[Senate Hearing 108-461]
[From the U.S. Government Publishing Office]

                                                        S. Hrg. 108-461




                               before the


                                 of the

                              COMMITTEE ON
                          GOVERNMENTAL AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                             SECOND SESSION


                            JANUARY 27, 2004


      Printed for the use of the Committee on Governmental Affairs

                            WASHINGTON : 2003
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                   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



                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:
    Senator Fitzgerald...........................................     1
    Senator Akaka................................................     4
    Senator Collins..............................................     5
    Senator Levin................................................     7
    Senator Sununu...............................................     9
    Senator Lautenberg...........................................    11

                       Tuesday, January 27, 2004

Richard J. Hillman, Director, Financial Markets and Community 
  Investment, General Accounting Office..........................    13
Hon. Eliot L. Spitzer, Attorney General, Office of the New York 
  State Attorney General.........................................    15
John C. Bogle, founder and former Chief Executive Officer of The 
  Vanguard Group, and President, Bogle Financial Markets Research 
  Center.........................................................    33
Peter T. Scannell, Weymouth Landing, Massachusetts...............    43
James Nesfield, Nesfield Capital.................................    45
Jeffrey C. Keil, Vice President, Global Fiduciary Review, Lipper 
  Inc............................................................    61
Travis B. Plunkett, Legislative Director, Consumer Federation of 
  America........................................................    63
Paul Schott Stevens, Partner, Dechert LLP, on behalf of the 
  Investment Company Institute...................................    65
Marc E. Lackritz, President, Securities Industry Association.....    68
John P. Freeman, Professor of Law, University of South Carolina 
  Law School.....................................................    70

                     Alphabetical List of Witnesses

Bogle, John C.:
    Testimony....................................................    33
    Prepared statement...........................................   106
Freeman, John P.:
    Testimony....................................................    70
    Prepared statement...........................................   266
Hillman, Richard J.:
    Testimony....................................................    13
    Prepared statement...........................................    81
Keil, Jeffrey C.:
    Testimony....................................................    61
    Prepared statement...........................................   179
Lackritz, Marc E.:
    Testimony....................................................    68
    Prepared statement...........................................   250
Nesfield, James:
    Testimony....................................................    45
    Prepared statement by James Nesfield and Ian Grigg...........   150
Plunkett, Travis B.:
    Testimony....................................................    63
    Prepared statement...........................................   205
Scannell, Peter T.:
    Testimony....................................................    43
    Prepared statement...........................................   131
Spitzer, Hon. Eliot L.:
    Testimony....................................................    15
    Prepared statement...........................................   102
Stevens, Paul Schott:
    Testimony....................................................    65
    Prepared statement...........................................   224


Prepared statements from:
    Peter J. Kugi, Grafton, Wisconsin............................   276
    Niels C. Holch, Executive Diretor, Coalition of Mutual Fund 
      Investors..................................................   278
    Roy Weitz, Publisher of Fundalarm.Com........................   295
Questions and responses for the Record from:
    Paul Schott Stevens, with an attachment......................   301
    Marc E. Lackritz.............................................   333
    John P. Freeman..............................................   334



                       TUESDAY, JANUARY 27, 2004

                                     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 10:07 a.m., in 
room SD-342, Dirksen Senate Office Building, Hon. Peter G. 
Fitzgerald, Chairman of the Subcommittee, presiding.
    Present: Senators Fitzgerald, Akaka, Collins, Levin, 
Lautenberg, and Sununu.


    Senator Fitzgerald. This meeting will come to order. Today 
we are conducting our second oversight hearing on the mutual 
fund industry. At our first hearing in November we examined the 
breadth and the depth of the illicit trading practices that 
have come to light in the past year. We also examined mutual 
fund management and governance and sought to identify statutory 
and/or regulatory reforms that should be enacted to better 
protect mutual fund shareholders.
    I would like to begin by welcoming all of our witnesses who 
are present today, and to thank each of them for taking time 
out of their schedules to share their insights with us. I see 
that some of them flew in last night, which turned out to be a 
good move given the weather conditions in Washington today.
    I also want to acknowledge the dedication and hard work of 
my colleagues with us today, Governmental Affairs Committee 
Chairman Susan Collins, whose experience as Maine's 
Commissioner of Professional and Financial Regulation has 
contributed an invaluable perspective to our reform dialogue; 
and the Subcommittee's Ranking Member, Senator Akaka, whose 
bill, S. 1822, introduced the U.S. Senate to serious 
legislative treatment of these issues. Also with us is Senator 
Levin from Michigan, whom I know to having a keen interest in 
the welfare of America's mutual fund investors.
    The general consensus of the panelists at the November 
hearing was that illegal late trading and illicit market timing 
were indeed very serious threats to investors, but that 
excessive fees and inadequate disclosure of those fees were an 
even more serious threat to American investors. We heard 
extensive testimony from industry experts who forcefully noted 
that small differences in mutual fund fees can add up to 
enormous differences in investment returns over time, but that 
poor disclosure of those fees, and in fact no disclosure of 
transaction cost, makes it very difficult for investors to 
compare funds.
    In general the experts agreed that regulators could readily 
stop illegal or illicit practices such as market timing and 
late trading, but that it would be far more difficult and 
complex to address the problem of excessive fees and the 
inadequate disclosure, in part because most mutual funds are 
organized in a manner that makes the interest of fund managers 
largely adverse to the interest of fund shareholders.
    The purpose of this hearing is to take the bull by the 
horns and to pick up where the last hearing left off. We will 
examine mutual fund fees, the whole menu, the whole panoply of 
mutual fund fees, their propriety and the adequacy of their 
disclosure under the current regime. We will attempt to lift 
the veil off hidden fees such as revenue sharing, directed 
brokerage and soft money arrangements. We will also attempt to 
unmask and deconstruct hidden loads such as 12b-1 fees. We will 
discuss how statutory or regulatory changes might improve 
disclosure and allow for more informed comparisons between 
    This Subcommittee has specific jurisdiction over Federal 
retirement benefits. Later this year we will hold a hearing on 
the unique mutual fund system that is available only to 
employees of the Federal Government. It is called the Thrift 
Savings Plan, or the TSP for short. I have a brochure right 
here from the Federal Thrift Savings Plan. The TSP is 
essentially a public sector version of the private sector 
401(k) plan. All Members of Congress, all of us up here, the 
Administration and their agency staffs, can invest their 
retirement savings in any or all of five TSP funds, each of 
which is either an equity or a debt security index fund.
    While I may be jumping ahead somewhat to a future hearing, 
it is worth mentioning here that the expense ratio of the 
average government TSP fund last year was only 11 basis points, 
or 11 cents per $100 invested, and that in previous years it 
has been as low as 7 or 8 basis points. In fact, one of the 
funds, the Government G Fund, in 1999 and 2000, had a net 
expense ratio of only 5 basis points.
    In contrast, according to the most recent data available 
from the Lipper Services, the average expense ratio for private 
sector S&P 500 Index Funds is 63 basis points. That is 63 cents 
per $100 invested. Many private sector S&P Index Funds have 
total expense ratios substantially lower than that, maybe as 
low as 17 or 18 basis points, but none even comes close to the 
Government Thrift Savings Plan. The difference between expenses 
of 11 cents per $100 invested and 63 cents per $100 invested 
may not sound like much, but keep in mind what all the experts 
emphasize, that small differences in fees add up to large 
differences in returns as the principal invested is compounded 
over long periods such as 10, 20 or 30 years.
    I point these facts out now because I think it ironic that 
Members of the House and Senate have managed to protect 
themselves from the sort of abusive practices and excessive 
fees which eat away at the savings of many Americans. If you 
are lucky enough to be a Senator or a Member of Congress, you 
simply do not have to worry about excessive fees, directed 
brokerage, revenue-sharing arrangements or soft dollar payments 
eating away and siphoning away your retirement savings like 
most Americans do. Nor do you have to worry about an incestuous 
board of directors that is beset with conflicts of interest 
because board members are completely independent and required 
by law to act solely in the interests of plan participants and 
beneficiaries. The TSP competitively bids out the management 
contract for the TSP Fund, and not surprisingly, the management 
fee charged to TSP shareholders is only a negligible percentage 
of the overall TSP expense ratio. I said that the expense ratio 
averaged 11 basis points last year for TSP participants. A 
large portion of that was for a computer system that they had 
to charge off. They entered a contract to change their 
computers. Chairman Collins is investigating that. In previous 
years the expense ratios for the TSP Fund have been much lower 
than that, and it is projected that next year it will go back 
down into the single digits, 7 or 8 basis points.
    The mutual fund industry is indeed 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. Is it not special that Members of Congress 
and Senators have set up a special separate mutual fund deal 
for themselves in which no skimming is allowed? Sad to say, 
retirement investing appears to be yet another instance in 
which Federal employees get a great deal, but everyone else 
gets the shaft. A Senator or a Congressman or a member of the 
SEC staff, for that matter, who participates in the Thrift 
Savings Plan will have more money at retirement than a member 
of the general public who invests the same amount for the same 
number of years in a comparable private sector index fund. That 
is not right. In fact, it is outrageous.
    This Committee and this Senate should not rest until 
Congress has given every American the same retirement savings 
opportunity that it has given itself.
    As we commence this oversight hearing, I would like to note 
that the Senate Committee on Banking, Housing and Urban 
Affairs, the authorizing committee which will ultimately decide 
questions of mutual fund industry reform, has scheduled a 
series of legislative hearings to examine the mutual fund 
scandal and the merits of various proposals. I commend the 
leadership of Chairman Shelby and Ranking Member Senator 
Sarbanes, and look forward to continuing to work with them on 
this issue in the coming months.
    Today we will hear a broad spectrum of informed opinion on 
the problems confronting the mutual fund industry. We will hear 
the State and Federal Government perspective in our first 
panel, the illuminating, in-the-trenches whistle-blower 
perspective in our second panel, and a truly diverse and 
academic perspective in our third panel.
    At this point I would like to also acknowledge Senator 
Lautenberg from New Jersey, who has joined us. Senator, we 
thank you for your participation. The Senator had a 
distinguished business career before coming into the Senate, 
and before retiring and then coming back into the Senate. 
Welcome back. It is good that you are here for this issue.
    Senator Lautenberg. Pleased to be here.
    Senator Levin. Mr. Chairman, if you could just yield on 
that. There was another event in Senator Lautenberg's life on 
Sunday which we all ought to take note off, which I just found 
out about. His beloved Bonnie is now his wife.
    Senator Fitzgerald. Congratulations. You did not go on a 
    Senator Lautenberg. Thank you for the mention, everybody. 
It is about time.
    Senator Fitzgerald. There we go. No honeymoon? Maybe later.
    Senator Levin. That is a sore point already probably. 
    Senator Lautenberg. In a safe, secure relationship, it is 
all right to take the precise week that you want for your 
    Senator Fitzgerald. Maybe wait until congressional recess 
to do that.
    Senator Lautenberg. Thank you very much.
    Senator Fitzgerald. At this time, before I introduce our 
witnesses, I would like to recognize our Ranking Member, 
Senator Akaka, who may have an opening statement, and then I 
will proceed to the Chairman of the full Committee, Senator 
Collins, and then to Senator Levin and Senator Lautenberg.
    Senator Akaka, thank you.


    Senator Akaka. Thank you very much, Mr. Chairman. I really 
appreciate your conducting this hearing today, and thank you 
for your leadership on the issue of mutual fund reform. I look 
forward to continuing to work with you, Mr. Chairman, along 
with our colleagues on the Senate Banking Committee in enacting 
meaningful legislation intended to protect investors.
    Mr. Chairman, I have found the betrayal of trust of mutual 
fund investors by fund companies and brokers appalling, because 
mutual funds are investment vehicles that the average investor 
relies on for retirement, savings for children's college 
education, or other financial goals and dreams. In one example 
directly related to worker retirees in the State of Hawaii, 
Putnam Investments had been responsible for managing $440 
million for the State of Hawaii's Employees Retirement System, 
which administers retirement and survivor benefits for over 
96,000 State and county employees in Hawaii before the company 
was fired due to the late trading abuses that one of our 
witnesses, Mr. Scannell, helped to bring to the attention of 
    Today's hearing will provide an opportunity to closely 
examine the hidden financial relationships between mutual fund 
companies and brokers. For example, shelf-space payment and 
revenue-sharing agreements between mutual fund companies and 
brokers present conflicts of interest that must be addressed. 
Brokers also compile preferred lists which highlight certain 
funds which typically generate more investment than those left 
off the list. It is not clear to investors that the mutual fund 
company also may pay a percentage of sales and/or an annual fee 
on the fund assets held by the broker to obtain a place on the 
preferred list or to have their shares sold by the broker. 
Brokers have conflicts of interest, some of which are 
unavoidable, but these need to be disclosed to investors. 
Without such disclosure investors cannot make informed 
financial decisions. Investors may believe that brokers are 
recommending funds based on the expectation of solid returns or 
low volatility, but the broker's recommendation may be 
influenced by hidden payments. Mutual fund investors need to 
know the amount of compensation the broker will receive due to 
the transaction instead of simply providing a prospectus. The 
bottom line is that the prospectus fails to include that 
detailed relevant information that investors need to make 
informed decisions. Mutual fund investors deserve to know how 
their broker is being paid.
    I am also concerned that although consumers often compare 
the expense ratios of funds when making investment decisions, 
they are not getting a realistic view of the true expenses of 
mutual funds. The expense ratios fail to take into account the 
costs of commissions in the purchase and sale of securities. 
Brokerage commissions are only disclosed to the investors upon 
request in the Statement of Additional Information. Brokerage 
commissions must be disclosed in a document and in a format 
that investors actually have access to and utilize.
    Mr. Chairman, I want to take a moment to commend the 
Securities and Exchange Commission for its proposals intended 
to improve the corporate governance of mutual funds and to 
increase the transparency of mutual fund fees that investors 
pay. The SEC has recently proposed rules to require an 
independent chairman for mutual fund boards, an increased 
percentage of independent directors to 75 percent, and a 
confirmation notice so that investors will be able to know how 
their broker gets paid in mutual fund transactions. These 
provisions mirror those in the Mutual Fund Transparency Act of 
2003, which I introduced along with Senator Fitzgerald and 
Senator Lieberman in November in order to restore public trust 
in the mutual fund industry.
    I am pleased that the Commission has taken these and other 
actions to protect the 95 million American investors who have 
invested a significant portion of their financial security in 
mutual funds. I am encouraged by the steps taken by the SEC and 
I look forward to the implementation of many of the proposed 
reforms. However, legislation is still needed to codify several 
of these proposals and to bring about additional changes so 
that comprehensive reform of the mutual fund industry is 
achieved. For working Americans, mutual funds are an important 
investment vehicle that offers diversification and professional 
money management.
    We must restore the trust of investors in mutual funds, and 
I look forward to today's discussion and what needs to be done 
to accomplish that essential goal.
    Thank you very much, Mr. Chairman.
    Senator Fitzgerald. Senator Akaka, Thank you very much. 
Chairman Collins.


    Chairman Collins. Thank you very much, Mr. Chairman. I want 
to thank you for holding a second hearing to examine the mutual 
fund industry, and particularly to recognize your leadership in 
focusing on a very important topic this morning, the fees paid 
and expenses borne by mutual fund shareholders.
    For many investors, as the Chairman has pointed out, high 
fees and excessive expenses are even more of a problem than 
market timing, late trading and other abuses previously 
examined by this Subcommittee. Mutual funds have long been 
promoted as a haven for the small investor who may not have the 
time nor the expertise to pick stocks. Many investors like to 
leave the difficult and worrisome decisions regarding which 
companies to buy and sell to a mutual funds professional 
manager. To achieve their saving goals, whether it's for a new 
home, a college education, or a secure retirement, many 
American families put their hard-earned savings into mutual 
funds. Savings for the future often mean sacrifices for the 
present. A secure retirement may mean a shorter vacation. A 
college education for children can equate to buying a used car 
rather than a new one. Saving for a first home means fewer 
dinners out and foregoing other luxuries.
    These sacrifices, Mr. Chairman, are why I am so concerned 
that we maximize investors' mutual fund returns, and even more 
important, that investors understand precisely the fees and the 
expenses they are charged. Maximum returns for investors cannot 
occur if fees are excessive or opaque, or if any other 
questionable practices that reduce investment returns are 
    By now we are all too familiar with the allegations 
regarding late trading, market timing, and other practices. 
What they revealed is that far too often there are two sets of 
rules, one for favored insiders and another set for the average 
investor. Perhaps most disturbing, however, was that these 
practices were carried out not by shady dealers in boiler 
rooms, but rather by senior executives at some of the most 
respected names in the mutual fund industry. In the most 
egregious cases these practices were not only tolerated by 
senior management but actually exploited by them as well. These 
executives seem to have forgotten the fundamental principle of 
money management, that the money given to them to invest is not 
their money but rather the shareholders' money. That is why 
Federal law imposes upon investment advisers who run mutual 
funds a fiduciary duty to the fund and its shareholders. At the 
very least this should mean, as one former regulator put it, 
that mutual fund executives are not spending their days trying 
to invent new ways to skim their shareholders' assets.
    Although mutual funds have been around for some 80 years, 
they have only become popular investment choices in the past 25 
years. The American public's investment in mutual funds has 
exploded during that time. In 1980, total assets amounted to 
about $135 billion, and only 10 percent of Americans owned 
mutual funds. Today approximately 50 percent of Americans own a 
mutual fund, and total assets are at least $6.4 trillion. It 
can be very difficult for consumers to choose among the 8,200 
mutual funds. Consumers often focus primarily on the historic 
rate of return, rather than on fees and expenses. Yet according 
to the former chief economist of the Securities and Exchange 
Commission, small differences in investor costs can make a huge 
difference in the ultimate return over the long run.
    For example, assume a worker chooses a mutual fund at the 
beginning of her working career. Should she choose one with 
high returns in recent years and expenses of 1.5 percent, or 
should she choose another with steadier, less spectacular 
recent returns, but only a 0.5 percent expense ratio? Sadly, 
there is a very good chance that most average investors will 
choose the former, but choosing the latter would, by the end of 
this woman's career, probably have returned 35 to 40 percent 
more money. That is the difference that the amount of fees and 
expenses charged can make.
    The government does not place limits on how much mutual 
funds can charge, nor should it, in my opinion. We know that 
U.S. mutual funds generally have lower costs than those in many 
other countries. But research by the General Accounting Office 
and the SEC suggest that we can do much better in lowering 
mutual fund investors' costs.
    It is my hope that today's hearing will shed more light on 
why the mutual fund market is simply not more cost competitive. 
It may be that consumers simply do not understand, or have not 
been given enough information to understand the impact of fees. 
But one problem clearly is that it is often very difficult for 
the average investor to discern the level of fees. We do not 
have a simple system such as we do with our checking accounts, 
where every month we can clearly see what fees were assessed. I 
think we need to look at the disclosure of fees and the 
location of that disclosure to bring increased transparency and 
disclosure to the process.
    Again, Mr. Chairman, I want to thank you very much for your 
leadership, and I look forward to hearing the testimony today.
    Senator Fitzgerald. Thank you very much, Chairman Collins. 
That is an incredible statistic, 8,200 mutual funds in the 
country. I believe there are only about 6,000 publicly traded 
corporations, so that statistic would seem to suggest it is a 
very good business to own or run a mutual fund.
    Senator Levin.


    Senator Levin. Thank you, Mr. Chairman. With 95 million 
Americans invested in mutual funds, hoping and planning to use 
their investment dollars for college expenses, mortgages, 
retirement, and to help their kids, the recently-exposed mutual 
fund scandals have brought home the need to look at potential 
reforms to stop late trading and market timing abuses, as 
previously examined by this Subcommittee. We are going to 
examine this morning to prevent hidden fees and to end ongoing 
conflicts of interests and other harmful practices that hurt 
mutual fund investors.
    Investors pay $75 billion each year in fees that support 
the mutual fund industry. The immense size of this dollar 
amount reflects the importance of the subjects of this hearing: 
Clear fee disclosure and the elimination of conflicts of 
interest. Investors deserve complete and accurate information 
about mutual fund costs so that they can make informed 
investment decisions and comparison shop to find well-run, low-
cost mutual fund products. They also need to have confidence 
that the fees that they incur are legitimate. They deserve to 
know that the persons in charge of their investments are 
exercising independent and careful judgments on their behalf 
and that their investment advisers are providing them with 
objective investment advice.
    As we consider appropriate mutual fund reforms, it is 
critical to recognize and address conflicts of interests and 
lax oversight practices. We can start at the top. Like a 
typical corporation, every mutual fund is governed by a board 
of directors that has a duty to act in the best interest of the 
funds' shareholders, but as we can see from recent scandals 
many of these boards, as currently constituted, have failed to 
provide needed oversight of their funds.
    One way to address director conflict of interest concerns 
is to make sure that the requirement for so-called independent 
directors is met with directors who are truly independent of 
the funds they oversee. For instance, right now a current 
officer or director of a service provider to a fund can be 
counted as an ``independent director.'' We must change that.
    Other troubling conflicts of interest arise when mutual 
funds make undisclosed arrangements with brokerage houses which 
now sell about half of all mutual fund shares. For instance, 
recent press reports indicate that some brokers receive 
undisclosed incentives from mutual funds, without telling their 
customers about the compensation they get to push that fund's 
products. These types of secret commissions and arrangements 
mean that investors are not getting objective investment 
    We need to throw a spotlight on hidden, difficult-to-
understand arrangements between mutual funds and brokerage 
houses involving so-called directed brokerage, revenue sharing 
and soft dollars arrangements. Directed brokerage occurs when a 
mutual fund buys stock from a brokerage firm for its holdings 
if that brokerage firm promotes the mutual fund's shares to 
their other customers. In so-called revenue sharing, the mutual 
fund gives the brokerage firm a share of its revenues if the 
brokers sell the mutual fund shares to their customers. With 
soft-dollar arrangements, a mutual fund pays a brokerage firm 
for research and other services, in the expectation that the 
brokers will promote the mutual fund's products. These hidden 
practices raise troubling conflicts of interest that need to be 
ended. As SEC Chairman Donaldson has said, ``Investors have the 
right to know everything that is inducing a broker to recommend 
a particular fund.''
    Another key reform would be to standardize the method for 
calculating and disclosing mutual funds' ``expense ratios'' and 
ensure that they include all material costs. That ratio is 
designed to show the total annual operating expenses of a fund 
is a percentage of its total assets. The figure is already 
compiled by every fund and theoretically should be one of the 
most helpful numbers to investors comparing fees. If designed 
well, it should function in a way similar to the per-unit price 
listed on a grocery shelf price tag, giving a ``price per 
ounce'' so that comparison shoppers can assess the price 
savings between different brands and sizes. But right now, many 
funds leave out key expenses when calculating that ratio. For 
example, while the ratio now includes the management fee 
charged by the fund management, distribution fees and other 
administrative expenses, it excludes what can be one of the 
fund's largest expenses, portfolio transaction costs such as 
broker commissions.
    According to consumer groups, these portfolio transaction 
costs sometimes exceed all the costs combined that are 
currently included in the expense ratio. These transaction 
costs ought to be disclosed in a standard and easily-understood 
    Other fee reforms are also needed. Many investors find the 
various fee options for mutual funds bewildering and rely on 
their broker's advice about which to choose. However, a 
broker's interest is often at odds with the investor's. The fee 
option with the greatest payoff for the broker may result in 
the highest charge to the investor. That conflict of interest 
could be addressed by requiring a clear fee disclosure prior to 
the purchase that presents a clear comparison of the dollar 
costs of investing in each class of shares over a certain 
period of time.
    Mutual funds are the investment of choice for a large 
percentage of Americans. It is their money that provides much 
of the fuel for economic growth. All of us have a duty to 
protect the average investor and in turn the American economy. 
It is sad but true that the mutual fund industry has shown that 
it cannot be relied upon to protect its customers. Strong 
reforms must be put in place in law and in regulation.
    I salute our Chairman, Senator Fitzgerald, Senator Akaka, 
Senator Collins, all of those who are involved in the 
leadership of advocating needed reforms for the mutual fund 
industry on behalf of the average investor.
    Thank you, Mr. Chairman.
    Senator Fitzgerald. Thank you, Senator. We have been joined 
by Senator Sununu from New Hampshire, and if I go in the order 
that Senators arrived, I would go first to Senator Lautenberg 
and then we will come back to Senator Sununu.
    Senator Lautenberg.


