[Senate Hearing 108-368]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-368

     MUTUAL FUNDS: TRADING PRACTICES AND ABUSES THAT HARM INVESTORS

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

                                HEARING

                               before the

     FINANCIAL MANAGEMENT, THE BUDGET, AND INTERNATIONAL SECURITY 
                              SUBCOMMITTEE

                                 of the

                              COMMITTEE ON
                          GOVERNMENTAL AFFAIRS
                          UNITED STATES SENATE


                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                               __________

                            NOVEMBER 3, 2003

                               __________

      Printed for the use of the Committee on Governmental Affairs


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                            WASHINGTON : 2003
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                   COMMITTEE ON GOVERNMENTAL AFFAIRS

                   SUSAN M. COLLINS, Maine, Chairman
TED STEVENS, Alaska                  JOSEPH I. LIEBERMAN, Connecticut
GEORGE V. VOINOVICH, Ohio            CARL LEVIN, Michigan
NORM COLEMAN, Minnesota              DANIEL K. AKAKA, Hawaii
ARLEN SPECTER, Pennsylvania          RICHARD J. DURBIN, Illinois
ROBERT F. BENNETT, Utah              THOMAS R. CARPER, Delaware
PETER G. FITZGERALD, Illinois        MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire        FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama           MARK PRYOR, Arkansas

           Michael D. Bopp, Staff Director and Chief Counsel
      Joyce A. Rechtschaffen, Minority Staff Director and Counsel
                      Amy B. Newhouse, Chief Clerk

                                 ------                                

     FINANCIAL MANAGEMENT, THE BUDGET, AND INTERNATIONAL SECURITY 
                              SUBCOMMITTEE

                PETER G. FITZGERALD, Illinois, Chairman
TED STEVENS, Alaska                  DANIEL K. AKAKA, Hawaii
GEORGE V. VOINOVICH, Ohio            CARL LEVIN, Michigan
ARLEN SPECTER, Pennsylvania          THOMAS R. CARPER, Delaware
ROBERT F. BENNETT, Utah              MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire        FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama           MARK PRYOR, Arkansas

                   Michael J. Russell, Staff Director
              Richard J. Kessler, Minority Staff Director
                       Tara E. Baird, Chief Clerk



                            C O N T E N T S

                                 ------                                
Opening statements:
                                                                   Page
    Senator Fitzgerald...........................................     1
    Senator Collins..............................................     4
    Senator Akaka................................................     5

                               WITNESSES
                        Monday, November 3, 2003

Stephen M. Cutler, Director, Division of Enforcement, U.S. 
  Securities and Exchange Commission.............................     7
Paul F. Roye, Director, Division of Investment Management, U.S. 
  Securities and Exchange Commission.............................    11
Hon. William F. Galvin, Secretary of the Commonwealth of 
  Massachusetts..................................................    15
Hon. Eliot L. Spitzer, Attorney General for the State of New York    17
Mary L. Schapiro, Vice Chairman and President Regulatory Policy 
  and Oversight, National Association of Securities Dealers......    20
Hon. Richard H. Baker (R-LA), Chairman, Subcommittee on Capital 
  Markets, Insurance and Government Sponsored Enterprises, 
  Committee on Financial Services, U.S. House Representatives....    33
John C. Bogle, Founder and Former CEO, The Vanguard Group........    38
Mercer E. Bullard, Founder and President, Fund Democracy, Inc....    40
Matthew P. Fink, President, Investment Company Institute.........    42

                     Alphabetical List of Witnesses

Baker, Hon. Richard H.:
    Testimony....................................................    33
    Prepared statement...........................................   120
Bogle, John C.:
    Testimony....................................................    38
    Prepared statement...........................................   130
Bullard, Mercer E.:
    Testimony....................................................    40
    Prepared statement...........................................   154
Cutler, Stephen M.:
    Testimony....................................................     7
    Prepared statement...........................................    59
Fink, Matthew P.:
    Testimony....................................................    42
    Prepared statement...........................................   186
Galvin, Hon. William F.:
    Testimony....................................................    15
    Prepared statement...........................................    97
Roye, Paul F.:
    Testimony....................................................    11
    Prepared statement...........................................    80
Schapiro, Mary L.:
    Testimony....................................................    20
    Prepared statement...........................................   111
Spitzer, Hon. Eliot L.:
    Testimony....................................................    17
    Prepared statement...........................................   105

                                Appendix

E. Scott Peterson, Global Practice Leader of Defined Contribution 
  Services, prepared statement...................................   210
Questions and responses for the record from Mr. Roye from Senator 
  Akaka..........................................................   222

 
     MUTUAL FUNDS: TRADING PRACTICES AND ABUSES THAT HARM INVESTORS

                              ----------                              


                        MONDAY, NOVEMBER 3, 2003

                                   U.S. Senate,    
                  Subcommittee on Financial Management,    
                  the Budget, and International Security,  
                  of the Committee on Governmental Affairs,
                                                    Washington, DC.
    The Subcommittee met, pursuant to notice, at 10:32 a.m., in 
room SD-342, Dirksen Senate Office Building, Senator Peter G. 
Fitzgerald (Chairman of the Subcommittee) presiding.
    Present: Senators Fitzgerald, Collins, and Akaka.

            OPENING STATEMENT OF SENATOR FITZGERALD

    Senator Fitzgerald. Good morning. I would like to call the 
Subcommittee hearing to order. I would like to thank our 
distinguished witnesses for being here today. I would also like 
to thank the Chairman of the full Committee, Senator Collins, 
for being present, as well as our Ranking Member, Senator 
Akaka.
    Today, we are conducting an oversight hearing on the mutual 
fund and investment advisory industry. We are here to 
investigate the breadth and the extent of the illicit trading 
practices that have come to light in recent months and to 
examine the impact that the abusive practices have had on 
ordinary mutual fund investors.
    We are also here to reexamine mutual fund management and 
governance and specifically to identify statutory and/or 
regulatory reforms that should be enacted in order to prevent a 
recurrence of the abuses and to better protect fund 
shareholders.
    Just two decades ago, the mutual fund industry was 
relatively small, but today it is enormous. In 1980, only a 
small percentage of Americans invested in mutual funds, and the 
assets of the industry only totaled about $115 billion. Today, 
roughly 95 million Americans own shares in mutual funds, and 
the assets of all of the funds combined are now more than $7 
trillion.
    Mutual funds have grown in popularity in part because they 
provide a convenient means of achieving diversification, 
professional management and liquidity, but the Federal 
Government has also given the mutual fund industry an enormous 
boost. In the past two decades, Congress has sanctioned or 
expanded a variety of tax-sheltered savings vehicles such as 
401(k)s, Keoghs, traditional IRAs, Roth IRAs, rollover IRAs, 
and college savings plans.
    One effect of these relatively new investment vehicles is 
that they have turbo-charged the growth of the mutual fund 
industry and given it a guaranteed and, at least to a certain 
extent, a captive clientele. Millions of Americans now set 
aside money from their twice-monthly paychecks and have it 
automatically funneled into their mutual fund accounts.
    As John Bogle, who will testify later this morning, has 
observed, the coming to light of the market timing and late 
trading scandals is a blessing in disguise. The growth of the 
mutual fund industry has been so rapid during the past 20 years 
that the industry has managed to escape the thorough review and 
oversight that it merits. The current scandal prods both 
Congress and regulators to catch up with the industry and to 
reexamine its whole setup. Given that mutual funds are now the 
repository of such a large share of so many Americans' savings, 
few issues we confront are as important as protecting the money 
invested in mutual funds.
    Several of the witnesses who are here today will explain 
the mechanics, the extent, and the scope of market timing, late 
trading and other abusive practices that harm ordinary fund 
shareholders. I am confident that the SEC, State Attorneys 
General and other regulators can curb these abuses in the 
future, and certainly Congress can pass laws, if necessary, to 
bolster the authority of the SEC in this regard.
    But our current focus on particular types of trading abuses 
must not prevent us from seeing the big picture. It is time for 
a wholesale reexamination of how mutual funds are organized and 
managed. As several of our witnesses will testify today, the 
governance structure of a typical mutual fund is a study in 
institutionalized conflict of interest. Until we eliminate the 
conflicts, many mutual funds will continue to engage in 
behavior that benefits fund managers at the expense of fund 
shareholders.
    Mutual funds typically have a board of directors, but no 
staff. The board outsources all investment functions to an 
outside investment advisory firm which charges the fund 
management and other fees. Almost always many of the directors 
of the mutual fund, including the chairmen, are also insiders 
of the investment advisory firm. Surprisingly, Federal law not 
only allows this incestuous relationship, it codifies it. The 
law apparently places faith in the false concept that fund 
directors can bargain at arm's length with themselves. Because 
of the incestuous relationship between mutual fund directors 
and their investment advisers, investment management and other 
fees charged to most mutual funds are far too high.
    As Attorney General Spitzer will testify, in 2002, mutual 
funds paid advisory fees of more than $50 billion and other 
management fees of nearly $20 billion, not to mention tens of 
billions that the funds spend on trading costs.
    Also, as Attorney General Spitzer points out in his 
testimony, in most industries, there are economies of scale. 
One would think that as mutual fund assets increased, advisory 
fees decrease, but, in fact, it appears that the reverse is 
true. It appears that as mutual fund assets have risen, 
advisory fees have risen even more. Mr. Spitzer, citing Mr. 
Bogle, will argue that between 1980 and 2000, mutual fund 
assets grew by 60 times, but the funds, fees and expenses grew 
by 90 times.
    America's mutual fund industry has enabled millions of 
Americans, who otherwise would have been unable, to invest in 
debt and equity securities. It has contributed substantially to 
keeping our country's capital formation system the best in the 
world, but its institutionalized conflicts of interest have 
cost Americans dearly. The recent industry scandals merely 
highlight that in trying to serve two masters, many fund 
directors have all too often preferred the investment advisory 
firms with which they are associated over the mutual fund 
shareholders whom they should theoretically be trying to 
protect.
    Late trading and market timing abuses cost fund investors a 
bundle, but management fees, distribution fees, sales charge on 
purchases, so-called loads, purchase fees, deferred sales 
charges, so-called deferred loads, account fees and other 
charges cost investors many times more. Even small differences 
in these fees can translate into the large differences in 
returns over time.
    The combination of excessive and opaque fees, abusive 
trading practices, coupled with government policies which 
channel investors, automatically, into mutual funds has 
transformed this once sleepy industry into a monster.
    The mutual fund industry is now the world's largest 
skimming operation--a $7-trillion trough from which fund 
managers, brokers and other insiders are steadily siphoning off 
an excessive slice of the Nation's household, college and 
retirement savings. We may only be talking about a skim of a 
few basis points here and a few basis points there, but when 
the skim is multiplied by $7 trillion, and then compounded over 
10, 20, 30 or more years, pretty soon we are talking about real 
money. But because no one has to write a check for these fees 
and costs and because it makes so much sense to have a tax-
sheltered retirement or college savings account, relatively few 
have questioned the industry's practices or fees, let alone its 
bizarre governance structure. And, unfortunately, too few have 
listened to industry reformers like John Bogle, who has been 
sounding the alarm for years, until now, that is, John.
    The current scandal gives us the opportunity to rethink the 
whole mutual fund industry. In my judgment, in addition to the 
obvious tightening to prevent market timing and late trading we 
must do at least the following:
    No. 1, require that at least 75 percent of the fund's 
directors, including and especially the chairman, be 
independent, and tighten the definition of independent 
directors;
    No. 2, clarify the fiduciary duty a fund director owes to 
fund shareholders and make that duty preempt any possible 
conflicting duties that a director may owe to any vendor to the 
fund;
    No. 3, require mutual funds to competitively bid out all 
investment advisory contracts and perhaps other contracts;
    No. 4, substantially tighten the fee disclosure 
requirements for mutual funds;
    No. 5, require brokers who steer customers into a 
particular fund to disclose in writing to the customer the 
compensation that the broker will receive due to the 
transaction. I am referring to so-called 12b-1 fees. In 
Chicago, they call those kickbacks. [Laughter.]
    No. 6, finally, we ought to consider facilitating the 
creation of more mutual funds that are truly mutual, ones where 
like Vanguard, the funds actually own the firm.
    Before I introduce our witnesses, I would like to ask 
Senator Collins and Senator Akaka if they have opening 
statements.
    We will allow the Chairman to go first, the Chairman of the 
full Committee.
    Chairman Collins. Thank you. We are both being so polite 
here.
    Senator Fitzgerald. That is right. Thank you. Senator 
Collins.

             OPENING STATEMENT OF CHAIRMAN COLLINS

    Chairman Collins. Thank you, Mr. Chairman.
    Let me begin by saluting you for your leadership and your 
hard work in investigating this issue and convening this very 
important hearing this morning. This hearing is about abusive 
and, in some cases, possibly illegal practices allowed by some 
mutual fund companies, but the hearing is about more than that. 
It is really about people, good, hardworking, middle-income 
families who are doing their best to plan for their retirement 
or to save for their children's education by investing their 
savings in mutual funds that have long been promoted as a haven 
for small investors.
    Of all of the components in the financial industry, the 
mutual fund sector has perhaps the greatest responsibility to 
safeguard the interests of small investors. Yet, within the 
last 2 months, more than a dozen companies have been named in 
allegations of misusing millions of dollars of their investors' 
money. These practices benefit a select few at the expense of 
the vast majority of mutual fund investors.
    As one of our witnesses has indicated, there is evidence, 
troubling evidence, that officials at fund companies profited 
personally at the expense of their customers by market timing 
their own funds.
    It is equally troubling to me that this is not a new 
problem. According to the securities administrator in the State 
of Maine, similar allegations involving these practices arose 
in the late 1990's, and yet little has been done since then to 
protect the Nation's 95 million mutual fund investors, 445,000 
of whom live in Maine. Surely, they deserve better.
    I question why the Securities and Exchange Commission, 
which has regulatory responsibility for the mutual funds and 
their broker-dealers, has failed to detect these practices, to 
oppose appropriate restrictions or to penalize those who appear 
to be misusing their investors' money. I question why mutual 
fund companies and their boards of directors would sacrifice 
the trust of their investors in the $7-trillion industry to 
benefit a select group of individuals who can afford to play 
the mutual fund market.
    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. 
We have a regulatory system that is supposed to ensure that 
companies are acting in an ethical and legal manner. Mutual 
fund companies have boards of directors who are supposed to 
fulfill their fiduciary obligations toward their investors, and 
yet these abuses occur over and over again. The system is 
obviously flawed.
    As the Chairman may well remember, I spent 5 years in the 
State of Maine as commissioner of the department with 
responsibility for securities regulation. This is an issue that 
is of great interest to me. We need to know what actions will 
be most effective in stopping these abusive practices once and 
for all, and this hearing is certainly a worthwhile step in 
that direction.
    Thank you, Mr. Chairman.
    Senator Fitzgerald. Thank you, Madam Chairman. May I just 
ask you what office had that responsibility for securities in 
Maine?
    Chairman Collins. I was the Commissioner of the Department 
of Professional and Financial Regulation, and that includes the 
Securities Division. Our administrator in Maine was the recent 
chair of the National Association of Securities Administrators 
and worked very closely with some of our witnesses today.
    Senator Fitzgerald. Well, thank you. Senator Akaka.

               OPENING STATEMENT OF SENATOR AKAKA

    Senator Akaka. Thank you very much, Mr. Chairman. I want to 
thank you very much and to tell you that I appreciate your 
conducting this hearing today.
    I also would like to thank Representative Baker for his 
leadership on the important issue of mutual fund governance.
    As the Chairman of the full Committee on Governmental 
Affairs mentioned, this hearing is about the hard-working 
people of our country who have placed their--and I want to 
emphasize this word,--``Trust'' in the hands of experts to 
ensure productive investments for a better future are being 
properly managed. Because of this, we are taking steps in the 
direction of improving what many in the mutual fund industry 
are doing and to, in some cases, because of the letters I have 
received, restore their trust.
    Trust, as we know, is the cornerstone of effectively 
functioning markets. The abuses involving mutual funds that 
have been revised include having different sets of rules for 
large and small investors, ethical misconduct, and individuals 
enriching themselves illegally at the expense of fund 
shareholders. I look forward to the examination of these abuses 
by this Subcommittee.
    These revelations are particularly troubling because, as 
the Chairman mentioned, 95 million individuals have placed a 
significant portion of their future financial security into 
mutual funds. Mutual funds provide working-class Americans with 
an investment vehicle that offers diversification and 
professional money management.
    Mutual funds are an investment vehicle that the average 
investors rely on for retirement, savings for their children's 
college education and other financial goals and dreams.
    Today's hearing provides us, and this is important, the 
opportunity to better understand the troubling issues involving 
mutual funds, such as market timing and late trading which have 
demonstrated a betrayal of the trust of investors by certain 
investment companies.
    I will be introducing legislation designed to restore 
public trust in mutual funds. I look forward to working with my 
colleagues, Chairman of the Full Committee Collins, Chairman of 
this Subcommittee Fitzgerald, and Representative Baker to 
address the issues of mutual fund corporate governance. The 
transgressions that have been brought to light make it clear 
that the boards of mutual fund companies are not providing 
sufficient oversight. To be more effective, the boards must be 
strengthened and made to be more independent. Investment 
company boards should be required to have an independent 
chairman, and independent directors must have a dominant 
presence on the board.
    In addition, shelf-space payments and revenue sharing 
agreements between mutual fund companies and brokers present 
conflicts of interest that must be addressed. Brokers must be 
required to disclose in writing, to those who purchase mutual 
company shares, the amount of compensation the broker will 
receive due to the transaction, instead of simply providing a 
prospectus.
    In order to increase the transparency of the actual costs 
of the fund, brokerage commissions must be counted on as an 
expense in filings with the SEC and included in the calculation 
of the expense ratio, so that investors can have a more 
realistic view of the expenses of their fund.
    My legislation will address the need for increased 
transparency of these financial relationships and transactions 
in order to ensure that individual investors are able to make 
fully informed decisions when purchasing mutual fund shares.
    I want to thank our witnesses for being with us today. I 
look forward to working with all of you to restore the 
shattered trust of investors and bring about significant reform 
of the mutual fund industry.
    Thank you very much, Mr. Chairman.
    Senator Fitzgerald. Senator Akaka, thank you very much, and 
I would like to second Senator Akaka's commendation of 
Congressman Baker. Congressman Baker is scheduled to be our 
first witness today, but I am advised that he is now en route 
to Washington, so we are going to accommodate him on a 
subsequent panel. He is another one who has been like John the 
Baptist, a voice crying in the wilderness, and talking about 
this issue for a long time. Before the current trading abuses 
came to light, he introduced a very good bill over in the House 
that would bring much needed reforms to the mutual fund 
industry.
    We will move now to this panel. Our first witness is 
Stephen M. Cutler, who is the Director of the Division of 
Enforcement at the U.S. Securities and Exchange Commission. His 
division investigates possible violations of securities laws, 
recommends Commission action, and negotiates proposed 
settlements on behalf of the Commission. Mr. Cutler joined the 
SEC in 1999 as Deputy Director of Enforcement.
    Also joining us from the SEC today is Paul F. Roye, who is 
the Director of the Division of Investment Management. Mr. Roye 
oversees the $20-trillion investment management industry and 
administers the securities laws affecting investment companies, 
including mutual funds and investment advisers. I would note 
that Mr. Roye has the same combination of college and law 
school that I have. He is an alumnus of Dartmouth College and 
the University of Michigan Law School.
    Our third witness is the Hon. William F. Galvin, Secretary 
of the Commonwealth of Massachusetts. As the State's chief 
securities regulator, Secretary Galvin has earned a national 
reputation aggressively protecting investors against fraud and 
has recovered millions of dollars for victims of securities 
fraud.
    Our fourth witness is the Hon. Eliot L. Spitzer, Attorney 
General for the State of New York. Mr. Spitzer's inquiry into 
the trading activities of Canary Capital Partners was the first 
of many subsequent announcements and actions against players in 
the mutual fund industry. Additionally, his investigations of 
conflicts of interest on Wall Street have been a major catalyst 
for reform in the Nation's financial services industry. Prior 
to being elected Attorney General, Mr. Spitzer served as an 
Assistant District Attorney in Manhattan from 1986 to 1992.
    Our fifth witness is Mary L. Schapiro. Ms. Schapiro is Vice 
Chairman and President of Regulation Policy and Oversight at 
the National Association of Securities Dealers. Prior to 
assuming her current duties at NASD, Ms. Schapiro was appointed 
the Chairman of the Commodity Futures Trading Commission in 
1994 by President Clinton. Prior to that, she was an SEC 
Commissioner from 1988 to 1993, when she was appointed Acting 
Chairman of the SEC.
    I would like to thank all of you for your appearances 
today, and in the interest of the time, your full statements 
will be included in the Subcommittee's record and we ask that 
you try to limit your summary remarks to about 5 minutes so 
that we can leave plenty of time for questions.
    Thank you. Mr. Cutler, you may proceed.

