfolio securities. These additional disclosures  would enable investors to better assess risks, policies, and procedures,  and determine if a fund’s policies and procedures were in line with their  expectations. Disclosure of a fund’s procedures in these areas would also  allow SEC to better examine a fund’s compliance with its stated  procedures and hold fund managers accountable for their actions.
To further stem market timing, on March 3, 2004, SEC issued a proposed  new rule to require mutual funds to impose a 2-percent redemption fee on  the proceeds of shares redeemed within 5 business days of purchase.  According to the proposal, the proceeds from the redemption fees would  be retained by the fund, becoming a part of fund assets. In addition, the  proposal addresses the pass thru of information from omnibus accounts  maintained by intermediaries. Specifically, the proposal identifies three  alternatives for funds to ensure that redemption fees are imposed on the  appropriate market timers through the use of Taxpayer Identification  Numbers. On at least a weekly basis intermediaries would be required to  provide to the fund, purchase and redemption information for each  shareholder within an omnibus account to enable the fund to detect  market timers and properly assess redemption fees. The rule is designed to  require short-term shareholders to reimburse funds for costs incurred as a  result of investors using short-term trading strategies, such as market  timing. The proposal would also include an emergency exception that  would allow an investor not to pay a redemption fee in the event of an  unanticipated financial emergency.
Unlawful late trading and certain market timing activities, which are not  currently illegal, can be unfair to long-term investors because these  activities provide the opportunity for selected fund investors to profit from  fund assets at the expense of fund long-term investors. SEC’s proposal to  address late trading with a hard 4:00 p.m. close appears, in the short-term,  to be the solution that provides the most certainty that all orders being  submitted to the funds legitimately deserve that day’s price. However, we  also recognize that this action could have a significant impact on many  investors, particularly those in employer-based retirement savings plans,  who own fund shares through financial intermediaries. As a result, we  urge the Commission to, as a supplement to their planned action, explore  alternatives to the hard 4:00 p.m. close more fully and to revisit formally  the question of how best to prevent late trading. Since some of the  financial intermediaries involved are either overseen by other regulators  or, in the case of third-party pension plan administrators, not overseen by  any regulator, any such assessment should include the development of a  strategy for overseeing the intermediary processing of mutual fund trades.  Having a sound strategy for oversight of the varied participants in the  mutual fund industry would ensure that all relevant entities are held  equally accountable for compliance with all appropriate laws.
We also commend SEC for proposing to require that mutual funds more  fully disclose their market timing and portfolio disclosure policies. By  increasing the transparency of these policies, industry participants will  have the incentive to ensure that their policies are sound and will provide  investors with information that they can use to distinguish between funds  on the basis of these policies. The disclosures will also provide regulators  and others with information to hold these firms accountable for their  actions. However, such disclosures would likely also require improving  related investor education programs to better ensure that investors  understand the importance of these new disclosures. We also support  SEC’s redemption fee proposal as a means of discouraging market timing.  Placing the proceeds of the fee back in the fund itself helps to ensure that  the actions of short-term traders do not financially harm long-term  investors, including pension plan participants who hold such funds.
section_title: Regulators Are Taking Actions to Improve the Effectiveness of Mutual Fund Boards of Directors
paragraphs: Mutual fund boards of directors have a responsibility to protect  shareholder interests and SEC has issued various proposals to increase  the effectiveness of these bodies. In particular, independent directors, who  are not affiliated with the investment adviser, play a critical role in  protecting mutual fund investors. To improve the independence of fund  boards, SEC has issued various proposals to alter the structure of these  boards and task them with additional duties.
subsections: section_title: Directors Have a Role in Overseeing Fees
paragraphs: Because the organizational structure of a mutual fund can create conflicts  of interest between the fund’s investment adviser and its shareholders, the  law governing U.S. mutual funds requires funds to have a board of  directors to protect the interests of the fund’s shareholders. A fund is  usually organized by an investment management company or adviser,  which is responsible for providing portfolio management, administrative,  distribution, and other operational services. In addition, the fund’s officers  are usually provided, employed, and compensated by the investment  adviser. The adviser charges a management fee, which is paid with fund  assets, to cover the costs of these services. With the management fee  representing its revenue from the fund, the adviser’s desire to maximize its  revenues could conflict with shareholder goals of reducing fees. As one  safeguard against this potential conflict, the Investment Company Act of  1940 (the Investment Company Act) requires mutual funds to have boards  of directors to oversee shareholder interests. These boards must also  include independent directors who are not employed by or affiliated with  the investment adviser.
As a group, the directors of a mutual fund have various responsibilities  and in some cases, the independent directors have additional duties. In  particular, the independent directors also have specific duties to approve  the investment advisory contract between the fund and the investment  adviser and the fees that will be charged. Specifically, section 15 of the  Investment Company Act requires that the terms of any advisory contracts  and renewals of advisory contracts be approved by a vote of the majority  of the independent directors.