    Senator Lautenberg. Thanks, Mr. Chairman. Senator Sununu 
has got all kinds of excitement going on in his State, so he 
has to get back to the TV screen and we will permit him to do 
so very shortly.
    Mr. Chairman and Chairman Collins, we thank you both for 
having this hearing at this opportune moment. We have been 
looking at hidden fees and misgovernance and self-dealing and 
other practices that have harmed investors in the mutual fund 
industry, and it seems that there is no end to corporate 
scandals shaking Wall Street and Main Street.
    I am a former chief executive and a founder of a company 
called ADP, Automatic Data Processing, and I always felt that 
my responsibility to the investor was a paramount part of my 
obligation, that if I could face them regularly, and even if we 
had an occasional dip in earnings because of the general 
economy, there was very good acceptance of our stock, and the 
PE, which I assume most people here are familiar with, was 
always at a very high level, and that is because they had faith 
and it is because that was the only way we knew how to run a 
    Now what we see is instead of working to enhance 
shareholder value, it seems that many directors and fund 
investment advisers have used their trusted positions to line 
their own pockets and the pockets of their industry cronies. I 
am on the board of the Columbia University Business School--it 
is my alma mater--and recently established a chair in corporate 
governance. And having served on the public corporation for 25 
years, I learned a lot from my trusted directors, including 
Alan Greenspan, who came to the Fed directly from the ADP 
Board, and recently departed Larry Tisch, who we all knew and 
who was a terrific example of credibility and care about how 
you treat public funds.
    So to see that the mutual fund principles have been so lax 
that their mission appears to be not to serve the shareholders, 
not the 95 million Americans who invest in mutual funds because 
they believe that the funds are diversified, well-regulated and 
managed by honest professionals, but it turns out that some 
investment fund managers are more concerned about creating 
arrangements that are profitable for them, leaving the 
leftovers for the investors, many of whom are counting on the 
safety and growth of what might be their only reserve.
    Today's witnesses--and I am pleased to see the list of 
witnesses, Mr. Chairman, are credible people, and we are 
pleased to have them. I am particularly familiar with Attorney 
General Spitzer's record and zeal in rooting out corruption 
wherever it can be found, and I salute that effort and urge you 
to continue it.
    Today's witnesses will testify--and this may be slightly 
repetitive but I think worth mentioning--that while the total 
assets of all mutual funds increased from $56 billion in 1978 
to $6.4 trillion in 2002, the expense ratio of the average 
mutual fund, which actually represents less than one half of 
all the costs incurred by fund investors, increased from 0.91 
percent in 1978 to 1.36 percent during the same period. It 
sounds like good business to me. That is an increase of 49 
percent in the expense ratio. Mutual fund investors have not 
realized any of the benefits of the economies of scale, and to 
make matters worse, industry experts have concluded that the 
return earned by the average mutual fund in the past 20 years, 
from 1982 to 2002, has lagged behind the return of the S&P 500 
by more than 3 percent. That is more than double the lag from 
the previous 20 years of 1950 to 1970. In other words, mutual 
funds have gotten more expensive, thus, their performance has 
realistically gone down.
    I am searching for a good reason why this has happened. It 
is hard to think of one. We do know that there has been a rash 
of corporate malfeasance that has extended into the mutual fund 
industry. It is clear that the fund managers and investment 
advisers seem to have become less interested in how their funds 
perform to the benefit of all shareholders, and more interested 
in creating schemes that line their own pockets regardless of 
performance. The New York Times reported last week that 
corporate executives at the World Economic Forum in Davos, 
Switzerland complained that the Sarbanes-Oxley Bill passed in 
the wake of the accounting scandals at Enron, WorldCom, Tyco, 
is hampering their ability to do business. They brought it on 
themselves. I think the simplest axiom for Sarbanes-Oxley is 
``tell the truth'' and then you do not have to worry about 
those kinds of imposing laws. They brought it on themselves. 
Someone has to look out for shareholder interests for the 
public interest, and there is too much at stake.
    Just think, this comes at a time when it is suggested that 
some part of Social Security ought to be permitted to be 
invested in the public marketplace. Well, I think that if that 
does happen, it is going to have serious scrutiny in the Senate 
and House, and we are going to make sure--if I can do anything 
about it; my colleagues here I think would agree--that we 
highlight the performance of the funds including the expenses 
both hidden and real and make them part of the reporting 
system. It comes up frequently and regularly.
    That is where this timing, Mr. Chairman, is so important. I 
congratulate you. I look forward to hearing the testimony of 
our distinguished witnesses. I think that we have heard much 
about Attorney General Eliot Spitzer, almost all of it very 
positive and very exciting. I urge him to continue. It is a 
difficult and painful review, but it is essential that we get 
the markets functioning properly again and restore the American 
people's faith in the fundamental way that this country 
conducts its business affairs, and I thank you.
    Senator Fitzgerald. Senator Lautenberg, thank you very much 
for that excellent opening statement.
    Senator Sununu, last but not least.


    Senator Sununu. Thank you, Mr. Chairman, and thank you for 
putting together this hearing. I am also a member of the 
Banking Committee and I look forward to the series of hearings 
that Chairman Shelby will also be holding on these issues.
    Let me begin picking up on a point that Senator Lautenberg 
made, and that is the importance of the board structures and 
the responsibility of the board structures. It is easy to be a 
little bit disdainful of wealthy board members that might be 
meeting overseas for a big economic forum and that they are 
lamenting some of the regulatory complexities of Sarbanes-
Oxley. But at the same time these are board members that are 
supposed to be representing shareholders' interests and if we 
pass regulations, whether it is Sarbanes-Oxley or any other 
piece of regulation, one that limits their ability or creates 
disincentives for them to make creative decisions and good 
investment decisions on behalf of shareholders, or two, if we 
pass legislation against Sarbanes-Oxley or any regulations 
having to do with the mutual fund industry that makes it 
difficult to encourage good people, independent minds, creative 
individuals to sit on boards, we will have done a disservice to 
shareholders. So while it is important that we have regulations 
in place that set a clear path, set clear standards for 
behavior, a bright-line for legal and illegal behavior, 
conflicts of interest and disclosure, we do not want to create 
an environment, whether they are volunteer or compensated, 
where good, qualified people no longer want to participate in 
the process or serve the interests of shareholders on boards 
because our financial systems and our markets will have been 
hurt significantly by it.
    We all have concerns about some of the issues that have 
been uncovered and revealed in part by the work of Eliot 
Spitzer and others. Late trading, market timing, these are 
practices in some cases that were discouraged if not outright 
illegal, that need to be clarified and dealt with either by the 
SEC or by legislation passed by Congress. Investors need to be 
protected by the impact of any illegal or inappropriate trading 
schemes. They can place undue burdens on the funds themselves, 
and they can also undermine the confidence that investors have 
in our financial system, and that is what we saw with some of 
the concerns that were addressed by Sarbanes-Oxley.
    First and foremost we are concerned about confidence in the 
marketplace because without confidence we cannot have efficient 
trading and investing activities. Disclosure is also extremely 
important and highlighted here in a number of cases. We want to 
have consistent standards for the fees reported by these mutual 
funds or any other investment vehicle. What are the costs, what 
are the fees as a percentage?
    But at the same time, the absolute level of the fee is not 
the most critical piece of information that consumers can have, 
and if we suggest otherwise as policy-makers or witnesses or 
anyone else, then we are doing the public a disservice. The 
most important number is the returns of the fund net of all the 
fees. That is how you compare one fund to another, and if I say 
this fund has expenses of 20 basis points and this one has 
expenses of 50 basis points, but one has a return that 
outstrips another, then we are not going to be giving the 
consumers all the information that they have, so it is 
important that we are able to discern that different funds are 
going to have different risk profiles, or different returns. We 
want to look at those returns net of all the fees.
    Given good information, I think consumers will make good 
decisions, and I think it is a mistake to suggest that the 
entire mutual fund industry is a giant skimming operation. 
There are some bad funds out there, of course, 8,000 funds, 
Senator Collins pointed out. There are funds that have 
individuals, managers, brokers that might have broken the law 
and they should pay. They should certainly be prosecuted under 
current or future securities laws. There are funds that have 
done a very poor job in delivering returns to their investors, 
and they should certainly pay in the court of public opinion 
that we call the marketplace. Eight thousand mutual funds 
suggest to me at least an extremely competitive marketplace 
that is good for investors, that is good for the country.
    By doing a good job here with our oversight to deal with 
disclosure issues, we can make that marketplace even stronger 
and healthier, but the oversight needs to be geared toward not 
just good disclosure but fairness in disclosure. Some of the 
proposals that I have seen seem to be weighted against 
independent research firms. The very firms that as a result of 
the settlement by the Attorney General of New York and the SEC 
has been encouraged and I think strengthened. Independent 
research is a good thing. We should not do anything now in our 
oversight or new regulations that put independent researchers 
at a disadvantage. I do not believe that we should undertake 
regulations that try to micro manage the selection of boards on 
behalf of shareholders. If anything, we should be looking at 
ways to give the shareholders themselves, whether it is a 
mutual fund or a public company, the power that they need to 
exercise a choice in selection over board members and even hold 
board members accountable, and it is not the topic for this 
hearing, but questions of proxy and how shares are voted and 
the disclosure of those votes are all very important, I think, 
to giving power to shareholders and the decisions that they 
    I appreciate the opportunity to make an opening statement 
and appreciate the work of the Chairman that he has done on 
this issue. Thank you, Mr. Chairman.
    Senator Fitzgerald. Senator Sununu, thank you very much. We 
are glad to have you here.
    I would like to now introduce our first panel of witnesses. 
Our first witness is Richard J. Hillman, who is the Director of 
Financial Markets and Community Investment at the General 
Accounting Office (GAO). Mr. Hillman has served at the GAO for 
the past 27 years and has worked on a series of reports 
regarding the mutual fund industry including an assessment of 
the industry's transparency, the quality of listing standards 
within securities exchanges and other corporate governance and 
oversight matters. The GAO conducted a review of the mutual 
fund industry and published an extensive report in June 2003 
stating the need for greater transparency. Of course, that was 
before the market timing and late trading scandals broke, and 
now that report is getting needed attention, as are many other 
reports you wrote in previous years, going at least as far back 
as 2000 that I have seen.
    Our second witness is the Hon. Eliot L. Spitzer, Attorney 
General for the State of New York. Attorney General 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.
    I would like to thank both of you for appearing before us. 
In the interest of time your full statements will be included 
in the record, so we would ask that you limit your summary 
statement to 5 minutes. Thank you very much.
    Mr. Hillman, you may proceed.


    Mr. Hillman. Thank you, Mr. Chairman. Thank you, Chairman 
Collins and Members of the Subcommittee.
    \1\ The prepared statement of Mr. Hillman appears in the Appendix 
on page 81.
    I am pleased to be here today to discuss GAO's work on the 
disclosure of mutual fund fees and the need for other 
disclosures of mutual fund practices. Concerns have been raised 
over whether the disclosures of mutual fund fees and other fund 
practices are sufficiently fair and transparent to investors.
    Our June 2003 report, entitled ``Greater Transparency 
Needed in Disclosures to Investors'' reviewed (1) how mutual 
funds disclose their fees and related trading costs and options 
for improving disclosure of those costs; (2) changes in how 
mutual funds pay for the sale of fund shares and how the 
changes in those practices are affecting investors; and (3) the 
benefits of and the concerns over mutual funds' use of soft 
dollars. This testimony summarizes the results of our report 
and discusses certain events that have occurred since the 
report was issued.
    In summary, we recommend that SEC consider the benefits of 
requiring additional disclosure relating to mutual fund fees 
and evaluate ways to provide more information that directors 
and investors could use to evaluate the conflicts of interest 
arising from payments funds make to broker-dealers and fund 
advisers' use of soft dollars.
    Specifically regarding mutual fund disclosures, we learned 
that although mutual funds disclosed considerable information 
about their cost to investors, the amount of fees and expenses 
that each investor specifically pays on their mutual fund 
shares are currently disclosed as a percentage of fund assets, 
whereas most other financial services disclose the actual cost 
to the purchaser in dollar terms. The SEC has proposed that the 
mutual funds make additional disclosures to investors that 
would provide more information that investors could use to 
compare fees across funds. However, SEC is not proposing that 
the funds disclose the specific dollars amount of fees paid by 
each investor, nor is it proposing to require that any fee 
disclosure be made in the account statements that inform 
investors of the number and value of mutual fund shares they 
own. Our reports recommend that SEC consider requiring mutual 
funds to make additional disclosures to investors including 
considering requiring funds to specifically disclose fees in 
dollars to each investor in quarterly account statements. Our 
report also discusses less costly alternatives that could also 
prove beneficial to investors and spur increased competition 
amongst mutual funds on the basis of fees.
    The work that we conducted for our report also found that 
12b-1 fees, which allow fund companies to deduct certain 
distribution expenses such as sales commissions from fund 
assets can raise cost to investors, but also provide additional 
ways for investors to pay for investment advice. Our work also 
found that mutual fund advisers have been increasingly engaging 
in a practice known as revenue sharing under which they make 
additional payments to the broker-dealers that sell their fund 
shares. Although we found that the impact of these payments on 
the expenses of the fund investors was uncertain, these 
payments can create conflicts between the interests of broker-
dealers and their customers that could limit the choices of 
funds that these broker-dealers offer investors. However, under 
current disclosure requirements, investors may not always be 
explicitly informed that their broker-dealer, who is obligated 
to recommend only suitable investments based upon the 
investor's financial conditions, is also receiving payments to 
sell particular funds. Our report recommends that more 
disclosure be made to investors about any revenue-sharing 
payments that their broker-dealers are receiving, and on 
January 14, SEC proposed new rules in this area.
    We are also reviewing a practice known as soft dollars in 
which a mutual fund adviser uses fund assets to pay commissions 
to broker-dealers for executing trades and securities for the 
mutual fund portfolio, but at the same time also receives 
research or other brokerage services as part of that 
transaction. These soft-dollar arrangements can result in 
mutual fund advisers obtaining research or other services, 
including research from third-party independent research firms 
that can benefit the investors in their funds. However, these 
arrangements also create a conflict of interest that could 
result in increased expenses to fund shareholders if a fund 
adviser trades excessively to obtain additional soft-dollar 
research or chooses broker-dealers more on their ability to 
provide soft-dollar offerings, rather than their ability to 
execute trades efficiently.
    SEC has addressed soft-dollar practices in the past, and 
recommended a number of actions, but has yet to act upon them. 
Our report recommends that more disclosure be made to the 
mutual fund directors and investors to allow them to better 
evaluate the benefits and the potential disadvantages of the 
fund adviser's use of soft dollars.
    In conclusion, GAO believes that various changes to the 
current disclosure and other practices would benefit fund 
directors and investors. Additional disclosures and mutual fund 
fees could help increase the awareness of investors of the fees 
they pay and encourage greater competition amongst funds on the 
basis of those fees. Likewise, better disclosure of the costs 
funds incur to distribute their shares and the costs and 
benefits of funds' use of soft-dollar research activities could 
provide investors with more complete information to consider 
when making their investment decision.
    Mr. Chairman, this concludes my prepared statement. I would 
be pleased to respond to questions at the appropriate time.
    Senator Fitzgerald. Thank you, Mr. Hillman. Mr. Spitzer.