   TESTIMONY OF STEPHEN M. CUTLER,\1\ DIRECTOR, DIVISION OF 
      ENFORCEMENT, U.S. SECURITIES AND EXCHANGE COMMISSION

    Mr. Cutler. Thank you, Chairman Fitzgerald, Ranking Member 
Akaka, and Senator Collins and other distinguished Members of 
the Subcommittee. Good morning. Thank you, Mr. Chairman, for 
inviting me to testify today on behalf of the SEC concerning 
abuses relating to the sale and operation of mutual funds.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Cutler appears in the Appendix on 
page 59.
---------------------------------------------------------------------------
    As each Member of this Subcommittee has mentioned, more 
than 95 million Americans are invested in mutual funds today. 
For that reason, the unholy trinity of illegal late trading, 
abusive market timing and related self-dealing practices that 
have recently come to light are matters that affect us all, and 
they go right to the heart of the trust, the covenant, if you 
will, between mutual fund and other securities professionals 
and the individual investor.
    As my colleagues and I have gathered evidence of one 
betrayal after another, the feeling I am left with is one of 
outrage, and I feel that not just as a prosecutor, but as a 
citizen and as a member of the investing public. It is 
intolerable when investment professionals, who are duty-bound 
to serve their customers' interests, instead serve their own. 
The conduct we have seen is antithetical to the duties that 
mutual funds, investment advisers, brokerage firms and their 
employees owe to fund shareholders. Individual investors have a 
right to expect fair treatment and, quite simply, they have not 
gotten it.
    Along with the other regulators sitting at this table, the 
SEC is fully committed to ensuring that those responsible for 
betraying the trust of mutual fund shareholders are held 
accountable and brought to justice. Indeed, that process has 
begun, starting, of course, with Mr. Spitzer's action against 
the Canary Partners hedge fund firm and its principal, Edward 
Stern. Since then, the Commission has brought five enforcement 
actions involving fraud against mutual fund investors. In each 
one, the Commission staff has worked in close coordination with 
State regulators, including my distinguished co-panelists, Mr. 
Spitzer and Mr. Galvin. I will touch on each of the cases very 
briefly.
    On September 16, the Commission filed a civil action 
against Theodore Sihpol, Canary's primary contact at Bank of 
America Securities. We allege that Mr. Sihpol played a key role 
in enabling certain hedge funds to engage in late trading. That 
is putting orders in after 4 p.m., but receiving the old 4 p.m. 
price. On the same day the Commission commenced its action, the 
New York Attorney General filed a two-count criminal complaint 
charging Sihpol with larceny and securities fraud.
    Less than 3 weeks later, the Commission and the New York 
Attorney General again announced parallel criminal and civil 
actions--this time against Steven Markovitz, formerly an 
executive and senior trader with a prominent hedge fund, 
Millennium Partners. According to the criminal charges and the 
SEC findings, Markovitz engaged in late trading on behalf of 
his firm. In an impartial settlement of the SEC's action, 
Markovitz agreed to be permanently barred from associating with 
an investment adviser or a registered investment company.
    In the first action against a mutual fund executive for 
permitting abuse of market timing, on October 16, the 
Commission and the New York Attorney General announced the 
arrest, conviction and lifetime industry bar of James P. 
Connelly, Jr., former Vice Chairman of Fred Alger & Company. 
Market timing, of course, refers to the practice of excessive 
short-term buying and selling of mutual fund shares in order to 
exploit inefficiencies in mutual fund pricing. In its 
administrative order, the SEC found that Connelly had approved 
agreements that, contrary to Alger's prospectus disclosure, 
permitted select investors to market time certain mutual funds, 
in some cases, in exchange for the timers leaving at least 20 
percent of their assets at Alger in buy-and-hold positions.
    The Commission's order bars Connelly from the industry and 
imposes a $400,000 civil penalty.
    Most recently, on October 28, in conjunction with the 
Secretary of Massachusetts, the Commission brought enforcement 
actions against Putnam Investment Management and two former 
Putnam portfolio managers, Justin M. Scott, and Omid Kamshad, 
in connection with Scott and Kamshad's personal trading in 
Putnam mutual funds.
    We allege that Scott and Kamshad market timed the very 
Putnam funds they managed and that Putnam failed to take 
adequate steps to prevent or disclose their self-dealing 
activity or that of other Putnam personnel who engaged in 
excessive short-term trading of Putnam funds.
    I think I can safely predict that many more enforcement 
actions will follow. We are currently conducting a broad-based 
inquiry of late trading, market timing and related self-dealing 
practices. On September 4, the Commission staff 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 that sell 
mutual funds in the form of variable annuities.
    Based on the responses to these requests, Commission staff 
have been dispatched to conduct on-site inspections and 
interviews and further investigation at dozens of firms. 
Although we are continuing to receive and analyze the 
responsive information, I would like to highlight some of the 
most troubling items. I must emphasize that these are only 
preliminary and are the subject of continued, active 
investigation.
    First, on the subject of late trading, more than 25 percent 
of responding brokerage firms reported that customers had 
received 4 p.m. prices for orders placed or confirmed after 4 
p.m. E-mails submitted by approximately 10 percent of the 
responding mutual funds contained references to situations that 
possibly involve late trading. Three fund groups reported--or 
the information they provided indicated--that their staffs had 
approved a late trading arrangement with an investor.
    Second, on the matter of market timing, we have already 
reported that 50 percent of responding fund groups appear to 
have had at least one arrangement allowing for market timing by 
an investor, but in addition to that, documents provided by 
almost 30 percent of responding brokerage firms indicate that 
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, a practice 
sometimes called cloning, to avoid detection by mutual funds 
that sought to prevent abusive market timing. Further, almost 
70 percent of responding brokerage firms reported being aware 
of timing activities by their customers.
    Finally, let me mention another potentially abusive 
practice that has gotten attention as well--the selective 
sharing of mutual fund portfolio information. More than 30 
percent of responding fund companies appear to have disclosed 
portfolio information in circumstances that may have provided 
certain fund shareholders the ability to make advantageous 
decisions to place orders for fund shares.
    The Commission staff is following up on all of these 
situations closely, along with my colleagues at the table. Let 
me also point out that we are actively engaged in enforcement 
and examination activities in four other important areas 
involving mutual funds, some of which I know that Mary Schapiro 
will address.
    The first area is mutual fund sales practices and fee 
disclosures. In particular, we are looking at just what 
prospective mutual fund investors are being told about revenue-
sharing arrangements and other incentives doled out by mutual 
fund management companies and mutual funds themselves to 
brokerage firms who agree to feature their funds.
    We are looking at whether there is adequate disclosure of 
the source and the nature of those payments and the fact that 
they may increase costs to investors, as well as create 
conflicts of interest between investors and the financial 
professionals with whom they deal.
    In one case involving a major financial institution, we 
have already issued a Wells Notice of the staff's intention to 
recommend what I think would be first-of-their-kind charges by 
the Commission.
    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 commonly referred to 
as A shares, B shares, and so on. Each class will have a 
different fee structure associated with it. In the last 6 
months, we have brought enforcement actions against two 
brokerage firms--Prudential Securities and IFG Network 
Associates--in connection with the alleged recommendations that 
customers purchased one class of shares when the firms should 
have been recommending another.
    The third area is the abuse of so-called break points. That 
is a fancy term for what are, in essence, volume discounts 
available to investors who make large purchases of mutual fund 
shares. Quite simply, we found numerous instances in which it 
appears that brokerage firms did not give investors the 
discounts to which they were entitled. This week, together with 
the NASD, we will be issuing Wells Notices to a significant 
number of brokerage firms for their failure in this regard.
    The final 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.
    Before I conclude, I would like to take a moment to address 
press 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. Do 
I wish that we would have brought the Putnam case 2 months ago, 
instead of 2 weeks ago? Of course, I do. 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, including giving more expeditious treatment to 
those that raise enforcement issues and instituting a monthly 
review of the disposition of each enforcement-related matter by 
the Division's senior management. Tips from whistleblowers are 
critical to our program. In fact, the investigation of personal 
trading at Putnam, which is what we ultimately sued Putnam for, 
was launched when we received a tip in that area just a few 
weeks ago.
    Speaking more generally, I am proud of the Commission's 
record in the enforcement area. In our just-concluded fiscal 
year, the Commission brought 679 enforcement cases involving 
just about every conceivable type of securities violation. That 
is a 40 percent jump from just 2 years ago. We accomplished 
this dramatic increase with almost no increase in resources, 
and included in our most recent year's totals are some 
extraordinary efforts on behalf of the investing public:
    One-and-a-half billion dollars in disgorgement and 
penalties designated for return to investors using Sarbanes-
Oxley fair funds, a total of 60 enforcement actions against 
public company CEOs;
    Nearly 40 emergency asset freezes and TROs to protect 
investors' money on a real-time basis, groundbreaking and 
important cases against brokerage firms and banks for their 
roles in the Enron debacle;
    The first-ever case against a mutual fund management 
company for failure to disclose a conflict of interest in the 
voting of its fund's proxies;
    A first of its kind case against a major insurance company 
for aiding and abetting an issuer's financial statement fraud;
    Multiple cases alleging violations of the Commission's new 
selective disclosure rule;
    And dozens of financial fraud cases against Fortune 500 
companies and their auditors.
    The dedication, commitment, and professionalism of our 
enforcement staff are second to none. With Congress's help, we 
have now begun to see additional resources. With more people 
and better technology, our mandate from Chairman Donaldson is 
to more proactively 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 examinations, and 
digging deeper into fund operations. We are working 
aggressively on behalf of America's investors to ferret out and 
punish wrongdoers wherever they may appear in our securities 
markets, including the mutual fund area. And at the same time 
that the Commission is looking backwards to identify and punish 
past misconduct, 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, Director of the Division of Investment Management, 
will discuss those initiatives.
    Thank you, and I would be happy to answer any questions 
that the Subcommittee has.
    Senator Fitzgerald. Thank you, Mr. Cutler. Mr. Roye.

TESTIMONY OF PAUL F. ROYE,\1\ DIRECTOR, DIVISION OF INVESTMENT 
      MANAGEMENT, U.S. SECURITIES AND EXCHANGE COMMISSION

    Mr. Roye. Thank you, Chairman Fitzgerald, Ranking Member 
Akaka, and Senator Collins, and distinguished Members of the 
Subcommittee.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Roye appears in the Appendix on 
page 80.
---------------------------------------------------------------------------
    Like Steve, on behalf of the Securities and Exchange 
Commission, I appreciate the opportunity to discuss possible 
regulatory responses to recent allegations of abusive practices 
in the mutual fund industry, and initiatives to improve the 
regulatory framework governing mutual funds.
    As has been noted, with over 95 million Americans invested 
in mutual funds, representing approximately 54 million U.S. 
households and a combined $7 trillion in assets, mutual funds 
are unquestionably one of the most important elements of our 
financial system.
    The conduct alleged in the various cases brought by the 
Commission, as well as the New York Attorney General and the 
Secretary of the Commonwealth of Massachusetts represent 
reprehensible conduct that are gross violations of the Federal 
securities laws, as well as basic fiduciary principles.
    As my colleague Steve Cutler just outlined for you, the 
Commission has put in motion an action plan to vigorously 
investigate these matters, assess the scope of the problem and 
hold wrongdoers accountable. Now, while our enforcement efforts 
are a key tool in protecting the Nation's investors, another 
critical component is the regulatory framework designed to 
prevent or minimize these abuses from happening in the future 
or happening in the first place.
    Before I discuss regulatory initiatives in this area, I 
would like to take a moment to place these initiatives in 
context. In recent years, the Commission has had a principle 
focus on strengthening the mutual fund governance framework. 
The Commission has adopted rules that effectively require fund 
boards to have a majority of independent directors, and require 
that independent directors select and nominate other 
independent directors to fill vacancies on fund boards.
    We promoted the concept of independent legal counsel for 
fund directors, enhanced disclosures regarding directors, 
including information concerning whether the directors own 
shares of the funds that they oversee, and information about 
independent director potential conflicts of interest; as well 
as disclosures about the board's role in how they govern the 
funds, including the basis upon which they renew a fund's 
investment advisory contract.
    More recently, the Commission has tailored the provisions 
of the Sarbanes-Oxley legislation to apply to mutual funds, 
including the provisions to improve oversight and internal 
controls, such as key officer certifications and code of ethics 
requirements. The Commission has proposed that each fund have a 
chief compliance officer reporting to, and accountable to, fund 
independent directors whose responsibility it would be to 
provide that the fund has procedures in place reasonably 
designed to ensure compliance with the Federal securities laws.
    And the Commission also has supported key provisions of the 
legislation that has been referenced that was introduced by 
Congressman Richard Baker, to further enhance mutual fund 
governance, including provisions that give the Commission the 
authority to close gaps in the definition of independent 
director in the Investment Company Act of 1940.
    Indeed, so far this year the Commission has proposed or 
adopted 16 different rulemakings related to mutual funds. 
Again, through these rulemakings, the Commission has sought to 
enhance fund governance and internal controls, improve fund 
disclosures, and minimize conflicts between funds and their 
managers.
    We sought public input on additional measures that the 
Commission should take to improve the mutual fund regulatory 
framework so that we can avoid these problems that we are 
currently investigating.
    In addition, our staff in September issued a comprehensive 
report on hedge funds, making a series of recommendations to 
improve the Commission's ability to monitor the activities of 
these vehicles, the most significant being a recommendation to 
require that hedge fund advisers register under the Investment 
Advisers Act of 1940, and therefore become subject to 
Commission examination and routine oversight.
    Now, this review of hedge funds and the staff's 
recommendations become all the more important when we consider 
that we have seen a number of hedge funds engaging in late 
trading and market timing activity of mutual fund shares, 
indeed, serving as the impetus for the current investigations 
and enforcement actions related to these activities.
    Now, the 16 rulemakings that we have done so far in 2003, 
along with those to come, combined with the staff's work on 
hedge funds, will represent, to my knowledge, the Commission's 
most productive year in investment management regulation since 
the Commission was charged in 1940 with overseeing this segment 
of the financial services industry, and I think fund investors 
are benefiting from these proactive initiatives, but we are not 
done yet.
    You can expect significant mutual fund regulatory 
initiatives before this year is through. On October 9, slightly 
more than a month after the New York Attorney General announced 
his actions against Canary Partners, Chairman Donaldson 
outlined a regulatory agenda to confront and address late 
trading and market timing abuses to help restore confidence in 
the fairness of the mutual fund operations and practices.
    He requested our staff to submit rulemaking recommendations 
to the Commission this month to address these issues, and we 
are going to meet that demand.
    In preparing its recommendations to the Commission, the 
staff is examining requiring that the fund or its designated 
agent, rather than intermediaries such as broker-dealers or 
parties that we do not regulate, receive a purchase or 
redemption order for fund shares by 4 o'clock for an investor 
to receive that day's price.
    Now, this hard 4 o'clock cut-off we believe would 
effectively eliminate the potential for late trading through 
intermediaries that sell fund shares. Staff is also considering 
recommending that the Commission address late trading in 
connection with the recommendation to adopt the mutual fund 
compliance policies rule which the Commission proposed in 
February of this year. Again, this proposal calls for a chief 
compliance officer who is accountable to the fund directors, 
whose responsibility it would be to ensure that funds have 
effective policies and procedures in place to prevent such 
activity as late trading.
    With respect to market timing, we are preparing 
recommendations to require explicit disclosure and fund 
offering documents of market timing policies and procedures. 
And this disclosure would enable investors to assess a fund's 
market timing practices and determine if those practices are in 
line with their expectations.
    The rule recommendations requested by the Chairman would 
have a further component of requiring funds to have procedures 
to comply with these representations regarding market timing 
policies. Thus, if a fund's disclosure documents stated that it 
took action or will take action to discourage market timing, 
the fund will be required to have procedures in place to assure 
that it is complying with these representations to investors.
    The establishment of formal procedures would enable our 
examination staff to review whether or not these procedures are 
being followed and whether or not the fund is living up to its 
representations regarding curbing market timing activity.
    The Commission also will emphasize the obligations of funds 
to fair value price their securities so as to avoid stale 
pricing, to minimize market timing arbitrage opportunities. We 
think this is an important measure to combat market timing 
activity.
    Steve mentioned allegations of portfolio managers market 
timing the funds they manage or other funds in the complex, 
This raises issues regarding insider trading, as well as the 
need for an adherence by fund personnel to policies and 
procedures to prevent the misuse of material nonpublic 
information. We expect that this issue will also be addressed 
in the rulemaking recommendations that we are going to submit 
to the Commission later this month.
    Recent allegations indicate that some fund managers may be 
selectively disclosing their portfolios in order to curry favor 
with large investors. Selective disclosure of a fund's 
portfolio can facilitate fraud and have severely adverse 
ramifications for a fund's investors if someone uses that 
portfolio information to trade against the fund. So, 
consequently, the Chairman has asked the staff to consider 
whether additional requirements are necessary to reinforce 
funds and adviser's obligations to prevent the selective 
disclosure of fund portfolio holdings information in a manner 
that can harm investors.
    In addition to these initiatives, we have been asked to 
consider whether funds should have additional tools available 
to thwart market timing activity, such as mandatory redemption 
fees or allowing funds to retain the profits of short-term 
traders in their shares. If we take away the profit potential 
that can be gained by market timers, we can eliminate abuses in 
this area.
    Now, Chairman Donaldson has emphasized that he will not 
hesitate to call for other regulatory measures if we discover 
additional information in the course of our investigation that 
merits regulatory action, and he has indicated that no reform, 
whether structural, fund governance or board composition is off 
the table. The Commission is committed to moving swiftly and 
aggressively to take all necessary steps to protect mutual fund 
investors from abusive and harmful activity.
    In addition to the initiatives to address late trading and 
market timing abuses, the staff and Commission have been 
working on other initiatives designed to assist mutual fund 
investors in making the best investment decisions for 
themselves, to attack inappropriate mutual fund sales practices 
and bolster confidence in the mutual fund industry.
    Now, these initiatives seek to provide for complete 
transparency of fees and expenses, improve the fund governance 
framework, including initiatives relating to fund advertising, 
fund-of-fund products, breakpoint disclosures regarding sales 
loads, shareholder report disclosure of operating expenses for 
investors in dollars and cents, more frequent disclosure of 
fund portfolio information so investors can make better asset 
allocation decisions, enhanced disclosure of incentives and 
conflicts that brokers have in offering mutual fund shares to 
investors, and giving investors greater input into director 
nomination initiatives.
    We are committed to moving forward with our mutual fund 
agenda in these areas as well. And I should also note that with 
the additional resources and funding from Congress, we are 
beefing up our oversight of the fund industry with additional 
staffing that will allow for more frequent inspections of funds 
to monitor for compliance with the Federal securities laws.
    In conclusion, I would like to reiterate that the 
protection of our Nation's mutual fund investors is of 
paramount importance to the Commission and the staff. I can now 
assure you and assure the American public that the Commission 
will deal immediately with the reprehensible abuses that are 
taking place. We are committed to rooting out the problems, 
punishing the perpetrators and putting the proper rules in 
place so that these abuses do not happen in the future.
    Again, I appreciate the opportunity to be here, and I would 
be happy to answer any questions.
    Senator Fitzgerald. Mr. Roye, thank you very much.
    Secretary Galvin, you may proceed. I would reiterate, we 
would ask that you stick to 5 minutes because we have to leave 
time both for another panel and for questions of both panels.
    Thank you.