Under section 36(b) of the Investment Company Act, investment advisers  have a fiduciary duty to the fund with respect to the fees they receive,  which under state common law typically means that the adviser must act  with the same degree of care and skill that a reasonably prudent person  would use in connection with his or her own affairs. Section 36(b) also  authorizes actions by shareholders and SEC against an adviser for breach  of this duty. Courts have developed a framework for determining whether  an adviser has breached its duty under section 36(b), and directors  typically use this framework in evaluating advisory fees. This framework  finds its origin in a Second Circuit Court of Appeals decision, in which the  court set forth the factors relevant to determining whether an adviser’s fee  is excessive.  The court in this case stated that to be guilty of a breach  under section 36 (b), the fee must be “so disproportionately large that it  bears no reasonable relationship to the services rendered and could not  have been the product of arms-length bargaining.” The standards  developed in this case, and in cases that followed, served to establish  current expectations for fund directors with respect to fees. In addition to  potentially considering how a fund’s fee compared to those of other funds,  this court indicated that directors might find other factors more important,  including  the nature and quality of the adviser’s services, the adviser’s costs to provide those services, the extent to which the adviser realizes and shares with the fund  economies of scale as the fund grows, the volume of orders that the manager must process, indirect benefits to the adviser as the result of operating the fund, and the independence and conscientiousness of the directors.
section_title: Concerns Over Directors’ Roles Exist
paragraphs: Some industry experts have criticized independent directors for not  exercising their authority to reduce fees. For example, in a speech to  shareholders, one industry expert stated that mutual fund directors have  failed in negotiating management fees. The criticism arises in part from the  annual contract renewal process, in which boards compare fees of similar  funds. However, the directors compare fees with the industry averages,  which the experts claim provides no incentive for directors to seek to  lower fees. Another industry expert complained that fund directors are not  required to ensure that fund fees are reasonable, much less as low as  possible, but instead are only expected to ensure that fees fall within a  certain range of reasonableness.
In contrast, an academic study we reviewed criticized the court cases that  have shaped directors’ roles in overseeing mutual fund fees. The authors  noted that these cases generally found that comparing a fund’s fees to  other similar investment management services, such as pension plans, was  inappropriate as fund advisers do not compete with each other to manage  a particular fund. Without being able to compare fund fees to these other  products, the study’s authors say that investors bringing these cases  lacked sufficient data to show that a fund’s fees were excessive.
section_title: Various Actions Taken or Proposed to Increase Board Effectiveness and Mutual Fund Oversight
paragraphs: In light of concerns over director roles and effectiveness, including  concerns arising from the recently alleged abusive practices, SEC has  taken various actions to improve board governance and strengthen the  compliance programs of fund advisers. To strengthen the hand of  independent directors when dealing with fund management, SEC issued a  proposal in January 2004 to amend rules under the Investment Company  Act to alter the composition and duties of many fund boards. These  reforms include  requiring an independent chairman for fund boards of directors; increasing the percentage of independent directors from a majority to  at least seventy-five percent of a fund’s board; requiring fund independent directors to meet at least quarterly in a  separate session; and   providing the independent directors with authority to hire employees  and others to help the independent directors fulfill their fiduciary  duties.
Under the Investment Company Act, only individuals who are not  “interested” can serve as independent directors. Section 2(a)(19) of the  Investment Company Act defines the term “interested person” to include  the fund’s investment adviser, principal underwriter, and certain other  persons (including their employees, officers or directors) who have a  significant relationship with the fund, its investment adviser or principal  underwriter. Broker-dealers that distribute the fund’s shares or persons  who have served as counsel to the fund would also be considered  interested. However, SEC has suggested that Congress give it authority to  fill gaps in the statute that have permitted persons to serve as independent  directors who do not appear to be sufficiently independent of fund  management. For example, the statute permits a former executive of the  fund’s adviser to serve as an independent director two years after the  person has retired from his position. This permits an adviser to use board  positions as a retirement benefit for its employees. The statute also  permits relatives of fund managers to serve as independent directors as  long as they are not members of the “immediate family” or affiliated  persons of the fund. In one case, SEC found that an uncle of the funds  portfolio manager served as an independent director of the fund. Giving  SEC additional rulemaking authority to define the term “interested person”  clearly seems appropriate.
As part of their proposal to alter the structure of fund boards, SEC is also  proposing that fund directors perform at least once annually an evaluation  of the effectiveness of the board and its committees. This evaluation is to  consider the effectiveness of the board’s committee structure and whether  the directors have taken on the responsibility for overseeing too many  funds. The proposal also seeks to amend the fund recordkeeping rule (rule  31a-2) to require that funds retain copies of the written materials that  directors consider in approving an advisory contract under section 15 of  the Investment Company Act.