    Mr. Spitzer. Thank you, Mr. Chairman, Madam Chairman, 
Members of the Subcommittee.
    \1\ The prepared statement of Mr. Spitzer appears in the Appendix 
on page 102.
    This Subcommittee's hearing last November played an 
important role in focusing attention on the conflicts inherent 
in an industry where directors were beholden to management. 
That hearing also started the process of crafting solutions to 
protect the $7 trillion Americans have invested in mutual 
funds. Several of the proposals that seemed radical when we 
discussed them in November have already become conventional 
wisdom. Requiring mutual funds to have truly independent 
directors and an independent board chairman are now the 
centerpiece of every reform proposal. There is now also 
widespread recognition that mutual fund directors must be given 
the staff and resources needed to allow them to effectively 
oversee the management companies that run the funds' day-to-day 
operations. Many reformers also recognize that mutual fund 
compliance officers should report to the funds' independent 
directors and not to the managers, whose activities are being 
monitored and reviewed. Perhaps most significantly, there is 
universal agreement that the disclosures provided to mutual 
fund customers are inadequate, and several competing proposals 
address this problem.
    I continue to believe that the proper approach would be to 
provide each investor with an itemized statement of the actual 
costs charged to his or her account. This would provide mutual 
fund customers with the information necessary to engage in true 
comparison shopping. That is the good news. The bad news is 
that the industry and many of its apologists are still opposing 
true reform in the area that most directly impacts investors, 
advisory fees.
    As I indicated when I was here last November, in 2002 
mutual fund investors paid advisory fees of more than $50 
billion and other management fees of nearly $20 billion. That 
is in addition to the tens of billions of dollars in marketing 
fees and trading costs imposed by the fund industry. The 
advisory fees that mutual funds charge their shareholders 
greatly exceed those charged to institutional customers. If 
mutual fund customers were charged the lower rate for advisory 
fees paid by institutional investors they would save more than 
$10 billion every year.
    The industry has asked whether there is a link between the 
advisory fees charged to investors and the late trading and 
market timing practices that were the initial focus of 
investigation. The answer is yes. Improper trading and 
exorbitant advisory fees are both a consequence of a desire by 
managers to enrich themselves at the expense of investors and 
an inability or unwillingness on the part of directors to 
protect investors. This can be demonstrated by the fact that 
the managers who permitted late trading and market timing in 
many instances did so in return for increased investments in 
other funds that they managed. As one mutual fund manager 
frankly admitted in an E-mail uncovered during the 
investigation, ``I have no interest in building a business 
around market timers, but at the same time I do not want to 
turn away 10 to 20 million dollars.''
    Mutual fund directors and managers breached their duties to 
investors in many ways, and we must pursue every manifestation 
of that breach. This includes breaches of duty that allowed 
managers to overcharge investors.
    When I was last before this Subcommittee I spoke in 
generalized terms about the advisory fee overcharges imposed on 
investors. Now that our investigation has progressed, I'd like 
to talk more specifically about the advisory fees charged by 
two fund complexes, Putnam and Alliance.
    In 2002 Putnam managed approximately $279 billion from 
mutual fund and institutional investors. Our investigation 
revealed that Putnam charged mutual fund investors 
significantly higher advisory fees than those charged to 
institutional investors. Here are the numbers. Putnam's mutual 
fund investors were charged 40 percent more for advisory 
services than Putnam's institutional investors. In dollar terms 
what this fee disparity means is that in 2002 Putnam mutual 
fund investors paid $290 million more in advisory fees than 
they would have paid had they been charged the rate given to 
Putnam's institutional clients, and these are for identical 
    There was a similar disparity in the advisory fees charged 
by Alliance. Once again mutual fund investors were charged 
significantly higher advisory fees than institutional 
investors. Specifically, Alliance's mutual fund investors paid 
advisory fees that were twice those paid by institutional 
investors. In dollars terms this means that Alliance investors 
paid more than $200 million in advisory fees than they would 
have paid had they been charged the rate given to Alliance's 
institutional clients.
    Because of these findings I refused to join in a settlement 
with Putnam that did not provide investors with some form of 
compensation for the advisory fee overcharges they incurred. 
Similarly, my office's settlement with Alliance requires them 
to return $350 million to investors by way of a 5-year 20 
percent reduction in their advisory fees. These actions have 
led some to accuse me of engaging in rate setting. That is 
simply wrong. Requiring mutual funds to return to investors 
money that should never have been taken from them is not rate 
setting. It is what regulators across the country do every day 
when they uncover evidence that consumers have been ripped off, 
and it is what I will continue to do as I uncover more evidence 
that mutual fund investors have been overcharged.
    When the charge of rate setting fell flat, the industry 
turned to a more audacious argument in defense of their 
advisory fees. Earlier this month the Investment Company 
Institute issued a report that attempted to rebut the evidence 
showing that mutual fund investors pay more than institutional 
investors for advisory services. The ICI report tries to rebut 
the important conclusions of an academic article published in 
the Journal of Corporation Law by Professors Freeman and Brown. 
Professor Freeman is testifying in a later panel and does not 
need my assistance to articulate the foundation of his 
analysis, but he is due our thanks for shedding light on an 
abusive practice that takes billions of dollars each year from 
the pockets of average family savings of families who are 
saving for a new home of their children's education.
    The ICI's conclusion that mutual fund investors do not pay 
more than institutional investors for advisory fees was 
unfortunately misleading and wrong. It was not based on data 
showing what mutual funds charge for advisory services. 
Instead, the ICI relied exclusively on data concerning the fees 
that sub-advisors, the outside advisors occasionally hired by 
mutual fund managers to give investment advice, charge 
management companies. There are three reasons it is 
inappropriate to rely on data concerning sub-advisors. First, 
fewer than 20 percent of all mutual funds employ sub-advisors. 
Indeed, after the ICI released its report, Business Week noted 
that as few as 7 percent of mutual funds employ sub-advisors. 
Second, unlike most mutual fund fees where directors rubber 
stamp their affiliated management companies request, the fees 
charged by sub-advisors are the product of an arm's length 
negotiation between disinterested parties. Third, even the 
small percentage of mutual funds that employ sub-advisors often 
impose their own costs on top of those of the sub-advisor. For 
example, if the sub-advisor charges the fund 30 basis points, 
the fund will tack on its own premium of 20 or 30 basis points 
and charge investors the combined amount. The ICI report used 
the amount charged by the sub-advisors without accounting for 
the premiums tacked on by the mutual funds and passed on to 
shareholders. The result is that even in mutual funds that are 
sub-advised, shareholders pay more for advisory services than 
the actual cost for that service incurred by the management 
company. Thus, the ICI report takes a number that reflects a 
narrow slice of the industry and is the only part of the 
industry where fees are a product of arm's length negotiation, 
ignores the markup imposed by mutual fund and then attempts to 
pass that number off as representative of the entire industry. 
The real data that reflected the overcharge throughout the 
overwhelming majority of the industry are those such as what I 
gave you from Putnam and Alliance, data, by the way, that the 
companies themselves provided to us.
    I know that the ICI has a representative testifying in a 
later panel. I hope the Subcommittee will explore the issue of 
sub-advised fees, especially the premiums that the funds impose 
on top of sub-advisory fees. My sense is that these premiums 
are often as much or more than the fees charged by the sub-
advisor itself. This raises the question of what service is 
being provided to justify these premiums. In the coming weeks 
my office will take a closer look at that question.
    When discussing advisory fees the challenge is not in 
determining the scope of the problem but in crafting an 
appropriate solution. I would like to ask this Subcommittee to 
consider a proposal endorsed a few weeks ago by the treasurers 
of California and North Carolina and by the New York State 
Controller. This proposal would require all mutual fund fee 
contracts to control break points providing economies of scale 
savings to shareholders, and would require mutual fund boards 
to justify fees in an analysis published in the fund's annual 
report. The analysis must include a comparison of the fees 
charged to institutional investors, a review of the management 
company's pretax profit and a detailed itemization of the costs 
of the various services including investment advice, marketing 
and advertising, operations and administration. I believe that 
this proposal, if enacted, would lead to savings of billions of 
dollars or more every year. I hope the Subcommittee will give 
it serious consideration.
    Thank you very much.
    Senator Fitzgerald. Thank you, Attorney General Spitzer. I 
wondered if you had any kind of response to Senator Sununu's 
opening statement where he argued that the investment returns 
of the funds are equally if not more important than the fees 
charged by the funds. I know that last time he was here, John 
Bogle, who will be on our final panel today, noted that 88 
percent of mutual funds underperformed the market, and that 
while some funds do outperform the market sometimes for a 
number of years, ultimately they all tend to revert to the 
mean, and they are at or a little bit less than the market 
return. So that in Mr. Bogle's view the fees are indeed very 
important over time, and I think that was reflected in Chairman 
Collins' opening statement. Do you have a response to Senator 
Sununu's argument?
    Mr. Spitzer. Yes, sir, I do. I think that certainly I am 
not going to dispute that the net return is a critical number 
that one should look at, but I think that as you just pointed 
out, Senator Collins and Senator Lautenberg and my great friend 
John Bogle, have pointed out that the fee component of the 
overall return is so critically important that the failure to 
explain adequately what fees are being built into that overall 
return really is what has been leading to substantial 
misinformation out in the marketplace. If we do not understand 
what fees are, why they keep increasing over time and how the 
compound impact of that fee will affect overall return, then 
investors are making a decision that is not based upon a full 
litany of the facts they should have.
    Clearly, return is a critical determinant to where we 
invest. Clearly as well, the fee structure, which is a constant 
number, is important, and I think it was Senator Collins who so 
well articulated if you have a momentary above-market return 
but high fees, that above-market return may be volatile and it 
may be that 2 years from now that return has returned back to 
the market mean, in which case the high fees that you are 
paying for will overwhelm that 1 year of high returns. And 
consequently, all these numbers are critical, must be 
disclosed, and the sort of disclosures that I laid out for you, 
that so many others have laid out for you I think is the way we 
should go.
    Senator Fitzgerald. The ICI and its allies, and even some 
perhaps at the SEC, seem to have been critical of you for 
negotiating settlements with mutual fund companies where you 
have required them to reduce their fees. What is your 
justification for bringing fees into the mix in your 
settlements? Is it your thought that telling them to end market 
timing and late trading and pay some kind of a fine really is 
just a slap on the wrist, that where they are getting rich 
really quickly is with these exorbitant fees. In my judgment we 
do not have a total free market here because disclosures are 
inadequate. Some funds are captive; they are in accounts that 
are tax sheltered that cannot just be moved into any other 
funds. To some extent these mutual funds have a lot of money, 
lazy money that cannot be moved. They have a guaranteed 
    What is your public policy justification for tying fees in 
to your settlements?
    Mr. Spitzer. Let me articulate it this way, Senator. I 
agree with everything you just said with respect to the market 
reason that fees are as high as they are. The assets in the 
mutual fund industry are sticky, by which we mean they do not 
move as rapidly as they should if investors were making a 
market determination every day or every quarter based upon 
returns and costs, and consequently there is a complacency in 
the board room. There is an improper relationship between 
boards and management companies. There has been inadequate 
    Having said all that, none of that would give me an 
appropriate rationale for seeking a fee reduction in a 
settlement absent a belief on my part, a provable belief on my 
part that the boards had breached their fiduciary obligation in 
a way that led directly to the increased fees. I believe that 
we need disclosure. I have laid out in my testimony--and others 
who have studied this much longer and in greater depth than I 
will speak more wisely than I to the types of disclosures that 
will lead to better market behavior. But I do believe that 
where a regulator finds a board that has permitted behavior to 
continue, behavior that is a breach of its fiduciary 
obligation, then you seek a remedy that addresses that breach. 
In this case the breach was permitting and acquiescing, and 
indeed sometimes soliciting overcharges that injured those to 
whom they owed a fiduciary duty, the investor.
    Senator Fitzgerald. In saying they breached a fiduciary 
duty are you describing that fiduciary duty in the traditional 
sense of corporate law, that the directors owe a fiduciary duty 
to their shareholders?
    My legal staff tells me they have canvassed all the 
reported cases out there and have never found an instance in 
which a mutual fund board was held to violate or breach a 
fiduciary duty, and my staff tells me that is because the 
fiduciary duty in the Federal laws, in the Investment Company 
Act, is a weaker fiduciary duty than the one we are accustomed 
to in State corporate laws, and the State courts have found a 
weaker fiduciary duty apply in State laws. Most mutual funds 
are organized either as a Delaware trust, I believe, or a lot 
of them are organized under the laws of the State of 
    Have you had an opportunity to examine the nature of the 
fiduciary duty that is imposed by law on mutual fund directors?
    Mr. Spitzer. We have looked at it and I would say this, 
that it is an area where these unique facts have really not 
been presented to the courts, and it is my belief that if we 
were ever to be forced to litigate a case where we could show 
that a board had knowledge and was aware that there were two 
different fee structures that had been imposed, one that 
permitted institutional investors to be getting a fee structure 
that was significantly lower than that was being charged to the 
other mutual fund investors, we would be able to demonstrate 
that was a breach of the duty and we would succeed in that 
    Senator Fitzgerald. One final question before I turn it 
over to my colleagues. It has come to my attention that some of 
the funds charge fees to their mutual fund shareholders in 
order to remit their dues to the ICI which has been fighting 
you so aggressively. I find it kind of incredible that fund 
boards debit everybody's account to get dues to pay for the ICI 
to go lobby in Washington against the interests of the 
shareholders that are paying for their lobbying. Do you have 
any thoughts on that issue, and what do we do about that, 
because does not the ICI really represent the insiders? They 
encourage the perception that they represent mutual fund 
shareholders, ma's and pa's here in Washington, but is it not 
really the case that they represent the insiders?
    Mr. Spitzer. I agree with your conclusion because I agree 
with your premise which is that the ICI does, in fact--and with 
all deference to my friends who are here from the ICI--the ICI 
has not been a voice for reform or protection of the 
shareholder, but really has been a voice for the status quo and 
a voice for the very internecine set of relationships that have 
led to the enormous breaches of fiduciary duty----
    Senator Fitzgerald. Do you think they have acted in the 
interest of mutual fund shareholders?
    Mr. Spitzer. No, I do not, and needless to say, I have 
disagreed, as my testimony makes clear, fundamentally with not 
only the conclusions but the very way that the ICI has 
addressed this issue. I will say that the way that the ICI 
addressed and thought about the issue of timing and other clear 
problems that existed, structural problems that existed within 
the industry has been deeply disconcerting to me because I 
think it was a voice for the status quo, a voice in opposition 
to meaningful and reasoned reform.
    Senator Fitzgerald. Thank you very much, Mr. Spitzer. It is 
wonderful testimony and we appreciate you coming to Washington 
in this adverse weather.
    Senator Akaka.
    Senator Akaka. Thank you very much, Mr. Chairman.
    Mr. Spitzer, I would like to ask you two things. First, a 
study conducted by John Freeman and Stewart Brown showed that 
the average actively managed mutual fund company investing in 
large cap stock paid 0.52 percent of fund assets for investment 
advice, as opposed to the 0.21 percent paid by pension funds 
for large cap portfolio management. My request is that you 
please explain to the Subcommittee why this difference exists, 
and would like the benefit of your experience and your 
insights. What should be done so that mutual fund companies act 
more like pension funds and reduce their expenses?
    Mr. Spitzer. Those numbers are perhaps the most important 
numbers that we should focus on because it is that net, that 
enormous margin between the 52 basis points and the 21 basis 
points that compounds every year to those enormous return 
differentials that investors are suffering from as a result of 
the disparity between what institutional investors pay and 
mutual funds by and large pay. What should be done falls into 
several categories, but first disclosure, and disclosure we all 
believe transparency. Disclosure ultimately will leave the 
marketplace and investors to make the appropriate 
determinations. But we also, given how broken the fund board 
structure is right now, we need to go beyond that to actually 
mandate--and this is what I wove into the final passages of my 
testimony--we need to mandate a particular methodology by which 
mutual fund boards would then begin to undertake this analysis. 
They can reach whatever conclusions they want of course. They 
are the board. But they must consider the factors that are 
enumerated, which are what fees are being paid by institutional 
investors, what are the margins that are being derived by those 
who are rendering this advice, what are the costs that are 
being incurred. Given the failure of the boards to properly 
weigh these factors--and we know that that is the case because 
of the 52 versus 21 basis point differential we just 
highlighted--we I think can fairly say to them: Do this 
analysis, reveal your conclusion. You are free to reach any 
decision you wish, but you must go through this analysis and 
give us the tools to evaluate the wisdom of your conclusion by 
giving us the data that you relied upon.
    Senator Akaka. Mr. Hillman, I am concerned that it is not 
clear to investors that the mutual fund company also may pay a 
percentage of sales or an annual fee on the fund assets held by 
the broker or both to obtain a place on the preferred list, or 
to have their shares sold by the broker. Investors may think 
that their broker is recommending funds based on the 
expectation of solid returns, low volatility or the needs of 
the investor, but the broker's recommendation may be influenced 
by hidden payments. Mr. Hillman, please describe for the 
Subcommittee what you have learned about the typical revenue-
sharing arrangements found at the large fund supermarkets, and 
also what the typical investor knows about these financial 
    Mr. Hillman. Thank you very much. What you are referring 
to, revenue sharing, is payment that is made by the fund's 
investment advisor from its own resources to finance the 
distribution of fund shares. SEC, in 1977, through Rule 10b-10 
of the Securities and Exchange Act, required that the nature of 
revenue-sharing arrangements be described in general terms 
which they are in mutual funds prospectus. However, a fairly 
simple statement amounting to the acknowledgement that payments 
are made to broker-dealers has historically met SEC's 
requirements. Therefore, no publicly available information that 
would allow one to quantify the nature or extent of revenue 
sharing at the fund or industry level exists. There is simply 
no transparency of these expenses. It is also a legal issue.
    As to whether payments are an indirect use of fund assets 
to finance the distribution, you would think therefore that 
they ought to be included within a 12b-1 plan that funds' 
boards of directors are supposed to be evaluating. Because, 
though they are taking out of the investment advisor's profits, 
there is limited disclosure to the board of directors of these 
payments, and therefore limited information being provided to 
them for their review.
    SEC has recently, January 14, proposed new rules to enhance 
the information that broker-dealers provide to customers at 
both the point of sale, which is critically important, as you 
mentioned in your opening statement, and during the 
confirmation process once a trade is executed, and we applaud 
the SEC for their initiative in this area.
    Senator Akaka. Thank you, Mr. Chairman.
    Senator Fitzgerald. Thank you, Senator Akaka. Chairman 
    Chairman Collins. Thank you, Mr. Chairman.
    Mr. Hillman, I want to explore with you the issue that the 
Attorney General brought up in his statement about the huge 
disparity in the fees charged institutional investors versus 
the every-day retain investor, at least in the two cases that 
he cited. For example, in the Putnam case I believe the 
Attorney General said there was a 40-percent difference, which 
is certainly substantial. In addition, one of our witnesses who 
will appear later this morning has also looked very closely at 
this issue and authored an article in the Journal on Corporate 
Law that also concluded that institutional investors were 
charged considerably less than the small investor.
    The mutual fund industry, as the Attorney General cited, 
has done a study that says that such differences can be 
accounted for by a different level of service or more work 
being done to serve institutional investors. I also wonder if 
perhaps the industry looks at the institutional investor as 
deserving of volume discount, if you will.
    What are your views on this issue? Is there a justification 
for having a very different fee structure, a much more 
favorable fee structure for institutional investors than for 
the average American who is investing in a mutual fund?
    Mr. Hillman. That is a very good question, something that 
we have not looked at as part of our study in June 2003, but 
let me offer these viewpoints. It is clear that institutional 
investors bring to the table greater assets, and therefore a 
reduced fee will allow mutual fund companies to retain large 
amounts of funds from those individual institutional investors 
that is drastically different from what might be coming 
available from an individual investor who may have a smaller 
portfolio, a smaller amount invested. Additional costs on the 
part of that fund to maintain information could cause for a 
difference to be there between institutional cost expenses and 
those of individuals. But the numbers that the Attorney General 
surfaced are quite astounding. The difference between those 
fees are enormous over the long term, and something that is 
deserving of additional attention.
    Chairman Collins. Mr. Spitzer.
    Mr. Spitzer. Senator Collins, could I just add one thought 
to that? Obviously, it is not only framed properly, but really 
cuts to the core of the issue. I would point out that the 
differentials we talked about are for essentially equivalent 
pools of capital even though the individual institutional 
investor may be larger, obviously, than the individual mutual 
fund investor. We are aggregating those pools and we are 
saying: What did you charge to provide advisory services for 
equivalent pools of capital? $100 million, $200 million; not 
$100 million to the $10,000 mutual fund investor. The 
incremental costs that clearly are borne, in terms of 
redemption fees, in terms of communication, in terms of 
statement issuance that attached to the small investor are not 
part of the advisory fee costs. Those are shown elsewhere. 
Those are other fees. This is an apples to apples comparison.
    When we generated these numbers, we went to Putnam and we 
said: Give us your best apples to apples comparison for 
identical services. The numbers were from them for that 
identical set of services.
    Chairman Collins. That is a very important clarification, 
and I appreciate you adding that to your testimony.
    I want to explore with both of you the best way that we can 
ensure that consumers have the information they need on the 
fees that they are paying. As, Mr. Hillman, you pointed out the 
amount of fees and expenses that each investor specifically 
pays now are currently disclosed only as a percentage of the 
fund's assets. Most other financial services disclose the 
actual cost to the purchaser in dollar terms, and again I go 
back to my checking account analogy, where you can see very 
clearly what fees you are being assessed every month. It is my 
understanding that the SEC has proposed additional disclosures, 
but still is not proposing that funds disclose the specific 
dollar amount of fees paid by each investor, nor is the SEC 
requiring that the fee disclosures be listed on the account 
statements. And yet the account statement is what most of us 
rely on. We do not go back and read the prospectus to determine 
our investment expenses are. So really that means we are not 
getting any timely, regular disclosure at all of the fees if 
you are the average investor.
    Starting with you, Mr. Attorney General, and I see my time 
is up, could you tell me if you think the SEC's proposal is 
adequate or whether you would like to see on the quarterly 
account statement a clear disclosure in dollar terms as well as 
percentages of the fees?
    And then, Mr. Hillman, I would like you to answer the same 
    Mr. Spitzer. Thank you for that question, Senator. I vowed 
I was going to come to Washington and leave without being 
critical of the SEC, and so I am going to answer your question 
a little differently. Rather than saying whether the SEC is 
good or bad, I would merely say that I think the format of 
disclosure that you described would be enormously helpful for 
investors and perhaps would be the most important way for them 
to understand what fees they have actually been charged. I 
think that there is certainly a desire--there should be a 
desire to give each consumer an actual dollar cost that he or 
she is paying. There also should be a desire to provide an easy 
comparative basis, which means a per-unit comparison akin to 
what we all see at the supermarket, where as either Senator 
Levin or Senator Lautenberg referred to it, as either a per 
ounce, what am I paying per ounce? So there should be both a 
per dollar disclosure and what your portfolio is being charged 
per quarter.
    Chairman Collins. Thank you. Mr. Hillman.
    Mr. Hillman. This is an area that we have done considerable 
work on, and the concern here really is over investor awareness 
of fees. Despite existing disclosures and educational efforts, 
the degree to which investors understand mutual fund fees and 
expenses remains a significant source of concern.
    There were studies conducted by the SEC and the OCC back in 
1996 which found that one in five fund investors could not give 
an estimate of the expenses for their largest mutual funds, and 
fewer than one in six understand that higher expenses lead to 
lower returns. A Vanguard money investor literacy test back in 
September 2002 found that 75 percent of respondents could not 
accurately define a fund expense ratio, and 64 percent did not 
understand the impact of expenses on funds' returns. Clearly, 
more needs to be done to make sure investors are aware of the 
impact of fees on the returns for their mutual fund investors. 
Special dollar disclosure could be the incentive that some 
investors need to take action to compare their fund's expenses 
to those of other funds and to make more informed investment 
    Chairman Collins. Thank you, Mr. Chairman.
    Senator Fitzgerald. Thank you. Senator Levin.
    Senator Levin. Thank you, Mr. Chairman.
    I would like to get into the area of revenue sharing and 
directed brokerage. This is a way that the mutual funds get 
money to brokers for selling their shares. I want to ask you 
just a very simple question about a public company that wants 
to have a broker sell its shares on the stock exchange and pays 
the broker a hidden fee of a dollar for every share of stock 
that it sells to that broker's customers. Is that legal?
    Mr. Spitzer. I think not.
    Mr. Hillman. It is not. Not a practice you would want to 
do, no.
    Senator Levin. How is it any different when a mutual fund 
pays a broker a hidden fee, and one of the two ways that are 
involved in either revenue sharing or directed brokerage, to 
sell its shares to the broker's customers; how is that any 
different from a publicly traded company saying: For every 
share you will sell of my company on the stock exchange, I am 
going to pay you a buck?
    Mr. Spitzer. I do not believe it is different. I think it 
is a hidden subversive interest that without full and complete 
disclosure runs contrary to the fiduciary duty that is owed to 
that customer to whom you are marketing the product.
    Senator Levin. You would agree with that, Mr. Hillman?
    Mr. Hillman. Yes. Hidden cost.
    Senator Levin. The fiduciary duty that we are talking about 
here actually, I believe, or from what I know is the broker's 
fiduciary duty.
    Mr. Spitzer. That is correct.
    Senator Levin. It seems to me that is what we have to 
really clarify. We have to focus on what conflicts of interest 
we are talking about here. With directed brokerage what we are 
talking about is that a mutual fund is going to agree that it 
will buy stock from a broker if that broker sells that mutual 
fund's shares. So it will give business in effect to that 
broker if that broker sells its shares. It is a hidden deal.
    Mr. Spitzer. For the mutual fund it is a disclosure 
violation, that it is not disclosed that it is providing this 
incentive to the broker, and that is a material fact that 
obviously should be disclosed in their hidden fee issues. For 
the broker, who has not disclosed to his or her client that 
there is a hidden benefit that he or she derives from that 
sale, it is a breach of the fiduciary duty.
    Senator Levin. Is it an illegal act for a broker to receive 
that hidden fee from somebody to sell a share to that broker's 
    Mr. Spitzer. Let me state it this way because I do not want 
to suggest that necessarily it would be a criminal act. We 
would have to look at all sorts of surrounding factors, but it 
is something that we would consider to be a violation of the 
Martin Act.
    Senator Levin. Of the what?
    Mr. Spitzer. Of the Martin Act, the New York State 
securities law.
    Senator Levin. If it is a violation of law for a broker to 
sell me a share of stock when unbeknownst to me he was paid by 
that company to sell me that share of stock, it seems to me 
that is obviously, it is more than a conflict of interest. It 
seems to me it is a violation of law. If it is not, it should 
    Mr. Spitzer. It is.
    Senator Levin. Now looking at the mutual fund that is 
paying the broker to do that, are they not aiding and abetting 
an illegal act?
    Mr. Spitzer. You could certainly try to bring them in as 
aiders and abettors, absolutely.
    Senator Levin. Should we try to bring them in as aiders and 
abettors either by regulation or by law? Are they not 
contributing to an illegal act by making a payment to somebody 
to sell me something that is not known to me? Is there not an 
inherent conflict there which either is or should be illegal on 
the part of the broker and should it not be illegal to do that 
because you are aiding and abetting that just the way--if I 
give you a bribe and you accept the bribe, you have violated 
the law by accepting a bribe. But have I not violated the law 
by offering the bribe? How is this different except that it is 
in a market setting?
    Mr. Spitzer. It is not different. I would come at it from a 
slightly different perspective. I would reach the same 
conclusion, but I think it is the behavior that we want to 
eliminate, and whether we eliminate the behavior by saying the 
mutual fund is aiding and abetting or whether we simply ban the 
behavior without full and fair disclosure to all participants 
and make everybody equally culpable, I suppose I could say I am 
indifferent to how you address it. The behavior we wish to 
eliminate is the hidden fee shifting.
    Senator Levin. I agree with that, but when we come to 
eliminating behavior we do it in two ways. One is disclosure, 
but the other one is a prohibition with a fine at least, an 
administrative fine and maybe sometimes a criminal fine, but 
nonetheless there are a number of ways to address the conduct. 
I agree with you, we want to stop the conduct, but disclosure 
is one way. It may or may not succeed by the way, just like 
these fee disclosure may or may not succeed depending on how 
complicated they are. You get a fee disclosure on your 
telephone bill, most people do not have the vaguest idea, 
looking at a complicated telephone bill, what the heck is in 
that bill. That is disclosure, but it does not do the job.
    I guess this is my final question because my time is up. It 
seems to me that is a critical question which we face. We have 
got to act against the conduct. It is clearly a violation of a 
fiduciary duty on the part of a broker, it seems to me, to be 
selling something to me without disclosing to me that he is 
getting paid by the guy whose share he is selling to me or 
whose stock he is selling to me, to sell it to me. If that is 
not a violation of law, it surely ought to be. But, what we 
need to do is decide do we want to get at the conduct from the 
mutual fund side by either forcing disclosure, but if it is 
improper, it should not just be disclosed. We do not just want 
to disclose impropriety. We want to stop impropriety it seems 
to me. And if it is a conflict or aiding and abetting in a 
conflict, why should we not just ban that action rather than 
simply say disclosure is good enough? That is my final 
question. It sounded like a speech but it is really a question. 
    Mr. Spitzer. With all due respect, if I were in the 
courtroom I might have objected to the question as being 
compound, but that is all right.
    Senator Levin. I think it was a leading question.
    Mr. Spitzer. I am going to hedge right now on whether there 
should be a ban because I can imagine situations where smaller 
mutual fund companies would want to announce to the world: We 
have many representatives out there, who when they sell your 
products, we give them some degree of compensation. There are 
salesmen who have relationships with us and many other mutual 
funds as well. As long as the investor is fully aware--and I do 
not mean the sorts of disclosures that are on the third page of 
an 18-page contract. I mean they are really being informed why 
the salesman, the broker as it were, has an interest in pushing 
particular funds over others. Then I can imagine that that is a 
    Senator Levin. A financial interest?
    Mr. Spitzer. Correct.
    Senator Levin. Has a financial interest.
    Mr. Spitzer. That is correct, because that is a way to 
disseminate and market the product.
    Senator Levin. I would end with a request then, that you 
would give us advice for the record on that issue because I 
think that is one of the really fundamental questions we face 
as to whether disclosure is going to be adequate or whether 
there ought to be some kind of a prohibition that we ought to 
urge on the regulators.
    Thank you, Mr. Chairman.
    Senator Fitzgerald. Senator Levin, those were excellent 
questions, and I hope to have the opportunity to share with you 
a bill I am working on, because I tend to agree with you that a 
lot of these practices, these shadowy practices which people 
are only vaguely aware of, should simply be banned as opposed 
to disclosed in a better fashion. I think your analogy with 
what if a publicly traded corporation, not a mutual fund, went 
to brokerage houses and said: We will give you a dollar for 
every share of our stock that you sell. That would be an 
outrageous fraud on the public. Right now you have brokerage 
firms steering their clients into certain mutual funds, not 
because it is necessarily in the best interest of their client, 
but because they are going to get revenue sharing or some other 
fee from the mutual fund. In Chicago they call that a kickback, 
as I said at the last hearing. I do not think it is right.
    Senator Sununu.
    Senator Sununu. Thank you, Mr. Chairman.
    I did not understand all of the details of the previous 
question, but I assume in the public equities market to a 
certain extent, provided it is disclosed the right way and you 
comply with the laws, it is also called a commission. The 
brokers make commission all the time for selling stocks. You 
want it to be disclosed, and depending on who else they are 
doing business with there could be some conflicts of interest, 
and that is obviously what the line of questioning gets to, but 
simply being a broker is making money by selling mutual funds 
or stocks does not necessarily mean they are doing anything 
    I want to pick up on a point that you made, Mr. Spitzer, 
and I think it is a very important one, which is in this 
discussion about the financial arrangement, you emphasize that 
there could be a situation where a small mutual fund in 
particular, your example, was disadvantaged. In other words, 
you focused on the disclosure but you could imagine, I think 
you said, a situation where a small mutual fund was trying to 
get out information about the new fund. Without getting into 
the particulars of the example, I think that is an important 
point because there are other areas of regulation here where we 
might see practices we would enjoy better disclosure of. We 
want to make sure we are not disadvantaging new mutual funds, 
smaller funds, at the expense of the larger funds or to the 
benefit of the larger funds. I was not very clear there, but we 
want to make sure we have a level playing field, which gets to 
my first question.
    Would you be concerned about regulations that treat 
independent research in a discriminatory manner with respect to 
the large full service brokerage houses?
    Mr. Spitzer. Let me restate your question. I have seen the 
articles that I gather you have seen as well that suggest that 
if there were a straight ban on soft money as a means of 
compensating certain entities, that could have a disparate 
impact and a very negative impact on some of these smaller 
independent research boutiques that are there.
    Senator Sununu. That qualify either a straight ban or a 
discriminatory reporting report, that one set of fees has to be 
reported in a particular way, and another set of fees for the 
full service does not have to be reported.
    Mr. Spitzer. The answer to your question is yes, I am 
worried that we not act in a way--and as you pointed out in 
your opening statement, one of the efforts 2 years ago now 
really was to resuscitate the role of independent research and 
to make sure that there was somehow a business model that would 
work. I think we need to think carefully as we address the 
issue of soft money and the issues relating to these regulatory 
schemes, what collateral impact there may be in the context of 
    Now, I do not say any of that to justify what I think is at 
best a very murky area, which is the enormous sum of money that 
flows through these soft dollar commissions which is untracked 
and hard to understand, and I think is an area that 
significantly cries out for some very careful thought.
    Senator Sununu. Are you for banning all soft dollar 
transactions, or are you for uniform disclosure of those 
    Mr. Spitzer. I have said in prior testimony, and my 
position has not changed since then, I simply have not looked 
at the issue to have an informed judgment on the matter. I have 
seen obviously enough to know that there is, as I said, 
significant area for inquiry, but there are also significant 
subtleties in how we deal with it.
    Senator Sununu. A hypothetical. Two funds, they are mid-cap 
funds. They are the size----
    Mr. Spitzer. Mid-cap, I am sorry, you said?
    Senator Sununu. Mid-cap funds. They advertise themselves in 
the same way, have generally the same requirements for 
investment, about the same size in total assets. One has a 5-
year return of 11 percent and an expense ratio of 40 basis 
    Mr. Spitzer. Five years, 11 percent, OK. I want to make 
sure I get my numbers. I do not have an HP 12.
    Senator Sununu. One has a 5-year annualized return of 8 
percent and expenses of 20 basis points. Which one was the 
better investment?
    Mr. Spitzer. I will have to ask Mr. Bogle. He is the master 
of these numbers.
    Senator Sununu. I think both the esteemed Mr. Bogle and you 
could come to the same conclusion. The 11 percent with the 20 
more basis points in the expense is going to be the better 
return over the 5 years. I mean 300 basis points and at least 
the gross returns really does make a difference in the long 
run. A simple example, I know, but it just comes back to this 
point that we want to make sure we are emphasizing the 
important statistics for investors, and I will consistently 
come back to the issue of returns net of all expenses I think 
is the best barometer because it takes into consideration 
different levels of investment, different levels of assets. I 
could have expenses of $387 for my mutual fund investment, but 
it obviously makes a difference whether my total assets are 
$350 million invested in that or $1,000 in the expense ratio.
    So the dollar value could be important. I could imagine 
circumstances where I would want to be able to compare that, 
but I think the return net of all expenses is the one that 
consumers will use most often to compare mutual fund 
performance across their own portfolio or to other funds that 
are out there.
    With regard to the board structure, you support the idea of 
an independent board chair, correct?
    Mr. Spitzer. That is correct.
    Senator Sununu. Did any of the firms against whom you 
brought charges have independent board chairs?
    Mr. Spitzer. Yes. In fact, let me just clarify. I support 
the notion of an independent chair and the 75 percent 
threshold, but have always made it clear these are not 
panaceas. To go back to a slightly different context, if you 
were to look at the Enron board and look at the constituency of 
that board on paper you would say: What a spectacular board. So 
clearly when you define board membership, and we try to promote 
good board behavior by defining constituency, that does not 
guarantee any result. It is sort of like a prospectus. But it 
perhaps permits us to be in a situation where we can raise 
expectations and get divergent views.
    Senator Sununu. Unless there is an academic study out there 
that I am unaware of, and I would be very interested in seeing 
it, why support a ``reform'' if there is no empirical evidence 
that it has ever resulted in better behavior or better results 
for shareholders or investors?
    Mr. Spitzer. I think you are drawing the wrong logical 
conclusion. To say that it does not inevitably guarantee an 
appropriate result does not mean that it is not logically 
superior as a matter of principle to have an independent board 
chair who would then be in a position to negotiate at arm's 
length with a management company to which he or she does not 
owe a parallel duty.
    Senator Sununu. Do the independent board members not 
participate in those negotiations with fund managers now?
    Mr. Spitzer. They might participate but I think the record 
suggests that the participation has not been adequately 
vigorous, and that is why as a theoretical matter, what we are 
trying to do--as I think we all, even you, I dare say, would 
agree with the notion that we want to resuscitate the vigor 
with which the mutual fund board enters these negotiations. As 
a matter of principle it seems quite clear that having a board 
which does not have a significant overlap with the management 
company is more likely to give you an arm's length negotiation.
    Senator Sununu. But I come back to my belief, which could 
be wrong, that there is no empirical evidence that shows that 
those boards led by independent chairmen have had their boards 
engage in these negotiations ``more vigorously'' than boards 
that do not have independent chairmen. You can feel free to 
respond, but I think it would be wrong to suggest that we know 
there would be a better result if there were an independent 
chairman, even though we cannot show that in all the cases 
where there were independent chairmen there was a better 
result. That seems to me to be a non sequitur.
    Mr. Spitzer. I am happy----
    Senator Sununu. No, you do not have to respond.
    Mr. Spitzer. I think we have stated our positions with some 
clarify, but I think the premise of independence is one that 
most people feel would move us in the right direction.
    Senator Sununu. Do you support--one final question, it is a 
yes or no; can I just ask one more? I am sorry.
    Senator Lautenberg. Time is flying, and we are trying to 
parcel it out.
    Senator Sununu. Do you support the same proposal for every 
public in America, that they have to have an independent 
disinterested chairman?
    Mr. Spitzer. I do not, but I will tell you some of the most 
staid and conservative corporate lawyers in America have come 
to that conclusion. I would point to Ira Millstein at Weil 
Gotshal, who has for years been calling for independent chairs 
as one of the critical ways to resuscitate board behavior.
    Senator Sununu. Thank you.
    Thank you, Senator Lautenberg. I apologize for running 
    Senator Lautenberg. That is all right.
    Senator Fitzgerald. Senator Lautenberg.
    Senator Lautenberg. Thank you, Mr. Chairman.
    I want to say to Senator Sununu I think that he is on a 
good track, and the hearing thus far has been excellent, and I 
thank both of the witnesses here for their testimony.
    I look at this a little bit differently. First of all, I 
think that in the case of an underwriting, which I think was 
Senator Levin's kind of focus, compare it to the difference 
between--may I call it--wholesale and retail, because everyone 
knows that if you want to buy a car, Mr. Levin's example 
perhaps ought to be--that what you pay does not give you all of 
the details about what the dealer you bought it from paid. You 
make your decisions based on a net, but it is a lot easier to 
compare Chevrolet to Ford, etc., than it is for the arcane 
business of details about mutual fund purchases, etc. For most 
of the public it is foggy. For most of the people in our 
business it is foggy because it is very complicated, hard to 
    One of the things I think we might have to do is--I think 
Senator Sununu was on the right track with one exception, and 
that is that simply measuring the net performance of a mutual 
fund to its shareholders is not quite sufficient because you do 
not know what these hidden costs are, and maybe the shareholder 
ought to get more. Just because they got 11 percent compared to 
an 8 percent, maybe they should have gotten 15 percent, and had 
they been aware of where it was going, that they would have 
required that. Someplace along the way we have to make this 
knowledge comprehensible about what people ought to look for. I 
do not know whether it is an index, a mutual fund index that 
says here are the costs, here is the net result, the difference 
between the two is thus, and give people an easy way of forming 
opinions about whether or not they go ahead and purchase these 
    The thing that is scandalous is the amount of--some call it 
baksheesh; it is a common term in the Middle East, and we paid 
plenty for that in Iraq--but it is distributed around. I think 
that if they are giving away your money, even if you got a 
pretty good return for it, that is not appropriate.
    Mr. Spitzer, I would like to know if anything has happened 
since you broke the mutual fund scandal in September? Have you 
seen anything that says: Uh-huh, they are making changes that 
would correct some of the conditions that brought on these 
    Mr. Spitzer. Yes, sir. I think the answer is that it is--I 
do not know if it was Justice Holmes, I may be wrong--light is 
the best disinfectant, which is not only the premise to 
disclosure but the enormous spotlight that has been beamed and 
been focused upon the industry over the last number of months 
that has revealed not only the warts and improprieties but also 
those who are good, has led every board to reconsider and 
rethink its behavior, and therefore we are seeing embers, that 
hopefully will burst into flames, of changed behavior. So, yes, 
there is change that results from first the sheer embarrassment 
of having the names of companies in the headlines, the fact 
that people have been taken away in handcuffs and sentenced to 
jail, and so, yes, there are changes.
    Senator Lautenberg. There are still people being taken away 
in handcuffs.
    Mr. Spitzer. And there will be more.
    Senator Lautenberg. This is kind of a pet subject of mine, 
and that is directorships and how they function, and I think 
one day that in America we will see a class of executive called 
director. I know this, that when I was running ADP and we 
started with nothing, we had nothing to invest except our hard 
work, and the company that we started many years ago, today has 
over 40,000 employees and had the longest growth record of any 
company in America, over 10 percent gain each and every year 
for 41 years straight in a row. It was a good investment. I 
should not have sold my stock. [Laughter.]
    But I do believe that to obtain the interest of a director 
away from a company, I never took another company's board seat. 
I did for a while and decided that was not for me. If I was 
going to run my company, I wanted to focus exclusively on my 
company. If I wanted to do something that was a not-for-profit 
or something like that, I enjoyed it, but I did not believe 
that I had the right to take time away from my company, no 
matter how comfortable they offered to get me there or whether 
it was an overnight conference in Las Vegas, that that was 
enough to divert me from my appointed rounds, as I say. I think 
we are going to see a class some day of directors exclusively, 
people who will have attained a degree of experience and 
reputation and so forth that can qualify as directors, and they 
will sit on several boards. This is where I think we are going, 
and I think it is essential. Otherwise, it is too tough. People 
become friends. There are relationships, serious relationships 
that develop.
    But to respond to Senator Sununu's question about have you 
see any different result as a consequence of an independent 
board, I think it is fair to say that what you have seen is 
just the reverse of that, which is a corollary, and it says, 
hey, when you look at Enron and you look at the people and you 
look at some of the people who were directors, they closed 
their eyes. They did not have the time, they did not have the 
    You made a very important statement, directors should be 
furnished with a staff person, resources, and information 
expanded that the public can understand. No matter what 
happens, I do not think the CEO of a company--this is a 
personal thing--ought to be able to walk away with the profits 
of the store unless he owns the store. I think that he has a 
job like everybody else, and when a chief executive walks away 
from a job that paid millions and millions and millions of 
dollars, and then there is still a reach out, there are grasps 
out there to see that the favorite wines or the favorite 
airplanes or the favorite massages are still included. I think 
it is a travesty.
    One thing we have to make sure of is that we have people 
taking their assignments seriously. Maybe they begin to 
understand that when they too are punished for either lack of 
interest of lack of action on their part when they see these 
    I commend you, Mr. Chairman, for holding this hearing. We 
are going to go much further before these subjects are fully 
    Senator Fitzgerald. Thank you.
    As I wrap up, I just would like to make my own comments on 
Senator Sununu's suggestion. I think, again bringing up the 
analogy of the Government Thrift Savings Plan that we are all 
members of, our directors have to be independent by law, and 
they competitively bid out the management contract. The 
management contract was won on a competitive bidding basis by 
Barclays Global Investors in London. They charge an exceedingly 
low fee to manage the TSP fund for Federal employees. I wonder 
how we would feel if all of a sudden we changed the law and the 
directors of our TSP board did not have to be independent and 
they could instead be insiders at the outside manager. What if 
the chairman of the TSP board were an officer of Barclays 
Global Investors and owed a fiduciary duty to shareholders of 
Barclays? We might not sleep as well at night knowing that.
    Yes, there are independent directors who do not have 
conflict who are not very bright or are not very diligent or do 
not work very hard or whatever. So having an independent 
director is no guarantee that you are going to have a good 
director, but certainly it helps to eliminate conflicts that 
could otherwise arise. We do not have to worry about that for 
our retirement funds because Congress has created a separate 
investing regime for Members of Congress. We get one special 
deal, and the whole rest of the world is stuck in this rotten 
world where conflicts are all over the place, where fees are 
exorbitant, where there is revenue sharing, directed brokerage. 
We do not have to worry about that, but my goal is that 
hopefully we can give the rest of America as good a mutual fund 
deal as Congress has given itself.
    With that, I want to thank these two witnesses. They have 
been excellent. We have gone on for 2 hours. You have been very 
patient. We are going to give you leave to go back to New York 
or go back to your offices. Thank you very much for being here.
    Mr. Spitzer. Thank you, sir.
    Mr. Hillman. Thank you.
    Senator Fitzgerald. Our next panel is the whistleblower 
panel, and before I introduce them I am going to take a 2-
minute break so that we can all stretch. We have been here for 
2 hours. So why don't we take a 2-minute break and then we will 
    Senator Fitzgerald. During the break there was a request 
made to take one of our panelists out of order because he has a 
plane to catch, and we are happy to honor his request.
    John Bogle probably needs no introduction. In the mutual 
fund world I think he is probably the best known investor in 
the country. He is the founder of Vanguard. It is something he 
had wanted to do since he was in college and wrote his thesis 
at Princeton I believe on the Massachusetts Investment Fund at 
the time. He had this dream of creating a truly mutual mutual 
fund, and he had the opportunity to fulfill that dream in 
founding Vanguard and watching it grow in a short period of 
time to be one of the two largest mutual funds in America. He 
is the author of several books on mutual funds. He is an 
industry expert without equal, as far as I am aware, and we are 
honored and delighted to have him back for the second time 
before this panel.
    So without further ado, Mr. Bogle, thank you very much for 
being here.