   TESTIMONY OF HON. WILLIAM F. GALVIN,\1\ SECRETARY OF THE 
                 COMMONWEALTH OF MASSACHUSETTS

    Mr. Galvin. Thank you, Mr. Chairman. I am Bill Galvin, 
Secretary of State and Chief Securities Regulator of 
Massachusetts. I want to commend Senator Fitzgerald, Senator 
Collins, and Senator Akaka for calling today's hearing to 
examine mutual fund abuses.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Galvin appears in the Appendix on 
page 97.
---------------------------------------------------------------------------
    Mutual funds, as has been stated, play a major role in the 
wealth and savings of our Nation. Today, half of all American 
households invested nearly $7 trillion in mutual funds, but 
mutual funds are about more than money under management. Mutual 
funds are about the hopes and dreams of middle-income 
Americans, the hopes 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.
    Investors have placed their trust in mutual funds with the 
understanding that they would be treated fairly, that the risk 
of the market would be offset by the skill and commitment of 
fund managers. We are here today because in too many instances 
the mutual fund industry has failed to live up to its duty. The 
common theme running through all of the mutual fund issues that 
we have exposed in recent months is that the mutual fund 
industry is putting its own interest ahead of their consumers 
and customers.
    While they market trust and competence, too often they have 
delivered only deceit and underperformance. We are also here 
today because self-policing and government laws and law 
enforcement have also failed to effectively protect the 
investor. The evidence that self-policing has failed is in the 
willingness of the entire industry to quietly tolerate known 
market abuses while they parse words trying to describe clearly 
unethical practices as not illegal. Their past silence has 
convicted them of ineffectiveness.
    Government laws and law enforcement have failed because 
they have failed in the past to aggressively and properly 
enforce the law. For too long, 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 can come up with a more 
clever way to do what they just said they would not do again.
    For too long, while the merry-go-round of accusation and 
nonadmission goes round and round, investors have been the 
losers. 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.
    We have uncovered insider trading in Massachusetts 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 Investment, the Nation's fifth-largest mutual 
fund company. Simply put, investors were cheated.
    In August, my office uncovered a hidden compensation scheme 
at Morgan Stanley, including cash prizes and other lucrative 
benefits designed the push Morgan Stanley mutual funds on 
unsuspecting investors who were seeking honest advice.
    These enforcement actions are only two examples of the deep 
problems in the industry. Mutual funds violate investor trust 
in a number of ways--when mutual funds allow market timing for 
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 
fund shares, when mutual funds pay higher commissions to 
brokers or other incentives to sell proprietary or in-house 
funds to investors rather than funds that may be more suitable 
to the investor's needs and when break-point discounts are 
ignored or concealed.
    State securities regulators are often the first to identify 
investment-related problems and to bring enforcement actions to 
halt and remedy these problems. Any suggestion that the 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.
    H.R. 2420 is a positive response to some of the many 
problems investors in mutual funds now face, and I endorse its 
objectives. The bill can be improved, however. The original 
language of Section 1, regarding fund operating expenses, 
should be restored. Each individual investor should be notified 
of the actual cost they are paying, and instead of simply 
disclosing soft-dollar costs, they should be banned.
    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, but laws alone are 
not enough. They must be vigorously enforced.
    Again, I want to commend the Subcommittee for focusing 
attention on this situation. With strengthened laws and 
vigorous enforcement, we can give our Nation's investors the 
fairness and honesty they seek and the protection they deserve.
    Thank you. I will be happy to answer any questions you 
might have.
    Senator Fitzgerald. Secretary Galvin, thank you. Attorney 
General Spitzer.

TESTIMONY OF HON. ELIOT L. SPITZER,\1\ ATTORNEY GENERAL FOR THE 
                       STATE OF NEW YORK

    Mr. Spitzer. Thank you very much, Mr. Chairman, Senator 
Collins, and Senator Akaka. Thank you so much for having this 
hearing today.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Spitzer appears in the Appendix 
on page 105.
---------------------------------------------------------------------------
    Senator Fitzgerald, I would be tempted to ask that my 
testimony be stricken and your opening statement be substituted 
for it. It was a very powerful statement encapsulation of 
precisely what is wrong with the industry and, indeed, many of 
the ideas that need prospectively to be adopted to remedy the 
problems we have been discussing in past months.
    I would also share in your kind words for Mr. Bogle, who 
for many years--decades perhaps--has been, as you said, a voice 
in the wilderness diagnosing these problems, and yet nobody 
wished to hear it.
    It is indeed the case that others have said this 
occasionally, and I would wish to quote Paul Samuelson, who was 
not only a Nobel laureate in economics, but also one who was 
very wise in his understanding about capital markets. He said, 
about 35 years ago, ``I decided that 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.''
    He understood very well, ultimately, how the incentive 
structure we created would result in money being made by those 
who managed, not necessarily to the exclusion, but certainly to 
the hindrance, of those on behalf they were investing.
    One of the pities of what has now become a well-documented 
story and tale of abuse is that the evidence of this abuse is 
very obvious. Those who wish to look should have been able to 
see it. Those in management positions have understood, and if 
those on boards of directors or advisory companies or 
management companies had gone to even the minimal effort that 
they are supposed to go to, they would have seen these abuses.
    Unfortunately, just as we saw last year in our 
investigation of conflicts of interest at the investment 
companies with respect to research, internal compliance, 
internal aggressiveness simply was not there. Indeed, most 
remarkably, the mutual fund companies, over the past 3 years, 
have protested their innocence. They have claimed that they are 
pure, they are clean as the driven snow. For many of us, the 
most remarkable intersection and most remarkable evidence of 
this was about a year ago, when there was a proposal, a very 
wise proposal that I think has been adopted by the SEC that 
would have required mutual fund companies to disclose how they 
were voting their proxies.
    The mutual fund company, in what can only be described as 
an act of grotesque arrogance, said, no, we do not want to 
disclose this information. It will be too expensive--too 
expensive to tell the American public how they were voting the 
proxies of shares that were owned in trust for the American 
public at the very time that they were raking off $50 billion 
in fees, of advisory fees, and $20 billion in fees above and 
beyond that. Too expensive they said.
    That, for me, and for many others, I believe, was the 
opening salvo in what, for us, was an effort to unwind what has 
been clear and ongoing abuses by an industry that has, until 
now, held itself to be above the law.
    As you pointed out Senator Fitzgerald, in your opening 
comments, between 1980 and the present, funds under management 
have grown by 60 times, and yet fees have grown by 90 times. 
Where are the economies of scale that have been promised year 
after year by this industry, economies of scale that have been 
used, they believe, they have argued, to justify not only the 
12b-1 fees, but every other type of fee that has been piled on 
top of what they have charged the American consumer.
    CEO tradings. CEO trading has been revealed in past months. 
That should have been cleared to internal compliance, but 
nobody asked.
    Redemption rates. There were many multiples of the assets 
under management. Clearly, this is a red flag that should have 
made it very evident to somebody somewhere inside these 
companies that trading patterns were amiss, and yet again 
nobody did anything. Clearly, there has been a problem here. 
And just to put this into perspective, in terms of an order of 
magnitude, we believe, and we know that there will be a dispute 
of this figure by the ICI. We believe these numbers are 
correct. We believe that on the order of a 25-basis point 
differential exists between what mutual funds are charged for 
management versus pension funds.
    Twenty-five basis points does not sound like a great deal 
unless you aggregate the numbers. Twenty-five basis points 
spread across the entirety of the funds under management would 
save the American mutual fund investor $10 billion every year.
    If mutual funds were charging what pension funds were 
charged for what we believe to be comparable services, $10 
billion would flow back to the American investor. Those numbers 
swamp the impropriety that we have found in late-day trading 
and timing, and therefore deserve to be the subject of intense 
focus. Again, to put this into perspective for the individual 
investor, a small investor or an individual investor with 
$100,000 over 10 years would aggregate an incremental $6,000--
merely by reducing by 25 basis points the fees that are charged 
by the management companies.
    Why is this relevant? It is relevant because we do not 
believe the management companies have in any way, shape or form 
negotiated aggressively to drive those fees down.
    Now, let me--and I understand that time is of the essence 
here--let me very quickly discuss two areas that are important, 
and this is the area, a question of how we handle this 
prospectively. Prospectively we must address two entirely 
distinct issues. One is the regulatory framework for timing and 
late-day trading. I think it should be understood by all 
investors and this Subcommittee that the rules with respect to 
those issues are basically clear. We do not necessarily, 
although I would encourage the SEC to adopt new rules, the 
problem here has not been an absence of rules, the problem has 
been a failure of compliance. It is outright illegal conduct 
that was not caught, that should have been caught and that is 
now being caught and will be aggressively prosecuted.
    In order to reach a settlement with my office for 
violations of either late trading or timing, let me make it 
very clear what the companies that committed improper acts will 
have to do, and I will merely focus on two issues. One, they 
will have to assure us that there is a compliance program that 
will guarantee that these abuses will be caught prospectively;
    In addition to full disgorgement and restitution to 
shareholders, there will need to be a disgorgement of all--and 
I repeat the word ``all''--fees that were earned with respect 
to any fund during the period of time during which there was 
illegal behavior. There is absolutely no room for the receipt 
of fees during the period of time during which funds are 
violating a clear fiduciary duty. This number will be big, it 
will impose pain, and it should.
    Second, there is an entirely distinct area, and this you 
alluded to, Mr. Chairman, the governance of these funds. This 
is where we need to rethink, in its entirety, the framework 
that has been created legislatively. There is no question at 
all the boards of directors of the mutual funds have been 
inert, they have been passive, they have failed. They have 
utterly failed the investor. They have misunderstood their 
role. They have not been responsive to the appropriate parties, 
and this must change. The ideas that you captured in your 
opening statement, at a minimum, must be embodied in law, and I 
applaud you for suggesting them.
    Let me add one more notion to that litany that you 
described, and that is something called a Most Favored Nation's 
clause. This is a notion that I think should be forced upon the 
boards. They should require that their fee structures with 
management and advisory companies include a Most Favored Nation 
clause that would stipulate that if any other entity is 
receiving a lower price for the same service, the entity on 
whose board they sit must receive that lower price. This would 
cut to the heart of what we believe is an impropriety, which 
permits pension funds and others to pay less than mutual funds 
are paying for comparable services and would address that 
chasm, the $10-billion divide that separates what investors get 
from what they should get.
    Let me make one very quick final point. Much has been said 
and made recently of the relationship between my office and the 
SEC. There are times when, indeed, I have been critical of the 
SEC and their failure to catch some of these abuses. I do not 
regret or withdraw my comments or my feeling that we 
collectively, as prosecutors and regulators, should have done 
better. However, I wanted to be perfectly clear at several 
levels.
    One, we have, we will continue, and we have absolutely no 
difficulty corroborating in entirety with the SEC. We will work 
hand in glove with them as we go forward. They are, must be and 
will continue to be the primary regulator of the securities 
markets. The enforcement bureau, under the leadership of Mr. 
Cutler, has done a yeoman's work in the past years trying to 
clean up what has been a torrent, a tidal wave of abuses, and I 
have nothing but respect for the job that they have done. And 
so I hope that those who think that there is some divide 
between us and wish to play upon that perception, I hope that 
they will be corrected in that very important misconception.
    Thank you very much, Mr. Chairman.
    Senator Fitzgerald. Thank you, Mr. Spitzer. Ms. Schapiro.

 TESTIMONY OF MARY L. SCHAPIRO,\1\ VICE CHAIRMAN AND PRESIDENT 
  OF REGULATORY POLICY AND OVERSIGHT, NATIONAL ASSOCIATION OF 
                       SECURITIES DEALERS