According to the SEC proposal, the changes to board structure and  authority are designed to enhance the independence and effectiveness of  fund boards and to improve their ability to protect the interests of the  funds and fund shareholders they serve. Specifically, SEC noted that  commenters on a 2001 amendment believed that a supermajority of  independent directors would help to strengthen the hand of independent  directors when dealing with fund management, and help assure that  independent directors maintain control of the board in the event of illness  or absence of other independent directors. Also, SEC concluded that (1) a  boardroom culture favoring the long-term interests of fund shareholders  might be more likely to prevail if the board chairman does not have the  conflicts of interest inherent in his role as an executive of the fund adviser,  and (2) a fund board may be more effective when negotiating with the  fund adviser over matters such as the advisory fee if it were not led by an  executive of the adviser with whom it was negotiating. SEC also noted that  separate meetings of the independent directors would afford independent  directors the opportunity for frank and candid discussion among  themselves regarding the management of the fund. In addition, it saw the  use of staff and experts as important to help independent directors deal  with matters beyond their level of expertise and give them an  understanding of better practices among mutual funds.
According to SEC’s proposal, having fund directors perform self- evaluations of the boards’ effectiveness could improve fund performance  by strengthening the directors’ understanding of their role and fostering  better communication and greater cohesiveness. This would focus the  board’s attention on the need to create, consolidate, or revise various  board committees such as the audit, nominating, or pricing committees.  Finally, according to SEC staff, the proposed additional recordkeeping  rule would allow compliance examiners to review the quality of the  materials that boards considered in approving advisory contracts.
In response to concerns regarding the adequacy of fund board review of  advisory contracts and management fees, on February 11, 2004, SEC also  released proposed rule amendments to require that funds disclose in  shareholders reports how boards of directors evaluate and approve, and  recommend shareholder approval of investment, advisory contracts. The  proposed amendments would require a fund to disclose in its reports to  shareholders the material factors and the conclusions with respect to  those factors that formed the basis for the board’s approval of advisory  contracts during the reporting period. The proposals also are designed to  encourage improved disclosure in the registration statement of the basis  for the board’s approval of existing advisory contracts, and in proxy  statements of the basis for the board’s recommendation that shareholders  approve an advisory contract.
In addition, to facilitate better board governance and oversight, SEC  adopted requirements to ensure that mutual funds and advisers have  internal programs to enhance compliance with federal securities laws and  regulations. On December 17, 2003, SEC adopted a new rule that requires  each investment company and investment adviser registered with the  Commission to    adopt and implement written policies and procedures reasonably  designed to prevent violation of the federal securities laws, review those policies and procedures annually for their adequacy and  the effectiveness of their implementation, and   designate a chief compliance officer to be responsible for  administering the policies and procedures.
In the case of an investment company, the chief compliance officer would  report directly to the fund board. These rules are designed to protect  investors by ensuring that all funds and advisers have internal programs to  enhance compliance with federal securities laws.
To ensure that fund investment adviser officials and employees are aware  of and held accountable for their fiduciary responsibilities to their fund  shareholders, SEC also released a rule proposal in January 2004 that  would require registered investment adviser firms to adopt codes of ethics.  According to the proposal, the rule was designed to prevent fraud by  reinforcing fiduciary principles that must govern the conduct of advisory  firms and their personnel. The proposal states that codes of ethics remind  employees that they are in a position of trust and must act with integrity at  all times. The codes would also direct investment advisers to establish  procedures for employees, so that the adviser would be able to determine  whether the employee was complying with the firm’s principles.
In addition to these actions, SEC had previously adopted rules that  became effective in April 2003 that require funds to disclose on a quarterly  basis how they voted their proxies for the portfolio securities they hold.  SEC also required client proxies to adopt policies and procedures  reasonably designed to ensure that the adviser votes proxies in the best  interests of clients, to disclose to clients information about those policies  and procedures, to disclose to clients how they may obtain information on  how the adviser voted their proxies, and to maintain certain records  relating to proxy voting. In adopting these requirements, SEC noted that  this increased transparency would enable fund shareholders to monitor  their funds’ involvement in the governance activities of portfolio  companies, which may have a dramatic impact on shareholder value. We  are currently reviewing whether pension plans have similar requirements  to disclose their proxy voting activities to their participants and will be  reporting separately on these issues later this year.