    Mr. Bogle. Thank you, Chairman Fitzgerald, and thank you 
particularly for the courtesy in accommodating my schedule. 
Sometimes we get a little bit over scheduled and that is the 
position in which I find myself today.
    \1\ The prepared statement of Mr. Bogle appears in the Appendix on 
page 106.
    I am very happy to be here because when you think about it, 
if you do for a moment, out of all the persons you have heard 
from, I am the only one who has actually been in the mutual 
fund business. I have been the Chairman of the Investment 
Company Institute back in 1970-71, I think, and I have actually 
been in this business for more than half a century. So I hope 
the perspective that I can bring to you is helpful. My entire 
career has been in this business, and I have observed in that 
period that this industry has changed greatly in that half 
century and it has not changed for the better. It has been a 
business that originally focused on prudent stewardship. It 
focused on long-term investing. It focused on putting the 
shareholder first. It had very low costs and attracted people 
who were attracted to the wisdom of long-term investing.
    Since then the industry has changed in almost every 
measurable way. Portfolio turnover is higher. Costs have 
doubled for equity funds. Funds hold their shares for a much 
shorter period of time, meaning we are selling the public 
speculative funds that basically are capitalizing on the folly 
of speculation rather than the wisdom of long-term investing. 
Instead of running this industry in the interest of fund 
shareholders, we are running this industry, I am sorry to say, 
to too great an extent in the interest of fund managers. We 
have become too much of a business and not enough of a 
profession. So this industry has to rethink, has to stand back 
and look at itself.
    I think the steps that are necessary to bring this change 
around--I will not deal with the technical steps too much--
requires us to figure out how to give the mutual fund investors 
the fair shake they deserve. Part of that is to give the weight 
of the mutual fund structure more heft, if you will, on the 
mutual fund shareholder side and less left on the mutual fund 
manager side. To that end I believe deeply that we need a more 
independent board, a completely independent board chairman, and 
I believe we badly need an express Federal standard of 
fiduciary duty which requires directors to act with loyalty and 
care in the best interest of fund shareholders.
    I think we need to help fund investors better understand 
their costs, and what would do that is the full disclosure of 
the total costs you bear as a shareholder in your fund, 
including transaction costs and others, the actual dollar cost 
each investor pays. I think it would be unarguably a great 
advantage for investors.
    We also need something that has not been brought up today. 
We need mutual funds to report not just their per share 
results, which are the time-weighted, returns you read in the 
paper--we got a return of, say, 11 percent per share--but the 
returns their shareholders actually earn, what are called 
dollar-weighted returns. So many mutual fund purchases are done 
at the wrong prices at the wrong time and the wrong funds that 
those dollar-weighted returns are often as many as 6 or 7 
percentage points behind the returns that the funds actually 
report. That should be reported. It is a known number. It 
should be reported in fund reports. I think those will help.
    I also think that we should direct the Securities and 
Exchange Commission to undertake a comprehensive economic study 
of the mutual fund industry. With $7 trillion in assets, in 
mutual funds, the national public interest and the interest of 
investors would be well served by shining the simple spotlight 
of disclosure on the revenues and expenditures of mutual funds 
and their managers, taking into account the fees, the sales 
charges, the transaction cost, where they are spent, where they 
come from, where are they spent, and how much is left for 
manager profits. Mutual fund investors incur not only the $70 
billion of costs that were referred to earlier. That $70 
billion is the direct cost that the mutual funds pay, but they 
pay another $40 or $50 billion in transaction costs, sales 
charges and other expenses like that. We need to follow that 
money because those costs of $120 billion are the amount by 
which mutual fund returns are apt to fall short of the financed 
markets' returns year after year.
    I also think, strongly agreeing with Attorney General 
Spitzer, that we need a requirement for fund advisors to 
provide, and fund directors to consider, the amount and 
structure of fees paid by institutional clients. One brief 
example to show how shocking this disparity can be. One advisor 
charged its mutual fund 97 basis points on a $4.5 billion fund, 
$41 million. But it charged a fee of 98 basis points, less than 
one-tenth as much, for a $900 million fund for California 
retirement system, or one-sixtieth as many dollars, just 
$700,000. California also pays investment incentive fees for 
investment success, but such fees, so-called performance fees, 
are conspicuous by their absence in the mutual fund industry.
    Finally, as I say in my formal statement, there are two 
firms in this business--actually three now that you mention the 
Federal Thrift Savings Plan--that have in fact been truly 
mutual in their struture. One is Massachusetts Investors Trust, 
which started the first mutual fund 80 years ago, had an 
excellent record, was the largest fund in this industry for 45 
years with the lowest cost. It abandoned that structure in 
1969. Five years later Vanguard adopted a similar mutual 
structure, albeit very different in concept and development. 
And we are unique in many other ways.
    So over 75 of this industry's 80-year history, we can 
observe how mutuality worked. Our costs are the lowest in the 
industry, 100 basis points below the industry norm. We operate 
at a quarter of 1 percent compared to 1.4 percent for the 
industry. Our market share has gone up 20 years in a row from 1 
percent of assets to 9 percent of industry assets. So mutually 
has been a successful business strategy. It has provided above-
peer returns to our shareholders and the lowest cost in the 
industry. I think we have to have some language in the new 
legislation that requires mutual funds to consider, once they 
reach a certain size, the option of mutualization. It works for 
    Directors also need an independent staff, I believe, when 
they get to a certain size or when directors oversee a certain 
number of funds, a staff that will be independent of the 
manager, giving them the objective information they need.
    Who would pay for that? Let me tell you how we did that at 
the inception of Vanguard. We said to the manager, ``We are 
going to have our own independent staff to evaluate you, and we 
will not only reduce your fees by the cost of that staff, we 
will reduce them by a 50 percent fee markup because that is the 
profit you are making in those services.'' I think it would be 
a wonderful example for other firms to follow.
    Thank you, and sorry to be a couple of minutes long, Mr. 
    Senator Fitzgerald. Mr. Bogle, we are so honored to have 
you here. I appreciate your coming down a second time, and as 
always, your comments were directly on point. You and I talked 
the last time you were here about the fact that Vanguard was 
the only private sector mutual fund. We have now identified the 
Government Thrift Savings Plan as being in essence a truly 
mutual mutual fund in that it is not directed by somebody else 
who is profiting off it.
    I was troubled by the fact that mutual funds in America are 
allowed to call themselves mutual funds because that implies 
they are mutuals, like Mutual of Omaha, or a mutually-owned 
insurance company like State Farm in my State, in which the 
owners are actually the policy holders. We have a system in 
this country for chartering mutual savings banks. There are 
lots of mutual savings banks in which there are no 
stockholders. The depositors in the banks are the actual owners 
of the savings bank.
    Do you think it is appropriate that we allow mutual funds, 
when they are in fact not mutual and they are not owned by 
their fund shareholders? They are in effect used by an outside 
private company that is stock held to make money. I mean, do 
you think it is appropriate that mutual funds be allowed to 
call themselves mutual funds, or does the name ``mutual'' not 
mean much to younger people today so it is no longer a 
misleading term? Do you have any thoughts on that?
    Mr. Bogle. We have somehow tried to get around that by 
calling ourselves mutual mutual funds, which is a little bit 
repetitious but gets the point across. I think we would have a 
hard time changing the name that everybody has come to give 
this industry, and of course, I would be enough of a rebel to 
say that maybe what we ought to do is do the opposite, require 
mutual funds to be mutual, and I think we can do that without 
going to a full mutualization, by the way, simply by giving 
that board the heft, the weight that I talked about in my 
    Senator Fitzgerald. I know you want to comment on Senator 
Sununu's suggestion in his opening remarks that one of the most 
important things for investors to focus on is investment 
returns, and that if investment returns in a given fund are 
very high, then a higher fee will not really matter over time. 
What is your response to that? That line of reasoning suggests 
that the Senate, this panel, should not be so concerned about 
mutual fund fees. What do you think about that?
    Mr. Bogle. With all due respect to Senator Sununu, I hope 
he does not invest the way that little syllogism of his would 
suggest. That would be very unwise indeed. Because what we have 
here is a--of course, he is mathematically correct. If a fund 
earns twice as much as another, let us say 20 percent compared 
to 10, and they charge you 9 percentage points a year, you 
would have been better off in that 20 percent minus 9, rather 
than the 10 percent fund minus 1. I mean that is just 
    However, the reality of the matter is that we know that 
over time the lowest cost funds win. A simple statistic, and 
that is if you take the lowest-cost quartile of funds--and this 
is not in any selected 10-year period; this is every 10-year 
period we have looked at--the lowest-cost quartile of funds 
outperforms the highest-cost quartile of funds by 2\1/2\ to 3 
percent per year in all of the Morningstar boxes. So you know 
from looking back, cost matters. It has been said that the 
mutual fund industry is the only industry in the world where 
you get what you do not pay for. Think about that. You get what 
you do not pay for, and that is a truism.
    What happens in our business, however, is the broker or the 
salesman that wants to sell a high-cost fund, he picks a high-
cost fund because there are plenty of them, and he picks one 
with a high return in the past, and he makes the exact argument 
that Senator Sununu was putting forth. But the reality is that 
the past has nothing to do with the future. We did a study 
about a year ago, and we looked at the 10 highest-performing--I 
am sorry--the 20 highest-performing mutual funds of the 3 year 
period, 1997, 1998 and 1999, and compared those returns of 
those funds with the 3-year period 2000, 2001, and 2002. It was 
literally biblically true that the first shall be last. The 
first mutual fund, number 1, in the first performance derby was 
last in return, 841st, I think the number was, among those 
groups of funds that had been in business all that time over a 
certain minimum size level, 841st. And the other 20 funds--I 
believe this was the number--there was one that was not ranked 
below 700 out of those 800 funds. So much for past performance. 
It tells you nothing except probably the manager is 
speculating, exactly the opposite of what that Federal Thrift 
manager is doing.
    Senator Fitzgerald. Senator Collins.
    Chairman Collins. Thank you, Mr. Chairman.
    Mr. Bogle, thank you so much for testifying before us 
today. I am a great admirer of yours and I think we have a lot 
to learn from your experience, because as you pointed out, you 
have actually done this for much of your life.
    One of the challenges that we face is making sure as we 
attempt to bring about reforms that we do so in a way that does 
not cause unintended problems down the road, and therefore it 
is difficult to decide what should be legislative, what should 
be left up to SEC, and what should we look to the industry to 
do for itself to self reform.
    My inclination is to believe that we need a combination of 
all three. We are dealing with a law that I think in the mutual 
fund area has not been significantly revised in approximately 
65 years. I suspect that it does need to be brought up to date. 
But can you give us any guidance of the areas that you think 
should be codified versus the reforms that you think the SEC 
ought to pursue via regulation, versus the areas that we should 
just stay out of and expect industry to pursue?
    Mr. Bogle. Yes, thank you. I would say on the regulatory 
side things like a redemption fee on short-term transactions, 
things like disclosure about soft-dollar brokerage, things like 
perhaps banning the shelf space sort of payments that are made 
that are such a cost for investors and so misshape the 
distribution process. Those kind of things I believe should be 
left to the regulators. I believe that the Congress, speaking 
for the people of the United States, should do its best to have 
a governance structure that improves on the governance 
structure that was given to us in the 1940 Act. That Act, as 
you know, says that mutual funds must be organized, operated 
and managed in the interest of shareholders, rather then the 
interest of investment advisers, and that is clearly not what 
is happening. That is why I feel we need to chairman of the 
board to be independent. That is why I feel we need a heavy 
majority--indeed, sometimes I wonder why any management 
representative should be on the board--and that is why we 
deeply need this Federal standard of fiduciary duty for fund 
directors. These are things that will require legislation.
    As to the industry, I do not know how many of you have had 
a chance to read my paper on the development of mutualization 
that was my formal statement before the Committee, but it talks 
about how mutualization work, how it came, the struggle it was 
to get it done. An SEC report that was delivered in 1966 called 
Public Policy Implications of Investment Company Growth, that 
suggested many of the problems that we came to face later on. 
In that report, the SEC recommended very good solutions, but 
they were never implemented in law because the lobbying power 
of the Investment Company Institute was just too great. They 
wanted a requirement that the fees be reasonable. Well, nobody 
in the industry wanted that. So we got to where we are today I 
think through that route.
    But at the end of my formal testimony is a very important 
point, and that is you can legislate a structure, let us say 
more power for the board of directors of the funds or the 
requirement that a mutual structure be made available or be 
considered at certain levels at fund size, but a structure will 
only take you so far.
    I also mentioned next you have to have the right strategy 
in that structure. The Federal Thrift Savings Plan has that 
structure, and they have followed with the right strategy. The 
structure gives the power to get cost out of the equation and 
give the participants, Federal Government employees, basically 
the total return the stock market delivers, a magnificent 
return over the long run.
    But the third thing you need--and this is the hardest part, 
we can't legislate it--is the spirit. How do you get that 
spirit into the mutual fund industry once you have the 
structure and once you have the strategy? I think we have to 
rely on the individual investor, the man on the street, and I 
have talked to thousands and thousands of mutual fund 
shareholders individually, and I do not know how many hundreds 
of thousands in groups, and the people that come out to the 
meetings or the people that I meet with sense that spirit. How 
do you get it out to the public? That has a lot to do with the 
kind of cost disclosure. Investers will learn. They will learn 
in the long run, but they will be hurt as they. I would like to 
make the experience of mutual fund investors a very positive 
one for them, but it takes all of those fronts, as you say, 
Chairman Collins.
    Chairman Collins. Thank you. My second question that I want 
to ask you has to do with soft dollars. We have heard comments 
about that today. I think of soft dollars in terms of campaign 
finance reform, but here we are learning of another kind of 
soft dollars, but one that once again creates possible 
conflicts of interest. Is the answer a ban on soft dollars?
    Mr. Bogle. I think ultimately the answer is yes, there 
should be a ban on soft dollars, and it seems to me it comes 
down to a very simple principle, and that is, it is amazing how 
cheap everything you buy is if you buy it with other people's 
money, and that is true of distribution services and it is true 
of research, which of course as we all know, has as soon as it 
is out in the public eye, a value of zero. Because everybody 
has it, it cannot be capitalized on any longer. It would be 
very disruptive to the brokerage system and the market system, 
but I think that should be the direction.
    In the meanwhile, I am somewhat concerned about banning 
soft dollars for the smaller research firms when the large 
firms, the big brokerage firms, will just collect more and more 
hard dollars in the guise of payments for research. As 
enlightened as that solution may appear at first glance, it is 
not the right solution. So I think we need a more global 
solution for soft dollars than that.
    Chairman Collins. Thank you.
    Senator Fitzgerald. I have a follow-up on that. Soft 
dollars are expenses that, if a mutual fund paid for its 
research, would show up in its expense ratio. So what they do 
is in order to get research or other services, such as when 
some mutual funds want to get a new set of computers, they cut 
a deal with the brokerage firm. The brokerage firm will buy 
them new computers for their office. One mutual fund had a 
brokerage firm buy new carpeting for their office, and the way 
the brokerage firm was able to do that is the mutual fund 
permitted the brokerage firm to charge an excessive brokerage 
commission, which was passed along to their mutual fund 
    There seems to be an impulse on the part of mutual funds to 
convert operating costs into brokerage expenses or transaction 
costs because then they do not show up in the expense ratio. Am 
I not right about that? And that is a problem with our 
disclosure law, we do not require transaction costs to be 
disclosed so mutual funds keep trying to convert their ordinary 
overhead, like buying computers and carpeting, into a 
transaction cost which does not have to be disclosed.
    Mr. Bogle. You are quite right, Chairman Fitzgerald and I 
have even heard an anecdotal story that goes beyond the 
computers for these traders who are working so hard. This may 
be apocryphal, but I was told with a straight face that the 
person offering the soft dollars said: Well, these traders are 
working so hard we not only get them good computer systems, but 
we ought to get them golf club memberships so they can relax on 
the weekend. Both arguments are equally valid. Once you start 
going down that long trail, you are going to be wasting the 
shareholders' money.
    But the reality is that it is in the manager's economic 
interest. And one thing we should always be confronted with is 
that these directors who are directors of both the manager and 
the mutual fund, have a fiduciary duty to the manager's 
shareholders as well, and that is something that we cannot get 
away from. They have two sets of loyalties and are trying to 
be, as the biblical quote says, ``men who can serve two 
masters.'' I do not think it can be done. When they are buying 
research with soft dollars they ae maximizing the profitability 
of the manager. If they took that, say, $25 million of soft 
dollars and expensed it through the manager's books, the 
manager would earn $25 million of lower profits. So of course 
they want to get their own expenses as low as they can.
    So it is a very tough system to beat, but it is going on, 
and that is certainly where very strong action, both disclosure 
and I think ultimately regulatory will have to be required.
    Senator Fitzgerald. Senator Lautenberg.
    Senator Lautenberg. Thanks very much, Mr. Chairman.
    It is interesting to see how you can play it straight and 
make so much money, Mr. Bogle. It can be done in this great 
country of ours. Obey the rules and do it the way you should do 
    These situations, a lot of these funds are regarded as if 
they are a gold mine, and if you mine it hurriedly, you know 
that you have yours all taken care of before it goes to the 
marketplace, and frankly, I think that the problem is an 
informational problem. How do we get a message to the mutual 
fund investor that makes them clear, informs of the risk, 
informs them of the cost, other than perhaps hiring Howard Dean 
to go out and put out the message. [Laughter.]
    The fact of the matter is, that does not get him elected 
President, but it does show that your message can be delivered.
    How do we tell the public that they are getting gypped in 
part, that this idea of, well, simply say 11 versus 8 or what-
have-you, but as I said earlier, that 11 maybe ought to be 20. 
I ask you this with a degree of innocence because I am not as 
familiar with the mutual fund industry as you might be. I know 
that you do a pretty good job. Is yours the lowest cost?
    Mr. Bogle. By far. Our second lowest-cost competitor, 
lowest cost next to us, has costs that are approximately 200 
percent higher than ours. We run for about 26 basis points, and 
the second lowest cost is up there around 75 basis points.
    Senator Lautenberg. You have managed to grow with that 
modest cost, have you not?
    Mr. Bogle. Our market share has grown from 1 percent of 
industry assets to 9 percent, and has not declined in any one 
of the last 20 years.
    Senator Lautenberg. How much is invested now, and are you--
how much are the funds that you are managing these days?
    Mr. Bogle. We started in 1974 with one billion dollars 
under management. We used to celebrate each billion additional, 
and our most recent number was $700 billion, so we gave up the 
one billion celebrations quite a while ago.
    Senator Lautenberg. That is a nice celebration to give up, 
on to the larger increments. Is there a way, when we see a 
prospectus or proxy or a mutual fund that parallels that for 
industry generally----
    Mr. Bogle. Mutual fund prospectuses are singularly 
unhelpful. There are pages after pages of type. There is no 
highlighting of things like costs, or even for that matter 
returns or returns compared to the market, or the total dollar 
amount of costs. I think we need a uniform disclosure document 
in which certain things are highlighted in large type, the 
dollar amount of the fee, the fund's record compared to the 
stock market over long periods of time, the impact of cost on 
returns, things of that nature, in a very simplified way, and 
then throw in the rest of the prospectus afterward.
    Senator Lautenberg. Does a typical mutual fund annual 
statement include salaries or profits made by the senior 
executive team?
    Mr. Bogle. No, sir, it does not, and it does not because we 
have never been able to pierce the corporate veil. The mutual 
fund itself reveals its directors' compensation, but all we 
know about the manager's compensation is the total fee paid. I 
believe we absolutely need disclosure of the officers and the 
management company's salaries, disclosure of portfolio 
manager's salaries, disclosure of the transactions and 
ownership they have in the funds, none of which is out there 
now, and disclose of each individual's share of the profits the 
management company has earned. I would also add that we need 
disclosure of how the manager spends that money--and that is 
why I want this economic study of the industry done. If the 
manager is getting paid $100 million, is it spending $10 
million on investment management and $50 million on marketing, 
and has a profit of $40 million or whatever the case may be? We 
have been unable to get to that because the management company 
is a separate and often privately-held company.
    I should add to that there is another extremely unhealthy 
trend that has taken place in the years over the last half 
century, and that is, 36 of the largest 50 mutual fund 
management companies are subsidiaries of giant financial 
conglomerates. Believe me, sir, you know enough about corporate 
America to know that those conglomerates are in this business 
to earn a return on their capital, not a return on the capital 
of the mutual fund investors. When those two conflicting goals 
butt up against each other, as we have now seen in some of 
these scandals, it is the return on capital to the manager that 
has taken precedence. While I do not think we can ban that 
conglomerate ownership, we ought to think long and hard about 
whether the American public is served by conglomerating this 
once professional business.
    Senator Lautenberg. Is there any kind of an index out there 
that identifies the efficiency of the operation of a fund and 
shares its cost basis in a way that the public can understand 
it, or would it be a good idea? I think in terms of indices 
because we used to, at ADP, we delivered the Alan Greenspan 
econometric space. They sold it, but we would deliver it 
through our network. It seems to me that there is a heck of a 
value out there if we can put this information in a simple 
enough form that it tells the investor, hey, these people have 
this kind of a cost ratio, they have that kind of a result, and 
really understand what it is. There is a comfort derived from 
thinking that you are going into a mutual fund that everybody--
you said it, Mr. Chairman--is like an insurance company, that 
here we are all in this together so everybody is going to take 
care of everybody and we need not worry about it. Meanwhile, we 
have seen some of the most outrageous scandals that have come 
across the financial marketplace in this hidden array of things 
that are there.
    Mr. Bogle. The array of costs and revenues and ways money 
gets spent, and profitability of managers, is so vast that I 
have to confess to you that I am not sure, other than dealing 
with the most basic information I think would be understandable 
and palatable to the public. When you get to the real 
information to see how this industry works, I think it is more 
complex than that, and therefore, I think what we need very 
urgently is to have a staff responsible to the board of 
directors that can provide that information to directors on an 
independent basis. The present consultants to boards are always 
paid by the mutual fund managers, so they shape that 
information--for example, they often leave Vanguard out of the 
comparisons I am told--but I think it is up to the fund 
directors to be responsible in this industry, where unlike 
corporate America there are no large owners; in corporate 
America, we have 100 large financial institutions that own 50 
percent of all stock, and if they just asked for information, 
they would receive it. There is no such dominant body in the 
fund industry, so I think we need the fund directors to assume 
their responsibility.
    I agree with you, by the way, on the potential emergence of 
a kind what we will call a director class. I think it is an 
excellent idea, because the responsibility in this business 
largely owned by small investors is to have a board that puts 
those small investors first. The board will be able to digest 
any information that we can think of, particularly if it is 
provided by independent sources.
    Senator Lautenberg. Just this closing question. Is there a 
point in time when size becomes a determinant as to whether or 
not another fund under the same management company must be 
created so that there is not such a mass in one place, it can 
destroy a company's value if there is a decision to sell?
    Mr. Bogle. Yes. You bring up a very good point, Senator 
Lautenberg. In this business, when you are in the business of 
asset gathering and fee maximizing, which is what a management 
company does--you can argue it is fine, for that is their 
business--you tend to let funds grow to awesome size. One of 
the funds in the industry grew actually to $100 billion. They 
had a 1 percent management fee. They were paid $1 billion for 
investment management. And of course, by the time they were 
that large, they turned into an index fund. They did not want 
to be an index fund, but they had no other choice. They could 
not buy small-cap stocks or mid-cap stocks in any appreciable 
way. So you can observe them now kind of going along the index 
route, which is fine for me--I mean I love it--except at a cost 
that means they are destined to fall short of the index return. 
So, yes, we let funds get to too large a size, and no, we do 
not cut funds off at a reasonable level, and it is very 
difficult to replace one large fund with another fund doing the 
same thing. In other words, they say, we are going to close 
Fund A and start Fund B. But if you use the same advisor, 
clearly the problems do not go away, unless, as we did at 
Vanguard in the case of Windsor Fund and Windsor II, you use a 
totally different advisor. So it is another area that I believe 
the SEC should be looking at very carefully. I do not think 
that is a legislative issue on fund size because I do not think 
any of us can articulate it very well.
    But, yes, there is a size beyond which you cannot 
differentiate yourself because the cost of portfolio 
transactions simply overpowers your ability to move the money.
    Senator Lautenberg. I appreciate your candor. Thank you 
very much.
    Mr. Bogle. Thank you, sir.
    Senator Lautenberg. Thanks, Mr. Chairman.
    Senator Fitzgerald. Thank you, Senator.
    Mr. Bogle, we want to thank you once again for making the 
journey down to Washington in the inclement weather, and as 
promised, we will have you out of here in time to make your 
plane. But thank you very much for coming here. We really 
appreciate it.
    Mr. Bogle. Thank you all for your courtesy. It has been a 
privilege to be here.
    Senator Fitzgerald. Thank you. Now I would like to go to 
the whistleblower panel.
    Mr. Bogle. I am not one. [Laughter.]
    Senator Fitzgerald. You are not one of the whistleblowers. 
Well, I guess you are, yes.
    I would like to ask Peter Scannell and James Nesfield to 
please come up to the witness table. Thank you very much for 
being with us today, and we appreciate your patience waiting 
through the first panel and giving a special dispensation to 
John Bogle so we could accommodate his schedule.
    Mr. Scannell began working for Putnam Investments in March 
2000. As a preferred services specialist in Putnam's call 
center, Mr. Scannell noticed a pattern of high-volume trades by 
a group of investors. In March 2003--that is nearly a year 
ago--Mr. Scannell disclosed this repeated trading to the Boston 
office of the Securities and Exchange Commission, then 
subsequently presented his information to the Massachusetts 
Securities Division within the Office of the Secretary of 
State. Shortly thereafter, William Galvin, the Massachusetts 
Secretary of State, issued subpoenas seeking further 
information that later led to disclosures about Putnam's mutual 
    Our second witness on this panel is James Nesfield, a 
former contractor with Canary Capital Partners. Mr. Nesfield 
cooperated with authorities in their investigation of market 
trading abuses. When Mr. Nesfield was hired by Canary as a 
consultant, he was asked to help find companies willing to 
allow Canary to actively trade their funds and find points of 
access to enter orders for market timing purposes. Mr. Nesfield 
has extensive knowledge of trade processing systems on Wall 
Street that enabled him to communicate directly with many 
mutual funds.
    I would like to note for the record at this time that Peter 
J. Kugi \1\ of Grafton, Wisconsin, has submitted a statement 
for the record. Mr. Kugi was recently profiled in Newsweek 
Magazine as an aggrieved investor who saw the savings he 
invested in mutual funds for his son's college education 
dwindle by more than half. Mr. Kugi considers himself to be an 
above-average investor. As reflected in his statement, however, 
even he found that he could not understand the fee structure of 
the mutual fund in which he invested, leading him to believe 
that the vast majority of average investors are likely to share 
his frustration.
    \1\ The prepared statement of Mr. Kugi appears in the Appendix on 
page 276.
    Thank you both for appearing today. Mr. Scannell, you may 
proceed. As with the earlier witnesses, we will ask you to 
submit your written statement for the record. It will become 
part of the permanent record of this hearing, and if you are 
able, we would appreciate it if you could summarize your 
testimony in 5 minutes. Thank you.
    Mr. Scannell.