    Ms. Schapiro. Thank you very much. Good morning, Mr. 
Chairman, Senator Akaka and Senator Collins. I appreciate 
having the opportunity to testify on behalf of NASD.
---------------------------------------------------------------------------
    \1\ The prepared statement of Ms. Schapiro appears in the Appendix 
on page 111.
---------------------------------------------------------------------------
    NASD is the world's largest securities self-regulatory 
organization. We 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.
    Due to their enormous growth and 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 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.
    Throughout routine examinations, we have found that in 1 
out of 5 transactions in which investors were entitled to a 
breakpoint discount, that discount was not delivered. Thus, 
many brokers imposed the wrong sales load on thousands of 
mutual fund investors--in effect, overcharging investors, by 
our conservative estimate, $86 million in the last 2 years.
    NASD has directed firms to make immediate refunds, and in 
the next several weeks, with the SEC, we will announce a number 
of enforcement actions seeking 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 contests 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.
    We have also 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 proprietary funds. Customers have a 
right to know that these compensation deals which create 
serious potential for conflict of interest exist, whether the 
compensation is paid in cash or in the form of basketball 
tickets.
    Over the last 2 years, NASD has brought more than a dozen 
major cases against brokers who have recommended that investors 
buy Class B shares of mutual funds in which the 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 on-line 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 were not always able to tell with 
clarity whether or not they had entered trades late. This 
imprecision indicates poor internal controls and recordkeeping, 
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 website that allows investors to compare 
expenses and fees for funds and fund classes and highlighting 
when they should look for breakpoint 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.
    In closing, I also want to commend Congressman Baker for 
his work. NASD supports H.R. 2420 and applauds his efforts to 
bring increased transparency to the mutual fund industry.
    I thank you, Chairman Fitzgerald, for your leadership in 
investigating this area, and we appreciate again the 
opportunity to testify. I would be happy to answer questions.
    Senator Fitzgerald. Thank you very much.
    We will begin the questioning now, and I would like to 
start with Mr. Cutler.
    I just want to get this straight. In your opening 
statement, where you describe the results of the surveys you 
have sent out to brokers, did you send surveys to 34 brokers 
and brokerage firms?
    Mr. Cutler. That is right. Actually, they are compulsory 
because, given our inspection power, the brokerage firms must 
provide us with the relevant information, but, yes, you have 
it.
    Senator Fitzgerald. And you sent the survey to 88 mutual 
funds?
    Mr. Cutler. Mutual fund complexes, that is correct.
    Senator Fitzgerald. Complexes.
    Mr. Cutler. Yes.
    Senator Fitzgerald. Now, you found that 25 percent of the 
brokers are allowing late trading; is that correct?
    Mr. Cutler. Well, first, let me again emphasize that these 
are preliminary findings and further follow-up is certainly 
going to happen, but, indeed, more than a quarter of the 
responding brokerage firms reported that they are aware that 
customers have received 4 p.m. prices for orders placed after 
or confirmed after 4 p.m.
    Senator Fitzgerald. And late trading is a violation of the 
law.
    Mr. Cutler. Yes, it is, Senator.
    Senator Fitzgerald. And you also reported that more than 30 
percent of the mutual funds have selectively disclosed 
nonpublic fund information to certain customers; is that 
correct?
    Mr. Cutler. Well, at this point, I would not say that it is 
to customers, but, yes, we have concerns that at least in 30 
percent of the responding fund companies, that there was some 
disclosure of portfolio information under circumstances that at 
least raise a question in our minds, was this intended to 
benefit an investor? There are some circumstances, of course, 
Mr. Chairman, in which it is appropriate to make fulsome 
disclosure of portfolio information to a ratings agency under 
circumstances where a ratings agency would agree to keep the 
information confidential.
    The responses we got did not give us that assurance that 
the disclosure, on a selective basis of portfolio information, 
was done under circumstances with appropriate confidentiality 
agreements in place.
    Senator Fitzgerald. If someone uses the material, nonpublic 
information, given to them from a mutual fund to trade in the 
mutual fund's shares, would that be a crime?
    Mr. Cutler. I think that would be a violation of the 
central provision of the Federal securities laws, Section 
10(b), the anti-fraud provision, and any violation of the 
Federal securities is also potentially a criminal violation. 
We, at the SEC, do not have criminal jurisdiction, but, yes, 
indeed, it is potentially a subject of criminal prosecution as 
well.
    Senator Fitzgerald. Getting to the bottom line here, we are 
talking about serious wholesale criminal violations coming to 
light, are we not, Mr. Cutler?
    Mr. Cutler. Again, I am loathe to pre-judge until we have 
done a more complete investigation, but I certainly share your 
concerns 100 percent.
    Senator Fitzgerald. Mr. Roye, you are in charge of the 
policy development; is that correct?
    Mr. Roye. That is correct, Senator.
    Senator Fitzgerald. You have a lot of good ideas about how 
we can fix specific problems that have come to light in the 
investment industry, such as the late trading, and market 
timing and so forth. But at the end of the day, is it not 
becoming apparent that there is just so much abuse going on out 
there, and we are treating so many problems, and as soon as we 
treat some of these problems, new problems are likely to arise? 
Do you not think it is time we need to reassess how mutual 
funds are governed to make sure that the directors' interests 
are better aligned with those of their fund shareholders?
    Mr. Roye. I would agree with that statement. I think that 
we have been sidetracked, if you will, by the latest series of 
matters that have come to light. The Commission for several 
years has been engaged in an effort to try to strengthen, as I 
outlined in my oral statement, the mutual fund governance 
framework.
    And again we spent a lot of time responding to both 
Congressman Baker and Ranking Member Kanjorski, on the House 
side, in terms of identifying issues. They sent detailed 
information requests to us. We outlined a number of issues that 
we were concerned about, and we were pleased to see a lot of 
the initiative that was reflected in the bill that Congressman 
Baker put forth in the House Financial Services Committee, and 
the Commission largely endorsed that.
    But I think that it does point up, and as has been 
outlined, the number of issues that we are having to deal with 
from breakpoints to sales practice issues and some of the 
issues that Steve pointed to, in terms of proxy voting 
violations, valuation issues that go beyond the pricing issues.
    We need to focus on those issues, and you are right, we can 
write rules, but a lot of these rules and a lot of the 
practices are already illegal, as has been outlined, and it 
calls for a collective effort, from an enforcement standpoint, 
to hold wrongdoers accountable and then perhaps structural 
changes to enhance the oversight of the industry.
    In connection with our compliance rule proposal, we asked 
for comment from the public as to other private sector 
initiatives that the Commission might pursue to bolster its 
oversight of the industry. We asked questions about whether or 
not there should be a self-regulatory organization for the 
industry. We asked whether or not there were additional things 
that auditors could do in the scope of auditing funds. Should 
we have third-party independent compliance reviews of funds? We 
asked those questions and asked for comment.
    We supported an increase in the percentage of independent 
directors. We pointed out that there were gaps in the 
definition of who an independent director can be on funds and 
pointed out the problems with that. So I think there are 
fundamental issues that we have to grapple with.
    Senator Fitzgerald. Mr. Spitzer, you have looked carefully 
over the last few months at the Investment Company Act. What do 
you think about it, in general, since we have all of these 
conflicts of interest between the investment managers and the 
fund directors? And what do you think should be done with 
respect to the Investment Company Act, specifically?
    Mr. Spitzer. I agree with your initial critique of it in 
your opening statement; that it is not only porous, but it 
makes Swiss cheese look like a solid wall, that there are 
clearly dynamics that have emerged over the past few decades 
that were not contemplated by those who enacted the statute. 
There has been, at its most basic level, a complete failure of 
the fiduciary obligation on the part of those who sit on the 
boards. Some of this can be traced back to the statute. We want 
to redefine who the governing entities must be, can be, who the 
individuals who serve on those boards should be, and I think 
this calls for the sort of legislative solution that you have 
outlined in your opening statement.
    It must be revisited. The governing structure of the mutual 
fund industry needs to be reexamined from the very top.
    Senator Fitzgerald. Now, the Investment Company Institute 
is going to testify in the next panel. Many in the fund 
industry might say that the interests of the investment adviser 
are aligned largely with the interests of fund shareholders. 
Because if the advisory firm is charging too high a fee, for 
example, to the fund, then the returns will not be that good. 
Ultimately the fund will not grow as rapidly as it otherwise 
might, and therefore they will not gain business. They are 
going to have to treat their fund well or their own business is 
not going to grow.
    What would you say to that critique?
    Mr. Spitzer. Well, sometimes good logic still gets you to 
an illogical conclusion. I think the logic is not necessarily 
flawed, but the problem is that if you look at the track 
record, what you see is that virtually, there is no evidence 
that boards actually reconsider who the adviser should be, who 
the fund managers should be. Because the boards have been 
chosen by the managers and the advisers themselves, the boards 
never ask the hard questions and, in fact, say to a fund 
manager or to an adviser, we are getting rid of you. We are 
switching our funds elsewhere.
    In addition, what we have found, and I think this is where 
the gamesmanship of the past year fits in, what we have found 
is that fund advisers and fund managers have found other ways 
to increase their own compensation. They can increase the funds 
undermanagement by striking deals with market timers to get 
sticky funds into various funds, to let them lie fallow in 
those other funds, therefore, increasing their own 
compensation, even if the returns are not sufficient. And the 
reason the insufficient returns do not trigger their dismissal 
is the boards have been complacent.
    The common thread that runs through the mutual fund 
industry, that has run through the entirety of the scandals 
that exploded over the last several years from Tyco, WorldCom, 
Enron, on down to the issues we dealt with, with research 
analysts on Wall Street has been board complacency--boards that 
simply do not rise up to the task with which they have been 
charged.
    And the issue that I think faces the Congress and your 
Subcommittee is how do you craft a statute that will 
reinvigorate those boards to get them to actually challenge 
investment advisers and fund managers to do what has to be 
done?
    Senator Fitzgerald. You have on your books in the State of 
New York the Martin Act, which goes back to, I think, 1921, and 
it is thought to be the broadest securities law on the books 
anywhere. In enforcing the Martin Act, do you view as illegal 
when a mutual fund allows an investor to have market timing 
capacity?
    The SEC has testified that a large percentage--I think you 
said 50 percent--of the mutual funds have disclosed an 
arrangement with someone that gives them market timing 
capacity. It is not clear to me, under Federal law, whether 
merely giving someone market timing capacity is a crime. Do you 
believe it is a crime under the Martin Act?
    Mr. Spitzer. The answer is it depends. I believe it is a 
violation of the fiduciary duty that a board and a manager have 
to protect the interests of their shareholders.
    Senator Fitzgerald. Well, they have that duty under State 
law----
    Mr. Spitzer. Under State and Federal law.
    Senator Fitzgerald [continuing]. And Federal law.
    Mr. Spitzer. Absolutely.
    Senator Fitzgerald. So, if it is a violation of the 
fiduciary duty, would it not be a violation of the Investment 
Company Act?
    Mr. Spitzer. I believe that it is a violation of their 
fiduciary duty and therefore violative of the law. That is 
correct. Now, we can parse it a bit more carefully because 
there are disclosures that are made by mutual funds in their 
prospectuses that address the issue of market timing, and one 
has to examine, theoretically, those prospectus statements to 
determine whether or not the behavior that the entity, the 
fund, undertook violates that prospectus.
    Senator Fitzgerald. Can a disclosure that they allow market 
timing trump a fiduciary duty to treat all fund shareholders 
the same?
    Mr. Spitzer. It cannot trump a fiduciary duty, but if there 
is a specific disclosure that says there will be those who try 
to market time, we will do our best to prevent it, but will not 
be able----
    Senator Fitzgerald. Well, it is essentially then a 
disclosure that we are going to give somebody preferential 
treatment.
    Mr. Spitzer. No. If they fail to catch somebody, perhaps 
they are not violating their fiduciary duty. If they knowingly 
permit and then accept compensation for permission to time, 
then there is no question in my mind they are violating their 
fiduciary duty, violating the law and will be charged if they 
are caught.
    I have added the component of payment and knowledge, which 
I think is--knowledge I think everybody would agree you could 
not charge them without knowledge. Payment we take as perhaps 
the final push over the edge.
    Senator Fitzgerald. I am going to turn it over to my 
colleagues to ask questions, but I just wanted to see if either 
of the witnesses from the SEC would care to comment on that 
issue.
    Mr. Cutler. Sure. I think Mr. Spitzer is right insofar as 
you can certainly overcome, in my mind, a prospectus disclosure 
if you can also establish that the adviser personally benefited 
from the arrangement, and where we can show that, where we can 
show it was not a matter of one slipping through the nets, but 
that there was an advantage taken----
    Senator Fitzgerald. Are they not getting fees every time 
there is trading?
    Mr. Cutler. Of course, they are, but it depends on the type 
of arrangement that is reached. And we are obviously looking at 
all of these very hard.
    You start with the prospectus disclosure, but you do not 
end the analysis there.
    Senator Fitzgerald. Well, thank you.
    I would like to turn it over to Chairman Collins to ask 
questions.
    Chairman Collins. Thank you, Senator Fitzgerald.
    Mr. Roye, Mr. Bogle noted in a recent interview that there 
is an old saying in corporate America, and that is, ``When you 
have strong managers, weak directors and passive owners, it is 
only a matter of time before the looting begins.''
    I want to talk to you about the role of the boards of 
director and, in particular, about the possibility that the 
directors are not doing an effective job because they are so 
overcommitted. They are serving on so many different boards 
within a family of funds.
    In looking at the SEC filings, I noticed that there is 
tremendous overlap among the boards of directors in fund 
families. There are, in fact, plenty of fund family directors 
who serve on the boards for 80 or even 90 different funds, 
which seems too many to me.
    The Chairman of Bank of America's Nation's Fund sits on the 
boards of 85 funds. The Chairman of Janus sits on 113 fund 
boards. Now, I realize that many of the funds have similar 
structures and approaches. So there may be some economies of 
scale, if you will, but it is hard for me to see how anyone, 
any one director, could effectively monitor the activities of 
so many different entities.
    Is the SEC taking a look at this area as far as issuing 
guidelines to limit the number of boards that a director can 
serve on within the same family of funds?
    Mr. Roye. I think you point out real limitations in terms 
of director oversight. I think every director who serves on a 
mutual fund board, who is in a mutual fund complex, has to ask 
him- or herself whether or not they are effective.
    You point out that there are directors who sit on multiple 
fund boards. As you indicate, there are common issues between 
funds. When you get into issues like how they are sold, and how 
their transfer agent is operating, a lot of those issues are 
the same for every fund. So, once directors ask questions about 
those types of operations, the answers apply really across the 
board to all funds. Of course, when you get to particular 
funds, you get into different investment objectives, policies, 
different portfolio managers, different performance, and you 
get into individual issues with regard to each fund.
    But I think you are right in that there is a limit, and I 
think the problem that we have, as the government, is 
prescribing exactly what that limit is. To this point in time, 
I think what we have done is look to the directors to exercise 
that judgment.
    And there can be benefits of serving on multiple boards in 
the sense that issues come up, problems come up, and you can 
make sure that those issues do not creep into your other funds 
where you see a problem in one fund and directors sitting on 
common boards can benefit from that information flow.
    But I think you are right, that there is a limit, and I 
guess the question is, from the standpoint of the government, 
what should our role be? What is the right number of funds to 
effectively oversee? And to this point, we have looked to the 
directors to make that judgment.
    I know that the Investment Company Institute, in its best 
practices for fund directors, has recommended that directors do 
a self-evaluation periodically to assess whether or not they 
are effective, are they organized the right way. I think that 
we try to get a sense of that when we go in and do 
examinations, looking at their committee structures and how 
they function. But to this point, we have not gone down the 
path of coming up with what is the right number.
    Chairman Collins. I would note that there are also monetary 
issues at work here. It is very lucrative if you are serving on 
many of these individual boards, and given the pattern that we 
have seen of lax oversight, widespread abuses and the lucrative 
incentives to serve on as many boards as you possibly can, I 
think this is an area that the SEC really needs to take a hard 
look at.
    I cannot imagine how individual directors, serving on 80, 
90, even 100 boards, even if they have a lot in common, can be 
doing a truly effective job, and yet those directors are well 
compensated for serving on each of those boards. So I would 
encourage the SEC, as you take a look at the issue of whether 
or not there need to be more independent directors, to also 
look at whether directors are overcomitted and not able to 
exercise effective oversight.
    Mr. Roye. Let me just add that, in terms of director 
compensation, this is an area where we have forced disclosure 
of how much directors are paid so that investors can make 
judgments about that compensation.
    I think this is also an area where, at the SEC, when you 
talk about the regulatory framework and the statute, we have 
certain authorities where we can act. And, indeed, as I 
outlined how the rulemaking tried to require a majority of 
independent directors, self-nominating directors, independent 
legal counsel, when we advanced issues like that through 
rulemaking, there were people who told us that we were 
exceeding our authority to do that, and so this might be an 
area where we may need some legislative help in terms of 
addressing an issue like you outlined.
    Chairman Collins. Thank you.
    Mr. Cutler, you explained to us that the SEC receives 
thousands of tips from the public and that it is difficult 
sometimes to sort through those, and it may be difficult to 
identify ones that are worth following up on, but the SEC has 
another I would argue far more effective tool to use, and that 
is the examination and audit process.
    I would like to know, first of all, whether you believe 
that the current audit schedule is adequate to enforce the law. 
I know mutual funds have to register with and regularly report 
to the SEC. They must submit to regular audits and examinations 
by the Commission staff. I am wondering why these problems were 
not revealed through the examination and audit process.
    Mr. Cutler. And I do not oversee that process, but let me 
do my best to address your question, Senator Collins. I think 
it is a very fair question.
    I know that in recent years the SEC could examine funds and 
fund advisers only once every 5 years. There are over 6,000 
mutual funds in our country and over 7,000 advisers, and so 
there are some resource constraints here at issue. As recently 
as 1994, I am told, the average frequency for examining 
advisers was once every 22 years. So that number has come way, 
way down.
    With the additional resources that I know that you were 
instrumental in helping us to get, Senator, in the last few 
months, we have moved towards a cycle of every 2, 4 or 5 years 
for advisers and funds based on the level of risk posed by the 
individual firms. And as we absorb new staff, I know that our 
Office of Compliance Inspections and Examinations will be 
continuing to evaluate whether the cycle should be further 
reduced. But you are absolutely right. Examinations have to be 
a key component to how the agency gathers intelligence and 
understands what is happening out there in the industry.
    Chairman Collins. Thank you, Mr. Chairman.
    Senator Fitzgerald. Senator Akaka.
    Senator Akaka. Thank you very much, Mr. Chairman.
    The testimony this morning has indicated that there is 
serious abuse out there. There is a need to take steps to stop 
the abuse and restore investor confidence.
    Mr. Cutler, on page 2 of your statement you indicate that 
the SEC's second area of focus is on sales practices. You pose 
a question about customer understanding of revenue sharing and 
shelf space payments. What have you learned about consumer 
understanding of these relationships, and what is necessary for 
investors to be able to make informed decisions?
    Mr. Cutler. Well, from my perspective, and it is an 
enforcement vantage point, as opposed to a regulatory vantage 
point, I have seen at least one significant matter in which--
and there are more--but one that is on the forefront of my mind 
where it is clear to me that customers did not have a fulsome 
understanding of what it was that the broker who was selling 
them the product was getting out of that sale. And it strikes 
me that that is the fundamental question we all have to ask. 
When someone recommends a transaction to you, Senator, you have 
a right to understand that the person recommending that 
transaction to you, the firm recommending that transaction to 
you has an interest and that they may have gotten a payment, if 
you will, to feature that recommendation.
    You mentioned shelf space, and I think that is the right 
terminology. We have learned of many situations in which funds 
were paying the brokerage community to feature their product on 
a premier shelf, and it strikes me that investors deserve to 
know that sort of incentive has been created.
    Senator Akaka. Thank you. Let me shift to the other side of 
the panel.
    Ms. Schapiro, you mentioned that you are conducting an 
examination sweep of brokers and dealers to determine how 
investment companies pay to be included on firms' featured 
mutual fund lists and why they receive favorable promotional or 
selling efforts.
    What have you learned so far about these relationships 
during the sweep?
    Ms. Schapiro. Thank you, Senator.
    Well, we are, in fact, conducting a sweep focused on 12 
major broker-dealers to determine how they have been paid by 
funds for inclusion on a preferred or recommended list, and as 
I said, we are looking at all different kinds of broker-
dealers--on-line firms, discount firms, full service and fund 
distributors.
    Clearly, we are in an environment where there are so many 
mutual funds who are vying for visibility in the distribution 
chains that they are willing to pay a broker-dealer or direct 
brokerage commissions to a broker-dealer in return for 
appearing on that preferred or recommended list. It is a clear 
violation of NASD rules. We will announce some cases very 
shortly and, as I said, we have an examination sweep ongoing in 
that area as well as in a number of other areas.
    If I can harken back to your question to Mr. Cutler, the 
concern about investors understanding fees and expenses I think 
underlies many of the problems we have here. There is a lack of 
clarity in the disclosure. Investors have to go multiple places 
to find out about things like directed brokerage, soft dollars, 
expenses, front-end sales loads, contingent deferred sales 
charges, many things you all have referenced in your opening 
comments.
    We need to have disclosure that is concise and in one place 
so that investors understand what they are paying for with all 
of the fees and expenses, what reduces their initial investment 
and what the impacts are on their return as a result and, as 
well, what are the conflicts that compensation practices create 
for brokers that encourage them to sell one product over 
another because it benefits the broker and not necessarily the 
investor?
    Senator Akaka. Mr. Galvin, let me pursue soft dollars. In 
your statement, you state that soft dollars should be banned.
    Mr. Galvin. Yes.
    Senator Akaka. Please explain to the Subcommittee why you 
believe it is necessary to ban the use of soft dollars.
    Mr. Galvin. Well, I think oftentimes soft dollars are 
places that funds develop additional sources of revenues and 
fees that really ultimately end up coming out of the consumer, 
but are hidden from them--I think just what Ms. Schapiro was 
describing, the complexity of an individual confronting a 
broker to find out what it is actually going to cost them.
    I think we have to put this all in context, especially in 
mutual funds. Mutual funds are where people go for a sense of 
safety. Oftentimes, people who go there are either 
unsophisticated or choose not to be sophisticated. They want a 
simple transaction. They want some protection, and they ought 
to know what the fees are. They ought to know what the costs 
are. And I think the good part of the disclosure provision of 
the current bill, H.R. 2420, is good, but I frankly think they 
ought to be banned because I cannot see a basis for where does 
the benefit go to consumers that soft dollars are still part of 
the system. It is complex enough without dealing with soft 
dollars already. Why can we not make it more clear? I think we 
need to draw bright lines.
    One of the difficulties, and I think it is apparent here, 
as we have all been grappling with these various terminologies 
is, although it is a simple concept, mutual funds, it is very 
complex when you try to explain it to people, and we all have 
some idea what we are talking about. Imagine the average 
consumer that is confronted or trying to understand exactly 
what is going on.
    I think we have to somehow codify a sense of ethics, a 
catch-all for the industry so that there will be the 
opportunities so that we will not be having to think twice or 
three times whether something that is clearly unethical is also 
criminal.
    One of the things we saw for instance in the sales 
practices issues at Morgan Stanley was the complete failure to 
disclose any sales contests, huge bonuses to office managers, 
deferred compensation. Imagine, for a minute, Senator, if I 
were your broker and said to you, ``I recommend you buy this 
product, but before you buy this product, Senator, I want to 
tell you I am getting more money to sell it to you. My deferred 
compensation has improved, and I am entered in a trip, and I 
can go to some nice place, but that had absolutely nothing to 
do with my decision to recommend this product to you.'' I think 
you would ask me some other questions, and yet I do not think 
that individuals get the benefit of that, and that is the 
problem.
    Senator Akaka. Mr. Spitzer, following up on soft dollars, 
what is your evaluation of the use of soft dollars, and do you 
agree with Secretary Galvin's assessment that they should be 
banned?
    Mr. Spitzer. I am not yet at the point where I wish to make 
that bright line or statement. We have not been investigating 
the soft dollar issue in particular. We have been having enough 
fun tracing the hard dollars, and we found those flowing to 
more interesting places.
    There have been so many opportunities for fraud and 
misconduct, and I think the numbers that Steve revealed in his 
testimony, in terms of the frequency of abuse, make that clear. 
We have been looking at the overall structural relationships 
among the parties and trying to clarify to the consumer what 
the problems were.
    In answer to your question before, what have we learned 
from our inquiry, the first thing I learned is the companies do 
not want us to look; the second thing we learned was that they 
will try to hide the evidence occasionally; the third thing we 
found is that when we finally get the E-mails, it is not a 
pretty picture. And the end result is that we have opened up a 
window into a morass of conflicts of interest, not only the 
soft dollars, where I have no reason to disagree with Bill's 
conclusion, but I am not yet at the point where I have studied 
the issue sufficiently to say outright ban them. I think 
inquiry needs to continue.
    But what is eminently clear is that this is a window into 
what has been foggy, murky and impossible to understand. And if 
you think about, to draw an analogy, somebody mentioned shelf 
space, which you think about in a supermarket context most 
often, when you pick up a product at the supermarket, it has a 
nice little chart on the back that gives you your nutritional 
information, which Congress thought was an appropriate type of 
disclosure for folks so they would understand what they are 
eating, what they are buying. And we have rules about pricing, 
common pricing among equally weighted products, things that 
have worked well for consumers.
    We do not have those rules for mutual funds. There is no 
capacity to seek comparability in the examination of costs, 
returns, and what you actually pay. That is what I think the 
consumer is owed and what we are demanding.
    Senator Akaka. Thank you. Let me continue to pursue the 
issue of soft dollars and ask Mr. Roye and Mr. Cutler about 
their use.
    The SEC released a study on soft dollars in September 1998. 
The report indicated that soft dollars were used to pay for 
research, salaries, office rent, telephone services, legal 
fees, entertainment, among other expenses. What trends, if any, 
in the use of soft dollars have you seen since a report was 
issued?
    Mr. Roye. I will respond to that.
    You are correct, the Commission examination staff did a 
study of soft dollars and made a series of recommendations in 
that area to improve disclosure, improve transparency. Indeed, 
we have some follow-on proposals that are pending in that area 
for investment advisers.
    I think, as was pointed out again in the Baker legislation, 
the Commission endorsed the reexamination of the soft dollar 
area. It does introduce conflicts. You know, managers 
generating commissions to produce benefits, they could be 
research benefits, they could be nonresearch benefits, and the 
way the statute works is that they are protected if they gained 
research for that, but if it is outside the research 
definition, it could be problematic, even unlawful.
    Indeed, Steve's group has brought enforcement actions 
against some investment advisers for violations of soft dollars 
and soft dollar abuses. So we still see abuses in this area, 
but it is an area where conflicts are introduced, and they have 
to be managed, at the very least they have to be disclosed, and 
we have endorsed the reexamination of that.
    It is a complicated issue in the sense that if you ban soft 
dollars, the way some have argued, you get into issues of how 
research is paid for? Mr. Spitzer, Steve, the Commission 
negotiated a settlement of the research analyst matter. A lot 
of that research that is provided by independent research 
analysts is paid for in soft dollars. So it is a very 
complicated issue, but I think it is one worthy of further 
examination. Indeed, they are looking at it in the U.K. 
currently and deciding what approach they are going to take on 
soft dollars.
    Senator Akaka. Thank you very much.
    Senator Fitzgerald. Senator Akaka, thank you.
    All of you, you have been wonderful witnesses. Thank you so 
much for being here.
    We are going to move on. Actually, Congressman Baker is 
here now. He has arrived in Washington, and if the second panel 
would just hold back for 1 minute so we can let Congressman 
Baker give his statement, we will then take a 5-minute break 
and reconvene with the full second panel.
    Thank you all for being here. You have been terrific 
witnesses. Thank you.
    Congressman Baker, thank you very much for being here. I 
know that you have a full schedule, and we are happy to 
accommodate you at this time. While you were gone, Senator 
Akaka and I both commended you on the extraordinary leadership 
you have shown in attempting to reform the mutual fund 
industry, and I likened you to John the Baptist as a voice 
crying out in the wilderness. You, like John Bogle, had been 
talking about this issue for years. You introduced a wonderful 
bill before the current scandals came to light.
    Congressman Richard H. Baker is from the Sixth District of 
Louisiana. He is Chairman of the House Financial Services 
Subcommittee on Capital Markets, Insurance and Government 
Sponsored Enterprises. That includes Fannie Mae and Freddie 
Mac, and that is a whole other area in which that we have had 
hearings.
    Congressman Baker introduced H.R. 2420, the Mutual Funds 
Integrity and Fee Transparency Act of 2003. I believe you 
introduced that in June of this year. This bill would help 
investors gain a clearer understanding of the fees they are 
charged for investing in mutual funds and strengthen the role 
of independent directors who are charged with guarding the 
interests of fund investors.
    He has also been a leading advocate of regulatory reform in 
the securities industry and is working tirelessly to restore 
investor confidence.
    I also want to take this opportunity to recognize the year-
long effort of the House Financial Services Committee to reform 
the mutual fund industry. Led by Chairman Oxley and 
Subcommittee Chairman Baker, long before any scandals came to 
light, the Financial Services Committee has brought the issue 
of mutual fund reform to the forefront.
    My Subcommittee will continue to collaborate with the House 
Financial Services Committee on this and other important issues 
facing the securities industry.
    Congressman Baker, I welcome you to the Senate and thank 
you for making the time to participate in this hearing. You may 
proceed with your statement, and I understand you just flew 
into Washington this morning. Is that correct?
    Mr. Baker. Yes, sir, that is correct.

  TESTIMONY OF HON. RICHARD H. BAKER,\1\ A REPRESENTATIVE IN 
CONGRESS FROM THE STATE OF LOUISIANA, CHAIRMAN, SUBCOMMITTEE ON 
      CAPITAL MARKETS, INSURANCE AND GOVERNMENT SPONSORED 
  ENTERPRISES, COMMITTEE ON FINANCIAL SERVICES, U.S. HOUSE OF 
                        REPRESENTATIVES

    Mr. Baker. I appreciate the gentleman's very gracious 
introduction, and I would perhaps characterize my efforts 
slightly differently. My dad told me if you hang a tie in the 
closet and leave it there long enough, sooner or later it will 
come back into fashion. And I kind of feel like I have been 
hanging in the closet for a long time and events have just 
changed. But I do appreciate very much your interest in the 
subject and your leadership here in the Senate in providing 
direction. I look forward to working with both of you as we 
move forward on this difficult subject.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Baker appears in the Appendix on 
page 120.
---------------------------------------------------------------------------
    When the bill was introduced, there really was not a 
crisis. I was merely directing attention to the difficulty in 
understanding what it is that working families get at the end 
of a year when they get that mutual fund statement and sit down 
at the kitchen table and try to figure out where the money 
went.
    My son, who is doing better in life than I, had two 
different funds, and came to me, the smart guy, to help him 
understand. After a bit of embarrassment, I determined that I 
needed to go to school and try to understand how this reporting 
system was intended to work. That led to a number of other 
observations that I thought would be in the best interests of 
working families.
    As the Senators know, 95 million Americans now invest in 
mutual funds, over half of all households, virtually everyone, 
through the workplace or through some other opportunity, is a 
direct investor in this great economy, and that is as it should 
be because those investors now, in such large number, provide 
enormous capital for business expansion and job opportunities. 
So it is important we have a system that functions properly--
one that they feel they are being treated fairly.
    I also want to speak to the work for a moment of that of 
Attorneys General Spitzer and Galvin. Although we have had 
disagreements on other substantive issues, I think their work 
in pursuit of wrongdoers in the mutual fund industry is 
outstanding and highly appropriate.
    In only one example of Mr. Galvin's work, there was a group 
of New York State union officials, apparently, who had access 
to information and each afternoon would engage in market timing 
events. Ten such individuals engaged in over 3,000 trades over 
a 3-year period. It became known within the mutual fund company 
that facilitated the trades as ``the boilermaker hour.'' That 
type of conduct is so egregious it is hard for one to imagine 
how it could be endured by those in a professional position of 
responsibility as fiduciaries of working families' money.
    With the introduction of H.R. 2420, there are a number of 
elements to the bill which I will quickly recite and 
concentrate only on one or two that I think warrant a little 
discussion.
    We enhanced fee disclosure. We require enhanced portfolio 
manager disclosure of compensation and their holdings. We try 
to make sure that the breakpoints, those discounts you earn 
when you buy more of the shares, are given appropriately, 
disclosure of revenue sharing agreements, portfolio transaction 
expenses. This is something that I think deserves a great deal 
of attention.
    That is how frequently the shares or the stocks held by the 
fund are bought and sold. Some call it churning. On average, a 
fund will hold a stock now for only about 11 months. It 
certainly adds a new perspective to long-term investing.
    There is a fund, Fred Alger Management Fund, with assets of 
about $2 billion for the year 2002, had $9 billion of 
redemptions in a single year, for a turnover rate of 440 
percent. One has to question the legitimate purposes for such a 
high level of turnover, and there are many who have in excess 
of 100 percent of turnover, disclosure of directed brokerage 
arrangements, disclosure of the soft dollar arrangements, and 
some attention has been given by the first panel to whether 
soft dollar arrangements should be made illegal entirely. 
Almost as to refocus the debate a bit, whether it is a good 
thing or a bad thing, we at least ought to know about it, but 
more importantly, the scope of soft dollar problems fades in 
far less importance when you are looking at the broader picture 
of mutual fund mismanagement.
    And so I would hope that we not let that issue cloud the 
judgment on the broader array of reforms which are really 
warranted.
    Enhanced Audit Committee requirements, a simple thing. A no 
load fund ought to be no load. Today, you can have up to 25 
basis points of 12b-1 fees assessed, and you still maintain the 
title ``No Load Fund,'' even though you do not know that you 
are paying that fee.
    I would like to focus a little bit on things that are not 
in the bill. I think we made a good start, but I do not believe 
we have got it all right, and this is where I think the members 
of this panel can be very helpful.
    I waged a valiant effort, but in the end lost, on the 
importance of an independent chair for mutual fund governance. 
Most investors do not really get the real picture of what the 
chairman of the mutual fund's responsibilities are as the CEO 
of the management company.
    The board hires the management company to come in and run 
the investment portfolio of the mutual fund company. The mutual 
fund is owned by its individual shareholders--the moms and 
pops. The management company is also owned by shareholders, but 
it is a different group of shareholders.
    The two goals of those two companies are different. The 
mutual fund company wants to make as much money as possible by 
limiting the payments to the management company. The management 
company shareholders want to make as much money as possible by 
making fees from the mutual fund.
    I think it incredibly important, particularly given the 
operational professional judgments that have been absent in far 
too many cases for the chairman, and with the addition of a 
chief compliance officer who would report only to the 
independent chairman, to have the authority to determine if the 
management company is performing its job in a manner 
appropriate for the shareholders of the mutual fund. Imagine 
how hard it must be for those individuals who are CEO of the 
management company, as the chairman of the board of the mutual 
fund, to fire themselves from their own contractual 
relationship.
    It seems to me to be a clear-cut conflict of interest, and 
so I would heartily recommend the Subcommittee revisit that 
issue.
    There should be a clear and explicit prohibition, although 
I believe it to be a violation of insider trading provisions, 
to preclude market timing in their own funds. There should be a 
prohibition that makes it impossible for a manager to 
simultaneously operate a mutual fund and a hedge fund. Hedge 
fund payments to management tend to be a bit more lucrative 
than those payments made by a mutual fund because of the risk 
engaged in operating a hedge fund.
    There is a case where a manager was market timing his 
mutual fund for the benefit of his own hedge fund. That 
behavior is, if not criminal, certainly ought to be soon.
    Another issue is whether any mutual fund at all should be 
permitted to utilize market timing as a management tool. I 
question the validity or benefit to the shareholders of such 
action.
    I believe there should be clear, concise disclosure of 
executive and portfolio manager compensation. Simply stated, 
are they investing in the funds just like the shareholders for 
whose money they are charged with the responsibility of 
managing, and how much do they make at your expense? This is 
the case for all Fortune 500-traded publicly operating 
companies. Mutual funds should be no different with that 
enhanced disclosure.
    Mr. Chairman, I think your work is creating a unique 
opportunity for us in the Congress, but it is in recognition of 
our significant responsibilities on behalf of those 95 million 
investors. Many had dreams of early retirement, of buying that 
special home, perhaps of putting the kids through school or 
college, and those plans have been dramatically restructured.
    Now, almost every investor in the market has felt 
discomfort over the past several years, but the reasons for the 
financial loss were clearly printed on the front page of the 
newspaper. We did not like it. We all understood it, and we 
accepted our losses.
    However, in my opinion, significant amounts of money have 
also been taken from mutual fund shareholders that they do not 
know they are losing. It is not clearly illegal acts that the 
attorneys general are pursuing that cost shareholders money. It 
is the legally permissible conduct that is simply not 
disclosed. Providing investors with a clear, concise statement 
of the investing facts is all that is really required.
    Mutual funds can be a very helpful tool for financial 
security, but not all mutual funds are equal. About 80 percent 
of all mutual funds in a given year underperform the stock 
market's S&P 500 index, and the average actively managed stock 
mutual fund returns about 2 percent less to its shareholders 
than the stock market returns in general, and fees matter, as 
Mr. Bogle, I am sure, will visit in a moment.
    A $10,000 investment for 20 years, with an average 
annualized return of 12 percent, you will get dramatically 
different results with just a small change in administrative 
expenses. With a half-a-percent rate, your investment net is 
about $87,000. With a full service 2 percent fee charge, your 
investment is worth about $64,000. The only variable is the 
difference between a 2 percent management fee and a half-a-
percent fee, and that equates to $22,862. Fees do matter.
    Whether a particular mutual fund meets your needs should be 
an informed decision every investor should make based on the 
facts and full disclosure. In the capital markets hearing back 
in March of this year, one of the industry representatives said 
it very well. ``Investors then are fully informed and free to 
make their own decisions about whether a fund offers the right 
combination of investment performance and service that 
justifies the fee being charged or not. As in any competitive, 
free-trading market, the ultimate power rests, as it should, 
with the judgment and wallets of mutual fund shareholders.''
    That is the way it should be, and I believe there are many 
within the industry, and certainly many within the Congress, 
who want to work together to structure a marketplace that works 
that way. Unfortunately, I have come to the conclusion it is 
not working that way at all.
    With your leadership, Mr. Chairman, and the assistance of 
the Members of your Committee, I think we can provide a 
blueprint for what the industry says it wants to build, and 
that is a mutual fund marketplace that is fair to all, based on 
complete disclosure of the investing facts, with rules applied 
equally to everyone.
    Thank you, Mr. Chairman.
    Senator Fitzgerald. Congressman Baker, thank you so much 
for coming over here, and, again, we want to commend you on the 
outstanding job you have been doing. We hope to work with you 
in the future. Senator Akaka has a bill that he has prepared 
that would help reform the mutual fund industry along the lines 
of the bill you have introduced in the House, and I intend to 
work with Senator Akaka as we pursue bipartisan legislation in 
the Senate that would mirror the reform efforts you have begun 
in the House.
    We wish you good luck in your pursuits over there because I 
know we are fighting against a very powerful industry. There is 
actually an old phrase that a Chicago alderman once said. His 
name was Paddy Bauler. And back in the 1950's, he famously 
observed that ``Chicago ain't ready for reform.''
    Well, I am not sure the mutual fund industry is ready for 
reform yet, but whether it is ready or not, it needs to be 
reformed. And so I thank you and look forward to continuing to 
work with you. Thanks for coming over today.
    Mr. Baker. You are very kind and generous with your 
remarks. I look forward to working with you gentlemen as well.
    Senator Fitzgerald. Thank you.
    Senator Akaka. Mr. Chairman, I also want to add my 
gratitude to Congressman Baker for your leadership in this 
effort. I look forward to working with you as well. Thank you.
    Mr. Baker. Thank you, Senator.
    Senator Fitzgerald. At this time we would like to take a 
very brief 2- or 3-minute break so everyone can stretch. Then 
we will reconvene with the second panel. Thank you.
    [Recess.]
    Senator Fitzgerald. I would now like to introduce our next 
panel of witnesses.
    John C. Bogle is the founder and former CEO of the Vanguard 
Group and the President of Bogle Financial Markets Research 
Center. He created Vanguard in 1974 and served as Chairman 
through 1997 and Senior Chairman through 1999. Mr. Bogle has 
received a number of awards and distinctions for his leadership 
at Vanguard, which is one of the two largest mutual fund 
organizations in the world and the first organization to offer 
an indexed mutual fund. If I am not mistaken, Vanguard is the 
only mutual fund where the funds actually own Vanguard.
    Mr. Bogle. That is correct, Mr. Chairman.
    Senator Fitzgerald. Mr. Bogle is also the author of four 
books on investing and mutual funds.
    Also with us today is Mercer E. Bullard. Mercer Bullard is 
the founder of Fund Democracy, a nonprofit membership 
organization that serves as an advocate and information source 
for mutual fund shareholders and their advisers. Mr. Bullard is 
also an Assistant Professor of Law at the University of 
Mississippi, where he teaches in the areas of securities and 
banking regulation, corporate finance, and contracts. Mr. 
Bullard was formerly an Assistant Chief Counsel in the SEC's 
Division of Investment Management, where he was responsible for 
a wide range of matters involving mutual funds and investment 
advisers.
    Matthew P. Fink is the President of the Investment Company 
Institute, the National Association for the American Mutual 
Fund Industry, representing over 8,600 mutual funds across the 
country. Mr. Fink has been with the Investment Company 
Institute since 1971 and has served as its president for the 
past 12 years.
    Again, I would like to thank all of you for being here 
today to testify. In the interest of time, we would ask that 
you submit your written statements for the record. They will be 
included in full as part of the record. And we would ask that 
you try as best as you are able to summarize your remarks for 
the Subcommittee in a 5-minute opening statement.
    Now, I am informed that Mr. Bogle needs to leave this 
building at 1:30 so we can get him on a train out of town, and 
we are going to try and keep that commitment to Mr. Bogle.
    Mr. Bogle, we may begin with you, and I mentioned in my 
opening remarks that Vanguard, as I understand it, is the only 
fund in the country that is set up in a truly mutual way in 
which the fund owns Vanguard. In all other instances of mutual 
funds, you have a separate advisory firm typically that, I 
gather, sets up the funds, and you set up Vanguard so that the 
interests of the operators of Vanguard were more aligned with 
the funds. Could you address that structure that you have just 
at the outset? I think it is a very important point.