In our view, these SEC proposals should help ensure that mutual fund  boards of directors are independent and take an active role in ensuring  that their funds are managed in the interests of their shareholders. Many  fund boards already meet some of these requirements, but SEC’s proposal  will better ensure that such practices are the norm across the industry.  Although such practices do not guarantee that funds will be well managed  and will avoid illegal or abusive behavior, greater board independence  could promote board decision making that is aligned with shareholders’  interests and thereby enhance board accountability. While board  independence does not require eliminating all nonindependent directors,  we have taken the position in previous work that it should call for a  supermajority of independent directors. Our prior work also recognized  that independent leadership of the board is preferable to ensure some  degree of control over the flow of information from management to the  board, scheduling of meetings, setting of board agendas, and holding top  management accountable. To further ensure that board members are truly  independent, we would support the Congress giving SEC rulemaking  authority to specify the types of persons who qualify as “interested  persons.” Having compliance officers report to fund boards and having  advisers implement codes of ethics should also provide additional tools to  hold fund advisers and boards accountable for ensuring that all fund  activities are conducted in compliance with legal requirements and with  integrity.
section_title: Regulators Have Responded to Broker- Dealer Compensation Issues
paragraphs: In addition to addressing alleged abusive practices, securities regulators  are also introducing proposals that respond to concerns over how broker- dealers are compensated for selling mutual funds. Specifically, SEC is  seeking comments on how to revise a rule that allows mutual funds to  deduct fees to pay for the marketing and sale of fund shares. In addition,  to address a practice that raises potential conflicts of interest between  broker-dealers and their customers, SEC and NASD have also proposed  rules that would require broker-dealers to disclose revenue sharing  payments that fund advisers make to broker-dealers to compensate them  for selling fund shares. SEC has also recently proposed banning a practice  called directed brokerage that, if adopted, would prohibit funds from using  trading commissions as an additional means of compensating broker- dealers for selling their funds.
subsections: section_title: 12b-1 Fees Have Increased Investor Choice but Alternatives Could Provide Additional Benefits
paragraphs: Approximately 80 percent of mutual fund purchases are made through  broker-dealers or other financial professionals, such as financial planners  and pension plan administrators. Prior to 1980, the compensation that  these financial professionals received for assisting investors with mutual  fund purchases was paid either by charging investors a sales charge or  load or paying for such expenses out of the investment adviser’s own  profits. However, in 1980, SEC adopted rule 12b-1 under the Investment  Company Act to help funds counter a period of net redemptions by  allowing them to use fund assets to pay the expenses associated with the  distribution of fund shares. Under NASD rules, 12b-1 fees are limited to a  maximum of 1 percent of a fund’s average net assets per year.
Although originally envisioned as a temporary measure to be used during  periods when fund assets were declining, the use of 12b-1 fees has evolved  to provide investors with flexibility in paying for investment advice and  purchases of fund shares. Instead of being offered only funds that charge a  front-end load, investors using broker-dealers to assist them with their  purchases can now choose from different classes of fund shares that vary  by how the broker-dealer is compensated. In addition to shares that  involve front-end loads with low or no 12b-1 fee—typically called Class A  shares, investors can also invest in Class B shares that have no front-end  load but instead charge an annual 1 percent 12b-1 fee paid a certain  number of years, such as 7 or 8 years, after which the Class B shares  would convert to Class A shares. Other share classes may have lower 12b- 1 fees but charge investors a redemption fee—called a back-end load—if  shares are not held for a certain minimum period. Having classes of shares  allows investors to choose the share class that is most advantageous  depending on how long they plan to hold the investment.
Because 12b-1 fees are used in ways different than originally envisioned,  SEC is seeking public comment on whether changes to rule 12b-1 are  necessary. In a proposal issued on February 24, 2004, SEC staff noted that  modifications might be needed to reflect changes in the manner in which  funds are marketed and distributed. For example, SEC staff told us that  rule 12b-1 requires fund boards when annually re-approving a fund’s 12b-1  plan, to consider a set of factors that likely are not relevant in today’s  environment.
In the proposal, SEC also seeks comments on whether alternatives to 12b- 1 fees would be beneficial. One such alternative would have distribution- related costs deducted directly from individual customer accounts rather  than having fund advisers deduct fees from the entire fund’s assets for  eventual payment to selling broker-dealers. The amount due the broker- dealer could be deducted over time, say once a quarter until the total  amount is collected. According to the SEC proposal, this alternative  would be beneficial because the amounts charged and their effect on  shareholder value would be completely transparent to the shareholder  because the amounts would appear on the shareholder’s account  statements. According to a fund official and an industry analyst, having  fund shareholders see the amount of compensation that their broker is  receiving would increase investor awareness of such costs and could spur  greater competition among firms over such costs.