    Mr. Scannell. Thank you, Mr. Chairman, Subcommittee Members 
and Senators. I have submitted my written testimony. It is 
fairly lengthy, so I will do an overview. Again, I would like 
to thank you for this extraordinary opportunity to come forward 
before you to share my experiences and profound concerns.
    \2\ The prepared statement of Mr. Scannell appears in the Appendix 
on page 131.
    If I was told a year ago that I would be present at a 
Senate Subcommittee hearing addressing the very issues I was 
trying to expose, I would not have believed it possible. Every 
step of this fight was met with obstacles designed to keep 
someone like myself, without a corporate title, from being 
    I became aware of the market timing abuses taking place at 
Putnam Investments in April 2000, and tried to expose those 
abuses to the Boston office of the Securities and Exchange 
Commission in March 2003.
    I was working at the fifth largest mutual fund company in 
the world, and although most prospectuses state that market 
timing is either prohibited or discouraged, known to be a 
detriment to the unwitting long-term investor, it was my 
experience it was occurring daily. My fear was that market 
timing abuse and exploitation of the mutual funds were not only 
an accepted practice at Putnam, but that my understanding of 
the darker side of human nature and the research I had done 
told me it may be an accepted practice for those with influence 
and money throughout the mutual fund industry. For years no 
news was good news for both the mutual fund industry and the 
regulators who had oversight responsibilities.
    A tangled web has been woven, and from my perspective in 
the mutual fund scandal, it is an imperative that we fully 
understand the scope and the depth of those abuses. of 
fiduciary malfeasance and the lack of proactive regulating. 
These abuses should have been brought to light years ago.
    Senators, the important part of my testimony is not about 
my family and I, but it is more importantly about what happened 
to me on this road not traveled by others. Every step in this 
fight has been met with an imposing force. That is, until I met 
with Massachusetts Deputy Secretary of State Matthew Nestor. 
Mr. Nestor immediately understood the magnitude of what I was 
presenting to him, and also understood the immensity of the 
burden that I carried. I put my welfare and the welfare of my 
family aside because of the importance of bringing to light 
this behavior.
    I must emphasize that there were thousands of decent, 
honest, hard-working Putnam employees who live in the area I 
call my home, and most if not all, had no knowledge of the 
abuses I speak of, yet their lives could be greatly impacted as 
well. In my neighborhood there is outrage. We have read that 
the American public does not seem to have great concern because 
of the inflows of monies to the funds. The American family, who 
is being responsible for their future retirement needs and 
their children's higher education have no other choice. For 
them, mutual funds are the only game in town, and they realize 
that however lopsided that game may be, they have to 
participate. They know it is time in the market, not timing the 
market that will help them reach their goals. Families are 
working two jobs, taking care of their children, and deeply 
concerned for the world they live in. They have no time and 
energy left to protest in the streets over the mutual fund 
    Senators, let me commend you for your deep concern and 
understanding of the issues that face the American worker, who 
is the taxpayer and who ultimately is the long-term investor. 
Every single day they are getting nickeled and dimed to death, 
and through no fault of their own they are being scammed on 
such a daily basis their heads are spinning. Here we are, the 
very lifeblood of our economy, and to think that there are some 
of the many who manage the mutual fund industry think the 
contributions entrusted to them are theirs to divvy up amongst 
themselves is outrageous. The longer it takes mutual fund 
companies that are under scrutiny to address their past, the 
longer it is going to take them to move ahead, if they can move 
ahead at all. For a CEO to leave Putnam Investments in such a 
horrendous state, risking the livelihoods of all the innocent 
rank and file has to be a crime.
    Individuals in these corporations need to be held 
accountable. Consequences need to be imposed and licenses need 
to be yanked. If you do not care about your neighbor, you need 
to get out of the mutual fund business. And for those who do 
not think market timing is not a real problem, I believe we 
should think again. After I read Stanford University Professor 
Eric Zitzewitz' study on market timing, I was not surprised. I 
was validated. But there was one question that was not 
addressed that I thought was critically important, so I gave 
Eric a call and asked him quite simply, ``Did market timing in 
the last 5 years contribute to the historic volatility we have 
experienced affecting all markets?'' His answer was, ``Sure it 
did, but it would be unquantifiable.''
    So that means we permitted a select group, not just market 
timers but those who allow market timing, to affect our markets 
in a way we will never fully understand, and that is a very 
troubling thought.
    Mutual fund trading abuses and hidden fees can be curtailed 
with the appropriate regulation, but there is one form of 
uncovering abuse that has yet to be suggested. As the Federal 
Government has in place a very effective Whistleblower Statute 
for the monies we entrust the government to spend, so too 
should there be a replicated statute for the securities 
    The Sarbanes-Oxley Act of 2002 will not inspire those who 
may want to come forward but are not willing to risk their 
careers and maybe more. Every regulator that I have spoken to 
has said: Peter, it is going to take an insider like you to 
make a difference. It is the proverbial needle in a haystack, 
and with the technologies available today, as well as future 
technologies, which will magnify thousands of times, we can 
make the difference. Maybe the next person to step up to the 
plate may have even more to offer than a former waiter from 
Boston's North End,
    Senator, as I have read to you and submitted my previous 
testimony, I have been dismissed by a CPA, a CEO and the SEC, 
and all of them more than likely regret it. I was bashed in the 
head for the American investor.
    It is our once in an investor's lifetime opportunity now to 
level the playing field. I remember Matt Nestor saying that he 
worked on the side of the angels, and to do effectively you 
must think like the devil. Let us not close the back door to 
have offenders slip in the side window. There will always be 
those who will try to take what is not rightfully theirs.
    I would like to thank you once again for allowing me to 
present these issues for your consideration, and it is truly a 
privilege and an honor for me to do so.
    Senator Fitzgerald. Thank you for being here, Mr. Scannell. 
Mr. Nesfield.


    Mr. Nesfield. My name is James Nesfield. I have worked in 
the securities industry at various levels since 1978. In 1999, 
I was approached by Hartz Trading, later to be named Canary 
Capital, to find brokerage firms, trust companies and mutual 
fund managers that would be willing to accept large orders at 
frequencies generally not available to the average shareholder. 
This activity is known as market timing. A critical feature is 
permission by funds managers or a way to hide the volume of 
frequency of the transactions from the fund managers, thereby 
avoiding being blocked.
    \1\ The prepared statement of Mr. Nesfield and Mr. Grigg appears in 
the Appendix on page 150.
    In 5 minutes of testimony I will not be able to relay the 
intricacies and techniques developed by timers, mutual fund 
managers, administrators, and other agencies to thwart 
detection. It has taken hours and days of multiple 
communications to convey my knowledge to the AG's Office. My 
job was to find those that would bend the rules for Canary 
because they were richer and could provide a quid pro quo of 
investing in other funds or private equities or separate 
accounts operated by the fund managers.
    I found these people simply by reading the news, public 
directories and searching for their E-mails. Most people within 
the fund industry hated timers, as that was the official 
doctrine. I found as I got closer to the upper levels of 
management, the morality was gray and easily shaded by 
immediate need or greed. The same is true of brokerage firms 
and trust companies. It is the golden rule that he who has the 
gold rules, and if you want a friend get a dog.
    No support staff member sets out to originally break a law 
or help the boss break a law. There is a slow process of 
inclusion, indoctrination, that pulls the helpers into the 
complex web. It was that naive perspective that would convince 
me that the founders and former managers of Hartz Mountain Pet 
Food were pursuing legitimate investments. Lawyers had vetted 
them with opinions on the strategy, and it was shocking to 
learn these pillars of society were violating laws.
    Because I worked from my home in North Carolina I learned 
from the newspapers that Mr. Stern, the Chief Executive at 
Canary Capital, had computers in his office connecting directly 
to the mutual funds, and he was purloining portfolio inside 
information from them and making investments with every edge 
imaginable. While it was a secret shared by many mutual funds 
that the Sterns were late timing and receiving portfolio inside 
information, the pawns were not enlightened. Each knew their 
part. None could fathom the entire picture. Although any one 
could see if they examined the NSCC FundServ system, that late 
trading was possible and easily transacted.
    I was never once at a meeting with Mr. Stern or a mutual 
fund manager or had any other significant business contact 
through Mr. Stern. I was never given information about the 
trades except after they were complete and mismarked in 
execution to hide the true time of execution so that no one 
would know. A good conspiracy rotates on its ability to keep 
the critical elements apart. Canary Capital kept staff 
separated from both trading parties and from senior management. 
Even Noreen Harrington, who is another mutual fund 
whistleblower, only reported suspicions by overhearing some 
mutual fund lingo on the trading form. I filled in technical 
detail and produced the errant confirms, but the AG still had 
to find the extent of the trading through subpoena.
    Even today it is unclear if the $40 million penalty was 
commensurate with the profits on and offshore.
    I may not have originally understood all the parts of Hartz 
Mountain's operations, as we had come to know them, because I 
was not the accountant or the trader with direct responsibility 
for transactions. But once I understood the severity of these 
allegations without legal representation, as I still am here 
today, I came forward to inform completely. I like to think 
that if I knew earlier, I would have come forward voluntarily. 
Indeed, in December 2002, I filed a form CA-1, a Form 1 with 
the SEC outlining potential industry abuses, a way to stop them 
through automation.
    The lesson here is that if there is a legislative solution, 
it is that mutual funds needs to be regulated on par with 
broker-dealers as they occupy a strange place of issues, 
investment advisor, and in many cases points of distribution. A 
coordinated regulatory regime and checks and balances must be 
established for mutual funds that can be verified in a robust 
manner. The lack of expenditures by mutual funds for compliance 
and critical self assessment warrants concern and suggests an 
almost intentional neglect of public trust.
    I also hope that the Securities and Exchange Commission 
will review its duty to the public in the strictest terms as 
well. If legislation is passed in this Congress, the SEC should 
take care to consider the best interest of the investor first 
and foremost in implementing any legislation.
    Too many times I have seen legislative mandates watered 
down by interpretations of agencies implementing them. The 
mutual fund industry should have a higher level of disclosure 
and inspection since the shareholders are not protected by the 
Security Investor Protection Act. Mutual funds are exempted.
    Thank you.
    Senator Fitzgerald. Mr. Nesfield, you have come forward and 
given your story to the New York Attorney General's Office, as 
I understand it. You cooperated with Attorney General Spitzer's 
office, and ultimately your cooperation, as well as that of a 
couple of others led to the charges that were announced in 
early September of this past year against Canary and others.
    Did the Attorney General grant you immunity?
    Mr. Nesfield. No.
    Senator Fitzgerald. Apparently because of your cooperation, 
they have not pursued any criminal charges against you for your 
    Mr. Nesfield. No, there has been none.
    Senator Fitzgerald. What were you doing before 1999? You 
were a consultant of some sort?
    Mr. Nesfield. Before I went to work for Canary I worked at 
SIPC liquidation in Longview, Texas.
    Senator Fitzgerald. What did they do?
    Mr. Nesfield. SIPC is the Security Investors Protection 
Corp. A brokerage firm had gone under, and I was working for 
the trustee.
    Senator Fitzgerald. OK. You were hired as a consultant by 
the trustee?
    Mr. Nesfield. Yes.
    Senator Fitzgerald. When you were hired by Canary, were you 
hired as an outside contractor or as an employee?
    Mr. Nesfield. Outside contractor.
    Senator Fitzgerald. Outside contractor. Who at Canary hired 
    Mr. Nesfield. I was contacted by Andrew Goodwin.
    Senator Fitzgerald. Andrew Goodwin.
    Mr. Nesfield. Yes.
    Senator Fitzgerald. What is his position or was his 
    Mr. Nesfield. He was one of the traders there.
    Senator Fitzgerald. He was one of the traders.
    Mr. Nesfield. Yes.
    Senator Fitzgerald. What did he say to you? Did he call you 
up on the phone? How did he find your name?
    Mr. Nesfield. He basically saw my resume on the Web and it 
lists a number of skill sets I have in regards to some of the 
technical aspects of the business.
    Senator Fitzgerald. He called you up. What did he say?
    Mr. Nesfield. ``I would like to meet with you. I will pay 
you,'' basically, if you want to----
    Senator Fitzgerald. Did he tell you what he was interested 
in over the phone?
    Mr. Nesfield. No.
    Senator Fitzgerald. So he met with you in his office at 
    Mr. Nesfield. I went up to Secaucus, New Jersey and met 
with him, Eddie Stern and Noah Lerner.
    Senator Fitzgerald. And Mr. Stern----
    Mr. Nesfield. Yes.
    Senator Fitzgerald [continuing]. Was in the room. And Mr. 
Stern and Mr. Goodwin?
    Mr. Nesfield. Yes.
    Senator Fitzgerald. And a lawyer?
    Mr. Nesfield. No. Noah Lerner. He is another gentleman that 
worked with Mr. Stern.
    Senator Fitzgerald. Noel Lerner?
    Mr. Nesfield. Noah, as in the boat.
    Senator Fitzgerald. Noah, OK. Noah Lerner, Mr. Stern and 
Mr. Goodwin, they met with you?
    Mr. Nesfield. Yes.
    Senator Fitzgerald. What did they say to you in that 
    Mr. Nesfield. They basically said, ``We do market timing.'' 
I knew what it was. I had talked to somebody else. This might 
have been 5 years before that I knew about market timing. And 
somebody had approached me to--mutual fund companies had 
started implementing automated means of detecting market timing 
activity so they would be able to block those orders or stop 
timers. If you look at the design of the system that is used to 
put orders in for mutual funds, there is a way to subvert that, 
and essentially that is what they hired me to do.
    Senator Fitzgerald. Did you advertise your ability to help 
them engage in market timing?
    Mr. Nesfield. No.
    Senator Fitzgerald. They called you in. You did not know 
exactly what they wanted to hire you for, and then they 
explained to you, ``We do market timing. Can you help us?''
    Mr. Nesfield. You have to understand market timing is not 
illegal, correct?
    Senator Fitzgerald. Maybe illicit. Could be illegal in 
certain circumstances.
    Mr. Nesfield. It is what you call gray, is that correct?
    Senator Fitzgerald. Well, it could be illegal in certain 
circumstances. If Mr. Stern, as you said in your opening 
remarks, was receiving insider portfolio information----
    Mr. Nesfield. I did not know that directly. I learned that 
in the paper.
    Senator Fitzgerald. You did not know that by working there?
    Mr. Nesfield. No. I never put an order in for Mr. Stern. I 
was never--as I said, I never had direct knowledge.
    Senator Fitzgerald. OK.
    Mr. Nesfield. I knew all the technical aspects of it, but 
that is why Mr. Spitzer's office had to go and get Mr. Goodwin 
because Mr. Goodwin had the direct knowledge.
    Senator Fitzgerald. So when they were hiring you, you did 
not view this as them asking you to help them with any illegal 
    Mr. Nesfield. Basically, just find people, find the people 
that had access to this.
    Senator Fitzgerald. What did you tell them? Did you tell 
them you thought you could help them with that?
    Mr. Nesfield. I knew I could.
    Senator Fitzgerald. You knew you could.
    Mr. Nesfield. Yes.
    Senator Fitzgerald. That you knew the processes at mutual 
funds and you would be able to sift out the ones that would----
    Mr. Nesfield. Well, it is not just mutual funds, OK?
    Senator Fitzgerald. OK.
    Mr. Nesfield. Anybody that is an NSCC FundServ 
    Senator Fitzgerald. NSCC?
    Mr. Nesfield. Right. National Security Clearing Corp.
    Senator Fitzgerald. OK.
    Mr. Nesfield. Anybody that is an NSCC FundServ participant 
can time mutual funds with or without the permission.
    Senator Fitzgerald. OK.
    Mr. Nesfield. So Mr. Bogle's fund was timed.
    Senator Fitzgerald. Did they tell you at that meeting how 
much they would pay you? Did you settle on an arrangement?
    Mr. Nesfield. Yes. $50 an hour to start.
    Senator Fitzgerald. So you were paid by the hour?
    Mr. Nesfield. Initially, yes.
    Senator Fitzgerald. Initially.
    Mr. Nesfield. Yes.
    Senator Fitzgerald. Did that fee later go up?
    Mr. Nesfield. About 2 weeks later.
    Senator Fitzgerald. What did it go up to?
    Mr. Nesfield. It went on a percentage of assets they put 
into timing capacity channels I had found.
    Senator Fitzgerald. What was that percentage?
    Mr. Nesfield. A tenth of 1 percent or 10 basis points.
    Senator Fitzgerald. You got 10 basis points. That is the 
total expense ratio for the Government Thrift Savings Plan.
    Mr. Nesfield. Well, I worked harder. No.
    Senator Fitzgerald. How much money did you make doing this?
    Mr. Nesfield. Over 4 years, maybe between $250,000 and 
    Senator Fitzgerald. Over 4 years?
    Mr. Nesfield. Yes.
    Senator Fitzgerald. How much in total assets did you find 
market timing capabilities for them?
    Mr. Nesfield. I do not know. A great deal. I was not paid 
on some of it.
    Senator Fitzgerald. You were not?
    Mr. Nesfield. No.
    Senator Fitzgerald. Did they owe you money at the end?
    Mr. Nesfield. Well, Mr. Stern has a funny way of accounting 
for things. He owes me money and he owes Mr. Goodwin money as 
    Senator Fitzgerald. How much money do you think you are 
    Mr. Nesfield. I do not know. I do not have full disclosure, 
but I mean if I take a guesstimate, not concerned about how it 
appears, he might owe me $3 million.
    Senator Fitzgerald. Do you have other clients that you have 
helped market time?
    Mr. Nesfield. No. Mr. Stern nailed me to an exclusivity 
    Senator Fitzgerald. Had you ever helped any other entities 
engage in market timing?
    Mr. Nesfield. Someone proposed the question to me years ago 
before Mr. Stern. I gave them my best answer and they would not 
take my advice.
    Senator Fitzgerald. So you have not done this, provided 
this service to anyone else?
    Mr. Nesfield. No.
    Senator Fitzgerald. Just for Canary Capital.
    Mr. Nesfield. Right.
    Senator Fitzgerald. It is quite a story. It is really an 
interesting story. You said that you wondered whether the fine, 
the $40 million penalty that the Attorney General's Office 
assessed on Canary, you wondered whether that was enough. How 
much do you think they made?
    Mr. Nesfield. I think the Attorney General's Office 
probably--this is my assumption, but they probably did not go 
and turn over every rock inside the Stern organization. I mean 
they probably trusted what was given to them for----
    Senator Fitzgerald. How big is the Stern Hedge Fund?
    Mr. Nesfield. It was $4 billion.
    Senator Fitzgerald. It was $4 billion. How big was it when 
you started in 1999?
    Mr. Nesfield. It was $300 million.
    Senator Fitzgerald. So it grew really fast?
    Mr. Nesfield. Yes, but it's not just----
    Senator Fitzgerald. With this market timing it was having 
abnormally high returns?
    Mr. Nesfield. They made 110 percent the first year.
    Senator Fitzgerald. One hundred seven percent?
    Mr. Nesfield. One hundred ten percent.
    Senator Fitzgerald. One hundred ten percent?
    Mr. Nesfield. Yes.
    Senator Fitzgerald. How about the second and third years?
    Mr. Nesfield. Diminished returns, 25 or 26 percent.
    Senator Fitzgerald. Is that because the fund was getting 
bigger and bigger?
    Mr. Nesfield. Yes.
    Senator Fitzgerald. Were they making most of their money 
from market timing or did they have some real good investments? 
And a lot of this--the market crashed in 2000, right?
    Mr. Nesfield. You have to understand, if you--the mutual 
funds need market timing. I mean nobody really understands. 
There is this organization called Reflow.com that has been 
funded by--what is his name--Getty, the oil guy, Gordon Getty? 
He started this investment advisory firm. What it does is it 
helps mutual funds deal with negative redemptions, and in some 
sense it was the prudent--I mean it sounds obtuse to say this 
at this point, but it was the prudent manager of the mutual 
fund who actually required cash, additional cash coming in from 
market timers to handle the impact of negative redemptions. So 
it is really a money management technique, even though when 
Stern does late timing, or anybody does late timing, it is 
    The fund manager, when--some fund managers like MFS ran a 
trading program or a timing program. When they were doing it, 
it was basically a means for them to borrow money short term in 
order to handle a falling market or negative redemptions. So 
while they might not ordinarily accept that, during a falling 
market, which we have experienced, which we are still in more 
or less, they are going to have to take some rather weird type 
of money management things. They have to get their money where 
they can get it.
    The other thing that happened is since 1999 the investment 
advisory companies collateralized their fees. There is actually 
bonds that are issued on the fee income derived from mutual 
fund managers. One of the reasons they are so adverse to having 
the assets under management go down is because it will affect 
their debt service on those bonds that they have written. You 
know, you can put your finger in the water, but it is a pretty 
mixed pond. There are a lot of things going on there. That is 
why when I hear people talk about legislative solutions, it is 
not so clear cut. It is not as easy to perceive--I mean it is 
not as easy as everybody would like to make it. It is very 
complex and it has got to be done carefully.
    Senator Fitzgerald. Let me ask you this. You started trying 
to search out mutual funds that would give market timing 
capacity to the Stern Hedge Fund.
    Mr. Nesfield. Right.
    Senator Fitzgerald. How many mutual funds did you find over 
the course of your 4 years there?
    Mr. Nesfield. Hundreds.
    Senator Fitzgerald. Hundreds?
    Mr. Nesfield. Yes.
    Senator Fitzgerald. What were the five biggest funds?
    Mr. Nesfield. Janus.
    Senator Fitzgerald. Janus.
    Mr. Nesfield. Invesco.
    Senator Fitzgerald. Invesco.
    Mr. Nesfield. AIM, A-I-M. That's part of Invesco.
    Senator Fitzgerald. A-I-M.
    Mr. Nesfield. Putnam.
    Senator Fitzgerald. Putnam?
    Mr. Nesfield. Yes. And that's all I can recall off the top 
of my head.
    Senator Fitzgerald. OK. But it was hundreds of them, so 
many that----
    Mr. Nesfield. Yes, everybody had a deal.
    Senator Fitzgerald. OK. But typically----
    Mr. Nesfield. Kinetic is another one, yes.
    Senator Fitzgerald. Who?
    Mr. Nesfield. Kinetic Funds. They're a small group of 
funds. Kinetic had one.
    Senator Fitzgerald. Kinetic.
    Mr. Nesfield. Yes.
    Senator Fitzgerald. So on your first go-round with these 
people, how would you--a lot of times you are turned down. Were 
there some that accepted you right away?
    Mr. Nesfield. Well, my motto--and it held true--is if you 
heard no, you didn't ask the right person, or you didn't ask at 
the right time.
    Senator Fitzgerald. Were there any that turned you down?
    Mr. Nesfield. Yes.
    Senator Fitzgerald. Who turned you down?
    Mr. Nesfield. Scudder. But I have recently found out in the 
newspaper that they had a timing program, so obviously it was 
the wrong time and the wrong person.
    Senator Fitzgerald. Scudder turned you down. Who else 
turned you down?
    Mr. Nesfield. Well, I was turned down by most of them. It 
is just I had to reapproach it--see who do you ask.
    Senator Fitzgerald. Who kept turning you down and never 
changed their mind?
    Mr. Nesfield. Nobody.
    Senator Fitzgerald. Oh, once you told them that you are 
huge, you are big, you are a multi-billion-dollar----
    Mr. Nesfield. Kind of like the same pick-up lines you use 
at a bar, yes. I am kidding around; it is a joke. I'm sorry.
    Senator Fitzgerald. So they all were agreeing ultimately. 
Were they putting any limits on you at Janus?
    Mr. Nesfield. They would have limits, but I didn't discuss 
them. They would--once the contact became like affirmed, if you 
will, then I turned it over to Mr. Stern, and he would 
negotiate with them.
    Senator Fitzgerald. And then Stern would negotiate with 
them personally?
    Mr. Nesfield. Yes. I didn't have the latitude to actually 
negotiate the deal.
    Senator Fitzgerald. Now, you probably made them, if they 
had 102-percent return the first year you came on board, you 
probably just made millions and millions of dollars for them, 
and all you got paid was $250,000 over 4 years.
    Mr. Nesfield. Just my luck, right?
    Senator Fitzgerald. Just your luck.
    Mr. Nesfield. Yes.
    Senator Fitzgerald. Mr. Scannell, turning to your 
experience with Putnam, you noticed large, repeated timing 
trades happening at Putnam, apparently in accounts of some 
union members?
    Mr. Scannell. Yes. Those are the ones that would stand out, 
Senator, only because of----
    Senator Fitzgerald. What union was it?
    Mr. Scannell. The initial union was the Joint Industry 
Board of Electricians. This was a 27,000-member union. That was 
in 2000, and probably almost 3 weeks into my employment after 
training, again, for a complete career change, this was very 
unique. I believe one of the things that made it stand out to 
me is because I didn't have a background in the financial 
services industry. They were marketing timing two tech funds, 
and they were being hurt significantly. They were losing 
literally thousands and thousands of dollars in individual 
accounts. These gentlemen had two, three, four hundred thousand 
dollars in their accounts. I've given examples in my testimony 
to you. And they just went away in 2000, September 2000, a 
little later. The NASDAQ just wouldn't provide enough recovery 
for the systems or the techniques that they're using to market 
    It was my belief that it was almost like scuttlebutt or 
what have you. They'd call up--I mean, these are hardworking 
guys. They'd call up between three and four, Hey, people, 
what's the NASDAQ doing? And, put me in, put me out.
    Senator Fitzgerald. They would call into your call center 
where you worked?
    Mr. Scannell. Exactly.
    Senator Fitzgerald. And initially you were probably helping 
some of them, not knowing what they were doing.
    Mr. Scannell. I was executing transfers at the request of 
participants and/or members, of which they were. This was 
something that many representatives brought up to our 
supervisors, and this was a----
    Senator Fitzgerald. Had you been trained to look out for 
    Mr. Scannell. Absolutely not. There was no training.
    Senator Fitzgerald. You had no training.
    Mr. Scannell. No. As a matter of fact, one of our concerns 
was, as the market was plunging in 2000, the mantra in the 
industry was diversity, suitability, really trying to get 
people to do it. And I'd address supervisors with that and 
would talk with preferred services specialists like myself who 
were becoming licensed and more educated in regards to the 
mutual fund industry and what detriment this was doing.
    Senator Fitzgerald. So did you understand the detriment to 
the other funds?
    Mr. Scannell. Absolutely. Before I even received my first 
    Senator Fitzgerald. At what point did you go--you went to 
supervisors at Putnam?
    Mr. Scannell. Yes.
    Senator Fitzgerald. Who was your supervisor?
    Mr. Scannell. I had many supervisors.
    Senator Fitzgerald. You had many supervisors.
    Mr. Scannell. Yes. It's a very high-turnover call center, 
and what happened was we actually became very adept at what we 
were doing. Putnam increased our ability to form multi-task and 
do the----
    Senator Fitzgerald. What did the supervisors tell you?
    Mr. Scannell. Just discouraging the discussion. Yes, 
stating we cannot give advice. We were always constantly 
being--it was trying to be told to us that there was a bill 
before the legislature that would allow us to give advice over 
the phone. I mean, it was fairly----
    Senator Fitzgerald. Just they would give you the 
    Mr. Scannell. Exactly.
    Senator Fitzgerald. Did you take it beyond your supervisors 
in the call center?
    Mr. Scannell. Yes.
    Senator Fitzgerald. Where did you go to?
    Mr. Scannell. Well, later on, discussing, again, after I 
received my Series 63, and Series 7 license, we became this 
preferred services unit where we encountered a different market 
timing strategy, and that was an international fund market 
timing. Now, this was a fund that the--it happened to be just 
another union. We had a lot of market timers at Putnam 
Investments throughout the 2,000 plans. But, again, because 
they had a technique and as a group they had the fund within 
their plan, they had the ability to market time.
    Senator Fitzgerald. And what union was this?
    Mr. Scannell. This was the Boilermakers Local 5.
    Senator Fitzgerald. In Boston?
    Mr. Scannell. No, it was not in Boston. I believe it was 
New York or New Jersey.
    Senator Fitzgerald. In New York or New Jersey?
    Mr. Scannell. Yes.
    Senator Fitzgerald. And you start getting boilermakers 
calling you.
    Mr. Scannell. Right. And, unfortunately for myself, the 
connotation unions, market timing, and what it's conjuring 
isn't the case. I mean, they had a technique that we allowed 
them to do. It was the International Voyager Fund, and any fund 
family that has their participants or members, as we describe 
union members, had a particular group of funds that they could 
invest in.
    Now, they had the ability to transfer those funds daily 
from an International Voyager Fund into a guaranteed investment 
contract fund. That was the technique. It was done 100 percent, 
as Mr. Nesfield was discussing. That was very common. The 
market going down was insignificant for transfers of Internal 
Voyager Fund and their ability to turn a profit.
    Senator Fitzgerald. So you began to wonder why your firm 
permitted this because you knew it was harming the other fund 
    Mr. Scannell. It was not only harming the other fund 
shareholders, but, again, I'm going back to the initial, Joint 
Industry Board for the Electrical Industry (JIB), that it was 
actually--we were allowing--I compared it to a pharmacist--and, 
again, not the boilermakers--refilling a prescription over and 
over again knowing that it's doing great harm to somebody.
    Senator Fitzgerald. Was anybody else in your call center as 
concerned as you?
    Mr. Scannell. Absolutely.
    Senator Fitzgerald. And did anybody else do anything?
    Mr. Scannell. Absolutely. We brought it up to the 
attention--of senior management. It was discussed in front of 
one senior manager that said it wasn't criminal in a preferred 
services specialist meeting where one of my peers brought it to 
their attention. We had a great buffer between senior 
management for obvious reasons.
    Senator Fitzgerald. But you did get in to see the senior--
    Mr. Scannell. Well, we were at a meeting, and it was 
brought up.
    Senator Fitzgerald. With the senior manager there.
    Mr. Scannell. Exactly, and his reply was it's not criminal.
    Senator Fitzgerald. Who was that senior manager?
    Mr. Scannell. His name was Robert Capone.
    Senator Fitzgerald. Like Al Capone.
    Mr. Scannell. Exactly.
    Senator Fitzgerald. OK. And you brought it up to Mr. 
Capone, and what did Mr. Capone say?
    Mr. Scannell. It was brought up to Mr. Capone by another 
representative in front of another senior vice president, and a 
human resources representative----
    Senator Fitzgerald. Is Mr. Capone still there?
    Mr. Scannell. I believe so.
    Senator Fitzgerald. He is?
    Mr. Scannell. I believe so. I'm not sure.
    Senator Fitzgerald. OK. It was brought up at one of those 
meetings. You weren't the one who brought it up. Someone else 
brought it up.
    Mr. Scannell. Yes.
    Senator Fitzgerald. And his response was? Mr. Capone's----
    Mr. Scannell. It's not criminal.
    Senator Fitzgerald. It's not criminal so don't worry about 
    Mr. Scannell. It was very shocking to hear him say that.
    Senator Fitzgerald. OK.
    Mr. Scannell. But that he would say that in front of us--
for myself, understand as well that----
    Senator Fitzgerald. Was this after-hours trading or market 
    Mr. Scannell. This is market timing.
    Senator Fitzgerald. OK.
    Mr. Scannell. And it could be just as successful as after-
hours trading with an international fund. Again, it's well 
known now, we all seemingly have a good idea of market timing. 
It does not take a positive movement in the market. It just 
takes taking advantage. It's the arbitrage that's available.
    Senator Fitzgerald. OK. So after it was brought up to Mr. 
Capone and he just said it's not illegal and dismissed it, then 
what? Did you or your----
    Mr. Scannell. One of the representatives, again, who--and 
because he's still working there actively, I'd rather not 
mention his name. He confronted a supervisor with a spread 
sheet. I already had a spread sheet active in my--an Excel 
spread sheet. I was tracking them. I knew that they knew I was 
tracking them. Everything that I did was monitored, whether it 
was on my computer or on my phone--everything.
    So I was putting myself in a position that, well that's----
    Senator Fitzgerald. Did anybody tell you, warn you off, to 
quit pursuing this line?
    Mr. Scannell. Well, what happened--no, they wouldn't. But, 
again, it wasn't applauded. And the efforts--one of the 
interesting things was that we were constantly told that there 
is not a system to do this. And that was for a number of years.
    And back to your point about another supervisor, I put this 
spreadsheet together, and I actually gave them the account 
numbers of market timers, and nothing was ever done. That's 
when I decided that I need to take my time and make sure I 
provided all the documents I could not only to protect myself 
but to expose Putnam. And I found internal documents that 
suggested Putnam was aware of this in 2000.
    Senator Fitzgerald. You then went to the SEC?
    Mr. Scannell. Exactly.
    Senator Fitzgerald. Was that the first place you went?
    Mr. Scannell. Yes.
    Senator Fitzgerald. OK. And when did you go to the SEC?
    Mr. Scannell. I went to the SEC at the end of March. First 
I went to--I have a brother who is an attorney, and he said, 
``You need a securities attorney.'' And I was fortunate enough 
to find a firm in town, and she happened to be an employment 
specialist. It was through a family friend. So it was decided 
in March that I would go to the SEC and provide them the 
    Senator Fitzgerald. Did the lawyer go with you?
    Mr. Scannell. Well, there was some discussion first. 
Evidently this wasn't incredibly welcome news, and it was 
described what I did have, a very compelling and succinct 
anthology of what I believed was something disturbing at Putnam 
    It took a number of communications, as I provided in my 
testimony, before they would even meet with my attorney. I 
wanted to remain--my identity to remain confidential. 
    Senator Fitzgerald. OK. So they didn't meet--you didn't go 
initially to the SEC?
    Mr. Scannell. We had a number of communications through my 
    Senator Fitzgerald. Through your attorney.
    Mr. Scannell. There was about seven.
    Senator Fitzgerald. Seven, before they met with her?
    Mr. Scannell. Before they met with her, three attorneys on 
76 Tremont Street.
    Senator Fitzgerald. And how long did that take?
    Mr. Scannell. That was in April.
    Senator Fitzgerald. So you started this process at the end 
of March, and by April----
    Mr. Scannell. April 24, I believe it was.
    Senator Fitzgerald. April 24, your attorney----
    Mr. Scannell. I finally was able to meet with them. This 
was happening----
    Senator Fitzgerald. Did they meet with your attorney first?
    Mr. Scannell. They met with my attorney first. I believe it 
was on April 14.
    Senator Fitzgerald. OK. And they were interested?
    Mr. Scannell. Again, they came back to me--I mean, my 
attorney came back to me, and there was some more discussion. 
They did not agree to meet with me yet.
    Once I met with them, I needed to provide them with the 
prospectuses of the funds that I was concerned about, and in 
doing so, obviously identify myself. There was a number of 
websites out there and there was a number of people at Putnam 
Investments that knew that it was me that was----
    Senator Fitzgerald. Now, it wasn't necessarily illegal 
activity you were bringing to their attention, but perhaps 
activity that----
    Mr. Scannell. It wasn't mine to judge that it was illegal. 
I was just seeing--I was seeing something that I didn't believe 
was in the best interest of initially the actual members doing 
it and losing hundreds of thousands of dollars.
    Senator Fitzgerald. Did it contradict the promises in the 
    Mr. Scannell. That was interesting. When I met with three 
attorneys from the SEC, they handed me back the prospectus that 
I gave them and asked me what my opinion was of it. I found 
that, as not an attorney, I read very clearly that it stated 
that short-term trading--this was not a vehicle for short-term 
trading. It would be prohibited. Putnam would do anything 
within its management ability to curtail or to stop or to 
refuse transactions, whether it was from one fund to another.
    Senator Fitzgerald. So there is the violation, they 
advertise in their prospectus that they discourage this market 
timing, but then you see them allowing it every day.
    Mr. Scannell. And there was also a disclaimer in it that 
said--there was a 1-percent redemption fee, which we now know 
that that would not stop market timing, a 1-percent redemption 
    Senator Fitzgerald. Were they imposing that redemption fee 
or they were----
    Mr. Scannell. That 1-percent redemption fee would not be 
imposed to anybody in a 401(k) Putnam-managed fund, omnibus 
plan, or variable annuity.
    Senator Fitzgerald. OK.
    Mr. Scannell. So that was kind of where it started to point 
me. Well, let's get into a Putnam plan, and if you don't have 
to worry about tax consequences, if you don't have to worry 
about redemption fees, you are all set.
    Senator Fitzgerald. OK. So you meet April 24 with the SEC?
    Mr. Scannell. Yes.
    Senator Fitzgerald. You personally meet. Then what happens?
    Mr. Scannell. With my attorney. We had a meeting for an 
hour and a half. They thanked me for my courage. And I went on 
my way.
    Senator Fitzgerald. Did you hear from them again?
    Mr. Scannell. My attorney contacted them in about 2 weeks. 
There was nothing to report. Then it went on for about 3 weeks, 
another 3 weeks. I asked her to contact them, and previously 
they asked me if I was going to be going anywhere else, to let 
them know first. And then for whatever reason, it was 
communicated through my attorney that they're not interested in 
updating me or keeping me abreast. All the while I knew that 
market timing was continuing at Putnam Investments.
    Senator Fitzgerald. And at what point did you then go to 
somebody else, the Secretary of State's office?
    Mr. Scannell. September 11, 2003. I met with Matt Nestor in 
the Federal Reserve Building where my attorney's offices are.
    Senator Fitzgerald. And that was after the charges had been 
brought in New York against Canary, which Mr. Nesfield has 
worked for?
    Mr. Scannell. Yes, right about that time.
    Senator Fitzgerald. OK. And then you got the idea, you saw 
a State attorney general was pursing this in New York.
    Mr. Scannell. Yes, and I had a lot of admiration for what 
Attorney General Spitzer was doing. At the same token, our 
Secretary of State William Galvin was investigating Prudential 
Securities before that for brokers--I believe it was trading 
after hours.
    Senator Fitzgerald. OK.
    Mr. Scannell. So obviously I went to my----
    Senator Fitzgerald. And the Secretary of State, Mr. 
Galvin's office, got on it right away in September.
    Mr. Scannell. Well, in about 4 hours after having met with 
Matthew Nestor, who I informed, that the SEC never got back to 
me and seemingly was not interested. From what I believed and 
from the market timing I knew was continuing, he assured me 
that William Galvin's office wouldn't behave like that, they 
would be acting on this. He was very impressed with the 
    Senator Fitzgerald. Are you still working at Putnam?
    Mr. Scannell. No, I'm not. Excuse me. I am on disability 
from Putnam Investments. I was assaulted over what I believe 
    Senator Fitzgerald. When did you go on disability?
    Mr. Scannell. February 2.
    Senator Fitzgerald. OK. So you were bringing these concerns 
to the SEC after you had gone on disability?
    Mr. Scannell. What happened to me right before February 2, 
I compiled my information and left, knowing--and telling a 
supervisor, an assistant vice president there, that I'd no 
longer be accepting transactions for known market timers. I was 
told to be careful and I had to do what I had to. It was the 
following Sunday at a meeting that I regularly attended that I 
was assaulted by somebody that I believed was trying to make 
me--the person who assaulted me looked like they were a 
Boilermaker Local 5 member.
    Senator Fitzgerald. When were you assaulted?
    Mr. Scannell. The following Sunday, February 2.
    Senator Fitzgerald. On February 2.
    Mr. Scannell. My disability is from my assault.
    Senator Fitzgerald. Your disability is from your assault?
    Mr. Scannell. Yes.
    Senator Fitzgerald. And you had been raising concerns 
within Putnam?
    Mr. Scannell. And downloaded documents and, again, that 
they're well aware that I did, once I left. People were aware 
that I was--I wasn't going to----
    Senator Fitzgerald. Where did the assault occur?
    Mr. Scannell. In Quincy, Massachusetts.
    Senator Fitzgerald. OK, and you believe it related to your 
whistle-blowing activities within Putnam?
    Mr. Scannell. Yes.
    Senator Fitzgerald. Who do you think were----
    Mr. Scannell. Actually, I feel kind of uncomfortable 
talking about this in detail, Senator. I've included that in my 
testimony to you very----
    Senator Fitzgerald. OK.
    Mr. Scannell. In descriptive form. It's another incredible 
coincidence, and that's something that a lot of people have 
wanted me to believe that all these coincidences are just 
that--coincidences. And I'm concerned that there's more to it 
than that.
    Senator Fitzgerald. Did you tell the SEC when you met with 
them that you had been assaulted?
    Mr. Scannell. Yes.
    Senator Fitzgerald. And that you thought it related to 
    Mr. Scannell. Yes.
    Senator Fitzgerald [continuing]. Complaints. OK. Well, I 
compliment you on your courage. I compliment both of you for 
coming forward. I think you have done a great public service by 
helping shed a spotlight on the experiences that you two had 
within the industry. A lot of this is difficult for people 
outside the mutual fund industry to understand technically how 
some of these activities, the market timing and late trading, 
actually occur. And both of you show a lot of courage by coming 
forward, testifying before Congress, and we certainly 
appreciate it.
    Mr. Scannell, we do have your full statement for the 
record, and we can read the details there. And if you have more 
ideas, please feel free to be in touch with my office as all of 
this progresses.
    Is there anything else either of you would like to add 
before we close up? Well, if not, we will allow you to get on 
your way, and thank you very much.
    Mr. Nesfield. Thank you, Senator.
    Mr. Scannell. Thank you for the opportunity, Senator.
    Senator Fitzgerald. OK. We are set to begin the third 
panel, and I want to begin by thanking all of you for your 
patience. You have probably been waiting here since the first 
panel, and I know it has been a long day. And I am sure many of 
you traveled a long way as well in the inclement weather, so we 
appreciate all that you have done to be here.
    Our first witness on the third panel is Jeffrey C. Keil, 
who is vice president of Global Fiduciary Revier at Lipper, 
Incorporated, headquartered in Denver, Colorado. Mr. Keil has 
been analyzing the mutual fund industry for the past 12 years 
and has specialized in mutual fund fees and expenses as well as 
regulatory and disclosure issues.
    Last week, Lipper released a study on the feasibility of 
eliminating the 12b-1 fees that mutual fund companies charge to 
cover costs such as marketing and advertising and 
reimbursements to brokers for distributing their funds. We look 
forward to hearing from Mr. Keil on Lipper's findings in their 
    Our second witness is Travis B. Plunkett, who is the 
legislative director at the Consumer Federation of America. The 
Consumer Federation of America is an association of 300 
organizations that work to promote and protect the consumer 
interests by engaging in advocacy, education, and network 
building. Mr. Plunkett's focus at the CFA is on financial 
services, including credit reporting, credit counseling, and 
consumer privacy and insurance.
    Our third witness is Paul S. Stevens, who is a partner at 
Dechert LLP, in the firm's financial services group. Mr. 
Stevens is with us today on behalf of the Investment Company 
Institute, known as ICI, where he served as senior vice 
president and general counsel from 1993 to 1997. While serving 
in this capacity, Mr. Stevens is credited for leading the ICI 
in its efforts to support passage of the National Securities 
Markets Improvement Act of 1996, as well as in the adoption of 
mutual fund disclosure reforms by the SEC and the formation of 
new industry standards on personal investing. In his position 
at Dechert, Mr. Stevens leads the firm's practice in the areas 
of mutual fund governance and bank/broker-dealer activities.
    Our fourth witness on this panel is Marc E. Lackritz, who 
is the President of the Securities Industry Association. The 
Securities Industry Association represents the shared interests 
of over 600 securities firms, including mutual fund companies, 
investment banks, and broker-dealers. Mr. Lackritz has a great 
deal of experience in the securities industry, having served 
not only as SIA president since 1992, but also as executive 
vice president to the organization and as executive vice 
president at the Public Securities Association, which is now 
known as the Bond Market Association.
    And, finally, with us today is Professor John Freeman of 
the University of South Carolina School of Law. Professor 
Freeman was referred to in remarks by Attorney General Spitzer. 
Professor Freeman holds the John Campbell Chair in Business and 
Professional Ethics and has taught courses in legal ethics and 
securities laws for the past 30 years. Professor Freeman has an 
extensive background analyzing mutual fund and other investment 
issues, and he recently co-authored an extensive study entitled 
``Mutual Fund Advisory Fees: The Cost of Conflicts of 
Interest.'' That was the report Attorney General Spitzer was 
referring to.
    Again, I would like to thank each of the witnesses for 
being here, and in the interest of time, if you could all be 
kind enough to submit your written remarks for the record and 
we will include those remarks as part of the permanent record 
of this Subcommittee hearing, and if you could summarize those 
remarks in no more than a 5-minute opening statement, we would 
greatly appreciate it.
    So, Mr. Keil, we will begin with you. Thank you for being 


