[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
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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?
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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.]
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