We commend SEC for seeking comments on potentially revising rule   12b-1. Such fees are now being used in ways SEC did not intend when it  adopted the rule in 1980. We believe providing alternative means for  investors to compensate broker-dealers, like the one SEC’s proposal  describes, would preserve the beneficial flexibility that investors currently  enjoy while also increasing the transparency of these fees. An approach  like the one SEC describes would also likely increase competition among  broker-dealers over these charges, which could lower the costs of  investing in fund shares further.
section_title: Regulators Respond to Revenue Sharing Payment Concerns
paragraphs: Regulators have also acted to address concerns arising from another  common mutual fund distribution practice called revenue sharing.  Revenue sharing occurs when mutual fund advisers make payments out of  their own revenue to broker-dealers to compensate them for selling that  adviser’s fund shares. Broker-dealers that have extensive distribution  networks and large staffs of financial professionals who work directly  with and make investment recommendations to investors, increasingly  demand that fund advisers make these payments in addition to the sales  loads and 12b-1 fees that they earn when their customers purchase fund  shares. For example, some broker-dealers have narrowed their offerings of  funds or created preferred lists that include the funds of just six or seven  fund companies that then become the funds that receive the most  marketing by these broker-dealers. In order to be selected as one of the  preferred fund families on these lists, the mutual fund adviser often is  required to compensate the broker-dealer firms with revenue sharing  payments. According to an article in one trade journal, revenue sharing  payments made by major fund companies to broker-dealers may total as  much as $2 billion per year. According to the officials of a mutual fund  research organization, about 80 percent of fund companies that partner  with major broker-dealers make cash revenue sharing payments.
However, revenue sharing payments may create conflicts of interest  between broker-dealers and their customers. By receiving compensation  to emphasize the marketing of particular funds, broker-dealers and their  sales representatives may have incentives to offer funds for reasons other  than the needs of the investor. For example, revenue sharing arrangements  might unduly focus the attention of broker-dealers on particular mutual  funds, reducing the number of funds considered as part of an investment  decision—potentially leading to inferior investment choices and  potentially reducing fee competition among funds. Finally, concerns have  been raised that revenue sharing arrangements might conflict with  securities self-regulatory organization rules requiring that brokers  recommend purchasing a security only after ensuring that the investment  is suitable for the investor’s financial situation and risk profile.
Our June 2003 report recommended that SEC consider requiring that more  information be provided to investors to evaluate these conflicts of interest;  SEC and NASD have recently issued proposals to require such disclosure.  Although broker-dealers are currently required to inform their customers  about the third-party compensation the firm is receiving, they have  generally been complying with this requirement by providing their  customers with the mutual fund’s prospectus, which discloses such  compensation in general terms. On January 14, 2004, SEC proposed rule  changes that would require broker-dealers to disclose to investors prior to  purchasing a mutual fund whether the broker-dealer receives revenue  sharing payments or portfolio commissions from that fund adviser as well  as other cost-related information. Similarly, NASD has proposed a change  to its rules that would require broker-dealers to provide written  disclosures to a customer when an account is first opened or when mutual  fund shares are purchased that describe any compensation that they  receive from fund advisers for providing their funds “shelf space” or  preference over other funds. SEC is also proposing that broker-dealers be  required to provide additional specific information about the revenue  sharing payments they receive in the confirmation documents they provide  to their customers to acknowledge a purchase. This additional information  would include the total dollar amount earned from a fund’s adviser and the  percentage that this amount represented of the total sales by the broker- dealer of that advisers’ fund shares over the 4 most recent quarters.
We commend SEC and NASD for taking these actions. The disclosures  being proposed by SEC and NASD are intended to ensure that investors  have information that they can use to evaluate the potential conflicts their  broker-dealer may have when recommending particular fund shares to  investors. However, such disclosures would likely also require improving  related investor education programs to better ensure that investors  understand the importance of these new disclosures.
section_title: SEC Has Also Proposed Eliminating Another Potential Mutual Fund Conflict
paragraphs: SEC has also taken another action to address a practice that creates  conflicts of interest between fund shareholders and broker-dealers or fund  advisers. On February 11, 2004, SEC proposed prohibiting fund advisers  from using trading commissions as compensation to broker-dealers that  sell their funds. Such arrangements are called “directed brokerage,” in  which fund advisers choose broker-dealers to conduct trades in their  funds’ portfolio securities as an additional way of compensating those  brokers for selling fund shares. These arrangements represent a hidden  expense to fund shareholders because brokerage commissions are paid  out of fund assets, unlike revenue sharing, which is paid out of advisers’  revenues. We support this action as a means of better ensuring that fund  advisers choose broker-dealers based on their ability to effectively execute  trades and not for other reasons.
section_title: Other Areas Requiring Continued SEC Attention
paragraphs: SEC is considering actions to address conflicts of interests created by  “soft-dollar arrangements” and has taken actions to enhance disclosures  related to the costs of owning mutual funds, including considering making  more transparent costs included in brokerage transactions. Although SEC  has taken some actions, we believe that additional steps could be taken to  provide further benefits to investors by increasing the transparency of  certain mutual fund practices and enhancing competition among funds on  the basis of the fees that are charged to shareholders.
subsections: section_title: Soft Dollar Arrangements Provide Benefits, but Could Adversely Impact Investors
paragraphs: Soft dollar arrangements allow fund investment advisers to obtain  research and brokerage services that could potentially benefit fund  investors but also increase investor costs. When investment advisers buy  or sell securities for a fund, they may have to pay the broker-dealers that  execute these trades a commission using fund assets. In return for these  brokerage commissions, many broker-dealers provide advisers with a  bundle of services, including trade execution, access to analysts and  traders, and research products.