    Mr. Keil. My pleasure. Thank you, Chairman Fitzgerald. 
Lipper appreciates the opportunity to be here and address the 
Subcommittee today.
    \1\ The prepared statement of Mr. Keil appears in the Appendix on 
page 179.
    I wish to address four issues vital to the business today 
in the next few minutes: Lipper's recent study on 12b-1 fees; 
generally on fees and expenses of mutual funds; costs opaque to 
investors; and fund governance. My aim is to clear up some 
misperceptions about these particular topics and outline some 
recommendations for reform.
    First, with regard to 12b-1 fees, several misperceptions 
will require a bright light at this time. Rule 12b-1 fees 
frequently are referred to as an advertising and marketing fee 
borne by investors. Frankly, 95 percent of the fees pay for 
sales charges, investor service fees, and administration, while 
only 5 percent actually pay for advertising and promotion.
    Second, given this particular reality, saying the 12b-1 
sheets should create commensurate economies of scale through 
asset growth is effectively outdated since advertising and 
promotion is only 5 percent.
    Finally, funds closed to new investors must continue to 
provide certain service to investors covered by the 12b-1 plan. 
Hence, some plans should be--are justified for closed funds.
    Briefly, the highlights of our study on Rule 12b-1 
recommendations update the factors that boards should consider 
when reviewing and continuing 12b-1 plans, issue more 
definitive guidelines as to acceptable 12b-1 expenditures, 
provide more investor transparency on the specific uses of 12b-
1 fees, and commission a study that considers whether sales 
charges, meaning commissions to brokers actually under the 
rules, should be removed from underneath Rule 12b-1, and 
generally recraft Rule 12b-1 to account for today's market 
realities, as it is woefully outdated at this point. It hasn't 
been updated for about 23 years, if I'm correct. I believe I'm 
    Copies of our 12b-1 study have been provided in its 
entirety to the Subcommittee for your review.
    With regard to funds' management fees and expense ratios, 
based on Lipper expense data, most shareholders are not paying 
more in both management fees and total expenses than they were 
10 years ago. Using funds' size-weighted ratios, fees for most 
investors have not risen. When simple average ratios are cited 
to the investing public and through the press, they are highly 
skewed by a larger proportion of very small funds not held by 
the vast majority of investors.
    To the point about pension funds and mutual funds, we would 
maintain that funds do not necessarily pay substantially more 
in advisory fees than pension funds do. We have maintained that 
a more definitive study still needs to be authored that 
uncovers all reasonable benchmarks to the extent that the data 
actually is available, which is one of the limitations that the 
data are not available to a large extent; hence, the ICI study 
using sub-advisory comparisons.
    A full 1.5-percent difference between the industry-wide 
median total expense ratio and a much lower ratio weighted for 
fund size indicates that size economies are being passed to 
investors. That obviously doesn't address the actual amount of 
the fee, but there are economies of scale that do exist in this 
business. I see it on a daily basis.
    Finally, to extend the economies-of-scale argument to an 
entire fund business based on aggregate assets of the business 
is illogical. Scale is realized on the fund and the complex 
level only, not the entire business. This business has quite a 
few hundred variable very small fund complexes which have not 
reached any serious asset threshold, and there are very few 
economies to be had. Simple as that.
    As far as Lipper's recommendations, we support initiatives 
to report hypothetical expense levels in dollars in shareholder 
reports. We suggest an aggressive investor education initiative 
on cost impacts on returns be launched. That comes from 
comments earlier. Last, we feel enhanced disclosure should be 
provided in the prospectus on expense benchmarks. This comes 
from earlier discussion as well so that investors know, in 
relation to some type of average or index, what are they 
    With regard to costs opaque to investors, I would certainly 
echo the sentiment today that most of the lack of transparency 
centers around brokerage fees. There are very few 
misperceptions about brokerage fees because, frankly, there 
isn't a lot of disclosure about brokerage fees. We recommend 
transparency of all brokerage arrangements. That includes soft 
dollars, directed brokerage, etc.
    Boards should review all brokerage arrangements and ensure 
shareholder interests are protected. Regulation considering 
requiring the quantification of brokerage costs based on 
consistent algorithms across all complexes. And to the 
benchmarking comment, require brokerage costs be reported as a 
ratio in the prospectus alongside the total expense ratio, 
again, for comparative purposes.
    And, finally, with regard to fund governance, we recommend 
the following: We support the appointment of chief compliance 
officers reporting directly to independent trustees or 
directors. We also support calls for board administrative 
support and a 75-percent independent majority. We urge formal 
independent certification of board members' financial and 
fiduciary knowledge. Election of board chairpersons by 
independent board members would allow outside directors to 
determine whether they function more effectively with inside 
assistance or are hindered.
    We feel, in line with several comments today, we think that 
the general level of fiduciary duty of boards needs to be 
elevated. We do not feel, however, that advisory contracts 
should be put out for bid. We feel market forces and investor 
demand should set prices.
    We feel we can strengthen the current board structure 
through clear oversight guidelines. And probably the punch 
line, perhaps, of my oral testimony, we do not endorse or 
support punitive damages levied through indiscriminate advisory 
fee reductions unrelated to trading charges. Damages do not 
replace board activism. Rather, we feel if fees are reviewed by 
regulators as unreasonable, we feel a structured and equitable 
solution be designed to provide boards with a road map for 
ensuring reasonable costs are borne by investors and market 
forces are left to their own devices.
    In closing, we wish to caution legislators and regulators 
to proceed with care. Quickly assembled reforms may have 
unintended consequences and costs unforeseen during this period 
of improprieties and investor outcry. We fully support reform 
of the mutual fund business to the extent it bolsters 
competition, protects investors, and strengthens the business 
long term.
    Thank you.
    Senator Fitzgerald. Mr. Plunkett.


    Mr. Plunkett. Good afternoon. I am Travis Plunkett, 
legislative director of the Consumer Federation of America. I 
want to congratulate you, Mr. Chairman, and Ranking Member 
Senator Akaka, for holding hearings on a mutual fund scandal 
that does far more harm to its victims than the recently 
revealed trading abuses, as shocking as those are. That is the 
scandal of how mutual funds are sold to unsuspecting investors 
and the high costs that result.
    \1\ The prepared statement of Mr. Plunkett appears in the Appendix 
on page 205.
    My concern today is primarily with the nearly 50 percent of 
mutual fund transactions that are conducted between broker-
dealers and retail investors. What sets these transactions 
apart is the veneer of impartial advice that attaches to them. 
Despite their fancy titles and polished advertising campaigns, 
however, broker-dealers are not advisors. They are salespeople. 
And the overwhelming evidence now suggests that all too many 
brokers select mutual funds and other products they recommend 
not based on which offer the highest quality at the lowest 
price, but on which funds offer lucrative financial incentives 
to the brokerage firm and the individual sales representative. 
This is a phenomenon sometimes called ``reverse competition.''
    This is allowed to occur because only a relative small 
portion of the mutual fund marketplace could be said to be 
truly cost competitive right now, and that is the 13 percent of 
mutual fund transactions that occur directly between the fund 
company and the retail investor outside of any employer-
sponsored retirement plan.
    In the growing number of fund transactions that occur 
through retirement plans, however, investors generally have 
very limited options and, therefore, cannot effectively make 
cost-conscious purchase decisions. And in the rest of the 
market, funds that rely on broker-dealers and other salespeople 
outside of company-sponsored retirement plans, as I mentioned, 
this portion of the market competes in ways that drive costs to 
investors up, not down, through a number of mechanisms we have 
heard about today: Sales loads, 12b-1 fees, payments for shelf 
space, and directed brokerage. This allows mediocre, high-cost 
funds to survive and even thrive that could not do so in a 
truly competitive market.
    Another major factor undermining effective competition is 
the lack of good disclosure, either of mutual fund costs or of 
the conflicts of interest that can bias sales recommendations. 
For disclosures to be effective, they must provide the 
information investors need, in a form they can understand, at a 
time when it is useful to them in making their purchasing 
decisions. Mutual fund costs and conflict disclosures fail all 
three tests. In particular, they leave out key information, 
such as expense portfolio transaction costs.
    Now, let's talk a little bit about the SEC's regulatory 
response. Initially, the SEC was slow to acknowledge the need 
for fundamental cost disclosure and governance reforms. 
Although the Commission now appears to be making important 
progress on these and other issues, there are still serious 
gaps in their regulatory agenda. For example, the SEC does not 
have the authority to strengthen the definition of independent 
director, as legislation introduced by Senator Akaka and 
Chairman Fitzgerald would.
    Even if the Commission's promising disclosure proposals on 
broker conflicts of interest are offered--and we are waiting 
for the actual details there--they appear to have serious 
holes. We will not know for sure until the rule is proposed, 
but it does not appear that the Commission intends to include 
information about the non-distribution-related expenses of the 
fund, the annual expense ratio, in either the point-of-sale 
document or the confirmation statement. If the Commission is 
going to take the unprecedented step of requiring point-of-sale 
disclosure, it should do more to ensure that it covers all the 
information investors should have prior to sale, including 
information on investment risks, for example, and comparative 
information on fund costs, not just sales incentives. Congress 
should build on what the Commission has begun and ensure that 
all the key information investors need pre-sale is included in 
these reports.
    Chairman Donaldson has indicated the agency will study use 
of soft dollars, but the SEC does not have the authority to 
repeal the safe harbor for this unacceptable conflict of 
interest. Congress should.
    A major shortcoming of the SEC approach is that it relies 
exclusively on better disclosure of broker-dealer conflicts of 
interest rather than on bans of conflict-inducing practices. 
Such an approach ignores the fundamental reality of how 
investors relate to brokers and the degree to which they rely 
on them for advice. We doubt that even the best disclosures 
will be able to overcome multi-million-dollar advertising 
campaigns that encourage investors to view financial 
professionals as objective advisors. It is long past time to 
require brokers to either live up to the advisory image they 
project and accept the attendant responsibility to make 
recommendations that are in their client's best interest or to 
cease misrepresenting themselves to clients as advisors.
    One timely idea is to get mutual funds out of the business 
of determining distribution prices entirely, not just by 
eliminating 12b-1 fees, directed brokerage, and payments for 
shelf space, but also by getting funds out of the position of 
determining commission levels altogether. If funds got out of 
the business of competing to be sold and brokers' compensation 
came directly from the investor and did not depend on which 
fund they sold, then brokers might begin to compete on the 
basis of the quality of their recommendations, and funds might 
have to compete accordingly by offering a quality product and 
good service at a reasonable price.
    I want to thank the Subcommittee again for exploring these 
important issues, and we look forward to working with you as 
you move forward.
    Senator Fitzgerald. Thank you, Mr. Plunkett. Mr. Stevens.


    Mr. Stevens. Chairman Fitzgerald and Ranking Member Senator 
Akaka, thank you very much.
    \1\ The prepared statement of Mr. Stevens appears in the Appendix 
on page 224.
    I think it is appropriate to begin by underscoring on 
behalf of the Institute its strong support for the ongoing 
efforts of Federal and State Government authorities to root out 
abusive trading practices affecting mutual funds. The Institute 
is committed to taking whatever steps are necessary to prevent 
such abuses in the future and to fulfill the industry's 
fiduciary obligations to its tens of millions of fund 
shareholders. The SEC has moved swiftly across a broad front to 
bolster regulatory protections, and the Institute pledges its 
cooperation as Congress, the SEC, and other interested parties 
work to restore and maintain the confidence of fund investors.
    I welcome the opportunity to present the Institute's views 
on mutual fund fees and expenses. My written testimony goes 
through a whole variety of issues. There are three in 
particular that I would like to emphasize here.
    First, although you might not know it from this morning's 
discussion, we all should recognize that this is at least a 
glass that is half-full. Indeed, fully informing investors 
about mutual fund fees and expenses has been a long-time 
objective of SEC regulations. Current regulations, including 
the very prominent standardized fee table that appears in every 
mutual fund prospectus, assure a high degree of transparency 
about the costs of mutual fund investing. Is there more that 
might be done? This is the question that, Mr. Chairman, your 
hearing poses. Yes. And the SEC is developing a variety of new 
additional disclosure requirements. Maybe there are things that 
the SEC has not yet considered or proposed that should be added 
to that. Fair enough. But building on existing regulations, 
these and other reforms, it seems to me, will provide a level 
of information to fund investors that is unrivaled by any other 
financial product. I am more than prepared to discuss the 
details, but I want you to know that the Institute strongly 
supports precisely that objective.
    Second, with respect to recent research on trends in mutual 
fund costs, I believe the consensus of all serious recent 
research is that the costs of mutual fund investing have 
trended downward significantly over the past 20 years. The 
Institute's own extensive published research supports this 
view. So, too, does the independent analysis that has been 
conducted by the SEC and the GAO. And it is fair for us to ask, 
why is that? Well, I believe there are a variety of market 
forces at work in producing this result, including, among 
others, the healthy level of competition that exists among fund 
providers, and the very widespread availability to investors of 
information about mutual fund costs, performance, and services.
    In fact, if you look at trends over that 20-year period, 
the fact that mutual fund shareholders are now heavily invested 
in the lowest-cost funds suggests that they and their financial 
advisors understand and recognize the importance of fund fees.
    Finally, Mr. Chairman, in light of the interest in this 
topic that has emerged during this hearing, I want to address 
how mutual fund fees compare with those of pension managers, 
other institutional investment managers, as well as--and this 
is a subject to which you have returned a couple of times--
those that are associated with the Federal Thrift Savings Plan.
    My colleague, Professor Freeman, on this panel and others 
have contended that differences between the ``investment 
advisory fees'' paid by a pension plan and the ``management 
fees'' paid by a mutual fund indicate that mutual funds are 
overpriced. The analysis is provocative. It is one that 
Attorney General Spitzer has cited numerous times. But, 
unfortunately, the analysis is seriously flawed.
    The two types of fees that Professor Freeman and his 
colleagues compare are fundamentally different. A pension 
plan's ``advisory fee'' primarily covers portfolio management 
services. I have been a mutual fund lawyer for 25 years, and I 
know that, by contrast, a mutual fund's ``management fee''--
that is, the number that is reported in a fee table, the number 
available through Morningstar--covers a host of additional 
costs that are spelled out in the fund's contract with its 
manager. These can include a whole variety of things: Pricing 
the fund, providing it office space and equipment, providing a 
clerical staff and bookkeeping support, defraying the salaries 
of fund officers and directors, and paying for legal and 
regulatory compliance, which in the case of a fund is no small 
undertaking. And these are to name just a few.
    The comparison drawn in Professor Freeman's study is for 
this reason incorrect and misleading. The ICI study that 
Attorney General Spitzer referred to earlier--and invited you, 
Mr. Chairman, to ask me about--is a study that makes precisely 
the point I just made: That this is an apples-to-oranges 
comparison, and the data is not normalized, if you will, in 
order to draw any inferences.
    Now, the ICI study also suggests that if you compare the 
pure investment advisory fees of a pension plan with some 
equivalent in the mutual fund arena, the two would appear to 
pay comparable amounts for similar portfolio management 
services. Attorney General Spitzer and, I suspect, probably 
Professor Freeman, don't accept that comparison, but even if 
they don't, it doesn't make the comparison drawn in Professor 
Freeman's article accurate. The fact of the matter is the 
comparison he was drawing is just simply misleading.
    Now, what about institutional versus retail money 
management? This is important and it is a subject that Attorney 
General Spitzer addressed this morning.
    Institutional investment managers and retail investment 
managers occupy a very different space, and I think it is a 
truism in the business that it is much more difficult and 
expensive to deal at a retail than it is an institutional 
level. And if you think about it for a moment, it is 
intuitively obvious why that is the case.
    First of all, retail assets are much harder to attract. 
They are out there in a much more disparate universe, belonging 
to households and individuals. Institutional assets come from 
institutions, of which there are fewer, and they are more 
readily identifiable and approachable.
    Retail assets are also harder to manage. In a mutual fund 
form, for example, a high percentage of the assets has to be 
maintained in a liquid form. That is under SEC rules. But it is 
also to provide the daily transaction capabilities and 
redemption capabilities that a mutual fund promises to its 
investors, which institutional managers don't have to deal 
    They are also more difficult to administer, again, because 
of legal and regulatory issues, and they are harder to retain. 
Individual mutual fund investors make decisions every day about 
redeeming, exchanging from one fund to another, or moving to 
another manager, and the open-end form of their funds assures 
them the ability to do that. Institutional money, however 
sticky it may seem retail mutual fund money is, is far 
    Now, if it were, in fact, the case that institutional money 
managers' fee schedules are so much more reasonable by 
comparison to retail managers, you would think institutional 
money managers would be making a lot--retail money managers, 
rather, would be making a lot more money. That is simply not 
the case. We can provide for the Subcommittee's consideration 
after these hearings information concerning this point. Capital 
Resource Advisors conducts an annual survey called 
``Competitive Challenges,'' where it addresses these issues, 
among others.
    In 2001, on average, as a percentage, retail investment 
managers' total operating profit margin was 22.3 percent. 
Institutional managers' profit margin you would think would be 
less if their fees were so much more reasonable. Well, it was 
not. It is 29.5 percent. In 2002, the comparison was 16.5 to 
28.5. The truism is, I think, demonstrated in the profitability 
of the businesses. The retail part of investment management is 
simply a much more expensive and difficult exercise.
    And then, finally, Mr. Chairman, I know my time is up, but 
let me say just a few things about the Federal Thrift Savings 
    When I was at the Reagan White House for 3 years, I 
participated in the Federal Thrift Savings Plan, so I know it 
from the point of view of an investor as well.
    Senator Fitzgerald. Do you still have it, or did you get 
rid of it?
    Mr. Stevens. Well, as you know, President Reagan has been 
out of office a long time, and since I hadn't been back in 
Federal Government any longer, I did cash out my interest in 
the plan.
    Senator Fitzgerald. OK.
    Mr. Stevens. Maybe that was a mistake, but it is a decision 
I made.
    Senator Fitzgerald. It almost assuredly was a mistake.
    Mr. Stevens. Well, perhaps.
    But I think one of the things that it reinforces to me, at 
least, my familiarity with both the Thrift Savings Plan and the 
retail mutual fund business, is that they are very different 
animals. For example, all of the Thrift Savings Plan's 
portfolios are indexed, and all of them are very large. That is 
not true with retail mutual funds.
    Many of the costs that we think of in a mutual fund arena 
as administrative and distribution costs are actually 
subsidized by the Federal Government. They are borne by the 
agencies whose employees participate in the Thrift Savings Plan 
and are never taxed back to the expense ratios of the 
portfolios themselves. So there is a governmental subsidy. I am 
not saying it is inappropriate. It just does not appear in the 
performance figures.
    And then, finally--and this is significant as well--there 
are no regulatory or related costs in running the Thrift 
Savings Plan. And I want to tell you, 25 years of being a 
mutual fund lawyer underscore to me those costs are not 
    So at least some observations, Mr. Chairman, that may be of 
use. Thank you.
    Senator Fitzgerald. I will hold my rebuttal until all the 
witnesses have finished, but thank you very much for that very 
good presentation.
    Mr. Lackritz, thank you very much for being here.

                      INDUSTRY ASSOCIATION

    Mr. Lackritz. Thank you, Mr. Chairman and Ranking Member 
Senator Akaka. Thank you very much for the opportunity to 
testify today on behalf of the Securities Industry Association.
    \1\ The prepared statement of Mr. Lackritz appears in the Appendix 
on page 250.
    First of all, let me begin by commending you and your 
Subcommittee for your long tradition of protecting the public, 
and I would add we look forward to working with you and your 
colleagues and the other committees in the Senate and the 
Commission to restore the public's trust and confidence in the 
Nation's securities markets and in mutual funds.
    Our members, Mr. Chairman, underwrite securities--stocks 
and bonds--to raise funds--capital--for private companies and 
public bodies. These entities use the funds we raise to expand 
and grow--hiring new workers, investing in new equipment, and 
building public works. Our industry has raised more than $21 
trillion over the last 10 years to finance innovation and 
growth in the form of new enterprises, new processes, new 
products, and new bridges, roads, hospitals, and schools.
    We also help individual investors achieve their financial 
goals, such as planning for a child's education or for a 
comfortable retirement. Thus, as intermediaries between those 
who have capital on the one hand and those who need it on the 
other, we serve the very essential function of channeling 
capital to its most productive uses.
    The securities industry is based on two bedrock principles: 
Disclosure and competition. The format of securities regulation 
was articulated by Justice Louis Brandeis back in the early 
part of the 20th Century, and the architecture of the 
securities laws reflect, that you need both full disclosure and 
vigorous competition. Justice Brandeis was also credited with 
the notion that sunshine is the best disinfectant, electric 
light is the best revealer. I think in this discussion that we 
are having about what to do in this area, Justice Brandeis' 
teachings are actually very relevant here, that, in fact, what 
we need is more transparency and what we need is better 
disclosure, because public trust and confidence are really the 
bedrock principles on which our market participants succeed, 
and as long as the same rules are vigorously and fairly 
    Mutual funds are the vehicle by which an overwhelming 
majority of investors participate in our markets. Nine out of 
ten investors have at least some money in stock mutual funds, 
and just over half invest exclusively in funds. As a result, 
the health of our securities markets depends to a great extent 
on the public's continued robust participation in mutual funds. 
Yet, as we know from these hearings and other disclosures, not 
all is well with mutual funds. Revelations of wrongdoing, 
including late trading and market timing, contrary to fund 
prospectuses, as well as other practices, have shaken 
investors' confidence in many fund organizations and in the 
intermediaries distributing the funds.
    To restore public trust and confidence in funds and their 
distributors, the interest of investors must come first. 
Investors must be assured, Mr. Chairman, that fraud, self-
dealing, and dishonesty will not be tolerated and will be 
vigorously enforced and punished. Investors should be treated 
fairly and should be given complete, clear, and useful 
information about the funds that they buy. All aspects of the 
mutual fund business, including fund fee structures, financial 
incentives offered to intermediaries, fund investment and 
redemption policies, and fund governance must be as transparent 
as possible. And all investors should be assured of prompt 
execution in fair pricing of their fund transactions.
    We think a two-pronged approach is necessary to restore the 
public's trust in mutual funds. First, swift, sure, and tough 
enforcement actions are the proper remedy to address clear 
violations of the law. I might add that, in addition to tough 
enforcement and swift enforcement, the time has come to 
implement some necessary reforms as well.
    We support efforts to improve disclosure and sales and 
trading practices to ensure that investors' interests come 
first. Specifically, investors should have clear, direct, 
timely information in a useful format that allows them to 
comparison shop and that promotes consumer choice and 
competition. Disclosure must be easily accessible and investor 
friendly rather than a ``Where's Waldo?'' search through 
fragments of disclosures and long prospectuses and long 
legalese for relevant information.
    In that vein, we strongly support efforts to enhance the 
transparency of revenue sharing agreements, including the 
nature of services received and differential compensation 
arrangements. Such disclosures should be uniform across 
regulatory agencies and should focus on arrangements that are 
likely to influence recommendations made to investors. 
Disclosures should provide investors with material information 
that they need. Finally, investors should have full, clear, and 
useful information on mutual fund fees, since they will have a 
significant effect on the investor's return.
    With respect to both soft dollars and directed brokerage, 
the key investor protection here is to maintain best execution 
for the customers. We believe that soft dollars are both pro-
investor and pro-competitive, particularly for third-party 
research, as we heard earlier. But advisors, fund trustees, and 
broker-dealers must always put investors first. Thus, we 
support improved disclosure of soft-dollar arrangements to both 
investors and to fund trustees.
    We have been appalled by reports of late trading of mutual 
fund shares. As Attorney General Spitzer noted earlier, such 
activity is the equivalent of betting on a horse race after it 
is over. Reforms should make late trading virtually impossible 
to achieve. At the same time, we believe strongly that any 
reforms here should not penalize innocent investors, 
particularly those in 401(k) plans or 529 plans or those who 
buy their mutual funds from broker-dealers rather than directly 
from funds.
    We look forward to working with the SEC and your Committee 
to eliminate late trading in a way that protects all investors 
and does not create competitive disadvantages for some. Late 
trading has had a terribly corrosive effect on investor 
confidence, and we must find and implement an effective remedy 
    Mr. Chairman, we are very proud of the capital our industry 
has raised, the jobs we have helped create, the innovation and 
growth we have helped foster, the new products and services we 
have made available, and the dreams we have helped our 
consumers achieve. Yet, we abhor the abusive activities 
involving mutual funds that you have shone a spotlight on. We 
urge the SEC, the NASD, and State authorities to continue to 
bring wrongdoers to justice swiftly and surely. And we are 
eager to do our part to improve mutual funds so that they can 
continue to be an effective investment vehicle for all 
    Thank you very much.
    Senator Fitzgerald. Thank you, Mr. Lackritz. Professor 
Freeman, thank you for being here.