  TESTIMONY OF JOHN C. BOGLE,\1\ FOUNDER AND FORMER CEO, THE 
                         VANGUARD GROUP

    Mr. Bogle. Yes, I am happy to do that. We created an 
organization in which actually the mutual funds own all of the 
common stock of Vanguard Group, Incorporated, which is our 
investment manager. We operate at cost, and each fund just 
picks up its own proportion, its share of that cost. There is 
no profit to any outside organization. When we actually employ 
external investment managers, we negotiate with them very 
vigorously on behalf of the funds that they are negotiating 
with. And, in fact, in some cases we get the fees down to less 
than one basis point--not 10 basis points, Mr. Chairman, one 
basis point. So we not only have the ability to run at cost, we 
have the ability to negotiate at arm's length.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Bogle appears in the Appendix on 
page 130.
---------------------------------------------------------------------------
    Senator Fitzgerald. You get the fees for investment 
management down to one basis point?
    Mr. Bogle. Yes. I will confess that our equity funds 
sometimes run as high as 10 or even 15 basis points.
    Senator Fitzgerald. Not one point. We are talking basis 
points. One basis point.
    Mr. Bogle. Yes. Our Ginnie Mae fund is a managed mortgage-
backed securities fund, and it has a fee of nine-tenths of a 
basis point, not 10 basis points but less than one basis point.
    Senator Fitzgerald. What kind of a fee does the typical----
    Mr. Bogle. Well, just 0.9 basis points generates a 
staggeringly large fee of--I think it is about $3 million a 
year. How could anybody possibly spend that much on that kind 
of management? Just think about it for a minute. So we ought to 
all be looking, by the way, Mr. Chairman, at dollar amounts of 
fees and not fee rates. You know, this industry, it is almost 
as if there was a conspiracy many years ago, and they said, 
What is the biggest number we can think of to relate our 
management fees to? And someone said, How about we use all the 
assets of the fund? So we get this 1.5 or 2 percent fee, which 
looks very small, but we do not say that 3 percent all in 
costs, counting trading costs for equity funds, is 30 percent 
of the stock market return in a market returning 10 percent and 
actually 100 percent of the equity premium--that is to say, 
stocks usually yield about 3 percentage points more than bonds, 
and at a 3 percent cost in an equity fund, you might just as 
well own a bond fund as a stock fund. It is a staggering large 
cost.
    Now, if I may move on to my opening statement, first of 
all, I obviously deeply appreciate your incisive and insightful 
opening statements, and I have to say, Mr. Chairman, I am 
deeply humbled by your comments because the only thing I have 
ever had to offer this industry or this world is common sense--
I am not a big brain--and some sense of trust for other 
people's money. It is interesting that my extreme statements of 
yesterday seem overnight to be statements of great moderation, 
and that which was once heresy is now dogma.
    I have been involved in this industry ever since 1951--or 
1949, when I began to write----
    Senator Fitzgerald. Could you pull that microphone a little 
bit closer so everybody can hear? Thank you.
    Mr. Bogle. Yes. I began my involvement with this industry 
ever since 1949 when I began to write my senior thesis at 
Princeton University. In 1951, I went to work with industry 
pioneer Wellington Management Company and headed that company 
from 1965 to 1974, during which period I was also the Chairman 
of the Board of Governors, part of that period, of the 
Investment Company Institute. It was in 1974 when I founded 
this new mutual fund organization called the Vanguard Group of 
Investment Companies.
    It is peculiar but true that Vanguard represented my 
attempt to create a firm that would measure up to the goals I 
set forth for the mutual fund industry in that original senior 
thesis at my university, to place the interests of fund 
shareholders as the highest priority, to reduce management fees 
and sales charges explicitly, to make no claim of ability to 
beat the stock market, and to manage funds--and this is a 
direct quote from that ancient thesis--``in the most honest, 
efficient, and economical way possible.'' And through Vanguard, 
we have done our best to meet those goals, and as a result, 
Vanguard has become the lowest-cost provider of financial 
services simply by delivering the staggering economies of scale 
that exist in the money management business. In fact, 
Vanguard's unit costs are down about 60 percent since we began, 
and the industry's unit costs are up about 60 percent. That is 
quite a contrast. And also with $650 billion of assets, that 
low-cost theory has enabled us, because some investors 
understand, to become one of the two largest firms in this 
field.
    After I gave up my position as Vanguard's senior chairman, 
I have been engaged in writing, researching, and speaking about 
investing in the fund industry and, for that matter, corporate 
America and the New York Stock Exchange, including half a dozen 
op-ed pieces for the New York Times and the Wall Street 
Journal, one of which castigated the industry for taking the 
position that we should not tell our own owners how we are 
voting their shares, as well as several additional books, now 
four in all, all presenting strong and, I hope, well-reasoned 
views of this industry's imperative need to better serve its 
shareholders.
    But I am sorry to tell you, Mr. Chairman, the fund industry 
has yet to measure up to those idealistic yet wholly realistic 
goals that I urged upon the industry back in 1951.
    Disgusting, as they are to someone like me, who has made 
fund management his life's work, the recent market timing 
scandals, as you observed yourself, sir, have a good side. They 
call attention to the profound conflicts of interest that exist 
between fund managers and fund shareholders, conflicts that 
arise from an inherently flawed governance structure in which 
fund owners in practice have little, if any, voice. The trading 
scandals are just the small tip of an enormous iceberg of 
conflict.
    While the costs of international time zone trading has been 
estimated at about $5 billion, the costs of managing the 
industry's nearly $7 trillion of assets in stock, bond, and 
money market funds came to some $123 billion, counting trading 
costs, in 2002 alone, a cost that is largely--think about this 
a minute, sir--indeed almost entirely responsible for the 
reason that mutual fund returns fell short of the returns 
available in the financial markets. Gross return minus cost 
equals net return. It is inescapable and, yes, sir, costs 
matter.
    If the management fees that represent the major portion of 
those costs were subject to arm's-length negotiation between 
funds and their managers, it is true that tens of billions of 
dollars could be saved and added to investor returns year after 
year after year.
    The kind of stewardship that demands that fund directors 
effectively represent the shareholders who elected them and to 
whom they are responsible under the law is rarely found in this 
industry. Rather, managers focus on salesmanship, their agendas 
dominated by a desire to bring in assets under management. That 
marketing agenda led us, as you know, sir, to create hundreds 
of risky new economy funds during the stock market bubble, not 
because they were prudent investments but simply because we 
thought the public would be eager to buy them. And in the 
ensuing market crash, those very funds cost our shareholders 
hundreds of billions of dollars, even as fund managers were 
reaping tens of billions of dollars in extra advisory fees.
    The conflicts of interest that engendered these unhappy and 
costly outcomes for fund shareholders must be resolved, and 
must be resolved in favor of fund owners and not fund managers.
    My formal statement sets forth a series of governance 
reforms that I believe are required to set the balance 
straight, and I strongly urge you to consider them.
    I want to add just very briefly, let me say that I love the 
mutual fund industry, and I have loved it ever since we first 
met in 1949. But we have lost our way, and we must return to 
our proud heritage. It is the recent scandals that give us the 
opportunity to build a fund industry that is worthy of our 
heritage, one that returns to what I have been doing and trying 
to get done a long time, sometimes I think I have been working 
on it forever: Giving the mutual fund industry's 95 million 
investors a fair shake.
    Thank you, sir.
    Senator Fitzgerald. Thank you very much, Mr. Bogle. Mr. 
Bullard, you may proceed.

TESTIMONY OF MERCER E. BULLARD,\1\ FOUNDER AND PRESIDENT, FUND 
                         DEMOCRACY, INC

    Mr. Bullard. Thank you. Chairman Fitzgerald, Ranking Member 
Akaka, and Members of the Subcommittee, thank you for inviting 
me to testify here today.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Bullard appears in the Appendix 
on page 154.
---------------------------------------------------------------------------
    The occasion for this hearing is for me, and I believe all 
of us, an unhappy one. The U.S. fund industry is in the middle 
of the worst scandal in its history. Shareholders' faith in the 
securities markets has once again been shaken, this time with 
respect to an industry that has had a relatively scandal-free 
reputation.
    About this few disagree. About how to deal with this 
scandal there is significant disagreement. Some believe that 
the scandal involves only a few bad apples, a few isolated 
instances of fraud, the failure of fund rules. In my view, the 
scandal involves more than a few bad apples. It reaches into 
the highest executive ranks of some fund managers. It involves 
a number of different types of frauds at a large number of fund 
complexes. It demonstrates not a failure of fund rules but a 
systemic failure of compliance.
    The alleged frauds were no surprise. They were open and 
notorious. The most substantial harm to shareholders, harm 
caused when funds used stale prices, has been well known for 
years and exploited by professional and retail investors alike.
    Academics have published numerous studies on stale pricing, 
estimating that shareholders lose hundreds of millions or even 
billions of dollars every year. There have been articles 
describing how to exploit stale prices in popular financial 
press. Three years ago, I wrote two articles describing the 
problem of stale pricing and showed how a fund using stale 
prices could lose 2 to 3 percent of its assets because of stale 
prices in a single day.
    This has not been a problem for some complexes that have 
chosen to protect their shareholders. Vanguard and Fidelity, 
for example, among others, routinely fair-value their 
portfolios to ensure that their funds' prices are not stale. 
The question for this Subcommittee is why managers and 
directors of other funds did not take steps to protect their 
shareholders.
    The alleged frauds of late trading, market timing, and 
commission overcharges similarly reflect a shocking failure of 
oversight by fund managers and directors. Commission 
overcharges, late trading, stale pricing, and illegal market 
timing can and will happen and probably continue to happen, 
even in an ideal compliance environment. Fund directors and 
managers cannot and should not be held accountable for 
individual instances of fraud. But the extraordinary 
pervasiveness of these frauds demonstrates that the problem is 
that the compliance environment in much of the fund industry 
has become corrupted. The scope of these frauds could not have 
been realized if fund directors and managers had ensured that 
procedures were in place that were reasonably designed to 
detect and prevent these frauds and that periodic spot checks 
were conducted to ensure the procedures were working.
    When alleged frauds such as these show a systemic failure 
of compliance, structural reform is necessary. It is not enough 
to change the rules when the problem is that existing rules 
were routinely ignored. The oversight system for mutual funds 
must be addressed.
    Toward that end, I propose that Congress create a mutual 
fund oversight board to supplement the SEC's oversight of the 
fund industry. The Board would have examination and enforcement 
authority over fund boards. It would be financed from 
assessments on fund assets and appointed by the SEC.
    Americans are increasingly being expected to prepare for 
their retirement security on their own. But if their 
investments are simply going to be lost to fraud, in some cases 
perpetrated by the very persons to whom they have entrusted 
their financial futures, they will naturally turn away from our 
markets with potentially disastrous consequences for their 
retirement security and this country's economic future. I 
strongly recommend that Congress take strong steps to restore 
America's faith in the fund industry.
    Thank you again for the opportunity to appear before you 
today, and I am happy to answer any questions you might have.
    Senator Fitzgerald. Thank you. Mr. Fink.

TESTIMONY OF MATTHEW P. FINK,\1\ PRESIDENT, INVESTMENT COMPANY 
                           INSTITUTE

    Mr. Fink. Thank you, Mr. Chairman. Like many of you here 
today and the witnesses that preceded me, I am outraged at the 
shocking betrayal of trust exhibited by some firms and people 
in our industry.
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    \1\ The prepared statement of Mr. Fink appears in the Appendix on 
page 186.
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    As you said, Mr. Chairman, I have been at the institute for 
32 years. Mr. Bogle, who was one of the people who hired me 32 
years ago, I love the mutual fund industry. And in virtually 
every discussion I have had over those three decades with 
Members of Congress and regulators and the media, when asked 
why the mutual fund industry has been so successful, I have 
attributed it largely to what Mr. Bullard just said: It has had 
a pretty scandal-free record because it has been committed to 
integrity.
    The investigations raise very serious questions about that 
integrity. I can assure you that I and the fund leaders are 
totally committed to answering every one of those questions. We 
want to rebuild trust, renew public confidence, and reinforce 
our history of putting the interests of fund shareholders 
first. This is because it is the best way for the funds, many 
funds who are not involved in the investigations, to continue 
to serve their investors well and for those who are involved to 
turn around and embrace needed reforms. And I can assure you, 
Mr. Chairman, that as far as we are concerned, every type of 
reform is on the table for consideration.
    I think it is clear that action has to be taken in three 
areas: first, government officials must identify and sanction 
every single person or firm who violated the law; second, fund 
shareholders who were harmed must be made right; and, third, 
strong regulatory reforms must be put in place to make sure 
these abuses never happen again.
    Let me turn to the third area of regulatory reform. The 
SEC, as you heard this morning, has laid out a blueprint. In 
connection with this, last week the Investment Company 
Institute called for three actions in each of the three areas 
of major abuse: Late trading, short-term trading, and trading 
by insiders.
    First let me talk about late trading. Current law, as you 
have heard, requires that orders to buy or sell fund shares 
have to be placed by investors by 4 p.m. Some orders may not 
actually be received by the mutual fund until many hours later. 
For the large number of transactions, 90 percent, that do not 
go directly to the fund but come through brokers or 401(k) 
plans or other intermediaries, the fund gaining assurance that 
the orders were placed before 4 p.m. is very difficult and, in 
fact, in many cases is impossible. Therefore, our 
recommendation is designed to solve this problem.
    We have called upon the SEC to require that all orders must 
be received by the fund itself by 4 p.m. This is very tough 
medicine, Mr. Chairman. Longstanding business practices will 
have to change. Millions of shareholders, thousands of brokers, 
banks, 401(k) plans, and other intermediaries will be affected. 
And hundreds of fund companies will be affected. Nevertheless, 
we urge the SEC to move as quickly as possible, given the 
practical changes of implementing this scheme.
    My chairman, Paul Haaga, has stated that the 4 p.m. 
deadline ``represents all that can be done to slam the late 
trading window shut.'' We are committed to keeping this window 
shut and locked permanently.
    The second area is abusive short-term trading, market 
timing. Chairman Donaldson has outlined ways to address these 
concerns. While some funds had policies and disclosure to 
discourage market timing, they, in fact, applied those policies 
unfairly or inconsistently, to say the least. And we endorse 
all of Chairman Donaldson's plan.
    We have also concluded that on top of that, a substantial 
new regulatory requirement is needed. In fact, about the same 
day Mr. Bogle came out with the same type of plan. Mutual funds 
face great difficulty in enforcing their policies against late 
trading because for many accounts--and I cannot give you an 
estimate, but I would say perhaps 30 percent of fund assets--
the shareholder's account is not with the fund. The fund does 
not even know his or her name. It is with a broker, bank, 
401(k) plan, a so-called omnibus account. There we only know 
the omnibus account name. We do not know anything about the 
individual shareholders or their transactions. Therefore, the 
funds cannot easily, or it may be impossible for them to 
enforce, their bans on short-term trading. Therefore, we 
recommend that the SEC require virtually all funds in this 
country to impose a 2 percent redemption fee on any sale of 
fund shares for 5 days following purchase. I think Mr. Bogle 
recommended a 30-day window, but it is the same type of idea.
    A standard industry-wide requirement like this could help 
intermediaries police their accounts. And I also want to make 
it clear that 100 percent of the proceeds of the redemption fee 
goes to the fund and its long-term shareholders, not to the 
fund's management or the intermediaries.
    Let me just talk about the last and I think the most 
shocking issue: Abuse of trading by fund insiders. Last week, 
we learned of allegations that some fund managers have 
themselves engaged in short-term trading in their own funds. 
This is totally abhorrent. We support any steps necessary to 
make it clear that this is illegal. Moreover, we have called 
upon our members to amend their existing codes of ethics.
    Back in 1994, there was a scandal, smaller than the current 
one, where people who worked at mutual funds were buying stocks 
or bonds in front of their funds or possibly in front of their 
funds, and the industry came out with very tough procedures, 
best practices, to stop that. It included, for example, Mr. 
Chairman, any gains anybody who worked for a mutual fund made 
on a trade within 60 days, even if the fund never thought about 
buying or selling that security, would have to be disgorged--
reporting, post-trade monitoring, prior clearance, a whole 
bunch of controls. We understand both from the mutual funds and 
from the regulators this seems to have stamped out insider bad 
trading, short-term trading in stocks and bonds. Nobody thought 
at the time, frankly, to cover mutual fund shares. Everybody 
thought it would be a good idea for the fund managers to eat 
their own cooking and invest in their funds. We think these 
codes ought to be extended appropriately to cover trading in 
mutual fund shares.
    Let me just conclude, Mr. Chairman. It is also clear, as 
all the witnesses have said, that broader reforms are needed. 
We can address these three existing ones, but we do not want to 
be back here addressing a fourth one next year or 2 years from 
now. It is clear to me we need strong compliance systems and 
far better mechanisms for fund directors to determine that 
those compliance systems are working, not just in late trading 
and market timing but in all areas.
    The SEC recently issued a major rule proposal in this area, 
and we urge its adoption as swiftly as possible. We are also 
open to many of the measures that have been discussed today. I 
probably heard 20 or 30. And I have a feeling that if you took 
all the witnesses--government, industry, industry critics, 
etc.--there is probably 70 or 80 percent agreement among all 
that list. There will be differences of opinion, but I think 
there is general agreement.
    Mr. Chairman, in conclusion, I recently announced--I might 
say before the scandal--that I would be retiring after 32 
years. And I promise with all of my heart to every member of 
this Subcommittee, all the other government officials involved, 
and, above all, the Nation's 95 million shareholders, that I 
personally will use all of my own energies during my remaining 
tenure to see that these abuses are stamped out and that 
necessary reforms are, in fact, put in place. Thank you.
    Senator Fitzgerald. Thank you very much, Mr. Fink. It is 
indeed an irony that you were hired 32 years ago by Mr. Bogle 
and here you wind up on the same----
    Mr. Fink. Among others. I don't think he wants to----
    Senator Fitzgerald. Among others. [Laughter.]
    I am not quite sure how they ever made Mr. Bogle the 
president of the ICI, and I want to ask him about how the 
industry has changed over the years.
    You said in your testimony, Mr. Fink, that any and all 
reforms, including several of those discussed by the previous 
panel, are on the table and you are open to consider. Let's 
talk about some of those reforms.
    Mr. Fink. Sure.
    Senator Fitzgerald. What about having an independent 
chairman of the board for the mutual fund, independent of the 
advisory firm?
    Mr. Fink. Well, I knew you would ask the difficult ones. If 
I said 80, you are into the 20 percent. I have to say, 
factually, I am very worried about solutions that appear to do 
something and do not do anything. Of the four firms in Canary 
that Mr. Spitzer brought his first case against, two have 
independent chairs. Of the total of eight firms that have been 
named today, as the list has grown--Alger, Alliance, Putnam, 
etc.--three of the eight have independent chairs. So I have a 
feeling----
    Senator Fitzgerald. Do you think it is a problem with the 
definition of ``independent?''
    Mr. Fink. No. These are truly independent. I think an 
independent chair does not make much difference, Mr. Chairman, 
and I will tell you why. Right now, by law, by SEC rule, you 
have to have a majority of independent directors. Industry best 
practices are two-thirds. Probably industry practice may be 
two-thirds or better, in fact, so those independent directors 
can choose whoever they want to be chair from among themselves. 
They can set the agenda. They can set priorities. And when I 
ask independent directors who I respect they want the 
management company person to stay as the chair. Why is that? 
Well, that job is largely administerial, organizational, agenda 
building. It is easier for the person who is there full-time to 
do that. They say we will make the big decisions, but we only 
come in once a month or once a quarter. So I think there is a 
practical issue.
    I would just be wary of something that sounds good. Only 20 
percent of the industry have independent chairs now, and yet 
three of the eight cases have independent chairs and it has not 
been a cure-all. So I guess in my own view, Mr. Chairman, I am 
skeptical.
    Senator Fitzgerald. Well, let me ask you this, Mr. Fink: 
Why is it that Vanguard is able to negotiate lower fees with 
its investment advisers than virtually all others. Does any 
other mutual fund have lower fees from their investment 
advisers than Vanguard?
    Mr. Bogle. I think it is fair to say as a categorical that 
no other funds--there may be a single isolated fee here or 
there, but I would be astonished to see even one that pays 
lower advisory fees than Vanguard.
    Senator Fitzgerald. And you have set up Vanguard so that 
you have eliminated those conflicts between the director of the 
funds and vendors to the fund.
    Mr. Bogle. Right.
    Senator Fitzgerald. Well, why is it that not one of the 
other 8,600 mutual funds in this country is not able to 
negotiate the kind of fees that Mr. Bogle's firm has?
    Mr. Fink. Well, I think Mr. Bogle put his finger on it. You 
have got to remember--and Jack can correct me--Vanguard was 
created with existing--a lot of money in existing funds that 
reorganized themselves to do this. And as Jack said, there is 
no profit motive, so it would not pay Senator Fitzgerald or 
Matt Fink to go out and start a fund company that way because 
we would not make any money at it. So you kind of need an 
existing body of assets and then, I don't know, internalize, 
mutualize. It is an unusual thing. But that is unrelated to the 
independent chair issue, Mr. Chairman.
    I am simply saying that you could pick--we have 20 percent 
of the industry with independent chairs. I do not think their 
track record for compliance, ethics, is any better than the 80 
percent without independent chairs.
    Senator Fitzgerald. Mr. Bogle, would you care to respond?
    Mr. Bogle. Yes. First, let me say that Vanguard started 
with an existing asset base of around $1 billion, $1.4 billion, 
and so we did have an asset base on which to build this mutual 
structure. And I will say, Mr. Chairman, I do not expect 
anybody to start a mutual fund group, except sort of someone 
like me, without an idea of an entrepreneurial profit. But that 
should not go on forever. You know, a child becomes an adult, 
and when we leave the billion-dollar level and have scores of 
fund organizations that are running $10 and $20 and $100 
billion, they ought to grow up and think about having an 
internally managed structure.
    It almost offends common sense to think a $200 billion 
aggregation of assets has to hire another company to run it. 
What sense would that make?
    Senator Fitzgerald. Well, let me ask you this: Are there 
any other truly mutual mutual funds? Vanguard is the only one. 
We do have mutual savings banks. We have credit unions. They 
are organized. They are not-for-profit. Theoretically, they 
should have better interest rates that they offer to the 
customers. I think what has happened in practice is they have 
not been able to run banks or savings and loans out of town 
because their service is not as good, probably because there is 
not the profit motive there.
    But what would be wrong if the government created a means 
to encourage the formation of more truly mutual mutual funds?
    Mr. Bogle. I think public policy should work in the 
direction of requiring consideration of mutualization after a 
fund gets to a certain size. One way this industry has changed 
over the long span I have been in it was, when I came in it, 
all management companies were private companies. They were 
private partnerships or private corporations owned by the 
investment adviser, and the SEC successfully kept people from 
going public to capitalize their fiduciary office. The SEC lost 
a case in court in 1958. We now have many public companies. And 
we also have what is really harmful to the industry and to the 
shareholders, and that is, 36 of the 50 largest fund 
organizations are giant financial conglomerates. And when a big 
conglomerate buys a mutual fund business for $2 billion, they 
say to whoever they get to run it for them, ``We want $240 
million a year of profit--that is a 12 percent return on their 
capital--and if you cannot get it, we will hire somebody who 
can get it.''
    So that conglomeratization has moved the management away 
from this closely held group out into this distant financial 
colossus. At that stage fund complexes, if they have an 
independent board and an independent staff, will be able to 
say, look, we are going to mutualize.
    Mr. Fink. Mr. Chairman, two things. Jack paints a golden 
age. Well, we would not have had the Investment Company Act in 
1940, which is the toughest of Federal securities statutes, if 
bad stuff was not going on in the 1920's and 1930's by these 
wonderful non-conglomerate people. I mean, bad stuff was going 
on----
    Senator Fitzgerald. We called them investment trusts in 
those days.
    Mr. Fink. Yes, investment trusts.
    Second, why does somebody start a mutual fund? I am XYZ, T. 
Rowe Price, Fidelity. I start it. I spend a lot of money to get 
it growing. I hope to make a lot of money in the future. I do 
not expect that my directors 5 years from now, unless I do 
something terribly wrong, are going to move it. It is my 
creation. And the investor does not expect it. When I invest in 
the T. Rowe Price X fund, I do not expect tomorrow they are 
going to move the management to Fidelity or Putnam or Strong. 
It is a different situation.
    If I can just say this, Mr. Chairman, the Investment 
Company Act was created, and the problems we face today are 
because there are inherent conflicts in managing other people's 
money. No doubt about it. The Investment Company Act tried to 
put in checks and balances to address that. In 1970, before my 
time, Mr. Bogle worked on it. Congress made the only major 
amendments to the Act to increase those checks and balances. We 
may very well be at a point where more checks and balances 
ought to be considered. But I do not think we have moved from a 
golden age to an age of knaves. There has always been a 
problem. It takes different forms. And we all have to think 
about--the industry for its own well-keeping has to think 
about--how to do it.
    Senator Fitzgerald. Mr. Bullard.
    Mr. Bullard. Mr. Chairman, it is important to remember that 
while Vanguard is the leader on cost, there are fund companies 
that are competing directly with Vanguard on cost and in some 
cases doing it very successfully. TIAA-CREF, USAA----
    Senator Fitzgerald. Now, TIAA-CREF is someone----
    Mr. Bullard. It is a separate entity, but it is a 
nonprofit.
    Senator Fitzgerald. It is not-for-profit, right. Does 
anybody else----
    Mr. Bullard. Well, for example----
    Senator Fitzgerald. Does any for-profit firm compete 
closely on cost?
    Mr. Bullard. Yes, sir. In fact, the biggest threat to 
Vanguard right now is exchange-traded funds, which are 
consistently offered by for-profit entities, and most people 
believe Vanguard missed a great opportunity to reduce its 
expense ratios that are now being undercut by those funds being 
offered by Barclay's Global.
    And I also might add, the largest fund complexes generally 
correlate fairly consistently with lower costs, with Fidelity, 
Vanguard, American Funds, and T. Rowe Price.
    Senator Fitzgerald. The exchange-traded funds do in general 
have lower costs. Is that correct?
    Mr. Bullard. Yes, they have lower costs with the same 
indexed funds than those offered by Vanguard.
    Senator Fitzgerald. Vanguard offers an exchange-traded 
fund.
    Mr. Bogle. We do. Let me be clear on this. First, nobody 
competes with us on cost, Mr. Bullard notwithstanding. I mean, 
TIAA's costs are about 10 or 15 percent higher; USAA's are 
probably 100 percent higher; Fidelity's are 200 to 300 percent 
higher. So no one competes there with really rock-bottom costs.
    The trick of the ETFs, the exchange-traded funds, is all 
the costs of administration are basically thrown over to the 
marketplace, so people pay for them with their brokerage 
commissions and things of that nature. We have an ETF owning 
the total stock market index. We can run that for--I believe 
the number is 12 basis points, where the fund itself when we 
run is 15 to 20 basis points. So the differences are small but 
they are there. So we are in the business. No one is going to 
take that business away.
    Senator Fitzgerald. While we are talking about fees, what 
about enhanced disclosure of fees? Is it not true, Mr. Fink, 
that small differences in fees, in management fees and other 
fees, charged to a mutual fund can over time result in very big 
differences?
    Mr. Fink. I could not agree more, and the SEC has issued--
the debate here is which way to enhance fee disclosure, 
generally. The SEC has issued a proposal that the annual report 
you get and the semiannual report--you get a report twice a 
year--would tell you at the beginning of the period if you had 
$10,000 invested what the $10,000 would be worth at the end of 
the period and what the expense--what your pro rata share of 
the expense would be.
    Senator Fitzgerald. Does that SEC regulation require every 
single expense be included in the calculation?
    Mr. Fink. We have to define ``expense.'' The ongoing 
operating expenses, we get back to an issue with Mr. Bullard 
whether you can put--and maybe Mr. Bogle. Brokerage commissions 
and trading costs are not in there because they are generally 
hard--they are not ongoing expenses.
    Senator Fitzgerald. Well, aren't we deceiving an investor 
in a fund that allows a lot of churning and market timing if we 
are not making some attempt to quantify how they are being----
    Mr. Fink. I am all for an attempt to quantify, but I would 
not put it in the expense ratio.
    Senator Fitzgerald. You are offering an attempt to 
quantify. The ICI would go----
    Mr. Fink. Yes.
    Senator Fitzgerald [continuing]. Along with that.
    Mr. Fink. Yes.
    Senator Fitzgerald. Mr. Bogle, would you like to address 
what fees are not disclosed in the required disclosures that 
the SEC mandates in the prospectuses?
    Mr. Bogle. Yes, I would like to at least make this one 
comment. The SEC and the ICI seem to have come to agreement 
that you can multiply $10,000 by the fund's expense ratio to 
get the amount of dollars that would be involved. But they do 
not seem to be able to multiply the actual value of your 
account times that expense ratio.
    I find that absolutely astonishing in this technological 
age. It is one simple multiplication that the computer can do 
to give you the dollar cost number you want. So I do not 
understand what is going on over in this negotiation.
    Senator Fitzgerald. I want to make sure I understand this. 
Are you recommending a change to the SEC disclosure 
requirements? Instead of having them pick $10,000, you are 
recommending that they pick what?
    Mr. Bogle. The asset value of your account at year-end. 
Multiply that by the existing expense ratio.
    Now, I would not yet go----
    Senator Fitzgerald. Does the expense ratio encompass all 
expenses?
    Mr. Bogle. No. That is just the fund expenses, which are 
essentially management fees and other operating expenses.
    Senator Fitzgerald. What are the other expenses?
    Mr. Bogle. The other expenses are--well, they are quite 
numerous. One is portfolio turnover costs, which I have a very 
low estimate of, much lower than most people. I put that in at 
about 8 percent--8/10s of 1 percent, excuse me. So you would 
add that, for example, to the 1.6 average expense ratio, and 
that would get you to 2.4 percent.
    Most funds have sales charges. If you amortize them over 
time, it is probably another 40 basis points, something like 
that. There are out-of-pocket costs. There are opportunity 
costs. Most funds are not fully invested so you pay an 
opportunity cost, that being the difference between long-term 
stock market returns and, say, money market returns, which 
comes to around another 30 basis points.
    So if one wants to think that mutual funds cost around 3 
percent a year, one would not be far off. The fact is, Mr. 
Chairman, that we have done the study of fund performance since 
1984, and the average fund has turned in a 9.3 percent annual 
return while the stock market has turned in a 12.2 percent 
annual return. That happens to be a 2.9 percent percentage 
point difference.
    And if I may expand on that, we have also found out the 
average fund investor during that period has earned a return of 
just 2.6 percent, which I believe to be substantially 
overstated. That is for another day.
    Senator Fitzgerald. So we are missing 7 percent somewhere.
    Mr. Bogle. Yes, somewhere along the way, and----
    Senator Fitzgerald. Is that part of what I referred to in 
my opening statement as the skim? Was that all skimmed off?
    Mr. Bogle. Well, actually, that is not the skim. That is 
the net result of an industry that used to sell what we made 
becoming an industry that makes what will sell, and that is, we 
market funds, technology funds, right at the high of the 
market. The money pours into them, and then it starts to pour 
out when it goes down. Even at the high, the money is pouring 
out of value funds, let's call them old economy funds, into new 
economy funds. And investors have paid a huge penalty for that, 
partly, in fairness, their own fault, their own greed, probably 
their own jealousy of their neighbor. But the industry brings 
out those funds, promotes them, advertises them, and if you 
look at the March 2000 issue of Money Magazine, 44 mutual funds 
were advertising their performance there, and they were 
offering to the investment public, believe this or not, Mr. 
Chairman, an average return over the previous year of plus 85.6 
percent, come and get it. But, of course, nobody got it. The 
market went down and they lost their money.
    Senator Fitzgerald. Mr. Fink, what about Mr. Bogle's 
suggestion that in the prospectus, in addition to the expenses 
that are now required to be disclosed and netted out in 
calculating the return over the years, what if we add portfolio 
turnover costs, sales charges, out-of-pocket costs, and 
opportunity costs?
    Mr. Fink. A lot of them are in there now. At the front of 
every prospectus is a fee table that lists the operating 
expenses that the fund pays.
    Senator Fitzgerald. Are they in a graph? Are they in a bar 
graph?
    Mr. Fink. The opportunity costs, I want to be clear, some 
are in, some are not, because opportunity cost experts do not 
know how to capture that. There is a debate, to be fair about 
that.
    But 90 percent, I think to be fair, of what Mr. Bogle 
listed is in the prospectus fee table, and then it tells you, 
if you had $10,000 invested for 1 year, 3 years, 5 years, 
exactly how much you would have paid out from those expenses.
    Senator Fitzgerald. So you have no trouble with disclosing 
all those costs and putting them in the graph?
    Mr. Fink. Some of the opportunity costs, I don't----
    Senator Fitzgerald. Except for maybe opportunity costs.
    Mr. Fink. Maybe one other, but, yes, no problem at all.
    Senator Fitzgerald. You have no problem if we require all 
of those expenses to be put in the calculation that is used to 
derive the graphs?
    Mr. Fink. I think I am right. Yes, I think so.
    Senator Fitzgerald. OK. You think so?
    Mr. Fink. I don't know if I am missing something. That is 
all.
    Mr. Bogle. You are not missing anything.
    Senator Fitzgerald. Senator Akaka.
    Mr. Bogle. We have a new convert.
    Senator Akaka. Thank you very much, Mr. Chairman.
    I want to shift the discussion a little bit. We have been 
talking about management and I want to shift more towards 
disclosure and particularly shift to information. I want to 
know what is the most useful and understandable relevant 
information that investors need to have to make sound financial 
decisions prior to purchasing mutual fund shares. I would like 
to move into that. As part of that discussion, I want to talk 
about mutual fund advertising since that is where many 
investors learn about funds.
    Mr. Bogle, what is your evaluation of mutual fund 
advertising? Do you believe that it is misleading to investors, 
and what needs to be done to prevent investors from being 
misled by advertisements?
    Mr. Bogle. The first thing, and I did not always feel this 
way, but we live and learn. I believe that mutual fund 
performance advertising is inherently misleading on the face of 
it. We get this free shot. When times are good, we advertise 
very high returns. When times are bad, we either advertise 
nothing or we advertise our bond funds. The record is very 
clear on that. It is opportunistic, it is overly zealous, and 
it is inherently misleading.
    So I would say you cannot show performance numbers, and 
when I started Vanguard, I said we will never advertise a 
performance number, nor ever have we. So that is what should 
not be shown.
    What should investors think about? Investors should just 
simply understand that active management is in many respects a 
charade, that all mutual fund active managers end up being 
average. How could it be otherwise? And, therefore, they lose 
the market by the amount of costs. So investors ought to think 
first about how diversified is the fund and shouldn't I just 
own the entire stock market rather than trying to pick a 
manager.
    Second, it is so important that they understand costs, that 
is right up there after diversification.
    Third, they ought to look at fund portfolio turnover. There 
is direct correlation not only between cost and investment 
returns, but between level of turnover in investment returns. I 
mean, it cannot be more obvious, and if you look in my written 
statement, you will see that if you combine those two costs, 
the low-cost quartile of funds does better than the high-cost 
quartile of funds by 3.5 percentage points every year. And you 
can put that in every one of the Morningstar nine boxes. The 
pattern is unmistakable. The higher the turnover, the higher 
the costs, the worse the returns investors get. If we could 
talk investors out of looking at past performance, that would 
be a good thing.
    If we could talk them out of buying specialty funds and 
sector funds--they are always doing it after they turn in good 
performance. Investing is actually a matter of great 
simplicity. Get the diversification as wide as you can, the 
cost as low as you can, and close your eyes and hold on for the 
rough ride that common stocks have been giving investors since 
the beginning of time. So my first rule is: Don't do something, 
just stand there. And my second rule is: Don't peak, never 
look. And you'll be fine when you retire if you follow those 
rules.
    Senator Akaka. Thank you, Mr. Bogle. Mr. Fink, do you 
believe that brokers should be required to disclose in writing 
to those who purchase mutual company shares the amount of 
compensation the broker will receive as a result of the 
transactions? If so, why?
    Mr. Fink. We have called, I think beginning in 1995, for 
brokers to----
    Senator Fitzgerald. If I could just interject for a moment, 
Mr. Bogle has to leave now, and I want to thank Mr. Bogle for 
coming here today. He has honored us by his presence. We thank 
you for the good work you have done over your illustrious 
career, and I hope to stay in touch with you as we work through 
some reforms that you have been arguing for for years.
    Thank you so much for being here.
    Mr. Bogle. I would be glad to help, Mr. Chairman, in any 
way that is within my power. Thank you, sir.
    Senator Fitzgerald. Many thanks.
    Mr. Fink, I am sorry for that.
    Mr. Fink. First of all, Mr. Akaka, your question is a good 
one because I ought to point out, 90 percent of funds are not 
bought directly as in Vanguard. Ninety percent of people buy 
through a broker, a bank, a financial adviser, or 401(k) plan. 
So the amount of people who look at an advertisement right away 
for a prospectus is a very small sliver, just to put it in 
context.
    Yes, the broker should disclose if he is getting special 
compensation for shelf space for featuring one fund over 
another. Now, it may be hard to do an exact dollar amount 
because the arrangements don't run that way. Some brokerage 
firm will say pay us $1 million this quarter, we will feature 
your fund. It would be hard for the broker, that individual 
broker, to explain what he or she is getting. It's maybe 
nothing. But there ought to be disclosure if the broker is 
being specially compensated, yes.
    Senator Akaka. Mr. Ballard, which is the more accurate 
indicator of transaction costs: Portfolio turnover or brokerage 
commissions, and why?
    Mr. Bullard. I am aware of only one academic study that 
actually looks at the correlation between actual commissions 
and turnover, and that concluded that there is not a very 
strong correlation between turnover and commissions. And, in 
fact, the expense ratio itself, which does not include 
commissions, is a stronger indicator. So in a choice between 
the two, at least to the extent we have some academic 
literature on it, the sign is that turnover ratios are not a 
strong indicator.
    In addition to that, I would say that when you have the 
number available itself, there really is not a good argument 
for using a proxy for that number. We know the dollar amount of 
commissions being paid by funds. There is no excuse for not 
immediately incorporating that into the expense ratio.
    And to answer the other part of your question--what are the 
other components of portfolio transaction costs?--they are 
generally considered to be four: Commissions, which are dollar 
amounts that all agree are generally objective; two other 
areas, market impact--that is the actual impact on the price of 
a security caused by the fund trading it--is another cost; a 
third cost is spread impact--that is the amount of the spread 
between the bid and the ask price that is paid by a fund every 
time it trades; and then, finally, what you were talking about 
before, which are opportunity costs, which there is general 
agreement are the most difficult to measure.
    As a general matter, fund directors are responsible for 
reviewing the execution obtained by fund managers, and they are 
legally required to consider commissions, market impact, and 
spread costs. So they are being objectively quantified and 
being considered by directors. I don't know if there are any 
who are looking at opportunity costs, and that may be something 
that is too subjective to incorporate in that number. But at a 
minimum, those three elements--commissions, market impact, and 
spread--should certainly be included in an objective amount 
that, albeit not perfect, certainly is better than leaving 
investors in the dark about what may be a fund's single largest 
expense.
    Senator Akaka. Thank you. This is a question that either 
one of you can answer. There have been some, including 
Secretary Galvin on the previous panel, who have called for 
banning the use of soft dollars. Do you believe soft dollars 
should be banned and why? Mr. Fink please respond first.
    Mr. Fink. OK. I want to make it clear. It was Congress who 
blessed soft dollars in 1974 in Section 28(e)--maybe I 
shouldn't say that with the Senators sitting here, but Congress 
did it in 1974 in Section 28(e) of the 1934 Act. All advisers, 
mutual funds, pension funds, public pension funds, charities, 
endowments, all managers--this is not a uniquely mutual fund 
problem. We are considering in our own office a position on 
total abolition, but there is an easier first step to take that 
we are also considering.
    For many years after 1974, the SEC took a very restrictive 
reading of what were legitimate soft dollars. There had to be 
research produced by the brokerage firm that you did the 
execution with. In 1978, they came out with a much broader 
interpretation which allows people to buy all kinds of stuff. 
So an easy remedy, barring trying to get Congress to repeal it, 
would be to cut it back to 1978, not just for mutual funds but 
for all users of soft dollars.
    One other thing, Senator Akaka. You read before some of the 
uses people were making based on the SEC report. That report I 
think is 4 years old. It looked at both mutual funds and 
private money managers. It found a series of abuses in private 
money managers. I hold my breath these days, but I think it did 
not find a single abuse in the mutual fund area. So I am saying 
I think the funds have been pretty good, at least the last 
check, living up to the current rules. But an easy thing for 
the SEC to do, an easier thing to do would be to cut it back, 
cut the permissible usage back, and then think about abolition.
    Senator Akaka. Mr. Bullard, what are your comments on 
whether the use of soft dollars should be banned?
    Mr. Bullard. Certainly, Senator. I would agree with Mr. 
Fink's recommendation, but I think there is a broader question 
involved. And as a general matter, my view is that you should 
leave, when you can, these questions to the market to decide. 
If the market believes that a fund manager who pays 6 cents a 
share for a trade and gets research is making efficient use of 
those dollars, then that is something that we should be able to 
live with. If the market decides they want the fund manager to 
spend 2 cents a share and not get research, we should also be 
able to live with that.
    The problem, though, is that the market cannot make a 
decision. The market is not being told in any way the actual 
cost, that actually 4 cents a share more that is being paid for 
the fund using soft dollars. So before we get to the point of 
deciding whether to abolish soft dollars, I would rather have 
them disclosed. They are included in commissions. Include them 
in the expense ratio and let the market decide. And if it wants 
to punish funds that use soft dollars, so be it.
    But as Mr. Fink pointed out, they are used very widely. 
They are used by Vanguard. Vanguard uses its soft-dollar 
payments essentially to reduce its custodial fees, generally.
    So this is a practice that isn't inherently abusive. It may 
drive up costs, but I think principally because it is not fully 
disclosed and transparent.
    Senator Akaka. Thank you gentlemen for your responses. My 
time has expired, Mr. Chairman.
    Senator Fitzgerald. Mr. Bullard, I would like to ask you 
about a proposal I have recommended, and I think Attorney 
General Spitzer also recommended it in his opening statement. 
We recommend that mutual fund directors be required to 
competitively bid out their management, their investment 
management contracts. What do you think of that proposal?
    Mr. Bullard. I think that proposal would substantially 
change the mutual fund industry as we know it in ways that we 
could not predict. As a general matter, if you have good 
disclosure of fees and you have standardized disclosure of 
performance, again, I would leave it to the market to decide 
which funds they want to invest in.
    Essentially, we have a board of directors who sits in a 
sense second-guessing judgments made by shareholders to which 
manager they want and what expense ratio they want to pay. And 
in a best world, I would like to leave that decision to 
shareholders and have fund directors applying an ultimate 
fiduciary test to make sure as a back-up that those fees are 
not excessive and that those fund managers are complying with 
the law.
    So I would not recommend requiring that they bid out those 
contracts because essentially it is not clear to me what 
decision the shareholder would be making anymore if they buy a 
Fidelity fund and----
    Senator Fitzgerald. Do you advise any mutual funds?
    Mr. Bullard. Do I? No.
    Senator Fitzgerald. Mr. Fink, what do you think about 
requiring that the investment advisory----
    Mr. Fink. I think it is contrary to the factual situation. 
I decide--Mr. Bogle knows me and I decide to buy the Vanguard 
XYZ fund because it is managed by Vanguard. I do not expect 
tomorrow that the Vanguard board says, gee, we are leaving for 
Fidelity or T. Rowe Price or Putnam or Strong.
    You have to remember, people created these funds as 
products. There are conflicts in running it. That is why you 
have independent directors. But the fund is not a freestanding 
entity that every year just decides what it wants to do. The 
manager created the fund as a product. We ought to control the 
manager, disclosure, conflict rules, but it would make no sense 
to put the contract out for bid. I am a consumer. I am buying a 
Ford. I do not expect tomorrow that magically it is going to be 
a Chevrolet. I mean, it is a funny kind of thing.
    Senator Fitzgerald. Do the funds that have the lowest fees 
seem to attract the most funds in the marketplace?
    Mr. Fink. Generally, yes. I don't know if I can phrase that 
right. Not perfectly, but the last time we looked, 77 percent 
of shareholder accounts that we could identify were in funds at 
the lower half of the expense thing. Now, that is probably 
because over time expense and performance have some 
relationship. So generally, yes. Fidelity is the largest fund. 
Vanguard, which is the cheapest, is the second largest. Not 
perfectly, but in general, yes.
    Now, I would make another point if I can. This gets 
confusing. We keep talking about the 10 percent of people who 
are doing their own, sitting in their living room, reading Mr. 
Bullard, reading Mr. Bogle's editorials, reading Morningstar. 
Ninety percent of people do not act like that. They rely on 
their broker, financial planner, etc., and their funds are 
going to be more costly than the direct funds because they have 
costs relating to distribution.
    Senator Fitzgerald. And most of them do not know that their 
broker is getting a 12b-1 fee for steering them to a fund, do 
they?
    Mr. Fink. That I do not know.
    Senator Fitzgerald. Do you have any problem if the brokers 
are required to send a written confirmation to the person they 
have steered into a mutual fund that that broker is getting 
12b-1 fees?
    Mr. Fink. I think it is proposed now, but not required. Am 
I right, 12b-1 is in the prospectus?
    Senator Fitzgerald. It is in the prospectus, but I am 
saying----
    Mr. Fink. Not confirmation, no.
    Senator Fitzgerald. I have recommended that there be a 
written statement sent from the broker to the customer who is 
being steered into a fund that this broker is getting a fee for 
steering the person.
    Mr. Fink. That is----
    Senator Fitzgerald. I do not know how many people are going 
to get that from reading the prospectus, but they would 
probably have to have a law degree and have had a securities 
law course, and particularly a securities law course that 
focused on the Investment Company Act to really glean 
everything that could be gleaned out of there.
    Mr. Bullard. That is right, Senator. You really hit on the 
key division between types of disclosure. There is the 
prospectus, which really gets to how much is this investment 
going to cost me. But what you are getting at is a different 
kind of disclosure, and that is, what are the incentives that 
broker has for pushing this fund? If you buy IBM stock or Dell 
or some other company, you are required to get a confirmation, 
and it tells you how much your broker got paid. Mutual funds 
are virtually the only kind of security that are excepted from 
that because of an SEC no-action letter issued more than 20 
years ago.
    Mr. Fink. I think the SEC is revisiting that, by the way, 
if I am right, as part of the break points.
    Mr. Bullard. They have been reviewing it for about 4 years. 
That is true.
    Senator Fitzgerald. Mr. Fink, in my opening statement I 
said that Congress had, in effect, turbocharged the growth of 
the mutual fund industry by setting up all sorts of vehicles 
for tax-deferred savings, 401(k) plans, IRAs, multiple types of 
IRAs, Keogh plans, and college loan accounts. Is it not true 
that Congress' actions in that regard have benefited the growth 
of the mutual fund industry?
    Mr. Fink. Tremendously, but to put the numbers on the 
table, if you took 401(k) and all defined contribution plans, 
yes. The answer is yes. But I do not want to exaggerate it. If 
you took all the 401(k), 457, 403(b), all the DC plans, mutual 
funds are about 30 percent. Investments are going 70 percent 
into something else; IRAs, individual recruitment accounts of 
all types--Roth IRA, back-end IRA, front-end IRA, etc.--with 40 
percent. So, yes, it has been a big boost for the fund 
industry, but it has been a big boost for insurance annuities, 
bank collective funds, company stock, you name it. We are not 
the only beneficiary. That is all I want to say.
    Senator Fitzgerald. Well, given that Congress has set up 
such vehicles that benefit and facilitate the growth of the 
mutual fund industry, wouldn't it be reasonable to expect, 
since Congress has funneled so much of America's household, 
college, and recruitment savings to your industry, that we have 
some really pretty tough safeguards, tougher than are now on 
the books, to guard all that savings?
    Mr. Fink. Absolutely, yes.
    Senator Fitzgerald. And you are prepared to work with this 
Subcommittee and others to address some of the reforms, and you 
understand, too, that if trust in the industry is eroded over 
time, it will erode the industry's growth?
    Mr. Fink. Oh, yes. This is not beneficent on the industry. 
The industry realizes that in a product that does not have FDIC 
insurance or state insurance funds, we are totally reliant on 
public confidence. And anything like these scandals that erodes 
it is terrible for the industry itself. And, in fact, Mr. 
Baker's bill, as it came out of the Committee, we were fine 
with. I think there the debate was not the terms of that bill, 
but whether it could be done better through Congress or the 
SEC. I mean, that was part of the debate.
    Yes, we are open to reforms. I said earlier--I tried to 
keep a running list when I was sitting there of the 20 things I 
heard. I think 75 or 80 percent are probably fine. On the rest, 
there probably is as much dispute among the critics as among 
the industry and the critics, I think.
    Senator Fitzgerald. I wonder if you agree with those who 
question whether directors can be both insiders of the 
investment advisory company and directors of the fund? I 
believe that it is difficult for human beings to serve two 
masters.
    Mr. Fink. I looked it up. It is from St. Matthew, oddly 
enough. [Laughter.]
    But if I can, yes, no one can serve two masters. So the 
Investment Company Act does two things about this. One is it 
says that, through SEC rules, a majority have to be 
independent. And whenever there is a conflict issue--if you 
think of yourself at a board meeting, 12 issues, probably 10 or 
11 do not present a conflict between the fund and the adviser, 
between the shareholders and the adviser. The law requires in 
areas like contract renewal, on the advisory contract, the 
underwriting contract, 12b-1, etc., that there you need a 
separate vote of the independent directors. So in cases where 
there is conflict, you take the interested people out. They do 
not count.
    Senator Fitzgerald. How come so few of the funds are 
competitively bidding out their investment advisers?
    Mr. Fink. I think for the reason that Mr. Bullard said. 
When someone buys a share of Vanguard prime cap fund, I am 
really buying Vanguard management. I do not expect the 
directors tomorrow to move me to Fidelity or T. Rowe Price.
    Senator Fitzgerald. But isn't your clientele here somewhat 
captive? They have a 401(k), and money is automatically 
funneled into it every month. So isn't some of this money kind 
of lazy? It does not investigate as it ought to investigate, 
and so maybe we have to have special rules here in Congress?
    Mr. Fink. I think you need special rules for mutual funds, 
yes, for collective vehicles where there are millions of 
people, they have to be represented by directors, there have to 
be rules on conflicts.
    Senator Fitzgerald. So why not require competitive bidding 
of investment managers?
    Mr. Fink. Just for the reason I stated. I think even in the 
typical 401(k) plan, or a lot of the big ones, you have 
Fidelity, Vanguard, T. Rowe Price, and Putnam. So people can 
move around among them in those funds.
    Mr. Bullard. Chairman Fitzgerald, I think it is possible 
that in the long run that step may be needed. But one step that 
I think we have never really tried is to light a hot enough 
fire under fund directors so they would negotiate hard over the 
fees that are currently in place. And it is clear, as indicated 
by these massive compliance breakdowns, they are not doing 
that.
    Senator Fitzgerald. Aren't most fund directors often they 
are employees of the money manager?
    Mr. Bullard. That is right. Many of them are. And what I 
would like to see is----
    Senator Fitzgerald. Isn't most of their annual income 
coming from the firm they would be negotiating with?
    Mr. Bullard. That is exactly right.
    Senator Fitzgerald. So how can you have a negotiation with 
yourself?
    Mr. Bullard. Well, I would propose to have some source of 
an outside independent body setting out what the fiduciary 
standards are for reviewing advisory contracts, which currently 
does not exist and the SEC does not do. There are funds that 
have expense ratios that are 10 or 15 percent of assets, and 
the SEC has chosen never to bring an action against them for 
the director's violation of fiduciary duty.
    Senator Fitzgerald. Ten or 15----
    Mr. Bullard. Ten of 15 percent. And the SEC has decided to 
completely----
    Senator Fitzgerald. Can you name any names?
    Mr. Bullard. If you go on Morningstar's site, you will be 
able to run a check, and you will find tiny funds with 10 
percent expense ratios. And if the SEC is not going to go after 
those funds, it is pretty hard to ask the fidelitys to 
negotiate fees separately.
    Senator Fitzgerald. Mr. Fink, a final question.
    Mr. Fink. Can I comment?
    Senator Fitzgerald. Yes, go ahead.
    Mr. Fink. When you are negotiating the contract--I happen 
to have my handy-dandy copy of the Investment Company Act. It 
says that the contract has to be approved by a majority of the 
directors who are not parties to such contract or affiliated 
parties to such contract, and they meet without the interested 
directors being there. So in the negotiation----
    Senator Fitzgerald. Well, what do you think is wrong with 
the fund directors that Mr. Bullard referred to who agreed to 
an investment advisory contract that charges--did you say 10--
--
    Mr. Bullard. An expense ratio, not an advisory contract.
    Senator Fitzgerald. But that would include the----
    Mr. Bullard. That would include--the advisory contract 
might be 2 percent or 3 percent.
    Senator Fitzgerald. OK.
    Mr. Fink. They can be sued. They can be sued not only by 
the SEC but by any shareholder. Section 36(b) of the Investment 
Company Act gives an express Federal right of action for any 
fee that breaches a fiduciary duty or is unreasonable.
    Mr. Bullard. The SEC has never sued such a fund.
    Senator Fitzgerald. But private lawsuits would be welcome 
in this regard?
    Mr. Fink. I do not know about welcome----
    Mr. Bullard. There are class actions all over----
    Mr. Fink. There are a lot of them.
    Mr. Bullard. There is no money in it.
    Senator Fitzgerald. There is no money in those suits?
    Mr. Bullard. There is no money in suing a $10 million fund 
for charging a 15 percent expense ratio.
    Senator Fitzgerald. Final question. Attorney General 
Spitzer said that he wants to make sure that all the mutual 
funds that he has found in his investigation of the late 
trading and market timing disgorge all of the fees that they 
earned during the period that the illegal practices were going 
on. What is the Investment Company Institute's position?
    Mr. Fink. I have no position on that. It seems to me that 
is between Mr. Spitzer and the defendants, sir.
    Senator Fitzgerald. OK. All right. Thank you both. Senator 
Akaka.
    Senator Akaka. Thank you very much, Mr. Chairman. This 
hearing has been very helpful and it will help us craft the 
kind of bill that will help the people of our country. I want 
to thank our panelists for your responses.
    Thank you.
    Senator Fitzgerald. Thank you. You have both been terrific. 
We appreciate your patience. It has been a long morning and 
afternoon. Thank you very much.
    For your information, the hearing record will remain open 
until 5 p.m. on Friday of this week in the event that other 
Senators would like to submit questions. And if there is no 
further business to come before this Subcommittee, this hearing 
is adjourned.
    [Whereupon, at 1:49 p.m., the Subcommittee was adjourned.]


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