Soft dollar arrangements are the result of regulatory changes in the 1970s.  Until the mid-1970s, the commissions charged by all brokers were fixed at  one equal price. To compete for commissions, broker-dealers  differentiated themselves by offering research-related products and  services to advisers. In 1975, to increase competition, SEC abolished fixed  brokerage commission rates. However, investment advisers were  concerned that they could be held in breach of their fiduciary duty to their  clients to obtain best execution on trades if they paid anything but the  lowest commission rate available to obtain research and brokerage  services. In response, Congress created a “safe harbor” under Section  28(e) of the Securities Exchange Act of 1934 that allowed advisers to pay  more than the lowest available commission rate for security transactions  in return for research and brokerage services. Although legislation  provides a safe harbor for investment advisers to use soft-dollars, SEC is  responsible for defining what types of products and services are  considered lawful under the safe harbor. Since 1986, the SEC has  interpreted Section 28(e) as applying to a broad range of products and  services, as long as they provide ‘lawful and appropriate assistance to the  money manager in carrying out investment decision-making  responsibilities.’  Some industry participants argue that the use of soft dollars benefits  investors in various ways. The research that the fund adviser obtains can  directly benefit fund investors if the adviser uses it to select securities for  purchase or sale by the fund. The prevalence of soft dollar arrangements  also allows specialized, independent research to flourish, thereby  providing money managers a wider choice of investment ideas. As a result,  this research could contribute to better fund performance. The  proliferation of research available as a result of soft dollars might also  have other benefits. For example, an investment adviser official told us  that the research on smaller companies helps create a more efficient  market for securities of those companies, resulting in greater market  liquidity and lower spreads, which would benefit all investors including  those in mutual funds.
Although the research and brokerage services that fund advisers obtain  through the use of soft dollars could benefit a mutual fund investor, this  practice also could increase investors’ costs and create potential conflicts  of interest that could harm fund investors. For example, soft dollars could  cause investors to pay higher brokerage commissions than they otherwise  would, because advisers might choose broker-dealers on the basis of soft  dollar products and services, not trade execution quality. Soft dollar  arrangements could also encourage advisers to trade more in order to pay  for more soft dollar products and services. Overtrading would cause  investors to pay more in brokerage commissions than they otherwise  would. These arrangements might also tempt advisers to “over-consume”  research because they would not be paying for it directly. In turn, advisers  might have less incentive to negotiate lower commissions, resulting in  investors paying more for trades.
Regulators also have raised concerns over soft dollar practices. In 1996  and 1997, SEC examiners conducted an examination sweep into the soft  dollar practices of broker-dealers, investment advisers, and mutual funds.  In the resulting 1998 inspection report, SEC staff documented instances of  soft dollars being used for products and services outside the safe harbor,  as well as inadequate disclosure and bookkeeping of soft dollar  arrangements. SEC staff told us that their review found that mutual fund  advisers engaged in far fewer soft dollar abuses than other types of  advisers. To address the concerns identified, the SEC staff report  proposed recommending that investment advisers keep better records and  make greater disclosure about their use of soft dollars. A working group  formed in 1997 by the Department of Labor (DOL) to study the need for  regulatory changes and additional disclosures to pension plan sponsors  and fiduciaries on soft dollar arrangements recommended that SEC act to  narrow the definition of products and services that are considered  research and allowable under the safe harbor. The working group also  recommended that SEC prepare a specific list of acceptable purchases  with soft dollars that included brokerage and research services.
subsections: section_title: Additional Actions to Address Conflicts Raised by Soft Dollars Could be Beneficial
paragraphs: Although SEC has acknowledged the concerns involved with soft-dollar  arrangements, it has taken limited actions to date. SEC staff told us that  the press of other business prevented them from addressing the issues  raised by other regulators and their own 1998 staff report. However, in a  December 2003 concept release on portfolio transaction costs staff  requested comments on what types of information investment advisers  should be required to provide to mutual fund boards regarding the  allocation of brokerage commissions for execution purposes and soft  dollar benefits. In addition, SEC staff told us that they have formed a  study group with representatives of the relevant SEC divisions, including  Investment Management, Market Regulation, and the Office of Compliance  Inspections and Examinations, to review soft dollar issues. This group also  is collecting information from industry and foreign regulators.
Regulators in other countries and other industries have acted to address  the conflicts created by soft dollars. In the United Kingdom, the Financial  Services Authority (FSA), which regulates the financial services industry  in that country, has issued a consultation paper that argues that these  arrangements create incentives for advisers to route trades to broker- dealers on the basis of soft dollar arrangements and that these practices  represented an unacceptable market distortion. As a result of  recommendations from a government-commissioned review of  institutional investment, FSA has proposed banning soft dollars for market  pricing and information services, as well as various other products. FSA  notes that their proposal would limit the ability of fund managers to pass  management costs through their customers’ funds in the form of  commissions and would provide more incentive to consider what services  are necessary for efficient funds management, both of which could lower  investor costs. However, FSA staff has acknowledged that restricting soft  dollar arrangements in the United Kingdom could hurt the international  competitiveness of their fund industry because fund advisers outside their  country would not have to comply with these restrictions.
In addition, DOL has placed more restrictions on pension plan  administrators use of soft dollars than apply to mutual fund advisers. SEC  requires mutual fund boards of directors to review fund trading activities  to ensure that the adviser is obtaining best execution and to monitor any  conflicts of interest involving soft dollars. However, section 28(e) allows  fund advisers to use soft dollars generated by trading in one fund’s  portfolio to obtain research that does not benefit that particular fund but  instead benefits other funds managed by that adviser. In contrast, DOL  requires plan fiduciaries to monitor the plan’s investment managers to  ensure that the soft dollar research obtained from trading commissions  paid out of plan assets benefits the plan and that the benefits to the plan  are reasonable in relation to the value of the brokerage and research  services provided to the plan.
Some industry participants have also called on SEC to restrict soft dollar  usage. For example, the board of the Investment Company Institute (ICI),  which is the industry association for mutual funds, recently recommended  that SEC consider narrowing the definition of allowable research under  Section 28(e) and eliminate the purchase of third-party research with soft- dollars. According to statements released by ICI, SEC’s definition of  permitted research is overly expansive and has been susceptible to abuse.
ICI recommends that SEC prohibit advisers from using soft dollars to  obtain any products and services that are otherwise publicly available in  the marketplace, such as periodical subscriptions or electronic news  services. In a letter to the SEC Chairman, ICI wrote that its proposal would  reduce incentives for investment advisers to engage in unnecessary  trading and would more closely reflect the original purpose of Section  28(e), which was to allow investment advisers to take into account a  broker-dealer’s research capabilities in addition to its ability to provide  best execution.
Beyond these proposals, some industry participants have called for a  complete ban of soft dollars. If soft dollars were banned—which would  require repeal of Section 28(e)—and bundled commission rates were  required to be separately itemized, fund advisers would not be allowed to  pay higher commissions in exchange for research. Advocates of banning  soft dollars believe that this would spur broker-dealers to compete on the  price of executing trades, which averages between $.05 and $.06 per share  at large broker-dealers, whereas trades conducted through other venues  can be done for $.01 or less. Critics fear that this ban would reduce the  amount of independent research that advisers obtain, which would hurt  investors and threaten the viability of some existing independent research  firms.
To address concerns over soft dollars, our June 2003 report recommends  that SEC evaluate ways to provide additional information to fund directors  and investors on their fund advisers’ use of soft dollars. Because SEC has  not acted to more fully address soft dollar-related concerns, investors and  mutual fund directors have less complete and transparent information  with which to evaluate the benefits and potential disadvantages of fund  advisers’ use of soft dollars. However, such disclosures could potentially  increase the complexity of the information that investors are provided and  require them to interpret and understand such information. As such, an  enhanced investor education campaign would also likely be warranted.
Although disclosure can improve transparency, it may not be sufficient for  creating proper incentives and accountability. In our view, the time for  SEC to take bolder actions regarding soft dollars is now. Allowing the  advisers of mutual funds to use customer assets to obtain services that  would otherwise have to be paid for using advisers’ revenues appears to  create inappropriate incentives, and inadequate transparency and  accountability.
We commend SEC for initiating an internal study of soft dollar issues. As  part of this evaluation, we believe that SEC should consider at a minimum  the merits of narrowing the services that are considered acceptable under  the safe harbor. Concerns that SEC’s current definition of permitted  research is overly expansive and susceptible to abuse have been  recognized for years. Acting to narrow the safe harbor could reduce  opportunities for abusive practices. It could also lower investor costs by  reducing adviser incentives to overtrade portfolio assets to obtain soft  dollar research and services. We also believe that SEC’s study should  consider the relative merits of eliminating soft dollar arrangements  altogether. The elimination of soft dollars, which would require legislative  action, could create greater incentives for broker-dealers to compete on  the basis of execution cost and greater incentives for fund advisers to  weigh the necessity of some of the research they now receive since they  would have to pay for such items from their own revenues.
section_title: New and Proposed Rules Could Provide Added Transparency of the Costs of Investing in Mutual Funds
paragraphs: SEC recently adopted rules and rule amendments aimed at increasing  investor awareness by improving the disclosures of the fees and expenses  paid for investing in mutual funds. In February 2004, SEC adopted rule  amendments that require mutual funds to make additional disclosures  about their expenses. This information will be presented to investors in  the annual and semiannual reports prepared by mutual funds. Among  other things, mutual funds will now be required to disclose the cost in  dollars associated with an investment of $1,000 that earned the fund’s  actual return and incurred the fund’s actual expenses paid during the  period. In addition to allowing existing investors to compare fees across  funds, SEC staff indicated that placing these disclosures in funds’ annual  and semiannual reports will help prospective investors to compare funds’  expenses before making a purchase decision.
In addition to this action, SEC amended fund advertising rules in  September 2003 to require funds to state in advertisements that investors  should consider a fund’s fees before investing and direct investors to  consult the fund prospectus for more information. Additionally, in  November 2003, NASD proposed amending rules to require that mutual  funds advertising their performance present specific information about the  fund’s expenses and performance in a more prominent format. These new  requirements are aimed at improving investor awareness of the costs of  buying and owning a mutual fund, facilitating comparison of fees among  funds, and make presentation of standardized performance information  more prominent. Specifically, NASD’s proposal would require that all  performance advertising contain a text box that sets forth the fund’s  standardized performance information, maximum sales charge, and annual  expense ratio. In doing so NASD’s proposal would go beyond SEC  requirements by requiring funds to include specific performance and  expense information within advertising materials.
Another cost-related rulemaking initiative by SEC staff seeks to improve  the disclosure of breakpoint discounts for front-end sales loads. In March  2003, SEC, NASD, and the New York Stock Exchange issued a report  describing the failure of some broker-dealers to issue discounts on front- end charges paid to them by mutual fund investors. Mutual funds with  front-end sales loads often offer investors discounts or “breakpoints” in  these sales loads as the dollar value of the shares purchased by investors  or members of their family increases, such as for purchases of $50,000 or  more. To better ensure that investors receive these discounts when  deserved, SEC is proposing to require funds to disclose in their  prospectuses when shareholders are eligible for breakpoint discounts.  According to the SEC proposal, such amendments are intended to provide  greater prominence to breakpoint disclosure by requiring its inclusion in  the prospectus rather than in the Statement of Additional Information,  which is a document delivered to investors only upon request.
However, these actions would not require mutual funds to disclose to each  investor the specific amount of fees in dollars that are paid on the shares  they own. As result, investors will not receive information on the costs of  mutual fund investing in the same way they see the costs of many other  financial products and services that they may use. In addition, these  actions do not require that mutual funds provide information relating to  fees in the document that is most relevant to investors—the quarterly  account statement. In a 1997 survey of how investors obtain information  about their funds, ICI indicated that, to shareholders, the account  statement is probably the most important communication that they receive  from a mutual fund company and that nearly all shareholders use such  statements to monitor their mutual funds.
Our June 2003 report recommends that SEC consider requiring mutual  funds to make additional disclosures to investors, including considering  requiring funds to specifically disclose fees in dollars to each investor in  quarterly account statements. SEC has agreed to consider requiring such  disclosures but was unsure that the benefits of implementing specific  dollar disclosures outweighed the costs to produce such disclosures.  However, we estimate that spreading these implementation costs across  all investor accounts might not represent a large outlay on a per-investor  basis.
Our report also discusses less costly alternatives that could also prove  beneficial to investors and spur increased competition among mutual  funds on the basis of fees. For example, one less costly alternative would  require quarterly statements to present the same information—the dollar  amount of a fund’s fees based on a set investment amount—recently  required for mutual fund semiannual reports. Doing so would place this  additional fee disclosure in the document generally considered to be of the  most interest to investors. An even less costly alternative would be to  require that quarterly statements also include a notice that reminds  investors that they pay fees and to check their prospectus and ask their  financial adviser for more information. Disclosures such as these could be  the incentive that some investors need to take action to compare their  fund’s expenses to those of other funds and thus make more informed  investment decisions. Such disclosures may also increasingly motivate  fund companies to respond competitively by lowering fees.
This concludes my prepared statement and I would be happy to respond to  any questions at the appropriate time.
section_title: Contacts and Acknowledgements
paragraphs: For further information regarding this testimony, please contact Richard J.  Hillman or Cody J. Goebel at (202) 512-8678. Individuals making key  contributions to this testimony include Toayoa Aldridge, Barbara  Roesmann, George Scott, and David Tarosky.
This is a work of the U.S. government and is not subject to copyright protection in the  United States. It may be reproduced and distributed in its entirety without further  permission from GAO. However, because this work may contain copyrighted images or  other material, permission from the copyright holder may be necessary if you wish to  reproduce this material separately.