[Senate Hearing 108-711]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-711

                    REVIEW OF CURRENT INVESTIGATIONS
                    AND REGULATORY ACTIONS REGARDING
                        THE MUTUAL FUND INDUSTRY

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

                                HEARINGS

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                        FIRST AND SECOND SESSION

                                   ON

    INVESTIGATIONS AND REGULATORY ACTIONS REGARDING THE MUTUAL FUND 
                   INDUSTRY AND INVESTORS' PROTECTION

                               ----------                              

NOVEMBER 18, 20, 2003, FEBRUARY 25, 26, MARCH 2, 10, 23, 31, AND APRIL 
                                8, 2004

                               ----------                              

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs

For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800; (202) 512ï¿½091800  
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                                                        S. Hrg. 108-711


                    REVIEW OF CURRENT INVESTIGATIONS
                    AND REGULATORY ACTIONS REGARDING
                        THE MUTUAL FUND INDUSTRY

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

                                HEARINGS

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                        FIRST AND SECOND SESSION

                                   ON

    INVESTIGATIONS AND REGULATORY ACTIONS REGARDING THE MUTUAL FUND 
                   INDUSTRY AND INVESTORS' PROTECTION

                               __________

NOVEMBER 18, 20, 2003, FEBRUARY 25, 26, MARCH 2, 10, 23, 31, AND APRIL 
                                8, 2004

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs



            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire        THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina       DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island      JON S. CORZINE, New Jersey

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                Douglas R. Nappi, Deputy Staff Director

                       Bryan N. Corbett, Counsel

                 Dean V. Shahinian, Democratic Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)


                            C O N T E N T S

                              ----------                              

                       TUESDAY, NOVEMBER 18, 2003

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................     4
    Senator Enzi.................................................     5
    Senator Reed.................................................     7
    Senator Allard...............................................     7
    Senator Corzine..............................................     8
    Senator Bayh.................................................     9
    Senator Dodd.................................................    10
    Senator Miller...............................................    50

                               WITNESSES

William H. Donaldson, Chairman, U.S. Securities and Exchange 
  Commission, Washington, DC.....................................    11
    Prepared statement...........................................   110
Matthew P. Fink, President, Investment Company Institute.........    37
    Prepared statement...........................................   118
Marc E. Lackritz, President, Securities Industry Association.....    39
    Prepared statement...........................................   125

                              ----------                              

                      THURSDAY, NOVEMBER 20, 2003

Opening statement of Chairman Shelby.............................   135

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................   136
    Senator Dodd.................................................   138
    Senator Johnson..............................................   139
    Senator Corzine..............................................   141
    Senator Reed.................................................   142

                               WITNESSES

Eliot Spitzer, Attorney General, the State of New York...........   142
Stephen M. Cutler, Director, Division of Enforcement, U.S. 
  Securities and Exchange Commission.............................   146
    Prepared statement...........................................   167
Robert, R. Glauber, Chairman and Chief Executive Officer, 
  National Association of Securities Dealers.....................   149
    Prepared statement...........................................   173

              Additional Material Supplied for the Record

Letter to Senator Richard C. Shelby from John W. Snow, Secretary, 
  U.S. Department of the Treasury and Alan Greenspan, Chairman, 
  Board of Governors, Federal Reserve System dated November 18, 
  2003...........................................................   179

                              ----------                              

                      WEDNESDAY, FEBRUARY 25, 2004

Opening statement of Chairman Shelby.............................   181

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................   184
    Senator Crapo................................................   185
    Senator Carper...............................................   186
    Senator Hagel................................................   186
    Senator Sununu...............................................   186
    Senator Corzine..............................................   215
    Senator Enzi.................................................   224

                               WITNESSES

Tim Berry, Indiana State Treasurer and President, National 
  Association of State Treasurers................................   187
    Prepared statement...........................................   225
James S. Riepe, Vice Chairman, T. Rowe Price Group...............   189
    Prepared statement...........................................   230
Don Phillips, Managing Director, Morningstar, Inc................   192
    Prepared statement...........................................   240
Gary Gensler, former Under Secretary for Domestic Finance, U.S. 
  Department of the Treasury.....................................   194
    Prepared statement...........................................   245
James K. Glassman, Resident Fellow, American Enterprise Institute   196
    Prepared statement...........................................   253

              Additional Material Supplied for the Record

The Non-Correlation Between Board Independence and Long-Term Firm 
  Performance by Sanjai Bhagat and Bernard Black.................   263

                              ----------                              

                      THURSDAY, FEBRUARY 26, 2004

Opening statement of Chairman Shelby.............................   307

Opening statements, comments, or prepared statements of:
    Senator Bayh.................................................   322
    Senator Sarbanes.............................................   323
    Senator Sununu...............................................   324
    Senator Allard...............................................   330

                               WITNESSES

David S. Ruder, former Chairman, U.S. Securities and Exchange 
  Commission, William W. Gurley Memorial Professor of Law, 
  Northwestern University School of Law, and Chairman, Mutual 
  Fund Directors Forum...........................................   308
    Prepared statement...........................................   346
David S. Pottruck, Chief Executive Officer, The Charles Schwab 
  Corporation....................................................   311
    Prepared statement...........................................   354
Mellody Hobson, President, Ariel Capital Management, LLC/Ariel 
  Mutual Funds...................................................   313
    Prepared statement...........................................   362
John C. Bogle, Founder and former Chief Executive, the Vanguard 
  Group, President, the Bogle Financial Markets Research Center..   316
    Prepared statement...........................................   393

                              ----------                              

                         TUESDAY, MARCH 2, 2004

Opening statement of Chairman Shelby.............................   407

Opening statements, comments, or prepared statements of:
    Senator Allard...............................................   408
        Prepared statement.......................................   448
    Senator Hagel................................................   409
    Senator Sarbanes.............................................   420
    Senator Bennett..............................................   423
    Senator Carper...............................................   426

                               WITNESSES

William L. Armstrong, Independent Mutual Fund Director and 
  Chairman, the Oppenheimer Funds, former U.S. Senator (1979-
  1991)..........................................................   409
    Prepared statement...........................................   448
Vanessa C.L. Chang, Independent Director, New Perspective Fund...   411
    Prepared statement...........................................   452
Marvin L. Mann, Chairman of the Independent Trustees, The 
  Fidelity Funds.................................................   414
    Prepared statement...........................................   455
Michael S. Miller, Managing Director, The Vanguard Group, Inc....   416
    Prepared statement...........................................   463
Ann E. Bergin, Managing Director, National Securities Clearing 
  Corporation....................................................   436
    Prepared statement...........................................   471
William A. Bridy, President, Financial Data Services, Inc., on 
  behalf of the Securities Industry Association..................   438
    Prepared statement...........................................   495
Raymond K. McCulloch, Executive Vice President, BB&T Trust, on 
  behalf of the American Bankers Association.....................   440
    Prepared statement...........................................   499
David L. Wray, President, Profit Sharing/401(k) Council of 
  America on behalf of the ASPA, Association for the Financial 
  Professionals, Automatic Data Processing, Inc., Committee on 
  Investment of Employee Benefit Assets, The ERISA Industry 
  Committee, Flint Ink Corporation, Florida Power & Light 
  Company, Hewitt Associates, ICMA Retirement Corporation, Intel 
  Corporation, Procter & Gamble, Profit Sharing/401k Council of 
  America, Small Business Council of America, and Sungard Corbel.   441
    Prepared statement...........................................   503

                              ----------                              

                       WEDNESDAY, MARCH 10, 2004

Opening statement of Chairman Shelby.............................   505

Opening statements, comments, or prepared statements of:
    Senator Schumer..............................................   507
    Senator Sarbanes.............................................   521
    Senator Dodd.................................................   529

                               WITNESSES

David M. Walker, Comptroller General, U.S. General Accounting 
  Office.........................................................   506
    Prepared statement...........................................   536
Lori A. Richards, Director, Office of Compliance Inspections and 
  Examinations, U.S. Securities and Exchange Commission..........   508
    Prepared statement...........................................   566
Paul F. Roye, Director, Division of Investment Management, U.S. 
  Securities and Exchange Commission.............................   511
    Prepared statement...........................................   628
Mary L. Schapiro, Vice Chairman and President, Regulatory and 
  Oversight, National Association of Securities Dealers..........   517
    Prepared statement...........................................   635
    Response to a written question of Senator Johnson............   642

                              ----------                              

                        TUESDAY, MARCH 23, 2004

Opening statement of Chairman Shelby.............................   645

Comments of Senator Sarbanes.....................................   667

                               WITNESSES

Mercer E. Bullard, President and Founder, Fund Democracy, Inc., 
  Assistant Professor of Law, University of Mississippi School of 
  Law............................................................   646
    Prepared statement...........................................   681
William D. Lutz, Ph.D., J.D., Professor of English, Rutgers 
  University.....................................................   653
    Prepared statement...........................................   698
Robert C. Pozen, Chairman, MFS Investment Management, Visiting 
  Professor, Harvard Law School..................................   656
    Prepared statement...........................................   704
Barabra Roper, Director, Investor Protection, Consumer Federation 
  Of America.....................................................   661
    Prepared statement...........................................   707

                              ----------                              

                       WEDNESDAY, MARCH 31, 2004

Opening statement of Chairman Shelby.............................   777

Opening statements, comments, or prepared statements of:
    Senator Allard...............................................   778
    Senator Enzi.................................................   778
    Senator Sarbanes.............................................   803
    Senator Schumer..............................................   807

                               WITNESSES

Harold Bradley, Chief Investment Officer, Growth Equities, 
  American Century Investment....................................   779
    Prepared statement...........................................   814
Geoffrey I. Edelstein, CFA, CIC, Managing Director and Co-
  founder, Westcap Investors, LLC, on behalf of the Investment 
  Council Association of America.................................   782
    Prepared statement...........................................   879
Howard M. Schilit, Ph.D., CPA, Chairman and Chief Executive 
  Officer, Center for Financial Research & Analysis (CFRA).......   784
    Prepared statement...........................................   889
Benn Steil, Ph.D., Andre Meyer Senior Fellow in International 
  Economics, Council on Foreign Relations........................   787
    Prepared statement...........................................   892
Grady G. Thomas, Jr., President, The Interstate Group, Division 
  of Morgan Keegan & Company, Inc................................   790
    Prepared statement...........................................   910
    Response to written questions of Senator Enzi................   953
Joseph M. Velli, Senior Executive Vice President, The Bank of New 
  York...........................................................   792
    Prepared statement...........................................   914
    Response to written questions of Senator Enzi................   955

                              ----------                              

                           AFTERNOON SESSION

Opening statement of Chairman Shelby.............................   957

Opening statements, comments, or prepared statements of:
    Senator Fitzgerald...........................................   958
        Prepared statement.......................................   993
    Senator Collins..............................................   960
        Prepared statement.......................................   997
    Senator Levin................................................   962
        Prepared statement.......................................   999
    Senator Akaka................................................   964
        Prepared statement.......................................  1000

                               WITNESSES

Paul G. Haaga, Jr., Executive Vice President, Capital Research 
  and Management Company, Chairman, Investment Company Investment   970
    Prepared statement...........................................  1003
Chet Helck, President, Raymond James Financial, Inc..............   972
    Prepared statement...........................................  1039
Thomas O. Putnam, Founder and Chairman, Fenimore Asset 
  Management, Inc./FAM Funds.....................................   974
    Prepared statement...........................................  1045
Edward A.H. Siedle, President, Benchmark Financial Services, Inc.   976
Mark Treanor, General Counsel, Wachovia Corporation, on behalf of 
  the Financial Services Roundtable..............................   978
    Prepared statement...........................................  1051

                              ----------                              

                        THURSDAY, APRIL 8, 2004

Opening statement of Chairman Shelby.............................  1057

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................  1058
    Senator Bunning..............................................  1060
    Senator Reed.................................................  1061
    Senator Corzine..............................................  1062
        Prepared statement.......................................  1091
    Senator Stabenow.............................................  1062
    Senator Carper...............................................  1063
    Senator Sununu...............................................  1067
    Senator Santorum.............................................  1080
    Senator Enzi.................................................  1091

                                WITNESS

William H. Donaldson, Chairman, U.S. Securities and Exchange 
  Commission.....................................................  1064
    Prepared statement...........................................  1092
    Response to written questions of:
        Senator Reed.............................................  1102
        Seantor Corzine..........................................  1105
        Senator Enzi.............................................  1107
        Senator Miller...........................................  1111

              Additional Material Supplied for the Record

Letter from William H. Donaldson, Chairman, U.S. Securities and 
  Exchange Commission to Senator Corzine, dated June 29, 2004....  1112
Letter from various U.S. Senators to William H. Donaldson, 
  Chairman, U.S. Securities and Exchange Commission, dated April 
  8, 2004........................................................  1116

 
                    REVIEW OF CURRENT INVESTIGATIONS
                    AND REGULATORY ACTIONS REGARDING
                        THE MUTUAL FUND INDUSTRY

                              ----------                              


                       TUESDAY, NOVEMBER 18, 2003

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10 a.m. in room SD-538 of the Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing shall come to order.
    This hearing is part of the Committee's ongoing oversight 
of the mutual fund industry. Today, the Committee will review 
current investigations and enforcement proceedings and examine 
regulatory actions taken to date in order to fully inform and 
guide the Banking Committee's consideration of possible 
legislative reform.
    On September 30, 2003, this Committee first examined the 
scope of problems confronting the mutual fund industry. At that 
time, Chairman Donaldson testified about the SEC's ongoing 
enforcement actions and described the SEC's regulatory 
blueprint for adopting new regulations aimed at improving the 
transparency of fund operations and stopping abusive trading 
practices. Since Chairman Donaldson's testimony, we have 
learned that improper fund trading practices are a widespread 
problem that fund insiders, brokers, and privileged clients 
have profited from at the expense of average investors.
    In early September, New York Attorney General Spitzer 
uncovered arrangements through which brokers facilitated 
improper trades for their clients in certain prominent mutual 
funds in exchange for large, fee generating investments. Since 
this initial settlement, we have learned the extent to which 
both intermediaries, such as brokers, and fund executives have 
engaged in illicit trading activities. We have read about the 
backhanded ways by which the brokers colluded with their 
customers to disguise improper trade orders to make them appear 
legitimate, thus evading detection by mutual fund policing 
systems.
    Even in situations where mutual funds attempted to halt 
improper trading activity, certain brokers created fictitious 
names and account numbers to fool fund compliance officers and 
to continue trading. Recent investigations have also revealed 
that mutual fund executives and portfolio managers have 
actively engaged in improper trading activity. And these 
allegations are particularly troubling because fund executives 
and portfolio managers have 
represented themselves as protecting client assets, but they 
failed by either knowingly permitting improper trading by 
brokers or 
actively engaging in illegal trading activities themselves.
    Such practices may not only violate prospectus disclosures, 
but also violate the fiduciary duties that funds owe to their 
shareholders--the duties to treat all shareholders equitably 
and to protect shareholder interests. Further, regulators have 
indicated that they may soon file charges against funds that 
have selectively 
disclosed portfolio information to certain privileged investors 
and fund executives that may have engaged in illegal insider 
trading by acting on the basis of nonpublic information.
    As this Committee made clear during Chairman William H. 
Donaldson's September 30 appearance here, a regulatory response 
to improper trading activities is just one of the many actions 
that the SEC must take to address the many troubling issues 
that have come to light in the mutual fund industry. This 
Committee remains concerned with the transparency of fund 
operations and ensuring that investors can learn how their fund 
is being managed. It has become very, very apparent that many 
of the questionable fund practices that are now being examined 
are not just the result of a few bad actors, but are 
longstanding industry practices that have largely gone 
unregulated and not well disclosed to, or understood by, most 
investors.
    Therefore, this Committee must take a comprehensive look, I 
believe, at the industry to determine if the industry's 
operations and practices are consistent with investors' 
interests and the greater 
interests of the market. It may be that we must consider 
possible 
realignment of interests to ensure that mutual funds are 
operating as efficiently and fairly as the market and investors 
demand. We will examine fund disclosure practices regarding 
fees, trading costs, sales commissions, and portfolio holdings. 
So, we will continue to question the conflicts of interest 
surrounding the relationship between the investment adviser and 
the fund and how potential changes to fund governance and 
disclosure practices may minimize these conflicts.
    We will also focus on fund sales practices to ensure that 
brokers sell suitable investments to their clients, provide 
adequate disclosure of any sales incentives, and give clients 
any breakpoint discounts to which they are entitled.
    Chairman Donaldson has told this Committee that the SEC has 
the necessary statutory authority to reform the mutual fund 
industry and is in the process of conducting a comprehensive 
rulemaking. As we have learned in other contexts, however, 
additional regulation is not the only answer. Late trading is 
clearly illegal and market timing is actively deterred and 
policed. Despite prohibitions and warnings, these activities 
continued unabated because of the 
inadequate compliance and enforcement regimes at the SEC, the 
mutual funds and the brokers. Whether due to a lack of 
resources or other pressing priorities, mutual fund abuses 
simply did not receive adequate attention from the SEC. 
Although recent enforcement actions indicate that priorities 
have changed, we need to
understand how the SEC will revise compliance programs to 
detect and halt future fund abuses.
    Vigorous enforcement remains the key to restoring integrity 
to the fund industry, and Attorney General Spitzer's timely 
actions once again demonstrate, I believe, the significant role 
that States play in prosecuting fraud and abuse in the 
securities markets. Regardless of the number of rules or amount 
of resources, it would be impractical to expect the SEC to 
detect every single fraud and manipulation in the fund 
industry. Therefore, the mutual funds and the brokerage houses 
themselves must proactively adopt new compliance measures to 
detect fraud and abuse. For many years, participants in the 
mutual fund industry maintain industry ``best practices.'' 
These practices, however, have clearly proven to be inadequate 
as brokers and funds have disregarded conflicts of interest and 
colluded at the expense of investors without detection.
Although funds and brokers owe different types of duties to 
their investors, both groups have an obligation to refrain from 
knowingly ignoring their clients' interests and profiting at 
their expense.
    With over 95 million investors and $7 trillion--yes, $7 
trillion--in assets, mutual funds have always been perceived as 
the safe investment option for average investors. America has become a 
Nation of investors, but there is no doubt that recent 
revelations about mutual funds have caused very many to 
question the perceived fairness of the industry. Many are 
surprised to learn that the mutual fund industry is plagued by 
the same conflict that was at the root of the Enron scandal and 
the global settlement--one set of profitable rules for insiders 
and another costly set for average investors.
    Beyond the legal concepts of fiduciary duties and 
transparency, there is a more fundamental principle that should 
underlie the operation of the mutual fund industry and our securities 
markets in general.
    This principle is that securities firms and mutual funds 
should not neglect investors' interests and knowingly profit at 
their expense. Until firms can demonstrate an ability to abide 
by this ideal, investors will not trust the markets, nor should 
they. In our own way, Congress, the SEC and regulators, and 
industry participants must collectively work to reform the 
mutual fund industry in order to restore investor confidence. I 
believe, we must reassure investors that mutual funds are a 
vehicle in which they can safely invest their money and not 
fall victim to financial schemes. The mutual fund industry is 
simply too important to too many Americans to do otherwise.
    Examining the mutual fund industry is a priority for this 
Committee, and I look forward to working with my fellow 
Committee Members, especially Senators Enzi, Dodd, and Corzine, 
all of whom have already expressed significant interest in this 
issue.
    Our first witness today is Chairman Bill Donaldson, and on 
the second panel we will hear from Matthew Fink, President of 
the Investment Company Institute, and Marc Lackritz, President 
of the Securities Industry Association.
    Now, I will call on my Members.
    Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Chairman Shelby, and 
Chairman Donaldson, we are pleased to welcome you back before 
the Committee.
    Chairman Shelby, I want to thank you for scheduling this 
important and timely hearing, the first in a series of hearings 
on mutual funds the Committee will hold this Congress. We have 
a second one scheduled on Thursday afternoon, I believe.
    Chairman Shelby. That is right.
    Senator Sarbanes. As concerns mount through the country 
about unfair, improper, and illegal practices in the mutual 
fund industry, today's hearing gives us the opportunity to 
examine the status of current investigations and the regulation 
of the mutual fund industry. I also look forward to Thursday's 
hearing when we will hear from the Director of Enforcement at 
the SEC, Stephen Cutler, New York Attorney General Eliot 
Spitzer, and NASD Chairman and CEO Robert Glauber.
    Already, as you have noted, Mr. Chairman, a number of 
Senators have indicated their intention to work on this issue 
or have introduced legislation, including on our own Committee, 
Senators Corzine and Dodd. I am well aware of the strong 
interests of Senator Enzi, Chairman of the Subcommittee on 
Securities, with this matter, and I look forward to working 
with all of them. I should also note the strong interest of 
Senators Fitzgerald, Lieberman, and Akaka on the Government 
Affairs Committee, where a hearing was held just a short while 
ago.
    Chairman Shelby, I appreciate your undertaking hearings on 
this issue and your expressed interest to work with the 
Subcommittee and all Members of the full Committee, as you have 
consistently done in the past on many of the issues that have 
come before us.
    Almost 100 million Americans, representing 54 million 
households--more than half of all U.S. households--own mutual 
funds. The funds have a total, as Chairman Shelby noted, of 
more than $7 trillion in assets. Millions of small investors--
savers--entrust their investment decisions to fund managers who 
are not only more knowledgeable and experienced, but also, at 
least in theory, honest and fair. Many people have looked upon 
mutual funds as a reliable alternative to traditional savings 
accounts.
    In the last few months, deeply disturbing practices 
involving a growing number of funds have come to light. The 
disclosures began with New York Attorney General Spitzer's 
announcement on September 3, 2003, that a hedge fund, Canary 
Capital Partners, had engaged in illegal trading involving 
``late trading'' and ``market timing.'' And every week since 
then, we have been getting additional disturbing revelations.
    At the time of the Canary Capital Partners' settlement, 
Attorney General Spitzer said, ``I think it is a near certainty 
that other mutual fund companies will be named as having 
participated in these types of improper trading activities.'' 
Unfortunately, his prediction has turned out to be all too 
accurate.
    Chairman Donaldson said, on October 30, only a few weeks 
ago, ``The market timing and late trading issues are quite 
widespread. We are still gathering data on this and we think it 
is more widespread than we originally anticipated.'' Chairman 
Donaldson, we are looking forward to your update on these 
issues this morning.
    The revelation of these mutual fund practices are eroding 
investor confidence in some firms in the mutual fund industry. 
For example, The Wall Street Journal reported on November 11, 
2003, a week ago, that ``Assets under management at Putnam 
Investments, the first firm charged in the mutual fund trading 
scandal, dropped $14 billion in the week ended Friday.'' At 
least five States reportedly have dropped Putnam Investments as 
the manager of their retirement accounts.
    Just yesterday, the SEC announced a $50 million settlement 
with Morgan Stanley. The allegations in that particular case 
were that Morgan Stanley received incentives to push certain 
funds on investors instead of others, either through payments 
or through brokerage commissions that were paid in part to 
compensate the sale of funds.
    As the Committee launches these hearings, we must determine 
whether new laws, new regulations, or more effective 
enforcement of existing laws, or all of the above are needed to 
address these problems. Areas that need thorough examination 
include: late trading; market timing; fund governance; 
conflicts of interest; investor awareness of fund fees; special 
incentives to sell proprietary funds; fund structure; selective 
disclosure of portfolio holdings; trading by fund insiders; 
breakpoint discounts; sales practices; portfolio turnover; the 
effectiveness of the current regulatory scheme, including 
whether sufficient coordination exists at the SEC between the 
Divisions of Inspections and Compliance, Investment Management, 
and Enforcement; and whether an additional regulatory 
organization or board for the mutual fund industry would be 
beneficial.
    As we review these areas and others, we must ensure that 
managers of mutual funds and the broker-dealers that sell 
mutual funds are not profiting unfairly at the expense of their 
investors.
    Mr. Chairman, I think the witnesses we are starting off 
with today are uniquely positioned to address these issues, and 
I look forward to their testimony this morning.
    Chairman Shelby. Senator Enzi.

              STATEMENT OF SENATOR MICHAEL B. ENZI

    Senator Enzi. Thank you, Chairman Shelby, and thank you for 
holding this hearing today.
    During the past few months, I am not sure that a single day 
has passed without the abuses of the mutual fund industry 
appearing on the front pages of newspapers and being featured 
in television and radio interviews. The situation seems a 
little reminiscent of the scandals that led up to the passage 
of the Sarbanes-Oxley Act. You can tell there is a lot of 
interest by the number of Committee hearings that are being 
held by Committees of nonjurisdiction----
    [Laughter.]
    Senator Enzi. --as well as the number of bills being 
written both in the House and in the Senate to deal with this, 
even before extensive hearings have been held. I do hope that 
the same methodical, balanced process of hearings as with the 
accounting reform will be done on this issue.
    The troubles with the securities industry also bear a 
strange resemblance to the troubles that faced the banking 
industry in the late 1980's and in the early 1990's. During the 
early and the mid-1980's, the banking industry encountered a 
sizzling economy and a set of banking regulators that was 
considerably weak. The banking industry took advantage of the 
situation, and our Nation was faced with one of the most severe 
banking crises since the Second World War.
    In the late 1980's and the early 1990's, Congress passed a 
series of banking laws to give the banking regulators a much 
stronger regulatory scheme and enforcement authority to set the 
industry straight. Today, our banking system is very strong, 
and sound, and investor confidence in the primary banking 
business is high.
    Today, the securities industry mimics the banking industry 
of the early 1990's. The securities industry, like their 
banking counterparts, took advantage of a very strong economy 
of the late 1990's and a weakness with the regulator. Law 
changes came. Last year, when accounting irregularities 
surfaced, we started with the passage of the Sarbanes-Oxley Act 
to restore investor confidence. It appears almost certain that 
legislation will be necessary to restore investor confidence in 
the mutual fund industry now.
    The major difference that I would like to see in Congress' 
reaction to the crisis in the securities industry is to 
thoroughly evaluate the problem to find the right solution. One 
of the major problems that Congress had with passing several 
large pieces of legislation with the banking legislation in a 
relatively short period of time is today the banking industry 
may be overregulated, and that hurts community banks' ability 
to survive and to grow, and that is very important in the rural 
areas.
    With respect to the securities industry, we should not rush 
to pass legislation, as we may do undue harm to the industry. 
However, we should take the approach that we used in the 
Sarbanes-Oxley Act. Typically, for every action, Congress has a 
tendency to overreact. In this situation, we need to thoroughly 
review the problems to find the right solution. We know that 
the legislation that we pass is never perfect. With the 
Sarbanes-Oxley Act, we are still trying to be careful of the 
cascading effect that it can have on small entities.
    There may be unintended consequences to solutions that we 
now consider for mutual funds. Currently, the SEC has the 
authority under existing law to handle the late trading and 
timing issues. There is a record trail of all of these 
transactions. What needs to be done is to adjust the current 
regulatory scheme and to have greater enforcement of those 
rules.
    I welcome Chairman Donaldson here yet again. We thank you 
for appearing before the Committee. I know this has been a 
hectic year for you, and hopefully with the passage of laws to 
increase the appropriations and the hiring authority for the 
SEC, we have made the SEC much stronger. The examination and 
enforcement arms of the SEC are in need of greater assistance.
    Again, I thank the Chairman for holding this hearing.
    Chairman Shelby. Senator Reed.

                 STATEMENT OF SENATOR JACK REED

    Senator Reed. Thank you very much, Chairman Shelby, and I 
welcome Commissioner Donaldson.
    I want to thank Chairman Shelby for holding this important 
and timely hearing, and I hope that we will use this as an 
opportunity for a thoughtful discussion on effective and 
aggressive enforcement and also to continue to encourage all of 
the regulators--the SEC, the Nasdaq, and the Attorney General--
to work collaboratively to punish the wrongdoers.
    The behavior we have observed represents a profound breach 
of trust, and ultimately all markets rest on a foundation of 
trust. So this is not merely an example of technical problems; 
these very well could be existential problems if we do not move 
rapidly, aggressively and effectively, and I hope we can do 
that.
    There are approximately 8,200 mutual funds with over $7 
trillion in assets. Thirty-eight percent of those assets come 
from 401(k)s. To many investors, mutual funds or for 
professional advisers, instant diversification, liquidity and a 
wide range of investment choices, and the advantages of mutual 
funds would be hard to achieve for the small investor on his or 
her own.
    However, with these daily revelations of wrongdoing by some 
of the most reputable mutual fund companies, by allowing the 
favored investors to take advantage of rank and file, it is 
very clear that average investors are becoming increasingly 
worried about their financial futures.
    There was an article in last Sunday's New York Times that 
said it well: ``Employees saving for retirement cannot seem to 
catch a break. After nearly 3 years of painful bear market 
losses, revelations of improper trading by insiders and a few 
favored investors began to raise fundamental questions about 
the trustworthiness of mutual fund managers.''
    And if we do not rapidly and effectively answer those 
questions about trustworthiness, then the market will be in a 
serious, serious predicament. I hope this hearing will go a 
long way to start responding to the concerns of the investing 
public and maintain the advantages of mutual funds without the 
trading that has discouraged people today from participating as 
they should.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Allard.

               STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. Mr. Chairman, I would like to thank you for 
holding this important hearing, and I appreciate your special 
attention to this matter, as well as Senator Enzi, as we 
witnessed a disturbing amount of misconduct that apparently has 
overtaken the mutual fund industry in recent months.
    I do not think anybody can dispute the fact that mutual 
funds are a vital part of the U.S. economy. The $7 trillion in 
assets is a substantial amount of money based on anybody's 
standards. When you look at the number of households that are 
participating in 
mutual funds, I think Senator Sarbanes mentioned something like 
50 percent or so, and that is my understanding too. And 
households are using these dollars to meet the needs of the 
family. It is educational needs. It is retirement--especially 
retirement needs. That is a big part--educational needs and in 
some cases to help afford a house.
    So it is absolutely vital that we can assure people who are 
participating in mutual funds that it is a fair process and 
that it is something they can rely on for their future needs. 
In my view, all investors should be treated fairly, both the 
small investor, as well as the institutional investor. Recent 
events have proven that there is not equal access to the 
handling of mutual funds. In order for a fund to succeed and an 
investor to remain confident in his or her investment, all 
aspects of the mutual fund business must be as transparent as 
possible.
    Investors need to be able to have confidence in their fund 
managers and know that their money is not being manipulated by 
the manager. Therefore, investors need to be able to have 
confidence that there are not other investors who have 
privileged access to the handling of the mutual fund.
    Again, I would like to thank Chairman Donaldson for coming 
before the Committee today to discuss the ways the Commission 
can enhance the protection of the investor rights and prevent 
the abuses that have seemingly become widespread.
    I would also like to thank Mr. Fink and Mr. Lackritz for 
taking the time to be here today, and I look forward to their 
testimony, Mr. Chairman.
    Chairman Shelby. Thank you, Senator Allard.
    Senator Corzine.

              STATEMENT OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you, Mr. Chairman, and I appreciate 
you holding the hearings and beginning this process of 
examining both the issues and potential responses that we 
should be taking to deal with a problem that is very real. I 
welcome the Chairman as well. It has been an incredible year 
for you.
    Mutual funds, as all of us know, are a fundamental vehicle 
for investors to participate in America's capital markets, not 
just the equity markets, but also bond, real estate, and a 
whole series of assets. And we have heard that 95 million 
Americans invest nearly $7 trillion. This is really key and a 
cornerstone of the success of capital formation and savings in 
this country.
    The industry, which is one of our oldest, and at least from 
my perspective and understanding until recently, really one of 
the most respected industries, entrusted by those 95 million 
shareholders, and I think, for the most part, has done well in 
promoting those dreams and retirement and ability to pay a 
child's college tuition, buy a home, all of the things that we 
talked about.
    But it is quite clear that, in recent times, our mutual 
fund industry has moved away from some of those long traditions 
that I think have been a part of it, and it has been brought on 
by many individuals, their own actions, their own sense of 
excess, and some would even say greed. It started out as an 
investigation at the behest of whistleblowers to the New York 
State Attorney General's Office and has become really, I think, 
one of the underlying most serious scandals we have in the 
history of any marketplace, from my view, given the broad 
retail participation, small investor participation that goes on 
here.
    I am not going to go through the laundry list of issues. We 
have talked about them. I do think we need a very serious, 
thoughtful, not overreaching response, but one that restores 
the confidence of investors and participants in this market and 
needs to be done in a relatively expeditious manner.
    As the Chairman noted and others, Senator Dodd and I just 
announced a plan to introduce legislation at the end of this 
Committee's series of hearings on the mutual fund industry. We 
have laid out a number of the points of outline with regard to 
governance, and disclosure, and fund governance, and I think 
that action will be needed if we want to see what is an 
extraordinary asset in America's financial system to continue 
to prosper. And if we want to see capital formation in this 
country prosper in a way that I think makes us unique in the 
developed world, we need to get a handle on this and move 
relatively quickly.
    I thank the Chairman and I am looking forward to hearing 
the 
remarks not only of Chairman Donaldson, but also of the other 
witnesses as well.
    Chairman Shelby. Senator Bayh.

                 STATEMENT OF SENATOR EVAN BAYH

    Senator Bayh. I thank the Chairman, and I want to thank the 
Committee for conducting this hearing today. You know a subject 
is topical when we have a literally standing room only crowd in 
the hearing room. So, I thank you for focusing on a matter of 
such importance.
    Chairman Donaldson, thank you for your diligent efforts 
these last 9 months to get on top of some very difficult 
problems. I am tempted to ask if you have had any buyer's 
remorse since accepting this appointment. We thank you for your 
public service.
    This is critically important because it affects the 
continued democratization of our capital markets, which has 
been one of the great trends in American free enterprise over 
the last several decades. It would be truly unfortunate if 
average Americans concluded that the only safe place for their 
savings was back in the mattress once again, rather than in 
financial instruments on which they could rely. Such a 
conclusion would be harmful to our economy. It would be harmful 
to them. So it is this basic trust that convinces ordinary 
Americans that they can invest with confidence that we address 
here today.
    In my own State, Senator Corzine and others have mentioned 
the 95 million shareholders, we have 2.1 million mutual fund 
shareholders just in the State of Indiana. So this is a matter 
of great significance to ordinary people across the heartland 
of the country, and we look forward to hearing from you about 
that today.
    My colleagues have touched upon a variety of topics--two 
others I would throw out, starting with I hope at some point, 
either in response to questions or in your testimony you can 
address what can ordinary Americans do, what are ordinary 
investors to think? I suspect a lot of what we will talk about 
here today will sound like we are speaking in Chinese to them, 
but in layman's terms, what can they do to protect themselves? 
How can they be intelligent participants in the investing 
marketplace and seek out vehicles on which they can rely? What 
should they look at in terms of the companies in which they 
invest? To the extent that you can address that, I think it 
would be very helpful to empowering investors to protect 
themselves.
    Second, as a former Chief Enforcement Officer of my own 
State, in terms of the securities laws, I am curious as to what 
you perceive to be the appropriate balance, in terms of 
jurisdictional responsibilities, between the Federal Government 
and the States, the SEC and the various State authorities 
assigned to protect ordinary investors from potential abuses? 
That has been a matter of some controversy of late, 
particularly with regard to the Putnam issue, which I 
understand Senator Sarbanes mentioned. So if you could perhaps 
discuss what in your view is the appropriate balance of 
jurisdiction between the Federal and State authorities, I think 
that could be very helpful.
    I, again, commend you for your efforts and thank you for 
taking the time to be here today.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Dodd.

            STATEMENT OF SENATOR CHRISTOPHER J. DODD

    Senator Dodd. Thank you very much, Mr. Chairman, and 
welcome, Chairman Donaldson of the SEC. It is good to have you 
here before the Committee again.
    First of all, let me thank the Chairman of the SEC. You are 
going to be appearing a couple of times this week, both on this 
issue and on corporate governance issues. We appreciate your 
being here before the Committee.
    Chairman Shelby, let me thank you as well. The hearing 
today and the hearing I guess on Thursday that we will be 
conducting is very timely and important. With all we have going 
on, there is a lot on our agenda this week. This is truly a 
critical issue, I appreciate the leadership of you, Chairman 
Shelby, and Senator Sarbanes on making this a matter before the 
Committee.
    Just a couple of points. I presume some of these things 
have been mentioned already by my colleagues. Obviously, the 
volume, the number of Americans who seek out mutual funds as a 
way of producing wealth and also providing long-term financial 
security for themselves has been well documented. It is 
critically important that we not take this remarkable success 
story, which mutual funds have been, and have them, in some 
way, have people start to flee from them. I am sure all of us 
share that common thought. It is hard these days not to pick up 
the newspaper and find yet another story of another fund that 
has had some serious problems.
    My colleague from New Jersey has already mentioned the fact 
that he and I have at least put together some ideas as a bill, 
which we will be interested in your comments on, what you think 
of what we have suggested. It is rather lengthy in its nature. 
It covers about four major areas, in the area of governance, 
and cost, and oversight and the like. So, we would be very 
interested in the comments of the SEC on it.
    I respect as well the work that is being done by Senator 
Akaka, my colleague, Senator Lieberman, I think has legislation 
in, as well as Congressman Baker and Congressman Oxley as well 
are moving on legislation. So there are some legislative 
vehicles that are moving through the Congress, and it seems to 
me we should try and respond to those if, in fact, that is 
appropriate.
    There are obviously some fundamental changes I think that 
are going to be needed in the way of funds and how they are 
governed, and I would like to hear your thoughts on that and 
your testimony.
    The widening gap between what investors believe mutual 
funds cost and the actual cost is one of the areas that we have 
addressed very strongly in our proposed legislation, and I 
would be interested in your thoughts there as well and looking 
at the current oversight of the industry.
    Finally, I would say to you here obviously restoring 
confidence in the mutual fund industry is important. What also 
is important--and I know you share this thought--is restoring 
confidence in the SEC as well. I appreciate the article, the 
op-ed piece that you wrote. But it is very important that we 
get in front of this so that people will understand that the 
``cop on the beat,'' as well as the policy-setters, if you 
will, here are in tandem.
    Let me underscore the comment that was made by Senator Bayh 
as well. We need to get to the point where between what is 
going on in the States--and we are going to hear from Eliot 
Spitzer later this week--there are other attorneys general 
around the country that are moving in this area, and I think in 
order to try and not have this become more confusing for people 
to try and see to it that we are coordinating these activities. 
And that should not be one level of Government competing with 
another on this issue. We all should be heading in the same 
direction, rowing in the same direction, and I hope that is an 
issue we can address as well.
    So with that, Mr. Chairman, I thank you.
    Chairman Shelby. Now, Mr. Chairman, your written testimony 
will be made part of the record in its entirety. You may 
proceed as you wish.

               STATEMENT OF WILLIAM H. DONALDSON

                            CHAIRMAN

            U.S. SECURITIES AND EXCHANGE COMMISSION

    Chairman Donaldson. Chairman Shelby, Ranking Member 
Sarbanes, and Members of the Committee, thank you for inviting 
me to testify on the Securities and Exchange Commission's 
initiatives to address problems in the mutual fund and 
brokerage industry. When I testified before you on September 
30, the discovery of late trading and market timing abuses by 
personnel at the hedge fund Canary Capital had just erupted. I 
will update you on recent developments since then. First, 
though, I would like to share with you the fundamental rights 
that I believe every mutual fund investor not only should 
expect, but also to which every investor is entitled. We all--
regulators, legislators, the brokerage and mutual fund 
industry, the financial press and investors themselves--have 
spent much time lately wondering how the current abuses could 
have happened. I believe that a significant reason is because 
the industry lost sight of certain fundamental principles--
including its responsibilities to the millions of people who 
entrusted their confidence, the fruits of their labor, their 
hopes and their dreams for the future to this industry for 
safekeeping. These investors are entitled to honest and 
industrious fiduciaries who sensibly put their money to work 
for them in our capital markets. No one can argue with the fact 
that investors deserve a brokerage and mutual fund industry 
built on fundamentally fair and ethical legal principles.
    Let me just briefly outline these rights, as I see them, 
and the critical initiatives underway at the Commission to 
ensure that enhanced and crucial investor protections deriving 
from these rights are put in place as quickly as possible.
    First, mutual fund investors have a right to an investment 
industry that is committed to the highest ethical standards and 
that places investors' interests first. Every brokerage and 
mutual fund firm needs to conduct a fundamental assessment of 
its obligations to its customers and shareholders. These 
assessments must be put forth at the highest levels, and 
implemented so as to reach all employees. Senior management and 
the boards of directors must be ready to lay down and 
vigorously enforce rules that define an immutable code of 
conduct.
    Second, investors have a right to equal and fair treatment 
by their mutual funds and brokers. Our examinations and 
investigations of late trading and market timing abuses have 
revealed instances of special deals and preferential treatment 
being afforded to large investors, often to the detriment of 
small investors. The concepts of equal and fair treatment of 
all investors and the prohibition against using unfair 
informational advantages are embedded in various provisions of 
the Federal securities laws, including the Investment Company 
Act. The SEC will not tolerate arrangements of this kind that 
violate these fundamental principles.
    Third, investors have a right to expect fund managers and 
broker-dealers to honor their obligations to investors in 
managing and selling funds. Our examinations and investigations 
into the current abuses have revealed instances of fund 
managers placing their interests--and in the case of some 
portfolio managers, placing their personal interests--ahead of 
those of fund investors. We have also seen recent examples of 
abusive activity by broker-dealers and their representatives in 
connection with the sale of fund shares, including failure to 
give investors the breakpoint discounts to which they are 
entitled, recommendations that investors purchase one class of 
shares over another in order for the salesperson to receive 
higher compensation and other sales practice abuses. This 
cannot be and will not be tolerated.
    Fourth, investors have a right to the assurances that fund 
assets are being used strictly for their benefit. Clearly, fund 
assets, including the use of a fund's brokerage commissions, 
must be used in a manner that benefits fund investors. The 
Commission must engage in a reassessment of how fund commission 
dollars are used, including various soft-dollar arrangements 
and the lack of transparency to investors of these payments.
    Fifth, investors have the right to clear disclosure of 
fees, expenses, conflicts, and other important information. 
Mutual fund investors must have the tools and the information 
to make intelligent investment decisions. To that end, the 
Commission will take action to enhance disclosure to fund 
investors of fees and expenses, and the conflicts that arise as 
a result of the various arrangements between funds and brokers 
regarding the sale of fund shares, as well as other important 
information.
    Sixth, investors have a right to independent, effective 
boards of directors who are committed to protecting investors' 
interests. Investors need to be assured that their mutual fund 
directors have the independence and commitment necessary to 
carry out this crucial function. We are proposing to set 
enhanced standards for board independence and are considering 
other steps in this area.
    Seventh, investors have a right to effective and 
comprehensive mutual fund and broker compliance programs. 
Programs designed to ensure compliance with the Federal 
securities laws are an essential tool in the protection of 
investors. Fund investors need to be assured that all funds, 
advisers, and selling brokers have internal programs to ensure 
compliance with the Federal securities law. We will complete 
our pending rulemaking to strengthen procedures at mutual funds 
and advisers.
    Eighth, investors should expect that aggressive enforcement 
actions will be taken when there are violations of the Federal 
securities laws. We will continue to take strong and 
appropriate action against those who violate the Federal 
securities laws. So there will be serious consequences to those 
who violate the law. Wherever appropriate, we will ensure that 
investors receive restitution.
    By holding the industry--and I might add ourselves--to 
these standards, we can significantly minimize the possibility 
of future scandals that harm millions of mutual fund investors, 
and hopefully restore their confidence in the industry.
    Now let me just outline specific initiatives to ensure that 
the mutual fund investors' rights that I have outlined are 
realized.
    For too long, the Commission has found itself in a position 
of reacting to market problems, rather than anticipating them. 
There are countless reasons for this--not the least of which 
include historically lagging resources and structural and 
organizational roadblocks. The time for excuses has long 
passed.
    Since the President nominated me to the Commission in 
February, one of my top priorities has been to reevaluate and 
determine how the Commission deals with risk. Part of this 
evaluation has been a thorough review of the Commission's 
internal structure. The results of our work form the basis for 
a new risk management initiative that will better enable the 
Commission to anticipate, identify, and manage emerging risks 
and market trends that stand to threaten the Commission's 
ability to fulfill its mission.
    This critical initiative--the first of its kind at the 
Commission--will enable us to analyze risk across divisional 
boundaries, focusing on early identification of new or 
resurgent forms of fraudulent, illegal, or questionable 
behavior or products. Operating under the ``Doctrine of No 
Surprises,'' this initiative seeks to ensure that senior 
management at the Commission has the information necessary to 
make better, more informed decisions.
    The new initiative will be housed within a newly created 
Office of Risk Assessment, and will be headed by a director who 
reports directly to the Chairman. The director will coordinate 
and manage risk assessment activities across the agency, and 
will oversee a staff of five professionals, who will focus on 
the key programmatic areas of the agency's mission.
    The duties of the Office of Risk Assessment will be focused 
on the following areas: Gathering and maintaining data on new 
trends and risks from a variety of sources--including external 
experts, 
domestic and foreign agencies, surveys, focus groups, and other 
market data, including both buy-side and sell-side research. 
Analyzing data to identify and to assess new areas of concern 
across professions, companies, industries, and markets. 
Preparing assessments and forecasts on the agency's overall 
risk environment.
    The work of the Office of Risk Assessment will be 
complemented by a Risk Management Committee. Additionally, each 
division and major office will have one-to-two risk assessment 
professionals on staff, who will work closely with the division 
director or office head as a part of the risk management teams.
    I believe this important initiative will fundamentally 
change the way the Commission assesses risk and help us, I 
hope, head off major problems before they occur.
    In addition to fundamental changes in risk assessment, I 
have ordered the Division of Enforcement to enhance its 
existing mechanism and processes for handling complaints. In 
particular, the process of receiving, analyzing, and responding 
to all public tips has been streamlined and standardized. We 
receive approximately 1,000 complaints and tips every day. We 
are upgrading our system for handling these inputs to ensure 
that each one--regardless of where it comes from, how it comes 
to us, via phone, Internet, or 
e-mail--is analyzed, clearly logged detailing the nature of the 
complaint or tip, when it was received and how it was handled 
or disposed of by the SEC staff. To ensure speedy and 
appropriate
disposition of each tip or complaint, a senior manager will 
review the log on a regular and frequent basis.
    Now as to late trading and market timing abuses--late 
trading and market timing abuses represent the most recent 
violations against investors' rights. In addition to those 
abuses, we have seen other violations of investors' rights, 
including, to name but a few, violations of an investors' right 
to high ethical standards, fiduciary protections, clear 
disclosure, and equal treatment. While we are vigorously 
pursuing enforcement actions regarding this misconduct, we are 
also taking a number of regulatory steps immediately to deal 
specifically with these abuses.
    On December 3, the Commission will consider a package of 
reforms to combat late trading and market timing abuses. The 
package includes the staff 's proposal requiring that a fund or 
certain designated agents--rather than an intermediary such as 
a broker-dealer or other unregulated third party--receives a 
purchase or redemption order prior to the time the fund prices 
its shares, which is typically 4 p.m. Eastern Standard Time, 
for an investor to receive that day's price. This ``hard'' 4 
o'clock cutoff would effectively eliminate the potential for 
late trading through intermediaries that sell fund shares.
    With respect to market timing abuses, the Commission will 
consider requiring additional, more explicit disclosure in fund 
offering documents of market timing policies and procedures. 
This disclosure would enable investors to assess a fund's 
market timing practices and determine if they are in line with 
their expectations.
    The staff 's recommendations will have a further component 
of requiring funds to have specific procedures to comply with 
the representations regarding market timing policies. While our 
examination staff will use a variety of techniques to police 
for market timing abuses, the establishment of formal 
procedures will also enable the Commission's examination staff 
to review whether those procedures are being followed and 
whether the fund is living up to its representations. The 
Commission also will emphasize the obligation of funds to fair 
value their securities so as to avoid ``stale pricing'' to 
minimize market timing arbitrage opportunities as an important 
additional measure to combat market timing activity.
    Also on December 3, the Commission will consider adoption 
of new rules under the Investment Company Act and the 
Investment Advisers Act that will ensure that mutual funds have 
strong compliance programs. Specifically, the rules that the 
Commission will consider would require each investment company 
and investment adviser registered with the Commission to: One, 
adopt and implement written policies and procedures reasonably 
designed to detect and to prevent violations of the Federal 
securities law. Two, review these policies and procedures 
annually for their adequacy and their effectiveness. Three, 
designate a chief compliance officer to be responsible for 
administering the policies and procedures and to 
report directly to the fund's board of directors. A chief 
compliance 
officer reporting to the fund's board of directors will 
strengthen the hand of the fund's board and compliance 
personnel in dealing with fund management.
    Allegations of certain portfolio managers market timing the 
funds they manage or other funds in the fund complex raise 
issues regarding self-dealing. Recent allegations also indicate 
that some fund managers may be selectively disclosing their 
portfolios in order to curry favor with large investors. 
Selective disclosure of a fund's portfolio can facilitate fraud 
and have severely adverse ramifications for the fund's 
investors. You can expect that these issues will also be 
addressed in the rulemaking recommendations that the Commission 
will consider on December 3.
    The package of reforms that I have just outlined for you is 
designed to provide immediate reassurances and protection to 
mutual fund investors, but we cannot stop there. We will 
explore the full range of our authority, not only in the 
reforms discussed, but also in additional areas to further 
address market timing abuses.
    For instance, while the Commission's actions regarding fair 
value pricing should address the problem of stale pricing, 
which facilitates market timing, we will consider more in this 
area. As such, I have asked the staff to study additional 
measures for Commission consideration, including a mandatory 
redemption fee imposed on short-term traders and developing a 
solution to the problem of trading through omnibus accounts.
    Let me just touch on omnibus accounts for a minute. Trading 
through omnibus accounts, which are accounts held at 
intermediaries, such as broker-dealers, often means that mutual 
funds do not have the information on the identity of the 
underlying brokerage customer who is purchasing or redeeming 
the fund shares. This can make it difficult for funds to assess 
redemption fees, limit exchanges, or even kick out a 
shareholder who is market timing through an omnibus account 
because they just do not know the identity of that shareholder.
    To assist the staff as it moves forward in considering this 
issue, I have called upon the NASD to head an Omnibus Account 
Task Force consisting of members of the fund and brokerage 
industries, as well as other intermediaries to further discuss 
and study this issue and to provide the SEC staff with 
information and recommendations. Under the NASD's capable 
leadership, I am confident that working with the NASD and the 
industry, we will be able to develop a proposal that will 
adequately address the omnibus account issue, which is 
complicated.
    I also anticipate reforms in the area of fund governance. 
The statutory framework governing mutual funds envisions a key 
role for boards of directors in light of the external 
management structure typical for funds. The directors, 
particularly ``independent 
directors,'' are responsible for managing conflicts of interest 
and 
representing the interests of shareholders.
    I believe we need to improve and enhance the independence 
of fund directors, and there are a number of ideas for reforms 
including, but not limited to: Requiring an independent 
chairman of the fund's board of directors. Increasing the 
percentage of independent directors under SEC rules from a 
majority to three-quarters. Providing the independent directors 
the authority to retain staff as they deem necessary so that 
they do not have to necessarily rely on the fund's adviser for 
assistance. Requiring boards of directors to perform an annual 
self-evaluation of their effectiveness, including consideration 
of the number of funds they oversee and the board's committee 
structure; and adopting a rule that would require boards to 
focus on and preserve documents and information that directors 
use to determine the reasonableness of fees relative to 
performance, quality of the service and stated objectives, 
including a focus on the need for breakpoints or reductions in 
advisory fees and comparisons with fees and services charged to 
other clients of the adviser.
    I have also called upon the fund independent directors 
themselves to be active participants in the reform effort. 
Specifically, I have asked former SEC Chairman David Ruder's 
nonprofit mutual fund director's organization, the Mutual Fund 
Directors Forum, which is geared toward independent mutual fund 
directors, to
develop guidance and best practices in key areas of director 
decisionmaking, such as monitoring fees and conflicts, 
overseeing compliance, and important issues such as evaluation 
and pricing of fund portfolio securities.
    Another fundamental right of mutual fund investors is 
clear, easy-to-understand disclosure, including disclosure of 
the fees and expenses they pay. I anticipate that in January 
the Commission will consider the adoption of rules that will 
require actual dollars-and-cents fee disclosure to 
shareholders, coupled with more frequent disclosure of 
portfolio holdings information; this would allow investors to 
determine not only the fees and expenses they are paying for 
their particular funds and would also greatly facilitate 
comparison among different funds. We also want to provide 
investors better information on portfolio transaction costs so 
that they can factor this into their decisionmaking. 
Consequently, the staff is 
developing for Commission consideration in December a concept 
release to solicit views on how the Commission should proceed 
in fashioning disclosure of these costs.
    Investors deserve to know what fees and expenses their fund 
pays, and they also deserve to know how much their broker 
stands to benefit himself or herself from the purchase of a 
particular fund.
    Thus, we also plan to improve disclosure about mutual fund 
transaction costs through confirmations that broker-dealers 
provide to their customers. I have directed the staff to 
prepare for Commission consideration, by the end of this year, 
a new mutual fund confirmation statement that will provide 
customers with quantified
information about the sales loads and other charges that they 
incur when they purchase mutual funds with sales loads.
    Additionally, the staff will consider similar disclosures 
which will provide more information to investors at the point 
of sale. To address an investor's right to know about conflicts 
of interest that brokers may have when selling fund shares, the 
new mutual fund confirmation statement also will include 
specific disclosures regarding revenue sharing arrangements, 
differential compensation for proprietary funds and other 
incentives, such as Commission business for brokers to sell 
fund shares that may not be readily apparent to fund investors.
    To ensure that investors receive the benefits of fund 
assets to which they are entitled, the Commission will examine 
how brokerage commissions are being used to facilitate the sale 
and distribution of fund shares, as well as the use of soft-
dollar programs.
    I have also instructed the staff to consider rules that 
would better highlight for investors the basis upon which 
directors have approved management and other fees of the fund.
    The Commission long has recognized the importance of strong 
internal controls and will continue to explore additional 
approaches the Commission might pursue to require funds to 
assume a greater responsibility for compliance with the Federal 
securities laws, including whether funds and advisers should 
periodically undergo an independent third-party compliance 
audit. These compliance audits could be a useful supplement to 
our own examination program and could ensure more frequent 
examination of the funds and advisers.
    In addition to ensuring the funds' shareholders receive 
their fundamental rights, we also have to ensure effective 
enforcement of those rights and of the Federal securities law. 
Steve Cutler, the SEC's Director of Enforcement, will be 
testifying before you on our enforcement efforts Thursday, I 
believe, and he can answer your specific questions about the 
Commission's enforcement actions, as well as the results so far 
in our ongoing investigations.
    Let me emphasize, however, that I am appalled at the types 
and extent of conduct that is being revealed in our 
examinations and investigations. It is conduct that represents 
fundamental breaches of fiduciary obligations and betrayal of 
our Nation's investors. I can assure you we are committed to 
seeking redress for investors and meting out the appropriate 
punishment in these matters to send a strong message that these 
types of abuses will not be tolerated.
    Now if you will let me go for a couple of more minutes----
    Chairman Shelby. Go ahead, Mr. Chairman.
    Chairman Donaldson. Let me just touch on, and I realize I 
have been talking far too long.
    Chairman Shelby. Take your time.
    Senator Sarbanes. No, no. You should take all of the time 
you need to fully present this.
    Chairman Shelby. Absolutely. It is important.
    Senator Sarbanes. This is very important, and we need to 
know what the SEC has in focus.
    Chairman Shelby. Chairman, we are not rushing you at all. 
We have all day.
    Chairman Donaldson. Thanks.
    Senator Dodd. To a point--this is not a filibuster. We just 
went through that.
    [Laughter.]
    Chairman Donaldson. I want to discuss, briefly, last week's 
settlement of charges against Putnam relating to allegations of 
market-timing trades by certain Putnam employees. Among its 
many roles, the Securities and Exchange Commission has, in my 
view, two critical missions. The first is to protect investors, 
and the second is to punish those who violate our securities 
laws. Last week's partial settlement of the SEC's fraud case 
against the Putnam mutual fund complex does both. It offers 
immediate and significant protections for Putnam's current 
mutual fund investors. Moreover, by its terms, it enhances our 
ability to obtain meaningful financial sanctions against the 
alleged wrongdoing at Putnam and leaves the door wide open for 
further inquiry and regulatory action. And I want to emphasize 
that.
    Despite its merits, the settlement has provoked 
considerable discussion, and some criticism. Unfortunately, in 
my view, the criticism is misguided and misinformed, and it 
obscures the settlement's fundamental significance.
    By acting quickly, the SEC required Putnam to agree to 
terms that produce immediate and lasting benefits for investors 
currently holding Putnam funds. First, we put in place a 
process for Putnam to make full restitution for the investor 
losses associated with 
Putnam's misconduct. Second, we required Putnam to admit its 
violations for purposes of seeking a penalty and other monetary 
relief--an important point. And third, we forced immediate, 
tangible reforms at Putnam to protect investors from this day 
forward. These reforms are already being put into place, and 
they are working to protect Putnam investors from the 
misconduct we found in this case.
    Among the important reforms Putnam will implement is a 
requirement that Putnam employees who invest in Putnam funds 
hold those investments for at least 90 days, and in some cases 
for as long as a year, putting an end to the type of short-term 
trading we found at Putnam. On the corporate governance front, 
Putnam's fund boards of trustees will have independent 
chairmen, at least 75 percent of the board members will be 
independent, and all board actions will be approved by a 
majority or must be approved by a majority of the independent 
directors. In addition, the fund boards of trustees will have 
their own independent staff members who report to and assist 
the fund boards in monitoring Putnam's compliance with the 
Federal securities laws, its fiduciary obligations and duties 
to shareholders, and its Code of Ethics. Putnam has also 
committed to submit to an independent review of its policies 
and procedures designed to prevent and detect problems in these 
critical areas--now, and every other year.
    This settlement is not the end of the Commission's 
investigation of Putnam. If we turn up more evidence of illegal 
trading, or any other prohibited activity, including in the fee 
disclosure area, we will not hesitate to bring additional 
enforcement actions against Putnam or any of its employees.
    Meanwhile, the Commission is already moving forward with 
rulemaking that will address fee disclosure issues, and others, 
on an industrywide basis. Those lacking rulemaking authority 
seem to want to shoehorn the consideration of fee disclosure 
issues into the settlement of lawsuits about other subjects. 
But we should not use the threat of civil or criminal 
prosecution to extract concessions that have nothing to do with 
the alleged violation of law that we are investigating.
    Criticism of the Commission for moving too quickly, in my 
view, misses the significance of the Commission's action. While 
continuing our broader investigation of Putnam, we have reached 
a fair and far-reaching settlement that establishes substantial 
governance reforms and compliance controls that are already 
benefitting Putnam investors. It is a settlement where the 
Commission put the interests of investors first. As the 
Commission continues to initiate critical and immediate reforms 
of the mutual fund industry, and while we investigate a 
multitude of other cases involving mutual fund abuses, we will 
continue to seek reforms to provide immediate relief to harmed 
investors.
    In the meantime, as I noted earlier, our investigation of 
Putnam is ongoing, active, and focused on market timing and 
related issues. We will not hesitate to take additional actions 
if other wrongdoing comes to light.
    A few brief words on Morgan Stanley. I might note that just 
yesterday the Commission announced enforcement actions against 
Morgan Stanley arising out of the firm's mutual fund sales 
practices, a whole separate order of concern. Morgan Stanley 
has agreed to a settlement of the action that calls, in part, 
for it to pay a total of $50 million, all of which will be 
returned to investors. The action grows out of an investigation 
begun last spring.
    Few things are more important to investors than receiving 
unbiased advice from their investment professionals. Morgan 
Stanley's customers were not informed of the extent to which 
Morgan Stanley was motivated to sell them a particular fund.
    Our investigation also uncovered conflicts of interest in 
the sale of mutual funds at Morgan Stanley. This practice, 
which has been the subject of other Commission cases during the 
last several months, involves the sale of Class B mutual fund 
shares to investors who were more likely to have better overall 
returns if they bought Class A shares in the same funds.
    The abuses that are addressed in this case are significant 
and not necessarily limited to Morgan Stanley. The Commission 
is conducting an examination sweep of some 15 different broker-
dealers to determine exactly what payments are being made by 
the funds, the form of those payments, the ``shelf space'' 
benefits that the broker-dealers provide, and most importantly, 
just what these firms tell their investors about these 
practices. I also want to note that the potential disclosure 
failures and breaches of trust are not limited to broker-
dealers. We are also looking very closely at the mutual fund 
companies themselves.
    Taken together, the reforms that the Commission has already 
undertaken, and those currently being initiated are both 
substantial and far-reaching. We have, and we will continue to 
put the needs of mutual fund investors first.
    I appreciate the opportunity to share my views. I 
appreciate your patience in listening to them, and I would be 
happy to answer any questions you may have.
    Thank you.
    Chairman Shelby. Mr. Chairman, we appreciate your 
comprehensive statement.
    You brought up Putnam. Mr. Chairman, many people have 
criticized the SEC's recent settlement with Putnam for, among 
other things, failing to extract meaningful concessions from 
Putnam.
    For example, the settlement, as I understand it, does not 
force Putnam to change its fee structure or to disgorge the 
management fees that it earned during the period of improper 
training. Some have stated that the SEC rushed, as you 
anticipated here in your statement, to settle the charges 
against Putnam and missed, Mr. Chairman, a significant 
opportunity to create a template for reforming the whole fund 
industry. Some have even suggested that the SEC set the 
standard so low for a settlement that many funds will hurry to 
get the same deal.
    How do you respond to these criticisms? You alluded to them 
a minute ago. Is the Putnam settlement a model for the types of 
reform that the SEC is seeking? Why did you do it so quickly 
rather than trying to seek an industrywide settlement?
    Chairman Donaldson. Well, let me say several things.
    First of all, it is important to understand what the case 
against Putnam was all about.
    Chairman Shelby. Sure.
    Chairman Donaldson. The case against Putnam was all about 
failure to supervise the alleged actions of individual 
employees, who were purchasing fund shares of the funds that 
they were managing, failure to super----
    Chairman Shelby. Is that all it was about?
    Chairman Donaldson. Second, fraud because they did not 
disclose this practice. The management company did not disclose 
the practice to the directors of the funds themselves. Those 
were the issues.
    The issues of fees were not part of this settlement. They 
were not brought up, and I believe, as I tried to say, perhaps 
inarticulately, that these are other issues that need to be 
addressed as we find them, and when we find them, but we do not 
think that we should use a bludgeon at this time to bring in a 
whole lot of other reforms that may pertain to the rest of the 
industry or may just pertain to Putnam in this settlement.
    We thought the higher good, if you will, was bringing these 
charges to a conclusion, and in so doing, to hopefully begin to 
eliminate immediately the burdens that are currently being 
placed on Putnam fund shareholders by the redemptions that are 
going on. Clearly, the redemptions that are going on, and 
having to set aside money, and having to sell stocks, and so 
forth are causing an undue burden on existing shareholders; and 
we are very concerned, in the immediacy of this settlement, for 
those shareholders.
    I will say again that we have ongoing investigations at 
Putnam in a number of areas.
    Chairman Shelby. Mr. Chairman, how many mutual funds do we 
have in the United States, roughly?
    Chairman Donaldson. There are all sorts of different 
figures on that. I think there are probably somewhere around 
8,800 mutual funds in the country.
    Chairman Shelby. How many are you investigating here, 15, 
thus far?
    Chairman Donaldson. We immediately went out to 88 of the 
largest fund groups, and that--I cannot give you the exact 
figure--but that represented a substantial majority----
    Chairman Shelby. Of the money.
    Chairman Donaldson. --of the money in mutual funds. So, we 
are into those funds, and we have been questioning them. Our 
inspectors are out there.
    Chairman Shelby. But of the 15 you are looking at very 
closely, you have reason to believe that funny things have been 
going on there, do you not, more or less?
    Chairman Donaldson. Yes. When we originally went in with 
our inquiry, we felt that we found--not ``feel'' that we 
found--we found that upward of 50 percent of these funds had 
some special arrangements, that 30 percent had helped, in one 
way or another, with market timing, that 10 percent had helped 
with late trading, and that 30 percent disclosed details of 
their holdings. Those were our original survey. We are now back 
in there trying to put definitive facts on----
    Chairman Shelby. But this investigation is just beginning, 
is it not, into a lot of these?
    Chairman Donaldson. It is in full force, but it is early--
--
    Chairman Shelby. In full force, but I am speaking, in the 
time frame of recent weeks, it is just beginning.
    Chairman Donaldson. Yes.
    Chairman Shelby. In that sense.
    Chairman Donaldson. It is. Let me say it is in full force, 
Senator.
    Chairman Shelby. But you are a long way from completing 
your investigation.
    Chairman Donaldson. Absolutely. Absolutely.
    Chairman Shelby. Do you intend to look at every mutual 
fund? I know you are looking at the big ones now, but are you 
going to let some get swept aside?
    Chairman Donaldson. I think that we sent out Wells notices 
to a number of funds where we found egregious evidence. We will 
attempt, one way or another, to get to all of these funds. We 
are going to put some of the burden, in the early stages here, 
for having them come forward themselves by talking, as we have, 
to mutual fund directors, trustees, and the directors of 
management companies.
    We have talked to all of the trade organizations and 
written letters to the heads, asking them to stimulate the 
self-policing that should go on. So, we are going to get to all 
of them.
    Chairman Shelby. You do not believe these people can police 
themselves, do you? You are not saying that here, are you? I 
hope you are not.
    Chairman Donaldson. Well, I think we----
    Chairman Shelby. In view of all of what they have been 
doing, abusing their mutual fund holders, trading for 
themselves and for special----
    Chairman Donaldson. We are going to----
    Chairman Shelby. Are you suggesting--I hope you are not--
that they are going to police themselves?
    Chairman Donaldson. No, no, no. I am not suggesting that. 
What I am suggesting is that, by the force of what we are doing 
as we go about this methodically and with great intensity, we 
will stimulate the fund leadership and directors to insist on 
their own investigations, to insist on coming to us with their 
violations. We are going to get to them one way or another.
    Chairman Shelby. But where is the SEC going to be? If you 
are just waiting on them to come to you, you know, where is the 
SEC going to be, and what role are you going to play? Are you 
just going to wait for them to come to you or are you going to 
go, knowing that the practice is so widespread. I hope you are 
going to go after the culprits.
    Chairman Donaldson. Please be assured that we are going to.
    Chairman Shelby. Okay.
    Chairman Donaldson. I did not want to misrepresent to you 
that--you know, we do have 450, close to 500 staff here, but we 
also----
    Chairman Shelby. Absolutely.
    Chairman Donaldson. --have 8,000 and 6,000 or 7,000----
    Chairman Shelby. Mr. Chairman, we are going to furnish you 
what resources you need, and I think it is going to depend on 
what you want to do with those resources.
    Mr. Chairman, we have two back-to-back votes, cloture votes 
on the floor. You can tell by the absence of Members.
    Chairman Donaldson. I noticed that everybody disappeared.
    Chairman Shelby. What we are going to do, we are going to 
be in recess until we get back. It will probably be at least 20 
minutes or more.
    Chairman Donaldson. Fine. Thank you.
    [Recess.]
    Chairman Shelby. The hearing will come back to order.
    Chairman Donaldson, when this Committee considered the 
global settlement on research and analysts in May, we heard how 
the State and the Federal regulators coordinated their 
investigations and settlement efforts.
    Given the size of the mutual fund industry, which you just 
described earlier, the scope of trading abuses, and the shared 
goals of State and Federal regulators, it would seem to me that 
the regulators, that is, the SEC and the State regulators, 
should once again coordinate efforts. I do not think, to date, 
a lot of that appears to be happening, and perhaps you have a 
better view on it.
    Are there, Mr. Chairman, ongoing discussions concerning how 
State and Federal regulators, led by you, can coordinate 
investigations to more efficiently use resources and to 
implement broad-reaching reforms, like you have done before? 
And if not, why not?
    Chairman Donaldson. Well, as I may have mentioned the last 
time I appeared here, we have brought together a joint 
committee of State regulators out of NASAA--their trade 
association--and ourselves. We have met now formally early in 
November and have an ongoing program of discussing with the 
State regulators how we can cooperate with them in terms of the 
jurisdiction, overlap, et cetera, and we are working toward 
that goal with them.
    In terms of the bigger picture and rulemaking, I think, we 
can do a lot of talking about what the rules should be, seek 
their advice on that, but the final authority, in my view, must 
rest with the Federal authority.
    Chairman Shelby. The SEC.
    Chairman Donaldson. The SEC.
    Chairman Shelby. That does not mean the investigations 
should rest there, right?
    Chairman Donaldson. It does not.
    Chairman Shelby. You are not saying that, are you?
    Chairman Donaldson. As I have said before, and I will say 
again, we welcome the local authorities. They operate in an 
area that is an important supplement to what we are doing and, 
as has been shown, it may not just be a supplement, it may be 
an initiating factor, and that is all for the good.
    Chairman Shelby. Mr. Chairman, some have suggested that the 
recent fund abuses, and mutual fund abuses, demonstrate the 
pervasive conflict between interests of fund managers and fund 
shareholders. Some contend that these conflicts are a direct 
result of the 1940 Investment Management Act, which essentially 
created an industry structure in which each mutual fund more or 
less cedes control to the investment adviser. If the conflicts, 
Mr. Chairman, between the shareholders and fund managers are 
indeed institutionalized, then how do you propose to address 
these conflicts?
    Chairman Donaldson. I think there are several things that 
we are doing or plan to do, the most important of which are the 
setting up of Codes of Ethics at the manager level and at the 
fund level, the setting up of people responsible for monitoring 
the ethical guidelines in the management company, responsible 
for reporting to the fund directors instances where rules have 
been broken or about to be broken.
    I think that the independence of the fund directors is 
perhaps the most important----
    Chairman Shelby. An independent board?
    Chairman Donaldson. An independent board, independent 
chairman of that board, and a recognition----
    Chairman Shelby. We do not have that today, do we?
    Chairman Donaldson. No, we do not. Some do, some do not, 
but it is not----
    Chairman Shelby. It is not industrywide.
    Chairman Donaldson. It is not industrywide. Again, in terms 
of our settlement with Putnam, although this will be a 75 
percent independent board, no decisions can be taken in certain 
areas without the approval of just the 75 independent and not 
the inside.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Chairman Shelby.
    Chairman Donaldson, it seems clear that mutual funds, at 
least in a number of instances, are paying commissions quite 
large in comparison to other large investment managers, like 
pension funds and that these inflated commission costs cost 
individual investors, if you add it all up, it is small amounts 
for each investor, but there is a lot of money involved, so you 
are really talking about billions of dollars. Has the SEC 
studied the use of commissions by mutual funds to finance the 
marketing and distribution of fund shares?
    Chairman Donaldson. It is very definitely an area of 
inquiry for us and an area of concern, in terms of not only the 
disclosure of that fact to mutual fund purchasers but also how 
Commission inducements, undisclosed, may be causing brokers to 
sell certain funds rather than others.
    Senator Sarbanes. Well, now, Chairman Pitt announced 
publicly that the Commission would review current distribution 
practices, including indirect methods of financing and 
distribution. These were remarks he made to the Investment 
Company Institute in May 2002. I am now asking whether a study 
was done, pursuant to that announcement.
    Chairman Donaldson. I am not familiar with that study. Paul 
Roye tells me that our examination program has been looking at 
these practices. I want to tell you that I am concerned about 
the overall use of Commission dollars. As you know, there has 
been a safe harbor provision for the use of brokerage dollars 
for the benefit of shareholders, for the benefit of mutual fund 
shareholders, and I think that this is an area that has to be 
looked at very closely in terms of are those dollars being used 
for the benefit of shareholders or are they being used for 
other purposes, and clearly----
    Senator Sarbanes. I understand these Commission-generated 
payments for marketing and distribution, that they are not 
being itemized or disclosed to fund shareholders by their 
funds; correct?
    Chairman Donaldson. That is correct.
    Senator Sarbanes. If that is the case, is that not a 
violation of Rule 12b -1, which only permits funds to use their 
assets to pay for distribution, if such payments are made 
pursuant to a plan approved by fund shareholders and annually 
reviewed and approved by the fund's board? Would that not be 
contrary to 12b -1?
    Chairman Donaldson. The issue of 12b -1 is a complicated 
one, and I would just say, generally speaking, that clearly the 
use of commission dollars to induce sales of mutual fund shares 
is not using those commission dollars for the benefit of the 
mutual fund shareholders. It is using those commission dollars 
for the benefit of the management company.
    Now on 12b -1, that is a cloudy area, and I would like not 
to comment on that, but I will have to come back to you on the 
specifics of 12b -1 and the potential violations there.
    Chairman Shelby. I understand there is a Greenwich study of 
2002 that the mutual fund complexes with an average size of $32 
billion paid an average of $92 million in commissions. This 
equates to an average of 29 basis points of fund assets that 
were paid in commissions. As I understand it, when large 
pension funds or hedge funds buy or sell shares, they often pay 
1 or 2 cents on the stock trades, but the prevailing rate for 
mutual funds is 5 cents per share. When you add all of that up, 
this is big money that is at the expense of the investor.
    Chairman Donaldson. Yes. Again, there is a safe harbor 
aspect of commissions, which allows commissions to be paid for 
services that benefit the fund shareholders--research services 
and other services that benefit----
    Senator Sarbanes. Yes, but don't they have to have a plan 
in order to do that, approved by fund shareholders, and does 
the board not have to review and approve it each year?
    Chairman Donaldson. Senator Sarbanes, the board should be 
approving those expenditures.
    Senator Sarbanes. Have they been doing that?
    Chairman Donaldson. That is what we are looking into right 
now. I cannot give you a report fund-by-fund, but that 
certainly is on our agenda.
    Senator Sarbanes. How do you respond to the allegations 
that the SEC, including the Divisions of Investment Management 
Enforcement and the Office of Compliance Inspections and Exami-
nations, have not been sufficiently aggressive in overseeing 
and in
policing the mutual fund industry?
    Chairman Donaldson. Well, let me put it this way. Those 
offices have not been sitting on their hands. They have had a 
series of things that are out, in terms of compliance and 
examinations, and so forth, that they are examining for, a 
sense of priorities and so forth. And I believe that, given the 
risk analysis work that we are doing, that we can improve--
vastly improve--the place where risk lies, and I think we can 
vastly improve the quality and effectiveness of our 
inspections, and that goes without saying.
    You know, we get back to this business of the numbers of 
funds that we have to look at, and a number of advisers we have 
to look at, do you have enough people to do it, and clearly the 
answer to that is we have to be more effective in the way we do 
it. We have to be more effective in identifying where the real 
risk areas are.
    Senator Sarbanes. Oh, I think we have identified a risk 
area here with respect to the mutual funds.
    [Laughter.]
    I think that has been, regrettably, pretty well established 
over the last 3 months. I am concerned about the questions that 
are being raised about the effectiveness of the Commission of 
overseeing the mutual funds, whether there is sufficient 
coordination amongst the divisions. Some have questioned 
whether the Office of Compliance Inspection and Examinations 
has sufficient staff and whether the staff is experienced 
enough to function effectively. I think we have identified a 
problem area, much to the chagrin of virtually everybody, and 
we need to get on it.
    Now, we are trying to get your budget. There is $841.5 
million in the House bill and in the Senate bill brought out of 
the Committee. We have not passed that particular 
appropriations bill, but we are very hopeful we will be able to 
carry that money through for you. You turned some money back in 
last year, as I understand it, or did you keep it and put it to 
other use?
    But in any event, it seems to me there is a real urgency 
here for the Commission to get a real action program moving, 
and that is what I am trying to impress you to do.
    Chairman Donaldson. Yes. Several questions you are putting 
forth there. Number one is----
    Senator Sarbanes. I am doing that because my time has run 
out. I am trying to be fair to my colleagues here.
    Chairman Donaldson. Let me just say that in the inspections 
area, we have increased our personnel by 40 percent.
    Senator Corzine. Could the Chairman answer what that was 
from to--you know, the 40 percent as against what?
    Chairman Donaldson. I am sorry, I did not get that, 
Senator.
    Senator Corzine. What does the 40 percent mean in absolute 
numbers?
    Chairman Donaldson. In absolute terms, that means we have 
gone, in just the area of mutual funds and investment advisers, 
from 350 people to 500 people.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Corzine.
    Senator Sarbanes. Wait a minute. I think the Chairman is 
going to add something else.
    Chairman Shelby. Oh, are you going to answer?
    Senator Corzine. The Ranking Member asked good and detailed 
questions. There are probably a couple of dangling participles 
here with regard to his questions. I do not want to interrupt.
    Senator Sarbanes. Did you want to add anything further? 
Otherwise, I will turn you over to Senator Corzine.
    [Laughter.]
    Chairman Donaldson. I do not know which----
    [Laughter.]
    Chairman Shelby. Mr. Chairman, you do not have to make that 
choice. Senator Corzine is recognized.
    Chairman Donaldson. Let me just say that, clearly, we can 
improve the effectiveness of the way we go about things, and 
that is what we are trying to do. That is what I was talking 
about in terms of risk analysis. That is what we are talking 
about every day in the agency--how can we do it better.
    The only thing I was trying to say was that we have a whole 

series of things that we do inspect for that are very 
important. We did not inspect for late trading and market 
timing, nor has the Commission inspected for that for many 
years. This is not a new thing. This has been going on for a 
long time.
    Chairman Shelby. Was that widely understood to be going on 
in the industry for a long time?
    Chairman Donaldson. I am sorry?
    Chairman Shelby. The late trading, was that widely 
understood to be going on in the industry? Because it is so 
widespread.
    Senator Sarbanes. And the market timing.
    Chairman Donaldson. I can only quote from the press of a 
former outstanding Chairman of the Securities and Exchange 
Commission, who publicly stated that it was a surprise to him.
    Senator Sarbanes. So it is not like Claude Raines in 
``Casablanca,'' shocked that gambling was taking place in the 
back room? It is not like that?
    [Laughter.]
    Chairman Donaldson. I do not think so. I think that the 
extent of this has come as a surprise to even the 
professionals.
    Chairman Shelby. Senator Corzine.
    Senator Corzine. Thank you, Mr. Chairman.
    Building on the questions of the Ranking Member, how often 
are mutual funds inspected? These 350 going to 500 people, how 
often do they sit down and examine?
    Chairman Donaldson. Are you talking about what it has been 
or what it is going to be?
    Senator Corzine. What has been.
    Chairman Donaldson. I think that we have been trying to go 
on a basis of once every 5 years, if I am not mistaken. Yes, 5 
years. And we are trying to cut that at least in half.
    Senator Corzine. I think one could, just on the common 
sense of that, know that there is some personnel turnover over 
a number of years inside those mutual funds, that it is a long 
time to go without having any checks and balances or peeks into 
the kind of behavior that has maybe happened.
    Chairman Donaldson. Yes. It also goes to trying to get 
smarter about what you are looking for, through risk analysis, 
trying to get at things that are going on or may be going on, 
trying to anticipate that, as opposed to just doing a routine 
exam.
    Senator Corzine. I think risk analysis is a great idea 
inside any organization. To some extent, I am not certain I can 
see how you are going to be ahead of the most creative of those 
who want to break the rules. There is some possibility that you 
will think of every possible fraudulent kind of scheme that 
people can put forward, certainly know as one tried to manage 
an organization you try to do that so that you could stop 
things happening before they did. But I think it is a great 
concept and I welcome it, but I think that actually going in 
and checking and actually having compliance reviews and 
supervision reviews, which I think has been an issue with 
regard to frequency that is really a function of resources and 
the number of people that you have to be able to do that 
against 8,000 funds or whatever the number was that you talked 
about.
    I think one of the things we have to do is make sure that 
we have enough resources matched against the issue that you are 
trying to supervise and have responsibility for. Otherwise, I 
think you create a moral hazard, that people think something is 
going on when it really is not, and that is one of my worries.
    One of the concepts that Senator Dodd and I have talked 
about, which we are not yet recommending, although I am not 
certain about it, I think a lot of people think the PCAOB is 
off to a good start, that it is focused entirely on that aspect 
of our financial system, and will develop an expertise and 
targeted element, and it is also a way to self fund in the 
inspection process. I wonder if you thought about that at all 
at the SEC with regard to future directions, how you provide 
the oversight and secure it?
    Chairman Donaldson. The PCAOB has an indirect effect right 
now in terms of the inspections of accounting, auditing 
standards, et cetera, which will flow into the accounting that 
is used----
    Senator Corzine. I meant a mutual fund oversight board.
    Chairman Donaldson. If you are referring to a mutual fund 
oversight board----
    Senator Dodd. Chairman Donaldson, just to pick up on this, 
Bill McDonough yesterday made a public recommendation 
specifically along these lines, to utilize the example in the 
Sarbanes-Oxley proposal included in the mutual funds. The Dow 
Jones yesterday reported in an interview with him. Just curious 
whether you may not have known that.
    Chairman Donaldson. Two answers. Let me just go back for a 
second to your statement that you are not going to be on top of 
everybody that is trying to do bad things. Those were not your 
exact words. But I think that we can be a lot smarter than we 
are in terms of being out in the field, understanding exactly 
what is going on. There are a lot of things going on, as there 
are in any business, and if you are out there and trying to 
understand--I am not saying cavorting with the bad guys--but 
talking to people and so forth, I think you can bring a new 
sophistication to your inspection work that perhaps we have not 
had in the past.
    In terms of an oversight board, as far as I am concerned, 
everything is on the table in terms of how we address some of 
the problems. I would be unwilling to say right now that we 
cannot move ahead with the rules and regulations and remedies 
that I outlined earlier this morning, and do a very good job 
doing that. I think we have to prove to you and prove to the 
country that that cannot be done before we go to the expense 
and the bureaucracy and so forth of a whole new regulatory 
entity.
    But that is just a personal opinion of mine right now, and, 
as I say, we are willing to explore and discuss any remedy.
    Senator Corzine. Thank you.
    Chairman Shelby. Senator Dodd.
    Senator Dodd. Thank you, Mr. Chairman.
    Chairman Donaldson, I think that your statement is very 
good. I appreciated its thoroughness this morning as well--it 
covers a lot of ground. I think the risk assessment idea is 
very sound and makes a lot of sense. I agree with Senator 
Corzine in that regard.
    One of my questions was about the Bill McDonough suggestion 
in his interview yesterday about having a similar type of 
oversight board here, and ask you to take a closer look at that 
to see what you think. I did not expect you to necessarily 
endorse the idea this morning, but we are told it is working 
pretty well in its present construction in dealing with the 
accounting industry, and the reactions have been fairly 
positive, even from the industry, about it.
    Chairman Donaldson. I think that is true.
    Senator Dodd. It will be worthwhile to take a look.
    I just want to, quickly if I can, I want to get to a third 
question. But let me ask the second question. I reread your 
testimony here during other questioning going on to see if I 
understood it pretty correctly. I wonder if you might give us 
some greater clarity on the independence of the board, and just 
very specifically independence of the mutual fund boards. 
Should these boards be entirely independent, two-thirds, three-
quarters? Have you given that any more specific thought? How 
independent should the chairman of that board be, totally 
independent? Can you be more specific?
    Chairman Donaldson. My own personal view?
    Senator Dodd. Yes.
    Chairman Donaldson. I think the board chairman should be 
totally independent, and the further you can go to a totally 
independent board the better. I think that has to be balanced 
with some expertise, particular expertise that can be brought 
to the board. So if we have a 10-person board, if there are a 
couple people on that board that are ex-employees in the mutual 
fund industry or that particular mutual fund complex, and bring 
knowledge of that complex and so forth, I think that if you 
have 8 people that are independent and 2 inside, that maybe the 
benefits of the two are there. I would not say 100 percent, but 
that would be, I would be shooting toward, rather, three-
quarters, closer to three-quarters, 80 percent rather than 50 
percent.
    Senator Dodd. What about certification of the accuracy and 
the integrity of a fund's financial statements?
    Chairman Donaldson. We have taken steps for those funds' 
statements to be certified in accordance with Sarbanes-Oxley by 
the chief financial officer and the chief executive officer.
    Senator Dodd. I wonder if you might look, if you get a 
chance--we have not put this proposal in legislative form yet, 
but I think we will sometime possibly this week, and obviously, 
we will want to see legislative language in something that 
Senator Corzine and I have put together, but I think we would 
appreciate getting a response from you about what you think of 
these ideas. We have covered a lot of ground. Some we have not. 
As we just mentioned, we have been thinking about it. I would 
be very interested in what your thoughts might be. Again, you 
are getting a lot on your plate here, but nonetheless, we would 
be interested.
    Let me jump to the question of the State and Feds. We are 
going to have other witnesses here on Thursday. We have to 
break through this in a way. I do not think it is helping the 
cause to have people back and forth yelling at each other here 
when we have a lot of work to do. It is not to suggest that 
people who are making complaints are not without justification.
    How do you deal with this thing? We have to break through 
this. We cannot have you and Mr. Spitzer and the guy in 
Massachusetts screaming at each other in a public forum every 
day. That does not help in my view. So what are we going to do 
about that? How are you going to solve that? Let us get right 
to it. What are you going to do?
    Chairman Donaldson. I think the first step is for us to 
move as expeditiously as we can to install the remedial efforts 
that we are bringing to the table now. I think the faster we 
can get going the better. I want to assure you that as we move 
along that path, if we see things that we cannot do--and that 
gets pretty technical here--but in terms of certain definitions 
of independence and so forth, you know, that certainly would be 
helpful if we need legislation for that.
    If you are addressing the issue of regulators, State and 
Federal regulators, in some conflict, public conflict, I think 
that is very counterproductive. I think it is unfortunate, and 
we certainly are doing everything in our power to reduce that 
level of contention. As I mentioned, we are bringing the State 
regulators together. We are meeting with them regularly, and so 
forth and so on.
    Senator Dodd. Are there lines of communication? Is there 
anything, any effort being made? I mean just having competing 
op-ed pieces and so forth, I am just worried about where this 
is going to take us, if we are trying to fashion something here 
that makes sense. Obviously, there are going to be times when 
you cannot stop the differences appearing, but are there any 
structures you can put in place on a regular basis so we can at 
least minimize where at all possible?
    Chairman Donaldson. We are doing everything in our power to 
work with the State regulators, and that includes all of them. 
Unfortunately, we cannot control what certain State regulators 
decide they want to say publicly. I believe that it is very 
counterproductive, and we want to continue to work with the 
State regulators, and that includes all of them. We are doing 
everything in our power to do that. It gets a little bit 
frustrating to be working with somebody in partnership, and 
then read in a newspaper the next day that they are attacking 
your agency. That does not help the dedicated people in our 
agency who are breaking their necks to address these problems. 
I do not know what can be done other than to continue to try 
and work with them, to continue to recognize the role that they 
play, to be as candid as we can be, and that is why I wrote the 
op-ed piece today, to try and explain exactly what we did.
    I believe that the criticism of the Putnam settlement was 
totally unjustified and totally went to an issue of some other 
people's desire to use the current powers of a State regulator 
to attack and to bring to fore a whole series of remedies that 
did not pertain to the specific issue at hand. I believe that 
we are very conscious of our responsibility for developing 
remedies for the entire industry and, insofar as we bring 
enforcement actions, to bring to bear in the enforcement 
actions remedies that have to do with what we are enforcing. In 
the case of Putnam, what we were enforcing was the lack of 
supervision of some of their employees, and a lack of reporting 
of that, the knowledge of that to the fund directors. And to 
try and bring in ideas of fees and other things, to that 
settlement did not seem appropriate.
    Senator Dodd. But you made the point earlier that the 
Putnam case is still very much open.
    Chairman Donaldson. Oh, absolutely.
    Senator Dodd. And the SEC is aggressively pursuing these 
other questions?
    Chairman Donaldson. Absolutely, and that is part of my 
concern here with statements made that we have lost the 
opportunity to pursue Putnam. It is just plain wrong. We have 
not. In fact, in the other criticism coming out there is the 
language we use to ``neither admit nor deny'' and so forth; 
well, that is language that is used in civil litigation across 
the Federal Government. It is language that has been used in 
New York State litigation. It is language that has been used in 
Massachusetts, so it is counterproductive.
    Chairman Shelby. What about Connecticut?
    [Laughter.]
    Chairman Donaldson. I will check that.
    Senator Dodd. No, stay where you are. You are doing fine.
    [Laughter.]
    You understand that because this is the kind of stuff that 
it is critically important we get to the bottom of this, and do 
what we can to get this back on track again. Senator Corzine 
has said it better than I have. I think it sends so many 
different signals at a time when you are trying to do what you 
can to restore confidence in consumers, investors, in these 
very important instruments, and obviously we are going to have 
Mr. Spitzer here on Thursday to hear that side of the equation. 
But I would just hope that a real effort could be made here to 
achieve as much cooperation as possible.
    I would add just briefly, if in fact the numbers in the 
staffing requirements are needed here, whatever the SEC needs 
to get on track with this, I do not know what the schedule is, 
Mr. Chairman. We have an omnibus appropriation bill coming 
along. We should find out soon. I would hate to go through 
another whole year cycle in all of this. So to the extent you 
can look at those numbers and give us some idea, at least I 
would be interested to know what the needs may be of the agency 
so that you can have the people on the ground to do the job.
    Thank you.
    Chairman Donaldson. We will do that.
    Chairman Shelby. Chairman Donaldson, I believe you used the 
phrase earlier that the fund executives had lost sight of their 
duty. I believe that was your phrase. How long ago did they 
lose sight of their duty? Did they ever exercise that fiduciary 
duty, and if so, when did they quit, or do you know?
    Chairman Donaldson. I do not know, is the bottom line. I do 
not know, and I cannot make a judgment on when some of these 
practices began. I might say that the blanket indictment 
inherent in your statement goes a little far. I mean I think 
there are lots of fund executives out there who ----
    Chairman Shelby. The ones who have not been neglecting 
their duty or have not lost sight of their duty, they will 
prosper I am sure. This will come out. But the ones that have 
lost sight of their duty or never recognized their duty, they 
need to be exposed, for what it is worth.
    Chairman Donaldson. Absolutely.
    Chairman Shelby. If I could borrow Senator Sarbanes' paper, 
your op-ed piece today in The Wall Street Journal, says 
``Investors first.'' I do not think the investors have been 
first in a lot of what we have found out about the mutual fund 
industry. They should be first just like your op-ed piece 
headline today in The Wall Street Journal.
    Along those lines, how much time and effort has been 
expended by the SEC in supervising the mutual fund industry 
this year? I know this is your first year there, but since you 
went on your watch and were confirmed, it is not a long time in 
your tenure, but I wonder how much time and effort by the SEC 
was spent looking at the mutual fund industry. Maybe perhaps, 
well, even with your predecessors too. Let us go back say 10 
years, just use 10 years, and if you do not know, could you 
furnish that for the record because we would be interested in 
this because if the mutual fund groups were policing 
themselves, gosh, I do not think they had a gun or a uniform 
on. It obviously has not worked for the most part. But we would 
be interested in what the SEC has done, not only on your watch, 
but also on Mr. Pitts' watch, on Mr. Levitz's watch and others. 
I think that would be interesting.
    Chairman Donaldson. We would be very glad to try and put 
some numbers----
    Chairman Shelby. We are not here to indict you. We are here 
to learn.
    Chairman Donaldson. Sure. A totally legitimate request, and 
we will try to do that for you. I think that it is only 
partially----
    Chairman Shelby. In other words, have you been on top of 
things at the SEC, or did you think that the mutual funds, no 
complaints, no problems, everything is rosy. Seven trillion 
dollars, all this money out there, 95 million Americans, 
everything was fine. Is that the attitude, or has that been the 
attitude before the revelations of all the----
    Chairman Donaldson. I can only comment on my tenure, and 
clearly, we have had an acceleration of attention to the mutual 
fund industry. We have also, in our Investment Management 
Division, had an acceleration in our attention to the hedge 
fund industry.
    Chairman Shelby. Sure, and other scandals.
    Chairman Donaldson. I guess I would say that it is not just 
a matter of time; it is a matter of the sophistication of the 
way you go about it. And there is where I think we can do a 
better and better job.
    Chairman Shelby. Sophistication the way you enforce this 
and supervise it?
    Chairman Donaldson. Oh, no, no, no.
    Chairman Shelby. What do you mean?
    Chairman Donaldson. I am not worried at all about our----
    Chairman Shelby. Sometimes you have to use a sledge hammer, 
if it calls for it.
    Chairman Donaldson. What I am saying here is that I think 
that our anticipatory power--I will make a statement now that 
probably I have no right to make, but I will anyway, and that 
is that had we had hedge funds under our purview, perhaps, just 
perhaps, we might have had a screening device to look at how 
hedge funds were doing and how they were doing it, and we might 
have discovered that certain hedge funds were getting a large 
portion of their profits from market timing kinds of 
transactions, which might have led us into looking at that 
issue.
    We did not, and the fact of the matter was that in the case 
of Canary that was a collusive arrangement that was purposely 
hidden and only came to the fore via a tipster, if you will, 
going in and explaining it. But it is not something--but I 
think the chances of having picked that up would have been 
enhanced had we had more jurisdiction over hedge funds.
    Chairman Shelby. Mr. Chairman, I can tell you, we have had 
hearings on that here. I think this Committee and this Senate 
will give you as SEC Chairman, the tools, the legislation, the 
authority to do whatever you need to do to police the 
securities industry, to do it right, and that of course 
includes mutual funds, and what we need is some guidance from 
you, some help, and we will certainly continue to work with you 
and our staffs.
    In your testimony, Mr. Chairman, you described a 
comprehensive rulemaking initiative that calls for a number of 
rulemakings in December and January for additional study of 
certain issues. When do you expect the SEC to complete its 
rulemaking addressing the range of problems in the mutual fund 
industry?
    Chairman Donaldson. As I say, our first round of--I should 
say second and third round because we have done a number of 
things in the mutual fund industry up until now, in terms of 
mutual fund advertising and so forth--first round in connection 
with late trading and market timing comes in early December, 
December 3. We think right after the turn of the year we will 
be prepared on some other things.
    One of the challenges in rulemaking is to anticipate the 
unintended consequences of some of the rules that you make, and 
so it is a deliberate process. And if it is rushed too fast, 
without properly putting the rule out there for comment, then 
you make rules that have unintended consequences.
    Chairman Shelby. Chairman, do you at the moment, or did you 
say 3 months ago, have the authority to police the mutual fund 
industry had you focused on it, had the SEC investigators been 
involved in all aspects of it? Did you have the authority and 
did you have the manpower? Did you have all the tools to do the 
job?
    Chairman Donaldson. Did we have those tools a couple months 
ago?
    Chairman Shelby. Did you then and do you now? And if not, 
we want to help you get those tools.
    Chairman Donaldson. I think we were building rapidly. We 
have made substantial progress in adding to our staff. We have 
to train that staff. So in effect, although we have more people 
there in our inspection group, we have to train them to be good 
inspectors. That takes time. So, I think any of the 
inadequacies that are there because of inadequate personnel are 
gradually being resolved. I think it is clear that we had other 
priorities that we were inspecting for, and, in terms of what 
has developed now, we should have had a higher priority on 
market timing and late trading.
    Chairman Shelby. How important is the problem that you are 
facing with the mutual fund industry?
    Chairman Donaldson. How important is the----
    Chairman Shelby. How important is the problem that is 
facing you with the SEC.
    Chairman Donaldson. Oh, I am sorry.
    Chairman Shelby. You are head of the SEC. How important is 
that problem? Has it gotten to be one of the number one 
priorities?
    Chairman Donaldson. Hugely important. Very important. You 
cannot have something affecting this number of people, this 
number of investors with their savings without having it right 
up at the top of our priorities.
    Chairman Shelby. How do you get the word out to the mutual 
fund people that you are not going to tolerate, the SEC is not 
going to tolerate, the Congress is not going to tolerate 
cheating and stealing and all these things that go on in the 
industry, taking advantage of the mutual fund shareholder?
    Chairman Donaldson. I think the word is out there. I think 
it is out there in a number of different ways. I have tried to 
speak about it, as have the other professionals in the agency 
who speak about these things. I believe that we have made it 
very clear in terms of our examinations, our concern. I think 
we have made it very clear in terms of our conversations with 
the trade organizations. I think the word is out there, and we 
will continue to push it out there. It is a number one priority 
for us to remediate these problems, and we are going to do it.
    Chairman Shelby. Thank you.
    Senator Sarbanes.
    Senator Sarbanes. Thank you, Chairman Shelby. I know the 
hour grows late and we want to move ahead and we want to get at 
Mr. Fink and Mr. Lackritz. Actually, that is not a felicitous 
way to express it.
    [Laughter.]
    I am sure that we want to hear their testimony and have a 
chance to ----
    Chairman Shelby. We look forward to their appearance.
    Senator Sarbanes. Yes. But before the Chairman leaves, I 
just want to send maybe a somewhat different signal.
    It is my perception that the State officials, securities 
commissioners and attorneys general, play a very important role 
in complementing and supplementing the work of the SEC. There 
is some back and forth now, and I understand those 
sensitivities, but all of you, they and the SEC, operate within 
a framework whose end objective is to serve the public 
interest. And in the past I think we have benefited from that. 
The SEC does not begin to have the kind of resources and staff 
it would need to do all of the monitoring and policing that is 
done at the State level by these various attorneys general and 
securities commissioners. Would you agree with that 
observation?
    Chairman Donaldson. Absolutely.
    Senator Sarbanes. There are some efforts in Congress, not 
here, fortunately, but in some places, to pass statutory 
provisions which seek to restrict or limit or knock these State 
officials, if not entirely out of the picture, partly out of 
the picture. I take it the SEC is not behind that or supportive 
of that in any way. Would that be a right perception?
    Chairman Donaldson. The SEC has said in every way possible 
that it welcomes collaboration with the State officials. Having 
said that, the SEC says continually, and I have said 
continually, that when it comes to writing the rules, that that 
has to be our responsibility, and insofar as State regulators 
step over the bound in settlements and attempt to write rules 
that should be Federal rules----
    Senator Sarbanes. The rules that were written--I mean the 
only thing that I understand that potentially fits in this 
category were the rules on Wall Street where the analysts and 
the SEC participated in the writing of those rules, did it not?
    Chairman Donaldson. That was before my time, most of it 
was, and the answer is yes. But as you know, the combination of 
regulators attempting to get together and write these rules 
does not necessarily end up with exact rules that, if there was 
one regulator there, that you would write. We know the issue of 
compromise and adjustment and so forth inherent in that.
    Senator Sarbanes. I think one thing that has come through 
rather clearly through all of this is that if a vacuum exists, 
if a problem has developed, if investors are being abused, if 
the public perceives that the public interest is not being 
addressed, then whoever moves into that vacuum is going to be 
welcome. And all this does in effect is underscore some of the 
line of questioning I and others were pursuing earlier of how 
imperative it is that the SEC really be geared up in order to 
deal with these matters. Now, we know you are trying to do 
that, and I think the risk analysis on a broad basis is one 
thing. We have this risk and we need to address it, but I think 
it underscores the need for the SEC to move ahead in a very 
vigorous fashion, and as the Chairman says, we are supportive 
of that. We are prepared to support additional authorities if 
you judge that they are necessary, although some think you have 
quite extensive authorities as it is, and of course a bud-
get, which we are trying very hard to get for you. I mean the
budget of the SEC will virtually double over a 3-year period, 
and we need to put those resources to work. We have tried to 
send a signal to your employees that we are supportive of them. 
We want to boost the morale. We think you have had that impact 
on the agency in that regard, and we want to push that forward.
    I understand a certain amount of this back and forth that 
is going on. I know people are sensitive. No one is more 
sensitive to criticism than Members of the Congress of the 
United States, that is for sure. However, I do not think we 
should get so sensitive that it in any way might impede the 
substantive work that is ahead,
because there is plenty of substantive work, in my view, for 
the Commission and for the State Attorneys General and the 
State Securities Commissioners, wherever the particular State 
may place the responsibilities.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Corzine.
    Senator Corzine. Thank you, Mr. Chairman.
    Let me congratulate Chairman Donaldson for what I think is 
actually one of the most important issues, that while we focus 
on mutual funds, the idea that almost every tough situation we 
come in, the vacuum of lack of oversight of hedge funds. I do 
not think all hedge funds are bad. There are all kinds of good 
players and bad players in almost any industry. But the 
repetition of this without any kind of supervision I think is 
something that we all need to pull together on and try to put 
together an oversight that does not leave such an important 
part of our financial system completely outside of those 
purviews. I do not understand how the risk analysis system 
would actually work when some of these ideas generate outside 
of the purview of supervision. I congratulate you for focusing 
on that. I think it is a major step forward, to hear the 
Chairman of the Securities and Exchange Commission say that we 
should be addressing this. I just want to be on record of 
supporting that and looking forward to working with you on how 
that can be done in a way that does not undermine liquidity and 
depth of markets, but gives people a little more confidence 
that every time there is a problem in the industry, it does not 
somehow have some juxtaposition to what we have seen on a 
pretty regular basis. If you go back in history, I think that 
can be identified pretty clearly.
    One area that we have only touched on, but I think is 
extraordinarily important in this whole issue, and as you have 
identified in the Putnam discussion, you deal with one issue 
and you carry that through, at least from your perspective. It 
seems to me that there is virtually no ability for someone, 
just a normal human being, to sit down and do comparative 
shopping in this industry. It is very hard to figure out what 
the total costs are to an individual for managing the funds. I 
think about management issues, distribution issues or costs, 
management costs, distribution costs, and service provision to 
the groups. It seems to me that that is virtually impossible 
for any shareholder to know what it is that they are actually 
paying to get the investment services that they are having.
    I will take a little bit of both pride and probably shame 
in the proposition that somehow we need to get to a composite 
cost of what it is the investor is paying to get to the return 
that they are asking for. Are you all working on concepts that 
will do that, more than just giving a laundry list of what 
might be charged?
    Chairman Donaldson. Absolutely. First of all, I totally 
agree with you in terms of the difficulty for a ordinary 
investor. I might add, the difficulty----
    Senator Corzine. I do not know if you have to be too 
ordinary.
    Chairman Donaldson. Yes. It is difficult even for people 
who are very sophisticated in finance to define exactly what is 
going on, exactly what those costs are.
    Yes, we are working on that. We are working on a revised 
way for the funds to put that forth to a perspective buyer, 
either in the confirmation or better yet before the purchase is 
made, so that the buyer knows exactly what they are buying. 
That is very, very much front and center with us.
    Senator Corzine. I am sure Senator Dodd would say the same. 
I really believe, and I am sure the Chairman and Ranking Member 
feel the same way, this is an area that needs real depth to 
come to the right answer, where people can actually do a 
comparative shopping about how people are pricing the service 
that supposedly it is giving, which is incredibly difficult to 
derive in this process.
    I take that one step further on 12b -1 fees, were those 
originally formulated to start a fund, or were they ever 
anticipated, do you know from study and discussion inside the 
Commission whether they were ever intended to be a permanent 
feature?
    Chairman Donaldson. I do not know the history of it, 
Senator, but I do know that those fees have not always been 
there, and I think there are probably people in the room who 
can give the history of just exactly when the 12b -1 fees came 
in. I think it had to do with giving an assist to the funds and 
raising money which would rebound to the benefit of all 
shareholders by having a broader base of capital, and therefore 
the expenses would be less because you had a broader base of--
--
    Senator Corzine. Logic would say at some point that you 
have captured some of those economies of scale, logic presumed.
    Chairman Donaldson. Logic presumed, that is an area to take 
a look at, sure.
    Senator Corzine. Thank you, Mr. Chairman.
    Chairman Shelby. Chairman Donaldson, we appreciate your 
patience here with us today. We appreciate your statement, and 
I am sure you will be back. We will continue working on this. 
This is not an issue that is going to be swept away, and it is 
certainly not going to be swept under the rug.
    Chairman Donaldson. Thank you. Delighted to be here.
    Chairman Shelby. We are now going to call up our second 
panel. Matthew P. Fink, President of the Investment Company 
Institute, and Marc E. Lackritz, President of Securities 
Industry Association.
    Your written statements will be made part of the record. 
You have sat through these hearings already today. If you could 
sum up your opening statement within 5 minutes, it would help 
us move along.
    Mr. Fink, we will start with you.

                  STATEMENT OF MATTHEW P. FINK

            PRESIDENT, INVESTMENT COMPANY INSTITUTE

    Mr. Fink. Thank you, Mr. Chairman.
    I have to say that I am appalled by the circumstances that 
made you call this hearing. Like you and the other Members of 
the Committee, and most importantly, your constituents, I am 
personally outraged by the betrayal of trust and fiduciary 
duties exhibited by people in the fund industry.
    I have represented the fund industry at the Institute for 
32 years. I started when the industry had total assets of $54 
billion, which is less than 1 percent of what they have today. 
I have often been asked over the years, including by Members of 
this Committee, why has the fund industry succeeded so well? 
There are a lot of reasons, but I have always said the core 
reason is the 1940 Act, its tradition of integrity, and I 
regret to say with all my heart that today that tradition of 
integrity is widely questioned.
    The industry's goal today is simple. We want to work with 
you and other policymakers to rebuild trust, renew investor 
confidence and reinforce our previous history of putting the 
interest of investors first.
    I think action should be taken in three areas. First, 
Government officials must identify everyone who violated the 
law. Those who acted willfully against the interests of fund 
shareholders should be sanctioned and sanctioned severely. And 
those who are found to have violated the criminal laws should 
be sent to prison.
    In response to a question, Mr. Chairman, you had of 
Chairman Donaldson, what is the best way to get the message out 
to the fund industry? That is the best way.
    Second, shareholders who were harmed in any of these funds 
should be made right. It is a particular outrage that some 
funds permitted a few large shareholders to prey on smaller 
shareholders. This repudiates perhaps the most fundamental 
principle underlying mutual funds, that every shareholder, 
large and small, should be treated alike.
    Third, effective reforms have to be put in place to make 
sure that this kind of thing never happens again. Last month 
our Chairman, Paul Haaga, said, ``Everything's on the table.'' 
That was not just a cute sound bite. It was a call to action 
for the industry, and indeed, a few weeks after that, we called 
for major reforms in three of the areas that have been revealed 
by the investigations.
    First, with respect to late trading, trades coming in after 
4 o'clock but getting the 4 o'clock price, we have urged the 
SEC to require that all fund transactions must be received by 
the fund itself by 4 p.m. I was very glad to hear Chairman 
Donaldson indicate that that is what the SEC will propose.
    Chairman Shelby. How would that work, Mr. Fink?
    Mr. Fink. That would mean that presumably if you had an 
account with a broker, right now you can hit the broker by 4 
p.m. This would probably mean you would have to hit the broker 
by 2:30 p.m. If you are in a 401(k) plan, many of them take a 
day to process, so it would probably mean if you put your order 
in today, you probably would not get today's price, you might 
get tomorrow's price. But for 90 percent or more of fund 
shareholders who are buying for the long-term, you and I in our 
401(k) plan or Government Thrift Plan, we are not trying to buy 
today's price or tomorrow's price, we are putting our money in 
for the long-term. I think to stamp out late trading, which is 
against the law, but we found, according to Mr. Cutler, 10 
percent of fund companies saying they are aware of it, 25 
percent of brokers surveyed saying they were doing it, you are 
going to need some tough medicine like that.
    I have to say though that if technological developments now 
or later can occur which give the same assurance that if the 
order reaches the intermediary, the broker or bank by 4 p.m., 
that that can be as foolproof as reaching the fund by 4 p.m. We 
would support that as well. But for the moment, until somebody 
can show us or the SEC or the Congress something as good as a 
hard 4 p.m. at the fund, we will back a hard 4 p.m. at the 
fund.
    The second reform is abusive short-term market timing, and 
there we have urged the SEC to require all long-term mutual 
funds to impose a 2 percent redemption fee on any sale of fund 
shares within 5 days of purchase. All fees collected would go 
to the fund and not to its adviser. I am convinced, as are 
people in the industry, that an across-the-board uniform 2 
percent redemption fee has to be mandated to stop abusive 
short-term trading. You heard Chairman Donaldson before talk 
about the problems in omnibus accounts. These are accounts by 
brokers or banks or 401(k) plans where the fund has no idea who 
the individual shareholders are and has no way to police their 
individual activities. Intermediaries say rightly that they 
cannot police 20 different fund groups' special rules to get at 
these short-term timers, and that is why a 2 percent across-
the-board fee would get at that. Every intermediary could 
impose it easily.
    The third issue that came up in the investigations, Mr. 
Chairman, is the worst probably, and that is short-term trading 
of fund shares, not by outsiders, not by hedge funds, but by 
fund portfolio managers and indeed senior executives. And we 
stated our support for any steps to make it clear that that 
kind of practice is not just repellant, but should be made 
illegal.
    These were our initial recommendations which were designed 
to address the three major abuses that came out of the 
investigations. I also have to say, the need for additional 
reform is absolutely clear. Fortunately, we do not have to 
begin the process from scratch. We have a strong foundation in 
the Investment Company Act.
    Today, I must say I heard Chairman Donaldson lay out a 
laundry list. Senator Dodd referred to the legislation he and 
Senator Corzine are drafting. I would be happy to comment on 
the specifics of any of that.
    I just say, going back in history, this Committee passed 
unanimously the Investment Company Act in 1940, which set the 
foundation for the modern mutual fund industry. A number of 
observers including consumer advocates have pointed to the 
Investment Company Act as one of Congress' greatest 
achievements. I will make three points about the Act. First, it 
is much more demanding than the other securities laws, much 
more restrictive. Second, it is the only securities law that 
passed the Congress unanimously, and third, it is the only 
securities law that was supported by the industry it regulated, 
the mutual fund industry.
    When the Act was signed in 1940, the President made mention 
of the fact that it was supported by the industry, and asked 
that the industry continue to cooperate with the SEC and the 
Congress in the future. The Institute has done that for 63 
years, and we pledge to continue to do so.
    On a personal note, I might say that just before these 
scandals broke out, I announced that I would retire from the 
Investment Company Institute at the end of 2004. I want to 
personally promise every Member of this Committee that I will 
use all of my energies during this time to ensure that abuses 
are effectively addressed and regulatory weaknesses are 
remedied.
    I have to say that revelations about corporate misconduct 
during the past 2 years and about mutual funds since September 
3, provide reason for all of us to be cynical about how 
American businesses approach their responsibilities. But I hope 
if my appearance today is remembered for only one thing, it is 
the following. The 
Investment Company Institute is truly horrified at the betrayal 
of shareholders that has occurred at some mutual fund 
companies. We understand completely that enduring trust and 
confidence in funds will not be achieved by words or half 
measures. As the reform process continues, you and other 
policymakers should expect a lot from us. I respectfully ask 
only one thing, that our commitment to reform be judged by our 
actions.
    Mutual funds, as other witnesses have said, are where 
Americans invest. In over half of all households, more than 60 
percent of middle-income households, funds are an integral part 
of people's financial lives and an integral part of our capital 
markets. If we all do not get together and fix these problems, 
I think we all will suffer, and we cannot let that happen.
    Thank you.
    Chairman Shelby. Thank you.
    Mr. Lackritz.

                 STATEMENT OF MARC E. LACKRITZ

           PRESIDENT, SECURITIES INDUSTRY ASSOCIATION

    Mr. Lackritz. Thank you, Mr. Chairman. I appreciate the 
opportunity to be here in front of the Committee to talk about 
these issues involving the integrity of both mutual funds and 
the broker-dealers that I represent.
    While regulation of the securities industry is really based 
on the two principles of full disclosure and competition, the 
core bedrock asset underlying the success of the industry in 
the markets is the public's trust and confidence in the markets 
and in the professionalism of the individuals participating. 
So, we find anything that impugns the public's trust and 
confidence to be of the most urgent nature, and therefore, we 
pledge to do everything we can, Mr. Chairman, to work with you 
and the regulators to earn back the public's trust and 
confidence in this area.
    Over the past 10 years our industry has raised more than 
$21 trillion of capital for economic growth, for new 
enterprises, for new processes, for new systems, for hospitals, 
for roads, and for schools. That is only possible if the public 
has trust in the integrity of the markets so that the markets 
can efficiently and effectively channel capital from 
institutions and individuals that have it to institutions and 
individuals that need it.
    Mutual funds are the vehicle by which an overwhelming 
majority of investors participate in our markets, and as a 
result we are very dependent on the health and integrity of the 
public's continued robust participation in mutual funds and in 
the capital markets. The most recent numbers indicate that 
mutual funds owned a little more than one-fifth of the equity 
market capitalization. So, there are significant participants 
in the capital markets, and our ability to perform our roles as 
intermediaries depends on their continued vitality.
    Moreover, the retail investor is the backbone of both the 
mutual fund industry and our markets, and investors, as has 
been stated earlier by Chairman Donaldson and by Mr. Fink, have 
to come first. Our core value that we have been pushing in our 
industry has been to make sure to put clients' interests and 
customers' interests first if we want them to continue to 
entrust their money to mutual funds. They also must be assured 
that fraud, self-dealing, and dishonesty will not be tolerated 
in any way, shape or form. All investors have to be treated 
fairly and all aspects of the mutual fund business, including 
fund fee structures, financial incentives offered to 
intermediaries to recommend specific funds, fund investment and 
redemption policies and fund governance, must be as transparent 
as possible to investors and to the public.
    In addition, all investors should be assured of reasonably 
prompt execution and fair pricing of their mutual funds 
transactions.
    The recent behavior that has been addressed involves three 
issues that I would like to speak to. One is late trading or 
market timing in contravention of stated fund policies. Two is 
lack of full disclosure, and three is operational shortcomings 
relating to breakpoints. All of these instances share one 
element, Mr. Chairman--they hurt investors. Each of these 
issues has to be addressed
swiftly and comprehensively by tough enforcement actions first
and foremost where wrongdoing has occurred, by thoughtful 
regulatory revisions to make sure that these problems will 
never recur again, and by legislation to fill in existing gaps 
in the law where they may occur.
    At the same time it is equally important that regulatory or 
legislative solutions do not create new problems or other 
unintended consequences for investors in the course of 
remedying these existing ones.
    First of all, with respect to late trading, we, like 
everyone else, have been appalled by the number of instances of 
mutual fund late trading. In addition to stringent, tough, sure 
enforcement actions, we believe additional regulatory actions 
should be taken to ensure that these abuses can never happen 
again. Any new regulation here should make sure to be reliable 
and bulletproof to any new forms of evasion, should make sure 
to give investors--all investors--the widest array of 
opportunities to trade on information in the marketplace, and 
to treat all investors, large and small, institutional and 
retail, alike, equally. Finally, it should make sure to 
synchronize any new mandates with the existing and well proven 
operational systems that clear and settle these transactions 
today.
    Several proposals have emerged to address late trading by 
establishing a hard close for open-end mutual fund purchase or 
redemption that assures that order acceptance could be later 
than the New York Stock Exchange closing at 4 p.m. As discussed 
in greater detail in my written testimony, we think that a hard 
close that can only occur at the mutual fund has some very 
significant drawbacks for investors, and also may have some 
major operational difficulties. A hard close at the broker-
dealer or other intermediary would be preferable from the 
vantage point of most retail investors and retirement plan 
participants. In any event, we must demonstrate to the public 
not only that late trading will be punished severely, but also 
that it will be foreclosed from ever happening again.
    Now with respect to market timing, recent enforcement 
actions and press reports of ongoing investigations appear to 
involve instances in which funds and intermediaries facilitated 
market timing transactions despite statements in the fund 
prospectuses that the fund would not assist in such activities. 
We fully agree with SEC Chairman Donaldson that rules regarding 
disclosure of fund policies and procedures on market timing 
should be tightened, and that funds should be required to have 
procedures to fully comply with any representations that they 
make concerning their market timing policies.
    We would also propose a requirement that sufficient trade 
level customer detail be provided to funds to assist them in 
identifying market timing activities on transactions submitted 
by intermediaries on an aggregated basis by these omnibus 
accounts. A further step would be to permit funds to impose a 
fee on any fund shares redeemed within five days of purchasing 
them. And finally, we support SEC action to address the overall 
issue of stale pricing, because stale pricing really is at the 
core of these kinds of abuses. People take advantage of the 
stale prices. If we could find a way to eliminate the stale 
prices, that would go a long way to eliminating these abuses in 
addition to these other regulatory actions.
    In the area of disclosure, Mr. Chairman, we favor clear, 
direct, timely disclosure of all material information to 
investors in a central place or central document. It is 
important to make it investor accessible and investor friendly, 
rather than a ``where's Waldo'' search through fragments of 
disclosure for relevant information. In that vein, we strongly 
support efforts to enhance transparency of revenue sharing and 
differential compensation to mutual fund investors. We also 
believe investors should have full, complete, and useful 
information on fund fees, since they can have a significant 
effect on an investor's return.
    The most efficient means for providing this information to 
investors, and the basis on which they can do comparability 
surveys and use comparison shopping to see what others are 
offering, is to calculate these expenses based on a 
hypothetical $1,000 investment. We also believe that mutual 
funds should ensure effective disclosure of soft-dollar 
practices, both to investors and to fund trustees.
    Finally, we have worked very closely with regulators to 
ensure that broker-dealers and funds are adequately addressing 
breakpoint concerns. We are exploring additional ways in which 
breakpoint policies can be made easier to apply. In this way 
the risk of any further operational problems regarding 
customers receiving the correct breakpoint would be 
significantly reduced.
    Like many investors, regulators and yourselves, we have 
been surprised and extremely dismayed by the reports of abuses 
relating to the sale of mutual funds to investors. We are fully 
committed, Mr. Chairman, to addressing these concerns 
thoroughly by supporting vigorous enforcement of current rules 
and by supporting appropriate legislative and regulatory 
reforms where appropriate.
    We and our member firms will work with you, Mr. Chairman, 
and your colleagues to ensure that mutual fund investors once 
again can have justifiable faith in these products and our 
markets. We look forward, Mr. Chairman, to working with you and 
the Committee to earn back the public's trust and confidence.
    Thank you very much.
    Chairman Shelby. Thank you.
    Mr. Fink, some have stated that market timing and late 
trading activities have long been open secrets in the fund 
industry. Prior to the recent revelations regarding late 
trading and market timing, were you, sir, aware of such 
practices, and how did the Investment Company Institute advise 
its members to address such practices?
    Mr. Fink. Late trading--I was totally unaware. Late trading 
is a direct violation of the law. I could imagine or may have 
imagined some inadvertent----
    Chairman Shelby. You did not know anything about it?
    Mr. Fink. Never dawned on me, no, sir. Market timing, we 
knew a lot--first of all, there is some innocent market timing 
where people are reallocating, but the abusive----
    Chairman Shelby. And some noninnocent market timing.
    Mr. Fink. Sorry.
    Chairman Shelby. There is some noninnocent market timing.
    Mr. Fink. Noninnocent is what I am talking about. We knew a 
lot was going on because we could look at the redemption rates 
of international funds, which were high. And we read Professor 
Zitzewitz's paper. Our members came to us and said, ``We need 
more tools to combat it.'' So, we worked with the SEC. They 
came out with a release on addressing fair valuation, to 
address stale pricing. We did a compliance guide for our 
members. We went to the SEC to get an increase in redemption 
fees. So, I knew a lot was going on, but it never dawned on me, 
Mr. Chairman, that anybody at a fund group was selling 
outsiders the privilege to market time for a quid pro quo, no 
less than anybody in the fund group themselves were doing this 
abusive timing.
    I did find, going back through our files, one member told 
us--a couple of years ago--told one of my colleagues they were 
approached by an outside--it was a hedge fund or Canary--and 
dismissed it, told him to go away. I thought that was a fluke. 
It is incredible, but nobody at the Institute, SEC, NASD, that 
I have spoken to, ever had a clue that this stuff was going on.
    Chairman Shelby. Were they blind themselves, or were they 
blind because they did not want to see anything?
    Mr. Fink. Well, I do not know the answer to that.
    Chairman Shelby. Okay. Sir, I will ask you the same 
question. You represent the broker-dealers and so forth, the 
people who make the trades. Prior to the recent revelations 
regarding late trading and market timing, were you aware in the 
securities industry of such practices? And if so, how did you 
react to them? Because they were going on with your people.
    Mr. Lackritz. Mr. Chairman, with respect to late trading, I 
had no knowledge whatsoever that that was going on. First of 
all, it is clearly against the law. I mean, it is clearly 
illegal. And, therefore, anybody engaged in this would have to 
expect to be prosecuted. I had no knowledge of any of that.
    Chairman Shelby. No rumors, anything? Anything just 
widespread, this deep, as Senator Sarbanes said, involving the 
amount of money involved?
    Mr. Lackritz. I suspect in retrospect you could look back 
and say if somebody were going to follow the money and try and 
figure out where the money was going back during a period of 
time and you saw assets building up in some part of the market 
that was heavily engaged in certain kinds of trading, perhaps 
in retrospect you would say, Ah, that is where we should have 
gone. But I can tell you, I had no knowledge of it whatsoever, 
and I do not know of anybody else either in our organization, 
in any of the self-regulatory organizations, in the 
Commission----
    Chairman Shelby. Had the SEC ever notified you or shown any 
interest in this kind of stuff, late trading, market timing?
    Mr. Lackritz. No, sir.
    Chairman Shelby. What about you?
    Mr. Fink. Well, market timing, we knew a lot was going on 
with stale prices, so the SEC sent out letters to me or to the 
industry telling----
    Chairman Shelby. When was this?
    Mr. Fink. Two or 3 years ago? I am losing my dates. In 
2001.
    Chairman Shelby. By a letter, what do you mean?
    Mr. Fink. There was a letter from an assistant director at 
the SEC reminding people that on valuation of securities, 
foreign securities, after the foreign market closed there was a 
``significant event,'' the fund better consider not using those 
closing prices in Tokyo but use fair value.
    Chairman Shelby. And what happened to that letter? It 
wasn't heeded, was it?
    Mr. Fink. No, a lot of people did heed it. But I cannot 
tell you the level of compliance, Mr. Chairman, because we, my 
colleague behind me, prepared a compliance guide for our 
members to help them comply. And so, I think people did comply. 
I cannot talk about 100 percent, but there was compliance.
    Chairman Shelby. Senator Sarbanes, you have a question?
    Senator Sarbanes. Yes. Steven Cutler, the Enforcement 
Director of the SEC, has said, ``More than 25 percent of firms 
responding to an SEC mutual fund inquiry report that customers 
have received 4 p.m. prices for orders placed or confirmed 
after 4 p.m.'' More than 25 percent. ``Fifty percent of 
responding fund groups appear to have had at least one 
arrangement allowing for market timing by an investor.'' Fifty 
percent.
    ``Documents provided by almost 30 percent of responding 
brokerage firms indicate that they may have assisted market 
timers in some way, such as by breaking up large orders or 
setting up special accounts to conceal their own or their 
clients' identities, a practice sometimes called `cloning,' to 
avoid detection by mutual funds that sought to prevent abusive 
market timing. Almost 70 percent of responding brokerage firms 
reported being aware of timing activities by their customers.''
    Now, I have just listened to both of you, and it is a 
problem for all of us. Why weren't we aware of this? Why wasn't 
something done about it? Why didn't the Congress get at it? Why 
didn't the SEC get at it?
    But you sit at the top of the pyramid of your industries, 
and you are telling us here today, we did not know this was 
happening; it came as a total surprise to us. Yet, as the 
Chairman indicated in his question, we get reports now coming 
into us that say, well, it was an open secret that this was 
taking place. You have this survey now by Cutler that has 
these, 30 percent, 50 percent, 70 percent. I mean, what was 
going on?
    Mr. Fink. This is no defense, Senator, but remember, 
neither the SIA nor the ICI are SRO's. We are trade association 
lobby groups, and we do not go out and inspect our members. So, 
we would hear it almost as people would come to us with a 
problem. Again, we knew about market timing. And you cannot 
tell from that response, Senator, when Mr. Cutler said about 
funds or brokers, you cannot tell was it abusive or not. I have 
it in front of me.
    Chairman Shelby. Well, you could tell if it was abusive if 
you looked closely at it, though.
    Mr. Fink. No, from what Mr. Cutler even said in testimony, 
I think, he could not tell in each case was it abusive or not.
    Chairman Shelby. He did not look closely enough.
    Mr. Lackritz. If I could just talk about it, the market 
timing per se is not illegal. The problem here is that it was 
allowed to happen selectively in exchange for a quid pro quo to 
the detriment of every other fund shareholder.
    Chairman Shelby. So, they betrayed the shareholders, is 
what they did.
    Mr. Lackritz. I am sorry?
    Chairman Shelby. They betrayed the shareholders.
    Mr. Lackritz. Absolutely. Right, that is correct.
    Chairman Shelby. They were dealing on the side.
    Mr. Lackritz. That is correct.
    Senator Sarbanes. I take it, though, from your answer, Mr. 
Fink, about being a trade association that neither you nor the 
SIA feel any special or particular responsibility for the 
practices by your members. I mean, you are simply there to 
lobby against legislation or for legislation that affects their 
interests or to try to, I guess, strengthen their position 
within the industry and so forth. But you feel no 
responsibility with respect to addressing these----
    Mr. Fink. No, not at all, Senator. I simply meant that my 
own awareness of this issue, I do not go out and--we do not 
inspect and know what is going on day-to-day. I feel full 
responsibility, more than I can say, for these wrongs, and I 
and my organization will do everything to correct them. That is 
why we have called for these three tough measures that a lot of 
our members do not like, I have to say, Mr. Chairman, a lot of 
intermediaries do not like. That is why I am supportive of what 
I could hear Chairman Donaldson say. So if I misspoke, I do 
feel responsibility. Simply on the narrow issue of why I did 
not know, I am not out there, my staff is not out there 
inspecting funds and brokers.
    Senator Sarbanes. Let me just close, if I could, Mr. 
Chairman, with this one quote.
    Chairman Shelby. Okay. Go ahead.
    Senator Sarbanes. On March 12 of this year, the Chairman of 
the ICI appeared before the House Financial Services Committee 
and made the following statement: ``The strict regulation that 
implements these objectives has allowed the industry to garner 
and maintain the confidence of investors and also has kept the 
industry free of the types of problems that have surfaced in 
other businesses in the recent past. An examination of several 
of the regulatory measures that have been adopted or are under 
consideration to address problems that led to the massive 
corporate and accounting scandals of the past few years 
provides a strong endorsement for the system under which mutual 
funds already operate.''
    Now that is your Chairman telling the Congress.
    Mr. Fink. If I can try to speak on his behalf, Senator, he 
did not know about these issues either. The legislation 
proposal that he was talking about had nothing to do with late 
trading, market timing, selective disclosure. These issues 
blindsided him as much as they did Mr. Lackritz and me. I think 
what he was referring to, Senator, was that, for example, in 
1940, the Congress mandated a system of independent directors 
for mutual funds, and that model I think was used in Sarbanes-
Oxley, and then the New York Stock Exchange using unlisted 
companies. That is what I took his remark to mean, but I have 
to say he was as innocent--if that is the word--or dumb as I 
was because none of us knew this stuff was going on in March 
when he made the statement.
    Chairman Shelby. Mr. Lackritz, most individual investors, 
as you know, do not have the same level of financial 
sophistication as their broker. So, they trust or have 
heretofore trusted their broker to place them in a good 
investment. That is the order of the day. For this reason, and 
among others, I am very concerned about the allegations that 
brokers sold investors more expensive Class B fund shares in 
order to boost their own brokerage commissions. In these 
situations, brokers knowingly took advantage of their clients 
who may not have understood the technicalities of loads in 
12b -1 fees.
    How do you modify internal compliance programs to halt such 
activities? Further, how do you move beyond rules and 
regulations to change the corporate ethics so that brokers do 
not feel like they can take advantage of their clients? I 
believe myself that the mutual fund industry--and I hate to say 
this--is deeply tainted right now. You can see the exodus of 
money going out. Maybe not all funds, but it is widespread. Do 
you want to respond?
    Mr. Lackritz. Yes, absolutely, Mr. Chairman, and I think 
the question you are speaking to is something where we have an 
obligation to do everything we can both to change the culture, 
to make sure the values are right, and to drive that through 
organizations.
    Chairman Shelby. Not take advantage of the unsuspecting, 
innocent people who trust you to do these things.
    Mr. Lackritz. A lot of it has to do with making sure that 
our industry and our professionals understand that the most 
important value is to put the interests of the customer first, 
and that we emphasize that over and over again. In addition, we 
at least as an organization provide a series of professional 
education programs for our professionals so that they can 
continue to improve their level of understanding.
    I would also suggest that Steve Cutler's notion that each 
firm should do an internal audit of every single one of its 
business practices to identify conflicts and to either 
eliminate them or disclose them, and then to manage them more 
effectively is what a number of our firms are currently 
undergoing.
    I know a number of our largest firms have already initiated 
internal audits so that they, in fact, go through every single 
one of their processes, every single one of their products, to 
identify where there are potential conflicts. Then they either 
work to eliminate the conflict or to manage it and disclose it 
effectively to investors.
    But I think it gets back, Mr. Chairman, to something you 
said earlier. It gets back to a question of values and culture, 
and I think that is the most important issue, where we have to 
recommit ourselves to a culture of putting the customers' 
interests first.
    Chairman Shelby. It is going to be hard, too, isn't it?
    Mr. Lackritz. Well, yes, but I think this obviously has 
been a wakeup call for all of us, and I know our industry and 
my members take this very seriously. They are as appalled as 
anybody else at this kind of behavior and committed to doing 
everything we can to turn it around.
    Chairman Shelby. Is there any one thing that is more 
important than trust?
    Mr. Lackritz. No, there is nothing more important than 
trust. Plus it takes a very long time to build up a 
relationship of trust, and it just takes, you know, one 
incident to throw it away.
    Chairman Shelby. Absolutely.
    Mr. Fink, many contend that the conflicts between fund 
managers and shareholders are institutionalized in the 
structure of the fund industry. To address this conflict, some 
have proposed various reform proposals such as requiring funds 
to have boards with a super majority of independent directors 
and an independent chairman, and to submit the advisory 
contract to competitive bidding process. What are your views on 
this and other governance reform proposals?
    Mr. Fink. I think there is an inherent conflict, but it is 
true in every area of money management--pension management, 
bank trust departments. It is what Justice Brandeis called 
``other people's money.'' The Investment Company Act attempts 
to put checks and balances in, and I think they can be 
improved. The Act requires 40 percent of the directors to be 
independent. The SEC by rule has made it a majority. The 
Investment Company Institute's best practices make it two-
thirds. I think Senators Dodd and Corzine's legislation talks 
about 75 percent. I think increasing it would be a good thing, 
to two-thirds to 75 percent.
    The second thing that would be good would be a tougher 
definition of ``independence.'' Under the current statute, you 
can work as a fund manager, leave, and in 2 years come back as 
an independent director. I think that is a mistake. Our best 
practices say if you ever work for the manager, you cannot come 
back as an independent director.
    There is a law that deals with relatives. You cannot have a 
blood relative of somebody as the adviser. Somebody put his 
uncle on. That should be extended so not just blood relatives 
but more extended relatives. So, I would do those things.
    Chairman Shelby. Well, what about the brother-in-law and 
stuff like that?
    Mr. Fink. I cannot do enough of that. I can never figure 
out who is a great-uncle or--but it should be extended beyond 
parent-child, brother-sister.
    I think one thing to think about, though, Senator, are 
these caused by a breakdown in corporate governance, which I am 
not convinced, or the lack of the directors' having tools to 
find out what is going on. I am all for making better corporate 
governance, but I think here, just reading the newspaper 
accounts, there were compliance systems and the head of the 
company said, well, do not count me in the compliance system.
    Chairman Shelby. There are directors, and then there are 
directors that are involved. Aren't there different types of 
directors?
    Mr. Fink. Yes.
    Chairman Shelby. You can have directors----
    Mr. Fink. But they could be 90 percent independent, the 
brightest men and women ever, but they do not have the tools to 
find out what is going on. So, I think the most important 
proposal in my mind is the SEC's proposed compliance rule 
requiring every fund have a compliance officer--so, I would do 
that.
    The independent chair I am just wary of because it sounds 
like a magic cure, but only about 20 percent of the industry 
today have independent chairs.
    In Canary, two of the four firms that Mr. Spitzer found had 
independent chairs, and if my count this morning is right, of 
the 11 firms total that have been charged by the SEC or the New 
York Attorney General, four of the 11 have independent chairs. 
So it sounds good, but I am not sure it does much. And, more 
importantly, when I speak to good independent directors I know 
and I say, ``Who do you want as your chair? You are a majority, 
you are two-thirds. You can pick whoever you want.'' They would 
prefer a management company person because 90 percent of the 
matters that come before a fund board are ministerial, 
administrative, and the person regularly working there is 
better putting the agenda together. When they get to a conflict 
matter between the fund and the adviser, the 1940 Act requires 
that the inside directors leave the room and only the 
independent directors be there to decide. They could say rather 
than an independent chair, I would require that every fund's 
group of independent directors choose a lead independent 
director.
    I got long-winded, but I am all in favor of two-thirds to 
three-quarters, tougher definition of independence, compliance 
officer. I would prefer a lead independent director to a chair. 
Putting the contract out for bid I think is weird. T. Rowe 
Price in Baltimore, Mr. Price, decides to go into the money 
management business, manages rich people's money, foundations, 
and in 1950, he decides to create T. Rowe Price Growth Fund, 
spends a lot of money and energy, builds it up. There are 
directors there to watch out for shareholders, but Mr. Price 
would not go in the business if any day a T. Rowe Price 
director said, ``Gee, we are going to Fidelity.''
    And look at us as consumers. Mr. Lackritz and I have lunch. 
He has $100,000 to invest. We read Morningstar. We do a lot of 
research. We pick the Fidelity Growth Fund because Joe up there 
is a great growth fund manager. We do not expect the Fidelity 
directors tomorrow to say, ``We are taking the fund to 
Putnam.''
    I said in my testimony before the Committee without 
jurisdiction, Mr. Chairman, that it is as if I ordered a 
Chevrolet and a Ford showed up in my driveway. I think we need 
better directorial control, more fiduciary duties. I am in 
favor of tougher regulation, as well as sending people to 
prison. But I think putting the contract out to bid is upside 
down.
    Thank you.
    Chairman Shelby. Mr. Lackritz, a recent report described 
the multiple problems regarding the granting of breakpoint 
discount to investors. In response to this report, what actions 
has the broker-dealer community, your people, taken to ensure 
that investors receive the discounts to which they are 
entitled? For example, are brokerage houses considering changes 
to the way they use omnibus accounts?
    Mr. Lackritz. I am glad you asked that, Mr. Chairman. When 
we were first notified about the breakpoint problem by the NASD 
and the SEC last December, we participated, along with the 
Investment Company Institute----
    Chairman Shelby. Explain to the audience what a breakpoint 
problem is.
    Mr. Lackritz. The breakpoint problem is that mutual funds 
all have a list of fees in which they will give a discount, if 
you will, at certain breakpoints. If an investor is investing, 
say, $50,000----
    Chairman Shelby. Certain amounts.
    Mr. Lackritz. Certain amounts, that is right, certain 
threshold amounts. The challenge in this situation is investors 
sometimes have multiple accounts at different brokerage firms, 
sometimes deal directly with the fund families themselves. So 
it is very hard sometimes to aggregate the information 
operationally to do that.
    What the NASD discovered in their inspections and 
examinations indicated that there was a problem, and so we as 
an industry organization, along with the Investment Company 
Institute, jointly worked with the NASD on a series of measures 
to both figure out how to organize the information better and 
how to make sure that investors were getting the breakpoints 
they deserved, at the same time our firms are in the midst of 
refunding to all of their investors any breakpoint discounts 
that they did not receive that they should have received. We 
are in the midst of getting that done now.
    I actually think that the mechanism, this task force on 
breakpoints that was organized at the behest of the SEC by the 
NASD, the Investment Company Institute, and the SIA actually 
was a very good model for addressing a problem fairly quickly, 
fixing the problem prospectively going forward, and remedying 
the problem by refunding any overcharges that they found in the 
past. So, I think it worked very effectively.
    Chairman Shelby. Could you elaborate on how the 4 p.m. 
cutoff for trade orders would impact the trading activities of 
investors, such as individuals making changes to their 401(k) 
funds?
    Mr. Lackritz. Yes, sir. The proposal that there be a 4 p.m. 
hard close to the mutual fund itself would mean that an 
intermediary such as a broker-dealer, or a 401(k) plan 
administrator more particularly, would have to cut off trading 
a lot earlier in the day in order to process everything and get 
it to the fund by 4 o'clock and get it time-stamped. That means 
that a small investor, like my mother, for example--although I 
appreciate Mr. Fink's increasing my investment assets earlier--
but a small investor like my mother would not be able to trade 
on information in the marketplace from, say, 2 o'clock to 4 
o'clock because the intermediary had to get all the information 
to the fund by 4 o'clock.
    That is why we suggested on the hard close that it would be 
more effective for investors and much more effective from the 
standpoint of retirement plan participants, like 401(k) 
beneficiaries, to have a hard close either at the intermediary, 
at the broker-dealer, or, alternatively, to set something up 
with a utility like the NSCC. That idea is in the process of 
being developed now. That would be fairer to investors, and yet 
at the same time, we would create an electronic audit trail to 
make sure that it would not be gamed or evaded by anybody 
participating in it.
    Chairman Shelby. Gentlemen, we appreciate your appearance 
and we certainly appreciate your patience today. This has been 
a long hearing.
    On behalf of Senator Zell Miller, who could not be here 
today, I want to ask unanimous consent that his opening 
statement and two studies published by two Georgia professors 
on market timing be placed in the record. Without objection, it 
is so ordered.
    Chairman Shelby. This hearing is adjourned.
    [Whereupon, at 1:25 p.m., the hearing was adjourned.]
    [Prepared statements and additional material supplied for 
the record follow:]
               PREPARED STATEMENT OF SENATOR ZELL MILLER
    Chairman Shelby, the active trading (market timing) of mutual funds 
is an issue that we will discuss quite a bit today. Two Georgia 
professors, Professor Jason T. Greene, from the Business College at 
Georgia State University and Professor Charles W. Hodges, at State 
University of West Georgia recently published two studies entitled: 
``The Dilution Impact of Daily Fund Flows on Open-End Mutual Funds'' 
and ``Trading at Stale Prices with Modern Technology: Policy Options 
for Mutual Funds in the Internet Age.''
    I would like to commend to the Committee (and ask that both studies 
be included in the record), these two studies on market timing issues. 
The first study examines ``how mutual fund flows that are correlated 
with subsequent fund returns can have a dilution impact on the 
performance of open-end funds and the second study looks at the 
``economic and regulatory policy issues surrounding stale price trading 
in open-end mutual funds.'' And in particular the study looks at 
``International funds as especially vulnerable to stale price trading 
because the prices they use to calculate their net asset value (NAV) 
are often 12 to 15 hours old.''




               PREPARED STATEMENT OF WILLIAM H. DONALDSON
           Chairman, U.S. Securities and Exchange Commission
                           November 18, 2003

Introduction
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, thank you for inviting me to testify today on the Securities 
and Exchange Commission's initiatives to address problems in the mutual 
fund and brokerage industries. When I testified before you on September 
30, the discovery of late trading and market timing abuses by personnel 
at hedge fund Canary Capital had just erupted. I will update you on 
recent developments since then. First, though, I would like to share 
with you the fundamental rights that I believe every mutual fund 
investor not only should expect, but also to which every investor is 
entitled. We all--regulators, legislators, investment advisers, mutual 
fund managers, broker-dealers, the financial press and investors--have 
spent much time lately wondering how the current abuses could have 
happened. I believe that a significant reason is because the industry 
lost sight of certain fundamental principles--including its 
responsibilities to the millions of people who entrusted their 
confidence, the fruits of their labor, their hopes and dreams for the 
future to this industry for safekeeping. These investors are entitled 
to honest and industrious fiduciaries who sensibly put their money to 
work for them in our capital markets. No one can argue with the premise 
that investors deserve a brokerage and mutual fund industry built on 
fundamentally fair and ethical legal principles.
    Let me outline my visions of ``Mutual Fund Investors' Rights'' and 
the critical initiatives underway at the Commission to ensure that 
these enhanced investor protections continue to be carried out and that 
our new investor protections are put in place as quickly as possible.

Mutual Fund Investors' Rights
Mutual Fund Investors Have a Right to an Investment Industry that is 
        Committed
to the Highest Ethical Standards and that Places Investors' Interests 
        First
    Every brokerage and mutual fund firm needs to conduct a fundamental 
assessment of its obligations to its customers and shareholders. These 
assessments must be put forth at the highest levels, and implemented so 
as to reach all employees. Senior management and the boards of 
directors must be ready to lay down and vigorously enforce rules that 
define an immutable code of conduct.

Investors Have a Right to Equal and Fair Treatment by Their
Mutual Funds and Brokers
    Our examinations and investigations of late trading and market 
timing abuses have revealed instances of special deals and preferential 
treatment being afforded to large investors, often to the detriment of 
small investors. The concepts of equal and fair treatment of all 
investors and the prohibition against using unfair informational 
advantages are embedded in various provisions of the Federal securities 
laws, including the Investment Company Act. The SEC will not tolerate 
arrangements of this kind that violate these fundamental principles.

Investors Have a Right to Expect Fund Managers and Broker-Dealers to
Honor Their Obligations to Investors in Managing and Selling Funds
    Our examinations and investigations into the current abuses have 
revealed instances of fund managers placing their interests--and in the 
case of some portfolio managers, placing their personal interests--
ahead of those of fund investors. We also have seen recent examples of 
abusive activity by broker-dealers and their representatives in 
connection with the sale of fund shares, including failure to give 
investors the breakpoint discounts to which they are entitled, 
recommendations that investors purchase one class of shares over 
another in order for the salesperson to receive higher compensation and 
other sales practice abuses. This cannot and will not be tolerated.

Investors Have a Right to the Assurances that Fund Assets Are Being
Used for Their Benefit
    Clearly, fund assets, including use of a fund's brokerage 
commissions, must be used in a manner that benefits fund investors. The 
Commission must engage in a reassessment of how fund commission dollars 
are used, including various soft-dollar arrangements and the lack of 
transparency to investors of these payments.

Investors Have the Right to Clear Disclosure of Fees, Expenses,
Conflicts, and Other Important Information
    Mutual fund investors must have the tools and the information to 
make intelligent investment decisions. To that end, the Commission will 
take action to enhance disclosure to fund investors of fees and 
expenses, and the conflicts that arise as a result of the various 
arrangements between funds and brokers regarding the sale of fund 
shares, as well as other important information.

Investors Have a Right to Independent, Effective Boards of Directors
Who Are Committed to Protecting Their Interests
    In the words of the U.S. Supreme Court, the independent directors 
are the ``independent watchdogs'' that provide a critical and necessary 
check on fund management. The investors need to be assured that their 
mutual fund directors have the independence and commitment necessary to 
carry out this crucial function. We are proposing to set enhanced 
standards for board independence and are considering other steps in 
this area.

Investors Have a Right to Effective and Comprehensive Mutual Fund and
Broker Compliance Programs
    Programs designed to ensure compliance with the Federal securities 
laws are an essential tool in the protection of investors. Fund 
investors need to be assured that all funds, advisers and selling 
brokers have internal programs to ensure compliance with the Federal 
securities laws. We will complete our pending rulemaking to strengthen 
procedures at mutual funds and advisers.

Investors Should Expect that Aggressive Enforcement Actions Will Be
Taken When There Are Violations of the Federal Securities Laws
    We will continue to take strong and appropriate action against 
those who violate the Federal securities laws. There will be serious 
consequences to those who violate the Federal securities laws.
    By holding the industry (and ourselves) to these standards, we can 
significantly minimize the possibility of future scandals that harm our 
Nation's millions of mutual fund investors, and help restore the 
confidence of those investors.

SEC Risk Management Initiative
    For too long, the Commission has found itself in a position of 
reacting to market problems, rather than anticipating them. There are 
countless reasons for this--not the least of which include historically 
lagging resources and structural and organizational roadblocks. The 
time for excuses has long passed.
    Since coming to the Commission in February, one of my top 
priorities has been to reevaluate and determine how the Commission 
deals with risk. Part of this evaluation has been a thorough review of 
the Commission's internal structures. The 
results of our work form a new risk management initiative that will 
better enable the Commission to anticipate, identify, and manage 
emerging risks and market trends that stand to threaten the 
Commission's ability to fulfill its mission.
    This critical initiative--the first of its kind at the Commission--
will enable us to analyze risks across divisional boundaries, focusing 
on early identification of new or resurgent forms of fraudulent, 
illegal, or questionable behavior or products. Operating under the 
``Doctrine of No Surprises,'' this initiative seeks to ensure that 
senior management at the Commission has the information necessary to 
make better, more informed decisions.
    The new initiative will be housed within a newly created Office of 
Risk Assessment, and will be headed by a director who reports directly 
to the Chairman. The director will coordinate and manage risk 
assessment activities across the agency, and will oversee a staff of 
five professionals, who will focus on the key programmatic areas of the 
agency's mission.
    The duties of the Office of Risk Assessment will be focused on the 
following areas:

 Gathering and maintaining data on new trends and risks from a 
    variety of sources--including external experts, domestic and 
    foreign agencies, surveys, focus groups, and other market data, 
    including both buy-side and sell-side research.

 Analyzing data to identify and assess new areas of concern 
    across professions, companies, industries, and markets.

 Preparing assessments and forecasts on the agency's risk 
    environment.

    The work of the Office of Risk Assessment will be complemented by a 
Risk Management Committee, whose primary responsibility will be to 
review the implications of identified risks and recommend an 
appropriate course of action.
    Additionally, each Division and major Office will have one-to-two 
risk assessment professionals on staff, who will work closely with the 
Division Director or Office head as part of risk management teams to 
conduct risk assessment activities within each division.
    I believe this important initiative will fundamentally change the 
way the Commission assesses risk and will enable us to head off major 
problems before they occur.

Plan of Execution
    The SEC is dedicated to the underlying concept inherent in this 
statement: ``Mutual Fund Investors' Rights.'' Let me outline what the 
specific initiatives to ensure that Mutual Fund Investors' Rights are 
realized.

Late Trading and Market Timing Abuses
    Late trading and market timing abuses represent the most recent 
violations against investors' rights. In addition to those abuses, we 
have seen other violations of investors' rights, including (to name but 
a few) violations of an investor's right to high ethical standards, 
fiduciary protections, clear disclosure, and equal treatment. While we 
are vigorously pursuing enforcement actions regarding this misconduct, 
we also are taking a number of regulatory steps immediately to deal
specifically with these abuses. On October 9, I outlined a regulatory 
agenda to confront the abuses head-on to help restore investor 
confidence in the fairness of
mutual fund operations and practices. I asked the staff to submit 
rulemaking recommendations to the Commission this month to address 
these issues. As a result, on December 3, the Commission will consider 
the staff 's proposal to require that a fund (or certain designated 
agents)--rather than an intermediary such as a broker-dealer or other 
unregulated third party--receive a purchase or redemption order prior 
to the time the fund prices its shares (typically, 4 p.m.) for an 
investor to receive that day's price. This ``hard'' 4 o'clock cut-off 
would effectively eliminate the potential for late trading through 
intermediaries that sell fund shares.
    With respect to market timing abuses, we will consider the staff 's 
recommendation that the Commission require additional, more explicit 
disclosure in fund offering documents of market timing policies and 
procedures. This disclosure would 
enable investors to assess a fund's market timing practices and 
determine if they are in line with their expectations.
    The staff 's recommendations will have a further component of 
requiring funds to have specific procedures to comply with their 
representations regarding market timing policies. Thus, if a fund's 
disclosure documents stated that it discouraged market timing, the fund 
would be required to have procedures outlining the practices it follows 
to keep market timers out of the fund. While our examination staff will 
use a variety of techniques to police for market timing abuses, the 
establishment of formal procedures would also enable the Commission's 
examination staff to review whether those procedures are being followed 
and whether the fund is living up to its representations regarding 
curbing market timing activity. The Commission also will emphasize the 
obligation of funds to fair value their securities so as to avoid 
``stale pricing'' to minimize market timing arbitrage opportunities as 
an important measure to combat market timing activity.
    Also on December 3, the Commission will consider adopting new rules 
under the Investment Company Act and the Investment Advisers Act that 
will ensure that mutual funds have strong compliance programs. 
Specifically, the rules that the Commission will consider would require 
each investment company and investment adviser registered with the 
Commission to: (1) adopt and implement written policies and procedures 
reasonably designed to prevent and detect violations of the Federal 
securities laws; (2) review these polices and procedures annually for 
their adequacy and the effectiveness of their implementation; and (3) 
designate a chief compliance officer to be responsible for 
administering the policies and procedures and to report directly to the 
fund's board of directors. A chief compliance officer reporting to the 
fund's board of directors will strengthen the hand of the fund's board 
and compliance personnel in dealing with fund management.
    Allegations of certain portfolio managers market timing the funds 
they personally manage or other funds in the fund complex raise issues 
regarding self-dealing. Recent allegations also indicate that some fund 
managers may be selectively disclosing their portfolios in order to 
curry favor with large investors. Selective disclosure of a fund's 
portfolio can facilitate fraud and have severely adverse ramifications 
for a fund's investors if someone uses that portfolio information to 
trade against the fund. You can expect that these issues will also be 
addressed in the rulemaking recommendations that the Commission will 
consider on December 3.
    The package of reforms that I have just outlined for you is 
designed to provide immediate reassurances and protection to mutual 
fund investors. They deserve nothing less than an immediate response 
from the SEC. These critical reforms not only will tackle the immediate 
problem of late trading and market timing abuses that we have seen so 
far during our investigation, but also will provide powerful tools to 
prevent the types of abuses identified to date. However, we cannot and 
will not stop here. We will explore the full range of our authority, 
not only in the reforms discussed above, but also in the additional 
areas to further address market timing abuses.
    For instance, while the Commission's actions regarding fair value 
pricing should address the problem of stale pricing (which facilitates 
market timing), we will consider more in this area. As such, I have 
asked the staff to study additional measures for Commission 
consideration, including considering a mandatory redemption fee imposed 
on short-term traders and developing a solution to the problem of 
trading through omnibus accounts.
    With respect to the mandatory redemption fee, which would be paid 
to the fund (and, ultimately to the fund's long-term investors), it is 
a fee that would apply to short-term traders getting in and out of a 
fund over a short period of time, for instance 3 or 5 days. Such a fee 
could decrease the likelihood of market timers profiting from arbitrage 
activity.
    As for omnibus accounts, I believe that there needs to be better 
information shared between funds and brokers. Mutual fund shares often 
are purchased and redeemed through omnibus accounts held at 
intermediaries such as broker-dealers. Typically, a brokerage firm has 
one omnibus account with each of the mutual funds with which it does 
business and through which all of its brokerage customers purchase and 
redeem shares of those mutual funds. Consequently, these mutual funds 
do not have information on the identity of the underlying brokerage 
customer who is purchasing or redeeming the funds' shares.
    This arrangement often makes it difficult for funds to fulfill 
certain of their obligations to their shareholders. In the breakpoint 
context, omnibus accounts make it difficult for funds to track 
information about the underlying shareholder that might have entitled 
the shareholder to breakpoint discounts. In the market timing context, 
funds are not able to assess redemption fees, limit exchanges or even 
kick out a shareholder who is market timing through an omnibus account 
because they do not know the identity of that shareholder. Indeed, many 
of the market timing abuses identified through our examinations and 
investigations indicate that shareholders were market timing through 
omnibus accounts.
    The issue is further complicated because brokers are reluctant to 
release the underlying shareholder information to funds, citing privacy 
and competitive concerns. The brokers fear that by releasing the names 
of their customers who are purchasing fund shares to the funds 
themselves, the funds then can market directly to those customers, 
cutting out the brokers.
    Requiring broker-dealers and other intermediaries to provide 
information to funds regarding the funds' investors would allow funds 
to police for abusive market timing activity and to further provide for 
appropriate breakpoints. An alternative would be to require that 
broker-dealers and other intermediaries enforce funds' policies with 
respect to market timing and the offering of breakpoints.

Study
    To assist the staff as it moves forward in considering this issue, 
I have called upon the NASD to head an Omnibus Account Task Force 
consisting of members of the fund and brokerage industries, as well as 
other intermediaries to further study this issue and to provide the SEC 
staff with information and recommendations. Under the NASD's capable 
leadership, the Joint NASD/Industry Task Force on Breakpoints was 
extremely beneficial in dealing with the breakpoint issue and I am 
confident that, working together with the NASD and the industry, we 
will be able to develop a proposal that will adequately address the 
omnibus account issue.

Fund Governance
    As I noted, a fundamental right of investors is a strong, 
effective, independent board of directors. The statutory framework 
governing mutual funds envisions a key role for boards of directors in 
light of the external management structure typical for funds. The 
directors, particularly the ``independent directors,'' are responsible 
for managing conflicts of interest and representing the interests of 
shareholders. The problems that recently have come to light underscore 
the need for enhanced effectiveness of independent directors in 
carrying out their responsibilities. Toward that end, I believe there 
are a number of ideas for reform, including:

 Requiring an independent chairman of the fund's board of 
    directors.

 Increasing the percentage of independent directors under the 
    SEC's rules from a majority to three-fourths.

 Providing the independent directors with the authority to 
    retain staff as they deem necessary so they do not have to 
    necessarily rely on the fund's adviser for assistance.

 Requiring boards of directors to perform an annual self-
    evaluation of their effectiveness, including consideration of the 
    number of funds they oversee and the board's committee structure.

 Adopting a rule that would require boards to focus on and 
    preserve documents and information that directors use to determine 
    the reasonableness of fees relative to performance, quality of 
    service and stated objectives, including a focus on the need for 
    breakpoints or reductions in advisory fees and comparisons with 
    fees and services charged to other clients of the adviser.

    I recognize, however, that while the Commission can adopt rules to 
enhance and strengthen fund governance, that is not enough. Directors 
themselves must understand and carry out their responsibilities to 
protect fund investors. We need to take the necessary steps to educate 
directors regarding this crucial role and to ensure that they 
understand their role. Accordingly, in addition to asking the staff to 
develop these reforms for consideration by the Commission in January, I 
have also called upon fund independent directors themselves to be 
active participants in the reform effort. Specifically, I have asked 
former SEC Chairman David Ruder's nonprofit mutual fund director's 
organization, the Mutual Fund Directors Forum, to develop guidance and 
best practices in key areas of director decisionmaking, such as 
monitoring fees and conflicts, overseeing compliance, and important 
issues such as valuation and pricing of fund portfolio securities and 
fund shares. Mr. Ruder and the Board of Directors of the Forum--an 
organization geared toward independent directors and that promotes 
improved fund governance through continuing education programs and 
other activities that assist independent directors in advocating for 
fund shareholders--have agreed to develop this guidance and these best 
practices to assist independent directors. Rest assured, we will 
continue to consider every viable idea, from whatever source, for 
improving the way that mutual funds are structured and governed.
    In addition to these initiatives, in August of this year the 
Commission proposed rules regarding disclosure of fund nominating 
committee functions and communications between fund investors and fund 
boards, as part of the Commission's broader proposal on nominating 
committee disclosure. And just last month, the Commission, as part of 
its broader proxy nomination proposal, proposed rules to improve access 
of fund shareholders to the director nomination proxy process.

Disclosure
    Another fundamental right of mutual fund investors is clear, easy 
to understand disclosure. At the end of September, we adopted 
amendments to mutual fund advertising rules that require that fund 
advertisements state that investors should consider fees before 
investing and that advertisements direct investors to a fund's 
prospectus to obtain additional information about fees. The rules also 
require more balanced information about mutual funds when they 
advertise performance. The Commission also recently proposed rule 
amendments regarding fund of funds products that would require these 
products to include additional disclosure in their prospectus fee table 
of the costs of investing in underlying funds. The Commission also 
adopted rules that require funds and advisers to disclose their proxy 
voting policies and procedures and, in the case of funds, disclose to 
investors the voting records of the funds.
    Another key concept of the disclosure principle is clear, easy to 
understand disclosure to mutual fund investors of the fees and expenses 
they pay. I anticipate that in January, the Commission will consider 
adopting rules that would require ``dollars and cents'' fee disclosure 
to shareholders, coupled with more frequent disclosure of portfolio 
holdings information. This is an important reform, as it will allow 
investors to determine not only the fees and expenses they are paying 
on their particular funds, but will also greatly facilitate comparison 
among different funds. The Commission also will be considering in 
December a proposal to improve disclosure to shareholders regarding the 
availability of sales load breakpoints. We also want to provide 
investors better information on portfolio transaction costs so that 
they can factor this into their decisionmaking. Consequently, the staff 
is developing for Commission consideration in December a concept 
release to solicit views on how the Commission should proceed in 
fashioning disclosure of these costs.
    Investors not only deserve to know the fees and expenses their 
funds pay, they also deserve to know how much their broker stands to 
benefit from their purchase of a particular fund. Thus, we also plan to 
improve disclosure about mutual fund transaction costs through the 
confirmations that broker-dealers provide to their customers. I have 
directed the staff to prepare a new mutual fund confirmation statement 
that will provide customers with quantified information about the sales 
loads and other charges that they incur when they purchase mutual funds 
with sales loads. I expect that the Commission will consider this 
proposal before the end of the year. The Commission also will direct 
the staff to consider how disclosure of quantified information about 
sales loads and other charges incurred by investors might be disclosed 
in a document available prior to the sale of fund shares.
    To address an investor's right to know about conflicts of interest 
that brokers may have when selling fund shares, the new mutual fund 
confirmation statement also will include specific disclosure regarding 
revenue sharing arrangements, differential compensation for proprietary 
funds and for other incentives such as commission business for brokers 
to sell fund shares that may not be readily apparent to fund investors.
    To ensure that investors receive the benefits of fund assets to 
which they are entitled, the Commission will examine how brokerage 
commissions are being used to 
facilitate the sale and distribution of fund shares, as well as the use 
of so-called 
soft-dollar arrangements. Soft-dollar arrangements can create 
incentives for fund advisers to: (1) direct fund brokerage based on the 
research provided to the adviser rather than on the quality of 
execution provided to the fund; (2) forgo opportunities to recapture 
brokerage costs for the benefit of the fund; and (3) cause the adviser 
to over-trade the portfolio to fulfill its soft-dollar commitments to 
brokers. These are areas that raise complicated issues, but that we 
will nevertheless examine.
    I have also instructed the staff to consider rules that would 
better highlight for investors the basis upon which directors have 
approved management and other fees of the fund.

Compliance and Oversight
    The Commission long has recognized the importance of strong 
internal controls. For example, the Commission recently tailored the 
provisions of the Sarbanes-Oxley Act to apply to mutual funds, 
including the provisions to improve oversight and internal controls, 
such as key officer certifications and Code of Ethics requirements, 
thereby ensuring that mutual fund shareholders received the full 
protections of the Sarbanes-Oxley Act.
    In addition, I should note that the staff in September issued a 
comprehensive report on hedge funds, making a series of recommendations 
to improve the Commission's ability to monitor the activity of these 
vehicles--the most significant being a recommendation to require that 
hedge fund advisers register under the Investment Advisers Act and 
thereby become subject to Commission examination and routine oversight. 
This review of hedge funds, and the staff 's recommendations, become 
all the more important when we consider that we have seen a number of 
hedge funds allegedly engaging in late trading and market timing of 
mutual fund shares, serving as the impetus for the current 
investigations and enforcement actions related to these activities.
    We will continue to explore additional approaches that the 
Commission might pursue to require funds to assume greater 
responsibility for compliance with the Federal securities laws, 
including whether funds and advisers should periodically undergo an 
independent third-party compliance audit. These compliance audits could 
be a useful supplement to our own examination program and could ensure 
more frequent examination of funds and advisers.
    Also, as an effective regulator, we must have clear rules as to 
what is unlawful activity. We will continue to review our rules and our 
regulations to ensure that this is the case, much as we are doing now 
to combat late trading and market timing abuses.

Actions on the Enforcement Front
    Again, I believe that these investor rights are critical. Equally 
critical is effective enforcement of those rights and of the Federal 
securities laws.
    When I testified before you in September, I noted that the 
Commission had taken immediate enforcement action against a senior 
official at Bank of America. Since then, we have taken a number of 
additional enforcement actions against those taking part in these 
trading abuses.
    We have charged a senior executive of a prominent hedge fund with 
late trading, and barred him from association with an investment 
adviser. We also barred and imposed a $400,000 civil penalty on a 
mutual fund executive in connection with his alleged role in allowing 
certain investors to market time his company's funds. We instituted an 
action against a major investment management firm and two of its 
portfolio managers who allegedly market timed their own mutual funds. 
And we charged five brokers and a branch manager with having 
misrepresented or concealed their own and their clients' identities in 
order to facilitate thousands of market timing transactions.

Putnam Settlement
    Among its many roles, the Securities and Exchange Commission has 
two critical missions. The first is to protect investors, and the 
second is to punish those who violate our securities laws. Last week's 
partial settlement of the SEC's fraud case against the Putnam mutual 
fund complex does both. It offers immediate and significant protections 
for Putnam's current mutual fund investors, serving as an important 
first step. Moreover, by its terms, it enhances our ability to obtain 
meaningful financial sanctions against alleged wrongdoing at Putnam, 
and leaves the door open for further inquiry and regulatory action.
    Despite its merits, the settlement has provoked considerable 
discussion, and some criticism. Unfortunately, the criticism is 
misguided and misinformed, and it obscures the settlement's fundamental 
significance.
    By acting quickly, the SEC required Putnam to agree to terms that 
produce immediate and lasting benefits for investors currently holding 
Putnam funds. First, we put in place a process for Putnam to make full 
restitution for investor losses associated with Putnam's misconduct. 
Second, we required Putnam to admit its violations for purposes of 
seeking a penalty and other monetary relief. Third, we forced 
immediate, tangible reforms at Putnam to protect investors from this 
day forward. These reforms are already being put into place, and they 
are working to protect Putnam investors from the misconduct we found in 
this case.
    Among the important reforms Putnam will implement is a requirement 
that Putnam employees who invest in Putnam funds hold those investments 
for at least 90 days, and in some cases for as long as 1 year--putting 
an end to the type of short-term trading we found at Putnam. On the 
corporate governance front, Putnam fund boards of trustees will have 
independent chairmen, at least 75 percent of the board members will be 
independent, and all board actions will be approved by a majority of 
the independent directors. In addition, the fund boards of trustees 
will have their own independent staff member who will report to and 
assist the fund boards in monitoring Putnam's compliance with the 
Federal securities laws, its fiduciary duties to shareholders, and its 
Code of Ethics. Putnam has also committed to submit to an independent 
review of its policies and procedures designed to prevent and to detect 
problems in these critical areas--now, and every other year.
    This settlement is not the end of the Commission's investigation of 
Putnam. We are also continuing to examine the firm's actions and to 
pursue additional remedies that may be appropriate, including penalties 
and other monetary relief. If we turn up more evidence of illegal 
trading, or any other prohibited activity, we will not hesitate to 
bring additional enforcement actions against Putnam or any of its 
employees. Indeed, our action in Federal court charging two Putnam 
portfolio managers with securities fraud is pending.
    There are two specific criticisms of the settlement that merit a 
response. First, some have charged that it was a mistake not to force 
the new management at 
Putnam to agree that the old management had committed illegal acts. In 
fact, we took the unusual step of requiring Putnam to admit to 
liability for the purposes of determining the amount of any penalty to 
be imposed. We made a decision, however, that it would be better to 
move quickly to obtain real and practical protections for Putnam's 
investors, right now, rather than to pursue a blanket legal admission 
from Putnam. The SEC is hardly out of the mainstream in making such a 
decision. All other Federal agencies, and many State agencies 
(including that of the New York Attorney General), willingly and 
regularly forgo blanket admissions in order to achieve meaningful and 
timely resolutions of civil proceedings.
    Second, some have criticized the Putnam settlement because it does 
not address how fees are charged and disclosed in the mutual fund 
industry. While this issue is serious, the claim is spurious. The 
Putnam case is about excessive short-term trading by at least six 
Putnam management professionals and the failure of Putnam to detect and 
deter that trading. The amount and disclosure of fees is not, and never 
has been, a part of the Putnam case, and thus it would be wholly 
improper to try to piggyback the fee disclosure issue on an unrelated 
matter.
    If our continuing investigation of Putnam uncovers evidence of 
wrongdoing in the fee disclosure area, we will not hesitate to act, and 
the Commission is already moving forward with rulemaking that will 
address this issue, and others, on an industrywide basis. Those lacking 
rulemaking authority seem to want to shoehorn the consideration of the 
fee disclosure issues into the settlement of lawsuits about other 
subjects. But we should not use the threat of civil or criminal 
prosecution to extract concessions that have nothing to do with the 
alleged violations of the law.
    Criticism of the Commission for moving too quickly misses the 
significance of the Commission's action. While continuing our broader 
investigation of Putnam, we have reached a fair and far-reaching 
settlement that establishes substantial governance reforms and 
compliance controls that are already benefiting Putnam's investors. It 
is a settlement where the Commission put the interests of investors 
first. As the Commission continues to initiate critical and immediate 
reforms of the mutual fund industry, and while we investigate a 
multitude of other cases involving mutual fund abuses, we will continue 
to seek reforms that provide immediate relief to harmed investors.
    I also want briefly to discuss yesterday's announcement of the 
Commission's enforcement action against Morgan Stanley arising out of 
the firm's mutual fund sales practices. Morgan Stanley has agreed to a 
settlement of the action that calls, in part, for it to pay a total of 
$50 million, all of which will be returned to investors. The action 
grows out of an investigation begun in the spring of this year.
    The Commission's investigation uncovered two distinct, firm-wide 
disclosure failures by Morgan Stanley. The first relates to an 
exclusive program involving sixteen mutual fund families that Morgan 
Stanley sold to its customers under an exclusive program involving 16 
mutual fund families.
    Under the program, Morgan Stanley gave these fund families what is 
sometimes called ``premium shelf space.'' The firm encouraged its sales 
force to sell shares of the funds in the program and even paid its 
salespeople special incentives to sell those funds so that Morgan 
Stanley would receive from those funds a percentage of the sales price 
over and above ordinary commissions and loads. Morgan Stanley's 
customers did not know about these special shelf-space payments, nor in 
many cases they did not know that the payments were coming out of the 
very funds into which these investors were putting their savings.
    Few things are more important to investors than receiving unbiased 
advice from their investment professionals. Morgan Stanley's customers 
were not informed of the extent to which Morgan Stanley was motivated 
to sell them a particular fund.
    Our investigation also uncovered, and the enforcement action we 
have filed includes, another practice at Morgan Stanley involving 
conflicts of interest in the sale of mutual funds. This practice, which 
has been the subject of other Commission cases during the last several 
months, involves the sale of Class B mutual fund shares to investors 
who were more likely to have better overall returns if they bought 
Class A shares in the same funds.
    I want to emphasize that the abuses that are addressed in this case 
are significant and are not necessarily limited to Morgan Stanley. So-
called shelf-space payments have become popular with brokerage firms 
and the funds they are selling. Thus, the Commission is conducting an 
examination sweep of some 15 different broker-dealers to determine 
exactly what payments are being made by funds, the form of those 
payments, the ``shelf space'' benefits that broker-dealers provide, and 
most importantly, just what these firms tell their investors about 
these practices. I also want to note that the potential disclosure 
failures and breaches of trust are not limited to broker-dealers. We 
are also looking very closely at the mutual fund companies themselves.
    The SEC's Director of Enforcement, Stephen Cutler, will be 
testifying before you on our enforcement efforts this Thursday, and can 
answer your specific questions about these and the Commission's other 
enforcement actions, as well as the results thus far in our ongoing 
investigation. While he cannot speak to specific entities that the 
Commission has authorized the staff to investigate, he can brief you on 
the types of cases you likely will be seeing brought by the Commission 
in the near 
future. Let me emphasize, however, that I am appalled at the types and 
extent of conduct that is being revealed in our examinations and 
investigations. It is conduct that represents fundamental breaches of 
fiduciary obligations and betrayal of our Nation's investors. I can 
assure you that we are committed to seeking redress for investors and 
meting out the appropriate punishment in these matters to send a strong 
message that these types of abuses will not be tolerated.
Conclusion
    As you can see, taken together, the reforms that the Commission has 
already undertaken and those currently being initiated are both 
substantial and far-reaching. They are designed to address not only the 
immediate problems of late trading and market timing abuses, but 
represent a reevaluation of the Commission's oversight of the mutual 
fund industry as a whole. Most importantly, they put the needs of 
mutual fund investors first. I appreciate the opportunity to share with 
you my views, and I would be happy to answer any questions you may 
have.
                 PREPARED STATEMENT OF MATTHEW P. FINK
                President, Investment Company Institute
                           November 18, 2003

Introduction
    My name is Matthew P. Fink. I am President of the Investment 
Company Institute, the national association of the American investment 
company industry. The Institute's membership includes 8,664 open-end 
investment companies (mutual funds), 601 closed-end investment 
companies, 106 exchange-traded funds, and 6 sponsors of unit investment 
trusts. The Institute's mutual fund members have assets of about $6.967 
trillion, accounting for approximately 95 percent of total industry 
assets, and 90.2 million individual shareholders.
    I appreciate the opportunity to appear before the Subcommittee 
today to discuss the issues of late trading and market timing of mutual 
funds, and the industry's commitment to take whatever steps are 
necessary to make sure that the interests of fund shareholders are 
fully protected.
    The bedrock principle of the mutual fund industry is that the 
interests of mutual fund investors always come first. Consequently, the 
industry has reacted with shock and outrage to the allegations of late 
trading and market timing in the New York Attorney General's complaint 
in the Canary case \1\ and other recent allegations of abusive mutual 
fund trading practices. There can be no excuse for knowingly permitting 
the buying and selling of fund shares at old prices after the market 
has closed. And while restricting market timing may be easier said than 
done, silently selling to a select few the right to trade fund shares 
is deeply troubling. Even more abhorrent is the notion that, in some 
instances, fund insiders themselves may have engaged in market timing 
to reap personal benefits at the expense of other fund shareholders. 
The industry commends the New York Attorney General's office and the 
Securities and Exchange Commission for their investigative efforts and 
forceful responses to these alleged practices. It is imperative that 
the ongoing investigations by the SEC and others of these allegations 
are thorough and successful in rooting out trading activities that have 
compromised or harmed the interests of individual mutual fund 
shareholders.
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    \1\ State of New York v. Canary Capital Partners, LLC, Canary 
Investment Management, LLC, Canary Capital Partners, Ltd., and Edward 
J. Stern (NY S. Ct. filed September 3, 2003) (undocketed complaint) 
(Canary Complaint).
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    We cannot wait until those investigations are complete, however, to 
take the steps necessary to restore and to reinforce investor 
confidence in mutual funds. Investor confidence is every mutual fund's 
most precious asset. The industry earned the confidence of millions of 
Americans by serving their interests above all other considerations. 
Unfortunately, the business practices that have been alleged are 
inconsistent with this principle and are intolerable if mutual funds 
are to serve individual investors as effectively in the future as they 
have in the past. Forceful action will be the key to restoring and 
reinforcing investor confidence. The broad elements of what must be 
done to reassure investors are as follows:

 First, Government officials must identify everyone who 
    violated the law. Forceful and unambiguous sanctions must be 
    delivered swiftly wherever punishment is warranted.

 Second, if shareholders were harmed because of illegal or 
    deceptive business arrangements, these wrongs must be made right.

 Third, any gaps in the otherwise strict system of mutual fund 
    regulation must be identified and effectively addressed.

    With respect to the last point, SEC Chairman Donaldson has 
announced plans to propose tough new regulatory requirements addressing 
the late trading and abusive short-term trading of mutual fund 
shares.\2\ The SEC also will consider whether additional requirements 
are necessary to address the issue of selective disclosure of portfolio 
holdings information. The industry pledges its full support of the SEC 
in whatever course of action it determines will best protect mutual 
fund shareholders.
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    \2\ See SEC Chairman Donaldson Releases Statement Regarding 
Initiatives to Combat Late Trading and Market Timing of Mutual Funds, 
SEC Press Release No. 2003 -136 (October 9, 2003) (Donaldson 
Statement).
---------------------------------------------------------------------------
    To help advance this objective, the Institute's Board of Governors 
established two separate task forces to identify specific options to 
address the issues of late trading and abusive short-term trading 
involving mutual fund shares. Based on the findings of the task forces, 
the Institute has developed several recommendations, which are outlined 
below.
    Mutual funds themselves also have acted swiftly to determine 
whether wrongdoing occurred in their firms. They have initiated 
internal investigations, in some cases aided by independent outside 
experts to investigate and judge the findings, and communicated their 
findings and responses to their boards and shareholders. In addition, 
some fund boards have retained independent third parties to conduct 
investigations. As a result of these investigations, several funds have 
terminated senior executives. Many funds have committed to taking 
remedial actions, including compensating fund shareholders for any 
detrimental impact that improper or illegal transactions may have had 
on their investments. These actions reinforce that funds take very 
seriously their obligations under the Federal securities laws and the 
fulfillment of their responsibility to make sure investors' interests 
always come first.
    The remainder of my testimony will focus on the issues of late 
trading and abusive short-term trading of mutual fund shares. I also 
will discuss the practice of selectively disclosing information about 
fund portfolio holdings to shareholders, and oversight of hedge funds. 
Finally, I will discuss other initiatives to reinforce the protection 
and confidence of mutual fund investors.

Late Trading
    A basic tenet of mutual fund investing is the concept of ``forward 
pricing.'' Mutual funds are required to price their shares at least 
once each day, at a time or times designated by the fund's board of 
directors and disclosed in the fund's prospectus. Most funds price 
their shares as of 4 p.m. Eastern time, the close of regular trading on 
the New York Stock Exchange. All purchase and redemption orders 
received by a fund or its agents before 4 p.m. must receive that day's 
price. All orders received after 4 p.m. must receive the next day's 
price. The requirement that a purchase or redemption order be priced 
based on the fund's net asset value (NAV) next computed after receipt 
of the order is known as the ``forward pricing'' rule. The SEC adopted 
this rule in 1968 because it recognized that ``backward pricing'' 
(purchases and sales of fund shares at a previously determined NAV) 
could lead to dilution of the value of fund shares and could be 
susceptible to abuse in that it could allow speculators to take 
advantage of fluctuations in the prices of the fund's portfolio 
securities that occurred after the fund calculated its NAV.\3\ 
Unfortunately, the recent allegations of late trading appear to bear 
this out.
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    \3\ See Investment Company Act Release No. 5519 (October 16, 1968).
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    Under current SEC rules and staff interpretations, funds may treat 
the time of receipt of an investor's order by a person designated by 
the fund (such as a dealer) as the relevant time for determining which 
price the order will receive.\4\ Thus, it is common industry practice 
for intermediaries such as broker-dealers, banks, and retirement plan 
administrators to transmit their clients' purchase and redemption 
orders that were accepted before 4 p.m. to a fund for processing after 
4 p.m. at that day's price.
---------------------------------------------------------------------------
    \4\ See, e.g., Investment Company Act Release No. 5569 (December 
27, 1968).
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    Given the alleged abuses that recently have come to light, the 
Institute believes that existing regulations should be tightened to 
better protect against the possibility of late trading. The most 
effective solution to this problem would be to require that all 
purchase and redemption orders be received by a fund (or its transfer 
agent) before the time of pricing (that is, 4 p.m. Eastern time).\5\ 
While such a requirement could have a significant impact on the many 
investors who own mutual funds through financial intermediaries,\6\ the 
recent abuses indicate that the strongest possible measures are 
necessary to ensure investor protection. A 4 p.m. cut-off time at the 
fund would significantly limit opportunities for late trading by 
narrowing the universe of entities responsible for applying a 4 p.m. 
cut-off time to include only the funds and their transfer agents. In 
addition to limiting the number of entities involved, it would restrict 
them to SEC-regulated entities. This would simplify both funds' 
compliance oversight responsibilities and regulators' examination and 
enforcement efforts with respect to potential late trading. In doing 
so, it would likely enhance compliance.
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    \5\ As noted above, most funds price their shares as of 4 p.m. 
Eastern time. Thus, for simplicity, the discussion below assumes that 
this is the case. A fund that prices its shares as of a different time 
should be required to cut off orders by that time.
    \6\ Institute data show that the vast majority (approximately 85-90 
percent) of mutual fund purchases are made through such intermediaries, 
including both the financial advisers and employer-sponsored retirement 
plans. See Investment Company Institute, 2003 Mutual Fund Fact Book, at 
38. A 4 p.m. cut-off time at the fund will require intermediaries to 
apply an earlier cut-off time to the mutual fund orders they receive. 
This, in turn, will compress the time period during which investors 
conducting fund transactions through intermediaries could receive same-
day prices. The precise impact likely will vary among different types 
of intermediaries, and among individual firms. In many cases, investors 
may no longer have the ability to obtain same-day prices.
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    We note that Chairman Donaldson has specifically asked the SEC 
staff to examine the feasibility of such a requirement.\7\ The 
Institute believes that applying order cut-off requirements to funds 
and their transfer agents is the best way to address late trading 
abuses at this time.\8\ We urge the SEC to proceed expeditiously to 
adopt this approach.\9\
---------------------------------------------------------------------------
    \7\ Donaldson Statement, supra note 2.
    \8\ In the future, advances in technology may make it possible to 
devise systems (e.g., a system for ``time stamping'' mutual fund orders 
in a way that cannot be altered) that provide a high level of assurance 
regarding the time of receipt of an order by an intermediary. Nothing 
would prevent the SEC from revisiting this issue in that event.
    \9\ We note that a reasonable period of time will be needed to 
allow all affected entities to make the necessary systems changes to 
implement new cut-off requirements.
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Market Timing
    The ongoing investigations by the SEC and other governmental 
officials also involve issues relating to ``market timing'' of mutual 
funds. It is important to note that ``market timing'' is not a 
precisely defined term. Generally speaking, the term refers to a 
trading strategy involving frequent purchases and sales of mutual funds 
in an effort to anticipate changes in market prices. There is nothing 
inherently illegal or improper about such activity.
    At some level, however, frequent trading activity can be disruptive 
to the management of a fund's portfolio. For example, frequent trading 
may compel portfolio managers either to hold excess cash or to sell 
holdings at inopportune times in order to meet redemptions. This can 
adversely impact a fund's performance, and increase trading and 
administrative costs. For this reason, many fund groups have sought to 
employ a number of methods designed to limit short-term trading, such 
as imposing redemption fees, restricting exchange privileges, and/or 
limiting the number of trades within a specified period. Many funds 
disclose in their prospectus that they do not permit market timing or 
that they may take steps to discourage it.
    Different types of funds are affected differently by short-term 
trading, and higher turnover of smaller accounts has little effect on 
portfolio management. Funds also may seek to serve different types of 
investors; some funds are designed specifically to accommodate short-
term trading. Thus, there is no ``one size fits all'' solution with 
respect to market timing generally.
    The specific concerns that have been raised about market timing are 
not that funds did, or did not, have certain policies in place. Rather, 
it has been alleged that some funds were not applying their market 
timing policies fairly and consistently. A number of different steps 
can be taken to address these concerns, which are discussed below.

Written Policies and Procedures
    SEC Chairman Donaldson has outlined various regulatory measures 
that the SEC staff is considering to address the alleged practice of 
certain funds allowing a few investors to engage in market timing 
activities in a manner inconsistent with their policies.\10\ These 
measures include new rules and form amendments to: (1) require explicit 
disclosure in fund offering documents of market timing policies and 
procedures and (2) require funds to have procedures to comply with 
representations regarding market timing policies and procedures. The 
industry fully supports these measures.
---------------------------------------------------------------------------
    \10\ Donaldson Statement, supra note 2.
---------------------------------------------------------------------------
    While many funds already have market timing policies and 
procedures, requiring funds to adopt formal and detailed policies and 
procedures in this area will ensure that all funds have systems in 
place to address abusive activity. Such a requirement should also 
provide a more effective mechanism for boards and regulators to police 
compliance because more formal policies likely would limit discretion 
in dealing with short-term traders.
    Another element of Chairman Donaldson's regulatory action plan is 
to reinforce the obligation of fund directors to consider the adequacy 
and effectiveness of fund market timing policies and procedures.\11\ 
For example, fund boards could be required to receive regular reports 
on how these programs have been implemented. We strongly support 
reinforcing board oversight in this area.
---------------------------------------------------------------------------
    \11\ Id.
---------------------------------------------------------------------------
    Fund shareholders also will benefit from additional prospectus 
disclosure about a fund's policies on short-term trading by gaining an 
understanding of how the fund will protect their interests from abusive 
activity. Requiring that such disclosure be in a fund's prospectus 
could serve to enhance compliance with the policies. The disclosure 
also could have a deterrent effect by alerting potential abusers to the 
fund's policies.
    Additional steps are needed to address alleged abusive market 
timing activity by fund insiders. As noted above, this conduct, if 
true, is especially reprehensible. Thus, with respect to personal 
trading in fund shares by portfolio managers or a fund's senior 
executives, the Institute is urging all mutual funds to clarify or 
amend their codes of ethics to require oversight of personal trading 
activity by these persons in any funds offered or sponsored by the 
company.

Fair Valuation
    An issue related to market timing is the obligation of funds to 
determine the fair value of their portfolio securities under certain 
circumstances. Much short-term trading activity appears to be motivated 
by a desire to take advantage of fund share prices that are based on 
closing market prices established some time before a fund's net asset 
value is set. It has been suggested that one way to address this 
concern is to require funds to fair value their portfolio securities 
more often. As part of Chairman Donaldson's regulatory action plan, the 
SEC staff is considering rules that would ``emphasize the obligation of 
funds to fair value their securities under certain circumstances to 
minimize market timing arbitrage opportunities.'' \12\
---------------------------------------------------------------------------
    \12\ Id.
---------------------------------------------------------------------------
    The Investment Company Act establishes standards for how mutual 
funds must value their holdings. Funds are required to use market 
prices when they are available. This relies on the fact that market 
prices generally are objective and accurate reflections of a security's 
value. When market prices are not available, funds must establish a 
``fair value'' for the securities they hold. The Investment Company Act 
places primary responsibility for fair valuation on a fund's board of 
directors. There is no definition of ``fair value'' provided in the 
Act, nor an established or required uniform method for fair value 
pricing inasmuch as it necessarily calls for professional judgment and 
flexibility.
    In 2001, the SEC staff issued guidance that, among other things, 
discussed situations in which funds might need to utilize fair value 
pricing of foreign securities, even where those securities had closing 
prices in their home markets. In particular, the SEC staff said that, 
in certain circumstances, a significant fluctuation in the United 
States market (or a foreign market) may require a fund to fair value 
those securities.\13\
---------------------------------------------------------------------------
    \13\ Letter to Craig S. Tyle, General Counsel, Investment Company 
Institute, from Douglas Scheidt, Associate Director and Chief Counsel, 
Division of Investment Management, U.S. Securities and Exchange 
Commission, dated April 30, 2001 (2001 Valuation Letter).
---------------------------------------------------------------------------
    The rationale underlying the SEC staff 's position is the same as 
that underlying the forward pricing rule discussed earlier in my 
testimony. To the extent that prices of foreign securities are 
correlated with changes in the U.S. market, a significant change in the 
U.S. market that occurs after the time that a foreign market closes can 
indicate that the closing prices on the foreign market are no longer an 
accurate measure of the value of those foreign securities at the time 
the U.S. market closes (i.e., 4 p.m. Eastern time). Certain investors 
may attempt to exploit this situation by engaging in market timing 
activity. For example, a market timer might purchase shares of an 
international fund on days when the U.S. market is up significantly, 
and redeem shares of such a fund on days when the U.S. market is down 
significantly. Like late trading activity, this can hurt other 
shareholders in the fund by diluting their interests.
    Unfortunately, knowing when and how to fair value foreign 
securities in these types of circumstances is not an exact science, as 
there is no way to know for sure at what price those securities would 
be traded as of 4 p.m. Eastern time. Consequently, funds must exercise 
their best judgment in valuing these securities. In designing 
procedures to determine fair value, funds must take care not to 
introduce too much subjectivity into the valuation process. On the 
other hand, if fair value procedures do not provide for sufficient (and 
frequent enough) adjustments, then they run the risk of losing their 
effectiveness in protecting fund shareholders from losses due to 
activity of the type described above.\14\
---------------------------------------------------------------------------
    \14\ The potential for these losses can be mitigated by imposing 
restrictions on market timing.
---------------------------------------------------------------------------
    In order to appropriately balance these concerns, funds must have 
in place rigorous, board-approved policies and procedures concerning 
fair valuation. Some fund groups have developed detailed fair value 
pricing methodologies in-house; others are utilizing third-party 
service providers to assist them in valuing foreign and other 
securities. Either way, fair value policies and procedures can, and 
should, be updated as needed; as the 2001 SEC staff letter states, 
``Funds should regularly evaluate whether their pricing methodologies 
continue to result in values that they might reasonably expect to 
receive upon a current sale.'' \15\ The ICI has published two 
compliance papers for its members on valuation issues, which are 
intended to assist them in meeting their regulatory responsibilities 
and in ensuring that fund share prices are fair to purchasing, 
redeeming, and existing shareholders.\16\
---------------------------------------------------------------------------
    \15\ 2001 Valuation Letter, supra note 13, at 7.
    \16\ See Investment Company Institute, Valuation and Liquidity 
Issues for Mutual Funds (February 1997) and Investment Company 
Institute, Valuation and Liquidity Issues for Mutual Funds, 2002 
Supplement (March 2002).
---------------------------------------------------------------------------
    It is important to note that, while fair valuation can reduce the 
impact of harmful market timing activity, it cannot by itself 
completely eliminate such trading. Accordingly, as mentioned previously 
and as discussed further below, funds often employ additional methods 
to deter market timing activity.

Tools to Deter Market Timing
    The investigations referred to above involved situations where 
funds allegedly granted exceptions from, or did not enforce, policies 
against market timing. It is important to note that many funds that are 
susceptible to market timing have devoted significant resources to 
efforts to combat such activity. Frequently, however, the various means 
that funds have employed to deter harmful market timing activity have 
not proved effective. Funds and their shareholders would benefit if 
funds had additional ``tools'' to restrict trading activity that they 
determine to be harmful to their shareholders. Last year, the SEC staff 
responded favorably to an Institute request to permit funds to delay 
exchange transactions, in an effort to deter some market timing 
activity.\17\ There are additional methods for combating market timers 
that the SEC staff should consider permitting funds to employ. One such 
method would be to permit funds to impose a redemption fee (which is a 
fee paid directly to the fund to offset the costs resulting from short-
term trading) greater than the 2 percent limit currently imposed by the 
staff.
---------------------------------------------------------------------------
    \17\Investment Company Institute, 2002 SEC No-Act. LEXIS 781 
(November 13, 2003).
---------------------------------------------------------------------------
    A particular challenge that funds face in effectively implementing 
restrictions on short-term trading is that many fund investments are 
held in omnibus accounts maintained by an intermediary (e.g., a broker-
dealer or a retirement plan recordkeeper). Often in those cases, the 
fund cannot monitor trading activity by individual investors in these 
accounts. The Canary Complaint describes this practice as follows: 
``Timers . . . trade through brokers or other intermediaries . . . who 
process large numbers of mutual fund trades every day through omnibus 
accounts where trades are submitted to mutual fund companies en masse. 
The timer hopes that his activity will not be noticed among the `noise' 
of the omnibus account.'' \18\
---------------------------------------------------------------------------
    \18\ Canary Complaint, supra note 1, at par. 46.
---------------------------------------------------------------------------
    Steps clearly need to be taken to enable mutual funds to better 
enforce restrictions they establish on short-term trading when such 
trading takes place through omnibus accounts. One possible approach 
would be to require intermediaries to provide information about trading 
activity in individual accounts to funds upon request. Another approach 
would be to require most types of funds, at a minimum, to impose a 2 
percent redemption fee on any redemption of fund shares within 5 days 
of purchasing them. If funds had a standardized minimum redemption fee 
along these lines, it should be easier for intermediaries to establish 
and maintain the requisite systems to enforce payment of those 
fees.\19\
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    \19\ Funds should retain the flexibility to impose more stringent 
redemption fee standards, 
either in the form of higher redemption fees or longer minimum holding 
periods. As noted above, different types of funds are affected 
differently by short-term trading; hence, flexibility remains 
important. In addition, certain types of funds (e.g., money market 
funds and funds that are designed specifically for short-term trading) 
should not be required to assess redemption fees.
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    We look forward to working with the SEC and with other regulators 
and industry groups on these matters.

Selective Disclosure of Portfolio Holdings
    The SEC and other regulators are investigating allegations 
concerning the selective release by funds of their portfolio holdings 
to some but not all of a fund's shareholders. In particular, it has 
been alleged that some funds may have provided
information about their portfolio holdings to certain shareholders in 
order to enable them to trade ahead of the fund, to the potential 
detriment of the other shareholders. Such conduct, if true, is 
deplorable. The industry is committed to working with the SEC to 
determine the best approach to deal with this matter.
    One possible way to address this issue would be to require funds to 
adopt formal written policies in this area. The SEC could require that 
the policies be approved by the fund's board and that reports of 
instances when the information was released be provided to the board on 
a regular basis. In addition, funds could be required to publicly 
disclose their policies for releasing portfolio information. This 
approach would have many benefits. Similar to market timing, requiring 
funds to adopt formal policies would ensure that they have a system to 
prevent disclosure that is not in the best interests of shareholders 
and to police compliance. Board oversight and public disclosure would 
further enhance compliance with the policies. At the same time, this 
approach would preserve some flexibility in how funds release 
information. This is very important because many funds release 
portfolio information for purposes that benefit investors. For example, 
they may provide it to independent services that analyze mutual funds 
and to certain intermediaries that provide professional assistance to 
help investors make decisions such as which funds to invest in and how 
to allocate their assets among investments.

Hedge Fund Oversight
    The action brought by the New York Attorney General against Canary 
Capital also underscores the need for SEC oversight of hedge fund 
advisers. Currently, the Commission generally has access to records of 
trading on behalf of hedge funds through the records maintained by the 
brokers that the hedge fund advisers use and the markets on which they 
trade. The records, however, are dispersed and it is difficult to 
detect improper trading activities conducted by a particular hedge fund 
if such activities were effected through orders placed with multiple 
brokers and traded on multiple markets. The SEC recently issued a staff 
report on hedge funds \20\ that included a recommendation to require 
hedge fund advisers to register under the Investment Advisers Act of 
1940. The Institute supports this recommendation. As the Staff Report 
indicates, by requiring hedge fund advisers to register, the Commission 
would be able to more comprehensively and effectively observe the 
trading activities of the funds managed by such advisers. As a result, 
the Commission would be in a better position to detect improper or 
illegal trading practices.\21\
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    \20\ Staff Report to the U.S. Securities and Exchange Commission, 
Implications of the Growth of Hedge Funds (September 2003) (Staff 
Report).
    \21\ Id. at 92-95.
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Other Initiatives
    While the regulators have been actively involved in investigating 
and bringing enforcement actions relating to abusive mutual fund 
trading practices, as well as considering new regulatory requirements 
to prevent such practices in the future, it bears noting that these 
efforts are not the only current regulatory initiatives on behalf of 
fund investors. Other regulatory reforms, as well as voluntary industry 
actions, that are underway or have recently been completed also form an 
important part of overall efforts to reinforce the protection and the 
confidence of mutual fund investors. Current initiatives include the 
following:

Fund Compliance Programs
    In February, the SEC proposed a rule to require mutual funds to 
have compliance programs.\22\ Generally speaking, the proposal would 
require: (1) written compliance policies and procedures, (2) 
identification of persons responsible for administering the policies 
and procedures, (3) regular review of the policies and procedures, and 
(4) board oversight of funds' compliance programs. Requirements along 
these lines could provide an effective way to enhance protections 
against late trading, abusive short-term trading, and selective 
disclosure. The Institute generally supports this proposal.\23\
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    \22\ See Investment Company Act Release No. 25925 (February 5, 
2003).
    \23\ See Letter from Craig S. Tyle, General Counsel, Investment 
Company Institute, to Mr. Jonathan G. Katz, Secretary, U.S. Securities 
and Exchange Commission, dated April 17, 2003. In our letter we 
suggested certain modifications to ensure that the proposed requirement 
accommodates existing, effective compliance structures.
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Mutual Fund Advertisements
    The SEC recently adopted amendments to the mutual fund advertising 
rules to require enhanced disclosure in fund advertisements, 
particularly advertisements containing performance information.\24\ 
Under the new rules, fund performance advertisements will have to 
provide a toll-free or collect telephone number or a website where an 
investor may obtain more current performance information (current as of 
the most recent month-end). In addition, fund advertisements will be 
required to advise investors to consider the investment objectives, 
risks, and charges and expenses of the fund carefully before investing 
and that this and other information about the fund can be found in the 
fund's prospectus.
---------------------------------------------------------------------------
    \24\ See Investment Company Act Release No. 26195 (September 29, 
2003).
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Portfolio Holdings and Expense Disclosure
    The SEC is expected to adopt soon a proposal that would require 
funds to disclose their portfolio holdings on a quarterly (rather than 
semi-annual) basis, and that would improve disclosure in fund 
shareholder reports.\25\ As part of this proposal, funds would be 
required to disclose in their shareholder reports the dollar amount of 
expenses paid on a $10,000 investment in the fund during the period 
covered by the report. This disclosure, which would supplement the 
detailed fee disclosure currently required in fund prospectuses, would 
serve to remind investors about the impact of fund expenses and assist 
them in comparing the expenses of different funds. The Institute 
supports this proposal.
---------------------------------------------------------------------------
    \25\ See Investment Company Act Release No. 25870 (December 18, 
2002).
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Sales Charge Breakpoints
    Many mutual funds that are sold with front-end sales charges offer 
discounts to investors who invest specified amounts of money. The 
investment levels at which investors qualify for the discounts are 
called ``breakpoints.'' In late 2002 and early 2003, regulatory 
investigations revealed instances in which investors did not receive 
the benefit of sales charge reductions to which they were entitled. 
Most of these situations did not appear to involve intentional 
misconduct. These examination findings led to the formation of a Joint 
Industry/NASD Breakpoint Task Force, made up of high-level NASD, mutual 
fund and broker-dealer representatives. The Joint Industry/NASD 
Breakpoint Task Force recently issued a report making a series of 
recommendations designed to ensure that processes are in place to 
ensure that investors receive applicable discounts.\26\ The 
recommendations include additional required disclosure concerning 
breakpoint discounts. The Institute is working with its members, other 
securities industry participants and regulators on the implementation 
of the Breakpoint Task Force's recommendations and is committed to 
resolving the problems that have been identified for the benefit of 
mutual fund investors.
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    \26\ Report of the Joint NASD/Industry Task Force on Breakpoints 
(July 2003).
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Revenue Sharing Arrangements
    ``Revenue sharing'' arrangements involve payments by a fund's 
investment adviser or principal underwriter out of its own resources to 
compensate intermediaries who sell fund shares. The principal investor 
protection concern raised by these payments is whether they have the 
potential for influencing the recommendations of the financial 
intermediary that is receiving them. Disclosure concerning revenue 
sharing 
payments is already required in fund prospectuses, and the Institute 
has long 
advocated additional, point-of-sale disclosure by broker-dealers to 
help investors 
assess and evaluate recommendations to purchase fund shares.\27\ The 
NASD recently proposed new point-of-sale disclosure requirements in 
this area.\28\ The NASD proposal also addresses differential cash 
compensation arrangements, in which a broker-dealer firm pays its 
registered representatives different rates of compensation for selling 
different funds. The Institute supports the NASD proposal.\29\
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    \27\ See, e.g., Letter from Craig S. Tyle, General Counsel, 
Investment Company Institute, to Ms. Joan Conley, Office of the 
Corporate Secretary, NASD Regulation, Inc., dated October 15, 1997.
    \28\ NASD Notice to Members 03-54 (September 2003).
    \29\ See Letter from Craig S. Tyle, General Counsel, Investment 
Company Institute, to Barbara Z. Sweeney, NASD, Office of the Corporate 
Secretary, dated October 17, 2003.
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Fund Governance
    The recent disturbing revelations have caused some to question the 
effectiveness of the fund governance system. We do not believe it is 
fair to place blame upon directors, or the fund governance system. 
Directors cannot be expected to unearth every instance of wrongdoing, 
especially if such wrongdoing took place at an unrelated entity. At the 
same time, it seems apparent that steps need to be taken to enhance the 
ability of directors to exercise their oversight responsibilities, and 
some of those steps are discussed above.
    Overall, we continue to believe that the system of mutual fund 
corporate governance has served investors very well through the years. 
It has even served as a model for reforming the governance of corporate 
America. In recent years the fund governance system has undergone 
several enhancements. For example, in June 1999, an Institute advisory 
group composed of investment company independent and management 
directors recommended a series of 15 best practices--that went beyond 
legal and regulatory requirements--to enhance the independence and 
effectiveness of investment company directors.\30\ Subsequently, the 
SEC adopted rule amendments designed to further strengthen the 
independence and effectiveness of investment company directors.\31\ 
Last month, at the behest of the Institute's Executive Committee, the 
Institute's Board of Governors adopted a resolution recommending that 
Institute member companies adopt additional best practices with respect 
to: (1) the treatment of close family members of persons associated 
with a fund or certain affiliates as independent directors and (2) the 
standards for investment company audit committees. The resolution also 
recommended that Institute members, to the extent they have not already 
done so, adopt the best practices set forth in the 1999 Best Practices 
Report.
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    \30\ Report of the Advisory Group on Best Practices for Fund 
Directors (June 24, 1999) (Best Practices Report).
    \31\ SEC Release No. IC-24816 (January 2, 2001).
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Conclusion
    The alleged abusive late trading and market timing activities 
recently uncovered by the New York Attorney General and the SEC are 
deplorable. Swift and forceful responses are necessary to make clear 
that there is no place in the mutual fund industry for those who would 
put their own interests before those of fund shareholders. The industry 
pledges its commitment to take any steps necessary to make sure that 
its obligation to place the interests of fund shareholders above all 
others is understood and fulfilled.

                               ----------
                 PREPARED STATEMENT OF MARC E. LACKRITZ
               President, Securities Industry Association
                           November 18, 2003

Introduction
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, I am Marc E. Lackritz, President of the Securities Industry 
Association.\1\ I appreciate the opportunity to testify before the 
Committee today on a number of issues relating to the integrity of the 
mutual fund industry, as well as the broker-dealers that I represent.
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    \1\ The Securities Industry Association, established in 1972 
through the merger of the Association of Stock Exchange Firms and the 
Investment Bankers Association, brings together the shared interests of 
more than 600 securities firms to accomplish common goals. SIA member-
firms (including investment banks, broker-dealers, and mutual fund 
companies) are active in all United States and foreign markets and in 
all phases of corporate and public finance. According to the Bureau of 
Labor Statistics, the U.S. securities industry employs nearly 800,000 
individuals. Industry personnel manage the accounts of nearly 93 
million investors directly and indirectly through corporate, thrift, 
and pension plans. In 2002, the industry generated $222 billion in 
domestic revenue and $356 billion in global revenues. (More information 
about SIA is available on its home page: www.sia.com.)
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    The securities industry is based on two bedrock principles--
disclosure and competition. But the public's trust and confidence are 
the indispensable elements for the capital markets to play their 
effective roles in channeling capital to its most productive uses. Our 
industry has raised more than $21 trillion over the past 10 years to 
finance innovation and growth--new enterprises, new processes, new 
products, bridges, hospitals, roads, and schools. Without public trust 
and confidence, our market mechanisms cannot function effectively or 
efficiently. Our system has thrived 
because all market participants must adhere to the same rules, 
vigorously and fairly applied.
    Mutual funds are the vehicle by which an overwhelming majority of 
investors participate in our markets. They offer many small investors 
an inexpensive way to share in the benefits of owning stocks and bonds. 
Mutual fund portfolios give investors an avenue for diversifying a 
relatively minimal investment, thereby managing their risk exposures. 
For these reasons, mutual funds are extremely popular products for 
small investors, as well as for retirement plans such as 401(k) plans. 
As of January 2002, 89 percent of U.S. equity investors owned stock 
mutual funds, and 51.5 percent of equity investors held only stock 
mutual funds. Overall, 49.6 percent of all households in the United 
States owned mutual funds directly or through a retirement account.\2\ 
Twenty-six percent of all household liquid financial assets were in 
mutual funds as of mid-year 2003.\3\
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    \2\ Investment Company Institute, 2003 Fact Book, at 42- 43.
    \3\ www.sia.com/research/html/key_industry_trends_.html#securities.
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    Broker-dealers and other intermediaries play a critical role in the 
distribution of mutual funds. Third-party financial professionals such 
as full service broker-dealers, financial planners, banks and insurance 
companies distribute approximately 55 percent of mutual fund assets. 
``Mutual fund supermarkets,'' generally operated by discount brokers, 
distribute another 5 percent of mutual fund assets.\4\ Full-service and 
discount brokers benefit investors and promote competition among funds 
by offering investors a convenient and accessible way to compare and to 
select from a range of different mutual fund families.
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    \4\ Investment Company Institute, www.ici.org/stats/res/per09 -
03.pdf, at 5. By way of comparison, only 12 percent of purchases of 
mutual fund assets are made by individual investors 
directly from the fund.
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    The health of our markets depends to a great extent on the public's 
continued robust participation in mutual funds. In 2002, equity mutual funds had a market capitalization of $2.7 trillion dollars, roughly 22 percent of 
the total capitalization of our equity markets.\5\ Retail investors, 
the backbone of both the mutual fund industry and our securities 
markets, put their trust in the integrity of mutual fund managers and 
advisers, as well as in the financial advisers who assist their 
investment decisions and the brokers who implement their trade orders. 
The interests of retail investors must come first if we want them to 
continue entrusting their money to mutual funds. Investors must be 
assured that fraud, self-dealing, or dishonesty will not be tolerated. 
All investors should be treated fairly, and all aspects of the mutual 
fund business--including fund fee structures, financial incentives 
offered to intermediaries to recommend specific funds, fund investment 
and redemption policies, and fund governance--must be as transparent as 
possible. In addition, all investors should be assured of reasonably 
prompt execution and fair pricing of their mutual fund transactions.
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    \5\ SIA 2003 Securities Industry Fact Book, at 47, 59.
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    In the past several months, State and Federal regulators have 
uncovered a number of instances of distressing behavior by some mutual 
funds and intermediaries. These include: (1) late trading or market 
timing in contravention of stated fund policies; (2) lack of full 
disclosure; and, (3) operational shortcomings relating to breakpoints. 
All of these instances share a common element: They hurt investors.
    In the remainder of this testimony, I will discuss each of these 
disturbing revelations and the measures that we strongly support to 
resolve these problems and to earn back the public's trust and 
confidence. Each of these issues must be addressed swiftly and 
comprehensively by tough enforcement action where wrongdoing has 
occurred, thoughtful regulatory revisions to make sure that these 
problems cannot recur, and legislation to fill in existing ``gaps'' in 
the law. At the same time, it is equally important that regulatory or 
legislative solutions do not create new problems or other unintended 
consequences for investors in the course of remedying existing ones.

Late Trading / Market Timing
Proposals to Address Late Trading
Governing Principles
    SIA is greatly distressed by the number of instances of mutual fund 
late trading. We believe that stringent enforcement actions to ferret 
out and punish such illegal activity will have a strong deterrent 
effect. We agree with the Securities and Exchange Commission Chairman Donaldson, however, that additional regulatory action needs to be taken to eliminate opportunities for such activity in the future. 
Investors will not accept the status quo and mere promises to do 
better. New rules must be put in place that do right by investors and 
ensure that these abuses will never happen again.
    Appropriate regulatory action should meet several key principles. 
The rules should:

 Be reliable and ``bulletproof '' to new forms of evasion.
 Give investors the widest array of opportunities.
 Treat all investors--large and small; institutional and 
    retail--equally.
 Synchronize new mandates with the complexities of existing and 
    well-proven operational systems that investors count on to 
    seamlessly clear and settle many millions of transactions per day.

Proposals for Reform
    Several proposals have been advanced to address late trading by 
establishing a ``hard close'' for open-end mutual fund purchase or 
redemption order acceptance no later than the New York Stock Exchange's 
4 p.m. ET close of business. Each of these proposals is intended to 
ensure that no transactions accepted after that point in time can 
receive the fund's pricing for that day. The key difference among the 
proposals is where they prescribe the ``hard close.'' One approach 
would require that the mutual fund or its transfer agent must receive 
orders by 4 p.m. to receive same-day pricing. A second proposal has 
been circulated, but not finalized, under which orders received by the 
National Securities Clearing Corporation (NSCC), the centralized entity 
through which most mutual fund orders are cleared, would also satisfy 
the ``hard close'' requirement. Finally, a third approach would permit 
the hard close to occur at either the mutual fund, NSCC, or a broker-
dealer or other SEC- or bank-regulated intermediary or other entity, so 
long as the order recipient has a verifiable order capture system.
    As discussed below, we think that a hard close that can only occur 
at the mutual fund has some significant drawbacks for investors, and 
also may have some major operational difficulties. A hard close at NSCC 
may best meet concerns about a verifiable order entry deadline, while a 
hard close at the broker-dealer or other intermediary would be 
preferable from the vantage point of most retail investors and 
retirement plan participants. In any event, we must demonstrate to the 
public not only that late trading will be punished severely, but also 
that it will be foreclosed from ever happening again.

    (i) Hard Close at the Mutual Fund. One early proposal to emerge in 
response to the revelations about late trading is a suggestion that the 
SEC require that only orders that are received by a mutual fund prior 
to 4 p.m. ET should receive that day's pricing. This proposal may be an 
effective way of foreclosing late trading. However, measured against 
the principles that we articulated above it has several significant 
shortcomings.
    Most importantly, it would be likely to create a two-tiered market, 
in which institutional investors that clear their transactions directly 
with funds would have the ability to trade until 4 p.m. ET, while 
retail investors who generally hold their mutual funds through a 
broker-dealer or other intermediary, as well as administrators of many 
401(k) and similar retirement plans that generally rely on 
intermediaries for processing participant orders would have to get in 
their orders by a much earlier cut-off time in order to complete all 
processing necessary to transmit orders to the fund by 4 p.m.\6\
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    \6\ Broker-dealers that self-clear, or that act as introducing 
brokers and clear their transactions through a third party, must 
process and batch these orders and perform breakpoint analysis on the 
orders before they are sent on to NSCC, which processes and clears the 
orders and transmits them to the fund company through its Fund /Serv 
facility. Other entities that receive 
mutual fund transactions from customers, such as banks, must perform 
similar steps prior to sending the orders to fund companies.
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    Because of the multiple steps necessary to clear and settle mutual 
fund orders, in general investors would face a cut-off time 
approximately 2 hours prior to the 4 p.m. ET hard close at the fund, 
although the exact cut-off would vary from firm to firm. Individual 
fund investors that desire the service of broker-dealers or other 
intermediaries should not be prejudiced by an early cut-off while other 
fund investors would be free to trade for approximately 2 additional 
hours solely by virtue 
of their relationship with the fund.\7\ This could be a substantial 
hardship. These investors would lose the ability to shape their 
investment decisions by observing market developments in the last two 
hours of the trading day.
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    \7\ Moving fund holdings from intermediaries to the funds 
themselves may not be a viable option for many retail investors because 
they would lose the array of choices of different fund complexes that a 
broker-dealer can offer, as well as special execution services, such as 
the ability to liquidate equity or debt securities to purchase fund 
shares (or vice versa) or to exchange shares of funds of different fund 
complexes.
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    A 4 p.m. ET hard close could pose an even more serious disadvantage 
for the 36 million families who invest through employer-sponsored 
retirement plans. Institutions that provide recordkeeping services to 
401(k) plans would likely need to cut off order acceptance much earlier 
than broker-dealers.\8\ In the case of the west coast participants, 
this could mean that trades would have to be placed in the early 
morning hours of the business day, and may only be able to receive 
next-day settlement. This would place retirement plan participants at a 
marked disadvantage to other institutions.
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    \8\ This is because the 401(k) system has additional complexities 
than those faced by broker-dealer recordkeeping systems. For example, 
401(k) recordkeepers must place trades collectively, and perform a 
number of reconciliations at the participant and plan levels in 
executing transactions. In addition, recordkeepers perform other 
services that add time to the process such as determining eligibility 
for loans since Federal law regulates the amount of a loan based on a 
participant's account balance.
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    The durability of a hard close at the fund to attempts at evasion 
is also not clear. Unless it is accompanied by a requirement to use 
auditable technology to ensure that the order entry time at the fund is 
not subject to abuse, similar to what we propose in connection with the 
hard close at the broker-dealer alternative, concerns about late 
trading may linger.\9\
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    \9\ In a recent speech at SIA's Annual Meeting in Boca Raton, 
Florida, SEC Chairman Donaldson noted that 10 percent of funds, as well 
as 25 percent of broker-dealers, have been involved in enabling late 
trading by customers. Therefore, a verifiable order entry time stamp 
should be an essential element of any response to late trading that 
relies on when orders are received by a fund or an intermediary. 
Remarks of Chairman William H. Donaldson to the Securities Industry 
Association, November 7, 2003, http://www.sec.gov/news/speech/
spch110703whd.htm, at 2-3 (Donaldson Boca speech).
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    This approach would also pose significant operational challenges. 
Currently, there is no need for real-time capture, routing and 
execution of fund orders, since fund pricing is only established once a 
day. Consequently, many firms extract such orders to batch and route to 
the fund or NSCC. To require that firms present mutual fund trades to 
the fund by 4 p.m. ET would result in many broker-dealers extracting a 
day's worth of orders and transmitting all of them to the fund near the 
4 p.m. close. This could create a huge technology jam that funds may 
not be prepared to manage.
    Funds may also not be prepared to manage other aspects of the 
clearing process that this approach may effectively shift onto them. 
For example, in today's world a broker-dealer might receive an order 
prior to 4 p.m., and after the 4 p.m. close send a fund, via NSCC, an 
order to sell a certain number of shares (or a certain dollar amount) 
of a fund, including a post-4 p.m. ``enrichment'' of the data by 
factoring the closing price into performing its breakpoint analysis and 
crediting the customer's account for the cash (or debit it for the 
shares). With a 4 p.m. hard close, the fund itself would have to 
perform this enrichment function with the closing price data. Funds are 
not currently set up to do this, and might seek to subcontract this 
work back to NSCC. Thus, operationally the ``hard close at the fund'' 
approach could start to closely resemble the ``hard close at NSCC'' 
proposal.

    (ii) Hard Close at NSCC. We understand that NSCC (which operates 
the NSCC/Fund/Serv mutual fund processing system) is considering 
proposing the development of a centralized time stamp facility as an 
answer to concerns about late trading. That facility would enable 
intermediaries to transmit fund orders throughout the day to NSCC or 
batch them prior to 4 p.m., but still provide the opportunity to submit 
essential enrichment data which is necessary to complete the 
transaction after the close. Among other things, this data would 
include information related to breakpoint entitlement, calculation of 
contingent deferred sales loads, and exchanges 
between funds.
    This approach, while still under discussion, is a very promising 
way to address the late trading issue as measured against our key 
principles. It should be possible to design this proposal so that it is 
reliable and resistant to evasion. This is particularly the case since 
NSCC, as a third-party processor with no relationship to the customer 
and only a very limited relationship with the intermediaries and funds, 
would have no motive to circumvent the order entry timing requirement. 
This proposal also builds directly on a well-tested and experienced 
clearing system. While it would certainly require expanding some 
technology and systems, it appears to pose a much less daunting 
operational challenge than a hard close at the fund.
    The impact on investors would also not be as severe as under a hard 
close at the fund. However, the NSCC approach would still face some 
drawbacks on this score. Investors who transact mutual fund purchases 
and redemptions through broker-dealers and other intermediaries, and 
retirement plan administrators, would still have to get their trades in 
at some point before the 4 p.m. close in order to get the benefit of 
same-day pricing. We have not been able to determine how significant 
this gap would be, but it would certainly be a much smaller disparity 
than would be created by a requirement that would only permit same-day 
pricing for orders received by the fund by 4 p.m. ET.

    (iii) Hard Close at the Intermediary. The third proposal, which SIA 
advanced in an October 31 letter to the SEC, would permit same-day 
pricing for orders received by the broker-dealer or other intermediary 
by 4 p.m., as well as orders received by the mutual fund or by its 
processing agent by 4 p.m. This would be subject to the qualification 
that the recipient of the order must have an electronic order capture 
system, with verifiable order entry time aligned with an atomic clock 
to document receipt. This requirement would eliminate a salesperson's 
ability to either withdraw a fund order after 4 p.m. or receive current 
day pricing for an order entering the system after 4 p.m.
    This proposal is the most attractive of the three from the 
standpoint of investor fairness. Investors would receive same-day 
pricing under the same terms that they do today, regardless of whether 
they are institutional or retail, trading through a broker-dealer or 
other intermediary, or directly with a fund.
    For broker-dealers this approach is also workable as an operational 
matter. Broker-dealers are already required to use a verifiable order 
entry time stamp aligned with an atomic clock for processing equity 
transactions. Mutual funds and their processing agents, as well as 
banks and other intermediaries would need to build similar systems, but 
the technology and processes already exist.
    Bank regulators such as the Office of the Comptroller of the 
Currency would need to impose a companion rule to require a hard close 
on order acceptance by 4 p.m. together with a required electronic 
capture system. For entities which are unregulated, or unable to comply 
with the hard close time stamping requirement or other comparable 
verification systems, orders would need to be placed with the fund 
directly, or some other designated regulated entity that has electronic 
time stamping capability to ensure receipt by the hard close cutoff 
time.
    We are confident that this approach would not be subject to abuse. 
It would rely on the same electronic order audit system that the SEC 
and self-regulatory organizations required firms to adopt so that the 
regulators could monitor order-handling processes for equity 
securities. Components of the system should also include written 
policies and procedures to insure compliance, with senior management 
sign-off on the adequacy of those procedures, and an annual external 
audit to measure compliance with, and the effectiveness of, these 
procedures.

Proposals to Address Market Timing
    ``Market timing'' refers to a trading strategy in which an investor 
engages in frequent transactions in mutual funds in anticipation of 
changes in market prices. Usually this is done to try to profit from 
discrepancies between the time when an underlying asset is priced and 
the time when a fund's net asset value is set. A common example is a 
mutual fund investing exclusively in foreign securities traded in 
markets that close prior to U.S. markets, and which may be sensitive to 
changes in the U.S. market. A market timer may choose to buy or redeem 
fund securities, depending on whether the U.S. market is going up or 
down substantially on the day, in the hope that the opening price of 
the underlying asset will change as a result of the U.S. market move. 
The investor would receive an arbitrage profit on the lag between the 
pricing of the fund and of its underlying assets.
    Market timing is not inherently illegal, but it can pose problems 
for many mutual funds. For example, market timing activity can drive up 
a fund's administrative costs as the fund manager must either sell 
assets or hold extra cash to meet redemption demands of market timers. 
It also has the potential to dilute the interests of other fund 
shareholders who do not engage in market timing. Because of these 
drawbacks, many funds have policies and procedures to discourage market 
timing.
    Recent enforcement actions and press reports of ongoing 
investigations by Federal and State regulators appear to involve just 
such instances in which funds and intermediaries facilitated market-
timing transactions despite statements in the fund prospectus that the 
fund would not assist such activities. As a result of these 
developments, a number of regulatory proposals have been advanced to 
address market-timing transactions. Here are two potentially useful 
steps:

 SEC Chairman Donaldson has proposed that rules regarding 
    disclosure of fund policies and procedures on market timing should 
    be tightened, and that funds should be required to have procedures 
    to fully comply with any representations that they make concerning 
    their market timing policies and procedures.\10\
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    \10\ Additionally, in 2001, the SEC issued guidance suggesting that 
funds might have an obligation to apply methodologies to apply a fair 
value to fund assets in situations where changes in the U.S. market 
create a potential discrepancy between an international mutual fund's 
day-end net asset value and the overseas closing price of foreign 
securities that it holds. Letter to Craig S. Tyle, General Counsel, 
Investment Company Institute, from Douglas Scheidt, Associate Director 
and Chief Counsel, Division of Investment Management, U.S. Securities 
and Exchange Commission, April 30, 2001.

 SIA has also proposed, subject to customer privacy rights, a 
    requirement that 
    sufficient trade-level customer detail be provided to funds to 
    assist them in identifying market-timing activity on transactions 
---------------------------------------------------------------------------
    that are submitted by the intermediary on an aggregated basis.

    Both of these steps would do a great deal to deter market timing in 
contravention of fund policies. A further step would be to permit funds 
to impose a fee (of 2 percent or some other level) on any fund shares 
redeemed within 5 days of purchasing them. The proceeds of this fee 
would go to the fund for the benefit of the fund's long-term 
shareholders. As originally proposed, the only exceptions would be for 
money market funds, and for a fund that prominently discloses that it 
is designed for short-term trading and that secures a specific SEC 
exemption from the requirement.
    While we generally disfavor regulatory approaches that involve 
pricing regulation, the problems that have arisen are such that we 
support such a proposal. We think it will be a very effective step 
toward ending abusive market timing transactions. The only modification 
that we suggest is that the SEC provide a narrow exemption for hardship 
cases, so that an investor can make a single transaction without 
incurring the 2 percent fee if the investor can demonstrate in writing 
that the transaction is necessary to meet an unanticipated personal 
financial hardship.
    In addition to these steps, the recent amendment to H.R. 2420 would 
require the SEC to adopt regulations to eliminate stale pricing, the 
underlying source of both late trading and abusive market timing. While 
the steps outlined above may be sufficient to address this issue, we 
believe that swift action on many fronts needs to be considered. 
Therefore, we not only support the 2 percent redemption fee, but also 
SEC action to address the overall issue of stale pricing.
    We strongly support tough enforcement action against abusive market 
timing, as well as prompt implementation of regulatory reform. This 
will go a long way toward repairing the damage to public trust and 
confidence that revelations of abusive market timing have caused.

Disclosure Proposals
    We favor clear, direct, timely disclosure of all material 
information to investors in a central place. It is really important to 
make it investor-accessible and investor-friendly rather than a 
``Where's Waldo?'' search through fragments of disclosures for relevant 
information.

Revenue Sharing and Differential Compensation
    We strongly support efforts to enhance the transparency of revenue 
sharing and differential compensation to mutual fund investors. At a 
minimum such enhanced disclosure should embody the following elements:

 A balanced presentation of the nature of services received 
    (including the inclusion of funds on preferred or select lists, or 
    provision of shelf space) and expenses reimbursed pursuant to 
    revenue sharing arrangements.

 A listing of funds or of fund families with whom revenue 
    sharing arrangements exist.

 The aggregate amount of revenue sharing payments received 
    during a specified period.

 The funds or fund families with respect to which higher 
    percentage rates of compensation are paid to associated persons.

 The extent, if any, to which associated persons may only 
    recommend the purchase of funds with respect to which the broker-
    dealer participates in revenue sharing arrangements.

    As you all know, a number of regulatory and legislative initiatives 
directed at improving transparency have emerged in recent months. These 
include H.R. 2420 introduced by Congressman Richard Baker (R-LA),\11\ proposals made by Representatives Oxley and Baker in a letter to SEC Chairman 
Donaldson,\12\ an NASD rule proposal regarding compensation for the 
sale of investment company securities \13\ and testimony by SEC 
Chairman Donaldson on September 30, 2003, before the Senate Committee 
on Banking, Housing, and Urban Affairs, in which Chairman Donaldson 
stated that:
---------------------------------------------------------------------------
    \11\ See H.R. 2420 mark-up dated July 24, 2003. H.R. 2420 focuses 
on additional customer statement disclosure or other nonprospectus 
disclosure. Proposals regarding revenue sharing and differential 
compensation appear in Section 12 of the bill.
    \12\ Letter to SEC Chairman Donaldson from Representative Michael 
Oxley (R-OH), Chairman, House Financial Services Committee and 
Representative Richard Baker (R-LA), Chairman Subcommittee on Capital 
Markets, Insurance, and Government Sponsored Enterprises (July 30, 
2003).
    \13\ NASD Notice to Members #03-54 (September 2003). The NASD 
proposal appears to require additional disclosure to be delivered in 
some manner other than by means of the confirmation, the customer 
statement, or prospectus.

          I envision that a revised confirmation would include 
        information about revenue sharing arrangements, incentives for 
        selling in-house funds and other inducements for brokers to 
        sell fund shares that may not be immediately transparent to 
---------------------------------------------------------------------------
        fund investors. . . .

    Meanwhile, as a by-product of the recommendation of the NASD Mutual 
Fund Breakpoint Task Force--in which SIA has been an active participant 
and which I will discuss in a moment--task force working groups are 
currently developing confirmation modifications and a new disclosure 
document prototype to enhance disclosure of breakpoint information to 
customers. Each of these different initiatives has the potential to 
enhance the transmission of relevant information to mutual fund 
investors. However, when considered together, there appears to be a 
substantial risk of disclosure fragmentation and associated investor 
confusion, particularly if these initiatives proceed without 
coordination and consistency of treatment.
    Therefore, in submissions we have made to the NASD \14\ and SEC 
\15\ we have urged that any rulemaking in this area be designed to:
---------------------------------------------------------------------------
    \14\ Letter to Barbara Sweeney, NASD from Stuart R. Strachan, 
Chair, SIA Investment Company Committee ``Rule Proposal Regarding 
Compensation for the Sale of Investment Company Securities'' (October 
17, 2003).
    \15\ Letter to Paul F. Roye, Director, SEC Division of Investment 
Management from Stuart R. Strachan, Chair, SIA Investment Company 
Committee, ``Revenue Sharing and Differential Compensation'' (October 
31, 2003).

 Achieve a uniform approach across regulatory entities 
    regarding the disclosure mechanisms for information on revenue 
---------------------------------------------------------------------------
    sharing and differential compensation arrangements.

 Focus disclosure on circumstances where such arrangements are 
    likely to influence recommendations made to investors, or limit the 
    scope of recommendations that may be offered.

 Utilize disclosure vehicles that will facilitate, rather than 
    inhibit or deflect, investors' attention away from all material 
    information that should be considered when making a mutual fund 
    investment.

Disclosure of Operating Expenses
    SIA fully believes that investors should have full, complete, and 
useful information on mutual fund fees since they can have a 
significant effect on an investor's return. We believe that the most 
efficient means for providing this information to investors is for 
funds to calculate expenses based on a hypothetical $1,000 investment. 
House Report 108-351 accompanying H.R. 2420 (November 4, 2003) notes at 
11 that:

          The SEC recently proposed a new rule requiring disclosure in 
        a fund's semi-annual and annual report to include: (1) a dollar 
        example of the fees an investor would have paid on a 
        hypothetical $10,000 investment, using the actual exposes 
        incurred by the fund and the actual return achieved by the 
        fund; and (2) the same dollar example using the actual expenses 
        incurred but assuming a 5 percent return over the period so 
        funds could be compared against each other. * * * H.R. 2420 
        generally codifies the pending SEC proposal, but includes two 
        important changes: First, the dollar example in the annual 
        report must be based on a hypothetical $1,000 investment. The 
        Committee believes that using $1,000 as the example will make 
        it easier for investors to calculate the amount of fees paid. 
        Second, the legislation includes a requirement that account 
        statements include a legend prominently stating that: (1) the 
        investor has paid fees on the mutual fund investment, (2) those 
        fees have been deducted from the amount shown on the statement, 
        and (3) the investor can find more information by referring to 
        documents disclosing the amounts of those fees.

    SIA generally concurs with these provisions. Providing information 
on a $1,000 investment both with respect to that fund's return and with 
respect to a hypothetical 5 percent return will facilitate exactly the 
type of comparison-shopping that H.R. 2420 and the SEC contemplate. At 
the same time, the costs of these changes (which ultimately investors 
bear) will be in proportion to the benefit that investors derive.\16\
---------------------------------------------------------------------------
    \16\ See Memorandum from Paul F. Roye, Director, Division of 
Investment Management, SEC, to the Honorable William H. Donaldson, 
Chairman, SEC, June 9, 2003 at 13 -18. See also, GAO, Mutual Funds, 
Greater Transparency Needed in Disclosure to Investors, June 2003 
(GAO - 03-763) at 11 et seq.
---------------------------------------------------------------------------
    In addition, SIA appreciates the Report language noting that such 
disclosures should indicate that the customer's portfolio already 
reflects those charges and that they are not additional charges that 
the broker-dealer or fund will deduct. Absent such clarification, 
investors might be confused. SIA believes that any new disclosure 
should afford funds appropriate flexibility and ensure that fee 
disclosures do not receive disproportionate emphasis.
    SIA also believes that this aspect of H.R. 2420 attempts to place 
an appropriate emphasis on mutual fund fees as part of the larger 
investment decision. As noted, fees can have an important effect on an 
investor's return. But fees are only one aspect of an investment 
decision. Investors (and their brokers, in the case of broker-sold 
funds) need to consider not just expenses, but whether the investment 
is appropriate for the investor's situation.

Soft Dollars, Directed Brokerage, and Related Issues
    SIA supports efforts to improve disclosure of brokerage 
arrangements between funds, their advisers, and broker-dealers. When 
Congress enacted Section 28(e) of the Securities Exchange Act of 1934, 
it recognized the need for money managers to obtain research from a 
wide range of sources. Section 28(e) enables money managers to pay for 
research and related services through commission (soft) dollars rather 
than paying for them in cash. Such research helps money managers, 
including fund managers, do a better job of serving their customers. 
Over the years, the Commission has issued interpretations on the scope 
of research services that may be provided and examined industry 
practices.\17\ The 1998 Report notes, ``the vast majority of products 
and services received by advisers are within the safe harbor 
established by Section 28(e) of the Exchange Act.'' \18\ In general, 
SIA has viewed soft dollars as both pro-investor and pro-competitive.
---------------------------------------------------------------------------
    \17\ E.g., Interpretive Release Concerning Scope of Section 28(e) 
of the Securities Exchange Act of 1934 and Related Matters, Rel. 34-
23170 (April 23, 1986) (1986 Release) and Inspection Report on the 
Soft-Dollar Practices of Broker-Dealers, Investment Advisers, and 
Mutual Funds, September 22, 1998 (1998 Report).
    \18\ Id at 4.
---------------------------------------------------------------------------
    At the same time, we recognize that there are opportunities for 
abuse with respect to soft dollars. The 1998 Report documented problems 
and abuses of significant concern. SIA strongly supports SEC and SRO 
enforcement efforts to curb soft-dollar abuses and to deter others from 
engaging in such abuses. We also believe that mutual funds should 
ensure effective disclosure of soft-dollar practices both to investors 
and to fund trustees. Section 3 of H.R. 2420 is intended to address 
these concerns and we generally support those goals.
    Directed brokerage also has been a subject of concern. The 1998 
Report--in citing the 1986 Release--states that unlike soft dollars, 
directed brokerage does not present the same conflict of interest 
issues, since ``the fund's commission dollars [are used] to obtain 
services that directly and exclusively benefit the fund.'' \19\ In 
these situations the fund directs the money manager to execute a 
portion of the fund's trades through a particular broker-dealer. In 
return for the brokerage commissions the broker-dealer typically 
provides services directly to the fund or pays certain fund expenses.
---------------------------------------------------------------------------
    \19\ 1998 Report at 13 (emphasis added in 1998 Report, not in 1986 
Release).
---------------------------------------------------------------------------
    We believe that with respect to both soft dollars and directed 
brokerage, a key investor protection issue is best execution. If fund 
investors received mediocre executions because of soft dollar or 
directed brokerage arrangements, the relationships are indefensible. 
Poor executions in the absence of soft-dollar or directed brokerage 
arrangements would be just as indefensible. In short, advisers, fund 
trustees, and broker-dealers must serve the needs of fund investors 
with respect to research and execution services.
    SIA supports disclosure to investors and fund trustees to ensure 
that arrangements with broker-dealers are disclosed fairly and in 
context. Again, disproportionate emphasis on costs may confuse and 
distract investors or trustees from examining the investment and all 
relationships among service providers. Nonetheless, balanced disclosure 
of material information is essential if investors and the trustees 
acting on their behalf are going to make intelligent, informed 
decisions.

Breakpoints
Overview
    Late in 2002, the SEC and the NASD became concerned that investors 
in mutual funds were not receiving ``breakpoint'' discounts, which are 
essentially volume discounts for purchases. The NASD indicates that 
``during routine examinations of broker-dealers by [the NASD's] 
Philadelphia District Office, the NASD discovered that broker-dealers 
selling front-end loaded mutual funds were not properly delivering 
breakpoint discounts to investors.'' \20\ The regulators' concerns were 
first articulated in an NASD Notice to Members dated December 23, 2003, 
and a letter from the SEC to senior brokerage firm executives. SIA, 
along with the Investment Company Institute (ICI), cooperated fully 
with the SEC and the NASD in an effort to publicize regulators' 
concerns and to help ensure that broker-dealers and funds addressed the 
situation. For example, SIA subsequently urged its membership to review 
their breakpoint procedures and promptly take any necessary corrective 
action.
---------------------------------------------------------------------------
    \20\ Testimony of Mary Schapiro, NASD Vice Chairman and President 
Regulatory Policy and Oversight, Before the Subcommittee on Capital 
Markets, Insurance, and Government Sponsored Enterprises, Committee on 
House Financial Services, November 3, 2003, at 4.
---------------------------------------------------------------------------
    In March 2003, the SEC, the NASD, and the NYSE issued a report on 
breakpoint practices.\21\ After examining 43 firms, the Report noted:
---------------------------------------------------------------------------
    \21\ Staff Report: Joint SEC/NASD/NYSE Report of Examinations of 
Broker-Dealers Regarding Discounts on Front-End Sales Charges on Mutual 
Funds, http://www.nasdr.com/pdf/-text/bp_joint_exam.pdf.

          Most of the firms examined, in some instances, did not 
        provide customers with breakpoint discounts for which they 
        appear to have been eligible. Overall, examiners identified a 
        significant number of transactions that 
        appeared to be eligible for a discount, though did not receive 
        a discount 
        or incur other unnecessary sales charges. Three firms did not 
        provide a discount in all sampled transactions that appear to 
        have been eligible for a discount, and two firms provided 
---------------------------------------------------------------------------
        customers with all available discounts.

    However, the Report also noted ``many of the problems do not appear 
to be intentional failures to charge correct loads.''
Recommendations
    In response to a request from the SEC Chairman,\22\ the NASD 
organized a Task Force to address breakpoint concerns. The SEC asked 
the SIA and ICI to co-chair the effort. The Task Force was composed of 
a broad cross-section of the financial industry, including 
representatives from the NASD, NYSE, NSCC, broker-dealers, mutual 
funds, and transfer agents. SEC staff attended the meetings as well. On 
July 22, 2003, the Task Force issued its report with the following 
recommendations:
---------------------------------------------------------------------------
    \22\ Letter from then-SEC Chairman Harvey Pitt to the NASD Chairman 
Robert Glauber dated January 15, 2003.

    (A) Common Definitional Standards: The mutual fund industry should 
    adopt common definitions of terms frequently used in defining 
---------------------------------------------------------------------------
    breakpoint opportunities.

    (B) Central Breakpoint Schedule and Linkage Database: The mutual 
    fund industry should create a central, comprehensive database of 
    pricing methods, . . . breakpoint schedules, and the linkage rules 
    used to determine when a breakpoint has been reached and should 
    make that database easily accessible to broker- 
    dealers' registered representatives. . . .

    (C) Mutual Fund Prospectus and Website Disclosure: Mutual funds 
    should provide the critical data regarding pricing methods, 
    breakpoint schedules, and linkage rules in their prospectuses and 
    on their websites, in a prominent and clear format.

    (D) Confirmation Disclosure: Confirmations should reflect the 
    entire percentage sales load charged to each front-end load mutual 
    fund purchase transaction.

    (E) Standardized Checklists or Order Verifications: As an initial 
    matter, broker-dealers should require registered representatives to 
    complete electronic or paper checklists or place notations on firm 
    paper or electronic records.

    (F) Record of Linkage Information: At the time an investor first 
    purchases front-end load shares of a particular fund family, his 
    broker-dealer should record the investor's linking information, 
    preferably using a standardized worksheet.

    (G) Prospectus Disclosure Regarding Customer's Role in Assisting in 
    Securing Breakpoint Discounts: The SEC should mandate that a fund's 
    prospectus disclose that investors may need to provide their 
    broker-dealer with the information necessary to take full advantage 
    of the breakpoint discounts.

    (H) Confirmation Breakpoint Legend: Confirmations for purchases of 
    front-end load mutual fund shares should include a disclosure 
    legend that alerts customers that they may be eligible for 
    breakpoint discounts and refers customers to the appropriate 
    materials (that is, mutual fund prospectus or website) to determine 
    breakpoint discount eligibility.

    (I) Written Disclosure Statement: Broker-dealers should provide to 
    each investor a disclosure statement at the time of or prior to the 
    confirmation of his initial purchase of front-end load fund shares.

    (J) Registered Representative Training: NYSE and NASD rules require 
    broker-dealer registered personnel to undergo periodic training.

    (K) Investor Education: The investing public should fully 
    understand the availability of breakpoint discounts because there 
    are particular instances, as cited above, in which investors must 
    be active participants in assuring their receipt of an eligible 
    breakpoint.

    The Task Force has appointed working groups led by the NASD, the 
ICI, and the SIA to implement these goals. The Task Force met again on 
October 28, 2003, so that each working group could report on its 
activities. Briefly, the groups have made substantial progress in 
completing the effort, which will result in a better and more extensive 
flow of information to investors regarding breakpoint opportunities, an
enhanced investor ability to determine whether they received the sales 
charge reductions to which they are entitled, improved systems for 
capturing and storing information regarding accounts entitled to be 
aggregated for breakpoint purposes, and improved communication of 
information between funds and broker-dealers regarding breakpoint 
policies.
    While the development of standardized definitions of breakpoint 
terminology is very helpful, the wide variation in breakpoint policies 
across hundreds of fund families and thousands of funds still poses a 
daunting challenge. While we do not advocate a standardization of 
breakpoint policies, we do believe it appropriate for the regulators, 
the SIA and the ICI to continue to work together to explore ways in 
which breakpoint policies can be made easier to apply, so that the risk 
of any further operational problems regarding customers receiving the 
correct breakpoint is further reduced.
    It is important to note that the SEC charged the Task Force with 
addressing breakpoint problems prospectively. The SEC and the self-
regulators have been working with firms to ensure that mutual fund 
customers are made whole.\23\
---------------------------------------------------------------------------
    \23\ SIA understands that these efforts range from letters of 
caution from self-regulators to SEC notices of possible Enforcement 
action (so-called ``Wells'' notices). As a policy matter, generally SIA 
does not involve itself with enforcement matters.
---------------------------------------------------------------------------
Conclusion
    Like many investors, regulators, and policymakers, we have been 
surprised and dismayed by the reports of abuses relating to the sale of 
mutual funds to investors. Although any report of malfeasance in the 
financial industry is one too many, these reports have been 
particularly upsetting because mutual funds are the investment vehicle 
of choice for many Americans. Reports of abuses in this aspect of the 
financial world have a particularly corrosive effect on public trust in 
the investing and capital raising process. At SIA's recent Annual 
Meeting, SEC Chairman William Donaldson said:

          I have spent many years in and around the securities 
        industry, during which time I have seen that we have the 
        world's most creative, and most industrious workforce. I have 
        also seen that this industry is populated by fundamentally 
        decent and honest people. Indeed, these traits provide the 
        foundation of our economic vibrancy. The securities industry 
        has found itself stuck in a legal and ethical quagmire, but I 
        am confident that the industry will work together to pull the 
        industry out of the muck and live up to a higher ethical 
        standard. You can be sure that if you do not, those of us in 
        Government will.\24\
---------------------------------------------------------------------------
    \24\ Donaldson/Boca Speech.

    We are fully committed to addressing these concerns thoroughly--by 
supporting vigorous enforcement of current rules and by supporting 
appropriate legislative and regulatory reforms. We and our member-firms 
will work with policymakers to ensure that mutual fund investors once 
again can have justifiable faith in these products and our markets. We 
look forward, Mr. Chairman, to working with you and the Committee to 
earn back the public's trust and confidence.


                    REVIEW OF CURRENT INVESTIGATIONS
                    AND REGULATORY ACTIONS REGARDING
                        THE MUTUAL FUND INDUSTRY

                              ----------                              


                      THURSDAY, NOVEMBER 20, 2003

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 2:14 p.m. in room SD-538 of the 
Dirksen Senate Office Building, Senator Richard C. Shelby 
(Chairman of the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order.
    On Tuesday, Chairman Donaldson provided an overview of the 
SEC's regulatory response to the abuses in mutual funds. This 
afternoon, we will hear from the State and Federal regulators 
who are on the front lines investigating trading abuses and 
other questionable practices in the mutual fund industry.
    In late September, this Committee first discussed late 
trading and market timing activities with Chairman Donaldson. 
Since then, it has become apparent that revelations about late 
trading and market timing activities were just the beginning of 
the abuses that investigators would discover.
    Following Attorney General Spitzer's initial settlement, 
regulators have opened investigations into multiple fund and 
brokerage practices. Regulators are now investigating funds 
that have selectively disclosed portfolio information to 
certain privileged investors and fund executives that may have 
engaged in illegal insider trading. Regulators are also 
investigating brokers who receive additional payments and 
commissions to favor certain funds without disclosing such 
incentives to their clients, sell more expensive fund shares to 
unsuspecting investors in order to generate high commissions, 
or fail to give clients breakpoint discounts on fund purchases.
    It seems that a day does not pass when we do not read 
shocking new disclosures about fund executives and brokers 
neglecting their investors' interests and profiting at their 
expense. It seems as if each fund or brokerage house that is 
investigated has engaged in some level of misconduct, at least 
up to now.
    The scope of the recent revelations is particularly 
troubling. One has to question whether this is the result of a 
few bad actors, or widespread industry practices. I hope that 
these revelations are not evidence of the industry standard, 
but I am very suspicious. Nevertheless, we will get to the 
bottom of this.
    However, as a result of the SEC's recent examination 
survey, we have learned that a shockingly high number of funds 
and brokers have engaged in the practices now under 
investigation. For too long, these practices have not been 
disclosed to investors and were largely unchallenged. It is 
time, I believe, for the securities industry to realize that 
such practices cannot, and will not, be tolerated.
    Vigorous enforcement is crucial to regaining investors' 
trust and restoring integrity to our markets and the fund 
industry. Investors must be assured that fund executives and 
brokers who violate their duties to investors will be punished. 
Vigorous investigations are also critical to this Committee as 
we consider any potential legislative reforms. It is vital that 
we understand the full scope of the transgressions, conflicts, 
and structural problems that are at the root of the misconduct 
in the fund industry. Such an understanding will only come as 
the regulators define the full scope of the problems 
confronting the industry.
    The recent investigations into the fund industry 
demonstrate the benefits of a dual regulatory structure in 
which both State and Federal regulators protect the investors' 
interests. Regardless of who first initiated the probes, State 
and Federal regulators share the same goal of stopping 
misconduct and restoring investor confidence in the fund 
industry. Toward this end, Federal and State regulators have 
significant, yet distinct, roles to play as the investigations 
progress. State law enforcement and the SEC have different 
mandates and authorities, but should share a common goal--
assuring the rule of law and a fair deal for the ordinary 
investor. I believe that it is incumbent upon the State and 
Federal regulators to find a way to coordinate their 
investigatory and enforcement efforts in a responsible and a 
professional manner that always puts the investor first. 
Successful State and Federal collaboration is essential to the 
comprehensive investigation of this $7 trillion mutual fund 
industry.
    The duty to protect investors is a long-term 
responsibility. Inherent in this duty is a responsibility not 
only to make sure that the mutual fund industry operates in 
accordance with the highest standards, but also to avoid rush 
actions that could cause unnecessary damage to an industry that 
holds the assets of nearly 100 million investors.
    While Attorney General Spitzer's timely actions and the 
recent Federal investigations have raised the issues of mutual 
fund abuses and the public awareness, much, much remains to be 
done. I look forward to hearing the regulators describe their 
findings to date and detail their road map of future actions.
    Today, the Committee will hear from Eliot Spitzer, the 
Attorney General of New York; Stephen Cutler, Director of 
Enforcement at the U.S. Securities and Exchange Commission; and 
Robert Glauber, Chairman and CEO of the National Association of 
Securities Dealers. I look forward to your testimony.
    Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Chairman Shelby.
    At the outset, I want to commend Chairman Shelby for the 
on-going oversight of the securities industry being conducted by 
this Committee. This year alone, under Chairman Shelby's 
leadership, the Committee and the Securities Subcommittee of 
the Committee, of which Senator Enzi is the Chairman and 
Senator Dodd is the Ranking Member, have held 11 hearings 
involving securities matters, which clearly demonstrates how 
important the integrity and efficiency of the U.S. securities 
markets are in the estimation of the Congress.
    Today's hearing gives us the opportunity to continue our 
examination of the status of current investigations into the 
mutual fund industry. We must learn more about the nature and 
scope of the misconduct, why it was allowed to continue 
undetected or unpunished for so long, and what are the most 
effective and appropriate remedies.
    Mr. Chairman, I join with you in welcoming today's 
witnesses. Stephen Cutler is Director of the Enforcement 
Division at the U.S. Securities and Exchange Commission, an 
agency which in the past has been referred to as a ``jewel 
among Government agencies.'' Although in recent years the SEC 
has been underfunded, the legislation we passed last year, the 
Sarbanes-Oxley Act, authorized and the Congress appropriated a 
significant increase in budget, which has led to more staff 
being hired in order to meet its regulatory needs. On Tuesday, 
Chairman Donaldson described the Commission's new regulatory 
initiatives, and I am looking forward this afternoon to hearing 
Mr. Cutler describe the enforcement activities.
    I should note that the SEC's Division of Enforcement is 
today bringing significantly more enforcement actions. It is my 
understanding that the number of cases has increased from 484 
in fiscal year 2001 to 598 in fiscal year 2002 to a current 
high of 679 in fiscal year 2003. It is also my understanding 
that with the significant increases in funding granted by the 
Congress, we have gone from $515 million in fiscal year 2002 to 
$716 million in fiscal year 2003, and the legislation we are 
working on now has $841.5 million for fiscal year 2004; that 
the SEC is working diligently to hire and train new employees 
for key divisions and that since this time last year, the 
Division of Enforcement has hired over 75 new attorneys and 
accountants.
    I also look forward to hearing from Eliot Spitzer, the 
distinguished Attorney General of New York, who has repeatedly 
spearheaded major initiatives to protect investors. These have 
involved securities firms that issued fraudulent or misleading 
stock recommendations, which led to a landmark settlement 
agreement with Merrill Lynch. This action was followed by the 
global settlement entered into by 10 major securities firms, in 
which Federal and State regulators worked closely together to 
reform stock analyst practices. In September, just a couple of 
months ago, Attorney General Spitzer brought another landmark 
case against a major hedge fund for improper late trading and 
market timing in mutual funds. I think it is clear that his 
work and that of his counterparts in other States, whether 
attorney generals or securities commissioners, shows the 
important role that States play in protecting the investors.
    Mr. Chairman, I want to commend both the SEC's Enforcement 
Division Director Steve Cutler, as well as Attorney General 
Spitzer for their outstanding efforts in enforcement. Tension 
between the Commission and the States may very well go with the 
territory on occasion, but I think it is extremely important 
for investor protection, which is, after all, our prime goal, 
that the SEC and State regulators both are working to identify 
potential securities law violations and seeking to coordinate 
their investigations and enforcement activity wherever 
possible. I want to applaud the aggressive actions and 
competence of both of these dedicated public servants who are 
here today and are on this panel.
    Then I also, of course, want to express our appreciation to 
Robert Glauber for joining us, the Chairman and CEO of the 
National Association of Securities Dealers, a self-regulatory 
organization for broker-dealers. The sales practices of stock 
brokers selling mutual funds have been a major focus of public 
attention and we are looking forward to hearing more about the 
NASD's examination and enforcement activities with respect to 
brokers. Mr. Glauber, we are pleased to once again have you 
back before the Committee.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Dodd.

            STATEMENT OF SENATOR CHRISTOPHER J. DODD

    Senator Dodd. Thank you, Mr. Chairman. Let me add my voice 
to that of Senator Sarbanes and others and thank you for the 
series of hearings we have had on this subject matter. I 
certainly welcome our witnesses. To you, Bob, good to see you 
again, Mr. Glauber; and Mr. Cutler, Stephen, and Eliot Spitzer, 
the Attorney General, whom I have had the chance to get to know 
on several occasions. We thank all three of you for being here.
    Again, Mr. Chairman, I want to thank you and thank our 
staffs as well. This is a rather crowded time around here. 
There is an awful lot going on, obviously, on the floor with 
major issues before us: The Fair Credit Reporting Act, which I 
know the Chairman and Senator Sarbanes and the staffs are 
working on, trying to resolve that issue before we leave here. 
So the staff, both Majority and Minority, of the Committee 
deserve a serious thanks for their tremendous commitment and 
hard work, and we are all very appreciative of the efforts 
being made, in addition to conducting these hearings.
    Certainly, I want to thank our witnesses as well for the 
efforts they have been making to pursue and prosecuting the 
myriad of abuses that have been uncovered in and around the 
mutual fund business. I especially want to commend Eliot 
Spitzer. Your work, Mr. Spitzer, Mr. Attorney General, and the 
work of your staff has been a critical component in this 
effort, and without your diligent efforts as a ``cop on the 
beat,'' it is unclear how much longer these abuses would have 
continued.
    I would also be remiss if I did not express some concern 
over the seeming lack of coordination, and you and I have had a 
chance to talk about this already. I raised the issue the other 
day with Mr. Donaldson. And I do not want to dwell on the point 
here. You may want to address it in your own comments. The 
point Senator Sarbanes made is important, that the tension 
sometimes between the States and the Feds can work to the 
benefit of investors, but obviously when you can coordinate 
activities, that also can accrue to the benefit of everyone 
involved.
    So while I do not doubt that both the SEC and the State 
enforcement officials have the best interests of investors in 
mind, I would urge all the parties to work in a more 
complementary fashion in order to fight securities fraud and 
abuse in our Nation.
    Mutual funds, as we all know now, are a principal pathway 
that most investors achieve financial security. Over 95 million 
Americans and over $7 trillion have been invested in mutual 
funds. In the past, mutual funds have not only lived up to, but 
also in many cases exceeded the grand expectations of their 
investors. They are a true success story of our securities 
markets and our securities regulation.
    However, as we all know, in recent months a series of 
revelations has shaken investor confidence and the promise of 
mutual funds. I think it is our obligation collectively to 
restore the fair of investors in mutual funds and those who 
manage them.
    Late last week, my colleague Jon Corzine and I introduced--
or announced an intention, rather, to introduce some 
legislation to address these abuses and shortcomings which have 
received so much attention. We did so because we believe that 
there is much more that needs to be done than just regulatory 
changes which address market timing and late trading abuses.
    We believe that fundamental changes are needed in the way 
the funds are governed, and we intend to make substantive 
changes that enhance the independence of boards as well as 
provide greater accountability to fund shareholders. There is a 
widening gap between what investors believe mutual funds cost 
and the actual costs associated with those funds. Investors 
should have, in our view, a very clear, articulate 
understanding of what has become a maze of fees, loads, and 
hidden costs.
    We also believe that we must take a close look at the 
current oversight of the mutual fund industry and determine if 
there are sufficient resources and if the current structure and 
manner of regulation is appropriate.
    Mr. Chairman, I am looking forward to working with all of 
our colleagues here and addressing these issues, I hope in the 
not too distant future as other issues may take over our 
attention. So, I thank the Chair once again for having such a 
thoughtful set of hearings on the subject matter before we 
begin to legislate here.
    Chairman Shelby. Senator Johnson.

                STATEMENT OF SENATOR TIM JOHNSON

    Senator Johnson. Thank you, Chairman Shelby and Ranking 
Member Sarbanes, for holding today's hearing, and welcome to 
this distinguished panel. Frankly, Mr. Chairman, I am dismayed 
that just 1 year after we passed landmark corporate governance 
reform legislation, we are back again to deal with yet more 
wrongdoing in the marketplace.
    Mr. Chairman, I find this particular string of scandals 
especially demoralizing because of the demographics of the 
victims. Until now, the mutual fund industry has presented 
itself as the champion of the little guy, the embodiment of the 
democratization of the capital markets. Mutual funds allow 
small investors to put their money to work through a 
diversified portfolio of investments managed by financial 
professionals otherwise unavailable to the average family. And 
the model has truly revolutionized economic opportunities for 
millions of Americans.
    According to the Investment Company Institute, of the 95 
million mutual fund shareholders, the median income of the 
mutual fund-owning household is $62,000. And 33 percent, a 
third of all mutual fund shareholders have household incomes 
under $50,000. Of these shareholders, a staggering 44 percent 
of household financial assets are held in mutual funds, almost 
half, a testament not only to the power of the investment 
vehicle, but also to the trust of the typ-
ical investor.
    In short, mutual fund companies have been extremely 
successful at attracting their target demographic. What is now 
called into question, however, is whether these mutual fund 
companies have been as successful in fulfilling their fiduciary 
obligations to these customers.
    Now, I appreciate that it is not fair to tarnish an entire 
industry because of the bad actions of some. But at this point, 
the theft seems to be so widespread, and so brazen, that I do 
not know that we can assume we are dealing with just a few bad 
apples. And the examples that have cropped up over and over 
again all share a theme: An imbalance of power that results in 
the relatively unsophisticated investor getting taken advantage 
of.
    Among the most galling examples of fraud represent a sort 
of reverse Robin Hood: Hedge funds giving special after-hours 
trading access at the expense of mutual fund holders. Or private
equity funds and hedge funds standing first in line for 
lucrative IPO shares.
    Another example of where those in positions of fiduciary 
responsibility took advantage of their customers had to do with 
steering them to certain funds, not because they were 
appropriate for the investor, but because they yielded bigger 
commissions for the broker. I would be interested in survey 
results of how many investors understand the implications, for 
example, of buying ``B shares'' and the years of distribution 
fees that they imply.
    In fact, this misuse of the professional investment adviser 
relationship bears close scrutiny. We know that mutual funds 
sell their product not simply as a diversified portfolio, but 
as access to professional investment advice that would 
otherwise be unaffordable to the average consumer. And if we 
look at all the statistics, yet again the industry has been 
successful in targeting its marketing. The ICI breaks out three 
categories of investors based on how they purchase their funds: 
Nearly half through defined contribution plans in the 
workplace, one-sixth through direct marketing from fund 
companies or discount brokers, and over a third through so-
called ``sales force'' channels.
    This last category, the sales force channel, is the most 
vulnerable to steering, and as one might expect, is the least 
educated investor class. And not surprisingly, this category of 
investors typically pays the highest fees. The sales force 
investors are on average 8 years older than investors who 
purchase shares through retirement plans. Almost 30 percent are 
retired, and nearly half lack a col-
lege education. By contrast, investors who use direct marketing
channels such as online brokerages are younger, wealthier, and
better educated.
    Mr. Chairman, the point of these statistics is that both we 
in Congress and the mutual fund industry have a special 
obligation to ensure that this investor class is adequately 
protected. And these protections need to extend well beyond 
simple corporate governance issues. The Investment Company Act 
of 1940, known by most simply as ``The Forty Act,'' is clearly 
due for a comprehensive checkup to make sure that it still 
works.
    In addition to the governing statute, we clearly have a 
problem with enforcement. Without pointing fingers, enforcement 
is a point we need to address, and I hope the State and Federal 
enforcement arms can take their energy and motivation and begin 
working together on behalf of investors. Self-policing, as we 
learned during the Sarbanes-Oxley debates, is of limited use 
when good actors turn a blind eye to fraud and abuse and where 
enforcement agencies lack the capacity or the will to follow 
through.
    Finally, it is hard to overstate the importance of 
overhauling the disclosure requirements related to fees, and 
perhaps even rethink whether fees need to be restricted. Under 
current law, investors have very good access to uniform 
performance and tax information, which allows them to compare 
funds on these scores. And while some of the fee arrangements 
are disclosed, investors do not have access to the information 
they need to make an intelligent evaluation of the true costs 
of their investments. We also need to take a hard look at the 
true characteristics of so-called soft-dollar arrangements, and 
I hope today's witnesses will at least address that point 
either in testimony or during the question period.
    Mr. Chairman, the ICI's 2001 Profile of Mutual Fund 
Shareholders reveals that 91 percent of all mutual fund 
shareholders say the primary financial goal of their investment 
is to save for retirement. We have a special obligation to 
these investors, who work hard and save responsibly, to ensure 
that they have access to the marketplace in a first-rate, sound 
investment vehicle.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Corzine.

               COMMENTS OF SENATOR JON S. CORZINE

    Senator Corzine. As my other colleagues have suggested, I 
congratulate you and the Ranking Member and others for 
cooperation and focus on this vital issue that we have.
    One of the great pieces of both savings and the ability to 
allocate capital in this society is the mutual fund industry 
and mutual fund practice. And it is unfortunate that an 
industry that, long respected, has developed and created a 
number of problems for itself and really broken trust. I think 
I want to hear people that have looked at that, in specific 
talking about it, but we really do have to address the 
integrity if we want to have the kind of capital markets and 
savings structures that make this country great, getting money 
and investments to the places that will make our country really 
strong.
    I look forward to working with all of you, and certainly 
Senator Dodd and I have some ideas with regard to these issues. 
The elements that have been discussed so readily in the press--
late trading, market timing, and other issues--I think are 
important to deal with. But I think there is a fundamental 
problem here in just the ability for any human being to 
understand actually what they are buying and what they are 
paying for when they are buying. So, I am hopeful we can get to 
comparative shopping and some kind of ability for people to 
know what it is they are paying for.
    I am anxious to hear all of the witnesses speak to this 
issue, in particular, and there are a number of other issues 
that come to mind. But I appreciate it very much, and I commend 
all of those on the panel for, I think, their commitment to 
making our markets stronger. And I think in general they work 
very well together.
    Chairman Shelby. Senator Reed.

                 COMMENTS OF SENATOR JACK REED

    Senator Reed. Thank you very much, Mr. Chairman. Let me, 
too, commend you and Senator Sarbanes for continuing these 
hearings on a very important topic.
    The obvious fact is that the securities markets rest on 
trust more than anything else, and what we have witnessed is a 
massive breach of trust. Let me commend Attorney General 
Spitzer and his colleagues at the State level for aggressively 
protecting the rights of investors. Thank you very much, Mr. 
Attorney General.
    One of the issues that certainly will arise here is who 
should take the leadership role between the Federal Government, 
the SEC, the States. It reminds me of a saying that I learned 
as a young infantry lieutenant: Lead, follow, or get out of the 
way.
    If the SEC is to be the leader, then it needs the resources 
and authority to do the job. Frankly, I think the resources are 
probably the more pressing issue at the moment. And it is not 
just a few more attorneys or a few more analysts. As Senator 
Corzine alluded to, the sophistication and the use of 
technology is monumental in terms of some of these products, 
and the SEC and the regulators need the same type of 
information software, and that is a significant investment that 
we will have to make. If we do not make those investments, then 
all of our exhortations to be more aggressive and more forceful 
I think will be just that--exhortations.
    Thank you, Mr. Chairman. This is the beginning, I think, of 
a very important process.
    Chairman Shelby. Thank you, Senator Reed.
    Mr. Spitzer, we will start with you. All of the witnesses' 
written testimony will be made part of the record in its 
entirety. Mr. Spitzer proceed as you wish.

                   STATEMENT OF ELIOT SPITZER

              ATTORNEY GENERAL, STATE OF NEW YORK

    Mr. Spitzer. Thank you, Mr. Chairman and esteemed Senators. 
I appreciate the invitation to appear once again in front of 
you and also to share the witness table once again with my 
great friend and colleague, Mr. Stephen Cutler, with whom we 
work diligently on a regular basis.
    On September 3, my office announced the results of its 
investigation of the unlawful and improper trading practices of 
Canary Partners. Since that time, my office has worked closely 
with the SEC and others to uncover the extent to which mutual 
fund directors and managers breached their fiduciary 
responsibilities to the 95 million Americans who have invested 
$7 trillion in mutual funds.
    Our continuing investigations reveal a systemic breakdown 
in mutual fund governance that allowed directors and managers 
to 
ignore the interests of investors. In fund after fund, what we 
have seen is the wholesale abandonment of fiduciary 
responsibilities. As Chairman William Donaldson put it to this 
Committee on Tuesday, ``The industry lost sight of certain 
fundamental principles, including its responsibilities to the 
millions of people who entrusted their confidence and the 
fruits of their labor . . . to this industry for safekeeping.''
    Earlier today, my office, along with the SEC, brought 
actions against the founders of the Pilgrim Funds, Gary Pilgrim 
and Harold Baxter. These individuals served as directors of the 
various Pilgrim mutual funds and as fiduciaries of their 
investors' money. Nevertheless, when offered an opportunity to 
personally profit at the expense of their investors, they 
grabbed it. Although the Pilgrim Funds' prospectus prohibited 
shareholders from making more than four trades a year and their 
internal policies prohibited market timing, Mr. Pilgrim and his 
partners in another investment fund were permitted to engage in 
frequent market timing trades. Those trades were enormously 
profitable to Mr. Pilgrim and his partners, but were costly and 
detrimental to his shareholders. When Mr. Pilgrim was 
confronted with the choice between his lawful duty to investors 
and an unlawful opportunity for personal profit, he chose 
personal gain over his investors. That is the bad news. 
Unfortunately, there is certainly going to be more bad news to 
come as our investigations continue. But there is also good 
news.
    The good news is that the process of addressing these 
systemic failures by considering systemwide reforms has begun. 
These reforms would alter the current governance structure of 
most funds by requiring them to have truly independent boards 
of directors. Seventy-five percent of directors, including the 
chairman, would be independent of the management companies that 
operate the funds. The independent directors would also oversee 
a compliance staff that will ensure that the fund's managers 
are acting in the best 
interests of the funds shareholders.
    These reforms were all included in the package of proposals 
that I discussed when I testified before House and Senate 
Committees 2 weeks ago. I certainly agree with Chairman 
Donaldson that they are good ``first steps.'' Taken together, 
these reforms will hopefully foster board action that is more 
for the benefit of shareholders and not that of managers.
    At the same time, it is necessary for us to take the 
logical next step, which is to examine the fee arrangements 
between mutual funds and their managers. As I have said before, 
the 95 million Americans from 54 million households paid more 
than $70 billion in advisory and management fees in 2002. That 
comes to an average of $737 in fees paid by each individual 
investor and $1,292 paid by each household invested in mutual 
funds. These fees are in addition to the significant costs, 
such as trading costs, that are passed on to investors.
    Investors who paid those fees--via deductions from their 
account, often without full disclosure--are entitled to know 
whether they are fair.
    Some have questioned whether there is a nexus between the 
inquiry into fees that I am proposing and the investigation 
into the trading activities permitted by fund managers. The 
answer is yes.
    The improper trading and the exorbitant fees charged are 
both consequences of a governance structure that permitted 
managers to enrich themselves at the expense of investors. We 
know that the directors and the managers breached their duties 
to investors in every conceivable manner. As regulators and law 
makers, our duty to investors is to investigate every 
manifestation of that breach and to return to investors any and 
all fees that were improper or inappropriate. This includes the 
fees that the managers received during the very time that they were 
violating their fiduciary duties to investors.
    Moreover, the nexus between fees and the improper trading 
that we have uncovered is 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. Mutual fund managers get paid a 
percentage of the funds under management, and therefore seek to 
increase their funds' asset base to increase their 
compensation. As one mutual fund manager put it in an 
especially memorable e-mail, ``I have no interest in building a 
business around market timing, but at the same time, I do not 
want to turn away $10 to $20 million.''
    Simply stated, the desire for increased fees led the 
managers and directors to abandon their duty to investors and 
to condone improper and illegal activity. Common sense demands 
that we at least inquire whether the desire for increased fees 
also resulted in fee arrangements and charges that were 
improper.
    Common sense and a simple review of the numbers also 
dictate that the fees charged to investors by the Putnam Funds 
continue to deserve scrutiny. In 2002, Putnam had approximately 
$279 billion under management. The $279 billion was divided 
between mutual fund money and institutional investors.
    Our investigation has revealed that Putnam charged higher 
advisory fees for the mutual fund money that it managed, and 
charged lower fees for the advisory services that it provided 
to institutional investors. Here is what we have learned:
    There was an extraordinarily large disparity between the 
rate of advisory fees charged to mutual fund investors and the 
rate paid by institutional investors. Mutual fund investors 
were charged 15 basis points or 40 percent more for advice than 
Putnam's other investors. In dollar terms, this fee disparity 
meant that in 2002, Putnam mutual fund investors paid $290 
million more in advisory fees than they would have paid had 
they been charged the same rate that Putnam's institutional 
investors paid for advisory services.
    At a minimum, this disparity raises several fundamental 
questions: Why were mutual fund investors charged more than 
institutional investors for advisory services? What steps, if 
any, did the directors who negotiated these fee contracts take 
to protect the interests of investors and to ensure that they 
paid the lowest possible rate? Did managers take advantage of a 
conflicted and complacent board to extract unjustifiably large 
fees?
    These questions demand answers, and I will continue to 
insist that funds answer these questions as part of any 
settlement with my office.
    Perhaps the most important question that needs to be 
answered is this: What can be done to convince nervous and 
skeptical investors that the fees that they are charged in the 
future are fair and subject to the competitive pressures of the 
marketplace? Let me offer a few possible answers.
    First, mutual funds must be required to disclose the 
precise dollar amount of the fees charged to each investor in a 
quarterly or semiannual statement sent to the investor. This 
disclosure should be itemized, and consist of the dollar cost 
to the investor of advisory, management, marketing, and other 
administrative costs. Armed with this knowledge, investors can 
begin to engage in true comparison shopping among funds. There 
is no other industry that is exempt from informing their 
customers what they are being charged. It is an understatement 
to note that there is nothing about the manner in which the 
fund industry has conducted itself to warrant such an exemption 
here.
    Second, we must impose a fiduciary duty on fund directors 
that requires them to negotiate fee contracts that are 
reasonable and in their investors' best interest. To determine 
reasonableness, directors must consider what institutional 
investors are charged for similar services, and the actual cost 
of the service being provided. While mutual funds do need some 
services that institutional investors do not require, there is 
no reason that they should pay more than institutional 
investors for services such as core money management. Moreover, 
the directors should be obligated to make public a meaningful 
analysis that supports the fee agreements that they have 
approved.
    Third, we should consider requiring funds to obtain ``most 
favored nations'' clauses in their fee contracts. These 
contracts are common in procurement contracts throughout 
industry, and should not be ignored by the mutual fund industry 
itself. We should also consider requiring funds to put certain 
contracts out for competitive bidding. This may be especially 
suitable for many of the back-office and administrative 
services for which mutual funds pay.
    Some in the industry question whether the competitive 
bidding is appropriate. Perhaps they should be reminded that 
many fund complexes already hire sub-advisors to perform the 
services that investors pay for. What happens to the money 
saved when management companies sub-contract for the services 
that they are charging investors for? We believe that the cost 
savings should be passed along to investors and not pocketed by 
the managers.
    These ideas are not meant to suggest an exclusive or 
exhaustive list of the mechanisms available to achieve the goal 
of reducing fees. Rather, they are aimed at beginning a 
dialogue which is very necessary if we are to regain and retain 
the confidence of mutual fund investors.
    Please permit me to make one final point. My office and the 
SEC have worked together cooperatively since the day I 
announced the settlement with the Canary Hedge Fund. Each day 
since then, there have been--and will continue to be--dozens of 
points of contact, coordination, and cooperation. On rare 
occasions we have
disagreed. As is the nature of these things, those rare moments 
of
disagreement tend to get far more attention than all of our 
weeks of cooperation.
    I will continue to speak up for investors when necessary, 
but that should not obscure the productive and mutually 
beneficial relationship that my office has forged with the SEC. 
It is my desire and intention to continue to foster that 
relationship.
    Thank you.
    Chairman Shelby. Mr. Cutler.

                 STATEMENT OF STEPHEN M. CUTLER

               DIRECTOR, DIVISION OF ENFORCEMENT

            U.S. SECURITIES AND EXCHANGE COMMISSION

    Mr. Cutler. Thank you, Chairman Shelby, Ranking Member 
Sarbanes, and distinguished Senators. Good afternoon. Thank you 
for inviting me to testify today on behalf of the SEC 
concerning alleged abuses in the mutual fund area.
    The growing number of illegal practices that have recently 
come to light involving the sale, trading, and operation of 
mutual funds is a betrayal of the millions of Americans who put 
their hard-earned savings into mutual funds. The conduct we are 
finding is unethical, it is illegal, and it is profoundly 
wrong.
    Investors were led to believe that mutual funds were 
symbols of trustworthiness and security, and to the outrage and 
disappointment of all of us, that belief was, in many cases, 
misplaced. Rather than safeguarding the investors' money, some 
mutual funds, the brokers who sold them, and their personnel 
were busy feathering their own nests.
    I have in the past talked of the crisis of conflicts in the 
financial services industry. What we are also seeing is a 
crisis of character. The SEC will follow the facts wherever 
they lead. We will bring enforcement actions wherever we find 
violations, and I assure you that the Commission is fully 
committed to ensuring that violators are promptly and 
appropriately punished. That process has, of course, already 
begun. Since Mr. Spitzer announced his action against Canary 
Capital Partners, we have brought half a dozen cases involving 
abusive market timing, late trading, and self-dealing 
practices. Indeed, just this morning, as the Attorney General 
mentioned, the SEC and his office sued Pilgrim Baxter and its 
two founders, Gary Pilgrim and Harold Baxter in connection with 
alleged market timing by a hedge fund in which Mr. Pilgrim was 
himself a significant investor, and for providing nonpublic 
fund portfolio information to a personal friend who was market 
timing fund shares.
    In each of these cases we have worked with State regulators 
who have also filed their own charges. At the hearing on 
Tuesday and again at this hearing, Members of this Committee 
quite appropriately have expressed the need for cooperation 
among the various regulators working on these matters. I agree.
    While regulatory competition has its place and its 
benefits, it is also incumbent upon all of us to put investors 
first and to direct all of our energies and efforts to that 
cause. That is what the investing public expects and that is 
what the investing public deserves. And while it might not 
always seem that way, as a general matter I think we have been 
trying to do that. I know Mr. Spitzer would agree that our 
staffs have worked very well together and that our 
collaboration has resulted in stronger enforcement cases, and 
has certainly allowed us collectively to cover more territory 
than each of us could cover singly. As I have said before, we 
are both striving to achieve the same basic goals, the 
protection of investors and punishment of the wrongdoers. Now, 
we might not always see eye-to-eye on the best routes to get 
there and each of us has an obligation under those 
circumstances to do what we think best serves the investing 
public. Our partial settlement of the Putnam matter is, of 
course, a prime example of that.
    I will not repeat all of what Chairman Donaldson said about 
it to you on Tuesday, except to say that we believe that it was 
important to get in place a restitution process and safeguards 
for Putnam's mutual fund investors now, and that we took great 
care to do so without sacrificing our claim for a substantial 
penalty against the firm, our pending case against the 
individuals, or our ability to bring additional causes of 
action and relief against Putnam or others in the event that 
further wrongdoing comes to light.
    We did not, as I know Mr. Spitzer would have liked, require 
Putnam to revamp its disclosure of fees or the way in which 
fees are negotiated. We thought that was a subject better left 
to a case that involves violations relating to fees or to 
regulation of the industry as a whole, rather than the 
resolution of a case about fund trading by portfolio managers. 
But I agree with the sense of this Committee that it is time to 
put our differences with respect to the Putnam matter aside and 
to redouble our efforts to work together to bring cases 
expeditiously and to obtain meaningful relief and sanctions in 
all of our cases. I am committed to doing that, and I know that 
Mr. Spitzer is as well.
    I think it is important to point out that the Commission 
has also been engaged in significant enforcement and 
examination activities in the mutual fund area in addition to 
late trading and market timing. The first area is mutual fund 
sales practices and fee disclosures. In particular, we are 
looking at just what prospective mutual fund investors are 
being told about revenue-sharing arrangements and other so-
called shelf space incentives doled out by mutual fund 
management companies and mutual funds themselves to brokerage 
firms who agree to feature their funds.
    On Monday of this week, in what opened a new chapter in the 
Commission's efforts to combat abuse in the sale of mutual 
funds, we sued Morgan Stanley. Morgan Stanley had established 
an exclusive club of 16 mutual fund families in what it called 
its Partners Program. Under that program Morgan Stanley gave 
these fund families premium shelf space. The firm encouraged 
the sales force to sell shares of the Partners Program funds 
and even paid its sales people special incentives to sell those 
funds. Here is why. Under the program every time Morgan Stanley 
sold its customers shares of funds in the club, the fund family 
was obligated to pay Morgan Stanley a percentage of the sales 
price over and above the ordinary commissions and loads, but 
customers did not know about these special shelf space 
payments.
    Morgan Stanley agreed to settle this action by paying $50 
million, all of which, thanks to the Sarbanes-Oxley Act, will 
be placed in a fair fund and returned to investors. In 
addition, Morgan Stanley has agreed to significant undertakings 
to enable customers to see clearly and plainly what Morgan 
Stanley has to gain from selling them one fund over another.
    In light of the issues raised by the case, the Commission 
is conducting an examination sweep of some 15 different broker-
dealers to determine exactly what payments are being made by 
funds, the form of those payments, the shelf space benefits 
that broker-dealers provide, and most importantly, just what 
these firms tell their investors about these practices.
    And the potential disclosure failures and breaches of trust 
spot-lighted in the case are not limited to broker-dealers. We 
are also looking very closely at the role of the mutual fund 
companies themselves. Indeed, the aspect of the case that I 
find perhaps most troubling is this: Morgan Stanley said to the 
fund families that are part of the Partners Program--you can 
pay us in one of two ways. Either the fund management company 
can pay us in cash, or the mutual funds you manage can defray 
the fund management company's obligation by giving us a 
multiple of that amount in the form of extra commission 
business on fund portfolio transactions. Faced with that 
choice, some of the fund companies, rather than reaching into 
their own pocket to pay what they owed, reached into the 
pockets of their mutual fund shareholders and paid in 
commission dollars instead.
    Mr. Chairman, you can be certain that we are pursuing that 
issue, among others, as our investigation continues, and our 
exam sweep goes forward.
    Our second area of focus is the sale of different classes 
of shares in the same mutual fund. Very frequently a fund will 
have issued two or more classes of shares with different loads 
and other fee characteristics. In the last 6 months we have 
brought three enforcement actions in connection with alleged 
recommendations that customers purchase one class of shares 
when the firm should have been recommending another. We charged 
Morgan Stanley with violations in this area too, by the way.
    The third area is the abuse of so-called breakpoints, which 
I know Mr. Glauber will speak about. Quite simply, we have 
found numerous instances in which brokerage firms did not give 
investors the volume discounts, sometimes called breakpoint 
discounts, to which they were entitled. Earlier this month, 
together with the NASD, we issued Wells notices concerning 
breakpoint violations to a significant number of firms.
    The fourth area I want to mention is the pricing of mutual 
funds beyond the context of market timing. We are actively 
looking at a number of situations in which funds dramatically 
wrote down their net asset values in a manner that raises 
serious questions about how they price their fund shares in the 
first place.
    Before I conclude, I feel compelled to address one more 
topic. These days it has become fashionable in some quarters 
not just to critique the Commission, but also to question the 
will of the Agency and its staff. Yes, the Agency, including 
the enforcement program can and should continuously look for 
ways to improve our effectiveness, and I am steadfastly 
determined to do that. But I cannot
emphasize enough the dedication, the commitment, and the 
professionalism of our enforcement staff. I am proud to be one 
of them.
    In our just concluded fiscal year, as Senator Sarbanes 
mentioned, the Commission brought a record 679 enforcement 
cases, and that is a 40 percent jump from just 2 years ago with 
a very limited increase in resources during that same period. 
With the recent badly needed budget increase that you have been 
responsible for giving us, we have now begun to see additional 
resources, and they will allow us to look more proactively, to 
look around the corner for the next fraud or abuse. Indeed, 
that is what Chairman Donaldson's risk assessment initiative is 
seeking to achieve. With respect to mutual funds, I know that 
the Agency's routine inspection and examination efforts will be 
improved by adding new staff, increasing the frequency of 
examinations and digging deeper into fund operations. We are 
working aggressively to clean up the mutual fund abuses that we 
have seen and are committed to making sure that they cannot 
recur.
    Thank you.
    Chairman Shelby. Thank you.
    Mr. Glauber.

                 STATEMENT OF ROBERT R. GLAUBER

              CHAIRMAN AND CHIEF EXECUTIVE OFFICER

           NATIONAL ASSOCIATION OF SECURITIES DEALERS

    Mr. Glauber. Good afternoon, Mr. Chairman and Members of 
the Committee. I appreciate this opportunity to testify on 
behalf of NASD about our ongoing investigations and actions 
regarding the mutual fund industry.
    The picture that has emerged from current investigations 
into marketing of mutual funds is appalling and simply 
unacceptable. While regulators are still investigating the 
contours of this behavior, it is clearly not just a case of a 
few bad apples.
    At Tuesday's hearing before this Committee, SEC Chairman 
Donaldson announced a series of reforms in the realm of 
disclosure that NASD supports. Investors deserve clear and 
easy-to-read disclosure that tells them of all the costs 
associated with their mutual funds. Not just the load and fees, 
but also the other arrangements that affect the price investors 
pay for the fund, including Commission expenses and 
compensation arrangements between the broker and the fund. One 
of the bedrock principles of our free market system is that all 
participants have access to information about prices and costs 
that can influence their decisions. When this information is 
hidden or distorted, investors are not able to make the best 
decisions about where to invest their money.
    When they have this information, investors can be in the 
best position to discipline the behavior of those who create 
and sell these investment products. In line with Chairman 
Donaldson's recommendations, NASD recently proposed a rule 
requiring disclosure of two types of cash compensation, 
payments for shelf space by mutual fund advisers to brokerage 
firms that sell their funds, and differential compensation paid 
by a brokerage firm to its salesmen to sell the firm's 
proprietary funds. Customers have a right to know that these 
compensation differences exist. They create a serious 
potential for conflict of interest.
    We are also looking at other areas for improved disclosure 
including soft-dollar arrangements. Again, soft-dollar payments 
both affect the cost to investors from owning a fund and 
potentially create conflicts of interest between the fund 
adviser and shareholders.
    The enormous growth in popularity of mutual funds in recent 
years has led NASD to step up its oversight of how our 
regulated firms sell these funds. While NASD does not have 
jurisdiction or authority over mutual funds or their advisers, 
we do regulate the sales practices of the broker-dealers who 
provide one distribution mechanism for mutual funds.
    Our regulatory and enforcement focus has been on the 
suitability of the mutual fund share classes that brokers 
recommend, the sales practices brokers use, the disclosures 
brokers make to investors, compensation payment brokers get 
from funds and whether the brokers give customers appropriate 
breakpoint discounts. We have brought some 60 enforcement cases 
this year in the mutual fund area, and more than 200 over the 
last 3 years.
    Allow me to start with breakpoints. Through our routine 
examinations we have found that in one out of five transactions 
in which investors were entitled to a breakpoint discount that 
discount was not delivered.
    Chairman Shelby. Mr. Glauber, explain to us again what you 
mean by ``breakpoint.''
    Mr. Glauber. Very simply, Mr. Chairman, it is a volume 
discount that investors are entitled to if they buy, in many 
cases, greater than $25,000 worth of a mutual fund, it is just 
that simple.
    Chairman Shelby. Sure.
    Mr. Glauber. Thus many brokers charge the wrong sales load 
to thousands of mutual fund investors, in effect, overcharging 
investors, by our conservative estimate, $86 million in the 
past 2 years. NASD has directed firms to make refunds.
    In the next several weeks we will initiate a number of 
enforcement actions seeking significant penalties, and we have 
launched an advertising campaign urging investors to seek 
proper restitution for these overcharges.
    Next let me focus on sales incentives. Brokers are 
prohibited from holding sales contests that give greater weight 
to their own companies' mutual funds over other funds. These 
types of contests increase the potential for brokers to steer 
customers toward investments that are financially rewarding for 
the broker, but may not be the best fit for the investor. In 
September, we brought an enforcement action against Morgan 
Stanley for using sales contests to motivate its brokers to 
sell Morgan Stanley's own funds. The sales contest rewarded 
brokers with prizes such as ticket to Britney Spears and the 
Rolling Stones concerts. These cases resulted in one of the 
largest fines ever imposed in a mutual fund sales case.
    Just this week, NASD with the SEC announced further 
enforcement action against Morgan Stanley for giving 
preferential treatment to certain mutual fund companies in 
return for millions of dollars in brokerage commissions. Over 
the last 2 years, NASD has brought more than a dozen major 
cases against brokers who have inappropriately recommended that 
investors buy Class B shares of mutual funds in which investors 
incur a higher cost and brokers receive higher commissions. We 
have more than 50 additional investigations of inappropriate 
Class B sales in the pipeline.
    This kind of enforcement effort is continuing with great 
vigor at NASD. We are now looking at about two dozen firms for 
their practices of accepting brokerage commissions in exchange 
for placing particular mutual funds on a preferred list, and 
precisely what Mr. Cutler referred to. In this effort we are 
investigating all types of firms including discount and online 
brokers and fund distributors.
    The role of brokers and late trading and market timing has 
been a more recent focus of investigation at NASD. In 
September, we sought information regarding these practices from 
160 firms. Our review indicates that a number of firms clearly 
received and entered late trades. These investigations, more 
than 30 so far, have been referred to our Enforcement Division.
    As we continue our examinations and investigations into 
these matters, we will enforce NASD's rules with a full range 
of disciplinary options including fines, restitution to 
customers, and the potential for expulsion from the industry. 
These issues in the areas of broker sales and mutual funds go 
to the very heart of our mission to protect investors, 
strengthen market integrity, and rebuild investor confidence.
    I thank the Committee for its leadership and for asking me 
to testify today.
    Chairman Shelby. Thank you.
    Mr. Cutler, I will start with you. It appears that late 
trading and market timing practices have long been open secrets 
in the fund industry. Some people have suggested that the SEC 
failed to stop the abuses because it was out of touch with the 
markets and it could not effectively coordinate among its 
internal divisions, that is in the SEC. I recognize that you 
cannot speak to the operation of the SEC's Examination 
Division. You are head of the Enforcement Division, which is 
the division responsible, as I understand it, for monitoring 
the funds' ongoing legal compliance, is that correct?
    Mr. Cutler. It is.
    Chairman Shelby. With this in mind, how is it that such 
misconduct could continue for so long without detection and 
enforcement by the SEC? Was it a lack of attention, a lack of 
resources? Assuming that in a $7 trillion interest like most of 
us, that everything was fine and rosy or what?
    Mr. Cutler. I think that is a very good and fair question. 
The one thing I can assure you, Senator, and Chairman, is that 
it has certainly not been a lack of will. And as you have 
rightly pointed out, I think the Agency, and in particular our 
inspection program, was severely underfunded for a number of 
years. There are approximately 8,000 mutual funds in America. 
We have had on the order of 350 examiners responsible for 
inspecting that entire industry. That has not been enough.
    Chairman Shelby. Tell us, if you can, for the record, how 
many examinations in the last say 3 years--just use that as a 
calendar--have you done at the SEC of the mutual fund industry 
or the companies that make up the mutual fund industry, and if 
you do not have that now, could you furnish this for the 
Committee?
    Mr. Cutler. That would be better, because I would be 
guessing, Mr. Chairman. I think it is on the order of 2 to 300 
complexes are examined in any 1 year, but we need to get you 
the precise figures because it is not my division.
    Chairman Shelby. Sure, I understand that. Along those same 
lines, could you share with the Banking Committee, the Members, 
and the staff would be interested in this, what your 
examinations found, and were any of the areas, market timing, 
breakpoints, all of this, was there evidence of that going on 
in your examinations? And what did you do about it if anything?
    Mr. Cutler. I will start with the market timing question, 
because I think that is what launched all of this a couple of 
months ago in that particular area, in the Canary Capital and 
what followed from it. Again, I have to give you my impressions 
given where I sit. My impression of what happened here is that 
you had an industry that over the years was beseeching the 
Commission to give them more tools to combat market timing.
    Chairman Shelby. Well, how did they do that? You say you 
were beseeching.
    Mr. Cutler. With greater redemption fees, right? Give us 
the power to stop this. We hate it. I think that the mindset 
was--and I am not trying to excuse it, I am just trying to 
explain it--was that here you had a potential set of misconduct 
that the industry was saying we hate, we are trying to do 
everything we can to stop. The notion that the mutual fund 
industry was complicit----
    Chairman Shelby. Wait a minute. They said that they wanted 
to stop. But you can stop misconduct if you want to, can you 
not? I mean, not you. I am speaking of the industry themselves. 
They were kind of self-regulatory to a certain extent, were 
they not?
    Mr. Cutler. There are ways to stop it, but I would submit, 
Mr. Chairman, that there are ways to avoid being stopped.
    Chairman Shelby. We know that.
    Mr. Cutler. Yes. We have seen it, for example, by way of 
omnibus accounts.
    Chairman Shelby. Manipulation of the whole process.
    Mr. Cutler. Sorry?
    Chairman Shelby. Were they manipulating the whole process?
    Mr. Cutler. Well, we now know that there were many people 
who were manipulating the process, and those people are going 
to be severely punished.
    Chairman Shelby. