[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]



 
                      MUTUAL FUNDS: WHO'S LOOKING


                          OUT FOR INVESTORS?

=======================================================================

                                HEARINGS

                               BEFORE THE

                            SUBCOMMITTEE ON
                     CAPITAL MARKETS, INSURANCE AND
                   GOVERNMENT SPONSORED ENTEREPRISES

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                               __________

                          NOVEMBER 4, 6, 2003

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 108-61






                        U.S. GOVERNMENT PRINTING OFFICE

92-982                       WASHINGTON : 2004
_____________________________________________________________________
For sale by the Superintendent of Documents, U.S. Government Printing
Office Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800
Fax: (202) 512-2250  Mail: Stop SSOP, Washington, DC  20402-0001

                             





                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa                 BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska              PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana          MAXINE WATERS, California
SPENCER BACHUS, Alabama              CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware          LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York              NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California          MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma             GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio                  DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair   JULIA CARSON, Indiana
RON PAUL, Texas                      BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio                GREGORY W. MEEKS, New York
JIM RYUN, Kansas                     BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio           JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois         DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North          CHARLES A. GONZALEZ, Texas
    Carolina                         MICHAEL E. CAPUANO, Massachusetts
DOUG OSE, California                 HAROLD E. FORD, Jr., Tennessee
JUDY BIGGERT, Illinois               RUBEN HINOJOSA, Texas
MARK GREEN, Wisconsin                KEN LUCAS, Kentucky
PATRICK J. TOOMEY, Pennsylvania      JOSEPH CROWLEY, New York
CHRISTOPHER SHAYS, Connecticut       WM. LACY CLAY, Missouri
JOHN B. SHADEGG, Arizona             STEVE ISRAEL, New York
VITO FOSSELLA, New York              MIKE ROSS, Arkansas
GARY G. MILLER, California           CAROLYN McCARTHY, New York
MELISSA A. HART, Pennsylvania        JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia  JIM MATHESON, Utah
PATRICK J. TIBERI, Ohio              STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota           ARTUR DAVIS, Alabama
TOM FEENEY, Florida                  RAHM EMANUEL, Illinois
JEB HENSARLING, Texas                BRAD MILLER, North Carolina
SCOTT GARRETT, New Jersey            DAVID SCOTT, Georgia
TIM MURPHY, Pennsylvania              
GINNY BROWN-WAITE, Florida           BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona

                 Robert U. Foster, III, Staff Director
  Subcommittee on Capital Markets, Insurance and Government Sponsored 
                              Enterprises

                 RICHARD H. BAKER, Louisiana, Chairman

DOUG OSE, California, Vice Chairman  PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut       GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio                DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama              BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware          GREGORY W. MEEKS, New York
PETER T. KING, New York              JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma             DENNIS MOORE, Kansas
EDWARD R. ROYCE, California          CHARLES A. GONZALEZ, Texas
DONALD A. MANZULLO, Illinois         MICHAEL E. CAPUANO, Massachusetts
SUE W. KELLY, New York               HAROLD E. FORD, Jr., Tennessee
ROBERT W. NEY, Ohio                  RUBEN HINOJOSA, Texas
JOHN B. SHADEGG, Arizona             KEN LUCAS, Kentucky
JIM RYUN, Kansas                     JOSEPH CROWLEY, New York
VITO FOSSELLA, New York,             STEVE ISRAEL, New York
JUDY BIGGERT, Illinois               MIKE ROSS, Arkansas
MARK GREEN, Wisconsin                WM. LACY CLAY, Missouri
GARY G. MILLER, California           CAROLYN McCARTHY, New York
PATRICK J. TOOMEY, Pennsylvania      JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia  JIM MATHESON, Utah
MELISSA A. HART, Pennsylvania        STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota           BRAD MILLER, North Carolina
PATRICK J. TIBERI, Ohio              RAHM EMANUEL, Illinois
GINNY BROWN-WAITE, Florida           DAVID SCOTT, Georgia
KATHERINE HARRIS, Florida
RICK RENZI, Arizona






                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearings held on:
    November 4, 2003.............................................     1
    November 6, 2003.............................................    71
Appendixes:
    November 4, 2003.............................................   123
    November 6, 2003.............................................   249

                               WITNESSES
                       Tuesday, November 4, 2003

Bullard, Mercer E., President And Founder, Fund Democracy, Inc...    46
Cutler, Stephen M., Director, Division of Enforcement, Securities 
  and Exchange Commission; Accompanied by Paul F. Roye, 
  Investment Management Director, Securities and Exchange 
  Commission.....................................................    11
Haaga, Paul G. Jr., Chairman, Investment Company Institute.......    48
Levitt, Hon. Arthur, Former Chairman, Securities and Exchange 
  Commission.....................................................    41
Phillips, Don, Managing Director, Morningstar, Inc...............    44
Spitzer, Hon. Eliot, Attorney General, State of New York.........    15

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................   124
    Castle, Hon. Michael N.......................................   126
    Emanuel, Hon. Rahm...........................................   128
    Gillmor, Hon. Paul E.........................................   130
    Hinojosa, Hon. Ruben.........................................   131
    Royce, Hon. Edward R.........................................   132
    Bullard, Mercer E............................................   133
    Cutler, Stephen M............................................   173
    Haaga, Paul G. Jr............................................   195
    Levitt, Hon. Arthur..........................................   218
    Phillips, Don................................................   221
    Spitzer, Hon. Eliot..........................................   228

              Additional Material Submitted for the Record

Biggert, Hon. Judy:
    E. Scott Peterson, Global Practice Leader of Defined 
      Contribution Services, Hewitt Associates, prepared 
      statement..................................................   234
Cutler, Stephen M.:
    Written response to questions from Hon. Sue W. Kelly.........   246

                               WITNESSES
                       Thursday, November 6, 2003

Galvin, Hon. William Francis, Secretary of the Commonwealth of 
  Massachusetts, Chief Securities Regulator......................    78
Leven, Charles, Vice President, Secretary and Treasurer, American 
  Association of Retired Persons, Board of Directors.............   114
Schapiro, Mary L., NASD, Vice Chairman and President, Regulatory 
  Policy and Oversight...........................................    76
Zitewitz, Eric, Assistant Professor of Economics, Stanford 
  University, Graduate School of Business........................   116

                                APPENDIX

Prepared statements:
    Gillmor, Hon. Paul E.........................................   250
    Kanjorski, Hon. Paul E.......................................   252
    Galvin, Hon. William Francis.................................   254
    Leven, Charles...............................................   264
    Schapiro, Mary L.............................................   271
    Zitewitz, Eric...............................................   281


                      MUTUAL FUNDS: WHO'S LOOKING



                           OUT FOR INVESTORS?

                              ----------                              


                       Tuesday, November 4, 2003

             U.S. House of Representatives,
         Subcommittee on Capital Markets, Insurance
              and Government-Sponsored Enterprises,
                             Committe on Financial Services
                                                   Washington, D.C.
    The subcommittee met, pursuant to call, at 10:07 a.m. In 
Room 2128, Rayburn House Office Building, Hon. Richard H. Baker 
[chairman of the subcommittee] presiding.
    Present: Representatives Baker, Castle, Royce, Manzullo, 
Oxley (ex officio), Biggert, Capito, Brown-Waite, Frank (ex 
officio), Hinojosa, Lucas of Kentucky, Matheson, Emanuel and 
Scott.
    Chairman Baker. I would like to call our meeting of the 
Capital Markets Subcommittee to order.
    This morning we have two distinguished panels of experts 
who will give opinions as to the necessity for modifications or 
improvements in the current statutory environment for the 
functioning of free and transparent capital markets within the 
country.
    In recent weeks, due to efforts of State regulators and the 
SEC, unfortunate news has come to the public attention relative 
to individuals' conduct not consistent with current statutory 
law. As distasteful as those revelations are, I am confident 
that an aggressive enforcement authority at the State level as 
well as at the SEC will hold those individuals to account for 
their actions or omissions that are found to be inappropriate.
    That in itself is disturbing enough, given the fact that we 
have 95 million Americans now invested in the markets. Over 
half of all working households or all households in the country 
are directly invested in the markets.
    It certainly makes a fine point that we in the Congress 
have a direct obligation to oversee and assist in the 
modifications where professional guidance tells us it is 
necessary, but even beyond the stated criminal conduct which 
has now been identified, I have further concerns that where 
actions were taken completely consistent with current law, 
there are actions that can be taken through non-disclosure that 
diminish shareholder value without shareholders being aware 
that it is occurring, and I certainly believe that is an area 
where the committee should focus its attention.
    This committee has previously acted on H.R. H.R. 2420, 
which sets out modest beginnings for reform. That was first 
reviewed by the committee back in March of this year, before 
the revelations were made that we have recently been made aware 
of. In that light, I am not confident that the content of H.R. 
2420 as drafted today is sufficiently broad in scope and for 
that reason look forward to comments of those who are 
professionals in this area as to their guidance and 
recommendations where the committee may strengthen that 
proposal.
    Certainly one area that remains of some degree of 
controversy but I believe remains very important to overall 
reform is that of the appointment of an independent chair for 
the governance of a mutual fund board. I do believe that much 
of the conduct currently deemed to have been illegal could have 
been at least stemmed, if not prevented, by strong managerial 
oversight, aided with an independent chair and perhaps the 
appointment of a compliance officer as well.
    Those are two points which I believe the committee should 
spend some time and consideration of those recommendations. The 
risk is far too great to leave these matters unresolved. The 
worst action the Congress could take would be not to act in any 
fashion whatsoever.
    The concerns by investors, the lack of certainty, the fear 
that one cannot place their money in the hands of a 
professional fiduciary for enhancing their professional future 
is grave. When we have 95 million Americans investing, that is 
a tremendous source of capital providing for business expansion 
and job opportunities, and if that money should sit on the 
financial sideline it would come at grave cost to our economic 
recovery. So I believe we have a very strong responsibility to 
act, to act quickly, and in a manner that is appropriate, given 
the circumstances that we face.
    With that, I would like to recognize Ranking Member Frank 
for his opening statement.
    Mr. Frank. Thank you, Mr. Chairman.
    I should note that the ranking member of the subcommittee, 
the gentleman from Pennsylvania, who has been very, very 
diligent in his work here, is diverted by something called an 
election which they are having in Pennsylvania. I live closer 
to the airport so I was able to vote at 7 this morning and get 
here. Unfortunately, we implemented a new system and, instead 
of pulling levers, I had to color in lines. I was never good at 
that in third grade and never got much better.
    Chairman Baker. Would the gentleman yield on that point?
    Mr. Frank. Yes.
    Chairman Baker. Mr. Kanjorski brought to my attention the 
fact of the election today. We did try to accommodate the 
members.
    Mr. Frank. I appreciate that.
    Chairman Baker. The difficulty was with the panel of 
members we have this morning. We could not readily reschedule.
    Mr. Frank. I understand, Mr. Chairman. I didn't mean that 
as a criticism.
    Chairman Baker. No, but just for the record.
    Mr. Frank. The way Mr. Spitzer is going, he is not worrying 
about elections any more, so he did not have to show up at the 
polls like the rest of us did.
    There are a serious set of issues here. Mr. Chairman, as 
you know, you received a letter from 32 of the 33 people on 
this side urging you to agree with us that the efforts that 
have been going on for over a year to curtail State activity in 
the regulatory area be put to bed.
    We think that was always mistaken. We think particularly at 
this point it is a very poor idea. There have been various 
versions of it, to require everything be disgorged, to keep 
them out of business altogether.
    It first surfaced at the request of some Morgan Stanley 
people during Sarbanes-Oxley. Subsequently, Mr. Chairman, as 
you know, not on mutual funds, but dealing with SEC powers, 
language was included that would curtail State authority. There 
were arguments about how much. Mr. Spitzer and Secretary of 
State Galvin of Massachusetts, with whom I work closely, have 
both told me this would severely impair their ability to go 
forward.
    The problem is that, partly because of that controversy, in 
July when this committee met to mark up legislation, I believe 
at your request, Mr. Chairman, the bill that the SEC had 
requested for enhanced SEC powers was pulled because it 
included that section. You subsequently had a colloquy with Mr. 
Donaldson about it.
    Now I understand that there is a meeting this afternoon of 
State regulators and the SEC to begin to work out procedures. I 
am all in favor of that, but I am very unhappy about it going 
forward with some sword of Damocles being held over their head, 
as if it is chained to the wall, not a threat.
    I do not think there is any chance of Congress passing it, 
but there are two problems with the continued pendency of this 
pre-emption. In the first place, it has held up action on the 
SEC bill, and there were two bills that we considered on our 
agenda in July. One would have strengthened some regulations on 
the mutual fund and do not propose to go further because of 
some things that we learned, and I agree with the further 
proposals you have made, and I think we should go forward.
    That bill was held up going to the floor, not on our 
request. We were not opposing it when it came out of committee. 
I would agree with you it ought to be strengthened, but we also 
had the bill that at the SEC's request would enhance their 
powers. The SEC has been criticized; the head of our regional 
office in Massachusetts just left. I think it would have been a 
good idea if we give them those enhanced powers.
    That has apparently been held up, while people, including 
yourself, Mr. Chairman, await the outcome of these 
negotiations. I do not think we ought to be waiting for a 
surrender from the State regulators in principle, anyway, but I 
certainly do not want to see the SEC bill held up while those 
negotiations go forward, so I would urge you to agree that that 
SEC bill should go forward. We ought to mark it up right away, 
if you would just drop that pre-emption piece.
    On the mutual fund aspect, that bill came out of committee. 
Frankly, someone asked us why the Democrats hadn't co-sponsored 
it. Well, my answer is: It was reported out of the committee. 
You cannot under the rules cosponsor it. But then I was told 
that the report of the committee action has just been filed 
from July. That is a big slowdown. I didn't realize that.
    Yes, we could have co-sponsored it, if we had realized--
frankly, the polls were held up. I want to go forward and let's 
have another markup. The vote was reported out.
    I just reviewed your new proposals. They seem to be things 
on which we can get a consensus, so I would like to move 
forward, but I do think we have a serious problem with the bill 
the SEC requested for increased powers being held up and 
continued to be held up over the pre-emption. I know you said 
you didn't think, Mr. Chairman, that it would have interfered, 
but I said Mr. Spitzer, Mr. Galvin, both seem to have done so.
    I am glad to see that the chairman and Mr. Spitzer are 
coming together. The holiday season is coming. It is a time of 
healing and reconciliation. That is bad news for the press, 
because more fighting is better for them, but it is good news 
maybe for everybody else. But I would hope that we would 
celebrate this new union here, a civil union--but a union--I do 
not want to get into other issues. Let's say it is a union of 
civility, not a civil union. Let's consecrate that with an 
agreement that this proposed pre-emption was not a good idea.
    So I would urge you again, Mr. Chairman, the chairman of 
the subcommittee, let's activate the SEC bill, let's have a 
markup, and let's withdraw the pre-emption part.
    The other part I would note with regard to the SEC, I 
realize they asked for new powers and didn't get them. But much 
of last year after Sarbanes-Oxley, we fought to give the SEC 
enhanced staff. We fought very hard to give you more money, and 
then the SEC requested some flexibility in hiring. The 
gentleman from Pennsylvania, Mr. Kanjorski, worked with Mr. 
Baker to give the SEC not just a significant increase in money, 
probably the biggest increase outside the Pentagon, which 
always wins, but some flexibility in hiring, subject to the 
people then hired being fully protected. The SEC did give some 
of that money back.
    I wonder, is there anything we can do--and I recognize it 
is hard to do all this right in a hurry, but we--everything the 
SEC has asked for that would enhance either its staff capacity 
or its regulatory powers we tried to support. So I would say to 
Mr. Galvin, if there is anything further we can do to beef it 
up, we would be glad to do that.
    Last point, Mr. Chairman--I would appreciate just 30 more 
seconds--I want to say a word in defense of politicians. We are 
not always everybody's favorite role model, but let's be clear 
that what we have here, the lead has been taken in the mutual 
fund protection of the average investor not just by State 
regulators but by State regulators who are elected to office. 
Mr. Spitzer is elected Attorney General of New York. Mr. Galvin 
is elected Secretary of the Commonwealth of Massachusetts.
    I think it is not accidental that this concerns the average 
investor, the smaller guy. It is not a systemic issue as much 
as it is equity for the individual. I do not think it is an 
accident that elected officials who have to maintain that 
contact were in the lead on this.
    Finally, again, Mr. Chairman, I hope that we can put pre-
emption to bed and go forward with good legislation.
    Chairman Baker. I thank the gentleman.
    Mr. Oxley.
    Mr. Oxley. Thank you, Mr. Chairman. I would yield to you 
whatever time you may consume.
    Chairman Baker. I thank the gentleman.
    I do feel it appropriate to respond to the gentleman from 
Massachusetts' comments with regard to holding up legislative 
reform concerning H.R. 2179.
    I did not intend to get into this arena today, but since we 
have been invited so strongly, I will ask Mr. Cutler at the 
appropriate time, have any constraints, by failure to pass H.R. 
2179, been an inhibition to the SEC's authority to pursue 
wrongdoers and bring them to accountability?
    I would also indicate that in conversations with Mr. 
Spitzer and others we have sought in good faith to reach an 
accord which we believe is potentially achievable and make 
clear that we do not intend nor have we, in any way, inhibited 
State authority to pursue wrongdoers at any level to 
investigate, punish, or bring about any penalties.
    The only discussion has been and remains with regard to the 
remedy stage of those negotiations where, as a result of 
actions taken by Attorney Generals, the national market 
structure would be modified.
    I believe Mr. Spitzer has indicated on occasion that he 
accepts the view that the SEC should maintain primacy as the 
securities regulator but does have concerns as to the 
triggering mechanisms that would be required to institute such 
a fail-safe.
    Having said that, this committee was first on the block--
was out of the block long before there was a scandal, did 
conduct a hearing and can produce from the records statements 
from many members in opposition to H.R. H.R. 2420 and its 
consideration. If we take the elements of H.R. 2179 that were 
merely enhancements of current authority, did not create new 
causes of action, did not give any new power that the SEC does 
not currently have, they were enhancements to the current body 
of enforcement law, you look at H.R. H.R. 2420, which is by far 
the more aggressive remedy to the current conflict we face, 
creating new causes of action, creating new methods of 
accountability, establishing at one point the necessity for an 
independent chairperson to govern the Board, which this 
committee sought to delete, I think we can go back to the 
record if we so choose and discover who were the folks in favor 
of reform prior to the current conflict and who were, in fact, 
obstructing its passage.
    A letter sent to me indicating that I have, in any way, 
inhibited procedural consideration of something that is in the 
public good I find absolutely intolerable.
    I thank the gentleman for yielding.
    Mr. Oxley. Thank you Mr. Chairman.
    Thank you for holding this timely hearing. It is often said 
that we have become in the past two decades a nation of 
investors. While that is unquestionably true, I believe it 
would be more precise to say we are now a nation of mutual fund 
investors. By an overwhelming margin, these pooled investment 
products have become the preferred way for some 95 million 
Americans to access stock markets, so we ought to make sure 
these investors are well-protected.
    It appears that we are now in the early innings of what is 
now the biggest scandal in the 80-year-old history of the 
mutual fund industry. We do not know everything yet, but what 
we do know is troubling. Some have called the revelation 
shocking. Large institutional investors have been given 
preferential treatment to the detriment of individual investors 
and in violation of law in the funds' own stated policies.
    According to the firms themselves, some fund managers and 
executives have essentially been stealing from their own 
customers. At one large fund company, portfolio managers seemed 
to be market timing their own funds as far back as 1998, were 
not terminated and not even disciplined until a September 
subpoena brought this information to the public's attention.
    Perhaps the most troubling aspect of all this illegal 
conduct is that it appears to be so widespread. We cannot say 
that a few bad apples have violated the fiduciary duty owed to 
shareholders. We cannot say that only a handful of firms have 
mistreated their mom and pop investors who were supposed to be 
the industries bread and butter, and we cannot pretend that all 
of the fund companies were aware of this conduct.
    This committee was aware of mutual fund and investor issues 
long before these recent revelations. It has been my view, and 
certainly one shared by Chairman Baker and others, that the 
review of fund practices was inevitable, given the committee's 
work over the past few years. We have examined almost every 
other segment of the securities industry, including Wall 
Street's analysts conflicts and IPO allocation abuses, the 
accounting profession, corporate boards, the stock exchanges, 
credit rating agencies and indeed hedge funds.
    In this post-Sarbanes-Oxley world, the public demands full 
disclosure of all relevant information, and rightfully so. 
Indeed, our system, as we said time and time again, is based on 
trust; and once that trust is broken, we have a clear breakdown 
in our system.
    The committee's year-long review of mutual funds makes 
clear that more transparency is needed with respect to fund 
fees, costs, expenses and operations. There should be more 
useful disclosures regarding fund distribution arrangements so 
that investors are aware of any financial incentives that may 
influence the advice they receive. There should be stronger 
leadership by fund directors and clearly fund directors receive 
better oversight of the industry by the SEC.
    Chairman Baker's legislation which passed this committee by 
a voice vote in July addresses these issues in a responsible 
and measured way. In light of the recent scandals, I think few 
would disagree that it would be appropriate to consider 
strengthening this legislation.
    Mr. Chairman, congratulations on an excellent effort in 
this area, and I yield back.
    [The prepared statement of Hon. Michael G. Oxley can be 
found on page 124 in the appendix.]
    Chairman Baker. Thank you, Mr. Chairman.
    I would be remiss if I did not acknowledge your constant 
and continuing interest in the subject and ensuring that good 
public policy come out of this committee, and I appreciate your 
leadership.
    Chairman Baker. Does any other member wish to make an 
opening statement? Anyone at this side?
    Mr. Scott is next?
    Mr. Scott.
    Mr. Scott. Thank you very much, Chairman Baker.
    I thank you and Ranking Member Kanjorski for holding this 
hearing today regarding the mutual fund industry.
    I also want to thank the panel of witnesses today for their 
testimony.
    When I look back at this committee's earlier hearing on 
mutual funds, I feel as if we were looking at an industry that, 
at that time, was squeaky clean, but we now know that there are 
widespread practices where these funds are clearly not acting 
in the best interest of long-term investors.
    According to an SEC survey, one-fourth of the Nation's 
largest brokerage houses helped clients engage in the illegal 
practices of trading mutual funds after hours, and half of the 
largest companies had arrangements that allowed certain 
customers to engage in market timing.
    Given that more than half of all United States' households 
now hold shares in mutual funds, any discussion today will have 
an impact on millions of investors. We must look out for long-
term investors, and we must restore and reinforce investor 
confidence in mutual funds.
    Hopefully, this hearing will help us understand whether 
mutual fund investors are receiving fair value in return for 
the fees they paid. Late trading, market timing, insider 
trading, all should be no-nos. We have got to look into this 
problem forcefully. The American people are looking for help so 
that we can restore investor confidence in the trading of 
mutual funds.
    Mr. Chairman and the committee, I look forward to this very 
important hearing this morning.
    Chairman Baker. Thank you, Mr. Scott.
    Mr. Castle.
    Mr. Castle. Thank you, Mr. Chairman; and thank you very 
much for having this hearing. I put you in the category of one 
of these crusading people trying to do something about this.
    I think it is very important to understand the numbers. I 
will submit a full statement for the record, but I think it is 
important to understand the numbers. Because it was just two 
decades ago--that is only 20 years ago--that 6 percent of 
American households had mutual fund shares that were valued at 
$134 billion. Today, it is 50 percent.
    I have heard 95 million people, families, is the right 
number, but it is 50 percent of our households have $7 trillion 
at stake. That is about 50 times larger than what existed 
before. That is more than the debt of this country, which 
everybody thinks is the highest number in the world.
    Mutual funds represent about 10 percent of the total 
financial assets; and the number of funds have grown in that 20 
years from 500 mutual funds in 25 years, really, in 1980 to 
approximately 8,000 mutual funds today.
    Now most of these operate, I would believe, within the 
bounds of the laws in regulations of this country, but some do 
not, and investors suffer, and therein lies the rub. I must 
just say that pride cometh before the fall because, as we went 
through the corporate matters and the GSC issues, we are the 
only ones who are really clean, we do not have any problems.
    I have heard about stale pricing, market timing, commission 
overcharges, lack of independent boards of directors, 
completely interlocking boards of directors, lack of 
transparencies, nobody really knows who owns what in terms of 
management ownership or salaries or even the contractual nature 
by which they operate. There had been enforcement issues which 
fortunately are starting to be addressed. 12b-1 fees are still 
being charged by mutual funds which have closed, which is 
amazing that something like that can happen.
    So I think there are tremendous problems as far as the 
mutual fund industry is concerned. I think these hearings are 
very, very important. If nothing else, I cannot imagine that 
the people who are running mutual funds are not paying a heck 
of a lot of attention to what we are doing, so just the fact of 
having these hearings is extraordinarily important. I think 
there will be changes in behavior.
    But I must just say this, Mr. Chairman, before we get into 
the details of all of this. I think we need to put the tools in 
place to make sure that 5 or 10 years from now that we have put 
good laws and rules and regulations in place dealing with 
everybody at the State and the Federal level.
    I am very concerned that as we go through this process, the 
usual drip, drip theory of people saying we do not need this, 
we do not need that, will take place and we will get it right. 
On the other hand, I do not believe that we individually and 
perhaps collectively have all the knowledge with respect to 
what has to be done.
    I think I know something about the mutual fund industry, 
and every day I read something new or different. I do not want 
to say I can write the law. We really need to write this law 
properly and carefully and make sure that it is enforceable.
    Eventually, the end goal, frankly, is protecting our 
investors--we say the smaller investors, but particularly the 
non-institutional investors, whether they are small or not, but 
we must fully evaluate the situation in order to do that.
    I have a lot of questions I want to ask. My 5 minutes of 
questioning will not be enough for that from these individuals.
    You know, obviously, where has the SEC been?
    I think Mr. Cutler has come forward and helped with that, 
the illegal practices, we talked about that, the higher 
redemption fees and how they might affect the market timing. 
The bottom line, Mr. Chairman, is let's make sure we get 
something done. You have always been a good leader in this area 
and I thank the ranking members who care a lot about this 
issue.
    To me, this is an opportunity to do it correctly. Frankly, 
if we take the time to do it correctly, we will have done the 
investing public a good amount of good; and I hope to be able 
to do that.
    I yield back the balance much my time.
    [The prepared statement of Hon. Michael N. Castle can be 
found on page 126 in the appendix.]
    Chairman Baker. I thank the gentleman for his statement.
    Mr. Emanuel, did you want to reclaim your time?
    Mr. Emanuel. Thank you, Mr. Chairman; and thank you for 
holding the hearing today and for those who are attending today 
to testify.
    I want to pick up on what my colleague from Delaware said 
about the 95 million Americans who are now invested in mutual 
funds.
    Unfortunately, what we have uncovered, whether it is market 
timing, late trading, or insider trading, that principle has 
been turned upside down. In fact, what we have seen recently is 
a managers win-investors lose mentality. I think that what we 
are doing here can be done in a smart, thoughtful, bipartisan 
way, as we did during the Fair Credit Reporting Act debate. We 
can take action to restore that trust for investors so that 
they don't pull their money out so unnecessarily and hurt 
themselves even more than they've already been harmed. I think 
it's also important to emphasize that, although we're facing a 
crisis, mutual funds are still a safe place to invest. Anything 
we do either legislatively or regulatorily should strive to 
restore the basic principle of the fiduciary responsibility.
    As we continue to look at this issue, there are two points 
I want to bring to light:
    One is a question I will be asking about the hot IPO. Have 
State of Federal regulators looked at what happened in the hot 
IPO market and how mutual funds allocated the shares they 
received? Was there systemic and endemic abuse back then as it 
related to that market and the IPOs that were allocated? Were 
these allocations going to average investors or were they going 
to the managerial class and special investors?
    Another issue I'd like to raise is how I believe this 
scandal relates is general debate we've been having in Congress 
about the notion of privatizing social security. I will tell 
you, if there is anything that has ever shed light on the 
dangers of privatizing social security, it is what has happened 
here in the mutual fund industry and the ``managers first'' 
culture that has developed in the last 5 or 6 years; and I hope 
those who are rushing headlong to privitize social security 
would take a deep breath here. This scandal should be a 
flashing yellow light to all those who advocate the benefits of 
privatizing what has been a very good system, that is, social 
security, both as an insurance policy and a retirement policy.
    So for all those who have invested in mutual funds, whether 
for their life savings or their kids' college savings, we have 
an obligation to make sure their trust is restored. So I thank 
you for holding this hearing and look forward to the answers to 
the questions.
    [The prepared statement of Hon. Rahm Emanuel can be found 
on page 128 in the appendix.]
    Chairman Baker. Thank you.
    Mr. Royce.
    Mr. Royce. Thank you, Mr. Chairman.
    We thank our distinguished witnesses for coming here to 
testify on the oversight of the mutual fund industry.
    This summer we saw officials from New York, from 
Massachusetts and from the SEC. We saw them unearth a number of 
alarming market-timing activities within the fund industry. I 
encourage investigators and I am encouraging prosecutors to 
vigorously pursue those who have betrayed investors. I also 
sincerely believe we should use these revelations as an 
opportunity to improve the fund industry going forward, and I 
hope all parties involved will work together in a way that 
punishes the wrongdoers, that corrects inadequacies in 
regulation and results in a better climate for America's 
investing public.
    To that end, I am encouraged to see that there are a number 
of proposals being put forward by both interested and 
disinterested parties. In particular, I am pleased to see that 
both the SEC and the Investment Company Institute are looking 
at specific actions that can be taken such as requiring all 
trading orders to be received by 4 o'clock and devising a 
mandatory redemption fee for in-and-out investors and exploring 
fair-value pricing mechanisms and, lastly, improving compliance 
procedures at fund companies.
    In my view, the largest burden must fall on the fund 
industry itself to create better, more effective compliance 
policies.
    Once again, Chairman Baker, I thank you for having this 
hearing today. It is of great importance that this committee 
remains vigilant in ensuring that the investor marketplace that 
so many Americans invest in is fair, is transparent, and I look 
forward to working with my colleagues on this issue and yield 
back.
    [The prepared statement of Hon. Edward R. Royce can be 
found on page 132 in the appendix.]
    Chairman Baker. I thank the gentleman.
    Mr. Lucas.
    Mr. Lucas of Kentucky. Mr. Chairman, I am looking forward 
to hearing the testimony from the witnesses.
    Chairman Baker. Thank you, sir.
    Mr. Hinojosa.
    Mr. Hinojosa. Thank you, Chairman Baker.
    I want to thank you for holding this third hearing on 
mutual funds this year and for the additional hearing the 
subcommittee will hold the day after tomorrow, on Thursday, on 
the same subject.
    Mr. Chairman, I believe that this is going to be a very 
interesting hearing, based on all the news reports I have read 
on, one, the development in the mutual funds industry; two, the 
SEC's involvement; and, three, the role New York State Attorney 
General Eliot Spitzer has played in the investigation of 
malfeasance at certain mutual funds.
    I was alarmed to read in yesterday's CongressDaily P.M. 
that Senate Governmental Affairs Chairwoman Susan Collins 
stated at a hearing before her committee that, ``clearly, much 
more must be done to protect mutual fund investors, whether it 
is through legislation, tougher enforcement actions, new and 
stronger regulations, or all three of those I mentioned.''
    Governmental Affairs Financial Management Subcommittee 
Chairman Peter Fitzgerald inferred at that same hearing that 
``Federal law not only allows but codifies an incestuous 
relationship between the mutual fund board of directors and 
their investment advisors and managers.'' If they are correct, 
then the mutual fund industry is in dire need of reform.
    What I would truly like to learn today is if this series of 
events in the mutual fund industry is merely limited to 
particular funds or if these recent scandals represent a more 
serious systemic problem within the mutual fund industry that 
might require Congress to enact legislation to correct the 
situation.
    Many believe that adequate laws and regulations exist to 
police late trading and market timing issues raised in the 
suits against the mutual funds in question. I am not certain 
that I want the current allegations of abuse to cause an 
overreaction of legislation nor regulations to sweep up legal 
late processing with the illegal allegations. However, like 
most of my colleagues here today, I would like to learn more 
about market timing and late trading.
    Mr. Chairman, I look forward to the witnesses' testimony 
and to their views on whether adequate laws and regulations 
exist to police late trading and market-timing issues. For 
these reasons and more, this hearing is both timely and 
helpful.
    With that, I yield back the balance of my time.
    [The prepared statement of Hon. Ruben Hinojosa can be found 
on page 131 in the appendix]
    Chairman Baker. I thank the gentleman.
    Are there other members desiring to make an opening 
statement?
    If not, then it is my pleasure at this time to welcome to 
our hearing Mr. Stephen Cutler, Director, Division of 
Enforcement, for the Securities and Exchange Commission, who is 
accompanied here today by the Investment Management Director, 
Mr. Paul Roye, of the Securities and Exchange Commission.
    As you are aware, your statement will be made part of the 
official record. To the extent possible, limit your remarks to 
5 minutes for purposes of questions from members.
    We welcome you here and look forward to your comments. 
Thank you.

     STATEMENT OF STEPHEN M. CUTLER, DIRECTOR, DIVISION OF 
ENFORCEMENT, SECURITIES AND EXCHANGE COMMISSION; ACCOMPANIED BY 
 PAUL F. ROYE, INVESTMENT MANAGEMENT DIRECTOR, SECURITIES AND 
                      EXCHANGE COMMISSION

    Mr. Cutler. Thank you, Chairman Baker, thank you for having 
me, Ranking Member Frank and distinguished members of the 
subcommittee. Good morning. Thank you for having me here to 
testify today on behalf of the SEC concerning abuses relating 
to the sale and operation of mutual funds.
    Chairman Baker, I know you have been a champion for mutual 
fund reform; and I commend you for those efforts and for 
convening these important hearings today.
    The illegal late trading and the related self-dealing 
practices that have recently come to light are a betrayal of 
the more than 95 million Americans who put their hard-earned 
money into mutual funds. Quite simply, those Americans haven't 
gotten a fair shake. For too many of them, the phrase ``trusted 
investment professional'' was a misnomer, as they weren't 
worthy of their trust.
    The SEC is fully committed to ensuring that those who broke 
the law are held accountable and brought to justice. That 
process has already begun. Since Mr. Spitzer announced his 
action against Canary Partners and Edward Stern in early 
September, here is what we have done on the enforcement front. 
We sued Bank of America broker Theodore Sihpol for having 
allegedly facilitated late trading by some of his clients. We 
charged Steven Markovitz, senior executive of the Millennium 
Hedge Fund Group, with late trading and barred him from 
associating with an investment advisor.
    We also obtained an industry bar and imposed a $400,000 
civil penalty on James Connelly, an executive with mutual fund 
complex Fred Alger Management, Inc., in connection with his 
alleged role in allowing certain investors to market time his 
company's funds; and we sued Putnam Investment Management and 
two of its portfolio managers, Justin Scott and Omid Kamshad, 
who we allege market timed their own mutual funds.
    In each of these cases we have worked closely with Mr. 
Spitzer, Mr. Galvin, and others who have also filed their own 
charges.
    Today, in conjunction with the Secretary of the 
Commonwealth of Massachusetts, we are announcing still another 
enforcement action, this one against five Prudential securities 
brokers and their branch manager. We allege that the defendants 
defrauded mutual funds and their investors by misrepresenting 
and concealing their own identities or the identities of their 
customers so as to avoid detection by the fund's market-timing 
police. This allowed them to enter thousands of market-timing 
transactions after the funds had restricted or blocked the 
defendants or their customers from further trading in their 
funds.
    In addition to these enforcement actions, on September 4, 
the Commission sent detailed compulsory information requests to 
88 of the largest mutual fund complexes in the country and 34 
brokerage firms, including all of the country's registered 
prime brokers; and just last week we sent similar requests to 
insurance companies who sell mutual funds in the form of 
variable annuities.
    Let me briefly highlight some of the most troubling 
findings, but I have to point out these are only preliminary 
and are still the subject of continued active investigation by 
the SEC as well as our State colleagues.
    First, more than 25 percent of responding brokerage firms 
reported that customers have received 4:00 p.m. prices for 
orders placed or confirmed after 4:00 p.m..
    Second, three fund groups reported or the information they 
provided indicated that their staffs had approved a late-
trading arrangement with an investor.
    Third, 50 percent of the responding fund groups appear to 
have at least one arrangement allowing for market timing by an 
investor.
    Fourth, documents provided by almost 30 percent of 
responding brokerage firms indicate they may have assisted 
market timers in some way, such as by breaking up large orders 
or setting up special accounts to conceal their own or their 
clients identities, as we allege in the case we filed today.
    Fifth, almost 70 percent of responding brokerage firms 
reported being aware of timing activities by their customers.
    And, sixth, more than 30 percent of responding fund 
companies appear to have disclosed non-public information about 
the securities in their portfolios in circumstances that raise 
questions about the propriety of such disclosures.
    The Commission staff is following up on all of these 
situations closely.
    I should also point out that we have been actively engaged 
in enforcement and examination activities in other important 
areas, many of which have already been mentioned here today 
involving mutual funds.
    The first is mutual fund sales practices and fee 
disclosures. We are looking at just what prospective mutual 
fund investors have been told about revenue-sharing 
arrangements and other so-called shelf space incentives doled 
out by mutual fund management companies and mutual funds 
themselves to brokerage firms who agree to feature their funds.
    We have already issued a Wells Notice of the staff's 
intention to recommend charges against one firm based on 
inadequate disclosure of shelf space fees.
    Our second area of focus is the sale of different classes 
of shares in the same mutual fund. Very frequently, a fund will 
have issued two or more classes of shares with different loads 
and other fee characteristics. We have brought enforcement 
actions against two brokerage firms and certain of their 
personnel in connection with their alleged recommendations that 
customers purchase one class of shares when the firms should 
have been recommending another.
    The third area is the abuse of so-called break points. 
Quite simply, we found numerous instances in which brokerage 
firms did not give investors the volume discounts they were 
entitled when they purchased mutual funds.
    Yesterday, the NASD and the SEC announced that 450 
securities firms were being required to notify customers that 
they might be due refunds because they were not given break 
point discounts, that nearly 175 of those firms were being 
required to conduct comprehensive reviews of mutual fund 
transactions for missed break points and that a number of those 
firms were being referred for possible enforcement action. This 
week, together with the NASD, we will be issuing notices to 
those firms.
    The fourth area is the pricing of mutual funds beyond the 
context of market timing. We are actively looking at two 
situations in which funds dramatically wrote down their net 
asset values in a manner that raises serious questions about 
the funds' pricing methodologies.
    Representative Castle mentioned in his opening remarks 12b-
1 fees of funds that have closed, and that is another area that 
we have been looking at.
    Before I conclude, I do want to take a moment to address 
reports that several months ago an employee in Putnam's call 
operator unit told our Boston office that individual union 
members were day-trading Putnam funds in their 401(k) Plan.
    The SEC receives on the order of 1,000 communications from 
the public in the form of complaints, tips, E-mails, letters 
and questions every working day. That is more than 200,000 a 
year. We have made and are continuing to make changes in how we 
handle these complaints, including giving more expeditious 
treatment to those that raise enforcement issues and 
instituting a monthly review of all enforcement-related matters 
that come to us by the division's senior management. We have 
room to improve in this area, and we are going to improve in 
this area, but, let there be no mistake, the dedication, 
commitment and professionalism of our enforcement staff are 
second to none.
    In our just-concluded fiscal year, 679 enforcement cases 
were brought. That is a 40 percent jump from 2 years ago. We 
accomplished this with almost no increase in resources, and 
included in those totals are some extraordinary achievements: 
$1.5 billion in disgorgement and penalties designated for 
return to investors, using Sarbanes-Oxley fair funds; 60 
enforcement actions against public company CEOs; nearly 40 
emergency asset freezes and TROs; groundbreaking cases against 
brokerage firms and banks for their roles in the Enron scandal, 
against an insurance company for its role in facilitating an 
issuer's financial statement fraud, against the stock exchange 
for its failure to enforce its trading rules and against a 
mutual fund management company for its failure to disclose a 
conflict of interest in its voting of its fund proxies; the 
largest civil penalty ever obtained in a securities fraud case; 
and dozens of financial reporting cases involving Fortune 500 
Companies and their auditors.
    With the recent badly-needed budget increases you have 
given us, we have now begun to see additional resources. They 
allow us to identify problems and to look around the corner for 
the next fraud or abuse.
    With respect to mutual funds, I know that the agency's 
routine inspection and examination efforts will be improved by 
adding new staff, increasing the frequency of our examinations 
and digging deeper into fund operations. We are working 
aggressively on behalf of America's investors to ferret out and 
to punish wrongdoers wherever they may appear in our securities 
markets.
    At the same time that the Commission is looking backward to 
identify past wrongdoers, the Commission has been engaged in a 
comprehensive regulatory response designed to prevent problems 
of this kind from occurring in the first place.
    My colleague, Paul Roye, Division Director of our 
Investment Management group, can answer any questions you may 
have about those initiatives; and I ask that the written 
testimony that he provided yesterday on the Senate side be made 
part of the full record of this subcommittee as well.
    Chairman Baker. Without objection.
    Chairman Baker. Thank you very much for your fine 
statement.
    [The prepared statement of Stephen M. Cutler can be found 
on page 173 in the appendix.]
    Chairman Baker. I now wish to welcome the Honorable
    Eliot Spitzer, Attorney General of New York; and on the 
record I want to acknowledge your good work in bringing to 
account those who have clearly violated securities law for the 
benefit of investors. I have nothing but admiration for the 
work you have pursued for so long and assure you I have no 
intent to, in any way, inhibit future activities of that sort. 
Welcome.

  STATEMENT OF THE HONORABLE ELIOT SPITZER, ATTORNEY GENERAL, 
                       STATE OF NEW YORK

    Mr. Spitzer. Thank you, Congressman Baker. I appreciate 
your having this hearing and your kind words.
    Chairman Oxley as well, thank you for your presence and 
your leadership on these issues.
    Also, of course, many thanks to Congressman Frank who is a 
great friend for many years. I appreciate your kind words and 
support for State jurisdiction and also your reminder that 
today is Election Day. I will make sure I get home to vote.
    I feel compelled to begin by referring back to a quotation 
I have used elsewhere, but it is, I think, very instructive 
here. It is one from Paul Samuelson, who was, of course, not 
only a Nobel Laureate but a firm and wise observer of our 
capital markets. He said this about our mutual fund industry 35 
years ago when we were beginning to piece together the 
governing structure of our mutual fund industry. He said and I 
quote: ``I decided there was only one place to make money in 
the mutual fund business. As there is only one place for a 
temperate man to be in a saloon, behind the bar and not in 
front of the bar, so I invested in a mutual fund management 
company.''
    Unfortunately, even 35 years ago, wise analysts understood 
that those who were really going to make money were the 
managers of the funds, not necessarily those who were 
investing; and they understood the distinction of the 
dichotomy, the schism that existed between the managers and 
those to whom they owed a fiduciary duty, those who were 
investing. That is the problem we were trying to confront today 
in several different ways.
    Unfortunately, the record is now overwhelmingly clear. 
Despite protestations of purity I think we have heard for 
several decades from the mutual fund industry, where the 
industry tried to distinguish itself from other sectors of the 
capital markets where they would gladly acknowledge there were 
significant problems, significant violations of fiduciary duty, 
unfortunately, now we are seeing widespread abuses.
    This is no longer a case of one or two bad apples sullying 
the entire crate. It begins to appear that the entire crate is 
rotten. When we have numbers that are being generated by the 
very worthy analysis of the SEC that demonstrates 25, 50 
percent of the various funds were participating in or had 
knowledge of improper activity, we have got to come to the 
conclusion the problems are structural, they are systemic, and 
these are not just one or two individuals who are, 
unfortunately, tarnishing the reputation of others.
    The cost to investors has been huge. From market timing 
alone, academic studies predict that those studies practices 
are costing investors upwards of $5 billion a year.
    The late-trading costs are harder to calculate, but they 
are, in addition, very, very significant.
    We also have the very--the somewhat different issue, which 
I will address momentarily, disparate fees, where pension fund 
advisors seem to be paid less than mutual fund advisors for 
essentially the same services.
    And because you, Mr. Chairman, and others have recited the 
numbers, the vast numbers involved in terms of investment 
dollars in the mutual fund sector, the mere 25 basis point 
deferential in advisory fees paid would correlate to a $10 
billion loss for investors.
    The conclusion is that even small, marginal differences in 
fees paid correspond to enormous losses in return for 
investors. As a consequence, your efforts here today are 
critically, critically important.
    What begins to emerge, unfortunately, is an image of 28 
distinct sets of rules, one for insiders and one for everybody 
else, a set of rules for those who are big enough to play, 
because they know who to call, how to craft a separate 
arrangement, how to send sticky assets into a separate fund to 
get preferential treatment, whether it is late trading, timing, 
at the expense of the small investor whom we were supposed to 
be protecting.
    The other unfortunate conclusion is that boards should have 
known and--boards could have known and, even with minimal due 
diligence, boards would have seen evidence of this improper 
conduct.
    With all due respect to the cases that Mr. Cutler's office 
has made, Mr. Galvin's office has made and my office has made, 
these are not hard cases to make. It is like picking low-
hanging fruit. What that suggests to me is that not only should 
we as prosecutors have been there sooner but it begs the 
question, where have the compliance departments been of these 
mutual firms?
    It is an unfortunate tale that we have seen over and over 
and over again in every corner of the financial services 
sector. They come before us and they say, trust us. We have 
compliance departments. We have self-regulatory organizations.
    They have failed. They have utterly betrayed the American 
public, and they have exhausted the reservoir of trust that 
existed. It is a sad tale, and how we move forward from here is 
going to be difficult to figure out.
    One emblematic moment for me was about a year ago when the 
mutual fund industry said, we do not want to disclose to the 
public how we vote our proxies. They said, we know this is your 
money, but it would be too expensive to tell you how we are 
voting your proxies.
    It was an outrage. It was outrageous.
    With a straight face they tried to tell us this was a cost 
they could not absorb. They are wrong. Thankfully, the SEC 
overrode them, but the mere fact they would make that argument 
I think demonstrates the arrogance of the industry and, 
unfortunately, the callous disregard that they had for the fact 
that they have a fiduciary duty to those whose money they are 
handling, the American public.
    One final point before I get into two areas of where we can 
move forward, I believe, and that is this: We had, and you 
referred to this number, 6 million investors several decades 
ago, 95 million investors today. We have seen a tremendous 
democratization of the marketplace. Everybody in this room 
believes it is a wonderful thing. It has kept our capital 
markets vibrant, permitted the capital to be there for industry 
to expand. The question is, have we protected the small 
investors who do not know how to navigate through the very 
complicated world of the capital markets?
    I think the answer we are beginning to see, whether it is 
the research issues of last year, where research simply was not 
accurate which was being disseminated to small investors, or 
this year, where the mutual funds are, as a colleague across on 
the other side of the Capitol said yesterday, are routinely 
skimming money off the top, it has got to be our conclusion we 
are not adequately protecting the tens of millions of Americans 
whom we have invited into the marketplace and whose capital we 
want to see flowing into the marketplace.
    Let me make two final quick points if I might, sir:
    First, with respect to the particular areas of impropriety 
we have seen, late trading and market timing, the rules were 
reasonably clear. There we need vigorous enforcement. We will 
see it. We are beginning to see it. The laws there do not 
necessarily need to be rewritten, although I am sure that 
together we will come up with some ideas. A hard and fast 4 
o'clock cutoff, even the industry has proposed that. Everybody 
in the industry understood it. There we have an issue of 
enforcement.
    The larger issue and the one, Mr. Chairman, your bill was 
designed to address, and I know it has bipartisan support, is 
how do we change the governing structure of the mutual fund 
industry. I think there we need to really step back and ask the 
question, have the boards properly protected those to whom they 
owe a fiduciary duty? And the answer is, quite simply, no, they 
have not. They did not do that job properly.
    Although I think H.R. H.R. 2420 is a very good start and 
moves us in the right direction, there are a few things that I 
think could be added to it. Some of these ideas are in there in 
some way shape or form now, but I think it will be articulated 
with some greater specificity. Let me just roll them off, and I 
will be done.
    The first, we need a uniform, complete, categorized 
disclosure of the fees that investors pay for advisory 
services, management marketing services and trading costs. We 
need it to be done simply, in a way that is straightforward, in 
a way that is broken out so everybody can understand it and 
compare it across one fund to another. Much as you go into a 
supermarket and you see a nutritional chart that tells you how 
much fat, carbohydrates--I confess I do not look at it too 
often, perhaps I should--it should be nutritionally sound, 
there should be an equivalent information disclosure that is 
readily understood by investors.
    We need also to require boards to demonstrate that they 
have negotiated advisory and management fees that are in the 
best interest of their shareholders and perhaps--I say 
perhaps--require that they obtain multiple bids for those 
services. This is a complicated area, but nonetheless I think 
we know that the sole bid and nature of these pledges and the 
fact that you have a Fidelity or an Alger or a Putnam going in 
and giving to a board only one option and the board then votes 
on that one option has led to an environment where there is not 
adequate negotiation over those fees. Hence I think we have the 
disparity in fee structure that I was referring to earlier with 
respect to the 25 basis points for services that are paid for.
    Third, we can consider--and this would be a complicated 
issue. We could consider asking management companies or boards 
to put in a most-favored-nation clause that would stipulate if 
somebody is providing or getting identical services for a lower 
fee they be given the lower fee.
    It is a standard contract in the private sector. Many 
people insert it just to ensure they get the benefit of the 
prevailing market cost of any particular product. It is 
something that we could consider asking boards to put in, 
again, as a way to ensure that they get a fair market price.
    Perhaps most important we need an independent board 
chairman. Mr. Baker--Congressman Baker, you alluded to this. It 
is absolutely essential. Without the board chair there simply 
will not be the presence of mind on the board to exercise the 
independence that is required.
    I think we also need independent directors. I will leave to 
Congress to figure out how many and how you define that. 
Clearly, there has not been independence on the part of the 
boards of the funds themselves. That is an essential component 
as we move forward.
    I would also suggest that we should--since there has been 
an abject failure of compliance that perhaps we would want 
compliance departments no longer to be buried within the 
management companies or the advisory companies but to have the 
compliance departments report solely to the independent board 
chairs. If we can create that separate reporting line, move 
compliance into an area where they will be independent, perhaps 
we could reinvigorate their performance.
    I think these are some ideas we have had over time. I look 
forward to participating with the committee on both sides of 
the aisle. I know there has been enormous interest on the part 
of many members on this issue, and I look forward to working 
with you again.
    Let me clear up one issue. I have worked stupendously I 
hope, despite the occasional barbed comment, with Mr. Cutler 
with the SEC. We share a common objective, we work together, 
and we look forward to doing so as we move forward.
    Thank you.
    Chairman Baker. Thank you, sir.
    [The prepared statement of Hon. Eliot Spitzer can be found 
on page 228 in the appendix.]
    Chairman Baker. Let me continue with the line you brought 
up with regard to independent chair and compliance officer. I 
suggested yesterday to members of the Senate committee that we 
have a requirement for a fund to create a compliance officer 
responsibility that reports directly to the independent members 
of the board.
    It would seem from your work that there were clear 
violations of existing statute. In some cases, individuals who 
were engaging in wrongdoing were actually told by their 
managerial superiors to stop and do no longer; and the actions 
continued anyway. In that case, it almost really doesn't matter 
what the law says, if you have a person intent on breaking it, 
and that is why we need strong enforcement authority to go 
after those folks.
    The more difficult area I think is reflected in your 
comment as to the overall structure and countermeasures that 
might be needed to be created to keep good people good, so that 
somebody's always watching the shop. Then, on top of that, a 
disclosure regime, perhaps the comparability standard you 
suggest, but the ability of an average investing person to look 
at what they are being charged and understand the net value 
returned and to have that comparability between funds.
    So three targets: One is to understand from your 
perspective--and I think you perhaps initially indicated--are 
there any changes in statutory provisions with regard to 
criminal misconduct that the statutes do not currently enable 
you to pursue; secondly, what other mechanisms beyond the 
independent chair and the compliance officer might you think 
advisable as this committee goes forward; and then the review I 
have suggested in the legislation of a model thousand dollar 
investment being used as a standard for all fees to be deducted 
to show the recipient of the fund return exactly what they were 
charged and for what reason.
    Some have suggested that we need to go to an actual hard 
dollar calculation per every account. I have some concerns 
about that because of the complexity of doing so and the cost 
related--legitimate cost related to that calculation, and it is 
just a boilerplate thousand dollars or $10,000 sample 
sufficient for your purposes.
    Let me express my appreciation for your support of H.R. 
H.R. 2420 and the independent chair.
    You want to hit those three things quickly?
    Mr. Spitzer. Sure, I will try.
    With respect to existing statutes, I think I can fall back 
on the Martin Act, which is perhaps particular to New York. We 
have not had an absence of statutory authority, because we 
obviously are in a position to invoke New York State law as 
well.
    Having said that, I believe that every case where we have 
found wrongdoing constitutes straightforward fraud under the 
Federal securities laws, and I would defer to Steve's views on 
this as well, but I think we have not disagreed that every case 
where we have brought charges or have wanted to have brought 
charges there has been a sufficient predicate in the existing 
civil or criminal jurisdictions granted under the Federal 
securities laws and consequently I am not sure we need to 
expand the straightforward definition of fraud under--in 10b of 
the securities laws that has served us well for--I do not 
know--70 or so years, now.
    Having said that, I think at perhaps a regulatory level the 
SEC will consider refining the rules relating to the 4 o'clock 
cutoff in terms of the NAV or pricing mechanism. I do not want 
to speak for them, but I think that is an area where some 
additional rigidity will lend guidance, although I do not want 
to suggest, in any way, shape or form that any of the misdeeds 
we have highlighted can be attributed to a misunderstanding of 
what that law was. There simply is not an ambiguity there that 
provides a defense for the acts we are charging.
    So, yes, I think there are some forward steps we can take, 
but I think we also have a broad framework that permits us to 
charge fraud.
    In terms of the director issues, I think let's move 
forward, certainly, by getting independent directors and 
independent compliance department, additional disclosures.
    I think that the issue that you frame as a $1,000 model 
portfolio is perhaps better because of its simplicity as 
compared to the individualized determination of the individual 
portfolio of the investor. I guess I am tempted to say I am an 
agnostic on that.
    I would like to see what these pieces of paper look like. 
Maybe it is a matter of doing both.
    Maybe it is a matter of driving home--I think the argument 
that is most powerful to investors is when they see what the 
compound interest effect is over time of the differential and 
fees. I have often said that compound interest is the eighth 
wonder of the world. Many investors will say, the 25 basis 
points on a $1,000 portfolio is only $5, and I am happy. I am 
not going to switch from one fund to the next because of five, 
whatever it might be. I think when investors see what the net 
impact is over a decade of investing, that is when it is driven 
home to them how dramatic this impact is.
    Perhaps what I would add to that is a time horizon that 
would show that if fees are set at this point, which they are, 
right now, your portfolio, based on a projected return at the 
end of the decade would be why, and if fees were 50 basis 
points lower or 25 basis points lower, here is what your return 
will be. Because only then can it be driven home for investors 
how much this will really cost in a calculation.
    And I think these numbers are right. Somebody has estimated 
if you were to do that 25 basis points over 10 years for a 
$100,000 portfolio, the impact of that would be $6,000, $6,000 
over a 10-year time horizon. So I think at that point people 
say, wait a minute, if this is $6,000, I will either go to my 
board and say negotiate harder or I will switch to a different 
fund with lower fees. So it may not be a static analysis at 
this 1-year time frame, what is it, but perhaps over a longer 
time frame, what would the impact be on the investor?
    Chairman Baker. Let me just address one other question 
raised earlier. You and I have recently discussed the issue of 
SEC primacy with the regard to the States Attorney's General's 
abilities to pursue wrongdoing. I think I have made clear that 
I have no intent nor make no effort to, in any way, impair your 
ability to go after wrongdoers. However, there may be a 
triggering mechanism that we can mutually pursue that would put 
Mr. Cutler or the appropriate SEC person at the table when a 
market structure issue is going to be determined. Not that that 
in any way precludes you from making that judgment, but in 
consultation with.
    Now, we haven't reached agreement, we don't have language, 
but I merely want to establish on the record we are working 
together to seek a standard which would be operatively 
successful from your perspective while enabling the SEC to 
express its opinion.
    Mr. Spitzer. Mr. Chairman, thank you for raising that 
issue. I suppose in moments of weakness I acknowledge that the 
SEC is the primary enforcer in the securities markets, and I 
will concede that point.
    Chairman Baker. Brilliance comes in flashes.
    Mr. Spitzer. It does, indeed. I have not been willing to 
concede that we need to install a new triggering mechanism. I 
have often believed our press releases are sufficient and Mr. 
Cutler sees them and reacts. We have, I think, in New York, a 
good record of enforcing the law and bringing the SEC in to 
cases when our negotiations with defendants, in the context of 
injunctive relief, would begin to impinge upon market rules 
that we believe are the SEC's primary domain.
    Having said that, I believe that the current law is 
sufficient to ensure that there is a fair dynamic between the 
SEC and state regulators, the 80-plus years where there has 
been this duality of enforcement. I cannot think of a single 
case where a State has acted in a way that has created a rule 
of law or a regulatory conundrum that the SEC has needed to 
respond to in the context of an enforcement action.
    The concerns that have been raised have led to 
conversations between the SEC in not only New York, but all the 
States to make sure that there is an adequate flow of 
communication back and forth to ensure that we don't, as we 
move forward in our increasingly integrated capital markets, 
stumble upon or create such a situation where there would be a 
problem.
    So, to sum it up, I am comfortable that the law, as it now 
exists, is absolutely adequate; we do not need to try to craft 
anything legislatively that would address this problem. I am 
always happy to work with, in fact, believe it is my 
obligation, and the obligation of any enforcement entity at any 
level, to work with the SEC and others to ensure that we 
continue to not disrupt the markets in any way inadvertently. 
But I believe we are moving towards an understanding of how 
that communication should work.
    Chairman Baker. And to put further point on it: You do not 
wish to write national securities law as a States Attorney 
General.
    Mr. Spitzer. No, we have never tried to write national 
securities law. That is the domain of Congress and the 
regulatory authority. Congress, at the legislative level, 
Congress--and the SEC at a regulatory level.
    Having said that, we, in our injunctive relief, have always 
and will continue to need to craft measures that respond to the 
nature of the abuse. Those injunctive measures that we 
negotiate with individuals who have committed either civil or 
criminal wrongs obviously cannot, because of the supremacy 
clause, be inconsistent with Federal law. Sometimes they 
supplement obligations and we impose additional obligations on 
malefactors because they need additional compliance programs or 
other measures ensure they don't break the law as we go 
forward.
    So we have been very careful not to write rules that apply 
to the national markets. Obviously, last year in the global 
settlement with investment banks we only did that because we 
had the SEC with us, and therefore we were crafting a larger 
rule that applied to a significant number of entities. But we 
will, in our injunctive relief, obviously need to impose 
measures on firms that perhaps vary from, though are not 
inconsistent with rules and regulations that have been crafted 
by the SEC.
    Chairman Baker. Thank you.
    Mr. Cutler, Mr. Spitzer has exhausted our time, so I will 
come back to you on the next round.
    Mr. Frank.
    Mr. Frank. Mr. Chairman, let me just say to Mr. Spitzer, 
there is one other area where you are in specific agreement 
with the SEC when you say you can't think of a single case 
where State regulators have interfered with the need for a 
national market. Neither can the SEC. I asked Mr. Donaldson 
that his last time here; he said he couldn't think of one, he 
would check the records. And I haven't heard from one yet, so I 
think that we are in agreement.
    But there is still pending a bill--and there is a 
legitimate disagreement here and that is still pending with 
regard to State authority. And I want to get your specific 
response, because Mr. Spitzer has, in the past, been critical 
of some of your efforts. And I am glad that we seem to be 
moving toward some agreement, but the SEC enforcement bill that 
I mentioned, when it was introduced by Mr. Baker, he spoke 
highly of the bill, and I thought it did a lot of good things, 
and as I understood, they were all from SEC.
    By the way, that particular bill that we are talking about, 
the one that is being held up while we still wrestle with the 
preemption issue, it has on page 11, section 3, Investment 
Company Act of 1940, increasing penalties, strike 5,000, put in 
100,000; strike 50 and put 250; strike 50 and put 500,000. And 
then enforce the Investment Company Act, strike 5,000 and put 
in 100,000; strike 250,000 inserting a million.
    In other words, this bill contains significant penalty 
enhancements, which I think we ought to have. And I don't think 
it ought to be held up over what is dwindling dispute over 
preemption.
    But let me ask you, though. The bill that we have before 
us--and by the way, the proposal that was put forward to 
restrict State authority didn't just restrict their authority 
vis-a-vis the SEC. On page 25 of H.R. 2179, it talks not just 
about the Securities and Exchange Commission, but by any 
national security exchange or other self-regulatory 
organization, this bill would preempt your ability to add 
requirements where a regulatory organization--and let me ask 
you whether this would be an impediment to your enforcement 
efforts, Mr. Galvin's, and many other State officials. And I am 
quoting:
    No law, rule, regulation, judgment, agreement, or order may 
establish making and keeping records, bonding, or financial or 
operational reporting disclosure, or conflict of interest 
requirements for brokers, dealers, et cetera, that differ from 
or are in addition to the requirements in these areas 
established by the SEC or any national security exchange or 
self-regulatory organization.
    I don't think we are contesting--I hope nobody would try to 
contest. You can't differ with them, the supremacy clause. As 
Earl Long once said to the racist: The Feds have got the atom 
bomb; you don't win that fight.
    But where there is silence, where either a regulatory 
organization or the SEC hasn't done anything--and we are not 
talking here just about laws, rules, and regulations, but 
judgments, agreements, or orders. Would enactment of that 
language significantly interfere with your ability to do your 
job?
    Mr. Spitzer. Yes, it would. And I think you have zeroed in 
on two of the particular portions of the amendment that would 
be, in fact, were problematic to me. It was the extension not 
only from the--of drafting that extended the prohibition not 
only to SEC rules and regs, but also anything emanating from an 
SRO. And I think that was fundamentally, I won't say perverse, 
but it was intentionally problematic to me because the SROs 
have been failed regulatory organizations. I think we can see 
that.
    Mr. Frank. And I would say since then, as we have seen with 
some of the SROs, it has gotten problematicer.
    Mr. Spitzer. Problematicker. Exactly. I will have check the 
source for that word, but it has been----
    Mr. Frank. We have a certain rulemaking power here.
    Mr. Spitzer. Okay. I will defer to you.
    The other area, the other words in there that were 
problematic to me--problematicer--were in addition to. And I 
think that is where I really stumble, because obviously we 
cannot do anything inconsistent, we wouldn't want to, we 
wouldn't try to, we shouldn't. But in addition to is where in 
injunctive relief we often impose upon malefactors, obligations 
that do differ in, from and are in addition to, because----
    Mr. Frank. In other words, it seems to me that language--
and again, that was put forward. That is what is holding up the 
bill that would enhance the penalties that I just read. It 
says, in effect, going forward, you can't treat an offender 
differently than you treat everybody else. I mean, when you 
talk about it--it is not a rule here. And, again, I repeat, I 
hope we would drop that and go forward and bring forward on to 
suspension that SEC bill.
    Now, on the mutual funds. I want to acknowledge a change of 
heart here. On the independent compliance officer, I believe 
that is in the bill; I am all for it. Most of what is in the 
mutual fund bill went through this committee without objection, 
and as far as we were concerned, was ready to go to the floor. 
We did raise some objections to the independent chairman 
requirement being imposed on mutual funds only. That was the 
one I had. I must say, it was probably because I had not seen 
independent chairs elsewhere in the corporate world being much 
of a safeguard, but I am guided by what you and others have 
said, and I am now prepared to say, given the crisis we have 
seen here, we can go forward with that. I also agree with the 
chairman, who brought forward--the chairman of the 
subcommittee--some additional factors that have come out 
because of your investigation. So we are ready to go forward.
    Let me ask Mr. Cutler now. On the question of the SEC and 
the extent--what can we do to help? Let me ask you in 
particular: We fought hard to give the SEC more money and more 
flexibility. Is that a transitional problem? You just couldn't 
hire all those people at once? Is it too much money overall? 
What can we expect? Have we overappropriated for you, or did we 
just give you too much to eat too quickly?
    Mr. Cutler. I certainly don't think you have 
overappropriated for us. I mean, I think the Commission was 
starved for a long time, and with this committee's help, I 
think we finally got some of the resources that we have needed. 
We obviously want to go about the process of hiring people in a 
way that is appropriate and deliberate and thoughtful and 
intelligent so that we can get the right people in the door to 
do the job that we need to do. And we are in the process of 
really ramping up. We obviously couldn't do that the day the 
money came in the door, but we are well on our way to getting--
--
    Mr. Frank. I figured that--in fact, if you go back to the 
debates, those of us who were pushing for the additional money 
over and above what the administration was asking for and 
appropriated for voting, pointed out that there would be a time 
lag. So we weren't talking about a couple months, but the 6 or 
7 months after that.
    But you answered the essential question, which is, the fact 
that you did give back some of the money--and I appreciate 
that. If you can't spend it wisely, yeah, it is a good idea to 
give it back. That should not be held in the future to mean 
that there is a permanent limit. It was a temporary inability 
to spend the money for the staff, and the appropriate staffing 
levels should then go back as you are able to do that.
    Mr. Cutler. I couldn't agree with you more. No one wanted 
the agency to spend the money in a way that was unwise; but 
that doesn't mean we wouldn't want the money or need the money.
    Mr. Frank. As you know, we did collaborate with you in 
doing legislation that gave you more hiring freedom.
    Let me ask now about H.R. 2179, the bill that is being held 
up as we debate the preemption issue. How important is that? My 
understanding was that those were mostly thinking that were 
requested by the SEC. And what is your assessment? How helpful 
would it be if we were to pass H.R. 2179? Which again I would 
hope we would do quickly on suspension.
    Mr. Cutler. I think many of the enhancements in that bill 
are very important to us, but more importantly to the investing 
public. They increase penalties, they allow us more flexibility 
to get penalties in administrative proceedings, they allow us 
to go after money that we otherwise couldn't under current law 
because of homestead and other exemptions. So there are a lot 
of important pieces of that bill.
    Mr. Frank. I appreciate that. And as I reread the bill, 
there are a couple of sections in there that specifically 
enhance the authority both to get the penalties and increase 
the penalties with regard to mutual funds. So, yes, I think 
that something that we ought very much to deal with.
    Finally, for both or all three of the witnesses. We had a 
mutual fund bill that, as I said, passed this committee 
unanimously with differences only basically over the 
independent chairman. I am prepared to concede now we should go 
forward with that. The chairman has got some other provisions. 
Are there other statutory changes? Have you, between you, 
proposed all that you have? Obviously, it is important to note 
some of these things were already illegal, and that is why H.R. 
2179 is important, because it is one thing for it to be 
illegal, it is another for there to be a serious penalty to the 
point both--and people should understand, when we are talking 
about the seriousness of penalties, this applies both to the 
incentive to the regulator to go after it but also to the 
deterrent effect. So we want to get the--let me just put it 
this way. If there are any others, send them forward.
    Let me go back to the philosophical point--it is Election 
Day--Mr. Spitzer. And I really mean this one very strongly. I 
think it is very relevant, because in our culture, elected 
officials are often compared unfavorably in intellect, 
integrity, devotion to the public duty to high-level 
appointees. We are necessary to the system, but people 
sometimes almost wish that we weren't. And there was an 
argument particularly as you get sort of arcane. After all, we 
are not talking basic arithmetic here. When we talk about 
market timing and late trading and there are a lot of fairly 
complicated and sophisticated things going on. Like trading, 
maybe not, the difference between 4 o'clock and 4:30 is easily 
grasped, but some of these other issues are a little more 
complex.
    I would ask Mr. Spitzer if you would reflect on the fact 
that it was yourself, Secretary Galvin, and some others who 
were elected officials who took action here. And let me throw 
out a hypothesis that just really occurred to me as I was 
thinking about this, and it is just the beginning of a thought. 
And that is, the SEC plays a very important role. It is the 
national regulator. It is charged with keeping the system 
working. And I am wondering whether there might not be a 
tendency for the appointed national regulators with their very 
heavy responsibilities to focus more on systemic risk, to focus 
more on the overall functioning.
    What you and your colleagues in the State level have done 
here, to a great extent, is to focus on unfairness to 
individual investors. In some cases, there were losses that 
offset gains. But the primary thing that comes out of the most 
recent things is that it is the small mutual fund investor. 
Someone who is in it through his or her retirement plan, or has 
relatively small amounts of money, is not sophisticated enough 
or is smart enough not and try to make stock picks on his or 
her own, or as in the case of some of us, have so many 
conflicts of interest; if you try to buy an individual stock, 
that you had better buy mutual funds so people don't start 
yapping at you about anything else.
    But do you think that there is something to the fact that 
elected officials would be particularly sensitized to the 
question of the role of the smaller individual investor, as 
opposed to a focus on the broader systemic issues? Not that you 
would do one to the exclusion, but that the necessary focus on 
the systematic issues could diminish some of the attention 
given to the little guy.
    Mr. Spitzer. I think there may be some merit to that 
analysis. I think that it is certainly ingrained in the 
tradition of the attorneys general across the Nation, that our 
primary focus has been protecting the smaller consumer; the 
individual consumer has a grievance; and as a consequence, 
sometimes some of the issues that will arise that will make 
their way to our plate would fit that paragon and are therefore 
somewhat distinct from what the SEC might look at.
    I think there has been--let me just add this one last 
reflection very quickly. I think there has been a very healthy 
dynamic between States and the SEC over the decades and in 
reinforcing each other. Where one has perhaps failed to see 
something, the other picks it up. And I think that is the 
healthy nature of the federalism that we have established, and 
I think maintaining that proper balance is something we all 
strive to do, and working at it is something we are obligated 
to do.
    Chairman Baker. The gentleman's time has expired.
    Chairman Oxley.
    Mr. Oxley. Did the Chairman wish for me to yield briefly?
    Chairman Baker. If the chairman so desires.
    Mr. Oxley. Sure.
    Chairman Baker. Mr. Spitzer, returning to the point at hand 
relative to the features of H.R. 2179. And Mr. Cutler as well. 
It does provide enhancements. It does provide national notice 
of service, for example, doing away with the geographic limit 
on service. Some good things.
    Has the lack of passage of H.R. 2179 failed--caused you to 
fail in bringing to justice anyone who has been found to 
violate the law?
    Mr. Cutler. No. I think these are important enhancements. 
But do I think I have some very powerful and critical tools 
already? Of course we do. And that is why we are bringing the 
cases we are bringing.
    Chairman Baker. And then with regard to H.R. 2420, Mr. 
Spitzer, I think you generally agree it is a good start; it may 
need enhancements, we may need to do more. Along the lines of 
your suggestion of the independent Chair, I had others where 
you should not have simultaneous management of a hedge fund and 
a mutual fund by the same managers, those kinds of issues. But 
on its face, H.R. 2420 is plowing new ground.
    Mr. Spitzer. Absolutely. And I think it is a wonderful step 
forward.
    Chairman Baker. I thank the gentleman and I yield back.
    Mr. Oxley. Thank you, Mr. Chairman.
    Mr. Cutler, I wonder if you could describe, first of all, 
to a layman the difference between legal market timing and 
illegal market timing.
    Mr. Cutler. I am glad you asked, Mr. Chairman, because 
there is something of a misperception. Some people have a sense 
that all market timing is illegal. And market timing, just to 
remind everyone, is the practice of buying into and selling out 
of funds on a rapid basis, buying into a fund today and selling 
it tomorrow. And on its face there is nothing illegal about 
that. And the question is, does it violate, or does the fact 
that a mutual fund management company is allowing it to take 
place, does it violate a promise that the mutual fund company 
made to investors usually embodied in a prospectus that would 
say something to the effect of, we are not going to allow this 
practice. And if a mutual fund management company says we are 
not going to allow it, and then they allow it, that is a 
violation of law. And certainly among the cases that have been 
brought so far, that is one type of violative market timing 
conduct.
    Mr. Oxley. And does that tend to be boiler plate with most 
of the prospectuses?
    Mr. Cutler. Certainly a good number of them say we don't 
allow it, we prohibit it. Now, there are some that say--and one 
example is Putnam, which is a firm that we have already sued in 
connection with the trading of its port--market timing of its 
portfolio managers. What Putnam said was: We don't like timing, 
and in order to stop it or to discourage it, what we do is we 
impose redemption fees so that if you are into and then you 
immediately get out of a fund, we are going to make you pay a 1 
percent penalty.
    But then the prospectuses go on to say, but you know what? 
We are not going to impose that kind of restriction on 401(k) 
plans. And that makes for a much different kind of situation.
    Mr. Oxley. Okay.
    Now, Mr. Spitzer, you had said that the fund directors 
could have short-circuited this with due diligence in terms of 
market timing. That is correct?
    Mr. Spitzer. Oh, absolutely. And the reason for that, sir, 
is that if you were to look at the redemption rates and the 
ratio of redemptions to the underlying asset value, what you 
would often see in some of the funds where there was the most 
frequent timing by outsiders--or insiders, for that matter--is 
that the rate of redemption so far exceeds the underlying asset 
value that you know that there is a cycle, that there are 
people trading in and out more rapidly than should be 
permitted, and, therefore, at a minimum, inquiry should have 
been triggered.
    Could I add one more notion to what Steve said? And this in 
no way disagrees with him, but this is maybe in addition to 
what he said.
    In addition to the prospectus, there is also the issue of 
insiders doing this when outsiders are not permitted to do it, 
which obviously would be impermissible. And also, whether 
payment was made under the table--and that is not cash under 
the table necessarily, but whether some other quid pro quo was 
being offered in order to induce behavior that might have been 
permitted, might not have been permitted, such as the sticky 
assets that were referred to, that have been referred to so 
often, where people would say, we will put $100 million into a 
bond fund if you let us tie into your international fund. Those 
sorts of payments also add another issue, that would obviously 
make this improper and illegal behavior.
    Mr. Oxley. Improper and illegal?
    Mr. Spitzer. That is correct.
    Mr. Oxley. Why did the fund directors--in your estimation, 
why did the fund directors fail in this regard?
    Mr. Spitzer. I am not--I am always loathe to address issues 
of motivation. I believe, and I think it is fair to say in some 
cases they didn't address it because they themselves were the 
ones who were doing the timing. I think those are the cases 
that have been most egregious to us and most just jarring in 
terms of violation of fiduciary duty, where you have the CEO of 
one fund, who himself was timing his own funds to the detriment 
of investors, and, in fact, sent the timing police--they have 
what they call timing police who are supposed to detect it.
    He sent the timing police off on one beat and then he 
traded in a different precinct. I mean, this was a guy who was 
really Machiavellian in what he was doing in a way that was a 
gross betrayal. I think there it was an intentional oversight. 
I think in other cases, it may have been a lack of attention, 
which is why what we are hoping to do is to get boards and 
compliance departments to wake up and look at something that 
they should have been paying attention to, because these issues 
have been addressed in the academic literature and in the trade 
journals.
    Mr. Oxley. Mr. Cutler, the obvious question is, where was 
the SEC during this time? And what tools do you have to be able 
to spot that kind of activity?
    Mr. Cutler. And I think that is a fair question. I am not 
charged with responsibility for our examination and inspection 
program, but I have done some thinking about this. And I 
suspect that one of the things that was happening--and I am 
just trying to put this in some sort of context--is that this 
was going on at a time when the mutual fund industry, 
interestingly, was beseeching the Commission to give it more 
tools to combat market timing: We don't like market timers. 
Help us beat these guys back. Give us more power to impose 
higher redemption fees. We don't like timing.
    And so I think--and, you know, I am speculating here. My 
sense is that people weren't at the time thinking, gee, mutual 
fund companies are going to be complicit in something that they 
are telling us they are trying to beat back.
    Now, I think in hindsight obviously, you know, do we wish 
that we had identified this problem earlier? Absolutely. And, 
you know, I am confident that with the additional resources 
that we have gotten and are in the process of getting and 
Chairman Donaldson's risk assessment program that we will be in 
a position to identify these issues like this before they come 
up.
    You know, by definition, once we bring enforcement actions, 
the wrongdoing has already occurred. Right? And so in some 
ways, you are always following the misconduct. And I think the 
challenge that we have is to identify problems like this, 
potential problems like this before it is ever necessary to 
bring a law enforcement action.
    Mr. Oxley. As a practical matter, it would be virtually 
impossible for the SEC or the Congress to essentially outlaw 
market timing; correct?
    Mr. Cutler. Well, in fact, I don't know that you need to. 
Because we where it violates a prospectus term, I think that is 
a violation. As Mr. Spitzer added, where you have got 
situations where you are trading off something that is to the 
advantage of the advisor, and potentially to the detriment of 
shareholders, we have got the power to go after that. And I 
think Mr. Roye, on behalf of the regulators at the SEC, is 
working on sort of beefing up what it is that mutual funds 
would be required to disclose vis-a-vis their market timing 
policies.
    Mr. Oxley. And that, coupled with a high redemption fee or 
a substantial redemption fee, in your estimation, would at 
least begin to solve that problem?
    Mr. Cutler. Again, I am tempted to defer to Mr. Roye, if I 
could.
    Mr. Oxley. Of course.
    Mr. Cutler. Because he really knows the policy. When people 
violate the law, that is when I go after them.
    Mr. Oxley. Mr. Roye.
    Mr. Roye. I would be glad to address that.
    I think that you hit on several solutions to the problem. I 
think the way we look at it, there have to be multiple pieces 
to the solution here. Steve alluded to the disclosures. Quite 
frankly, the disclosures are not specific enough in some cases. 
We want funds to disclose exactly what they are going to do to 
curb market timing activity, when they are going to do it, and 
when they are going to make exceptions to that policy. So, one 
very clear disclosure.
    Mr. Oxley. And the SEC can do that, clearly.
    Mr. Roye. And we have the authority to do that, and we are 
working on form changes currently to effect that change.
    Now, if you really want to eliminate market timing, the 
economists will tell you that the way to do this is to 
eliminate stale pricing. It is that timing and international 
funds, where you are buying securities, where the market closed 
10, 12 hours earlier, and you have pricing at 4 o'clock, that 
arbitragers are trying to take advantage of that difference in 
the pricing, inefficiencies in the pricing. And so what we said 
to the funds is that they have an obligation to fair value 
price the securities in the fund's portfolio.
    Now, you are moving from an objective market closing price 
to your estimate of what you think that security is worth in 
light of significant market moving type of events. We have told 
funds they have to do this in a staff letter that went out in 
2001. We are looking at recommending that the Commission make a 
very firm statement in this area to eliminate the possibility 
of market timing activity. And then on top of that, we have 
been looking at, again, giving the fund industry additional 
tools to thwart the market timing activity such as mandatory 
redemption fees.
    Last year we did a letter for the industry allowing them to 
delay exchanges since a lot of that activity is moving from one 
fund to another. So we see a multifaceted approach. And then 
last but not least, a role for the board of directors here in 
overseeing this activity, monitoring the types of information 
that Attorney General Spitzer talked about in overseeing this 
activity.
    And then the addition of a compliance officer, which was 
part of Congressman Baker's bill to oversee and help the board 
in monitoring that activity.
    Mr. Oxley. Thank you, Mr. Chairman.
    Chairman Baker. Mr. Emanuel.
    Mr. Emanuel. Thank you, Mr. Chairman.
    In my opening statement, I made reference to the late 1990s 
hot IPO market. And I was wondering, Mr. Cutler or Attorney 
General Spitzer, in any of your investigations or any of the 
issues that you are looking at, have you seen any preferential 
treatment during that period of time where the philosophy of 
managers wins, investors loses dominated how those IPO 
allocations are done? And I don't want you to tip your hand if 
you're already investigating.
    Mr. Spitzer. And I won't do that. Thank you for the 
admonition. Last year--and I think Steve would agree with me on 
this--we spent a great deal of time looking at the IPO issues 
related to--issues relating to spending distribution of hot 
stocks and the uses--the improper uses that were made by 
investment banks and the distribution of those stocks, the 
ulterior motives that underlay the distribution most frequently 
in our experience last year to CEOs of client companies, where 
we believed--and I still believe that the spinning is violative 
of the fiduciary duty of the CEO to the company; it should be a 
corporate asset, if anybody gets it. But also the question 
arises, how were the investment banks that are doing the 
underwriting making the determination about the distribution of 
those hot stocks; and, as a consequence, as part of the global 
resolution that was signed, I believe, last Friday by a Federal 
judge, there is an outright prohibition on the receipt of hot 
stocks by CEOs of publicly traded companies.
    Now, we did not last year, that I am aware of, nor have we 
yet investigated the interception of spinning with mutual 
funds, but certainly it would be a fertile area to examine. And 
I take your point, and we will do so.
    Mr. Cutler. Well, I guess I would start by saying, first 
there is an NASD rule that expressly prohibits an individual 
associated with a mutual fund from receiving a hot IPO.
    Having said that, we have already brought cases involving 
the allocation of IPOs within a fund complex or that--to be 
more specific, I can point you to a case we brought called 
Nevis Capital, where what we allege is the managers actually in 
that case, interestingly, were directing hot IPOs to a fund; 
and the allegation is that they were doing that to the 
detriment of some of their other customers for, in some way, 
their own benefit, that is, that they stood to receive more 
fees if the mutual fund did well. They thought that that would 
bring in more investors. So, interestingly, in that case they 
were favoring a mutual fund over other customers.
    We have brought other cases involving the failure of some 
fund companies, including Van Kampen and Dreyfus to adequately 
disclose that their performance was heavily influenced by the 
receipt of IPOs.
    The one thing I think we haven't seen is precisely the 
point that you were making. That is, that managers were taking 
IPOs instead of giving them to mutual funds. But certainly the 
area of whether IPOs are equitably allocated by investment 
advisors has been a topic that the SEC has been concerned about 
and has brought cases on.
    Mr. Emanuel. As we think about this legislation and the 
rules of the road we want to write. Do you think there is any 
conflict of interest in the ownership of the mutual funds? That 
is, have any of these problems happened because insurance 
companies or commercial banks have now gone into this area? Do 
those types of ownership structures create any problems related 
to the management and the operation of mutual funds?
    Mr. Cutler. Well, certainly among the allegations in the 
cases brought so far are conflicts between brokerage firms that 
are affiliated with mutual funds. Indeed, as I mentioned in my 
oral statement, we have been looking very closely at whether 
there is adequate knowledge on the part of customers and 
disclosure to customers that when they are dealing with a 
brokerage firm that they understand that that brokerage firm 
may be making money as a result of the sale of the mutual fund 
that they are recommending.
    So, I mean, I take your point. I mean, there are some 
conflicts here. I don't know how sort of far out they reach, 
and maybe Mr. Roye has a sense of that.
    Mr. Roye. I was just going to refer to Mr. Spitzer's 
complaint. If you look at the complaint in the Canary case, a 
beautifully drafted complaint that the New York Attorney 
General did, I think it laid out just those kinds of conflicts 
within the Bank of America situation where you had deals being 
cut to benefit other parts of that organization at the expense 
of mutual fund investors; and I will let Mr. Spitzer address 
that.
    Mr. Spitzer. Thank you for the compliment on the drafting. 
I didn't do it.
    But it is vertical integration that often leads to these 
conflicts, and it is vertical integration that can twist the 
incentive structure so that you will have an effort to sell 
improperly, or also, in a more mundane way, vertical 
integration that will permit information flow such that it 
facilitates processing of trading patterns. And, indeed, in the 
Canary context, that was very integral to what happened. It was 
easier to integrate the information and process the trades 
because of the vertical integration of ownership. Now, that 
does not mean that we want to eliminate that vertical 
integration, but certainly it means that it raises issues that 
have to be thought through.
    Mr. Emanuel. As we look at this, one of the patterns we 
should closely study is how ownership structure has related to 
any conflicts of interest. Obviously, we are not going to 
regulate that insurance industries can't own mutual funds or 
commercial banks own investment banks. But we may need to take 
a look at creating not new walls but new rules of the road 
relating to cross ownership and the cross selling that goes on, 
so that the product lines don't create internal conflicts of 
interest in the future. Do you have any guidance on this issue?
    Mr. Castle. [Presiding.] Could we keep the answers brief, 
please, so we can keep moving?
    Mr. Cutler. I would certainly say that where there are 
conflicts that haven't been managed appropriately we have the 
power--I know Mr. Spitzer has the power to go after those 
conflicts and ensure that those who don't appropriately manage 
them are held accountable.
    Mr. Emanuel. Do I have time for another question?
    Mr. Castle. We will have a second round, Mr. Emanuel. We 
would like to get through everybody first, if we could. Since I 
have deposed the chairman temporarily here, I yield to myself 
for 5 minutes. I am kidding. I was next anyhow.
    Let me ask you this, Mr. Spitzer. You have been pretty 
critical of the SEC enforcement activities, ripped them, I 
would say, in some cases, and lately, yesterday in the Senate 
and here today a little bit you are making nice. It has become 
sort of Steve and Eliot and everyone seems to be getting along. 
Is there a reason for this? Do you have a different view of 
what they are doing? Or is Mr. Cutler doing such a wonderful 
job that you have been won over? Or are you just mellowing in 
your older age? It is helpful to us to have you this way.
    Mr. Spitzer. No. Well, let me be very serious about this. I 
have at various times articulated I think a frustration that we 
might all feel and probably all do feel that if the abuses are 
as widespread as the evidence is now suggesting they are--and 
indeed I think the SEC's examination and the data that Mr. 
Cutler revealed yesterday suggests whether 25 or 50 percent in 
different context of wrongdoing, there is a wealth of 
wrongdoing that could have been caught and should have been 
caught by compliance, by boards, by regulators, by prosecutors. 
There is a frustration we all feel, obviously, that we didn't 
catch it sooner.
    As a consequence, I think at different times I have asked 
the question not merely because it is fun or meant to be a 
barbed comment but I think a question that deserves to be asked 
of law enforcement is what do we have to do differently in 
order to catch it next time? Therefore, should we be doing 
something differently so that this problem does not expand to 
its current proportions before we intercede as well?
    I think it is in that spirit that I have tried, perhaps not 
always as gently or deftly as I might, to say we have to 
examine our own processes.
    Mr. Castle. Let me ask Mr. Cutler sort of a follow-up. How 
do you feel about where the SEC is right now? I mean, I am also 
somewhat critical of what I thought was a rather lax 
enforcement before. Obviously, we are all at a heightened 
awareness now than we were before. Do you feel that, without 
even starting to change laws which are clearly going to do with 
the regulations, do you feel that the SEC is up to where it 
should be in terms of the enforcement? And do you feel that we 
should clearly have both a State and a Federal component to 
this? I happen to agree with that, but I would like to hear 
your views on that briefly, if you could.
    Mr. Cutler. Sure. Well, first, let me say I don't think 
enforcement at the SEC has been lax, as I mentioned in my 
opening remarks. We have an obligation to be everywhere in the 
marketplace, and I think the 679 cases that we brought last 
fiscal year reflects that. I do think where we have room to 
improve is are we doing a good enough job identifying potential 
problems? That is, once we have identified them, I think that 
we are second to none in going after them, investigating them, 
litigating them, bringing the accountable people to justice.
    Mr. Castle. But identifying is an important part of that 
is--not to argue with you. But identifying is an important part 
of that. I mean, that is not something you just sort of gloss 
over. I mean, clearly if there are market-timing issues, and we 
saw some problems in New England and places like that, you 
can't just say, well, we weren't good at identifying them.
    Mr. Cutler. Right, And I agree with you. Identifying is 
very important, and I think we are taking steps to get much 
more proactive in that area. I know within the enforcement 
division itself we have decided actually to bring to the 
division people that have subject area expertise, that is, 
people who are more tapped in to what is happening in the 
trading and markets area, who are more tapped in to what is 
happening in the mutual fund area, more tapped in to what is 
happening in the corporate accounting and disclosure area, so 
that we can be better at seeing around corners. And I am 
determined to do that. With your help, we have gotten more 
resources, and I think we are getting there.
    Mr. Castle. Thank you.
    Mr. Spitzer, I am going to go back to a different subject. 
I own some shares of companies. I get these proxies in the mail 
about electing directors, and what is my 150 shares worth, and 
I frankly generally throw them out. We are talking about 
electing independent--you are talking about electing 
independent chairmen of the various mutual funds. We can define 
that--I have no problems with that, somebody who doesn't have 
ownership or whatever, and we can define the word independent. 
But the actual election process sort of bothers me.
    I assume that most of the mutual funds are incorporated 
under your State laws, or mine, for the most part, and perhaps 
others. But, you know, is it going to be done by a proxy 
business, or is it just going to be independent in that the 
person doesn't have a direct interest in it but happens to be a 
good friend of the person who is doing it? The nomination 
process corporately and mutual fund-wise is so protective of 
those who are sending out proxies and election statements it is 
almost impossible, in my judgment, to get the true independents 
we would like to see.
    Personally, I would like to have John Bogle running all of 
my mutual funds, if I had my druthers, but I don't think that 
is going to happen. But how do we get that done? I mean, I 
don't see--I think most mutual fund owners don't even 
understand they have ownership rights or voting rights in any 
of these things, much less actually really go to the level of 
independence that some of us are talking about. I am all for 
it, but I am worried about being able to really do it.
    Mr. Spitzer. I agree with your concern. We have to breathe 
life into a statute, that you can define independence as 
aggressively as you wish, but, nonetheless, if you have 
somebody there who doesn't bring enough aggressiveness to the 
job it won't mean a great deal. I think this is where we have 
to--and this is perhaps why I was also suggesting we would want 
to build into the statute some objective rules which would 
govern precise activities, such as most-favored-nation clause, 
such as multiple bids.
    In other words, if we really believed an independent board 
was going to act independently, you could stop right there and 
say, we want an independent board, boom, full stop; and 
everything else would follow based upon their behavior. If we--
we all share, I think, your concerns to a certain extent, 
although I think the right people will fulfill that mandate, 
and certainly prospectively they understand what that job 
requires. I think if you add to it certain additional 
requirements, such as I have already mentioned, maybe that will 
give us certain benchmarks by which we can measure their 
behavior or minimum thresholds that they would have to satisfy.
    Mr. Castle. Thank you, Mr. Spitzer.
    Mr. Scott is recognized for 5 minutes.
    Mr. Scott. Thank you very much.
    Let me ask you--going back to the debate with Mr. Frank and 
Mr. Baker on the deterrence and restitution issue, it seems to 
me that national markets should have a single regulator; that 
given the ability of 50 different States to override Federal 
laws just doesn't seem to make sense; that there should be a 
uniformity in our markets; but yet, bearing Mr. Frank's point, 
that we should preserve the State authority to investigate, to 
prosecute securities fraud, collect the penalties, and 
discouragement funds. Is that at the end of the day--because I 
do know that you and the SEC will be getting together later 
today. Is that by--to look into the future, is that what we are 
going to wind up with? Doesn't that make sense?
    Mr. Spitzer. Yes, it does. That is why I think I began my 
comments earlier by saying that I have never disagreed--in fact 
I have affirmatively stated, obviously, we need one primary 
regulatory--it is the SEC--we need uniformity in the 
marketplace, and that is what you seek when you have one 
primary regulator.
    Having said that, you used the word override. We 
certainly--because of the supremacy clause, we clearly can't 
override an SEC reg or Federal statutes, obviously. What we can 
do--and here is where I think you get shades of gray and areas 
of greater complexity.
    In individual consent decrees, injunctive relief that we 
get at the end of enforcement action, we will often impose upon 
a wrongdoer--classic example to be a boiler room operation 
where they have been selling phony stocks or have been playing 
games with stock pricing. We would force them to do certain 
things, have some compliance programs that are not inconsistent 
with Federal law, do not override Federal law but supplement 
and set a higher bar for them in terms of their behavior. I 
think that is what we have tried to do with due delicacy not to 
obviously disrupt or create a lack of common law in the capital 
markets. But in those enforcement actions we have often felt it 
was incumbent upon us to sanction the wrongdoer by imposing 
that sort of injunctive relief.
    Mr. Scott. Thank you.
    Mr. Cutler and Mr. Roye, I would like to go back to the 
market-timing issue. It seems to me that you said that, of 
course, late trading is illegal. Market timing is not illegal. 
Is that right? It is not illegal?
    Mr. Cutler. Well, it is not per se illegal. That is, there 
can be circumstances, and you have seen many of them already, 
in which it is, because of things like quid pro quo 
arrangements or prospectus disclosure, that the market timing 
contravened.
    Mr. Scott. Why wouldn't you recommend that we make it 
illegal? Is that possible, to make it illegal?
    Mr. Cutler. I will let Mr. Roye----
    Mr. Roye. Let me respond to that. I think it is important 
to note that probably every investor at some point is making a 
timing decision, trying to determine when to buy a fund, when 
to get out of a fund, when to move from one fund to another. 
You have mutual funds that actually cater to market timers. 
They are sold on the basis of we welcome market timers. You 
have funds that it doesn't make sense to market time, like 
money market funds where there is a stable net asset value. You 
know, there are funds that do have market timing issues. It is 
disruptive to their performance.
    To this point, we have relied on the funds to articulate 
what those procedures are that they are going to follow to 
discourage this activity to protect the rest of the fund's 
investors. So I think the question becomes--it is not per se 
illegal. We need to recognize that there are circumstances 
where timing, does make sense but also where it is harmful. 
And, indeed, where it is illegal we need to come down on it. 
But where it is harmful, we need to make sure that there is 
someone monitoring the situation, that they have the 
appropriate controls in place and that funds have all the 
necessary tools to deal with that type of activity.
    Mr. Scott. Also, the market timing seems to me that it 
would have a very--something you haven't touched on yet, but a 
profound impact on foreign markets, particularly in treating 
with foreign securities after their markets close or before 
ours close. How serious a problem is that? What is the impact 
that that has on market timing?
    Mr. Roye. Well, I don't know exactly. I haven't seen any 
studies that really go into that type of impact. But what I can 
tell you is that when investors and large investors are moving 
in and out of the funds, the reason a lot of portfolio managers 
don't like it, is because it means that they have to sell 
securities or they have to maintain high cash positions to deal 
with that kind of activity, and that can adversely impact 
performance. But I haven't seen any information to indicate 
that it is being disruptive to foreign markets, and I would 
have to defer to the economists on that.
    Mr. Scott. Well, the indication that I have some 
information--for example, a strong rally in the U.S. markets 
after the close of foreign markets could prompt market timers 
to purchase mutual funds with Asian stocks--that is a 
possibility--on the expectation that prices in those stocks 
will rise when the Asian markets open, creating the potential 
for strong gains in the value of mutual fund shares the next 
day.
    Mr. Cutler. Maybe I could help here. You are certainly 
right, that the opportunities to exploit inefficiencies in 
mutual fund pricing are most acute in funds that hold foreign 
securities, where Mr. Roye said earlier the closing price in 
the Tokyo market, for example, would have been 14 hours old 
before a fund sets its net asset value.
    Mr. Scott. That is why I am saying, on that evidence alone, 
it seems to me, the damaging impact it could do to world 
markets ought to put some emphasis on our ability to make such 
a practice illegal.
    Mr. Roye. Well, I am not sure you can draw the real 
connection between that type of arbitrage activity, where 
investors are moving in and out of the fund to take advantage 
of that activity. I think that, you know, in order for it to 
have an impact on foreign markets, you have to have sales of 
securities in those foreign markets driving those markets down.
    And I don't think that is what we are seeing, but I think 
what you are pointing to is that this opportunity is what 
affords the market timing advantage here, and what we are 
trying to do is to get the funds to deal with that in terms of 
having accurate values of those securities. We are trying to 
move them from using these stale prices, if you will, to a more 
accurate price, which candidly has to be some guesstimate on 
their part as to what the real value of those securities are to 
eliminate these arbitrage opportunities. Then you couple that 
with something like mandatory redemption fees, and maybe we can 
eliminate the problem you are talking about.
    Mr. Scott. Could I ask one more quick question--real quick? 
I just want to go back to Mr. Spitzer real quick.
    You said in your testimony, Mr. Spitzer, that the mutual 
fund directors rarely negotiate lower fees for their 
shareholders and that fund managers are rarely replaced. You 
highlight that the chairman of the board of directors of the 
fund is almost always affiliated with the management company. 
These are some real important observations you have made. Can 
you elaborate very briefly on how widespread this problem is 
and recommend what forms that this committee or the SEC should 
take to deal with this problem?
    Mr. Spitzer. I cannot give you a quantification, but I will 
endeavor to get that information to you in short order.
    In terms of a remedy, I think this is what speaks to the--
or what I think is a very wise idea, which would be to have an 
independent board share; and I think the definition of 
independence is something we can grapple with to make sure 
there is a sufficient buffer between the board share and the 
management or the advisory company, a critically important step 
we have to take. Again, because of the inadequate negotiation 
matters, perhaps the notion for a most-favored-nation clause or 
an obligation to get multiple bids again to ensure that there 
is an actual arms-length transaction that reflects the true 
market valuation of the services being provided.
    Mr. Scott. Thank you, sir.
    Chairman Baker. [Presiding.] Ms. Biggert.
    Mrs. Biggert. Thank you, Mr. Chairman.
    Before I begin my questioning, I would ask unanimous 
consent to submit for the record testimony from Hewitt 
Associates.
    Chairman Baker. Without objection.
    [The following information can be found on page 234 in the 
appendix.]
    Mrs. Biggert. I think this question will probably be 
directed to Mr. Roye, but if somebody else thinks he would like 
to answer, I want to talk a little bit about illegal, late-hour 
trading.
    In Mr. Spitzer's testimony, I believe that you said that 
you thought that the current rules surrounding illegal late-
hour trading were sufficient, but just needed to be enforced. 
And I have concerns that if we do change the current trading 
rules outright, it could put at risk the fairness and, 
potentially, even the cost effectiveness of 401(k) plans for 
participants. And it is my understanding that current SEC rules 
require that orders to purchase or redeem fund shares must be 
received by the fund or their agent before 4 p.m. Eastern 
Standard Time if they are to receive that day's closing price.
    One option reportedly under consideration would change the 
current regulations by requiring all entities, and that would 
include the record keepers, to submit mutual fund trades to the 
mutual fund by 4 p.m. And in 401(k) plans, this would 
effectively mean that 401(k) record keepers would have to 
complete this by the 4 p.m. deadline. And the processing takes 
quite awhile, so those investors in 401(k) plans would have to 
make their investment decisions several hours earlier than 4 
p.m., and that would put them at a substantial disadvantage 
with respect to the other fund shareholders.
    Could you address this?
    Mr. Roye. Yes, I can. I think you highlight what really 
ends up being a trade-off here; and as a staff person, I can 
tell you that we are thinking about the hard 4 o'clock cutoffs 
and alternatives to that; and I can't speak to what the 
Commission ultimately does with that. You know, we have a 
situation where it has been discussed, widespread abuse of the 
late trading obligation on the part of intermediaries that sell 
fund shares.
    Now, I want to emphasize that some of these intermediaries 
are regulated by the SEC and some aren't, and indeed some of 
the pension plan record keepers, they are not subject to SEC 
jurisdiction. So we have a situation where, if there is 
widespread abuse, we don't have jurisdiction.
    There is a requirement that they comply with the 4 o'clock 
cutoff, and orders that come in after 4 o'clock are supposed to 
get tomorrow's price rather than today's price. And they are 
supposed to have controls in place; indeed, all the mutual fund 
contracts essentially require the intermediaries to have 
controls and procedures in place to deal with this, and we 
found that they don't exist. As the Attorney General pointed 
out, there has been a massive breakdown in terms of how those 
procedures and controls are working.
    The further you get away from the fund, the greater the 
risk of abuse; and if we can change the rule so that these 
orders have to hit the fund by 4 o'clock, then we can eliminate 
the problem. We are looking at people that we don't regulate, 
and we see that they don't have the controls in place. We are 
very concerned.
    But you are correct. There is going to be a trade-off here 
because it is going to narrow the window of opportunity for 
certain investors to make their investment decisions.
    I guess I would point out that a lot of investors are long-
term investors, and hopefully, when they go into a mutual fund, 
they are taking a long-term perspective, and ultimately, it 
shouldn't really matter.
    I know it is going to impact some investors.
    We do have within our regulatory framework currently this 
issue we have variable insurance products, variable annuity, 
variable life insurance, they already live with the hard 4 
o'clock rule. And investors are buying mutual funds for those 
products. So that is the trade-off.
    Mrs. Biggert. You know, isn't it something as simple--like 
a time stamp when an investor decides to buy at 3:59 and it is 
stamped, then the calculations can be done?
    Mr. Roye. I will let Mr. Spitzer and Steve tell you how 
people have circumvented those problems.
    Mr. Cutler. It is pretty easy to time-stamp a ticket and 
then, as has been revealed in some of these cases, have the 
customer call back at 4:30 and tell the firm whether they 
actually want the order to go or whether they want the firm to 
toss the ticket. And that is what happened here. There is 
nothing that is fail-safe; but as Mr. Roye said, you know, 
moving this deadline closer and closer to the fund companies 
themselves can only help prevent abuse.
    Mrs. Biggert. Thank you. I see my time has expired and I 
yield back.
    Chairman Baker. Mr. Matheson, do you have a question?
    Mr. Matheson. Thank you, Mr. Chairman. A couple of 
questions I wanted to ask.
    One is, the Investment Company Institute has come out with 
their recommendation about this 2 percent redemption on 
transactions where it has been held for less than 5 days. Do 
you--what effect will that have in an effort to eliminate 
illegal late trading?
    Mr. Spitzer. I think the 2 percent notion is a good one 
whether it is 2 percent, 1 percent, 8 percent. Some calculus 
will have to be drawn to figure out what the fees should be 
imposed upon. It goes more to timing than to late trading, the 
quick in and out, although theoretically it could apply to late 
trading as well.
    What you are really trying to do is eliminate the profit 
margin, and those who are arbitraging based on timing are 
really looking for thin margins, but they are doing it over and 
over again with such speed and such volume that they end up 
doing quite nicely over time. Two percent per trade, the ICI 
obviously believes it would be sufficient to discourage it. 
Some imposition of a fee like that would make sense.
    In fact, there have been many funds that imposed a fee when 
you had a sequence of trades within some time frame. 
Unfortunately, as Steve just said, any system can be 
circumvented.
    What these funds did was waive the fee for those who were 
favored investors, who were giving them sticky assets with whom 
they were in cahoots. So they said, well, we will just ignore 
the redemption fees and go ahead and do your timing. If it were 
applied and if it were done fairly it would certainly be 
helpful.
    Mr. Matheson. Mr. Cutler, you mentioned this survey that 
had been done of a number of broker-dealers, and some of the 
issues about percentages, that were aware of market timing 
having taken place and whatnot were pretty high. You also 
mentioned--in response to Chairman Oxley, you said there is 
market timing that is appropriate and inappropriate.
    Do you have a sense with your survey how that breaks down 
in terms of firms that were aware that it was going on, but the 
type that was okay versus the type that is not okay?
    Mr. Cutler. I would recast that into legal and illegal, as 
opposed to appropriate and inappropriate. We are looking hard 
at all of those instances, and it may well be that some of them 
are not illegal; but I can tell you, in a disturbing number of 
cases, we believe that there was prospectus disclosure, for 
example, that would have been inconsistent with the notion of 
allowing or entering into a market timing arrangement with an 
investor.
    Mr. Matheson. And do you think you have the tools to bring 
enforcement action when this is illegal--market timing?
    Mr. Cutler. Yes, I do. Again, are there other--are there 
enhancements to those tools, including some of the ones that 
have been talked about here today in H.R. 2179? Yes. But I 
think, as you have seen already, we have--we do have the 
arsenal to go after this sort of misconduct. That is why we 
brought cases to date, and that is why you will see many more 
cases in the coming months.
    Mr. Matheson. You have tools in terms of the regulations 
that are in place, but I also want to touch upon--conversation 
that you had with Mr. Frank about the resources to do so. And 
we have got over 8,000 mutual funds. You said in your testimony 
earlier the SEC receives over 200,000 tips in a year. It seems 
to me, when we were looking in Congress to upgrade the 
resources going to the SEC, that was actually before this 
mutual fund issue came into play.
    I am curious what your perception is, if you think that the 
SEC is given adequate resources to truly perform their 
enforcement function.
    Mr. Cutler. Again, I think we have a big integration 
function or integration responsibility and challenge ahead of 
us to make sure that the resources that you have already given 
us are used intelligently and wisely; and we are still in the 
process of doing that.
    Where I think the biggest difference will be made is in the 
examination and inspection program that the Commission has. Up 
until the recent allocation of resources, there were 350 people 
that were doing examinations of the 7,000 mutual funds--I think 
I have got the right number; 8,000, sorry to have understated 
it--8,000 mutual funds across the country. That probably wasn't 
enough. We now have more people devoted to that function, and 
that is where you really get your intelligence at the SEC from 
the people who are, on a daily basis, walking into funds, 
examining them, walking into investment advisors and examining 
them. And I think that again--I don't oversee that program, but 
I think we are well on our way to beefing up that program to 
put us in a better position to be able to see around those 
corners.
    Chairman Baker. Mr. Manzullo.
    Mr. Manzullo. Thank you. I have a pretty simple question.
    Attorney General Spitzer, you had referred to the mutual 
fund industry as a cesspool in the Senate yesterday. I mean, 
first you have direct discharge of effluence, then the 
cesspools, septic and then water treatment. So this is pretty 
high up on the level of sludge that you used.
    Mr. Spitzer. You know your engineering better than I do.
    Mr. Manzullo. I live on a farm, so I know about that stuff. 
My comment would be, or rather my question is, in the midst of 
all the fines and the penalties, is there a way that these can 
be transferred or passed on to the investors themselves in the 
mutual fund through an increase in some type of a fee or 
something, some type of fees, or are these personal judgments?
    Mr. Spitzer. If I understand your question, can we pass 
back to the investors some of the funds that we recoup?
    Mr. Manzullo. That actually wasn't the question, but that 
is a good follow-up on it.
    My first question was, if, for example, Canary agreed to 
pay $40 million in fines, I don't know how much of that was 
fine and how much was restitution, but can the fine that the 
mutual fund itself pays end up actually being paid by the 
investors?
    Mr. Spitzer. I see. Will the investors be footing the bill 
because their costs will increase? I understand.
    I suppose it is always a possibility when you impose a fine 
on a corporate entity that the owners of that corporate entity, 
namely the shareholders, whether it is a mutual company or not, 
will end up being assessed their proportionate share, which is 
why we try to impose fines upon individuals and individual 
decision-makers who have been responsible for the wrongdoing.
    So, yes, as a theoretical matter, if you were to fine any 
of the major mutual fund families a significant sum of money, 
is it conceivable that somehow that gets referred back? We will 
endeavor to take it out of the fees that are paid, that have 
been paid into them already, and perhaps not permit them to 
allocate.
    Mr. Cutler. I think it is actually useful to be pretty 
precise here. When you charge a fund management company with 
wrongdoing--and that is what, to date, we have been charging--
that is not the mutual funds themselves, that is the advisor to 
the funds. And it certainly isn't our intention here to have 
investors foot the bill for the wrongdoing that fund management 
companies were engaged in.
    Mr. Spitzer. If they were to charge them back is the 
problem. How do you prevent them from charging it back? We will 
endeavor to make sure that that doesn't happen.
    Mr. Roye. Let me just point out that the Investment Company 
Act provides that you can't raise the management fee unless you 
go back to shareholders. The shareholders would have an 
opportunity, if that were to go on, to weigh in and vote no.
    Mr. Manzullo. I presume by the answers of all three of you 
that you will closely monitor the payment of those fines, the 
source of the fines and actually the fund itself for the next 
several years to make sure that those are not passed on to the 
fund investors.
    Mr. Spitzer. That is correct. And we are all, collectively 
in the funds that we receive, creating restitution funds that 
will go back to the shareholders themselves. Of the 40 that was 
paid by Canary, 30 is in a restitution fund and 10 is the 
straight fine. That goes to the government, but 30 is going 
back to the shareholders.
    Chairman Baker. Mrs. Capito.
    Mrs. Capito. Just to follow up on that, on the restitution 
fund of the 30 million, how is that disbursed to the 
shareholder? Do you get a certain percentage, certainly full 
restitution or is it full restitution?
    Mr. Spitzer. We don't yet know. We have only recently 
closed that transaction, and we are going to figure out what is 
the most appropriate way to ensure that that 30 million goes 
back to those that were injured in proportion to their--the 
magnitude of their injury. It is an issue that we and the SEC 
are grappling with simultaneously with respect to the global 
deal last year where there is a significant restitution fund.
    There are tough judgment calls that have to be made in 
terms of how you determine who the recipients should be, and 
what proportion to their injury. We are trying to work those 
issues through right now.
    Mrs. Capito. This question may reveal my naivete, but let 
me ask a question in terms of the issues of transparency and 
the fees that we are investigating and looking at right now, 
when we are in an up market. Has this become a function of our 
investigation because we have been in a down market so long? 
Because even when the market is going up, people aren't 
complaining about which way their investments are moving.
    Mr. Spitzer. Actually, I think not. I don't dispute the 
premise of your question which is that ordinarily in a down 
market, people will be a bit more aggressive in their 
complaints and allegations, perhaps, are more rapidly made.
    The issue of late trading and timing really are a response 
not to the direction of the market but to the volatility of the 
marketplace; and the arbitragers who take advantage, up or 
down, really need volatility. They don't care if the market is 
trending one way or the another.
    The information that was brought to us that triggered the 
set of inquiries wasn't brought to us because of a particular 
loss. It was just because of an understanding of the 
impropriety and the structure of the trades that were being 
conducted.
    Mrs. Capito. Thank you. I have no further questions.
    Chairman Baker. If there is no objection from anyone, I 
think we are going to mercifully say thank you to our first 
panel. We do appreciate your courtesy in appearing here, and 
your testimony has been of significant help to the committee 
and its work. We look to working with you in the days ahead 
toward an appropriate resolution.
    I would like to welcome the patient members of our second 
panel for their courtesy in appearing here today and moving 
forward. I would like to welcome back no stranger to the 
committee hearing room, the Honorable Arthur Levitt, former 
chairman of the Securities and Exchange Commission, who has 
been before this committee on many occasions.

  STATEMENT OF THE HONORABLE ARTHUR LEVITT, FORMER CHAIRMAN, 
               SECURITIES AND EXCHANGE COMMISSION

    Mr. Levitt. Thank you very much, Chairman Baker and Ranking 
Member Kanjorski and members of the subcommittee that have 
lasted so long this morning. I will try to be brief.
    I would like to thank you for inviting me to share my 
thoughts on allegations and, unfortunately, burgeoning evidence 
of self-dealing in the mutual fund industry.
    As regulators and lawmakers examine the sale and operation 
of mutual funds, I think it is important at the outset to 
remember that mutual funds represent the very best vehicle from 
which the individual investor has access to our markets. 
Regrettably, the industry has taken advantage of this fact. 
Investors simply do not get what they pay for when they buy 
into a mutual fund, and most investors don't even know what 
they are paying for.
    The industry often misleads investors into buying funds on 
the basis of past performance. Fees, along with the effect of 
annual expenses, sales loads and trading costs are hidden. Fund 
directors, as a whole, exercise scant oversight over 
management. The cumulative effect of this has manifested itself 
in the form of late trading and market timing and other 
instances of preferential treatment that cut at the very heart 
of investor trust. It would be hard not to conclude that the 
way funds are sold and managed reveals a culture that thrives 
on hype, promotes short-term trading and withholds important 
information.
    The SEC and other law enforcement, such as the New York 
Attorney General, no doubt will aggressively investigate and 
prosecute criminal activity. But for the longer term, it is 
well past time to consider meaningful change in the 
administration and governance of mutual funds.
    I hope the industry recognizes the grave threat these 
questions represent to its health, and that it will embark on 
substantive efforts to reform itself along with the necessary 
hand of the SEC.
    I would also like to thank Chairman Baker for his reform 
efforts in performing a vast civic benefit; he is often a 
lonely voice on behalf of investors. I believe that reform may 
include the following areas:
    One of the most effective checks against egregious abuses 
of the public trust is broken: the strict oversight of truly 
independent directors. Many so-called independent directors 
have professional or collegial ties with fund managers or, 
themselves, are recently retired managers. Fund boards, in my 
judgment, should have only one inside director. Everyone else 
on the board should meet a strict definition of independence 
from the fund complex.
    Equally important, the chairman of the fund company must be 
independent. That is one of the best ways to improve 
accountability for management practices. He or she should sit 
on a reasonable number of boards. For board members or chairmen 
to be compensated for services on as many as 100 boards is 
simply not reasonable.
    During recent weeks, State and Federal authorities, working 
together, have uncovered egregious and sometimes criminal 
violations of the public trust. Such miscreant entities should 
be required to appoint to their boards an investor ombudsman 
for a defined period of time. The largest mutual funds pay 
money management advisory fees that are more than twice those 
paid by pension funds. It is essential that investment company 
boards be required to solicit competitive bids from those who 
wish to undertake the management function. Furthermore, boards 
should justify to their bosses, fund shareholders, why they 
chose a particular investment advisor and each year should 
demonstrate that they have aggressively and competitively 
negotiated management fees.
    Sadly, funds have moved away from a culture of 
diversification and probity in favor of an almost phrenetic 
competition to market investment products as if they were soap 
or beer. The fund industry should themselves proactively ban 
performance advertising. Such misleading hype encourages bad 
practice such as portfolio pumping to boost quarterly 
performance. Companies that don't accept the importance of 
change to protect their franchise and continue to promote and 
hype performance should be required to advertise returns only 
after the effect of fees and taxes has been applied. What 
millions of American investors currently see in magazines and 
newspapers is just plain deceptive.
    Despite the SEC's efforts to persuade the use of plain 
English, the language of the industry is still hopelessly 
arcane. What average investor understands the meaning of 
12(b)(1) fees, closed end funds or ABC classes of shares. 
Mutual funds have a long way to go before they start talking in 
the language of investors.
    Executives, fund managers and directors of a fund complex 
must be required to disclose their compensation. A fund's 
shareholder should know how much they are paying someone to 
invest their money and if the incentives of that manager's 
compensation is in investors' long-term interest.
    In addition, the trading by managers of fund shares or 
securities that are part of a fund's portfolio should be 
prohibited in favor of long-term ownership. Having run several 
large sales organizations, I totally reject the specious 
argument that such practices are essential to retain competent 
managers or that such practices hone skills or approve 
commitment.
    I suspect market timing issues are far greater than the 
industry acknowledges. For instance, the closing down of 
unsuccessful funds that are then exchanged for a new fund 
within the same complex could well be considered an example of 
a market timing strategy with funds moving back and forth 
between stock and a money market fund.
    In 1940, the Investment Company Act stated that mutual 
funds are to be organized and operated in the interest of 
shareholders. We should consider a legislative amendment that 
precedes those words with a statement that it is the fiduciary 
responsibility of directors to ensure that funds are organized 
and operated in such a way.
    Not long ago, most investors bought directly from mutual 
funds themselves. Today, more than 80 percent of funds are 
purchased through brokers and not nearly enough of them 
disclose revenue-sharing deals that pay them more to put 
clients in a certain company's funds. The brokerage system of 
selling mutual funds continues to be riddled with conflicts, 
revenue sharing, sales contests and higher commissions for 
homegrown funds should be banned.
    I have long wrestled with the issue of soft dollars. It is 
clear that the practice of allowing higher commissions in 
return for broker directed research has created great potential 
for abuse. At the very least, investors should know what 
commissions they are paying and what the money is going toward. 
Disclose it and do it simply.
    More broadly, in light of the many abuses of this practice, 
Congress should seriously consider revisiting the safe harbor 
it granted to soft dollar arrangements shortly after the 
abolition of fixed commissions in 1975. ``seek simplicity and 
distrust it,'' someone once remarked; I can't help but wonder 
if they worked in the mutual fund industry.
    Mutual funds have a lot to answer for. But I have come to 
know many in the business and most realize that without 
investor trust, our markets simply can't function. I hope that 
they will speak out and that they will be the voice of 
meaningful and yet pragmatic change. In the last year, the 
voices in corporate America and on Wall Street were largely 
silent in the face of scandal. Mutual funds, given their very 
form and function, cannot afford to be. Thank you.
    Chairman Baker. Thank you very much, sir, for your 
statement.
    [The prepared statement of Hon. Arthur Levitt can be found 
on page 218 in the appendix.]
    Chairman Baker. Our next witness is Mr. Don Phillips, 
Managing Director of Morningstar, Inc.

STATEMENT OF DON PHILLIPS, MANAGING DIRECTOR, MORNINGSTAR, INC.

    Mr. Phillips. Mr. Chairman, thank you for the opportunity 
to appear before this distinguished committee.
    At Morningstar we currently cover mutual funds in 17 
countries. As such, we have seen how the fund industry has 
evolved in different settings with various structural and 
regulatory approaches.
    As a general rule, funds are structured in one of two ways, 
contractually or as corporations. The United States has wisely 
embraced the corporate structure of fund management, which is 
why the industry is governed by the Investment Company Act and 
not by an investment product or investment services act.
    In the U.S. And other countries where the corporate 
structure has been embraced, funds have enjoyed great success. 
The reason is clear. The corporate structure places investors' 
interests first. The beauty of the corporate structure is, it 
places the investor at the top of the pyramid. An independent 
board of directors is created to uphold shareholder interest 
and to negotiate an annual contract with a money manager to 
provide services to the fund. As defined by the 1940 act, the 
fund management company is not the owner of the fund but rather 
the hired hand brought in to manage the assets.
    While today's fund executives live by the letter of the 
1940 act, they don't always embrace its spirit. Go to any 
industry gathering and you rarely hear investors referred to as 
shareholders and even less frequently as owners. Instead, they 
are customers. In the vernacular of today's industry leaders, 
fund management companies are manufacturers of products that 
are sold through distribution channels such as mutual fund 
supermarkets to customers who operate presumably on the premise 
of ``buyer beware.'' .
    In effect, today's fund leaders have inverted the 
relationship envisioned by the framers of the 1940 act. Rather 
than being at the top of the pyramid, fund investors today find 
themselves at the bottom of the food chain. While the U.S. Fund 
industry does have a good long-term record of serving 
investors, this record owes not to the superior moral nature of 
fund executives, but rather to the industry's high level of 
transparency that has been brought about by the corporate 
structure of funds.
    In Morningstar's opinion, H.R. H.R. 2420 aptly sought to 
bolster this transparency. Its adoption, especially in its 
strengthened version, would go a long way towards better 
protecting the 95 million shareholders who put their faith in 
mutual funds.
    As for other issues this committee might consider in the 
efforts to protect investor interest, Morningstar would like to 
submit the following four principles:
    One, apply the same disclosure standards to investment 
companies as to publicly traded operating companies. If mutual 
funds are indeed corporations, let us treat them as such. 
Unless there is a compelling reason to draw the lines 
differently, there is no good reason to treat publicly traded 
investment companies, mutual funds, any different than publicly 
traded operating companies, stocks.
    However, because equity shareholders have historically had 
a louder voice than have fund shareholders, it is not 
surprising that disclosure standards for stocks remain far 
higher than those for funds in many areas. It is time for 
someone to speak up for shareholders and level the playing 
field.
    Every week we speak with mutual fund portfolio managers who 
tell us that before they buy stock in a company, they look to 
see how management is compensated. They want managers who eat 
their own cooking and whose interests are aligned with theirs. 
An equity investor has access to detailed information on the 
compensation and on the purchase and sales of aggregate 
holdings of senior executives and other insiders at an 
operating company.
    Stunningly, fund investors are denied access to the very 
same data about the managers of their funds. Such sunlight 
might well have been beneficial in the recent cases of several 
Putnam portfolio managers and Strong Funds Chairman Richard 
Strong, who have been accused of market timing their own funds. 
Could you imagine these executives engaging in such actions if 
they knew it would become public information that they were 
trading so rapidly?
    Why should such information that has long been disclosed on 
corporate insiders not be available on fund insiders? It is 
time to level the playing field.
    Two, bring more visibility to the corporate structure of 
funds and the safeguards it provides. The typical mutual fund 
investor is largely unaware of the corporate structure of 
funds. In fact, the names and biographical data of fund 
directors are not even included in many fund prospectuses, but 
instead are relegated to the seldom-read statement of 
additional information.
    To remedy this situation, Morningstar suggests that each 
fund prospectus begin with an explanation of the fund's 
corporate structure such as the following:
    ``when you buy shares in a mutual fund, you become a 
shareholder in an investment company. As an owner, you have 
certain rights and protections, chief amongst them an 
independent board of directors whose main role is to safeguard 
your interests. If you have comments or concerns about your 
investment, you may direct them to the board in the following 
ways: by bringing more visibility to the fund's directors and 
by alerting shareholders to their role in negotiating an annual 
contract with the fund management company.'' the balance of 
power may begin to shift from the fund management company 
executives where it now rests to the shareholders and directors 
where it belongs.
    In addition, we believe it is highly beneficial, if not 
essential, that the chairperson of the fund board be an 
independent director. In an operating company, there is only 
one party to which directors, be it independent or not, owe 
their loyalty, the stockholders.
    In a mutual fund, there are two parties to which the 
nonindependent directors owe their allegiance. One is the fund 
shareholders, the other is the stakeholders in the fund 
management company; only the independent fund directors have a 
singular fiduciary responsibility to fund shareholders.
    We also believe that this independent chairperson should be 
responsible for reporting to the fund shareholders in the 
fund's annual report, to address the steps the board takes each 
year in reviewing the fund's management performance and the 
contract that the fund has with the fund management firm. Only 
by having more visibility for the role of directors can they 
truly fulfill their function.
    Three, insist that fund management companies report to fund 
shareholders as they would to owners of a business. There is 
particular room for improvement in the way costs are 
communicated to investors. For many middle-class Americans, 
mutual fund management fees are now one of their ten biggest 
household costs. Yet the same individual who routinely shuts 
off every light in their house to shave a few pennies from the 
electric bill is apt to let these far greater fund costs go 
completely unexamined. Getting these fees stated at a dollar 
level that corresponds with an investor's account size is an 
important first step.
    We have truth-in-lending laws that detail to the penny the 
dollar amount a homeowner will pay in interest on his mortgage. 
Isn't it time for a truth-in-investing law that would bring the 
same common-sense solution to mutual funds, the retirement 
vehicle of choice for a whole generation of Americans?
    Four, ensure that all shareholders are treated fairly. Our 
final point is one that we wouldn't have thought needed to be 
raised 6 months ago, but in the wake of the recent fund trading 
scandals, it has become a significant issue.
    Morningstar supports fair-value pricing policies and the 
consideration of higher redemption fees for short-term trades. 
In addition, we support a hard close for mutual fund pricing. 
If a trade order is not in the fund's possession by 4 p.m. 
Eastern, it should be transacted at the next day's price.
    By bringing more visibility to the corporate structure of 
funds and by leveling the playing field between publicly traded 
operating companies and investment companies, this committee 
can demonstrate to American investors that mutual funds will 
continue to operate on one of the cleanest level playing fields 
in all of finance.
    Thank you for the opportunity to speak before you.
    [The prepared statement of Don Phillips can be found on 
page 221 in the appendix.]
    Chairman Baker. Our next witness is Mr. Mercer E. Bullard, 
President and Founder of Fund Democracy, Inc.
    Welcome, sir.

  STATEMENT OF MERCER E. BULLARD, FOUNDER AND PRESIDENT, FUND 
                        DEMOCRACY, INC.

    Mr. Bullard. Thank you, Chairman, and thank you for the 
opportunity to speak before the committee today. What I would 
like to do is, first, I would like to applaud you for 
addressing these issues before mutual fund regulation became 
the regulatory issue du jour, and I hope that the committee and 
the House and the Senate can get together and now get some 
effective fund legislation done.
    What I would like to talk about is to clarify a little bit 
about what is an issue of some confusion, and that is the 
nature of these different frauds and how to look at them and 
think about what is the proper role of Congress in dealing with 
them.
    One fraud is actually almost a year old. That is the 
Commission overcharges scandal that the SEC and other 
regulators discovered earlier this year where they found that 
in 30 percent of the cases in which fund shareholders were 
entitled to receive discounts on commissions, they did not 
receive them. This kind of systemic failure is the first 
example of fund directors and fund managers simply not doing 
their jobs.
    What could be more fundamental than making sure that your 
shareholders are not being overcharged? And what is even more 
shocking, as you heard Mr. Cutler talk about today, about 
actions being taken by the NASD and the SEC to require these 
broker-dealers to find out who they overcharged and, imagine 
that, repay them the amount they overcharge.
    The question is, how is it, 6 months after this fraud was 
uncovered, these fund boards are not doing the same thing? If 
you were a fund director, wouldn't you think the first thing 
that you would do when you found out your broker was 
overcharging your shareholders would be to say, Well, not only 
is this disgraceful, and I am considering firing you as a 
distributor, but I would like you to pay back the amount that 
you stole from my shareholders. Obviously they haven't done 
that, or else the NASD and the SEC wouldn't have to be forcing 
broker-dealers to repay the amount they overcharged their 
investors. Perfect example, number one, the fund director is 
not doing their job.
    The second example is late trading. Late trading resulted 
because the SEC as a practical matter said, You don't have to 
get your order in by 4 o'clock because, as Congresswoman 
Biggert pointed out, there is a problem with some 401(k) plans 
getting orders in time to meet that 4 o'clock deadline. The 
regulatory issue is whether it is received by 4:00, not whether 
the fund receives it by 4:00. All that fund directors have to 
do to the extent that the fund was receiving orders after 4 
o'clock is make sure there are procedures in place to ensure 
that they were received before 4:00 and cannot be canceled, and 
then to do spot checks to make sure that was happening. The 
pervasiveness of this fraud demonstrates that simply was not 
happening. And this again, like the Commission overcharges, is 
fundamental compliance.
    The third example is market timing. The market timing we 
are most concerned with is market timing that violated fund 
prospectuses. If you are a fund director, the first thing you 
should read would be the fund prospectus, and when you see a 
requirement in there, it immediately becomes incumbent to be 
sure that that requirement is being complied with. You do that 
by having procedures in place designed to enforce that 
requirement and by doing spot checks.
    It is very simple doing spot checks. You ask to see the 
cash flows of the fund, and if the intermediaries won't provide 
it, you insist on receiving it. Once again, the pervasiveness 
of this fraud demonstrates fund directors were not doing it.
    The worst example is the case of stale pricing, which you 
heard Paul Roye tell you earlier is flat out illegal. It is 
illegal to keep that 14-hour-old Japan stock market price when 
you know there are events that have affected its value and it 
is obvious there are events that affected its value. That is 
why 28 members of the boilermakers' union were market timing 
funds, because they knew the value of the fund was now 
underpriced. It is incredible to me that apparently the fund 
directors and the SEC didn't know.
    And what is most embarrassing about the stale pricing is 
that this was something that had been raised in the popular 
press for years. There were academic studies, at least four 
that I know of, where the academics went in and looked at the 
actual cash flows of these funds; and what they identified was 
that there was a massive amount of exploitation of stale 
prices. These were a matter of record and have been a matter of 
record for years.
    Since 1997, the SEC has been on notice that this is a 
significant problem; and until 2001, it did not come out and 
say that it was illegal. So what we have is a consistent 
failure to deal with open and notorious frauds, and the main 
problem is, at the fund management level and at the fund 
director level they are not doing their jobs.
    I applaud Chairman Baker for seeking to increase the 
independence of boards, but like Chairman Levitt, I think 
something more is needed. His idea of an ombudsman, as well as 
the SEC's proposal about a chief compliance officer and my 
proposal about a mutual fund oversight board, essentially share 
that same characteristic, which is that someone needs to be 
breathing down the necks of fund directors to tell them what 
their fiduciary duties are and to make sure they are doing 
them.
    With respect to the ombudsman and the compliance officer, 
the key there is they cannot be appointed by or be employees of 
the manager; they have to be completely independent for them to 
fulfill that role. But at a minimum, I think Congress is going 
to have to take some kind of step that changes the structure in 
a way that gives fund boards that kind of oversight.
    Thanks very much. I would be happy to take questions.
    In particular, Congressman Emanuel, I thought the answers 
to your questions about possible conflicts in IPOs was 
inadequate, and I would be happy to follow up on that if you 
would like.
    [The prepared statement of Mercer E. Bullard can be found 
on page 46 in the appendix.]
    Chairman Baker. Our next introduction is requested to be 
made by Congressman Royce.
    Mr. Royce. Thank you, Mr. Chairman. I would like to once 
again welcome fellow southern Californian, Mr. Paul Haaga, to 
the committee room. As you know, Mr. Haaga has previously 
appeared before this committee, and I would like to thank him 
for returning. He is the Executive Vice President and a 
Director of Capital Research and Management Company. And Mr. 
Haaga comes before us today, not as a former SEC official or a 
current investment executive, but rather in his capacity as 
Chairman of the Investment Company Institute.
    I look forward to his testimony, and I yield back, Mr. 
Chairman.
    Chairman Baker. Thank you. Please proceed at your leisure.

  STATEMENT OF PAUL HAAGA, JR., CHAIRMAN, INVESTMENT COMPANY 
                           INSTITUTE

    Mr. Haaga. Thank you for the kind introduction, Mr. Royce. 
I can safely say that it is the nicest thing anybody outside of 
my family has said to me in the last couple of months.
    Thank you, Chairman Baker and distinguished members of the 
subcommittee. My name is Paul Haaga, and I am here as Chairman 
of the Investment Company Institute's board of governors. While 
I appreciate the opportunity to appear before you today, I am 
appalled and embarrassed by the circumstances that cause you to 
convene this hearing. The abuses described to you this morning 
involving the conduct of some fund officials and others are 
shocking and abhorrent.
    The Investment Company Institute commends SEC Enforcement 
Director Cutler, Attorney General Spitzer, and Secretary of 
State Galvin and urge that their vigorous enforcement efforts 
continue.
    On the regulatory side, SEC Chairman Donaldson and his 
fellow commissioners and Investment Management Director Paul 
Roye have provided a strong blueprint for regulatory reform. We 
commend the SEC and the Congress for responding swiftly, and we 
pledge our full cooperation in crafting necessary reforms.
    As we wrote in a USA Today commentary a few weeks ago, 
serving investors, above all other interests, is mutual funds' 
first and only commandment. It is the reason that so many 
individuals have become mutual fund investors. Yet we now know 
that some have ignored this commandment.
    The abuses we have learned about are inconsistent with our 
fiduciary obligations, incompatible with our duties to 
shareholders, and intolerable if we are to serve individuals as 
effectively in the future as we have in the past. Simply 
stated, if we don't put shareholders first, we will no longer 
be the investment of choice for 95 million Americans, and we 
will no longer deserve to be.
    Nothing I say here today will, by itself, restore investor 
confidence in mutual funds. For that, we will need action in 
several areas. First, government officials must identify and 
sanction everyone who violated the law. Second, shareholders 
who were harmed must be made right. Third, strong and effective 
regulatory reforms must be put in place to ensure that these 
abuses never happen again. Everything is on the table.
    We pledge to you and other government officials our 
complete cooperation.
    Now these necessary actions will be very visible and will 
be taken over the coming weeks and months, but the most 
important action will be the least visible. It won't happen on 
any timetable and in fact, our efforts to achieve this goal 
will never end. And that action is making sure that everyone 
involved with mutual funds adheres to the founding principles 
underlying the Investment Company Act of 1940. It is just three 
words, investors come first. I and the Institute pledge not 
just cooperation, but leadership in this last, most important 
endeavor.
    Thank you again for the opportunity to testify here today. 
I would be happy to respond to your questions.
    [The prepared statement of Paul G. Haaga Jr. can be found 
on page 195 in the appendix.]
    Chairman Baker. Thank you very much, Mr. Haaga. I do 
appreciate your appearing and your statement today. Not that we 
can reach legislative accord this morning with just the 
opinions of this panel, but I suspect we will be addressing 
this subject frequently over the next few weeks. We have 
another hearing scheduled on Thursday with another 
distinguished group of panelists.
    But it seems that there are some themes that are pretty 
clear if we start with H.R. 2420 in its current form, that 
disclosure of a portfolio manager's fees and their holdings, 
prohibition on simultaneous management of a mutual fund while 
operating a hedge fund, require that there be a--and defining 
fundamental objectives of the fund, using that legal jargon 
that the firm's market timing policy be defined as a 
fundamental objective so it is principally, prominently 
disclosed to the potential shareholder; not only establishing a 
compliance officer, which is now in H.R. 2420, but having that 
officer report to an independent board.
    And sort of outstanding at the moment relative to the 
construct of independent members is whether it is maintained at 
a majority, whether it is three-quarters--the number at the 
moment is not decided--but certainly that the compliance 
officer should report to those independent members, that there 
be an independent chairman; that we consider recommending--I 
don't think we should establish by statute, but recommend to 
the SEC that they establish an enhanced redemption fee for the 
short-term trades at whatever level they think appropriate to 
have a market effect; require the SEC to clarify fair value 
pricing rules, so you can't use a stale price and profit from 
that arbitrage; enhance and perhaps, as contained in H.R. 2179, 
some increase of penalties for clearly established mutual fund 
violations; publication of the fund's code of ethics so people 
can pick it up and read it and see what their policy is.
    And then perhaps sort of the bumper sticker for the whole 
effort along the lines of what Mr. Levitt indicated is language 
that--something to the effect that consistent with the high 
standards of fiduciary conduct, the funds should be operated in 
the interest of investors, not in the interest of directors, 
officers, investment advisors, underwriters or brokers; to set 
in place a clear statutory statement of the standards for 
ethical conduct.
    Now that is just what I picked up this morning in the 
discussions. Let me throw it out.
    Mr. Haaga, I will certainly give you an opportunity to 
object or suggest where modifications might be appropriate. And 
I am making this request in this context.
    Perhaps the single most important thing for us to resolve 
is getting closure. And if, by the end of this session, if it 
were possible to get a bill out of the House and the Senate to 
bring resolution to this chapter of difficulty, I think it 
would be very helpful to the recovery of the markets next year. 
If we leave this unattended and unresolved into February or 
March of next year, I don't think that is a good thing for our 
economy.
    So I base those suggestions on, how do we get closure 
quickly on a package that makes sense, that we can work with 
the Senate on over the next few weeks?
    Mr. Haaga. What are you doing the rest of the afternoon? We 
will come over and talk. I would love to discuss these things 
in order and have everybody comment on them.
    Let me just say that we were in favor of most of the 
provision in H.R. H.R. 2420 as introduced. We suggested some 
changes. I won't characterize them as minor or major, but some 
changes.
    We continue to certainly support the core principles 
involved in the bill and have a few concerns about a few things 
that need attention. But I think we are very close. And as you 
said rather than negotiate it here, I would like to meet with 
the staff and the members and go over it.
    Let me tick off a couple of things in there. You talked 
about a bumper sticker. I think it was a solution here to 
establish that funds are operated in the interest of 
shareholders and not in the interest of managers. That is 
section 1 in the preamble to the 1940 act, so we don't need to 
enact that. We need everybody to read it a few times.
    Chairman Baker. Fiduciary standard, that is a little 
different from a financial company's perspective than a mutual 
fund's perspective. If I am going to do something that affects 
your material financial wealth, I had better have a good 
explanation or I am responsible. So that many of the judgments 
made in the recent months, it appears, were not consistent with 
a professional standard of fiduciary performance that is the 
addition that I made to Mr. Levitt's suggestion.
    Mr. Haaga. The boards have been mentioned a number of times 
here, so let me say something general about them.
    You know, not every failure is a failure of all systems and 
not every system failure is a structural failure. Sometimes it 
is one of operation in a perfectly good structure. These 
problems that have been talked about today are ethical problems 
first; compliance problems to a lesser extent, but ethical 
problems first. It pains me to say that. I would much rather 
say it is a structural problem. I would rather say, if we 
organized ourselves differently, it would not have happened, 
but I can't. I would like to.
    I hope as we go into these solutions, we don't fall into 
the trap of thinking that structural changes are going to solve 
everything. That is not to say there may not be changes in 
rules, in structures, et cetera, but let us remember exactly 
what the problem is and not take our eye off the ball. There 
were ethical lapses by some in the industry.
    Chairman Baker. Let me make clear, as best you understand 
it today, H.R. 2420, as passed by the committee absent the 
independent Chair, is a starting point for ICI today. You may 
consider additions to the bill as appropriate, but H.R. 2420 as 
it is currently constructed is something the ICI could support?
    Mr. Haaga. Yes.
    Chairman Baker. Did any of the other gentlemen want to 
comment on the list?
    Mr. Levitt. I would just comment that the notion of 
fiduciary responsibility does not address, in my judgment, the 
structural makeup of the industry, but goes to the very point 
that Mr. Haaga made that this is an ethical problem and this is 
an ethical response by clearly stating it as a fiduciary 
responsibility.
    And I also believe it is absolutely essential that 
managers' compensation must be revealed and that the trading of 
stocks or funds by managers' trading, as opposed to owning--I 
have no problem with owning, I have a vast problem with 
trading. And as I said before, I reject as totally specious the 
argument that this is a way they can hone their skills. That 
just isn't so. So I think these two elements together would be 
very important enhancements that go directly to Mr. Haaga's 
correct observation that this is an ethical rather than merely 
a structural problem.
    Chairman Baker. Does anyone else want to make a comment?
    Mr. Bullard. I think those are excellent recommendations.
    I would say with respect to the compliance officer, as I 
recall H.R. H.R. 2420, it is modeled to some extent on the SEC 
proposal, in which case I think the key issue--it is important 
that they report to the board, but it is probably more 
important that they not report to the fund manager. There has 
to be some complete separation so that they are an employee of 
the fund and have absolutely no allegiance or reporting 
obligation regarding the advisor----
    Chairman Baker. As suggested, it would be reported to the 
independent board member.
    Mr. Bullard. As far as separation of the hedge funds, I 
think that is an excellent proposal, and particularly if it 
goes deep enough to cover not just portfolio managers, but the 
research analysts where you can also have conflicts.
    And as to the redemption fee, I suspect that the SEC would 
probably want some kind of statutory authority, especially if 
what you are looking for is for them to acquire a redemption 
fee. The problem with redemption fees has always been that it 
is not clear they are consistent with fund shares being 
redeemable securities; and to give them the greatest leeway, 
what you might want to do is give them rule-making authority 
either to require or to permit redemption fees as they see fit.
    Chairman Baker. Thank you very much.
    Mr. Emanuel.
    Mr. Emanuel. Thank you, Chairman Baker.
    Mr. Bullard, since you mentioned my earlier question about 
the hot IPO market and ``spinning'', did you want to address 
those issues?
    Mr. Bullard. In the response, there was no mention of the 
fact that in the late 1990s the SEC increased the amount of the 
percentage of an IPO that can be put into an affiliated fund 
from 5 percent to 25 percent. And I thought that was ill-
advised at the time. And of course this was being done by, in 
some cases, the managers of those same funds.
    So it goes to your second question, too: Are there some 
sorts of structural relationships between the manager and the 
fund that may pose a problem? What we don't know is, even after 
they increase that to 25 percent, what has been the impact of 
that? Is there a higher correlation of IPOs being stuffed into 
affiliated funds or not? Do we know whether it had an impact on 
the setting of the IPO price?
    And, you know, my view is, when the SEC grants exemptions, 
which it has been quite liberal in doing lately, it should have 
a follow-up mechanism where it is going to check to see whether 
this is harming shareholders.
    I don't know the answer to this, but it would not surprise 
me if stuffing IPOs in affiliated mutual funds had something to 
do with the Internet bubble we experienced. But because the SEC 
hasn't looked at that issue, we don't know the answer.
    Mr. Emanuel. Okay, thank you.
    Chairman Levitt, do you see any reason for us to look into 
ownership issues relating to mutual funds, insurance companies, 
and banks, or is that really not a problem? Should we be 
addressing some of the cross-selling issues using the Canary 
and Bank of America case as an example.
    Mr. Levitt. I think it is a problem. I think, to the extent 
to which you diffuse the management structure by placing it as 
a subsidiary of a company, which has other interests, or to the 
extent to which it has become part of a brokerage firm or a 
bank, that is part of what I call a culture of salesmanship, as 
opposed to a culture of safety and preservation.
    The aggressive selling that we have seen in certain 
brokerage firms and banks I believe is the tip of the iceberg. 
The kinds of inducement, in terms of compensation, continue to 
be a problem that plagues the brokerage industry, and I suspect 
is pervasive in the banks, as well.
    I am not sure that there is any role for Congress to play 
at this point. I think that the undoing of the prohibitions of 
Glass-Steegel had the kinds of unintended consequences that 
many predicted, but I clearly believe that this makes the 
problem even greater for American's investors and commenting 
further, with respect to IPO's, once again it is another--it is 
another conflict, it is another instance where individual 
investors see that large investors are favored over small, and 
I think that, for Congress and for Americans, is an unfortunate 
by-product of all of this.
    Mr. Emanuel. Thank you. I would close, Mr. Chairman, by 
reiterating something I mentioned in my opening remarks. As we 
continue to look at these issues, and as some of my colleagues 
push to privatize about social security, I would hope that the 
issue will give them pause. This scandal should be a flashing 
yellow light to the privatization advocates. We have many 
issues to deal with here, but the notion of privatizing Social 
Security is one that should go by the wayside.
    Thank you Mr. Chairman. I yield back.
    Chairman Baker. Mr. Castle.
    Mr. Castle. A few things: Mr. Bullard's comment about the 
U.C. Internet and the SEC, you should look at. I think that's 
absolutely correct.
    There are a whole heck of a lot of people out there who 
are, in my judgment, becoming traders who were never traders 
before, who are probably market timing or doing some things we 
probably need to pay attention to.
    I would like to discuss our own involvement, and that is 
we, the customers and customer awareness, and I would hope that 
what we are talking about makes a difference as far as we are 
concerned.
    Basically, the no load funds, inevitably have the same 
earnings or higher earnings than do the load funds, so if you 
have an advisor, maybe you want to use the load funds, but 
people should understand they may be getting hit with 4 or 5 
percent they do not need to. The costs are generally printed. 
Anybody who does any reading about mutual funds can understand 
about where Vanguard is where they are concerned about costs. 
The publications, certainly Mr. Phillips' publications, 
Morningstar has all kinds of information in it.
    The Wall Street Journal, USA Today, magazines, do this on a 
regular basis. There is a lot of literature that is out there. 
Even some of the advertising out there, some of them will say 
all of our assets are invested in this fund, I would have to 
assume it is true, and if it is, that is a factor that I would 
consider.
    I saw an article one time saying that if a fund was named 
for an individual, it probably did much better. That was 
probably before Mr. Strong came along, and I am not sure I 
endorse that anymore. We were all in this together. This is a 
huge part of America's finances today. I am just really 
surprised at the figures of costs that have gone up in mutual 
funds, more so than the numbers of mutual funds. They have just 
gone up tremendously, and I try to get to the bottom of this. 
Unfortunately, I do not have time for all the questions I would 
like, but Mr. Levitt, because you mentioned it, I will deal 
with you.
    You mentioned at the end of your testimony that you have 
always wrestled with the issue of soft dollars. I have, too, 
because soft dollars is a little hard for me to understand. It 
is clear that the practice of allowing higher commissions in 
return for brokerage directed research has created great 
potential for abuse. At the very least, investors should know 
what commissions they are paying and what the money is going 
towards.
    Is my recollection correct that that comes out of the NAV, 
the net asset portion of it, as opposed to a separate cost when 
you are dealing with those soft dollars in which they are 
paying excessive amounts to the brokers who trade for them? Or 
if you do not know the answer, does somebody know the answer to 
that?
    Mr. Levitt. I think ultimately, yes.
    Mr. Castle. In other words, it is a hidden cost is my 
point?
    Mr. Levitt. It is a hidden cost and it is ill-defined. It 
is justified in all kinds of ways. The most frequent response 
from proponents is that, you know, Congress gave us a safe 
harbor, and my answer to that and I do not have an absolute 
formulaic response to it, because it cuts in many ways, but I 
think Congress should revisit that safe harbor, and, at the 
very least, the definition of where those dollars are going 
should be much more clear.
    Mr. Castle. Well, let me ask this of you and perhaps 
others, just to expand on that. You see the fees. You see them 
stated. You will see them in the literature that I referred to. 
You have a 12(b)(1) fee, other costs of doing business, 1.3 
percent of doing business or something like this.
    Is it my understanding those soft dollars are beyond any of 
those costs?
    Mr. Levitt. Yes, the directors realize----
    Mr. Castle. And maybe there are hidden costs that we are 
not even seeing.
    Mr. Levitt. Directors take the trouble to ask whether those 
dollars are going toward the purchase of furniture or whether 
they are going toward research and what kind of research and 
whether they are justifying other kinds of paybacks.
    Mr. Castle. Right.
    Mr. Levitt. And I do not think they do.
    Mr. Castle. Right.
    Are there other soft dollar or other hidden costs beyond 
the other stated costs that come out before they value what the 
mutual funds are worth, can any of you answer that?
    Mr. Phillips?
    Mr. Phillips. Yes, there are.
    What you see for expenses are the dollar costs that were 
spent for management fees, for operation fees, but none of the 
trading costs are included in that.
    Mr. Castle. Which is part of the soft dollars?
    Mr. Phillips. For the brokerage costs and the soft dollars 
would be appended to that are not included in the expense 
ratio, nor is the friction. When a manager is trying to buy a 
lot of shares with a thinly-traded stock, let's say $10, they 
may push the price up to $11 before they accumulate their 
entire position.
    When their forced buying stops, the stock may settle back 
to 10. The reverse may happen when they go to sell.
    Mr. Castle. And all of this is not a tight negotiation. 
Theoretically they are exchanging it because of better research 
or information on IPOs.
    Mr. Levitt. That is why the advertising is so deceptive, in 
terms of talking about performance above all else. They know 
perfectly well that performance is no indicator, no--past 
performance is no indicator of future performance.
    Mr. Haaga. Let me clarify something.
    I am a regular in this room. I was here in March on a panel 
with several fund industry executives, several opponents of 
mutual funds or critics of mutual funds, I call them, I do not 
think anyone is an opponent of the concept, but the one thing 
we all agreed that the structure of soft dollars need to be 
reviewed.
    Mr. Castle. Is there a revelation of what they are? We do 
not seem to find out what they are at this point?
    Mr. Haaga. Certainly, we know what soft dollars are. 
Chairman Oxley and Bachus wrote a letter to the SEC about soft 
dollars among other items back in March, and again in June, 
instructing the SEC to do a study. Let me also point out: Mr. 
Levitt mentioned furniture and whether soft dollars were being 
used to buy furniture, or other items beyond research.
    The SEC did a sweep of investment advisors and identified a 
number of cases in which soft dollars were being misused.
    Not one of those cases involved an investment advisor to a 
mutual fund. Mutual funds have enough problems without adding 
issues that aren't problems to our list.
    Mr. Levitt. You are saying there is no abuse of soft 
dollars in your judgment?
    That is the industry's position.
    Mr. Haaga. Excuse me.
    That there is no abuse of soft dollars? I think we could 
always improve the structure of soft dollars.
    What I am saying is, and I will say it, again: The SEC did 
a sweep of advisors, including a number of advisors to mutual 
funds and found no abuses. The soft dollars system, the rules 
relating to soft dollars, should be changed and should be 
tightened up. We believe that. That is what I said.
    Chairman Baker. Would the gentleman yield on one of your 
expense questions?
    Mr. Castle. I will be happy to yield if you will yield back 
after that for one question.
    Chairman Baker. Oh, sure.
    Just on the expense disclosure you were making reference to 
the portfolio transaction costs are really a big chunk 
potentially that are not clearly disclosed.
    There is a statement in the annual report, as to the 
percentage of turnover, but you do not know correspondingly the 
expense ratio assigned to that brokerage fee. It can be as high 
as 2.5 percent. It can be far in excess of the operating 
expense percentage rate and in one fund I made reference to in 
testimony yesterday, in 2002, had $2 billion in assets under 
management, had $9 billion worth of turnover and there was no 
explanation, for 440 percent turnover rate. I cannot imagine 
what the expenses associated with that level of turnover meant 
to the average investor. It is a huge problem. I yield back to 
the gentleman.
    Mr. Castle. Well, a lot of these funds are over 100. 400 
percent is really high. A lot of them are well up there, at 50, 
60 percent. That is a lot of turnover in the course of the 
year.
    Just a question very briefly of all of you, because my time 
is up. Is there anyone here, any of the four of you, who would 
suggest to the investors, the half of Americans out there who 
are invested, that the mutual fund industry is so tainted at 
this point, not individual funds but in general, that we need 
to consider whether we need to be in mutual funds, or not?
    We went through this with corporations and others as well. 
I do not think you are, but, if you are, I would like to hear 
that.
    Mr. Levitt. Absolutely not. I think mutual funds are a 
superb vehicle for America's investors, and I think what all of 
us are talking about are restoring public confidence in an 
industry that has been badly tainted by recent revelations and 
by shifts in both investor sentiment and management practices 
that were part of the bubble of the 1990s and bring us to an 
unhappy place with respect to not just funds and corporations 
and markets themselves, all of which have fallen into great 
public disrepute, and it is our communal job to restore that 
and doing what we have to do, and Mr. Baker has come up with a 
bill that I think certain refinements would go a long, long way 
toward the restoration of that confidence.
    Mr. Castle. Thank you.
    Chairman Baker. Thank the gentleman.
    Mr. Haaga. Could I answer that one, as well?
    Chairman Baker. Certainly.
    Mr. Haaga. We talk a lot about the 95 million mutual 
shareholders. That is a lot of people and who we are here 
representing in addition to the Investment Company Institute 
and the nearly 170,000 people who work in the mutual fund 
industry and several million advisors and brokers who use 
mutual funds with their clients. I can tell you that the great, 
great majority of them are just as appalled as I am and just as 
concerned about recent allegations. They are not engaging in 
these practices and they want us to fix it and so I hope we 
will all take that into account when choosing the adjectives 
and adverbs that we throw around at the industry.
    Chairman Baker. I thank the gentleman.
    Mr. Scott?
    Mr. Scott. Yes.
    Thank you very much, Mr. Chairman.
    To Honorable Levitt, you are the former Securities and 
Exchange Commission chairman, and with that, you bring a wealth 
of knowledge and experience, as we debate this issue of trying 
to bring credibility back to investors in mutual funds.
    You wrote a book, last year, I believe it was, called Take 
on the Street, and, in that book, you mention that the 
deadliest sin in owning mutual funds was the high fee cost.
    I find that to be very interesting, particularly in view of 
the late trading issue or 10 percent of companies, fund 
companies, are guilty of that, 25 percent of dealer brokers are 
guilty of that, with the multitude of market timing issues that 
are violated, and I was just interested why, why you would 
single out that one as the deadliest sin?
    Mr. Levitt. Well, I consider it the deadliest sin because 
that is the one that American investors least understand, and 
it is the one unfortunately that the industry, the mutual fund 
industry, in their advertising, least addresses, but the impact 
of what appears to be very minor adjustments in fund costs is 
devastating and is really hidden, in terms of prospectuses and 
documents which are so difficult for the typical investor to 
understand.
    I think, just in my judgment, there is no issue that goes 
more to the heart of whether an investor makes or loses money 
in a fund than what kind of fee structure there is. It is like 
running a 100-yard dash but starting out 10 yards behind the 
line. It is a great burden to absorb and I think it is the one 
that investors understand the least of all factors surrounding 
investment and mutual funds.
    Mr. Scott. That leads me to my--the second point of my 
question: I am very interested in financial literacy and have 
put quite a bit of work in this committee, along with some 
others, in dealing with financial literacy, because I really 
believe that education is the key, that so many of the problems 
that we have now is because of a lack of financial literacy, 
and, certainly, in the area of investor education.
    What recommendations would you make, from your experience, 
as to what we could do?
    Mr. Levitt. I think that you are absolutely right.
    My experience has been that a dollar spent on educating 
investors has vastly greater velocity than a dollar spent on 
developing regulations or a legislation, and I would urge 
industries that have fallen into recent public disfavor, such 
as the accounting industry and the investment company industry, 
to devote a much greater portion of their marketing money 
towards educating investors how to be smarter investors, how to 
understand these statements, how to know the difference between 
load and no load funds and what a broker brings to the table 
and doesn't bring to the table and what a sector fund means and 
the risks involved in that sector funds and what it means if a 
fund has bad performance, closes down, creates another fund 
with a different name with the same dollars and what are the 
implications to the investor.
    I think those dollars would be well spent in educational 
programs, and I would encourage both the investment company 
industry and the accounting industry, that are in the spotlight 
these days, to carefully consider reallocation of marketing 
dollars toward educating investors.
    Mr. Scott. Within our Broker Accountability Act and also 
within the legislation that we are putting forward on financial 
literacy, one of the features we are putting in is a 1-800 
number for constituents, for consumers, for people to gain 
information or get access to information.
    We are sort of developing this, as a result of the issue of 
predatory lending, to get information out there before the 
action is done.
    That is a requirement, also, with our Broker Accountability 
Act.
    Do you feel the application of a 1-800 number that is 
marketed and made accessible to the markets would be an 
approach that might be worth looking at?
    Mr. Levitt. I think it is one part of a much larger 
program, and I think it is useful. At the Commission, we had 
such a number, and employees of the Commission and 
commissioners themselves spent time down there answering that 
1-800 number, and I think it would be awfully useful to have 
managements of mutual funds be on the receiving end of 1-800 
calls, to get a much greater feel of what it is like to be the 
man or woman in the street. There is no better way to 
understand what motivates, what misleads, what directs, what 
impassions investors than to be in the trenches.
    Mr. Scott. Great.
    I enjoyed your book, Take on the Street. It is a good book, 
and I recommend it, as well.
    Mr. Levitt. Thank you.
    Mr. Scott. I will give you that little commercial plug.
    Finally, I want to ask you: We are grappling with an issue 
of investor restitution and how we deal. I am working with 
Chairman Baker on a bill that sort of deals with a way to bring 
the SEC together with having a kind of a single regularity. It 
just seems to me that having fifty States, with the possibility 
of overriding Federal policy in this area, doesn't make sense, 
and I do know we have some very outstanding Attorney Generals, 
and Attorney General Spitzer does a very good job, but I would 
like to get your take on that.
    It seems to me there ought to be room, and I am working 
both with Chairman Baker and our ranking member, Barney Frank, 
and I think that we are at a point where we are dealing with a 
conclusion of being able, but there just seems to me that there 
is some very substantive value in having a single regulatory 
function operating out of the Securities and Exchange 
Commission, while at the same time, protecting and allowing the 
States to maintain their authority, to prosecute, to 
investigate, and to deal with the collection of funds.
    Would you not think that is the best solution?
    Mr. Levitt. After your endorsement of my book, you make it 
so awkward for me to have to disagree with you, but as you said 
those words, I kept thinking of something that is going on in 
New York City, down at 6 Center Street as we talk, where a 
remarkable District Attorney of the State of New York is 
bringing a case against Dennis Kozlowski and has brought a 
myriad of cases, and there are Attorney Generals and securities 
directors around the United States that have a feel for the 
trenches and the individuals in those communities that cannot 
quite be replicated by a single regularity.
    The way this should work, in my judgment, the beauty in our 
system in America, is to fuel the juices of competition by 
having a multitude of markets, not just one market. We have a 
dealer and auction and electric markets.
    While I very much favor splitting off regulation from 
marketing in the New York Stock Exchange, I certainly would 
oppose a single regulator. Having run a market myself, the 
competition between regulators I believe is healthy, and by the 
same token, I think that, if coordinated appropriately, if you 
can work together in a cooperative reasonable way, Federal 
regulators have the resources, they have the law, they have the 
people power, but they can be supplemented in some instances by 
States and regulators who have a feel for the community and 
provide a better measure of investor protection than doing it 
just unilaterally in one single jurisdiction, in my judgment.
    Mr. Scott. Let me ask you: How do you respond to the 
concerns of our Federal--our Fed Chairman, Greenspan, who 
testified before this committee, just the opposite of what you 
have said, and your present chairman of the SEC, who says that?
    What is the difference, what is the--what makes you feel 
that their thoughts on this would not hold water?
    Chairman Baker. Mr. Scott, if I can jump in and maybe help 
a little bit. I think the gentleman's point can be aided by the 
observation we are not discussing the ability to investigate 
Prosecutor Fine.
    What the gentleman's concerns have been aimed at is with 
regard to the remedies and only where the remedy affects 
national market structure, should the SEC be consulted and be 
maintained in a position of primacy with regard to a single 
national Federal securities market, and that is where he and I 
have joined together, not knowing exactly where the phone call 
is to be made between Mr. Spitzer and the SEC when he is 
negotiating a settlement, but if he is going to cross over the 
line at the end of the day and change a regulatory structure 
that impacts national markets, the SEC needs to be consulted in 
the event that should take place, but in no way does it limit 
or hope it limits his ability to pursue wrongdoers however he 
sees fit, and I thank the gentleman for yielding.
    Mr. Levitt. I think consultation is always desirable. I 
speak from a perspective of someone who ran a brokerage firm, 
who is greatly concerned about redundant regulation dealing 
with the NASD, the New York Stock Exchange, the American Stock 
Exchange, and the SEC. I also ran a self-regulating 
organization, and I also was a Federal regulator, and I have 
seen the system, and I believe that this system works and works 
well.
    Are there offsets to it? Yes. Are there redundancies fueled 
occasionally by over zealous prosecutors who are seeking 
political gain? Yes. There is that danger. But the offset, in 
my judgment, is worth it, and I think a reasonable amount of 
coordination between the chairman of the SEC and State 
regulators can and has, in the past, addressed these issues.
    It occasionally will move in the wrong direction, but by 
and large, I would not favor a legislative fix to this, at this 
point.
    I think we are working pretty constructively on the two 
major areas of abuse that society faces today, and I would not 
like to send a message to the public that we, in any way, are 
trying to muscle any of those that they regard to be their 
protectors. Tomorrow morning on television, the question was 
asked of viewers if they had a case of securities fraud to whom 
would they make the first call, would it be to their State 
regulator, would it be to the NASD, would it be to the SEC. I 
will be curious to hear what the answer would be.
    Mr. Scott. So, right now, you support joint jurisdiction?
    Mr. Levitt. I support the system as we have it now.
    Mr. Scott. All right.
    What would be your response to broker dealers and the 
patchwork of overlapping and conflicting State and local 
regulations, right now?
    Mr. Levitt. One of the mandates that I gave to the SEC was 
in the newly-formed Bureau of Inspections and Examinations to 
eliminate that overlap, and the SEC can do that by bearing down 
on self-regulating organizations and asking the question: Are 
you redundant, in terms of your inspections, and, if you 
remember, layoff.
    That can be controlled, and I think it is a priority of the 
Commission to keep that from being burdensome to the industry.
    Chairman Baker. Mr. Scott, if I can, move on to the next.
    Mr. Scott. Yes.
    Chairman Baker. Chairman Oxley?
    Mr. Oxley. I thank you, Mr. Chairman, and welcome to our 
second panel.
    You are all familiar with the legislation that is pending, 
it was passed out of the committee, H.R. 2420, and I think all 
of us would agree that it is a good first step in trying to 
correct some of the problems, and this is something that 
Chairman Baker and I and others have worked on for quite some 
time.
    First of all, let me ask each one of you if there is 
anything in that legislation that you do not agree with, or is 
there something else that we could add before we go to the 
floor?
    Let me begin with you, Mr. Haaga.
    Mr. Haaga. There are no broad topics in the current version 
of H.R. 2420, broad provisions, with which we disagree.
    I think we want to talk about some of the language, 
particularly the language that specifies the duty of directors 
and make sure those provisions are drafted correctly and 
appropriately. But other than that, I think we are ready, but 
we do need to sit down with a pencil to tighten certain 
language.
    Mr. Oxley. One of the controversial areas that was 
considered, as you know, was the--an appearance of the board 
chairman. Has the ICI changed its position on that particular 
issue, which I understand was opposed to that change?
    Mr. Haaga. Let me talk about that, for a minute. I think we 
agreed with so much and supported so much of H.R. 2420 that I 
think people picked up on one area that we substantially 
disagreed with, and I think it has gotten too much attention. I 
have talked to our directors.
    Now, I am talking about American funds. I have talked to 
them about whether they want an independent chairman, and their 
response is that I think the response of many in the industry 
would be: For all practical purposes, directors are officially 
independent. They have a separate vote, a separate executive 
session of independent directors when they are going over the 
principal issues in which possible conflicts of interest lie. 
The contracts committee and approving the advisory agreement 
are separate meetings chaired by a lead director. That lead 
director, in effect, functions for all practical purposes as an 
independent chair, except in the circumstances where we are 
dealing with the administrative or non-controversial or non-
conflict issues. So I think I would. We still do not think it 
is an improvement or a good idea to require it.
    All mutual funds, have a two-thirds majority of independent 
directors, if the independent directors would like to vote for 
an independent chair, they certainly can. I would also add that 
it is no silver bullet. Three of the eight fund groups that 
have had the problems that have been cited so far, had 
independent chairs. One even had an independent compliance 
staff that reported solely to the board, so I think we want to 
be careful there.
    Having said all of that, I would like to discuss with the 
staff and with the committee chair and others some way to get 
through this and get some agreement here and figure out how we 
can structure this thing, because I think we are getting held 
up on something that we can solve.
    Mr. Oxley. Mr. Bullard?
    Mr. Bullard. Yes, I would make one significant 
recommendation. If I recall correctly, the bill that was passed 
only required the Commission to do a study on whether 
commissions should be required to be excluded in expense ratio, 
and I think that is--that should be changed to either it should 
be required to be included in expense ratio, or even better 
yet, as Mr. Phillips suggested, all portfolio transaction costs 
should be included in expense ratio.
    That expense can be larger than the entire expense ratio 
combined, and it is inexcusable that that is not something that 
the SEC has come out in front on and I would like to see the 
industry come out in front as well because that is an area 
where expenses vary greatly across different funds, so I do not 
know how you can compare funds when you do not have the tools 
with which to do it?
    Mr. Oxley. What about the issue of independent board 
chairman?
    Mr. Bullard. I am in favor of that. It, also, is not a 
cure-all. It goes without saying that all things being equal, 
an independent chair will be more independent.
    I think the best argument the industry makes is who do you 
want setting the agenda? Does it need to be someone who is 
advisable from the advisor or running the meeting or can it be 
someone who isn't necessarily as knowledgeable?
    My indication is the advisors and employees should be at 
the beck and call of the chairman, whether he is independent or 
not, and I do not think the chairman of this committee needs to 
be a mutual fund expert any more than the chairman of a mutual 
fund. The mutual fund's job is to make sure the shareholders 
are protected. Your job is to make sure the public interest is 
served and once you do, you go out and make sure you get the 
experts you need to get the job done.
    Mr. Oxley. Mr. Phillips?
    Mr. Phillips. I think visibility is perhaps even more 
important. We have had the case with Putnam with a number of 
whistleblowers, but none of them thought to go to the fund 
trustees, which says that we may have the right structures, but 
somehow they are not working in practice. I had the opportunity 
to speak several years ago with a gentleman who was on the 
board of a major mutual fund complex and oversaw a number of 
funds, and he was an independent director. He was also on the 
board of a publicly traded company and he made the comment to 
me that being on the board of a publicly-traded company, his 
identity was well-known and he received at least a dozen or so 
letters per month. He said he didn't always enjoy receiving 
those letters.
    In the aggregate, they made him a better director because 
they put him in touch with shareholders, but in working with 
mutual fund boards, he had never once referred a single letter 
from shareholders. There is no communication right now between 
investors and the independent directors who are supposed to be 
representing their interests. If we do not find a way to open 
up those communications and get some more visibility to the 
directors, it doesn't matter if they are independent or not. If 
they spend none of the time with the shareholders, ultimately 
they will end up reflecting the views of management, not the 
views of shareholders.
    Mr. Oxley. Why is that a failure? Whose fault is that? Is 
it the investors fault that they do not take enough time to get 
involved? Is it the structure? Is it a combination of those? 
What--and, obviously, the issue that we have is: Is it 
something that can be legislated?
    Mr. Phillips. I think it is incredibly healthy if we all 
think of mutual companies as investment companies and not 
investment products, even though top regulators oftentimes and 
other industry experts will refer to fund investors as 
customers. Mutual fund is not a product that you consume. The 
same way Ford Motor Company is not a product. When you buy corn 
flakes, that is a product. You do not have a board of 
independent directors to protect you on your consumption of 
corn flakes. There is a big difference between the two. 
Investors are more trained to be consumers. They do not think 
of themselves as owners. I think we need to put that front and 
center. The identity of the role of the independent director is 
something that has been relegated to the deep, deep, footnotes 
in marginal documents that an investor wouldn't typically 
receive.
    I think we need to bring this front and center. In my mind, 
one of the things that was so great about the 40 Act, and the 
reason it served the industry so long and so well is it came at 
a time when no one trusted mutual funds and the framers of that 
Act went out of their way to ensure investors that if they were 
to put their trust in a mutual fund, that their interest would 
be put paramount.
    I think the structure of the investment company is 
magnificent. As Jack Bogel said in this Sunday's New York 
Times, as an instrument for long-term investing, there exists 
in the mind of man no better vehicle than the mutual investment 
fund, but we need to get back to the spirit of it and the 
structure that that imposes as an investment company.
    Mr. Oxley. Thank you.
    Mr. Levitt, welcome back to the committee.
    Mr. Levitt. Thank you.
    I couldn't agree more with Don with selling mutual funds as 
soap and beer and corn flakes is just wrong.
    About 10 years ago, the head of one of the top 25 mutual 
funds in America met with me and I asked him about the 
difference between directors of corporations and investment 
companies, and he said, frankly, investment companies do not 
need any directors whatsoever, and I guess that has conditioned 
my thinking about this. I very much support the notion of a 
lead director, and I think the most valuable additions to this 
very sound legislation in my judgment would be adding fiduciary 
responsibility to the mandate of the 40 Act and maybe most 
importantly, the revelation of compensation of managers and a 
ban on trading by managers. I think these--again, when I say a 
ban on trading, I do not mean they shouldn't own shares in the 
entities they manage, but they should not be allowed to trade 
in and out of them, and the revelation of their compensation I 
think is terribly, terribly important.
    These are the additions I would suggest.
    Mr. Oxley. Well, obviously, you know, we have gone through 
that recently with the whole issue of publicly traded companies 
and more transparency and I think what you suggest certainly 
from our perspective makes a great deal of sense, in that more 
transparency normally provides for better governance and better 
understanding of the entire process.
    Thank you all for an excellent panel.
    Mr. Chairman?
    Chairman Baker. Thank you, Mr. Chairman.
    Mr. Frank?
    Mr. Frank. Thank you, Mr. Chairman.
    Mr. Haaga, you said you thought that the issue of the 
independent chairman, was getting too much attention. Well, I 
will explain to you why, the one issue in which there was any 
difference over the bill last time, and my advice is, give it 
up.
    I am skeptical. I must say it doesn't make much difference 
one way or the other and I heard the static you gave. If, in 
fact, we did a survey of the companies and tried to find out 
what differentiated them, whether they had a separate CEO and 
chairman wouldn't matter much. I would have to say I was not a 
great connoisseur of corporate boards before taking on this 
position as ranking member.
    I am singly impressed with them as a group. On the whole, 
the role of the corporate boards in almost all the standards I 
have seen is what Murray Camptom imputed to editorial writers. 
They come down from the hills after the battle is over and 
shoot the wounded.
    I am all in favor if people think it would help, we could 
have one. I think that is all we are going to need, but I also 
have a question for Mr. Levitt, because he was an extremely 
distinguished chairman of the Securities and Exchange 
Commission, and one of the issues that is now before us is the 
bill, H.R. 2179, that is being held up because of the dispute, 
although it is a lessening dispute over pre-emption, and I 
would be interested in how important--I do not know if you were 
familiar with all the details of all of that, but there were a 
series of requests, too, from the SEC for more enforcement, 
including, I think you were here when I read some of the 
serious increases, with regard to the Investment Company Act; 
it would significantly increase the penalties that could be 
levied, generally by a 500 percent figure, and it would also 
make it easier to bring them administratively. How important is 
the penalty structure, as a part of this operation, Mr. Levitt?
    Mr. Levitt. I think the penalty structure is part of it but 
not necessarily the most important part of it.
    Mr. Frank. Well, I understand, but we get more than one 
peck. It is not a case of whether you get only one peck; I 
mean, there are several things, several things that you get, so 
I would be interested in an evaluation of the penalty structure 
in and of itself. There are two separate bills, a bill on 
mutual funds that the committee voted out that has been held 
up, not at our request, and then there was the SEC bill that 
didn't get voted on. They were not competitive. If we get time 
to do both, it wouldn't take very long.
    Mr. Levitt. I am just not familiar with those bills to be 
able to give any meaningful comment. I am familiar with----
    Mr. Frank. That is not a rule around here, you know.
    Mr. Levitt. I have been--in terms of penalties I have seen 
extracted in cases of egregious fraud, I have often felt that 
they were far less effective, in terms of the deterrence of 
fraud than humiliation and embarrassment.
    Mr. Frank. Okay. Let me ask because I agree we have a 
problem with the culture here, and it is helpful to have a 
separate CEO, but how do you build in, you were talking about 
this, Mr. Bullard, how do you build in this sense, Mr. Levitt, 
you talked about it, too, when you said we do not need 
directors.
    Part of it is going to happen from the publicity. I must 
say as a mutual fund investor myself, I am now more aware of 
questions I should ask. I do not spend a lot of time on that, 
but I buy mutual funds and I ask questions. I will now be 
asking these questions and I think a lot of other people will, 
too, particularly those who buy mutual funds as fiduciaries for 
others. We have already seen this, with regard to pension funds 
and others, and people who kind of bundle other people's money 
and buy mutual funds will be more aware, so I think the 
transparency issue is going to work very well, but what would 
we do to try to institutionalize this, obviously, there are 
penalties, all these other things, but those are also signs 
there have been failures of the system. How--what would you 
build into the structure?
    We have one bill brought out of committee, there will be 
others. Are there any structural proposals you would make over 
and above what we are already seeing to make it better? Let's 
start with--yeah, go ahead.
    Mr. Bullard. What I propose is there be a mutual oversight 
fund board appointed by the SEC that would have examination and 
enforcement authority, and the need for that is that regulators 
in general are very good at enforcement and interpreting and 
objective rules, and, when it comes to boards, what you are 
dealing with is the traditional area of State, corporate law, 
which is the meaning of a fiduciary duty, and the SEC is simply 
not going to be the best vehicle for setting forth fiduciary 
guidelines for fund boards that go to the level of detail you 
would need to combat the late trading. You need a group that is 
going to say we have this trading issue.
    Here is what you need to do to satisfy your fiduciary 
duties, and to work with those boards and across all boards 
give them consistent guidance, as to what the expectations are, 
as to reviewing fees, reviewing trading, reviewing prospectus 
disclosure like market timing, and it is has to be a group of 
experts and a group that has enforcement authority. It would 
not be rule making authority. It would be the answer to what is 
a decades old problem in the industry and that is fund 
directors have been whipping posts of the fund industry for 
decades, and one thing I can say in their defense is there has 
been a real absence of strong guidance, exactly what they were 
expected to do at a minimum.
    Mr. Frank. Mr. Levitt, you ought to be allowed to comment 
on that.
    Mr. Levitt. I think that--I have said before that so much 
of this is a function of a cultural change that has swept 
America, and we are basically a friendly Nation. We go on 
boards of companies where we tend to know the chairman and 
other board members and we are reluctant to speak up when--once 
we are there.
    I do not know that that, in and of itself, is going to 
change, and I am not certain that any piece of legislation is 
guaranteed to change board behavior, but I think, if the 
responsibility is spelled out very specifically, as being a 
fiduciary responsibility, if the guidelines for those that are 
the custodians of the investment company assets, the fund 
managers, are bound by specific restrictions that could be 
imposed, either by regulation or legislation, I think that is 
about as far as you can----
    Mr. Frank. Let me finish with this, Mr. Chairman. I just 
want to break in. Seems to me what you are saying in part is 
since there is not enough natural orneriness around, since we 
all are intimidated by disagreeing face to face. It is not a 
pleasant thing. People do not like to do that, they shy away 
from that.
    The question is how do you build that in, and I think the 
question is you build it in by imposing legal liability. That 
is what we did, that is what the chairman of the industry did 
of the accounting industry. You basically say, I do not mean to 
be a bad guy here, but I got to protect myself, and when we 
kind of make it easier for people to be confrontational, I got 
to do that, and I say that because some of the criticisms we 
have heard of some of the people in the corporate world is: We 
make it too hard to find directors, because once you make them 
liable and once you hold them responsible, it is too hard to 
find directors.
    I think what you are saying, it has already been too easy 
to find directors and it ought to be too hard to find directors 
and people ought not to take on directorships, unless they are 
able to be different than the normal social views.
    Mr. Levitt. I also do not think we are looking in the right 
places for those directors. It hasn't been written in stone 
that you have to be a CEO to be a director. As a matter of 
fact, I believe that CFO's and CIO's and educators and others 
and people of good judgment, chances are they will be as good 
at their direct to recall responsibilities as overburdened 
CEOs.
    Mr. Frank. I understand, but I would also stress, you have 
helped me understand what is at stake here, and I think, as I 
think about this, I would be less willing to yield to an 
argument that would make it too hard to be a director. It ought 
to be hard to be a director.
    Mr. Levitt. Yes.
    Mr. Frank. And we have to build in institutional mechanisms 
to overcome this natural tendency to, A, one, pick your friends 
and then to get along.
    Thank you.
    Chairman Baker. Thank you, Mr. Frank.
    Mr. Royce.
    Mr. Royce. In addition to the issue of deterrence and 
adding criminal penalties as a way to change behavior, one of 
the real questions I have here is, on the question of 
compliance procedures: In these specific instances, where were 
the compliance procedures? Why weren't they strong enough for 
the funds or for the investment advisors?
    In the chairman's bill, we have taken certain actions to 
set up a chief compliance officer, so we will have that in 
place, but I was going to ask Mr. Haaga: In your view, how can 
the industry right itself in this area of compliance?
    Mr. Haaga. I think I would like to answer that question and 
also say something about directors, in light of the previous 
comments.
    The SEC has requested comments about a potential rule 
proposal requiring a specific compliance officer, it was both 
an SEC proposal and a provision in H.R. 2420, I think that is a 
very substantial assistance in this area and that we supported 
the rule, we support the legislation, and we look forward to 
complying with it.
    On behalf of directors, I have just got to say: This whole 
discussion is unfair to independent directors in a lot of what 
is being written and what is being said.
    I strongly disagree with Mr. Spitzer's characterization 
that this was a director problem, that they should have known. 
This was taking place in an area--in the delayed trading and 
market timing at an area--and a level where directors just 
cannot be aware of.
    That is our internal compliance shops that ought to have 
been picking that up and in many cases were picking that up. 
Probably the only word that I have used more often than shocked 
or appalled in the past couple of months is surprised. I have 
been involved for 32 years, and this is the first time I have 
ever heard of someone being involved in late trading. I am 
sorry that happened, but I have a hard time blaming independent 
directors for not finding something that 32-year veterans 
couldn't find because they simply didn't know it was happening.
    Mr. Royce. But the compliance officers would find it, that 
is their charge to find it.
    Mr. Haaga. I cannot guarantee that. I will say that it will 
be an enhancement and that they will find more things, and I am 
sure they will find late trading in the future. We do not need 
two wake-up calls.
    Mr. Royce. Let me ask you another question, because we had 
the suggestion here in the earlier panel that, perhaps, mutual 
funds should actively bid out management contracts to multiple 
advisors.
    On the surface, I think this sounds good, but are there 
issues involved here where we should be concerned about this 
proposal, in terms of its effect?
    Mr. Haaga. This issue comes up every so often over the 
years and it has a nice ring to it. It happens to be 
impractical. I think people who buy our mutual funds and set up 
their accounts with our companies are not expecting us to move 
management to another company. Let's remember that it is not 
just the shareholders. It is also advisors that they use and it 
is also the 401K Plan trustees who have selected the mutual 
funds and moving the investment advice away to someone else is 
certainly inconsistent with their expectations.
    The observation that is always made is, you know, mutual 
funds are not mobile and if mutual funds were mobile among 
advisors, then there would be better bargaining. That overlooks 
the fact that even though mutual funds are not mobile, 
investors are mobile and I think we have all seen the studies 
and seen the charts. The three largest selling fund groups 
would be three groups that have way below average expenses. 
Something like 80 percent of all investors are in funds that 
have below average expenses.
    So I think the results clearly prove that investors are 
mobile, investors are moving to the funds that are giving them 
the best results and the most appropriate, not lowest, but most 
appropriate expenses, and I do not think we have--we do not 
have to additionally make the mutual funds mobile, but I think 
it is a terrible----
    Mr. Royce. But would it be a disincentive for starting new 
funds?
    Mr. Haaga. That would be one of the many problems involved 
in the proposal.
    Mr. Royce. Mr. Levitt?
    Mr. Levitt. I would like to make a comment on that. I think 
Mr. Haaga represents one of the finest best managed funds in 
America, so I would not take his observations to apply across 
the broad spectrum.
    What I would suggest is that directors carefully consider 
alternatives and define the fact that they have considered 
alternatives to justify the retention of management.
    I do not believe that the continuation, the failure to 
change managers in the overwhelming number of instances is any 
more of a failure than the failure of analysts, sell-side 
analysts, who 98 percent of the time recommend buys rather than 
sales. That doesn't happen in a vacuum, and I think that it is, 
should be, the responsibility of directors to justify their 
selection, rather than merely going along with it.
    Mr. Royce. And, so--and so you would move down that--down 
the path towards encouraging this.
    Would you mandate it legislatively?
    Mr. Levitt. Generally speaking, I am reluctant to consider 
legislative mandates. Every time I have put something in stone, 
in terms of governance or issues of that kind, I have looked 
back and found that I have endured unintended consequences.
    Mr. Royce. Thank you, Mr. Levitt. Let me ask one more 
question, if I could, Mr. Chairman, and I wanted to ask Mr. 
Haaga, Attorney General Spitzer, in his testimony here, pointed 
out that fund investors are charged some 25 basis points a year 
more than pension investors.
    Are individual fund investors being treated in your view 
unfairly here or are there legitimate reasons for this cost 
differential that exists between the two investor classes?
    Mr. Haaga. I think there are very legitimate reasons. Among 
other things, we are dealing with a retail investment vehicle. 
We are not dealing with simple portfolio management. The sum of 
the cost differential is in the total expense, not just in the 
advisory fee, relates to the fact this is a big chunk of mutual 
fund expenses are paid to an individual advisor that advises 
the shareholder. Pension plans do not have that. They do not 
have individual advisors.
    It is interesting to note that where mutual funds or some 
mutual funds organizations manage funds, manage and serve as 
administrators and do the whole management thing for some funds 
and then simply serve as a subadvisor, only as a portfolio 
manager for a fund, which is an area which is much more 
comparable to managing the pension fund. It is just portfolio 
management, and, in those cases, their subadvisory fees tend to 
be very close to what is being charged to the Pension Fund 
because, in those instances, the services are much better.
    I guess I can go through a bunch of examples in our own 
firm and will not burden us with it, but I guess we can talk to 
the committee.
    I would say we have 6,000 employees. 200 of them are 
portfolio counselors or research analysts, actually about 200 
and a quarter.
    The other 6,000 are providing a lot of services and most of 
them are involved in providing services to mutual funds. To 
only look at what the cost of the 250, is missing a huge point.
    Mr. Royce. Mr. Chairman, thank you.
    Chairman Baker. Thank you, Mr. Royce.
    I just have one sort of clarifying question. Mr. Spitzer 
indicated yesterday that pursuant to charging some individual 
firms with trading abuses, finding them in law to be guilty, 
that he would then move to discourage all advisory fees during 
the time in which the alleged allegations took place.
    Given your comment earlier today, in favor of restitution 
for wronged individuals, is that an appropriate remedy in your 
view in those cases where you have reached a final accord in a 
court?
    Mr. Haaga. I would love to be responsive, but I cannot. I 
do not really know the facts involved, and, really, that is 
going to be between the Attorney General and the individuals, 
and I will go back to my previous comment about nearly 200,000 
people. When you take money from an organization, you take it 
from everybody, so I hope maybe we can find some ways to punish 
the wrongdoers financially and not merely punish someone who is 
appalled by the wrongdoing, and that is all I will say on that.
    Chairman Baker. And I do not want to see folks get fined 
for defrauding an investor and have it go to a governmental 
agency. I want it to go back to the people. That seems to be a 
radical thought, but I really think we ought to give it a try.
    Mr. Haaga.
    Mr. Haaga. That I can support unequivocally.
    Chairman Baker. Do you have anything else, Mr. Scott?
    Mr. Scott. Thank you, Mr. Chairman.
    I want to get your response, Mr. Haaga, and then from some 
of the others on two of the fundamental areas that is causing a 
lot of credibility thoughts with the investors of mutual funds.
    One is the late trading, and the other is the market 
timing, and I wanted to get your response on how you felt we 
should deal with these, and, specifically, to one 
recommendation that you may feel, particularly with the late 
trading.
    If we required that all orders be received by the fund, 
rather than by the dealer broker or his intermediary prior to 
the 4:00 p.m. Closing date at net asset value, would that 
eliminate illegal late trading?
    Mr. Haaga. I can never say for sure it would eliminate it, 
but I cannot see how you could do it.
    You would need collusion and you would need it at the fund 
group, and we receive these things through technical systems 
and so I think about it, but I am having a hard time imagining. 
I use the term ``slamming the window shut'' and I think it 
really does.
    Mr. Bullard. Okay. Since we have already had allegations of 
collusion with fund companies, there is no reason to believe 
that a 4 o'clock cutoff time would prevent the same type of 
collusion with respect to that cutoff time. The more important 
questions is whether people are going to comply with the rule. 
There will be marginal improvement. One reason is that it will 
put intermediaries out of the potential business of evading the 
rules, but as Congresswoman Biggert pointed out, that will 
impose costs on 401K plans and it will impose disproportionate 
costs and disadvantages to people invested in those plans, as 
opposed to individual investors or other institutional traders. 
So the real question is here: Why do we have a compliance 
failure, because the rules were clear before, and, if they are 
clear later, it is not necessarily going to make compliance 
better.
    Mr. Haaga. I disagree with that, but I won't repeat 
everything I said.
    Mr. Scott, if you don't mind, I would like to clarify or 
respond to a question that you asked earlier and that deserves 
a further response. You asked about the impact of the whole 
market-timing phenomenon on non-U.S. markets. Our firm, I won't 
say specializes, but we are well-known for our investments 
outside the U.S., or global international funds, and we have 
offices all over the world. To the extent that this market--
these market-timing problems have made global and international 
funds less attractive and made them earn less money for 
shareholders and brought less money into them, there is going 
to be less U.S. money that is invested outside the U.S., 
particularly in emerging markets, which is a big area of our 
investment, and that will have an impact. So we need to fix the 
international funds for the U.S. investors to help the non-U.S. 
markets.
    Mr. Scott. All right. I appreciate that. I think that those 
two issues, the late trading and the market timing, are 
probably two of the biggest concerns.
    Let me ask about redemption fee on short-term mutual sales. 
Would that help with the market timing or would it have too 
burdensome an impact on the institutional and noninstitutional 
customers?
    Mr. Haaga. Well, it will have a burdensome impact. And 
that--we have come to that reluctantly. I think all of us have. 
But we have concluded that it is necessary to--in addition to 
all the other remedies that exist in the market-timing area, 
that this is something that is worth doing despite the 
imposition on shareholders.
    There have been some studies about market timing that show 
that within the first one or two days you get at some enormous 
overwhelming majority of the advantages of market timing, you 
eliminate them; and so I think keeping a very short period we 
strike the right balance. It doesn't eliminate liquidity or 
doesn't reduce liquidity too much for shareholders. It lets 
them change their minds a few days after they invest it. But, 
at the same time, it gets at most of the market-timing problem.
    Chairman Baker. Thank you, Mr. Scott.
    Gentlemen, I certainly appreciate your participation at our 
hearing today. Your perspectives are very helpful to the 
committee's considerations. We look forward to working with you 
in the days ahead and hopefully coming to a speedier resolution 
rather than slower resolution on these important matters.
    Thank you very much, and our meeting is adjourned.
    [Whereupon, at 2:06 p.m., the subcommittee was adjourned.]


                      MUTUAL FUNDS: WHO'S LOOKING



                           OUT FOR INVESTORS?

                              ----------                              


                       Thursday, November 6, 2003

             U.S. House of Representatives,
     Subcommittee on Capital Markets, Insurance and
                  Government Sponsored Enterprises,
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to call, at 10:05 a.m., in 
Room 2128, Rayburn House Office Building, Hon. Richard Baker 
[chairman of the subcommittee] presiding.
    Present: Representatives Baker, Castle, Kelly, Shadegg, 
Green, Toomey, Kennedy, Tiberi, Renzi, Kanjorski, Hooley, 
Sherman, Inslee, Capuano, Frank ex officio, Lucas of Kentucky, 
Crowley, Israel, Clay, Baca, Matheson, Lynch, Miller of North 
Carolina, Emanuel and Scott.
    Chairman Baker. [Presiding.] I would like to call this 
meeting of the Capital Markets Subcommittee to order. I again 
advise that members are in various stages of travel to the 
committee this morning, so we will have others arriving. But in 
order not to unreasonably delay the proceedings, I thought we 
could start with appropriate opening statements. I am told Mr. 
Kanjorski will be here momentarily.
    The purpose of our hearing this morning is to continue the 
committee's work with regard to the adequacy of mutual fund 
oversight and regulation. I am particularly pleased to have the 
witnesses here today who can give us their particular expert 
view of recommendations for appropriate action. At the base of 
our consideration is H.R. H.R. 2420, passed out by the full 
committee, which sets in motion regulatory reforms the 
committee felt advised to adopt at that time. In the course of 
time since the bill was reported out, various inquiries have 
given the public knowledge of the broader base of concern about 
mutual fund management conduct. To that end, I will be 
appreciative of any perspective relative to H.R. H.R. 2420 and 
to any recommended additions which you might think advisable in 
light of the knowledge you have gained over the past months.
    It is clear that given the number of Americans who now 
invest in the mutual fund industry, the number of households 
who are directly invested in the marketplace, that resolution 
of this matter takes on a particular sense of urgency. I do 
believe it is in the best interest not only of consumers, but 
in the marketplace as well, to have the issues of governance 
resolved and behind us at the earliest possible moment. The 
numbers of individual investors are enormous and the flow of 
capital they provide to the marketplace is very important. To 
have confidence shaken and to have those investments on the 
economic sideline is not in anyone's best interest.
    To that end, I have discussed with Mr. Frank this morning, 
Mr. Kanjorski earlier, the desire to move the legislation at 
the earliest possible convenience and much of that process will 
depend, of course, on the agreements that can be reached on the 
various elements that perhaps would be part of a manager's 
amendment to H.R. H.R. 2420 on the House floor at a later time.
    I am particularly pleased that the participants in our 
first panel were able to be with us today. Mr. Galvin, your 
work has been extraordinary, and that of Mr. Spitzer as well. 
Although we have not necessarily agreed on all perspectives, I 
do believe that it is important for the policymakers and the 
frontline regulators such as Ms. Schapiro at the NASD, all have 
some consensus approach to resolution of this problem. I look 
forward to gaining that agreement on all matters and moving 
forward expeditiously. I think we all share the same common 
goal of providing for a fair, transparent marketplace in which 
all stakeholders are treated the same and where all rules are 
applied equally. I applaud you for your efforts to this date 
and look forward to working with both of you in the future.
    With that, I would yield to Mr. Kanjorski for his opening 
statement.
    Mr. Kanjorski. Thank you, Mr. Chairman, for the opportunity 
to offer my thoughts before we begin our second hearing this 
week on wrongdoing in the mutual fund industry.
    As you know, Mr. Chairman, the recent troubles at companies 
like Strong Capital Management, Janus Capital Group and Putnam 
Investments, among others, have caused me great concern. This 
unease led me to call upon you in late October to arrange for 
hearings so that we could identify the steps that participants 
in the mutual fund industry and their regulators are taking to 
protect investors's interests and restore investor confidence 
in light of these scandals.
    In my view, we have an obligation to American investors to 
monitor these developments. I therefore commend you for 
promptly responding to my request and others and convening 
these proceedings. With approximately 95 million investors and 
$7 trillion in assets, the dynamic mutual fund industry 
constitutes a major part of our securities markets. Heretofore, 
many experts had extolled the mutual fund industry for working 
to democratize investing of millions of average Americans, 
allowing them to easily participate in our capital markets with 
a diversified portfolio.
    During the last 2 months, however, we have learned about 
several alleged and/or demonstrated incidents of market timing 
and late trading abuses in the mutual fund industry. Because 
investor protection is a priority of mine on this panel, I am 
very concerned that the effects of these events on small 
investors who likely lost money as a result of these 
transgressions and probably became further discouraged about 
participating in our securities markets.
    I also believe that all participants in the securities 
industry have a responsibility to behave ethically and follow 
the rules. As a result, the announcement of each new case of 
misdeeds in the mutual fund industry has greatly disturbed me. 
Many parties are also now taking action to address these 
problems, including New York Attorney General Eliot Spitzer and 
Massachusetts Commonwealth Secretary William Galvin. The 
Chairman of the Securities and Exchange Commission has 
additionally noted that his staff is ``aggressively 
investigating the allegations and is committed to holding those 
responsible for violating the federal securities laws 
accountable, and seeking restitution for mutual fund investors 
that have been harmed by these abuses.''
    In addition, the Investment Company Institute has 
unambiguously reaffirmed that shareholders's interest must be 
placed before all else. As you also know, Mr. Chairman, I 
believe that it is very important for us to explore market 
timing and late trading problems in the mutual fund industry, 
as we have not previously examined these issues in the 108th 
Congress. Earlier this year, we considered and improved H.R. 
H.R. 2420, the Mutual Fund Integrity and Fee Transparency Act.
    In general, H.R. H.R. 2420 seeks to enhance the disclosure 
of mutual fund fees and costs to investors, improve corporate 
governance of mutual funds, and heighten the awareness of 
boards about mutual fund activities. Although we held two 
hearings in the Capital Markets Subcommittee to review numerous 
topics related to the mutual fund industry before marking up 
H.R. H.R. 2420 in the full committee, we did not specifically 
explore the issues of market timing and late trading. In light 
of the current public revelations about these abusive 
practices, I am consequently pleased that we are examining 
these matters now.
    Furthermore, Mr. Chairman, I share your concerns that our 
panel must continue to conduct vigorous oversight to examine 
whether our regulatory system is working as intended and 
determine how we can make it stronger. It is my hope that 
today's proceedings will help us to better understand the 
current problems in the mutual fund industry. Our goal in any 
further legislative efforts in these matters should be to 
ensure that we advance the interest of average investors by 
preventing these problems in the future and improving the 
performance of the mutual fund industry in the long term.
    In closing, Mr. Chairman, I look forward to hearing from 
our distinguished witnesses on these important issues. Mutual 
funds have successfully worked to help middle-income American 
families to save for early retirement, higher education and new 
homes. We need to ensure that this success continues.
    [The prepared statement of Hon. Paul E. Kanjorski can be 
found on page 252 in the appendix.]
    Chairman Baker. Thank you, Mr. Kanjorski.
    Mr. Castle?
    Mr. Castle. Thank you, Mr. Chairman. I do want to get to 
the witnesses. I will try to be brief. I just want to thank 
you, and I want to thank Mr. Frank and Mr. Kanjorski. I think 
you are doing absolutely the right thing. I think these 
hearings have been invaluable, just the hearings themselves, 
regardless of whether there is a product from them or not have 
been invaluable. I think the concept of moving this along as 
rapidly as possible, as you have indicated about H.R. H.R. 2420 
and the manager's amendment should put every one of us up here 
and everybody out there and everybody who is listening this or 
paying attention to this on notice that this is going to move 
quickly. I think we should. I think frankly there are abuses 
that have to be addressed so that we can prevent these abuses 
in the future.
    On the other hand, I am cognizant of the fact that none of 
this is very simple. Every time I look at this or listen to one 
of our witnesses or have a meeting with somebody, I realize the 
complexities. It is not easy to have blanket rules that apply 
fairly to everybody. So we are going to have to work really 
hard to make sure we do it correctly. I think we are doing the 
right thing by moving forward rapidly, but we need to move 
forward in a way that is going to be beneficial to everybody 
involved, with whatever we are going to do versus what the SEC 
is going to do, or whatever.
    I would also like to thank those who have really brought 
this to light. Mr. Galvin is one of those people. Mr. Spitzer 
is another. There is some discussion about the state versus the 
federal. My judgment is there is certainly a role for both. I 
think frankly if the States did not inspire this, perhaps the 
SEC would not be quite where they are today. I, for one, 
appreciate that. I also appreciate those good regulators 
represented here and otherwise who have come forward to make a 
difference. It just seems to me that there is potentially a 
good team effort here if we do all this correctly to take this 
industry, which is of extraordinary importance to the investing 
American public. Fifty percent of Americans have some 
involvement in mutual funds, and that may even be an 
understatement, if you really understood all your pensions and 
everything else.
    It is just absolutely vital that we run it correctly. It is 
not to be run as some sort of a market-timing piggy bank for 
those who are trading by the second or whatever. It has really 
always been established to be more of a long-term investment 
vehicle and we have to return it to them. I think we are taking 
a lot of very good steps here. So I do appreciate the hearings, 
and I appreciate all that you are doing. I, for one, stand 
ready to help in any way I possibly can.
    I yield back.
    Chairman Baker. Thank you, Mr. Castle, for that kind 
statement.
    Mr. Frank?
    Mr. Frank. Thank you, Mr. Chairman. I very much agree with 
what the Ranking Member of the subcommittee, the gentleman from 
Pennsylvania had to say. I think we are ready to pass 
legislation that will strengthen the law regarding the 
protection of investors in mutual funds, both the mutual fund 
bill and then parts of the SEC's request, which would enhance 
SEC powers. But it is also clear that much of what has happened 
shows the importance of enforcement of the laws that are 
already on the books.
    In that regard, particularly since I am going to have to be 
off at other meetings with some legislation, I welcome a former 
colleague of mine, of my colleagues Mr. Markey and Mr. 
Delahunt, the Secretary of the Commonwealth of Massachusetts, 
Bill Galvin, with whom I served in the Massachusetts House. I 
am very proud of the work that he has done in very thoughtfully 
and very seriously uncovering abuses.
    I think it ought to be very clear. We in Massachusetts, of 
course, have followed Mr. Galvin's work very closely. There is 
sometimes the accusation that officials in the enforcement 
business are tempted to kind of demagogue or overdo it. Mr. 
Galvin's work has been meticulous. No one has proven or no one 
has even alleged any effort of excess. I want to repeat what I 
said on Tuesday, because sometimes I get the impression that 
when I say something, not everybody pays sufficient attention 
the first time. Mr. Galvin and Mr. Spitzer are elected 
officials. They are elected officials who have pioneered in the 
enforcement of technically complex, but quite important issues.
    It is not an accident that the areas where they have taken 
the lead are areas which affect the equity interests of small 
investors. We have national institutions for the enforcement, 
and there is an understandable tendency on their part to be 
concerned about systemic matters; to be concerned about 
liquidity problems for the whole system. Sometimes in that 
framework, matters of fairness for individuals when they do not 
accumulate to a systemic risk, can get lost in the shuffle. 
Here we have two elected officials, the Attorney General of New 
York and the Secretary of the commonwealth of Massachusetts and 
others who have taken their responsibility to protect the 
individual investor very seriously.
    I am glad they have done that. I am glad that we now have a 
consensus, I hope we do, that the authority that they now have 
to be participants in the enforcement process ought to remain 
undiminished. I think that argument ought to be considered 
settled, that there is no basis for any legislative action that 
cuts back on the role they have played. We have benefited as an 
economy, individual investors have benefited, and now I think 
the next step is for us to pass some legislation that will 
strengthen the ability of regulators, the SEC, the self-
regulatory organizations, and the state authorities.
    Sadly, given the great scope of this, there is room for all 
of them. We will not have too many enforcers. If and when we 
reach that point, I will be glad to have someone make the 
argument, but right now our job is to give them even better 
tools. They have done, particularly the State officials, a very 
good job of using the tools they have. So the answer is both to 
leave the current set of enforcement powers in place and to 
enhance the powers that the enforcers. I look forward to our 
doing that and I think we ought to be able to do it, at least 
begin the process on our side, before we bet out of here this 
fall.
    Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Are members desiring to give additional opening statements? 
If not, then I would proceed at this time to the participants 
on our first panel, again extending welcome to both. At this 
time, I would recognize Mary L. Schapiro, Vice Chairman and 
President, Regulatory Policy and Oversight, at the NASD, and 
certainly no stranger to the committee room. Welcome.

  STATEMENT OF MARY L. SCHAPIRO, VICE CHAIRMAN AND PRESIDENT, 
                REGULATORY POLICY AND OVERSIGHT

    Ms. Schapiro. Thank you very much, Mr. Chairman. Good 
morning.
    Mr. Chairman and members of the subcommittee, I very much 
appreciate the opportunity to testify today on behalf of NASD. 
NASD is the world's largest securities self-regulatory 
organization. They have a nationwide staff of more than 2,000 
who are responsible for writing rules that govern securities 
firms, examining those firms for compliance, and disciplining 
those who fail to comply. Last year, NASD filed more than 1,200 
new enforcement actions, levied record fines, and barred or 
suspended more individuals from the securities industry than 
ever before.
    The reprehensible conduct that has brought us all here 
today, which cheats the public and degrades the integrity of 
American markets, will not be tolerated. Any broker or firm 
that misleads a customer or games the system can expect to be 
the subject of aggressive enforcement action. NASD strongly 
supports H.R. H.R. 2420 and calls on Congress for its prompt 
passage. Indeed, in those areas where NASD has jurisdiction, we 
have already begun the rulemaking process to implement some of 
the principles of H.R. H.R. 2420.
    We have recently proposed a rule requiring disclosure of 
two types of cash compensation, payments for shelf-space by 
mutual fund advisers to brokerage firms that sell their funds, 
and differential compensation paid by a brokerage firm to its 
salesmen to sell the firm's own proprietary funds. Customers 
have a right to know these compensation deals which create a 
serious potential for conflicts of interest.
    Due to their enormous growth in popularity in recent years, 
NASD has paid particular attention to how brokers sell mutual 
funds. While NASD does not have jurisdiction or authority over 
mutual funds or their advisers, we do regulate the sales 
practices of broker-dealers who provide one distribution 
mechanism for mutual funds. Our regulatory and enforcement 
focus has been on the suitability of the mutual fund share 
classes that brokers recommend, the sales practices used, the 
disclosures given to investors, compensation arrangements 
between the funds and brokers, and whether customers receive 
appropriate breakpoint discounts.
    We have brought some 60 enforcement cases this year in the 
mutual fund area, and more than 200 over the last 3 years. 
Through our routine examinations, we have found that in one out 
of five transactions in which investors were entitled to a 
breakpoint discount, that discount was not delivered. Thus many 
brokers imposed the wrong sales charge on thousands of mutual 
fund investors, in effect overcharging investors by our very 
conservative estimate of $86 million in the last 2 years alone. 
NASD has directed firms to make immediate refunds, and in the 
next several weeks we will initiate with the SEC a number of 
enforcement actions seeking very significant penalties.
    Brokers are also prohibited from holding sales contests 
that give greater weight to their own mutual funds over other 
funds. These types of contests increase the potential for 
brokers to steer customers towards investments that are 
financially rewarding for the broker, but may not be the best 
fit for the investor. In September, we brought a case against 
Morgan Stanley for using sales contests to motivate its brokers 
to sell Morgan Stanley's own funds. The sales contest rewarded 
brokers with prizes such as tickets to Britney Spears and 
Rolling Stones concerts. This case resulted in one of the 
largest fines ever imposed in a mutual fund sales case.
    Over the last 2 years, NASD has brought more than a dozen 
major cases against brokers who have recommended that investors 
by class-B shares of mutual funds in which investors incur 
higher costs and brokers receive higher compensation. We have 
more than 50 additional investigations of inappropriate B-class 
sales in the pipeline.
    This kind of enforcement effort is continuing with great 
vigor at NASD. We are now looking at more than a dozen firms 
for their practices of accepting brokerage commissions in 
exchange for placing particular mutual funds on a preferred or 
recommended list. In this effort, we are investigating all 
types of firms, including discount and online broker-dealers 
and fund distributors.
    A more recent focus of ours has been an investigation into 
late-trading and market timing. In September, we sought 
information regarding these practices from 160 firms. Our 
review indicates that a number clearly received and entered 
late trades. Other firms are not always able to tell with 
clarity whether or not they had entered late trades. This 
imprecision indicates poor internal controls and record 
keeping, issues we will also pursue.
    As we continue our examinations and investigations into 
these matters, we will enforce NASD rules with a full range of 
disciplinary options, including fines, restitution to customers 
and the potential for expulsion from the industry. Mutual funds 
have also been a focus of NASD's investor education efforts. 
This year alone, we have issued investor alerts on share 
classes, principal-protected funds, breakpoint discounts, and 
we unveiled an innovative mutual fund expense analyzer on our 
Web site that allows investors to compare expenses and fees of 
funds and fund classes, and highlighting when they should look 
for discounts.
    All of these issues, breakpoints, after-hours trading, 
market timing and compensation agreements, are important to 
NASD because they are important to investors. We are committed 
to building the integrity of our financial markets and view our 
mission in the area of broker sales of mutual funds as an 
important component of that overall goal.
    Mr. Chairman, NASD supports H.R. H.R. 2420 and applauds the 
committee's efforts to bring increased transparency to the 
mutual fund industry. We look forward to working with Congress 
and the SEC on technical issues that may arise as H.R. H.R. 
2420 moves forward and the SEC proceeds with rulemaking to 
implement its provisions.
    I thank you, Chairman Baker and Ranking Member Kanjorski, 
for your leadership in this area, and again for inviting NASD 
to testify today. We are of course happy to answer any 
questions.
    [The prepared statement of Mary L. Shapiro can be found on 
page 271 in the appendix.]
    Chairman Baker. Thank you very much.
    For the introduction of our next witness, I was going to 
call on Mr. Frank. He has stepped out momentarily. In his 
absence, it is my pleasure to introduce the Honorable William 
Francis Galvin, the Secretary of the Commonwealth of 
Massachusetts, the Chief Securities Regulator for the 
Commonwealth, and express our appreciation again to you, sir, 
for your fine work, and look forward to your remarks.

     STATEMENT OF WILLIAM FRANCIS GALVIN, SECRETARY OF THE 
   COMMONWEALTH OF MASSACHUSETTS, CHIEF SECURITIES REGULATOR

    Mr. Galvin. Thank you, Mr. Chairman.
    I am Bill Galvin, Secretary of State and Chief Securities 
Regulator of Massachusetts. I want to thank you, Representative 
Baker and Representative Kanjorski, for calling today's hearing 
to examine abuses in the mutual fund industry. I also again 
want to thank Senators Fitzgerald, Akaka and Collins for the 
hearing they held on the Senate side earlier this week. By my 
rapid transactions back and forth, I am beginning to think that 
I am a little involved in market timing myself.
    Representative Baker, while we may not have seen eye to eye 
on all issues in the past, I do want to thank you for your 
leadership in this area. Months ago, long before the recent 
abuses came to light, you put the spotlight on mutual funds, 
governance fees and conflicts of interest, and you deserve much 
credit for your foresight and your commitment to America's 
investors in our securities markets. The bill you crafted, H.R. 
H.R. 2420, adds important disclosures and addresses areas of 
abuse that we have seen relating to fund sales practices and 
operations and I support it. In two specific areas I think it 
could go further, and I will address those in a moment.
    Today, half of all American households are mutual fund 
investors. Americans have nearly $7 trillion invested in mutual 
funds. Mutual funds are about more than money under management. 
Mutual funds are about the hopes and dreams of middle-income 
Americans, the hope of a financially secure and dignified 
retirement, the dream of a college education for a child. 
Mutual funds are where America's dreams are invested. With the 
decline of interest rates paid on savings, mutual funds have in 
many instances become the substitute bank of necessity for 
middle-income Americans seeking a reasonable return on their 
savings. Investors have placed their trust in mutual funds with 
the understanding that they would be treated fairly; that fund 
managers would do their duty as fiduciaries. Unfortunately, we 
are here today because in too many instances the mutual fund 
industry has failed to live up to its fiduciary duty.
    The common theme running through all the mutual fund issues 
that we have exposed in recent months is that the mutual fund 
industry is putting its own interests ahead of its customers. 
Mutual funds have often promised trust and competence and 
delivered only deceit and underperformance. Another reason we 
are here today is because industry self-policing and government 
oversight have failed to effectively protect the mutual fund 
investor. In too many instances, a culture of compromise and 
accommodation has overwhelmed enforcement efforts. Too often 
the guilty neither admit nor deny any wrongdoing, and routinely 
promise not to cheat again until they come up with a better way 
to do what they just said they would not do again.
    The merry-go-round of accusation and non-admissions goes 
around and around, while investors lose. It has taken the 
coincidence of dramatic and tragic recent investor losses and 
aggressive state enforcement by people like Attorney General 
Spitzer and myself to convert investor outrage to a call for 
action. Any suggestion that state regulators have hindered 
federal enforcement of securities law is completely false. Any 
effort to restrict or preempt state enforcement must be called 
what it clearly is, anti-investor. Let's be clear. Mutual fund 
investors should have an equal opportunity for profit and an 
equal opportunity for risk. Mutual funds should be precisely 
that, mutual in all aspects.
    Unfortunately, that is not the case. Our investigations 
have revealed that special opportunities exist for certain 
mutual fund investors at the expense of the vast majority. We 
have uncovered insider trading at its worst, fund managers 
exploiting their inside knowledge for personal profit at the 
expense of their customers. We have uncovered a pervasive 
pattern of breach of duty and corporate deceit at Putnam 
Investments, the nation's fifth largest mutual fund company. 
Simply put, investors were being cheated. In August, my office 
uncovered a hidden compensation scheme at Morgan Stanley, 
including cash prizes and other lucrative benefits designed to 
push Morgan Stanley funds on unsuspecting investors who were 
seeking honest advice.
    Even more recently, this week, my office charged five 
former Prudential Securities brokers and branch managers with 
fraud in a scheme that enabled off-shore hedge fund clients to 
profit at the expense of mutual fund shareholders. The 
particular complaint alleges in vivid detail how a group of 
brokers, with the active connivance of managers and a see-no-
evil attitude by the company, were able to manipulate the 
mutual fund trading system for the benefit of certain select 
clients, to the detriment of the fund. Company policies against 
market timing and short-term trading were clear. Disciplinary 
action was nonexistent. For the sake of enriching themselves 
and their hedge fund clients, the branch managers and 
registered representatives allegedly engaged in fraudulent 
tactics and financially harmful trading activity and no one 
stopped them.
    These enforcement actions are only a few examples of deeper 
problems in the industry. Mutual funds violate investor trust 
when mutual funds allow market timing by their employees; when 
mutual funds allow market timing for certain outside investors, 
perhaps as an incentive to generate or retain business; when 
mutual funds allow late-trading in a funds's shares; when 
mutual funds pay higher commissions to brokers or offer other 
incentives to sell proprietary or in-house funds to investors, 
rather than funds that might be more suitable to an investor's 
needs; and when breakpoint discounts are ignored or concealed.
    As in the case involving Putnam, Morgan Stanley and 
Prudential Securities, state securities regulators are often 
the best and first to identify investment-related problems and 
to bring enforcement actions to halt and remedy these problems. 
H.R. H.R. 2420 is a positive response to the many problems 
investors in the mutual fund area now face, and I endorse its 
objectives. I endorse its provision to enhance the independence 
of fund board members and audit committees; to improve the 
disclosure of fund fees and expenses; to make board members 
responsible to oversee soft-dollar arrangements; to require the 
Securities and Exchange Commission to study soft-dollar 
arrangements, frankly I think they should be banned altogether, 
and other disclosure issues; to prevent funds from restricting 
share redemptions and require funds to hire compliance 
officers.
    The bill can be improved, however. I believe the bill could 
do more. First, instead of studying and disclosing soft-dollar 
arrangements, I would ask you to consider an outright ban on 
them. Funds should simply seek the best price and execution for 
their portfolio trades. At best, soft-dollar arrangements 
obscure the true cost of mutual fund overhead and they 
artificially inflate funds's trading costs. In far too many 
case, soft-dollar arrangements constitute severe conflicts of 
interest for fund managers because brokerage firms provide 
benefits to those managers in exchange for a portion of the 
fund's trading transactions. Soft-dollar arrangements have been 
criticized for many years as a fundamentally abusive practice, 
so this is not a matter that requires further study. Instead, 
we must act now to draw a bright clear line prohibiting soft-
dollar arrangements by mutual funds.
    In addition, it may be appropriate to advocate that section 
2(a)(1) of the bill be amended to restore the requirements that 
each investor receive disclosure of the fund costs and expenses 
paid by his or her fund account, rather than the costs payable 
on a hypothetical $1,000 investment. This would make disclosure 
more meaningful to individual investors. Prompt passage of this 
bill is important to bring the regulation of mutual funds to 
the level of regulation that their role in our financial system 
demands. The laws alone are not enough. They must be vigorously 
enforced.
    Representative Baker, I know that you share my opinion that 
this sort of behavior, the corrupt culture, is deplorable, 
outrageous and unconscionable, a serious breach of duty and 
trust, a betrayal of customers's faith, and that their 
interests come first. In these cases, I am afraid, greed trumps 
good business practices. I want you to know that we will not 
rest until we get to the bottom of this and punish those 
responsible. Investment in our markets is built on trust. This 
behavior is equivalent to picking the customers's pockets. 
Market timing, which is essentially day-trading, sends a simple 
message to long-term investors, do as we say, not as we do. 
Fund customers, long-term investors, did not know their money 
was being managed by day and traders out for themselves.
    These charges involve Massachusetts companies. The cases 
have had a profound impact on the image and reputation of local 
companies, and that is of great concern to me. I know people 
who work at these firms and so does my staff. These companies 
employ Massachusetts residents. They pay state taxes. They give 
to local charities. The actions of a few at these firms have 
put the jobs of many at risk, and threaten to destroy the 
reputations built over many years.
    This further underscores that our markets are built on 
trust, and how fragile that trust can be. For a relatively 
small amount of money, management winked at corrupt behavior 
and risked the reputation and future of multi-billion dollar 
enterprises. This case should be a lesson to others. Our 
investigation took many weeks. It involved substantially my 
entire securities division. We deposed people, took pains to 
corroborate testimony, talked to legal and other experts before 
deciding to move forward with formal charges. We are very much 
aware of what impact our actions could have had, and we acted 
with a sense of sadness as well as a sense of duty to investors 
in Massachusetts and across the country.
    Representative Baker and members of the committee, I again 
want to commend you for focusing attention on these issues. 
With tougher laws and vigorous enforcement, we can give our 
nation's investors the fairness and honesty they seek and the 
protection they deserve.
    Thank you, and I would be happy to answer any questions.
    [The prepared statement of Hon. William Francis Galvin can 
be found on page 254 in the appendix.]
    Chairman Baker. Thank you, Mr. Galvin.
    I would start with you in just making a statement I have 
made on many occasions for the record in your presence, that I 
do not contemplate, nor do I think any other member 
contemplates, any statutory provision that would on its face 
preclude, hinder, obviate or in any way limit the ability of 
any state regulator to pursue any cause of action they believe 
pursuant to investigation worth pursuing.
    The only question is with regard to provision 8(b) of H.R. 
2179 as to whether that language would in any way have 
precluded any of the conduct that state regulators have engaged 
in, there being a difference of opinion. I do not view it as 
being restrictive in any way. But in trying to come to some 
accommodation, we recently had the voluntary association of 
yourself, Mr. Spitzer, the SEC, and NSIA, in trying to come to 
some closure on how to get to the principle, which is under the 
provisions of NISMIA, State legislatures are prohibited from 
enacting State law that would affect national market structure.
    The theory, I believe, is consistent, but I would be 
hopeful, and not necessarily expecting a response immediately, 
but for your own evaluation, at least a consultative role with 
the SEC. I understand Mr. Spitzer, at least press reports as of 
yesterday, was contemplating potential settlements with various 
mutual fund violators and in the course of that announcement 
indicated that they would consult with the SEC in reaching 
final determinations in that matter. I think that would be a 
great way to get this matter behind us and move on. I think it 
has become unnecessarily distractive to the much broader and 
more important goals contained in H.R. H.R. 2420. I certainly 
would want to extend that concept to you and certainly would 
appreciate your thoughts if you have any on how we could move 
forward.
    Mr. Galvin. If I may respond, Mr. Chairman. First of all, 
thank you for the thoughtfulness. I do feel that the language 
of the previous bill that you referred to was problematic. I 
will tell you also that I think in many respects the problem 
that is allegedly solved is not a problem. I have not, and I am 
not aware of any instance where state action has preempted or 
prohibited the federal Securities and Exchange Commission from 
taking action, either in Massachusetts or elsewhere. As far as 
our conduct in Massachusetts, it has been our practice when we 
think it appropriate, which in most of these cases that is the 
case, to work closely with the SEC.
    Chairman Baker. I guess my point was, just to give you the 
reasoning for the approach, when Mr. Spitzer reached the 
Merrill settlement, it was without the SEC's involvement and 
there were market structure consequences. When the Merrill 
settlement was rolled into the Global settlement and the SEC 
was at the table, the problem went away. So that is the 
operative condition that from my initial reasoning for bringing 
up the concept, is just have the SEC at the table.
    I think as a matter of practice, if that is what you are 
telling me you would normally engage in, all we need is some 
agreement, statement, NSIA leadership somewhere, that 
conceptually your initial motive in pursuing these matters is 
not to write national market structure rules, but to go after 
wrongdoers, and in the course of the remedy phase if it does 
affect national market structure, coordinate it with the SEC. 
That is I hope not unreasonable.
    Mr. Galvin. I do not think your stated goal is unreasonable 
at all. I was just starting to say that our experience has been 
that we consult with the SEC usually on many cases. But 
oftentimes, for instance in the Prudential case that I just 
referred to in my testimony, both the SEC and other regulators 
have been involved in reviewing that. There were aspects of 
that case that the SEC chose to charge that we did not. I 
believe they believe that it is in the better interest of the 
industry that they pursue aspects of that case, and we 
certainly consulted with them. Before we brought the complaint, 
we advised them.
    Similarly in the case of Putnam, I personally called Mr. 
Cutler and informed him of our plans with regard to Putnam. I 
do not feel that I have to do that in every instance, and I do 
not think I should. I have to protect Massachusetts investors. 
But I do think it is important to consult with people, 
especially, as you suggest, when a remedy is being crafted that 
may have significant implications.
    The larger cases that you referred to earlier, the Merrill 
Lynch case, and as you know, Massachusetts was assigned Credit 
Suisse First Boston in the Global settlement issues. There was 
consultation at every level, but I think those cases were 
somewhat unique because we were in fact not only operating for 
ourselves, but indeed for other jurisdictions, and indeed for 
the country, in investigating at NSIA's behest, the operations 
of Credit Suisse First Boston.
    My concern is that these enforcement actions are often 
adjudicatory. They are adversarial. Any language that can be 
used by those who are accused to say, well, you do not have 
jurisdiction, will certainly be asserted by them. We have not 
seen instances, and I have yet to be told of an instance, where 
there has been a specific problem where something a state has 
done has prevented the SEC from taking action. I think the 
reality is that the States often hear about problems, as we did 
in Massachusetts on a number of issues, first. Most of the 
cases, if not all of the cases, with the exception of Credit 
Suisse First Boston, which we brought in the last year, were 
cases that began in Massachusetts. The conduct began in 
Massachusetts. We were in a unique position to hear about it. 
We acted upon it. We pursued our investigation. We certainly 
did not conceal anything from the SEC. We conducted joint 
depositions with them in a number of instances.
    So I really do not think there is a problem, but I 
understand your sincere interest in making sure that it does 
not affect national market issues. I certainly think 
consultation and further collaboration among the regulators on 
an informal basis is certainly worthwhile.
    Chairman Baker. I appreciate that. I am beyond my time, but 
it is my understanding that your inquiry with regard to the 
Strong fund, that there was a manager actually timing his 
mutual fund trades for the benefit of the hedge fund which he 
operated?
    Mr. Galvin. That would be no. The hedge fund cases that 
presently we have, although there may be others, in the 
Prudential case, Strong is not one of ours. Where we had 
managers actually doing it for themselves was Putnam. The thing 
that makes it particularly offensive is that the company knew 
about it for up to 3 years, and these people were left in 
charge. The company acknowledged on their own, after we issued 
a subpoena, that they had collaboratively taken about $700,000 
in profit, these fund managers. It was clearly insider trading, 
but they took no action against it. In fact, they concealed it 
and they denied it, which is one of the reasons that we acted 
against Putnam so promptly.
    I am pleased that you brought up the issue of hedge funds. 
I would like to invite your attention, Mr. Chairman. One of the 
things we have seen in our investigations is that for market 
timing to be worthwhile, there has to be a lot of money moving 
through. For instance, in the Prudential case that I just 
referred to, if you read the complaint in detail, it was hedge 
funds that were moving through. In fact, hedge funds in effect 
were being flushed through the mutual funds to take the benefit 
of the profit away from the smaller investors.
    I think at least there should be some study directed, 
perhaps in your bill, H.R. H.R. 2420, given the role that hedge 
funds play, given the fact that they are largely unregulated, 
and that they are now interacting with this very large segment 
of our financial services system, I think that role has to be 
explored. I would also like to invite your attention to the 
fact that there are financial holding companies that are 
totally unregulated, that hold large equity interests in mutual 
funds, and make a great deal of profit off them. These are 
largely unregulated.
    I think what we have to do is bring the regulation of 
mutual funds up to the role that it deserves, given the role it 
plays in our economy and given the role it plays in our 
financial services system. As I mentioned in my testimony, it 
is indeed the bank of necessity for many Americans and I think 
it has to be treated as that.
    Chairman Baker. Thank you. Just a real quick one. Mr. 
Galvin, I am sorry the time has gone so far. As I understand 
current rule, the Fair fund is a recipient of fines levied by 
the SEC for distribution back to defrauded investors. Do fines 
currently levied by the NASD, are they subject to distribution 
pursuant to the Fair fund, or is that something not now 
permissible?
    Ms. Schapiro. It depends on the particular case, Mr. 
Chairman. For example in the Global settlement on the research 
analyst conflicts of interest, all of the NASD fines went to 
the Fair fund and were not taken in by NASD. In a number of 
cases that you will see over the coming year, that will also be 
the case.
    We also strive in our own cases directly to get restitution 
to investors where they are identifiable, and do that through 
our own.
    Chairman Baker. In the interest of time, let me just 
request that if there are statutory reasons that we need to 
address to enable the expansion of the Fair fund reach from an 
NASD perspective, I would really request that. I am so far 
beyond the time limit, let me recognize Mr. Kanjorski.
    Mr. Kanjorski. I will take up the appropriate time, Mr. 
Chairman.
    Let me back up from the specifics of the individual things 
that you are involved in, and ask some questions in terms of in 
these instances of prosecution of timing and late trading, were 
they clearly illegal under existing law?
    Mr. Galvin. Mr. Kanjorski, we believe they were, and I will 
tell you why. Our theory is that they are fraud because in most 
instances the prospectus that was presented to the average 
investor said there was not going to be any market timing, 
there were not going to be rapid trades.
    Mr. Kanjorski. If they had made a disclosure in their 
prospectus that there would be market timing, would that have 
freed them?
    Mr. Galvin. It might have in some of the cases, in some of 
the fact patterns, but it certainly would not have in the case, 
for instance, of the fund managers that I just referred to at 
Putnam who were market-timing their own fund. That was clearly 
a breach of their fiduciary duty. That was insider trading. It 
clearly would not in the case of the brokers who were promoting 
large fund passes-through, because clearly the practices they 
were engaging in, I am speaking now of the Prudential case, 
they in fact used 62 different bogus identities to conceal 
their various transactions. So I think that in general these 
things are there. If your point is that I think there needs to 
be a clearer definition of market timing, I would agree with 
that. I think maybe the bill that is under consideration might 
provide that opportunity.
    One of the problems that I think we have seen in this 
industry is that they have a very great tendency to parse 
words. They will parse words even when practices that are 
clearly unethical, they will describe as not illegal. I think 
it is time to make sure that there is a parallelism between 
unethical practices and illegal practices.
    Mr. Kanjorski. Looking at some of the testimony that 
occurred in the Senate earlier, it seemed to me that there was 
an indication that almost 25 percent of the industry engages in 
these practices. From listening to your testimony, you said 3 
years of practice at one of these companies. So this is a long-
occurring situation, and very pervasive.
    Mr. Galvin. I believe it is. Mr. Cutler in his testimony 
before the Senate the other day referred to a survey the SEC 
had completed. The 25 percent statistic was 25 percent that had 
late-traded, which is clearly illegal, no one is disputing 
that, and about half that had market-timed.
    Mr. Kanjorski. That being the case, that it has continued 
for a number of years, that it is pervasive in the industry, I 
mean, our job is not to guarantee very transaction is performed 
legally, but it certainly seems to me a governmental and 
regulatory responsibility that these things do not go 
unnoticed. So it seems to me that there is a fundamental 
breakdown in the regulatory system, both at the national level 
and even perhaps at the state level, of getting to this 
information. It further seems to me that the reason that 
happens is that we really do not have inside capacity to 
understand what these organizations are doing until a 
whistleblower comes forward or until an extreme situation 
occurs where we focus a great deal of light on the subject.
    I was incensed to hear that one of the whistleblowers, I 
think that gave you the case, went to the SEC in March and 
nothing was done until you took action. So even though it had 
been pervasive and long-occurring before that, it did not seem 
to tilt. The explanation made for that by the regulator was, 
well, we were concentrating on other things. I am not sure that 
the American public or the Congress intends regulators to pick 
the flavor of the day, if you will, on what they are going to 
concentrate on. I can tell you quite frankly I assume that if I 
put money in a bank, the OCC or the Federal Reserve or the FDIC 
is regularly auditing and making sure and doing random audits, 
if not direct audits, to determine whether there is illegality, 
embezzlement or other activity occurring in that financial 
institution that threatens the depositor. That obviously is not 
happening in the securities industry.
    It seems to me in some of these instances they just 
recently had gone through a review by the SEC and were found 
not wanting. That is short of shocking to me. It sort of says 
to me what we call regulation is not regulation. It is only 
emergency action taken after it escapes from confidentiality 
within the firm to the public and then something is done about 
it. For all intents and purposes if that whistleblower had not 
come to you, they would still be operating. They would still be 
rewarding themselves. Everybody would be going on. And you 
agree that what they were doing is clearly illegal under 
existing laws.
    Mr. Galvin. We do. Let me just speak to that. We frequently 
are benefited by people in the industry. I think that says good 
things about the industry. I want to leave the impression with 
the committee that there are very ethical people in the 
financial services industry. The fact is that people inside the 
industry get upset when they see these kinds of practices and 
come forward. I will tell you, since these issues have emerged 
more publicly even since last Monday's hearing, my office has 
been inundated with additional information relating to this.
    I think the fundamental point you make is valid. Namely, 
there have to be more audits. There has to be clearer 
disclosure, required disclosure, both to regulators as well as 
to investors. There is a parallelism between mutual funds and 
banks in the sense that they are a repository for such a large 
part of our national savings. Obviously, there are differences, 
too, because there is risk involved, and that is part of the 
whole concept. But I do not think that excuses them from the 
oversight and presenting the information on a regular basis to 
regulators and to their investors, so that it can be examined 
and followed. I think there is where the gaps are presently in 
the system.
    Mr. Kanjorski. A lot of these firms are advertising 
extraordinary profits, when in fact it is not substantiated and 
they are not doing it. So they are misrepresenting in the 
marketplace. To limited investors who do not have the time to 
spend going through annual reports and all the studies, and 
with a fairly sophisticated knowledge of financial 
transactions, they rely on these representations as being true 
and accurate. Now, from your testimony and Ms. Schapiro's 
testimony, I gather we really do not know. These are open 
entities out there saying whatever they want to.
    What I am trying to get at is, the one thing that we want 
to protect, it seems to me, is the small, unsophisticated 
investor, so they can stay in the equity markets without 
retreating to deposit accounts. Banks had a reputation for 
making loans and doing nefarious things in the 1920s. We solve 
it very easily by putting an insurance program into place, 
which meant that there would be a premium and bad actors would 
pay higher premiums. Following the insurance, it required 
auditing and investigation on a very real-time basis. Is there 
any merit to thinking about instituting a small investors 
insurance fund that would require more periodic audit and 
investigation techniques to be used on some of these 
institutions?
    I know that the majority of the institutions are sound, 
honest, full of integrity. So in a way by doing that we would 
be punishing the good firms in order to get the bad firms. But 
we could institute situations like the CAMEL ratings so that 
the bad actors would be identified. The light of day would be 
shined on, and there would be an incentive within the industry 
itself to shine the light on the bad actors and get them out of 
the field.
    I think we have to do something, because I had the thought 
when I heard the testimony in the Senate. There have got to be 
guys in New York that are going down to the Harvard Club or 
some other club and sitting there and saying, damn, look what I 
did today; I turned a million bucks, and we did this and this, 
and we were involved. And the guy sitting next to him says, 
gee, I only ripped off $100,000 today; I have to go back. And 
some honest guy is sitting there and saying, man, I must be a 
fool. I am living on just what I am getting paid on my salary 
and I am not ripping anybody off, and it is pervasive in the 
industry so I better get into it.
    I think that is what has happened. We have allowed it to 
happen so long that when I hear 25 percent of an industry is 
engaging in illegal activity, we have to blow the whistle and 
we have to find a mechanism that protects the honest, protects 
those that act with integrity, protects the sound operator, and 
get at the bad actors. Sometimes the bad actors are not 
necessarily the funds themselves or the institutions 
themselves, but sometimes the employees and personnel. But we 
have to find some mechanism and regulation to get there.
    Would you give any thought on that?
    Mr. Galvin. My thoughts are that, again, audits are very 
helpful. I think there has been a climate of accommodation. I 
think that is one of the problems, and this is pervasive 
throughout the securities industry. There has been a history 
when you come to regulation of accommodation that suggests, 
well, they don't admit they did anything wrong. They will pay a 
fine, but they will never admit and deny they did anything 
wrong. Well, that has to stop. We have to get findings. We are 
going to insist on findings in these cases in Massachusetts; 
admissions they did do things wrong. There is no question about 
it. That way, you can establish what the standards are and you 
can punish those who are guilty.
    As far as an insurance fund, I think the problem with that 
that I perceive is that we are dealing with risk here. If you 
are talking about an insurance fund for fraud, that is one 
thing.
    Mr. Kanjorski. For fraud.
    Mr. Galvin. For fraud, because that might be worthy of some 
review, but I think it is risk. That is what makes it 
appealing, that people get in because they are going to get a 
higher return because there might be some there.
    In terms of the way funds present themselves, very often 
funds present themselves talking about their past performance. 
I think probably the greatest lack of understanding of the way 
funds are presented, apart from the sales practices problems 
that I addressed and Ms. Schapiro addressed also, is the issue 
of they are talking about past performance. They are not 
talking clearly about fees. The fees that are being paid and 
the costs that are incurred, and the classifications of shares, 
those are the things that I think the average investor is not 
being given clear and digestible information.
    The fact is that most people who go and look at mutual 
funds do so because they think it is a safe place to be. They 
either are unsophisticated or they prefer to be 
unsophisticated. They decide that somebody else will do the 
thinking for them. It is reasonable. That is kind of the 
service that mutual funds are marketing. They are saying there 
is safety in numbers. But unfortunately what we have uncovered 
is that everyone is not treated the same. That is the 
fundamental problem that some of these issues have presented.
    Chairman Baker. The gentleman's time has expired.
    Mr. Castle?
    Mr. Castle. Thank you, Mr. Chairman.
    Mr. Chairman, it just occurs to me in all this we have been 
going through that with the changes in technology, when you get 
into the issues that are non-pure fraud, the market-timing 
issues and issues like that, there is just huge change that is 
rapidly happening, but in our enforcement and everything else, 
we need to keep that in mind. It reminds me of our currency. We 
are changing our bills now on a regular basis because of the 
ability to be able to copy them too easily. The same thing 
pertains here. A lot of this is computers. I do not think we 
can introduce legislation to eliminate computers, so we need to 
make sure that we are ready to deal with this.
    I would like to start with Ms. Schapiro, if I can, because 
I am worried that we are missing the forest for the trees. This 
is probably a little beyond the subject of this hearing, 
candidly, but on page nine and also in your oral testimony, 
under investor education you talk about a number of things that 
the NASD has dealt with. I think that is important. But it 
seems to me that all these fees are significant. We obviously 
want to eliminate the fraud, and I am for doing all those 
things.
    And maybe you just didn't do it because it is not part of 
this, but you do not mention talking about the tax consequences 
of mutual funds, which can be a huge problem to an individual 
investor, much greater than some of these fees issues. For 
example, 2 or 3 years ago, all these funds had made a lot of 
money over a long period of time. Then they had a lot of sales, 
so they had to sell a lot of their securities. Obviously, they 
had great capital gains and they have to pass them on. So you 
had the double hit of you paid big taxes if you were an 
individual, but your mutual fund values also had gone down.
    Also, there is no discussion here of market risk, which is 
even a much bigger factor perhaps than anything else we have 
talked about. I assume that the NASD is very cognizant of these 
things and does some education in that area, and is not 
ignoring them. It is just not in your testimony. Maybe you 
would feel a little bit better about that.
    Ms. Schapiro. I would be more than happy to provide you 
with our investor alerts. You make excellent points. We of 
course talk about the tax consequences. I think we all 
personally felt the pain of paying taxes on declining-valued 
mutual funds over the last several years. We talk about the tax 
consequences there. We also talk about it in the context of 
changes to the tax law and what that has meant, for example, to 
variable annuities.
    Mr. Castle. Not to cut you off, but you do focus on this. 
You just do not have it in your testimony.
    Ms. Schapiro. We focus on that, and we always focus on 
risk; that people have to understand the risks of all these 
different investment options that are before them. I would be 
happy to send out a package of the investor materials.
    Mr. Castle. Okay, and perhaps the sheet funds which go 
riskless because they do not want to take any changes; a whole 
different issue.
    Let me switch to Attorney General Galvin, if I can. I am 
very interested in what you said in your testimony, again on 
page eight, about the soft-dollar arrangements. The definition 
of ``soft dollar'' has always eluded me a little bit, which is 
part of my problem here. But I assume that the soft dollars 
pertain to the costs of a mutual fund in terms of their actual 
transactions and that kind of thing. So there are some real 
costs there. But are soft dollars just the amount above what 
the real costs would be? How can you just eliminate that? I am 
very intrigued with the idea of doing that, frankly, so I want 
to know how we can do it. I am not questioning that. I just 
want to know how to calculate it.
    Mr. Galvin. I think you have to understand that soft 
dollars came into play after a 1974 decision by the SEC that 
further restricted fees. Soft dollars cover research, but they 
also now have been abused. Clearly, research is necessary for 
any mutual fund to operate and that is a legitimate cost, but 
that can be an identifiable cost. There is no reason it should 
not be identifiable. Now what is happening is soft dollar costs 
include other things such as office overhead, such as costs of 
conferences, and other hidden ways that people can get 
compensation. It gets back to the relationships within the 
mutual fund sales practices and within the mutual fund itself.
    I think one of the things the present bill, H.R. H.R. 2420, 
does a very good job of is starting to set up a model for how a 
mutual fund would operate, a directorship, if you will, 
explaining the audit committee, who the directors have to be. 
This issue of soft dollars flows in the same way.
    Mr. Castle. Not to interrupt you, but you said at the end 
of this, by prohibiting soft dollar arrangements by mutual 
funds. Are you saying you prohibit certain abuses, but you 
include certain things which are allowable by defining them 
specifically in the legislation?
    Mr. Galvin. Defining it. The way you would have to do it 
would be to define them. If there is actual cost relating to 
research, you would have to put that into the cost assignable 
to the individual account. As opposed to saying, this is soft 
dollars; it is a fuzzy thing.
    Mr. Castle. Right. It is too generic. It is too broad.
    Mr. Galvin. And it is abused. That is where some of the 
problems come in. The relationships here are often inherently 
engaged in conflict of interest and it creates more problems. 
When you have a receptacle that you can toss it into, it is a 
slush fund, if you will.
    Mr. Castle. Thank you. I will not ask you any more on that, 
but I am interested in that language. I think we all are. If 
there is a sense that we can do that, I think it would be a 
major improvement.
    Back to Ms. Schapiro, on the 12(b)(1) fees, which concern 
me a great deal, as I understand 12(b)(1) fees, they were 
basically introduced as a marketing-type of fee arrangement for 
mutual funds up to a certain percentage of something. I find 
now that mutual funds that have already closed still have 
12(b)(1) fees. It seems to me that we have created multiple 
categories of fees; 12(b)(1) fees are ones that are disclosed. 
But my question is simply, should we eliminate 12(b)(1) fees? 
Or should we somehow redefine them so that in certain instances 
they cannot be charged? It seems to me it just gets more and 
more confusing. I would rather see one set of fees and not a 
series of three or four fees, and you add it all up and 
whatever it may be. I just think it is more confusing.
    Ms. Schapiro. I agree with you completely. I think the 
single most important thing the SEC and the Congress could do 
in this area would be to require clear, concise and simple 
disclosure of all of the costs of owning a mutual fund, front-
end loads, contingent deferred sales charges, 12(b)(1) fees, 
administrative and management fees, directed brokerage, soft 
dollars.
    It is virtually impossible for an investor to understand 
generically, let alone for their own personal account, what are 
the fees and expenses that they are paying. They have to look 
in multiple places in the prospective, in the statement of 
additional information, in the fee table, to try to find this 
information, put it together for themselves, and then to try to 
compare across funds is virtually impossible.
    So I truly believe the single most important thing that 
could come out of all of this would be honest, complete, simple 
fee disclosure for investors that gives them comparability.
    Mr. Castle. Thank you, Ms. Schapiro.
    Thank you, Mr. Chairman.
    Chairman Baker. Thank you. The gentleman's time has 
expired.
    Mr. Crowley?
    Mr. Crowley. Thank you, Mr. Chairman.
    Attorney General, I know you have relations in some regard 
with the work of Attorney General Spitzer in New York. Do you 
think that has been effective in terms of cracking down on the 
scandals, as limited as they may be, in the mutual fund 
industry? If so, would you support or oppose legislation that 
would strip Mr. Spitzer or any State official from 
investigating and prosecuting these criminal offenses?
    Mr. Galvin. I will start of by saying I am the Secretary of 
State in Massachusetts. I have the civil jurisdiction with 
regard to securities regulations. Criminal activity in 
Massachusetts would be handled by our Attorney General. We 
often refer matters when we see criminal conduct.
    Mr. Crowley. Would Attorney General be a promotion or a 
demotion in your state?
    Mr. Galvin. It is hard to know.
    [Laughter.]
    Mr. Crowley. Okay.
    Mr. Galvin. In any case, we often refer matters when see 
criminal activity. Our focus, however, is on the civil side and 
it is primarily two things. One is to try to make the investor 
whole, and I am very pleased that we have a very good record. 
We have returned about $20 million to Massachusetts investors 
that they were defrauded of. The other is to police the 
industry. We do refer criminal matters when we see them. We 
refer them to the Attorney General of Massachusetts, to the 
United States Attorney General. When we were handling the CSFB 
matter, we were going through e-mails that we felt reflected 
criminal conduct. We referred that to Attorney General Spitzer 
and other New York prosecutors because we felt that was the 
appropriate place for jurisdiction.
    I addressed earlier in my remarks the issue of preemption. 
I would be very concerned about any effort to preempt. I had an 
extended colloquy with the chairman relating to that. 
Obviously, there are legitimate concerns about making sure that 
one group of enforcement does not adversely affect the other, 
particularly in terms of national market policy. But I am not 
aware of any instance where that has occurred. The danger I 
think is much greater on the other side.
    If you look at preemption at something that would stifle 
state enforcement activities, which as I pointed out in my 
earlier comments, these are often adversarial proceedings. The 
securities industry is very ably represented in these matters. 
They are certainly going to allege any opportunity they can or 
take any opportunity they can to allege lack of jurisdiction. 
So therefore I would be very concerned about any effort, 
however well meaning it might be, that might create a situation 
where State regulators would not be able to perform the task 
that we now do. I would perceive that as anti-investor.
    Hopefully, these recent cases and these matters where we 
have worked fairly closely with any range of regulators, from 
the SROs as well as the SEC, demonstrate that I think we can 
work collectively together.
    Mr. Crowley. Thank you, Mr. Secretary.
    For both of you, in the hearing before the Senate last 
week, Chairman Baker sat side by side with Attorney General 
Spitzer at that hearing. Chairman Baker revived a proposal that 
would strip out of his bill, H.R. H.R. 2420, which would 
require an independent chair as head of a mutual fund. I have a 
few concerns about that. One, wouldn't this mean in essence 
that Charles Schwab, for instance, could not head his own 
company? And wouldn't that result in putting inexperienced 
people on board who do not necessarily know the business and 
can be more easily hoodwinked, than by veterans who know all 
the issues?
    Secondly, I agree with the U.S. Chamber of Commerce, and it 
is not often that I say that, when they say, ``to be an 
effective chairperson, a person must be intimately familiar 
with the operations of a company. Forcing a mutual fund to 
utilize a chairman not familiar with the operations of the 
company could severely impact its progress and success.''
    Thirdly, I fear a regulatory slippery slope as many of us 
as well as industry were told by the Republican staff of this 
committee, that Chairman Baker and the Republicans would like 
to extend the independent chair requirement to all of corporate 
America. I believe that, as well, would be wrong for American 
business and American investors.
    I also understand that the SEC and the GAO told this 
committee that the inclusion of this independent chair 
requirement is unnecessary in assisting mutual fund 
shareholders.
    What are your both of your thoughts on the independent 
chair issue?
    Ms. Schapiro. I think the goals of H.R. H.R. 2420 and the 
corporate governance movement generally to dramatically 
increase the independence of board members is very, very 
important, and particularly important in the mutual fund area, 
where as we have all discussed, so many people count on so few 
to do a good job. When those few don't, the consequences are 
pretty devastating and dramatic.
    My experience in observing the corporate world is that the 
increased independence of corporate board members has had a 
very important and positive effect post-Sarbanes-Oxley on how 
corporate America conducts its business.
    Mr. Crowley. What about the chair?
    Ms. Schapiro. I guess I do not have a strong feeling one 
way or the other. I think it is absolutely worth exploring. I 
do not think it will hurt. I think people will find good chairs 
of boards and good board members even if they have to be 
independent and not affiliated with the mutual fund or the 
adviser. So I do not see a downside. Whether there is a great 
up-side, I am not really in a position to judge.
    Mr. Crowley. Secretary Galvin?
    Mr. Galvin. I would certainly endorse the idea of an 
independent board. Obviously, what we have seen in terms of 
governance up to now has been inadequate in terms of protecting 
the investors because there are inherent conflicts of interest. 
I think in the case of the chair, it comes down to this. I 
think it should be advanced as a hypothesis that we have an 
independent chair. If there are particular circumstances that 
arise where people of great expertise would be excluded for 
that, I think that case needs to be made during the course of 
debate.
    I know you are anxious to get the bill out, but it seems to 
me it will not take too long to ascertain whether that becomes 
an onerous requirement. It would be a goal that would be worthy 
of pursuit. If it turns out that you are excluding people of 
great skill and talent, or unique skill and talent, then it 
might be something that would have to be reconsidered, which 
might be offset by having a sufficiently high number of 
independent directors on the board itself.
    Mr. Crowley. My time has expired. I thank the Chair.
    Chairman Baker. I thank the gentleman.
    Mr. Tiberi?
    Mr. Tiberi. Thank you, Mr. Chairman.
    Let me follow up on Mr. Crowley's last question. The 
current language in H.R. H.R. 2420 creates a two-thirds 
majority independent board. What I have argued in the past is 
that those independent directors if they choose, can choose an 
independent chair. If they choose not to, they can choose not 
to, but two-thirds of the board shall be independent. Mr. 
Galvin, what is wrong with that?
    Mr. Galvin. There is nothing wrong with it. I just endorsed 
it. I think it is an excellent idea, and I think that is the 
more important point. What I am saying with respect to an 
independent chair is that that would be a goal. In an ideal 
world, it would be wonderful. I do not know. I think the 
problem that Mr. Crowley pointed out is that you might be 
excluding people of unique skill. I am not making his argument. 
I am sure he is very capable of making it himself.
    Mr. Tiberi. Let me interrupt you. I think we are in 
agreement here. If we have an independent requirement for two-
thirds of the board, aren't those members in the best position 
to decide who the chair should be?
    Mr. Galvin. I think they are. I guess the question is, are 
there abuses out there, and maybe there are and maybe there 
aren't. This is an evolving situation that suggests the chair 
is a unique person in a unique position. One of the things that 
came out of the Senate hearing the other day is that there are 
a number of officers, and I won't name the company because I do 
not want to mis-name it, where in a given family of funds, 
individuals sat on the boards of 85 or 100 different funds. How 
much time could they possibly devote to their duties, and 
presumably they were being compensated in each and every case. 
How much time could they actually devote to their duties? So 
there is a danger here that you are simply stacking the deck 
with even so-called independent people
    I think one of the other real problems, and it is a genuine 
one, and I don't know that we can solve it here this morning, 
is that we are asking independent chairs to step up to their 
fiduciary duty. We are expecting to do a great deal. I can 
imagine independent individuals saying, what do I need that 
for? It is going to be hard to recruit the caliber of people we 
really want in the number of funds that are out there, but I 
think it is necessary. I think what we have seen makes it 
necessary.
    To answer your question specifically, sure, if the board is 
truly independent and they can designate an independent chair, 
I think that will go a long way. I do not want to simply 
abandon the concept of an independent chair. I think it just 
needs to be explored. I can see legitimate arguments, 
particularly if it is a fund that requires particular 
expertise. Let's say it is a technology fund, and somebody who 
has a particular expertise in the market. There may be 
individuals out there that are uniquely qualified to be the 
chair.
    Mr. Tiberi. But why should we mandate that? Why shouldn't 
we just let the two-thirds of the independent board do it?
    Mr. Galvin. I am not sure that we should.
    Mr. Tiberi. Okay.
    Mr. Galvin. That is my answer to you. I am not sure. I am 
just saying I would not abandon it as a goal and say it is 
impossible. Let's explore it. Let those who would be excluded 
or those who would be concerned about their exclusion, come 
forward with specifics, as mentioned earlier. This whole 
subject matter is in some respect complex. This is another 
example of that. But it does not mean that we cannot get the 
answers. There are X number of funds out there. We can find out 
very rapidly where the problems are. The funds I am sure are 
very ably represented in this room right now. I am sure they 
can come up with the answers that you need for the discussion.
    Mr. Tiberi. Ms. Schapiro?
    Ms. Schapiro. I don't disagree at all. I guess one thing 
that we could maybe even hope for is that it becomes a point of 
differentiation to have an independent chairman if those two-
thirds elect an independent chair, and that that would be a 
distinguishing factor for a fund to demonstrate to the world it 
is taking its corporate governance issues very, very seriously.
    Mr. Tiberi. Thank you. You both endorsed H.R. H.R. 2420 as 
a positive response. We passed it here at the end of July 
unanimously on a voice vote. Much has happened since then in 
the mutual fund industry. We may take H.R. H.R. 2420 to the 
floor next week or the following week. Much may happen in the 
next month and a half or 2 months. Do you both believe that in 
general some of the abuses that have occurred, number one, are 
illegal? And number two, people will go to trial?
    Ms. Schapiro. Clearly, the late-trading is illegal. I 
believe people will go to trial and suffer severe consequences 
from that. With respect to market timing, as we have talked 
about, it is a little bit more complicated. Nonetheless, for 
our jurisdiction which extends only to brokerage firms, not to 
funds, anywhere where we see that a broker-dealer has 
essentially colluded with a mutual fund to help a customer 
evade market timing restrictions that are contained in the 
fund's prospectus; anywhere we have seen an insurance company 
work to market-time variable annuity sub-accounts; or we have 
seen a broker-dealer set up multiple accounts for a customer in 
order to facilitate their market timing, we will move very, 
very aggressively, and those people will be subject to strong 
sanctions.
    Mr. Tiberi. Mr. Secretary?
    Mr. Galvin. We believe that every case we brought will have 
the jurisdiction to complete action. We certainly think that, 
as I mentioned earlier, in the cases where fund managers funded 
in their own funds and where they used deceptive identities to 
trade or where they colluded, as Ms. Schapiro mentioned, we 
believe we have sufficient authority. I think the benefit of 
perhaps clearer and more definite language would be to send a 
message to other people out there in the funds. I go back to 
what was pointed out earlier. I think the statistics being 
offered by the SEC about the extent of market timing are indeed 
shocking. If that is the case, clearly there are many companies 
out there that need to be told clearly that this is illegal. So 
I certainly see no damage by doing something like that.
    Mr. Tiberi. Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Mr. Miller?
    Mr. Miller of North Carolina. Thank you, Mr. Chairman.
    I also want to ask about governance issues. We were here 
just a few months ago addressing specific practices that many 
regard as abusive. Now we are here discussing others that we 
did not know about then. I am very concerned that we will 
continue to chase specific abuses unless funds are managed in a 
way, governed in a way that takes into account the investors's 
interests and not the management's interest.
    The concern that I have with independent directors is not 
whether we have enough of them, but whether they are 
independent enough. We tend to look at independence as being 
anyone who does not have certain prohibited employment 
relationships or certain prohibited family relationships. How 
can we make sure that we have directors who have the knowledge 
to exercise independent judgment and who will look closely and 
skeptically at what the fund is doing, with an eye toward the 
best interests of the investors? Can we define ``independence'' 
a little better?
    Mr. Galvin?
    Mr. Galvin. I think you normally use the criteria that you 
just outlined. I think in terms of independence, beyond that, 
as Ms. Schapiro has noted, it might be a selling point for the 
companies to identify people of high caliber; people perhaps of 
either financial or academic accomplishment; people who perhaps 
have been in another aspect of the financial services industry 
or in some other corporate location that have demonstrated 
skill.
    I do not know, given the number of mutual funds that we 
could possibly define it down to such a point that we could 
say, you have to have X amount of directors with this 
qualification, and X amount of directors with that. I think 
what maybe is needed, and again it is very hard to legislate 
ethics, but there may need to be some sort of a statement that 
clearly defines more clearly what a fiduciary duty is in the 
law. In that sense, what we really speak about when we talk 
about lack of independence among the directors, we are not so 
much worried about their lack of ability to read or understand. 
We are worried about the fact that there are conflicts of 
interest; that they are not putting the interests of the 
investors first; they are putting the interest of either the 
fund or the fund managers first, or other special individuals.
    I think maybe some codification of duty by the directors 
may go further to identify true independence, because that is 
really what we are looking for. We are looking for their 
actions to be independent. We are not so much looking for what 
are their particular skills, what composition do they represent 
of the investor base, whatever it might be. We are looking 
really for their duties to be independent, to be thoughtful, to 
be in the best fiduciary interest of the investors.
    Mr. Miller of North Carolina. Ms. Schapiro?
    Ms. Schapiro. The only thing I would add to that is that we 
talk a lot about the fear that we will not find directors who 
are both expert and independent. I think we can find 
independent directors and I think we can train people to be 
expert. We dropped the ball, to some extent I think, on the 
issue of educating intelligent, hard-working people who are 
independent, about how funds work. They may well be in a 
position to ask some very basic questions that clearly need to 
be re-asked of this industry and how it operates. Is all this 
complexity necessary? Are we adequately disclosing our 
performance? Are we adequately disclosing our fees? Are we 
doing everything we can to keep the shareholders's interest 
paramount?
    I think we can train people in the intricacies and give 
them the expertise they need, if they are in fact truly 
independent and if there is a will to do that. That is an 
expensive undertaking, but I think it is an important part of 
advancing the corporate governance here.
    Mr. Miller of North Carolina. Okay. Back in June, I asked 
about whether there should be some limit on the sheer number of 
boards that directors can serve on; that this is a little too 
sweet a deal for somebody serving on 80 or 90 boards, and 
presumably gets some substantial fee with respect to each 
board; that if you have that kind of financial stake in it, you 
are less likely to exercise independent judgment and ruffle 
management if you owe management that position.
    I felt like I was kind of blown off then. I backed off of 
that proposal, and I saw in the press clips that Senator 
Collins raised the same issue this week on the Senate side. Is 
that something we should look at?
    Ms. Schapiro. I think it is worth looking at. I do not 
pretend to know what the right number is, but I will venture to 
say that there is no way you can serve on the boards of 40, 50, 
60, 100 funds and do an adequate job. There are efficiencies 
and economies when you are looking at different funds within a 
fund family, and there are certain issues, the performance of 
the transfer agent and others, that may translate across all of 
the funds. But there are many issues about performance that do 
not. If you are paying careful attention as a board member to 
issues like performance, you cannot do it adequately serving on 
that many boards.
    Mr. Miller of North Carolina. Mr. Galvin?
    Mr. Galvin. I would certainly agree. I think whether you 
want to legislate a number, or you might find that difficult to 
do, or perhaps authorize the SEC by regulation to come up with 
some sort of a number or plan might be the better approach on 
that, but I am sure you are capable of coming up with 
something, but I definitely think it is something you might 
want to address.
    Chairman Baker. The gentleman's time has expired.
    Ms. Kelly?
    Mrs. Kelly. Thank you, Mr. Chairman.
    Ms. Schapiro, in the Senate hearing on Monday, Eliot 
Spitzer stated several conditions that companies have to meet 
``to get a settlement with my office.'' They included things 
like a compliance program that would guarantee that no 
violations would occur again. He also included the full 
disgorgement of all fees that were earned related to any fund 
during the time that the illegal behavior occurred. Did you 
work with Eliot Spitzer on any of those conditions that he set 
forth?
    Ms. Schapiro. No.
    Mrs. Kelly. I am sorry. Did you say no?
    SCHAPIRO. No. To date, the cases that have been announced 
have largely involved the fund groups themselves. Again, we do 
not have jurisdiction over the funds, only over broker sales 
practices with respect to mutual fund distribution. We are 
working very closely with the State of Massachusetts, with the 
SEC, and with other regulators on a large number of 
investigations in the fund area, some of which do involve 
market timing and late trading, but they also involve 
inappropriate shares of B-classes, directed brokerage issues, 
sales contests and so forth.
    I think regulators working together here is particularly 
critical. I see this most acutely from where I sit. As I said, 
we do not have jurisdiction over mutual funds. We do not have 
jurisdiction over hedge funds. So it is important for the 
regulators who do have different jurisdiction to work together 
so that we can try to bring together as comprehensive a 
resolution to these issues as possible.
    Mrs. Kelly. Mr. Galvin, I would like to ask you a question. 
The SEC has actively lobbied states to return all fines and 
make restitution to the investors through the Fair fund. The 
chairman spoke about that. Do you think investors should be 
entitled to as much money as possible?
    Mr. Galvin. Yes. I regularly return it to them. I think the 
problem with the Fair fund which came up in the context of the 
so-called Global settlement is that no one seriously suggested 
that the cumulative amount of funds being paid to all entities 
under the settlement could ever even begin to compensate 
investors for what they lost. I recall a meeting on Wall Street 
discussing it. The point was made that we would not be 
returning cents on the dollar; we would be returning mils on 
the dollar. I had to remember what a mil was and realize how 
little it was.
    We work actively to return monies to our investors. That is 
very important for us. The Fair fund is a good-faith effort at 
doing that, but it is not the most efficient way. For instance 
just last week in Massachusetts, we had a rather tragic case 
involving a family that had trusted a relative by marriage who 
was a broker, and had squandered and taken away the money and 
spent it, and the family was totally destitute. They had lost 
all of their money. We were able to get it back for them. If 
that family had to go through some sort of an administrative 
proceeding in a Fair fund, obviously I do not think they would 
be getting back that much money.
    We oftentimes return money who are not represented by 
counsel, do not have lawyers, if we can get it back from them. 
That does not mean we are opposed to lawyers. I am a lawyer. I 
think lawyers are fine. We work with counsel. I think it is too 
simplistic to simply say there is going to be some Fair fund 
and all the money goes there.
    The second point as far as the monies going to the States 
are concerned, oftentimes the monies going to the States in 
fact pay for additional investigations. The cost of conducting 
these investigations is great. In the case of, for instance, 
the CSFB case that Massachusetts handled, we were confronted 
with hundreds of thousands of e-mails. I had to go out and 
recruit students from law schools to read through these e-mails 
to find material because the cost and the necessity and the 
scope of these investigations is so great. I think an effort to 
take all of those funds away would be a mistake.
    Mrs. Kelly. Mr. Galvin, you pointed out that without 
convictions or an admission of guilt, like we saw with the 
Global settlement, we have seen a lot of civil suits dismissed, 
as with the Global settlement. Don't you think this is another 
reason why we should require that all fines get returned to the 
investors, to maximize that amount of money? Just give me a yes 
or a no please.
    Mr. Galvin. All fines, no. I cannot give you a yes to that. 
There are costs involved. I think that the goal should be 
returning the money to investors, but you have to have the 
ability to continue prosecutions, and some of that cost has to 
be built into the settlement.
    Mrs. Kelly. Have you set up conditions to set up 
settlements? Or are you going to take this stuff to trial?
    Mr. Galvin. On the pending cases?
    Mrs. Kelly. On the pending cases.
    Mr. Galvin. No, we intend to take these cases to trial. We 
are certainly going to demand admissions. If there are 
settlements, it will be with admissions of wrongdoing. We are 
certainly not going to have cases where people are able to say, 
well, we did not do anything, but we will pay a fine. No, not 
at all.
    Mrs. Kelly. Ms. Schapiro, the NASD rule 2830 that you 
talked about expressly prohibits the award of non-cash 
compensation, and it prohibits brokers from favoring the sale 
of any mutual fund on the basis of brokerage commissions that 
they receive. Isn't the practice of selling mutual funds off of 
preferred lists where brokers paid more to sell the funds off 
that list widely practiced? If so, and I just want a yes or a 
no answer, are there widespread abuses of the NASD rule 2830 
that have gone unchecked?
    Ms. Schapiro. We have ongoing 12 investigations right now 
to determine whether funds have been inappropriately included 
on a broker-dealer's preferred list by virtue of having gotten 
directed brokerage, which is what 2830 goes to from that fund. 
We will be announcing a major case very shortly in the next 
several weeks. As I say, we have 12 major investigations going 
on.
    Mrs. Kelly. Thank you.
    My time is up. Thank you, Mr. Chairman.
    Chairman Baker. The gentlelady's time has expired.
    Mr. Inslee?
    Mr. Inslee. Thank you.
    I want to focus on the relative responsibilities and 
abilities of the federal and state regulators, if I can. I want 
to tell you that there is a perception out there on Main 
Street, at least the Main Street I walk down on my way to work, 
that the federal regulator has been grievously ineffective 
relative to the state regulators recently in this whole 
plethora of industry issues. I think there is some reason for 
that perception. I think it is not just a casual reading of the 
headlines. I think there is some actual reason to believe that, 
that there is some sort of systemic problem with our federal 
regulator in this regard that has not allowed them to be 
sufficiently aggressive or timely in these investigations or 
prosecutions.
    Now, realizing your close working relationship with our 
Federal government, I am not going to ask you to do too much 
critical thinking about their lack, or at least perceived lack 
of aggressiveness on this. But perhaps you can give us some 
thoughts as a colleague of theirs, if you can, on how to 
promote at least more timely action from our federal regulator, 
and share some of the positive experiences of your operation 
and others that you think the Federal government needs to think 
about utilizing as well, in the most positive way that you can 
put your comments. I am looking forward to your advice.
    Mr. Galvin. I think we have to recognize, and I think Mr. 
Frank alluded to this in his opening statement, that the 
federal regulators are looking at a bigger picture. They are 
looking at issues such as liquidity in the market. They are 
looking at the complete market. All too often, their focus has 
not been on the impact on small investors in particular.
    I think that that is in fact the advantage of the dual 
system that we now have, that the State regulators are more 
likely to see, it is a tired analogy by I will make it anyway, 
the cop on the beat, so to speak, and going to hear about 
something that has actually happened. In the case of 
Massachusetts, these issues arose in factual instances that 
occurred within the confines of the State of Massachusetts.
    If I were to make a constructive suggestion to the SEC in 
terms of enforcement, it would probably be that recognizing 
that it is a large bureaucracy and probably going to, in the 
interest of enforcement, grow larger, they have to find 
streamlined ways of promoting information up the channels to 
bring actions, and perhaps devolve more authority to some of 
the regional offices to commence actions. I cannot say for a 
certainty that that is a problem.
    I do sense, however, that like any bureaucracy, and I 
administer a bureaucracy as well, so I am well aware of its 
pitfalls, it is sometimes hard to get information up the chain, 
to let people know how to proceed. Oftentimes, especially in an 
industry that is so complex and so broad, and having so many 
individuals employed in it and so many individuals affected by 
it, there is such an overload of information it is hard to 
digest it all.
    So I think if I were to make a constructive suggestion, 
recognizing that the SEC's role has continued to be interested 
in the overall financial market, in terms of individual 
instances, it would be best to have some kind of streamlined 
system of proceeding with information that I am not sure they 
have right now.
    Mr. Inslee. Ms. Schapiro?
    Ms. Schapiro. It is a hard question for me because I am 
overseen directly by the SEC, and I spent 6 years there as a 
commissioner. I guess I would say just a couple of things about 
it. I think it is important that they have a more intensive 
examination program, that in the fund area in particular the 
examiners that the SEC employs need to spend more time in the 
mutual funds and in the advisers, and all regulators have to 
recapture a sense of skepticism about everything they see. The 
presumption that everybody is honestly doing business, and most 
probably are honestly doing business, has to become checked at 
the door when you are a regulator. You have to walk in, and 
everybody knows entering trades after 4 p.m. is illegal. I do 
not think anybody thought that that could possibly be going on 
on a widescale basis, and yet it was.
    So I think more examinations, more skepticism, and then 
more feeding of the results of examinations into the 
policymaking groups on a real-time basis so that where rules 
need to be written, they can be written and the enforcement 
program can move more aggressively and more quickly. I do 
believe the SEC's enforcement program, but that is the end of 
the chain, has worked quite aggressively over the last couple 
of years under Steve Cutler's leadership. I think some of the 
issues need to get to enforcement more quickly.
    Mr. Inslee. Do you think this legislation is a vehicle to 
look at some of these issues? Maybe that is outside your ken, 
but is there something unique enough about the mutual funds 
situation that in this legislation we ought to tackle some of 
those internal regulatory issues?
    Ms. Schapiro. I guess I am not really a good person to 
answer that question. I think the leadership of the SEC is very 
focused on tackling just those kinds of issues right now, and I 
have complete confidence that Chairman Donaldson will be able 
to do that. I think this legislation is very important for lots 
of other reasons, though, and Congress ought to move as quickly 
as possible to enact it.
    Mr. Inslee. Mr. Galvin had one more comment, I think.
    Mr. Galvin. My only comment was I think the audit part of 
the legislation or the discussions about audits would be very 
important. I would echo what Ms. Schapiro said, that I think 
that is a very important tool in the hands of enforcement 
people.
    Mr. Inslee. Thank you.
    Chairman Baker. The gentleman's time has expired.
    Mr. Toomey?
    Mr. Toomey. Thank you, Mr. Chairman.
    I just wanted to focus a little bit on the market-timing 
issue. The late-trading seems to be pretty straightforward and 
a clear violation of any sensible set of rules regarding this. 
It is illegal. Market-timing, my understanding is, generally 
speaking, not illegal. My first question is, are there common 
practices of market timing that you think should be illegal? If 
so, why? That would be my first question.
    Mr. Galvin. I think market timing in general, unless it is 
a fund devoted to market timing, and I guess there are some 
entities like that, should be clearly illegal. I believe in the 
instances that we have uncovered, it was illegal. As we 
discussed earlier, in many instances it was made available by 
deception. It would certainly disadvantage the average 
investor.
    Mr. Toomey. Could you explain, what is the economic cost to 
an investor who does not participate in market timing, and 
created by someone who does?
    Mr. Galvin. There are a number of consequences. First of 
all, as I mentioned earlier, it is our feeling, and I think so 
far the evidence has borne out, that the amount of money being 
flushed through the system in market timing is dramatic because 
it makes it worthwhile doing. So therefore, the returns are 
dramatic. For instance in our case against Putnam relating to 
market timing by Putnam customers, we had a group of people who 
were boilermakers affiliated with a 401(k) out of New York. The 
market timers who were taking advantage of the special rules 
for them in that case, in some instances were making up to $1 
million simply on the market timing. That was coming out of the 
fund.
    Secondly, there are tax consequences, as already has been 
averred by others this morning, because the fund oftentimes to 
meet the demands of paying out these people at some time makes 
sales of stock, keeping its portfolio balanced. So there are 
definite disadvantages. But beyond the technical disadvantages, 
and we could go further into what they are, it is fundamental 
fairness.
    Mr. Toomey. There is a fairness issue that I think is one 
issue. But what I want to understand is, and I think if market 
timing is allowed, it should be available to everybody. If it 
imposes a cost on the fund, then the cost ought to be borne by 
the person engaging in the market timing. But what I want to 
understand is whether or not the fact that one party engages in 
market timing and even makes a profit from that, does that 
truly come at the expense of another investor who chooses not 
to? You mentioned there is a liquidity issue, and there may be 
transaction costs. Is that it?
    Mr. Galvin. We are not clear. You would have to analyze 
when the market timing was done, exactly to what extent it was 
done. As I mentioned, what we are looking at now are hedge 
funds doing it, large amounts of money passing through. There 
has to be an impact of that. It gets back to the inadequacy of 
some of the accounting that is presently done in these funds.
    Beyond the fairness issue, to assess the damage that has 
been done by it, I think you have to get into deep detail as to 
when they did it and how they did it, and what the costs were. 
The general accepted theory is that it is costing investors 
money. It may not be a great deal of money to each individual 
investor at that particular time, but then you have to look at 
not only the cumulative effect on the fund as a whole, but also 
the interest of the investors who are holding over the long 
term. Over the long term, it is costing them a more substantial 
amount of money because it aggregates in that way also.
    Mr. Toomey. Is it appropriate to deal with that by charging 
an appropriate fee to people who engage in market timing?
    Mr. Galvin. That is the so-called 2 percent solution. There 
is a proposal out there that would charge them a 2 percent 
redemption fee. The problem with those types of things, in my 
view, is that once you say, well, it is okay if, how do we 
enforce the ``if''? One of the biggest problems with this whole 
discussion is it gets extremely complex. We have so many mutual 
funds out there. We have so many people out there. If we are 
going to say, you can do it if you adhere to these rules, we 
have rules. They are in the prospectus. They did not adhere to 
them. In fact, they worked around them and the companies in 
many instances helped them work around it.
    Mr. Toomey. But that essentially is an enforcement problem, 
not necessarily a problem with the rule itself.
    Mr. Galvin. But it is the same problem. You cannot separate 
the rule from enforcement, in my opinion, because the rule 
without enforcement is meaningless.
    Mr. Toomey. I am not disputing that, but I still think that 
there is a separate issue here.
    I would like to hear what your thoughts are, Ms. Schapiro.
    Ms. Schapiro. What I would add to that is that if a fund 
wants to advertise in its prospectus that it allows marketing 
timing and it will impose a 2 percent redemption fee, and it 
uniformly and always imposes that fee on every customer, good 
customers do not get a special deal and pay only 1 percent or 
nothing, I have less trouble with that than I do with what 
seems to be the prevalent problem here, which is a prospectus 
that states, we discourage market timing and we will take steps 
against people who market-time our funds, and then look the 
other way while the best customers market-time the funds.
    To me, the disparity of how people have been treated, that 
there are special investors and not-so-special investors is 
really very offensive.
    Mr. Toomey. Right. It sounds to me what you are saying is 
that the misrepresentation of what is allowed or tolerated or 
condoned by the fund is more objectionable than the activity 
itself.
    Ms. Schapiro. The activity can be objectionable, because I 
think in addition to saying we are going to impose a redemption 
fee and we are going to impose it consistently, is I think you 
have to explain to investors what does it mean if you choose to 
be in this fund, even if you are not going to market time. What 
is it market-timers are taking out of the fund? What additional 
cost is their activity imposing on you? I guess it goes back to 
the earlier conversation that people have to understand the 
performance. This affects the performance of the fund. If they 
are going to allow market timing, even with a high redemption 
fee, everybody else needs to understand what the impact of the 
activity is on their fund value.
    Mr. Toomey. I agree with you.
    Thank you, Mr. Chairman.
    Chairman Baker. The gentleman's time has expired.
    Mr. Emanuel?
    Mr. Emanuel. I want to thank the chair for holding this 
hearing, as well as the one on Tuesday.
    I would like to follow up a little on what the Chairman 
asked as it related to hedge funds and mutual funds. As we look 
forward to drafting bipartisan legislation or going forward 
with some type of legislation, your thoughts in the area of 
mutual funds being able to have inside the shell hedge funds in 
the coordination. This is the second case brought today as it 
relates to a hedge fund and mutual fund, and the type of 
special treatment for special accounts. We are going to deal 
with market timing and we are going to deal with late trading, 
independent boards, and greater transparency.
    My worry here is intermingling of two worlds that have 
never come together in the past, one marketing to a different 
clientele than the other. Again, we have a culture that says 
``heads I win, tails you lose,'' that we are going to take care 
of a special client at the expense of all the average investors 
getting the short end of the stick constantly. I suppose it is 
not really a question that I just made, and I apologize for 
that, but your thoughts as we start to think about drafting 
legislation that affects these two worlds now starting to 
bounce into each other, or blend and become one.
    Mr. Galvin. I think it is something we have to think about. 
That is why I mentioned it earlier, and I am glad the Chairman 
mentioned it as well. You are right. The perception on the part 
of the average investor is they are investing in this safe fund 
that they share risk and opportunity. They could not define a 
hedge fund for you, and hedge funds are largely unregulated, so 
they are these powerful entities. The fact that we are seeing 
them surface in the market timing thing suggests that they are 
the type of entities that get special treatment. They are not 
the only ones. There may be large pension funds or 401(k) 
groups, so they are not exclusively the bad people in this 
situation. But I think the question is, if we are going to 
acknowledge that mutual funds are such an important part of our 
financial savings system, as I mentioned earlier, the 
substitute bank for many people, is it wise to have hedge funds 
participating on an unrestricted basis?
    I do not have an answer for you this morning, because I do 
not know whether eliminating them would cause a great problem 
in the marketplace. I am concerned that their action, though, 
interacting with mutual funds, is potentially problematic, and 
I certainly think there should be some disclosure. I actually 
think hedge funds should be a lot more regulated. I also 
mentioned in my earlier testimony as well the issue of these 
unregulated entities, holding companies that hold perhaps a 
hedge fund and also interest in a mutual fund at the same time. 
Those are things that I think at least ought to be focused upon 
by the SEC at the very minimum.
    Ms. Schapiro. If I could address the structural issue about 
hedge funds and mutual funds being potentially harmed by the 
same manager or in the same family. My personal view is that it 
is an untenable conflict of interest to have a manager have to 
select where their best transactions are going to reside, in 
the hedge fund which may be paying higher fees and in which the 
manager may in fact even have an interest; or the mutual fund 
which is dispersed among a lot of people and has less effective 
voice to it in the whole process. I do not understand how you 
can have a situation where the same person manages both the 
hedge fund and the mutual fund.
    Mr. Emanuel. Thank you. Again, it is a structural issue, 
but it again deals with the conflicts of interest, higher fees, 
a different clientele, at the expense, my biggest worry, is 
that it is at the expense of the average mom-and-pop investors 
who have college savings. This is also the one area, unlike the 
others, and those are important for setting the rules of the 
road, that look forward in some sense, although what you are 
dealing with today is today's problems, but more sense about 
where the industry is going.
    Rather than kind of review this every 2 years, someone gets 
a clear line of direction that blending or coming together of 
the mutual fund and the hedge fund industry. My greatest 
concern here is that what we are trying to do is restore the 
Good Housekeeping seal to the mutual fund industry that has 
been tarnished in the last 3 months, so to say, that these 
cases have been brought, and really are about actions that have 
been taken over the last 3 or 4 years, because they are so 
essential to the democratization of the financial and capital 
markets that we have.
    One other area of inquiry, and then I will give up my time. 
Do I have time for one more question, Mr. Chairman? I asked 
Attorney General Spitzer and others on the panel the other day 
about the area of the IPOs and the hot market that existed in 
the late 1990s. Given that the industry somewhat lost focus on 
its fiduciary responsibility to its investors and had a culture 
of heads-I-win and tales-you-lose kind of dominate. Have any of 
your investigations to date or inquiries to date taken you into 
the area of how the hot IPO market, and where certain classes 
of the friends and family got distributed?
    Ms. Schapiro. We jointly chaired with the New York Stock 
Exchange, at the request of the SEC earlier this year, a blue 
ribbon advisory committee to look at the IPO market after the 
market meltdown. We do not actually have a hot IPO market again 
yet, but it looks to be heating up. That report generated a 
number of recommendations, including with respect to friends 
and family programs and limitations on those programs, and a 
number of other recommendations that are generally geared 
toward trying to make the initial public offering market a bit 
more public, and a bit less geared toward the insiders that 
have traditionally been able to get access to IPOs.
    That report resulted in for us a series of rule proposals 
that will go to our board next week and then be filed after 
that with the SEC. We would like to encourage Dutch auction 
activity in the IPO market; much more transparency about who 
gets IPO shares; much more involvement, quite honestly, of the 
issuer in the process of setting the price so that it is not 
just done by the investment bank to generate enormous first-day 
bounces.
    Mr. Emanuel. But my question is, to date either in that 
investigation or any of the ones that you have had up in the 
commonwealth of Massachusetts, have you seen any of the special 
offerings in the mutual fund industry to personal accounts, 
rather than to the accounts for the rest of the investors 
anywhere in that area, or to the management, or to a special 
investor?
    Ms. Schapiro. As you say, we have certainly seen it in the 
IPO market generally over the last several years and brought a 
number of cases related to that. We have not seen it, to my 
knowledge, in the mutual fund area.
    Mr. Galvin. We have not seen it as such. What we have seen, 
as I mentioned earlier, is fund managers market timing. We have 
not seen them try to take advantage of their IPOs.
    Chairman Baker. The gentleman's time has expired.
    Mr. Emanuel. Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Ms. Hooley?
    Ms. Hooley of Oregon. Thank you, Mr. Chairman, and thank 
you for holding this meeting.
    I have first a question for Mr. Galvin. Strong Financial 
founder and chairman Richard Strong is under investigation for 
market timing. The Strong Financial Company manages accounts 
for 529 college savings plans, including those in my home State 
of Oregon. State and federal law holds that Strong must place 
investors's interests ahead of his own, yet by engaging in 
market-timing trades for himself, his friends and his large 
clients, it appears that Mr. Strong was looking out after his 
own financial interest ahead of those who had college savings 
plans. Of course, the losers are the parents and the students 
that they were going to send to school.
    So I have three questions. How do we ensure that mutual 
fund companies put their investors's interests ahead of their 
own? Two, is there a comprehensive investor restitution system 
that is in place to get these college savings back? And three, 
should this Congress look to create a comprehensive investor 
restitution program?
    Mr. Galvin. First of all, clearly, let me start off by 
saying that the Strong case was not one that I have brought, 
but I am familiar with it, but the principles and the issues in 
the Strong case are the same as in some of these other cases, 
which as you say, is the people running the mutual fund putting 
their interest ahead of their investors.
    Clearly, one of the things that we are going to be looking 
for is restitution to the fund for whatever has been lost by 
market-timing practices or any other breach of fiduciary duty. 
I think that will be an essential for any resolve of these 
cases. In terms of preventing it in the future, I think the 
bill that is under consideration goes a long way towards that. 
It starts to speak of independence. I think the discussion we 
have had here this morning regarding audits is very important. 
I would like to echo what Ms. Schapiro said about a skeptical 
eye being turned on some of these matters.
    I also think in the case of, as you describe, college 
education funds, usually they are coordinated by some state 
authority of some kind, making them available to the general 
public. I frankly think that while we have talked a lot about 
states's rights here to enforce law, I think we have to talk 
about state responsibility, too. I think it is important that 
the state authorities that placed these funds take on that 
fiduciary duty just as they might in a pension fund to make 
sure that the fund is policed properly; to make sure that the 
fund is answering the right questions. I do not think we can 
absolve the customer in this sense. It is the state that is 
organizing, and not the individual parent that is trying to 
plan for their children's future, from responsibility. I think 
this bill would go a long way toward helping that.
    Ms. Hooley of Oregon. Need to look at an investor 
restitution program?
    Mr. Galvin. I think the program should be built into any 
violations that are uncovered. I think the cleanest way of 
getting restitution is to make sure that it is done by those 
who have actually perpetrated it. Mr. Kanjorski earlier asked 
about the creation of some kind of an insurance fund. My 
response to him at that time was if we are talking about fraud, 
maybe that might be worthwhile; if a fund was completely 
fraudulent or there was no investment, perhaps. I think in most 
instances here we are not talking about fraud.
    I think this might be an opportunity to restate something I 
have been saying a lot, and I want to make sure people 
understand this. Many average people get very nervous when they 
hear about these investigations. They think about, is the fund 
going to fail? Am I going to lose all my money? They might make 
rash decisions, and that would be a mistake. What is different 
in the fund situation from, for instance, a run on a bank, is 
that there are assets in these funds. They have invested their 
portfolios. It is unlikely, while the fund might be weakened by 
a lot of withdrawals, and that would be a cause of concern, 
unless there has been out-and-out fraud, it is quite unlikely 
it is going to go bankrupt. For an investor who is committed to 
long-term investment, to make a rash decision based on these 
representations that we have seen, even if they are true, might 
be a mistake.
    I think that argues all the more for prompt state and 
federal action, both in terms of enforcement and in terms of 
changes in the law. I do think it should be a cornerstone of 
any actions that are brought and resolved, however they might 
be resolved, through adjudication or by settlement, full 
restitution to those who have lost money because of 
inappropriate behavior by fund managers.
    I have a quick question for Ms. Schapiro. Obviously, mutual 
funds are what a lot of people have invested in as a low-risk 
way to enter the stock market. Three quick questions. You see 
these mutual fund scandals. They are on top of, now, all of the 
other corporate scandals. Do you see these scandals affecting 
the market as a whole? And how do these scandals affect the 
mutual fund industry and Americans's participation in it? And 
should we be prepared for more scandals?
    Ms. Schapiro. Thank you. I do think they affect the market 
as a whole, because they affect investor confidence. We need 
the capital and the contribution of investors to our economy to 
keep it growing. So I think to the extent that people are 
scared away by, first, the series of scandals with respect to 
investment banking and research analyst conflicts of interest, 
inappropriate allocation of initial public offerings, and now 
something that everybody thought was safe and sound and fair, 
mutual fund investing, I think investors are weary and scared, 
and may well decide that stuffing their money into a pillow and 
putting it under the bed is a better place to put it. I think 
that would be a real tragedy, because the fact is that mutual 
funds really were designed to be wonderful investment 
opportunities for diversification and professional management 
for people who could not otherwise afford it.
    So I think the mutual fund industry has a lot of work to do 
to restore confidence in their credibility and in the integrity 
of the investment vehicles that they offer. I am not sure if 
that answered all your questions. Or, what other scandals might 
we see?
    Ms. Hooley of Oregon. Should we be prepared for more? Yes 
or no?
    Ms. Schapiro. Maybe.
    [Laughter.]
    We are very, very focused, as I know the SEC is, in trying 
to look around the corners and see what else might be out 
there. We are doing a much more effective job, I think, than 
ever before of mining regulatory data; of understanding what 
the potentials are for problems out there; where all the 
conflicts of interests lie in this business; and combining 
conflicts of interest with opacity and complexity, and knowing 
that that may well be the next area for us to be looking at. We 
are trying to understand what all of those are and get out 
ahead of them.
    Chairman Baker. The gentlelady's time has expired.
    Ms. Hooley of Oregon. Thank you, Mr. Chairman.
    Chairman Baker. Mr. Lynch?
    Mr. Lynch. Thank you, Mr. Chairman.
    I, as well, want to thank both of the witnesses today for 
coming forward to help the committee with its work. I wish I 
agreed with our ranking member, Mr. Kanjorski, that this might 
be the result of the actions of a few bad individuals. It 
seems, though, that based on the reports that we have read, 
that this is rather endemic to the industry and that it is not 
just some renegade firms that are guilty of this conduct, but 
some fairly reputable firms.
    I would just say that if you look at the harm that has been 
done here and if you look at the measure of trust that has been 
lost by the industry, there is a real concern here because of 
the nature of the wrong being done to the investor. The whole 
system, the whole industry is built on trust, and it appears 
that the need for these firms to compete in this way, and I am 
talking specific toward late trading, is to get an advantage 
for the investor, this small group of investors.
    So they are choosing to compete with other firms by giving 
an advantage to a select group of investors. That is 
competition. It is illegal competition in many, many cases, and 
I know there are some borderline descriptions that you have 
rendered where it perhaps did not amount to fraud, but because 
what is driving this is competition among advisers and fund 
managers, not necessarily the fund itself, it would appear to 
me that the consequences and penalties for late trading and for 
market timing need to be a fairly serious consequence.
    I just want to ask you both, and maybe I will start with 
you, Mr. Secretary. What do you see as the best long term, and 
bear in mind I am not just out to get the bad guy so to speak. 
What is the best thing for the investor? What is the best thing 
for the industry and for the long-term success of the mutual 
fund industry, but getting rid of this practice or this series 
of practices that have so shaken the trust of the American 
investor in the mutual fund industry?
    Mr. Galvin. I would respond by thinking, first, that we 
have to proceed with the prosecutions we have already brought. 
Secondly, I think we have to make it clear that if there is any 
ambiguity in the law, while I do not believe there is, I think 
it can be put to rest by this committee and by this Congress 
right now that these practices should be clearly illegal. I 
think establishing a clear responsibility in the area of mutual 
funds of a fiduciary duty by those who administer and manage 
them and direct them, also enshrining that in law, would be a 
great way to guarantee that in the future.
    Then I think you have to have vigilant enforcement, not 
just by the States, but by the Federal government. I think an 
essential part of that is the audits and accounting that we 
have spoken about before. I think that we also then have to try 
to educate those who are participating in mutual funds. We do 
not expect them to get into the depth of detail of corporate 
management, how their fund is managed, as much as to be looking 
out for how their fund selections are made, what the fees they 
are charged actually represent, in digestible language, 
understanding not just fees, but also procedures and how the 
funds operate. I think those are important things that we have 
to do.
    Clearly, to build credibility or restore credibility in an 
industry like this, it takes an effort not only by the 
government to come up with clear lines, and bright lines at 
that, but it takes an effort by the industry itself. I think 
they have been shaken by this. I think it is in a sense a good 
thing because they shared in this. They hid it for a long time. 
It is in our interest to restore their reputation if they are 
worthy of it. I know you share with me the concern, coming from 
Massachusetts as you do, that we are the home to many of the 
financial services companies that employ people in 
Massachusetts. It is a big part of our economy. It is certainly 
not something we want to see destroyed.
    By the same token, we do not want to see it stay in 
business in a way that defrauds not only our own citizens, but 
the citizens throughout the country. So it is very important to 
all of us to get this cleaned up. I think that the contribution 
that Congress can make right now is to make it very clear what 
the duties of mutual funds are; to bring mutual fund regulation 
up to the level that it should be, given the responsibility 
that it has in our financial system.
    Mr. Lynch. Thank you.
    Ms. Schapiro?
    Ms. Schapiro. Thank you. I am not sure my answer is very 
different at all. I think we have to pursue these enforcement 
cases with a tremendous amount of vigor, with very meaningful 
sanctions against the funds's brokers, to the extent they are 
involved, and management individuals. People have to be held 
responsible for direct participation in these schemes or 
fostering a culture within the organization that permitted them 
to go on either undetected or, if detected, unaddressed.
    I think the second piece of it is rigorous, ongoing 
examination of fund practices and operations by the SEC on a 
continuing basis, a tremendous focus there, so that we are 
looking under the rocks all the time and finding the problems 
before they blow up.
    The third is fund governance. Again, to really echo what 
Bill has said, the shareholders's interests have got to be 
paramount here and it is up to the boards and the management of 
funds to ensure that that is happening.
    The fourth, I guess I have said about four times today, I 
believe we must have clear, more concise and consolidated 
disclosure of all the expenses and fees associated with buying 
a mutual fund, and then the impact of all of those on 
performance, so investors understand exactly what they are 
getting, exactly what they are paying, and how to compare those 
across different funds.
    Chairman Baker. The gentleman's time has expired.
    Mr. Lynch. May I?
    Chairman Baker. Do you want a follow up?
    Mr. Lynch. Please.
    Chairman Baker. Yes, sir.
    Mr. Lynch. Thank you, Mr. Chairman.
    I just want to say in closing, and I know that Mr. Crowley 
had the wish to get 30 seconds himself, but just on the issue 
of disclosure that I repeatedly hear here. I just hope you 
realize the body of information that is coming to the average 
investor, and the complexity of it. I am a recovering attorney 
as well, and sometimes I just hold my head when I read just an 
average prospectus from an average fund. I actually have an 
unwritten rule. When someone tells me they need more 
disclosure, they ought to come up with an idea of a few of 
those disclosures that we are providing now that are just pure 
gobbledygook that are costing the investors, costing these 
funds. I think a lot of it is a waste of money because it is 
not coming in an effective way to the investor. It is a waste 
of printing. It is a waste of money.
    Ms. Schapiro. I absolutely agree.
    Mr. Lynch. I want good, effective, valuable disclosures 
made to the investor. I do not want muddled, legal mumbo-jumbo. 
I want people to have usable information as a result of these 
disclosures.
    Ms. Schapiro. I think you are completely right. I think 
what they have right now is mumbo-jumbo, and you have to look 
in four or five different places to get disclosure about the 
fees and expenses associated with a fund. It needs to be clear. 
It needs to be concise. It can fit on one page. It can be done 
with pictures. There are ways to do it far more effectively 
than I think it has been done, and in a way that will benefit 
investors. We do not want to burden them with any more to read. 
They are already not reading what they are getting. There is a 
better way to do it, and I think it is really incumbent upon 
all of us to find that way.
    Mr. Lynch. Thank you.
    Thank you, Mr. Chairman.
    Chairman Baker. The gentleman's time has expired.
    Mr. Scott?
    Mr. Scott. Thank you very much, Mr. Chairman.
    I also want to thank you, Mr. Galvin and Ms. Schapiro, for 
coming before our committee this morning.
    Each day, it seems, we are learning more and more about 
these mutual fund scandals than we did the day before. In 
today's Washington Post and Wall Street Journal, for example, 
there are two more revelations of two more companies coming 
under scrutiny. Investor confidence is just going down. I came 
across today, according to Reuters, a new poll was released by 
a wealth management firm, the United States Trust Company, and 
they found that these scandals are having an extraordinarily 
profound impact on investor confidence.
    Sixty percent of Americans are now losing confidence in 
investments; 79 percent of those polled questioned the 
reliability of corporate financial statements and do not trust 
stock analysts; 67 percent do not trust corporate management; 
and 65 percent do not trust independent auditors of mutual 
funds, and that is even despite the recent very significant up 
tick in the stock market. And now today we find out from a 
story in The Washington Post of investment banks getting into 
the act as well. It seems like, as we are trying to handle 
this, it is like trying to put your hands around a bowl of 
Jell-O. You kind of squeeze it and another part oozes out.
    I want to ask just a couple of questions, going back to the 
article in this morning's Washington Post. It says that 
industry sources are quoted as saying that investment banks 
either played favorites among mutual funds when doling out 
shares in hot IPOs, or they placed poor-selling IPOs in their 
own mutual funds. Do you have any idea about how involved 
investment banks are in manipulating mutual funds? And if so, 
what do you recommend that we do to protect against this 
unsavory practice?
    Ms. Schapiro. We are investigating that very activity. I do 
not have a good answer for you at this point about how 
pervasive the problem is or how serious it is, but we will 
pursue our investigations. We will undoubtedly bring 
enforcement cases in that area. If necessary, we will write 
rules that will make it easier to enforce in the future.
    On your general issue, I think we will not make you happy, 
probably, by telling you there will be many more headlines. 
There will be many more discouraged investors, because there 
are many more cases to come just on this issue of late trading 
and market timing, from both the state regulators, the SEC and 
the NASD. So it will be awhile before I think we see light at 
the end of this tunnel.
    Mr. Scott. Mr. Galvin, on investment banks?
    Mr. Galvin. I think the investment bank issue, much like 
the hedge fund issue, raises the question, are these 
appropriate partners to be under the same tent? I think it goes 
back to the issue of independent boards of directors and making 
sure that they truly do not have conflicts of interest. In 
essence what you are suggesting, the scenario you are 
suggesting, is a conflict of interest, an investment bank 
looking to park fully performing IPOs or whatever shares in 
some other entity to the benefit of the fact that they took the 
business to promote or produce this IPO, or whatever it might 
be.
    It gets back to how do you ensure independence. I think 
that is why setting a fiduciary duty in statute, creating a 
requirement for independent directors that is based upon that, 
is probably the most effective thing you can do.
    I share your concern about investor confidence. As I 
mentioned to the gentlelady earlier, I am concerned that people 
are going to rush in now and say, I will take my money out. 
That is not the right thing for them to do right now. It is 
going to hurt them more. We do not want to see them hurt any 
more than they have already been hurt. So it does mean that 
moving on this legislation and moving on these prosecutorial 
efforts has to go forward as rapidly as possible.
    I think it is fair to say that it is now clear, or it 
should be clear to the industry at every level that is involved 
with mutual funds, that they need to come clean, too. Don't 
wait for them to catch us. Don't wait for them to see the law 
change so they have to adhere to it. Why not, if they are 
knowing of some issues that they have, I think it is much 
better for them to come clean to their investors right now over 
the next few weeks land address these issues, than waiting for 
you to change the law or us to enforce it.
    Mr. Scott. I had a gentleman and former Securities and 
Exchange Commission chairman who wrote an excellent book with a 
take on the street, and he said the deadliest sin that he felt 
was fees. I want to ask you this question as well. The cost of 
buying and selling mutual funds is often disguised as high fees 
charged by the providers. Some funds are able to get away with 
overly high fees because investors do not understand how fees 
can reduce their returns. What do you recommend to clearly 
explain the potential costs of fees to investors up front?
    Mr. Galvin. Again, we have talked a lot about disclosure. 
Mr. Lynch mentioned making it digestible. I think we have 
perhaps a model when people purchase homes in this country now, 
they have the benefit of when they sign up for a mortgage, they 
are presented with a document. It is usually not a single page 
any more, but not too many pages, anyway, that lays out the 
numbers. I think that is really the type of disclosure you 
need, something that lays out the numbers in understandable 
form. What does this actually cost you?
    I think we have to also think about, as this bill seeks to 
address or at least raises the topic of soft-dollar costs and 
how those fees are set. I think that is an important part of 
any fix in this whole area.
    Lastly, we have spoken, I know the NASD has and I have, and 
the Morgan Stanley case illustrates it, relating to contests 
and extra compensation for selling certain funds. I think that 
is important, too. I think it is important for brokers and 
those who sell funds to tell the customer if they are getting 
extra money to push a certain fund. If someone is getting extra 
money, that needs to be on the table. That is a material fact 
that the person is making a decision to purchase needs to know.
    Mr. Scott. Thank you. I am going to ask one more follow-up 
question.
    Mr. Galvin. Sure.
    Mr. Scott. One of my major efforts and concerns on this 
committee is financial literacy and financial education. I 
quite firmly believe that, as the old prophet Isaiah said, 
people without vision will surely perish. If we in this country 
cannot collectively come up with a strong vision of America as 
being literate financially, we are going to have more of these 
rows. I see some downturn to that. We are grappling with that 
and putting forward some legislative initiatives on financial 
literacy and investor education.
    I am concerned that many investors, and this is especially 
true for minority investors which are trying to encourage more 
in the minority community, to get involved in investing. Of 
course, with these scandals coming up, it is making it more 
difficult. But I am concerned that we are not fully educated 
about the risk of investing. What do you recommend that we can 
do to ensure that investor education is an effective tool, and 
not just throwing money at the problem?
    Mr. Galvin. I think you have to put it in simple terms. 
People have got to understand, you are going to give me this 
amount of money, that it has to be clearly stated when there is 
a risk. We have had cases in Massachusetts, which come up all 
too often, when people to into federally insured banks where 
they have money in the bank, and there is another table, same 
color, same logo, off to the side, and they are selling mutual 
funds or some other kind of risk investment.
    Now, there are requirements of disclosure, but you 
sometimes need a magnifying glass to see that down there. To 
the unsuspecting or unsophisticated investor, it looks like an 
employee of the bank. I think we have to make sure that is a 
clear demarcation line. You do hear oftentimes on the tail-end 
of commercial and presentations for reputable risk investment, 
you may lose all of your principal. We have to get that point 
across, not to scare people, but to have them understand there 
is a fundamental difference.
    I also think, and I know this is your ultimate purpose, in 
fact, to encourage people to invest.
    Mr. Scott. Absolutely.
    Mr. Galvin. So that being the case, it is important that we 
do not scare people away. One of the greatest concerns I have 
as I have brought these enforcement efforts is that I do not 
want to see people scared away from the financial services 
industry or investment, because investment in general is a very 
good thing. This has been a bad thing for the industry and the 
industry has done bad things to people, but it is time for us 
to make sure they do better things and to put in place the 
protections that people who do not have a lot of time, who are 
simply looking for a reasonable place, people of modest means 
looking for a reasonable place to park their savings, are 
treated fairly.
    That is why, I know we have talked back and forth about 
definitions, but it comes down to honesty and fairness. That is 
really what we are talking about. We cannot legislate, you 
cannot legislate and I cannot enforce something that says you 
are going to make money, because you may not. You may lose 
money. But we can insist that people be treated fairly and 
honestly. That I think we have an obligation to do.
    Mr. Scott. Thank you very much.
    Chairman Baker. The gentleman's time has expired.
    I want to address one thing that was brought to the 
committee's attention by Mr. Crowley a little earlier, 
referencing a Republican staff comment and quotes attributable 
to me relative to the assertion that I would be proposing 
independent chairmen for public operating companies. It kind of 
threw me back a bit. So I went back to the prior explanation in 
the committee markup of the bill and just will read this, 
because I am surprised I made sense. I went back and looked at 
it to make sure.
    The content of the independent chair proposition comes to 
this bill in recognition that an operating company, a company 
traded on the New York or American Exchange, is inherently 
different in structure from that of a mutual fund. A CEO and a 
CFO for a publicly traded corporation that is an operating 
company has one clear set of responsibilities, and that is to 
its shareholders. There are not conflicting sets of 
shareholders. Mutual funds are managed by corporations, 
corporations that have a different set of shareholders. Take 
company X which has been awarded the management contract for 
mutual fund 101. Company X has its own set of shareholders. 
Company X may manage 100 different mutual funds. They do that 
work for the benefit of company X's shareholders.
    If the person running the mutual fund is also the person 
running the management corporation, he has a conflicted set of 
shareholders. On the one hand, if fees are increased for the 
mutual fund management company, that decreases returns for the 
mutual fund. If he keeps fees low for the mutual fund 
participant, that decreases the revenue to the mutual fund 
management company. So the mutual fund director is in a 
distinctly different and unique position from the CFO or the 
CEO of an operating company, hence the reason for suggesting 
the chair should be independent.
    If the management company is not performing appropriately, 
charging excessive fees, or is just not doing its job in the 
proper rate of return for the mutual fund shareholders, do we 
really believe the chairman of the board of the mutual fund is 
going to suggest to his board dismissal of his own corporation 
as manager?
    That was the statement made, and I do not know from where 
Mr. Crowley reached his conclusion, but just on the record, I 
have no intent, and have not to my knowledge ever suggested 
that anyone other than a mutual fund structure should have an 
independent chair, but it did bring to light what I think are 
good policy reasons. The growth of the industry over the decade 
has been enormous, with now over 8,000 funds with trillions of 
dollars under management. One fund, one management company has 
277 different funds.
    I do not know where the maximum management time begins to 
diminish. I am not suggesting a fund and a board. There are 
efficiencies that occur from multiple funds being managed by 
the same board. Clearly, the industry growth I think 
exacerbates this managerial question, and hence my belief that 
inclusion of the independent chair in this proposal ultimately 
is in the best interest of the market as it is currently 
constituted. I will yield to the other gentleman since this is 
basically a second round on my part, if you choose to make any 
comment.
    Mr. Miller of North Carolina. Mr. Chairman, I would like to 
take advantage of that, particularly since I did honor the red 
light earlier in my questioning.
    I have one more question along the lines of what the chair 
was just asking, and also consistent with my earlier set of 
questions about governance. One alternative to an independent 
chair, and I think both of you thought there might be some 
circumstances in which it might be better not to have an 
independent chair, as we have defined ``independence.''
    The mutual fund industry itself has suggested that their 
best corporate governance practices should require that there 
be not just a set of independent directors, all of whom are 
supposed to be independent, all of whom are supposed to 
exercise independent judgment, but that there be a lead 
independent director who is supposed to be the point of contact 
between management and the independent directors; that that be 
the person they consult with, and that there be focused 
responsibility for skepticism, for independent judgment, and 
that that director have the authority to place items on the 
agenda, to call meetings, to obtain outside advice on behalf of 
all the independent directors.
    Do you know if that is being widely used in the industry? 
Has that been an effective method of assuring greater 
independence by the board? Is there a reason why that should 
not be part of what we require if we do not in fact require 
that the chair be independent?
    Ms. Schapiro. I cannot speak to the mutual fund industry. I 
know generally in corporate America, lead independent directors 
are being very widely used and I think to good success.
    As I said earlier, I am confident there is no harm in 
requiring an independent chairman, but I am not really in a 
position to judge whether that is a necessity. I think it is a 
good idea. If there is not going to be an independent chairman, 
then I think at a minimum you must have a lead director who is 
independent.
    Mr. Galvin. I think it is an excellent idea. It is an 
approach. I think it comes back to having a process internally 
within the mutual fund that guarantees it is steering the right 
course. I think that is what it comes back to. It really 
addresses the fact that there are all these mutual funds out 
there, and how possibly, even with the best-armed enforcement 
effort, are you going to police every single aspect of it. I 
think you have to enshrine some sort of fiduciary duty, but 
having a point person in the structure of the management who 
would have the responsibility of making sure it is adhering to 
the principles of fiduciary duty I think would make a lot of 
sense.
    Mr. Miller of North Carolina. Thank you, Mr. Chairman.
    Chairman Baker. Mr. Scott, anything further?
    Mr. Scott. Yes. I would like to just ask one point to each 
of you, if you could get to a response to this. We have talked 
about hedge funds a little earlier. We do know an increasing 
number of mutual fund companies now have begun to offer hedge 
funds in recent years. We have found in the articles this 
morning and beyond that Alliance Capital's managers ran both 
mutual and hedge funds. How common is it for these managers to 
run both funds? And shouldn't there be regulations to prevent 
what appears to me to be an outright conflict of interest?
    Ms. Schapiro. We do not have authority to prohibit a mutual 
fund from also operating a hedge fund, since we do not regulate 
them directly. My view is that it is an untenable conflict of 
interest for a manager to operate a hedge fund and a mutual 
fund at the same time. It should not be permitted.
    Mr. Scott. Do you see that that might be an area for our 
legislation to address, too?
    Ms. Schapiro. Perhaps, yes. The SEC obviously needs to look 
carefully at the issue, but it may well be an issue that should 
be addressed legislatively.
    Mr. Scott. Thank you.
    Mr. Galvin?
    Mr. Galvin. I definitely think that hedge funds need to be 
looked at. I think they are a potential problem. They should 
not be under the same tent as mutual funds. I think we have to 
also acknowledge their affect on the overall financial system. 
I think for a long time they have been kind of a stealth player 
in that system. I think what these mutual funds reveal, the 
scandals have revealed, is that they have been involved in 
mutual funds as well. They have been the beneficiary of some of 
these market-timing instances.
    I think the regulation of mutual funds should be put in a 
pristine situation, and therefore it should not be put under 
the same circumstances as hedge funds. I mentioned earlier some 
of these other entities, financial holding companies that hold 
both. I think there has to be a demarcation line drawn. The 
whole concept of mutual funds by the way it has been sold to 
the investing public, is totally distinct from hedge funds, 
which by definition are designed for people of very high income 
who can sustain great risk.
    Mr. Scott. Thank you very much, Mr. Chairman.
    Chairman Baker. Thank you, Mr. Scott.
    That is one of the elements that I outlined at the hearing 
on Tuesday, that we hope to have included in a manager's 
amendment. The slight distinction that we are contemplating is 
rather than prohibition against mutual funds and hedge funds 
being operated by the same company, just being managed by the 
same individual so that it would be permissible for a company 
to have a mutual and hedge fund operation, but to have 
distinctly different managers in charge of each activity. But 
it is one of the elements which we hope to reach consensus on, 
Mr. Scott, and include in some sort of amendment to the 
underlying H.R. H.R. 2420. I thank the gentleman.
    And let me express to each of you our appreciation, not 
only for your appearance here today, but for your good work 
over the past months. We look forward to continuing to work 
with you in the days ahead. Thank you very much.
    I will ask our participants on our second panel to come on 
up. Let me welcome each of you to our second panel this 
morning. As I am sure you are now painfully aware, we have 
debated at quite a length the need for additional regulation of 
our mutual fund industry. I look forward to your testimony. 
Your prepared remarks will be made part of the record. To the 
extent practical, attempt to limit your comment to 5 minutes, 
and we will certainly engage in questions at the conclusion of 
your testimony.
    It is my pleasure to first introduce Mr. Charles Leven, 
Vice President, Secretary and Treasury of the American 
Association of Retired Persons. Welcome, Mr. Leven.

   STATEMENT OF CHARLES LEVEN, VICE PRESIDENT, SECRETARY AND 
       TREASURER, AMERICAN ASSOCIATION OF RETIRED PERSONS

    Mr. Leven. Thank you very much. I guess it is now good 
afternoon, so I will change my statement a little bit.
    Chairman Baker, Ranking Member Kanjorski and members of the 
Subcommittee on Capital Markets, Insurance and Government 
Sponsored Enterprises, my name is Charles Leven. I am a Vice 
President of AARP's board of directors. I appreciate this 
opportunity to testify on behalf of the AARP's over 35 million 
members on a matter of great importance to the financial 
security of all Americans. That is the savings that they have 
invested in and entrusted to the mutual fund industry.
    Mutual funds control 21 percent of U.S. corporate equity, 
representing an estimated $19 trillion in assets. More than 95 
million Americans are invested in mutual funds, representing 
more than half of all American households. Mutual funds are the 
investment of choice for millions of our members and for mid-
life and older Americans in general. The consequence of lost or 
diminished investment savings can, and for far too many, may 
have been immediate, profound and lasting.
    AARP supports the efforts of this subcommittee under your 
leadership, Chairman Baker, to improve investor awareness of 
mutual fund costs, and to improve the independent oversight and 
governance functions of fund boards of directors. The 
legislation you introduced and which is now pending before the 
House, the Mutual Fund Integrity and Transparency Act of 2003, 
H.R. H.R. 2420, would put into effect an overdue upgrade in 
investor protection for the ordinary saver-investor. These 
reforms were already warranted by the continuing evolution in 
market practices and the growth in market choices.
    Real damage has already been done to the economic security 
and financial well-being of many Americans in or near 
retirement. This has been in part due to the market's natural 
cycles that has tracked the general economy downward over the 
last couple of years. But some of the damage was caused by 
corporate financial reporting, accounting transgressions and 
market manipulations. Apart from corporate reporting and 
accounting scandals, mounting allegations of illegal or, at 
best, unethical practices by mutual fund management companies, 
executives and brokers highlights the need for prompt remedial 
action.
    Startling results reported just this week from an SEC 
survey revealed the apparent prevalence with which mutual fund 
companies and brokerage firms had arrangements that allowed 
favored customers, including themselves, to exercise after-
hours trading privileges and market-timing options, as well as 
to participate in other abusive practices. These apparent 
violations of the fiduciary duty owed to investors has caused 
real harm, both in confidence and in lost dollars. These 
allegations come on top of other more recent examples of 
conflicts of interest in the industry.
    We must do more to protect the individual investor. With 
regard to initiatives designed to increase fund transparency, 
we strongly support H.R. H.R. 2420's provisions to require, 
among other new obligations, that fees be disclosed using 
dollar-amount examples; fee disclosures be enhanced so they can 
encapsulate all fees, including portfolio transaction costs and 
the structure of compensation paid to portfolio managers and 
retail brokers be disclosed, to include the holdings in the 
funds managed; disclosure of breakpoint discounts to investors 
be improved; and directed revenue sharing, brokerage and soft-
dollar arrangements be made to conform to the fiduciary duties 
to the funds and their investors.
    We are increasingly concerned that lay investor confidence 
in the mutual fund industry not be allowed to deteriorate 
further, specifically in its ability to reliably provide fairly 
priced benefits of investment diversification and expert 
management. While greater transparency is essential to fair 
competition among funds for investors, we believe it does not 
provide a sufficient check on the cost of fund governance. Most 
funds are not established by investors, but rather are 
incorporated by advisory firms, who then contractually provide 
research, trading, money management and customer support 
services, and who also have some representation on the fund's 
board. But the advisory firms have their own corporate charters 
and are accountable to their own boards of directors, posing as 
we see a range of potential conflicts of interest in the cost 
of services provided to the fund.
    We see these failures of mutual fund governance not simply 
as a lack of statutory or regulatory authority, but as a 
failure of compliance and enforcement. We support the 
provisions in H.R. H.R. 2420 designed to strengthen the role 
and independence of boards of directors, and further target 
directors's energies where potential conflicts of interest 
between the fund adviser and fund shareholders are greatest.
    Specifically, we strongly recommend the final measures 
include provisions requiring that a super-majority, somewhere 
between two-thirds and three-fourths of fund board members, 
should be independent. The board chairman should be selected 
from among the independent members, and the independent 
directors be responsible for establishing and disclosing the 
qualification standards of independence, and for nominating and 
selecting all subsequent independent board members.
    In summary, the importance of the mutual fund market as a 
critical component of the economic security of all Americans, 
especially older persons, should not be underestimated. We urge 
prompt, bipartisan passage of H.R. H.R. 2420 by the House. Full 
disclosure of expenses and requirements for stronger fund 
governance will help hold fund advisers accountable for their 
trading practices, which should reduce costs to investors.
    We believe these changes will introduce more vigorous price 
competition in the mutual fund marketplace. We look forward to 
working with you, Chairman Baker and Ranking Member Kanjorski, 
and with the other members of this subcommittee, in further 
perfecting and working to enact this important piece of 
investor protection legislation.
    I would be happy to take any questions you may have.
    [The prepared statement of Charles Leven can be found on 
page 264 in the appendix.]
    Chairman Baker. Thank you very much, Mr. Leven.
    Our next witness is Dr. Eric Zitzewitz, Assistant Professor 
of Economics at Stanford University Graduate School of 
Business. Welcome, sir.

 STATEMENT OF ERIC ZITEWITZ, ASSISTANT PROFESSOR OF ECONOMICS, 
        STANFORD UNIVERSITY, GRADUATE SCHOOL OF BUSINESS

    Mr. Zitzewitz. Thank you.
    Chairman Baker, Ranking Member Kanjorski, members of the 
subcommittee, thank you for the opportunity to discuss the 
issues of late trading and stale-price arbitrage, as I am going 
to refer to what is otherwise known as market timing in mutual 
funds.
    My name is Eric Zitzewitz. I am an Assistant Professor of 
Economics at Stanford's Graduate School of Business. I am the 
author of three studies related to the issues being examined by 
the subcommittee. I have also worked with the industry on the 
issues of fair value pricing and estimating the extent and cost 
of stale-price arbitrage trading. I will draw on my research 
and experience, as well as the work of other academics in the 
course of my testimony.
    Let me begin by summarizing some of the main conclusions of 
my research. My analysis of daily flows for a sample of funds 
reveals flows consistent with stale-price arbitrage in the 
international funds of over 90 percent of fund companies, and 
consistent with late trading in 30 percent. In 2001, a 
shareholder in the average international fund in my sample lost 
1.1 percent of their assets to stale-price arbitrage trading 
and another .05 or five basis points of their assets to late 
trading. Losses are smaller, but still statistically 
significant in funds holding small cap equities or liquid bonds 
such as municipals, convertibles, and high-yields.
    The source of these losses is arbitrageurs buying funds for 
less than their current value and selling funds for more than 
their current value. The source of that opportunity is the way 
we calculate our net asset values. We are calculating them 
using historical prices that in some cases are 12 to 14 hours 
old for international funds. We need to fix that problem. This 
is the source of the arbitrage problem. This is the most 
serious component of the market timing that people are talking 
about.
    Dilution rates have declined since the beginning of 2003, 
but not to zero. Even for September 2003, after the 
announcement of the investigation by state and federal 
regulators, international fund shareholders were still diluted 
at an annual rate of 0.3 percent. In April 2001, the SEC sent a 
letter to the fund industry remind it of its obligation to use 
fair value pricing to eliminate stale prices, especially in 
their international funds. Despite this, my statistical 
analysis of fund net asset values reveals that in 2003, over 50 
percent of fund families removed less than 10 percent of the 
staleness from the net asset values of their international 
funds. This implies that they are fair valuing extremely 
rarely, if at all. The average fund is removing just over 20 
percent of the staleness in their net asset values.
    Short-term trading fees and monitoring by the fund family 
alone are imperfect solutions to the problem. I find that 
dilution due to stale-price arbitrage is only 50 percent lower 
in funds with fees. This is because arbitrage can wait out the 
fees, because the fees cannot be applied in all channels and 
because the collection of fees is not always enforced. The SEC 
survey by Mr. Cutler reports that almost all fund families 
monitor for stale-price arbitrage, and yet dilution is still 
substantial in at least some of those funds.
    One important point to make, though, is that industry 
averages mask substantial heterogeneity. Just under 10 percent 
of fund families are fair-valuing their funds, frequently 
enough to remove over 70 percent of the staleness. Another 10 
to 15 percent are removing about 50 percent. Although almost 
every international fund has been diluted by stale-price 
arbitrage, about 75 percent of dilution is concentrated in the 
25 most affected international funds. I have found that fund 
families with more independent directors and lower expense 
ratios experience less dilution, were more likely to use fair 
value pricing, and short-term trading fees to limit arbitrage 
activity.
    Policymakers and regulators face two challenges. Number 
one, ensuring that affected investors are fairly compensated, 
and number two, ensuring that these and similar problems cease 
and do not reoccur. The first is a non-trivial issue. Simply 
relying on the reimbursement calculations of the affected firms 
may be insufficient, since affected firms will certainly be 
tempted to apply a narrow definition of damages, which could 
lead to an under-compensation of investors. Policymakers 
obviously may choose to provide some guidance here.
    I will devote my attention for now to the second issue. I 
believe that a complete solution to the market-timing and late-
trading issues needs to involve three components. Number one, a 
pricing solution. The most direct method of eliminating stale-
price arbitrage is to eliminate the staleness in NAVs via fair 
value pricing. It is already standard practice to use fair 
value pricing for corporate and treasury bonds, except we do 
not call it fair value pricing. We call it evaluated or matrix 
pricing, but it is basically the same thing. Fair value needs 
to be extended to international and perhaps small cap equities, 
and evaluated bond pricing should be extended to currently 
excluded asset classes such as convertibles and high yields.
    The SEC allows for fair value pricing, but as I noted, it 
has been underutilized by the industry. A cynical view might be 
that funds have dragged their feet on fair value to preserve 
the ability to allow favored customers to arbitrate their 
funds. This may be true in some cases, but adoption of fair 
value has also been limited by the vagueness of the SEC's April 
2001 letter. In particular, the SEC reminds funds of their 
obligation to fair value after a significant event, but does 
not define the term. Some funds have used such a narrow 
definition of a ``significant event,'' such as an earthquake or 
a 3 percent move in the value of international securities, that 
they end up fair-valuing extremely rarely. In some cases, this 
may be due to the perceived legal risk of fair valuing more 
frequently. In some cases, the perceived legal risk may be used 
as an excuse.
    In his testimony on October 9, 2003, SEC Chairman Donaldson 
listed as one response to these issues, emphasizing the 
obligation of funds to fair value under certain circumstances. 
It is vital that the SEC define, perhaps not exhaustively, what 
these circumstances are. In order for fair value to be 
effective, this definition will need to be broader than it is 
currently.
    Allowing fair value pricing to be done using an ad hoc 
process is dangerous, since it invites manipulation. A better 
approach is to use a model that updates the most recent market 
price for recent changes in market indicators, and I list some 
in the written testimony, on a security-by-security basis. The 
model could be calibrated using historical calculations and 
should be subjected to rigorous testing both before 
implementation and on an ongoing basis.
    I should emphasize that short-term trading fees or 
restrictions are not substitutes for fair value pricing. The 
greatest danger I see in the current debate is that this will 
not be recognized. Fees have not been fully effective 
historically for the reasons I mention. Even if the investment 
company institutes a proposed 2 percent fee for trades within 5 
days is perfectly enforced in every channel, which is far from 
certain, arbitrageurs could simply wait until day six to sell. 
A quick simulation I ran revealed that a mandatory 5-day hold, 
which is stronger than a 5-day trading fee, reduced arbitrage 
excess returns from only 48 percent to 24 percent per year, 
hardly enough to be a serious deterrent. Even a complete ban on 
selling within 90 days would only reduce arbitrage excess 
returns to 5 percent per year. These are still going to be 
attractive excess returns to hedge funds. My guess is that 
average investors would not appreciate such a ban. Fees may be 
a good idea, but they are not a substitute for eliminating 
stale prices.
    A related danger I see in the current debate is that the 
SEC might allow funds to use solutions that allow them to deny 
arbitrage opportunities to some investors, but allow them to 
others. Fair value pricing removes arbitrage opportunities 
equally to all investors. Other solutions such as short-term 
trading fees, monitoring by the fund company, and allowing 
funds the option, and I stress option, to either delay 
exchanges or return gains from short-term trades, can be 
applied or not applied as funds see fit. The limitation of many 
of the current popular solutions, this limitation of them, has 
clearly contributed to the recent scandal.
    The second component is a third-party monitoring solution. 
Fair value pricing addresses stale prices, price arbitrage, but 
there is no pricing solution for late trading. Furthermore, no 
fair value pricing formula will be perfect. Therefore we need 
to provide tools for boards, regulators and even shareholders 
to monitor trading activity in funds.
    One possibility would be to require funds to publicly 
disclose daily in-flows and out-flows, perhaps with a 2-month 
lag to alleviate any front-running concerns. This would allow 
anyone, including data and advisory firms, to use the formula 
for my and other academic studies to estimate dilution. An 
alternative would be to require the disclosure of this 
information to regulators, boards and a limited number of 
third-party firms who would disclose only the most egregious 
cases. My guess is that either way, this idea will meet with 
significant resistance from some in the industry. But you 
should ask yourselves, is there any good reason why these 
disclosures should not be made?
    Third, I believe part of the solution is governance. What I 
have to say here is not terribly unique, except to add that I 
support these proposals to make boards more effective.
    With that, I will conclude and I welcome your questions.
    [The prepared statement of Eric Zitewitz can be found on 
page 281 in the appendix.]
    Chairman Baker. Thank you, Doctor.
    Let me start. You suggest that there should be a model 
developed that would accurately determine fair value pricing 
that could be adaptable to market conditions. Do you have from 
your work such a conceptual model developed? Or is that 
something that would have to start from scratch, that we would 
ask the SEC to engage in over some period of time?
    Mr. Zitzewitz. Actually, I have helped a firm develop a 
model, so I should mention that in the interest of full 
disclosure. There is also a competing model. Those models are 
being used by some fund families. Those fund families I 
mentioned that are removing a lot of the staleness from their 
fair value prices, in large part that is how they are doing it. 
Some of them have their own proprietary models as well.
    Chairman Baker. So simply having the SEC develop a rule at 
our request, that would initiate utilization of modeling for 
the purposes of establishing fair value pricing, in your 
opinion, would not be premature.
    Mr. Zitzewitz. No, I think that would be feasible. In fact, 
I think you might even want to go further and mandate a 
performance standard. You should be removing X percent where X 
is something like 80 or something like that, I think that would 
be feasible, of the staleness from your fair value prices, 
because I think there is a danger that you mandate the use of a 
model, but if you do not specify how frequently it is used, 
some funds will not remove the staleness.
    Chairman Baker. Sure. If there any interim definition of 
``significant event'' that could be offered to help a more 
frequent updating to eliminate staleness? Or is that not worth 
the effort?
    Mr. Zitzewitz. No, I think we may want to get specific 
here. Using an S&P basis for a definition for a significant 
event is imperfect, but if we were to use one, something like a 
75 basis point movement in the S&P, if that were a significant 
event, of course there could be others like earthquakes and so 
forth.
    Chairman Baker. I was being a little more maybe politically 
creative there. If you define ``significant event'' as a 
triggering mechanism in the appropriate way, but offer as an 
alternative an appropriate modeling standard, the industry 
would probably pursue modeling with some degree of enthusiasm 
if the significant triggering event was drafted properly. Am I 
communicating?
    Mr. Zitzewitz. I see. I understand and agree.
    Chairman Baker. Okay, great.
    Mr. Leven, I appreciate the testimony given, and it is 
highly supportive of H.R. H.R. 2420. Contentious discussion 
tends to still focus on the necessity or desirability of the 
independent chair. You and the AARP have taken the position 
that the chair of the board should be selected from the 
independent members, and therefore support the concept of an 
independent chair.
    Mr. Leven. That is correct.
    Chairman Baker. I do believe that shareholder investors in 
mutual funds perhaps do not understand today adequately enough 
the authority and influence of the chair, particularly in light 
of board members not being able to give the necessary 
attention, perhaps, to each individual fund for which they are 
assigned managerial responsibilities. As I indicated to the 
earlier panel, I am aware of one management company that has 
277 separate funds. I do not know how they do the work.
    Does this rise to a level of concern for AARP, where if 
H.R. H.R. 2420 were to be considered and a manager's amendment 
were to be constructed, that the AARP would contact membership 
relative to the importance of the adoption of that amendment?
    Mr. Leven. Obviously, I cannot speak for the total board. 
Certainly, I will take it back to the board and to our 
executive committee for their point of view. I suspect strongly 
that I would support that. Whether the board will remains to be 
seen, of course.
    Chairman Baker. You have an independent board, I take it. 
That is a joke. I am just kidding.
    [Laughter.]
    Mr. Leven. Oh, very independent. I am the chair of the 
audit committee, which is even more independent. I would 
suggest to you that an independent chairman obviously is not 
going to be an expert in all areas of what he is going to do. 
What he is going to do is what any intelligent person would do. 
You would either call in experts from outside or hire experts 
from outside. An independent board clearly has full authority 
to do that.
    Chairman Baker. Removing one's own personal financial 
interests from the considerations you make is a key principle 
of independence, I think, and in making sure that you are not 
disenfranchising the interests of one set of shareholders to 
enrich another. That point has not been sufficiently made, 
apparently, in the course of our debate, but any help we can 
get from any interested party is certainly appreciated.
    Mr. Leven. We do support it. We will do our best to examine 
it and see whether appropriate support is required or necessary 
as we go forward.
    Chairman Baker. Let me read through the list that is being 
contemplated now for additions to H.R. H.R. 2420, and ask 
either of you to make comment about any one or group of the 
recommendations: reinstatement of the independent chair you 
have already commented on; require that all funds not only have 
a chief compliance officer, which is required by the bill, but 
that the compliance officer report only to the independent 
chair and the other board members; further refine the 
definition of ``independent'' so it precludes individuals with 
relationships with the management that would compromise their 
independence, for example a family member of the manager.
    Disclose the compensation of fund executives and portfolio 
managers, as they are disclosed for public operating companies, 
not to set a new standard, but simply extend the standard now 
required for public operating companies to the mutual fund 
managing company; disclose all purchases, sales and aggregate 
holdings of fund shares and portfolio securities of management 
and directors, as they are disclosed for public operating 
companies in specific section 16 reports under the 1934 Act; 
disclose on the fund Web site fund codes of ethics and reported 
violations of the code of ethics; prohibit short-term trading 
by portfolio managers and fund executives for their own 
account.
    Prohibit joint portfolio management of mutual funds and 
hedge funds by the same manager, not necessarily the same fund 
company; increase enforcement penalties applied to mutual fund 
violators; allow funds to choose whether they are going to 
permit market timing, but make the policy determination defined 
as ``fundamental,'' which means they will have to then make the 
policy clearly disclosable in the prospectus and unchangeable 
without shareholder consent; require the board of directors to 
certify the valuation procedures; permit funds to charge more 
than the current limit of 2 percent for short-term redemptions, 
but not mandate statutorily such a charge. This gives the funds 
the choice to permit investors to decide whether they wish to 
invest in a fund that is going to have a more restrictive 
short-term trading limit or not. And finally, a strengthening 
of the fiduciary duty that directors have to fund shareholders.
    Anything we are missing? That is on top of H.R. H.R. 2420.
    Mr. Leven. I did not hear independent audits, but I am sure 
it is in there.
    Chairman Baker. If it is not, we will make sure that that 
is on the list.
    Any comment, doctor?
    Mr. Zitzewitz. I already mentioned a couple of things that 
I might add to that, right? I think disclosure of daily flow 
data could be very valuable and I think you could allay any 
concerns about front-running with a delay and that disclosure. 
I think absent that, investors have no way of knowing whether 
their fund is being diluted. The range in which their funds 
have been diluted in the past, at least, it is bigger than the 
expense ratio range. So we spend all this effort educating them 
on expense ratios, and they have no way of knowing whether 
their fund is being diluted or not. I think that is something 
important to fix.
    Then we also talked about perhaps needing to go a bit 
further in terms of requiring fair value pricing.
    Chairman Baker. Yes. Although it was not on the pre-printed 
list, the fair value pricing is certainly something that rises 
to our attention.
    I want to express my appreciation to both of you for your 
patience in waiting through the long hearing today. Your 
recommendations are certainly important to the committee's 
work, and we look forward to working from this point forward 
into what we hope will be a prompt, but more importantly, an 
appropriate review and final passage of legislation to assure 
shareholders that they are being fairly and equitably treated, 
all appropriate disclosures are made, and that all the rules 
apply equally to all participants.
    I thank you very much. If you have no further comments, our 
meeting stands adjourned. Thank you.
    [Whereupon, at 12:50 p.m., the subcommittee was adjourned.]
                            A P P E N D I X



                            November 4, 2003
[GRAPHIC] [TIFF OMITTED] 92982.001


                            A P P E N D I X



                            November 6, 2003
[GRAPHIC] [TIFF OMITTED] 92982.125