    Mr. Freeman. Thank you for inviting me, Mr. Chairman and 
Ranking Member Senator Akaka. I am delighted to be here with 
    \1\ The prepared statement of Mr. Freeman appears in the Appendix 
on page 266.
    The issue isn't whether or not we should thoroughly 
regulate mutual funds. As my formal statement points out, there 
isn't an issuer of securities in the United States that is 
subject to more detailed regulation than mutual funds. They are 
the most heavily regulated financial product in our economy, 
and all this regulation and all this attention has gotten us a 
train wreck and a scandal that is beyond belief for somebody 
like me who has been watching and writing about the fund 
industry for about 35 years.
    Where to start? Basically, it is conflict of interest. 
Conflict of interest, conflict of interest, conflict of 
interest. Fiduciary duty, fiduciary duty, fiduciary duty 
breaches. The bigger the fund, the more money under management, 
the more the advisor makes. Raising that money, bringing that 
money in, means getting dollars in the hands of people who sell 
the funds. When I was working at the SEC on mutual fund 
distribution in the summer of 1977, this quote came in, which I 
have never forgotten and have often repeated: ``To close one's 
eyes to the reality''--this is from the industry--``that 
salesmen in the mutual fund industry have traditionally sold 
products which pay the most money is to regulate without a 
sense of what the industry is about.''
    Now, there has been talk about overcharging and fees, and 
let's talk about that. I have been criticized and called 
irresponsible by the ICI. And speaking of conflict of 
interest--you alluded to this earlier, Mr. Chairman--here is an 
entity that takes money from fund shareholders and uses that 
money unceasingly to protect the interests of sponsors who are 
exploiting those fund shareholders. I say the ICI epitomizes 
problems of conflict of interest in the mutual fund industry, 
and anything they say should be taken in light of that.
    But let's talk about their criticisms. They say: ``Oh, 
Freeman's got it wrong, he's too stupid, maybe, he's 
irresponsible. He's been dealing with this topic for 35 years. 
He's been teaching securities regulation in law school for 30 
years. He's been writing about this for a long, long time. He's 
working with a guy who's a Ph.D. and a chartered financial 
analyst. But they just can't get to the bottom of it. They just 
can't figure it out.''
    Well, let's assume that is true. If we can't figure it out, 
who on Earth can? Your average investor? No. Your average State 
regulator? No. The SEC itself, where I used to work, have they 
figured it out? I question that.
    Now, let's talk about the irresponsible statements in our 
report. We had a statement in our report that was to the effect 
that mutual fund shareholders--and this is the direct quote--
``pay nearly twice as much as institutional investors for money 
management. And that calculation doesn't even include any 
front- or back-end sales charges you may also pony up.'' And 
that was about our finding, and it is about double. And you 
say, well, Freeman and Brown, they don't know any better. That 
quote came from Ruth Simon. It was published in Money Magazine 
and is in Footnote 10 of our article. That was published in 
Money Magazine in 1995. It is so well known that the funds have 
been gouging their shareholders that when the Wall Street 
Journal wrote a story about our article--which is unusual for 
national press to write about a law review article--they did it 
in 2001, and the headline was, ``This is news? Study finds 
mutual fund shareholders being overcharged on fees.'' In other 
words, I mean, come on, guys, come up with something original.
    What we cited in our article, besides Ruth Simon and a lot 
of data talking about profitability, in the article is some 
evidence that when fund management companies are sold out, they 
command double the multiple for other institutional management 
companies. The marketplace values the lucrativeness of mutual 
fund management when the marketplace buys out these people. But 
we also quoted and referred to the Wharton Report, going back 
30 years--and you have heard references today--the Public 
Policy Implications Study. And what did those things find? What 
they found was the same thing we found: Fund shareholders being 
gouged, paying prices far in excess of other institutions.
    Now, the question is--it has been raised. Mutual funds are 
all these little people and you get these big institutions, 
they should be paying less. Well, let's take a look very 
quickly at that one.
    In the case of Alliance Fund, Alliance was charging the 
Alliance Fund shareholders 93 basis points, and Alliance was 
managing something like $16 billion. What was the fee? It was 
around $160 million a year for the Alliance Fund. The same 
management company using the same processes and the same 
theories and everything was managing a portfolio of about $900 
million for the Wyoming Retirement Plan for 10 basis points. So 
the fund shareholders at Alliance are paying $160 million or so 
a year, and the people at the Wyoming Retirement Plan are 
paying around $900,000 for the same services.
    Now, wouldn't you think some fund director might say to 
Alliance, ``Why don't you give us a 10-basis-point price?'' But 
that apparently hasn't happened.
    One thing that has been alluded to, but not said 
expressly--it is in our article; Mr. Spitzer has referred to it 
previously. Most-favored-nation treatment. Every mutual fund 
director should require the advisor, if the advisor is selling 
similar services in the free market, should require the advisor 
to give the board those prices and to justify the price 
differential between the prices that are being charged in the 
open market to the Wyoming Retirement Plan and the prices that 
are being charged or would be charged to the fund's 
shareholders. In other words, you want 93 basis points from us 
to manage $16 billion, but you are only charging them 10 basis 
point to manage $900 million. You are going to make a lot more 
money. Would you explain to us why this makes any sense?
    I could say a lot more. I will reserve my comments for 
answering questions.
    Senator Fitzgerald. Well, I can tell this is going to be a 
lively question and answer session. I appreciate that, 
Professor Freeman. It was very good.
    I would like to start with Mr. Stevens. Let's go back to 
the point that Professor Stevens raised, picking up on 
something that I said earlier.
    Mr. Stevens. Professor Freeman.
    Senator Fitzgerald. I am sorry.
    Mr. Stevens. I am Stevens.
    Senator Fitzgerald. I am sorry. Professor Freeman raised 
this issue, which I alluded to earlier, which is that dues to 
the ICI are paid by mutual fund companies by deducting money 
from mutual fund shareholders, and then the ICI gets all this 
money and, in effect, your interests are really adverse to 
mutual fund shareholders' in America, aren't they? You are a 
lobbying group that represents the managers of mutual funds and 
the mutual fund companies themselves, as opposed to the 
    Mr. Stevens. Mr. Chairman, I appreciate the chance to 
respond to this. It is almost a point of personal privilege on 
behalf of my client.
    The ICI was organized in 1940, essentially at the request 
of the SEC, because when the 1940 Act was passed, it needed an 
interlocutor, an industry representative, in order to begin 
developing the highly complex series of rules that were 
necessary to implement the Act. At that time, the Institute was 
organized to represent the interest of funds and their 
advisors, and it has continued to do so.
    One premise, though, of the critics of the ICI in this 
regard is--and I think it has been asserted numerous times 
today--that advisors' and funds' interests are antithetical 
across the board.
    If you think about it for a moment, I think you would 
realize that is not the case. Certainly they may be 
antithetical with respect to the price. It is the fund 
shareholders' interest to get the lowest possible price, and 
perhaps the manager wants to get a higher one, perhaps even the 
highest possible. But with respect to many other areas, I think 
their interests are common.
    For example, it is obviously in the managers' interest to 
get the best performance. Why? Not only because it serves the 
consumers best, but it is the best way that we know in this 
business of getting more consumers and attracting more assets. 
They have a joint interest in good shareholder service as well, 
for exactly the same reasons. Mutual fund investors are highly 
demanding in terms of the range and quality of the services. 
And, finally, to a very high degree, there is a common interest 
with respect to regulatory compliance. Either the fund or the 
advisor, or both, will pay the consequences if there isn't such 
    But now let me talk about what the ICI stands for and has 
stood for in that regard, and I speak from my own personal 
experience, but I think we could multiply the examples across a 
whole range.
    First, for many years, the Institute was up here on behalf 
of funds and their shareholders and their advisors urging the 
Senate and House of Representatives to greatly increase 
appropriations for the Securities and Exchange Commission 
because of their concern that the growth of funds, the growth 
of advisors, investor dollars, and investments was far out-
stripping anything that the SEC had to bring to bear to 
inspect, examine, and oversee the industry. Those calls are 
matters of record, and they went largely unheeded for a long 
period of time as funds continue to grow.
    I congratulate the Senate for having appropriated just this 
week over $800 million to the SEC, and we are catching up and 
we are giving the regulators the resources they need. That had 
been a bedrock of the ICI's legislative policy for a long time.
    But there are several other examples I can give you. One of 
the things that the SEC and the NASD both are rightly credited 
for and encouraged about is this notion that there should be 
point-of-sale disclosure of revenue sharing; that is to say, 
amounts that a mutual fund advisor out of its profits pays to a 
broker-dealer in connection with its marketing of the fund.
    What has never been acknowledged by the SEC or the NASD--
or, for that matter, even in the press--is that in 1996, 8 
years ago, that was a regulatory recommendation that the ICI 
made to the NASD and they never acted on, and I will be happy 
to provide you information in that regard.
    Another example--and, by the way, that was from my tenure 
as general counsel of the ICI.
    Another example: the compliance rule. Many people here 
today, including Jack Bogle, have said what a great idea, we 
need compliance programs that are consistent throughout funds. 
And we agree, frankly. But the germ of that idea was advanced 
to the SEC almost 10 years ago by the ICI in a proposal that I 
personally worked on and was transmitted to the SEC, and the 
SEC did nothing about it for a long period of time until the 
current scandals.
    Now, that is fine. I am not criticizing the SEC, and I am 
giving Chairman Donaldson all the credit for moving in the 
direction that he has. But it was an idea that came from the 
industry through the ICI, and we will provide information in 
that regard as well. And there are other examples, too: 
simplified disclosure for fund shareholders and reforms of the 
prospectus, new standards for personal investing, support for 
best practices with respect to the governance of funds.
    These are not proposals that advanced the selfish interests 
of advisors. They advanced, in fact, the common interests of 
advisors and funds and their shareholders and were all, as a 
matter of record, things that the ICI supported.
    So I reject the notion, frankly--and I kind of resent the 
ad hominem argument that is involved--that the ICI somehow or 
other is nefariously accepting some people's monies to advance 
another's causes.
    With respect to the issue of dues, as a result of the 
history of the Institute, it is indeed true that there are 
different sources of funding. Some are paid by fund 
shareholders. Some are paid by fund advisors. And those 
decisions are made at the fund complex level, not at the level 
of the ICI.
    Senator Fitzgerald. Professor Freeman, do you think ICI 
dues should have to be paid out of the advisor's own money as 
opposed to out of their shareholders' money?
    Mr. Freeman. Yes, I think that that they are a lobbying 
organization for the advisors, for fund sponsors, and they 
ought to take that money and just be straight up about it, and 
not pretend that they are actually representing the interests 
of fund shareholders, because I don't see it.
    Senator Fitzgerald. Mr. Plunkett, do you have a thought on 
    Mr. Plunkett. To the best of my knowledge, we don't have a 
position on this. I think Mr. Stevens raises an interesting 
    Senator Fitzgerald. I thought you were going to recommend 
that we pass a law imposing a one one-thousandth of a basis 
point fee on all mutual fund shareholders and give it to the 
Consumer Federation of America.
    Mr. Plunkett. Oh, it wouldn't have to go to us. It could go 
to a shareholder directed organization. I think the point that 
there are economic--that interests do diverge at the basic 
economic level means that public policy-wise, the ICI and 
consumer interests often diverge. They don't always diverge but 
often do. And I think that is an important point to note since 
we are talking about public policy here.
    Mr. Stevens. Mr. Chairman, if I could just respond.
    Senator Fitzgerald. Do you have any fund shareholders on 
your board, Mr. Stevens, at the ICI as opposed to fund 
    Mr. Stevens. We have independent fund directors on the 
board. We do not have fund shareholders who are representatives 
on the board.
    Senator Fitzgerald. OK.
    Mr. Stevens. But, Mr. Chairman, if I could just say, I 
think in order to resolve this issue of what the ICI stands 
for, you have to ask yourself in specific cases: What was the 
position that they took? I have offered to provide you the 
additional evidence, I suppose, of the public policy positions 
that the ICI has stood for.
    It is also, I think, fairly clear in this current crisis, 
post-September 3, 2003, where the ICI has stood with respect to 
a whole range of issues. There has been no blinking there and 
no trying to log roll with respect to protecting advisors, much 
less ones who have fallen afoul of the law. It is the 
Institute, for example, who has recommended the hard 4 o'clock 
close, for which it has been criticized by many other 
participants in the industry for prescribing medicine that is 
simply too strong.
    We also have recommend--and the SEC, I am pleased, is 
considering this--that there be a mandatory redemption fee for 
mutual fund investors who come in and out of a fund within a 5-
day period to make it very clear that this is not a short-term 
transactional vehicle, it is for longer-term shareholders, and 
to put a friction cost in place that would prevent their being 
    We have recommended stronger regulations with respect to 
the investments by fund insiders in their own shares so that 
there is oversight, so there is transparency in that regard. 
And, most fundamentally, we have said loudly and clearly from 
the very beginning, if any member, any participant in this 
industry has violated the law, they should have the book thrown 
at them. We make no apologies for that whatsoever and supported 
General Spitzer and Chairman Donaldson in the most aggressive 
enforcement activities that they are undertaking with respect 
to the industry.
    Senator Fitzgerald. Senator Akaka.
    Senator Akaka. Thank you very much, Mr. Chairman. Again, I 
want to add my praise to you for holding this hearing.
    Mr. Plunkett, in addition to improving the governance 
structure of mutual fund companies and increasing meaningful, 
relevant, and understandable disclosures, what should be done 
to improve the financial and economic literacy of investors? I 
ask this of you because you represent the Consumer Federation 
of America and what we want to do is help the consumers of this 
    Mr. Plunkett. Well, thank you, Senator Akaka, for the 
question. We have spent a lot of time on questions of investor 
education and financial literacy. The key here is to examine 
the experience of less sophisticated investors when developing 
educational programs. We know that a portion of investors are 
making sound decisions, either because they have the 
sophistication to do it on their own or because they are 
getting good financial advice from financial professionals. 
That is fine.
    In looking at how to improve investor education, however, 
and how to improve disclosures in particular, we need to start 
by looking at the experience of those many investors who are 
making poor decisions. I am thinking here of the investor who 
winds up in an S&P 500 index fund with a 2-percent expense 
ratio, for example. We need to know what sources of information 
they are relying on and how they make decisions before we can 
educate them to make better decisions. And we believe any 
efforts in this area should start from a study of those issues.
    Mr. Lackritz. Senator Akaka, could I intervene? I would say 
that improving investor education and financial literacy is one 
of the top priorities of our organization. We have a website 
that provides first-class investor education without selling 
anything, and describes the basic things people should know. It 
is available free to anyone. It is called siainvestor.org.
    We also have a foundation for investor education, and we 
run a program in schools, an exercise in schools, that involves 
economic education that teaches kids from middle school through 
high school about the differences between saving and 
consumption, about interest rates, about compounding, about the 
difference between equities and debt, all that kind of thing. 
Currently, we have 550,000 kids every year that engage in this 
program, and we are trying to expand it. We have, I think, a 
program active in Hawaii, too. We would be happy to talk to you 
about that and see if we could help you see a demonstration of 
the program in a school.
    Senator Akaka. I am glad that you brought this up, and I 
will ask others to comment on this. Let me ask Mr. Stevens the 
same question I asked Mr. Plunkett. You are representing 
another side. What do you believe must be done to improve the 
financial and economic literacy among investors?
    Mr. Stevens. Well, It is a daunting challenge, Senator, I 
grant you that, and the Institute has many programs supporting 
investor education initiatives that are similar to those in the 
Securities Industry Association. And I grant you that in many 
respects mutual funds are complex products, so they are hard to 
know, hard to understand.
    Our appetite as a government--and I am thinking now of the 
regime that the SEC administers--has been to devise a 
disclosure document, the prospectus, and as Jack Bogle said, 
throw everything including the kitchen sink in it and hope that 
people will read it and understand it.
    The challenge is not so much making sure the information is 
out there. I grant you, it should be out there, and it should 
be accessible. But, beyond that, with respect to a more complex 
financial product, crafting a set of information which covers 
the key points that an investor needs to know, this was one of 
the things that we worked on extensively when I was at the ICI. 
It was called the profile prospectus. It was eventually adopted 
in the SEC rules in another way as the front end or summary of 
existing prospectuses, and it tried to select all the key 
    Much of what we are talking about here, by the way, it 
seems to me, while it is information that ought to be out 
there, I would agree with Mr. Bogle it is not necessarily 
information that is so key that an investor has to know it 
beforehand. Let me give you one example.
    There has been a lot of emphasis on improved disclosure of 
transaction costs, and there is complexity about that, and the 
issue becomes how do you do that, because it is not just 
commission dollars. It is market impact. It is spreads on debt 
instruments. And so there is a big challenge in getting the 
information out there.
    But all of the costs that are implicit in funds transaction 
in portfolio securities are already reflected in the 
performance information that an investor gets. It is all net of 
that because it is built into that number.
    Now, ask yourself the question: In order to make a good 
mutual fund investment, do I have to know all of the details 
with respect to the transaction costs? Maybe not. Maybe there 
is a shorthand way of providing it. But if we begin putting 
hurdles like that in front of mutual fund investors, what I am 
afraid is we make it preternaturally more difficult to make 
good investing decisions. That is the challenge: Getting the 
information out, but also crafting it in a way that it is 
meaningful and communicates effectively with the investor 
    Senator Akaka. Mr. Chairman, may I?
    Let me ask Mr. Keil, it is quite clear that investors need 
to have additional information about the transaction costs of 
their mutual funds because the expense ratios fail to include 
them, and the brokerage commissions are buried in the statement 
of additional information, which investors are only given upon 
request. It is a lengthy and complicated document that does not 
easily facilitate comparison among funds.
    Mr. Keil, in your statement you mentioned that trying to 
fully quantify brokerage costs in total, given every trading 
scenario, is ``similar to attempting to nail''--and I wanted to 
say this--``Jell-O to a wall.'' What do you recommend to 
improve the disclosure of transaction costs in a meaningful, 
understandable way to investors?
    Mr. Keil. Well, let me make the point that I still stand 
behind my statement that you cannot quantify every last 
brokerage scenario to the satisfaction of most academics. But I 
think that the scenario, the way it exists today, is thoroughly 
inadequate. There is no way for an investor to quantify what 
they are paying in brokerage. There is just no way to do it.
    The aggregate dollars, as you point out, are shown in the 
SAI, but let's face it, if it is a challenge to get the 
investors to read the prospectus cover to cover, they are going 
to go nowhere near the SAI. It is an ineffective document as 
far as disclosure is concerned.
    I would make the statement that there are ways to quantify 
the different types of brokerage. Whether you segment them or 
put them in one number is another issue. But I would not 
recommend that once you take those dollars, you put them in the 
form of a ratio so that they are the same basis as an expense 
ratio. That should be included in the total expense ratio. We 
are really talking about apples and orange--total expense 
ratio, which is focused on operating expenses, or brokerage is 
truly transaction costs.
    So from my perspective, the investor needs to be able to 
make the judgment call whether what they are paying in the 
brokerage costs is reasonable given the returns that they are 
being given by the fund itself.
    Senator Akaka. Mr. Chairman, my time has expired.
    Senator Fitzgerald. Well, thank you. We are going to have 
to wrap up because I have been informed that a vote began at 
2:30, and apparently the weather, as bad as it was this 
morning, I am told that it has deteriorated to the point that 
the Federal Government is going to be shutting down at 3 p.m. 
today. The Office of Personnel Management has put that advisory 
out. But I did not want to conclude this hearing without going 
back to the point on the Federal Thrift Savings Plan.
    I have met with the executive director and others of the 
TSP. The back-office expenses for separating people's accounts 
and so forth, those are all included in the expense ratios for 
the TSP fund. In fact, that is most of the expense. The 
advisors' fee, I am not allowed to tell you how low it is 
because it is a confidential fee that was subject to bidding. 
At least that is my understanding. The fee is exceedingly low. 
Most of the expense ratio is for the cost of paying employees 
of the Agriculture Department down in Louisiana to do all the 
back-room functions. And I guess there are well over 100 of 
those people, and those costs are being paid by the fund 
shareholders, and they are paying full Federal Government 
benefits to those Agriculture Department employees, including 
Federal health insurance, sick leave, other leave, the TSP 
expenses for those Agriculture Department employees and so 
forth, which are probably much more expensive than the private 
    It may be that the TSP fund could get their expenses even 
lower by not using the Agriculture Department and bidding out 
those back-room operations. The only things that may be taken 
care of internally by the Department--for example, I am a 
Member of the Senate. There is a Senate Financial Office that 
every year sends me a brochure and tells me how to contact the 
TSP, and they forward a form from the TSP to change your 
withholding amount. But I would think that most companies, if 
you work at IBM, the personnel office at IBM is going to be 
giving a similar transmittal to their employees, and then the 
employees will fill out that form, and it will actually go to a 
Hewitt and Associates or some company that does the back-room 
operations for IBM, and then it will be invested.
    And I do think in my opening statement I was careful to 
make the comparison between the expense ratios of the TSP fund, 
which I noted were index funds, and I compared them to the 
average expense ratios as reported by Lipper for S&P 500 stock 
index funds. And last year, the TSP expense ratio was 11 basis 
points, and the average for all mutual funds was 63 basis 
points. That is just an enormous difference.
    And so I think my point is valid, that we have created two 
regimes for investing--one for ourselves and one for the whole 
rest of the world--and I am not sure that is right.
    On the 12b-1 fees, I do want to ask a question about that. 
A lot of investors think they need to get into a no-load mutual 
fund. They want to avoid a front-end load and they want to 
avoid a back-end load, and then they go into a fund that 
advertises no load, but that fund may have a 12b-1 fee, which 
is basically, as I understand it, a load paid over time. It is 
really compensation paid over time to the broker who put them 
into that fund. And I think, Mr. Keil, your report showed that 
95 percent of 12b-1 fees wind up getting paid to the brokers 
who are distributing the funds.
    Mr. Keil. Well, let me give credit where credit is due. 
That actually is an ICI statistic where they did a survey of 
the fund companies themselves. There is not disclosure 
sufficient for us to quantify exactly how 12b-1 fees are used. 
It is not a disclosure requirement at this time.
    Mr. Stevens. Mr. Chairman, if I could clarify, my 
understanding is that under the NASD's rules--and the NASD is 
sort of the keeper of what you can and cannot call a no-load 
fund. If you have asset-based charges not in excess of 25 basis 
points, even if they are adopted under a Rule 12b-1 plan--and 
there are some advantages to doing so. Even if they are not 
under a Rule 12b-1 plan, you can still describe yourself as a 
no-load fund.
    The point of the 25 basis points----
    Senator Fitzgerald. Isn't that misleading? Because if you 
are essentially paying a load over time--in fact, you may be 
paying more of a load over time than you would just to pay the 
500 bucks, or whatever it is, up front.
    Mr. Stevens. I think the NASD rule got to that point years 
ago because the 25 basis points typically is used to defray the 
cost of shareholder services, often recordkeeping, which would 
be a cost the fund would have to bear in many instances no 
matter what. It is not a classic sales charge, and they cut it 
off there, and they said anything more than that we will regard 
as a sales charge. And certainly any front-end sales charge, 
back-end sales charge, or level load, as it is called in the 
business, you could not be a no-load fund.
    But the thinking of the NASD at that time was, as long as 
that asset-based charge is 25 basis points or less, that would 
be consistent with calling yourself a no-load because that 
would not be regarded as a sales load.
    Mr. Plunkett. Mr. Chairman, I would like to say that we do 
think it is a deceptive practice, and as investors have become 
increasingly reluctant to pay front loads, brokers began 
looking for ways to offer funds that looked like no-load funds. 
That is how we got Class B shares. The broker still got his up-
front commission paid out of fund company assets, and the fund 
company got the money back over time through 12b-1 fees. That 
is exactly what is happening here.
    Mr. Freeman. Mr. Chairman, just very quickly, 12b-1 is a 
monument to the law of unintended consequences. It came in to 
try to help funds advertise and sell and get the word out. What 
it became in the 1980's and ever since is a mechanism used to 
sell Class B shares, to sell shares that have a load as if they 
were no-loads and to unfairly compete against no-load shares. 
That is how it is being used to a great extent out in practice, 
which is deceptive.
    Senator Fitzgerald. And isn't it true when the SEC 
promulgated Rule 12b-1 to allow funds to charge a fee to 
compensate brokers for distributing their funds and to pay for 
advertising, the theory was that if the funds got bigger, 
expenses as a percentage of the assets would go down. Is there 
any evidence that fund expenses have gone down in the 24 years 
we have had Rule 12b-1?
    Mr. Freeman. There is no proof that you can spend your way 
to economies. All the evidence is that 12b-1 fees, insofar as 
they are supposed to generate savings, are a dead weight cost 
and don't do it.
    Senator Fitzgerald. Mr. Stevens, do you want to comment? 
You have got to be brief.
    Mr. Stevens. This is a long tale, but the bottom line is if 
you look at trends in distribution costs since the inception of 
Rule 12b-1, it has introduced a degree of flexibility in the 
way that these kinds of costs can be paid. That has put 
downward pressure on sales charges. It is true, many funds have 
adopted 12b-1 fees, but if you add the sales charges to the 
costs under Rule 12b-1, distribution costs experienced by 
individual shareholders have trended downward.
    Now, that is what the ICI research indicates, and I think, 
Mr. Chairman, what may seem counterintuitive to you about this 
is that those costs covered by 12b-1 are going to be paid for 
some way because of the nature of the costs themselves. They 
represent the costs of the broker-dealer in terms of its 
marketing. They represent shareholder services. In many 
instances, they represent recordkeeping.
    If you were to abolish Rule 12b-1 tomorrow, you would not 
abolish the expenses; you would not abolish the fees. You would 
merely transfer them to some other place. Now, maybe that is a 
good idea, maybe it isn't. Mr. Plunkett here has said perhaps 
all of that should be taken out of the fund and put on the 
distributor, and that is certainly one way you could look at 
the problem. But 12b-1 pays for things that are going to be 
paid for no matter what. It provides a degree of flexibility in 
the way that they are paid for and transparency--it appears in 
the fee table, the 12b-1 charges--and oversight because the 
fund boards have got to superintend those costs under the SEC's 
    Senator Fitzgerald. Professor Freeman, final comment.
    Mr. Freeman. Very quickly, we do not have transparency. 
What we have is revenue sharing to the tune of $2 billion a 
year to get push money to the brokers, and that is coming out 
of the advisory fee, and it is coming out of overcharges. We 
have got directed brokerage, which is, I believe, illegal 
because the way to pay for sales activity is through a 12b-1 
plan. We have a lot of funds that are already maxed out on 
that. Then they are using brokerage commissions to accomplish 
the same thing, double dipping and I think treating 
shareholders unfairly.
    Senator Fitzgerald. Well, you have been a wonderful panel, 
and we appreciate it. All of you have been very articulate and 
vigorous spokesmen for your point of view.
    That concludes our questions. I want to emphasize that the 
record will be kept open for additional materials until the 
close of business this Friday, January 30. So if you have any 
further submissions you would like to make available to the 
Subcommittee, we would appreciate it.
    Thank you all very much. This hearing is adjourned.
    [Whereupon, at 2:45 p.m., the Subcommittee was adjourned.]

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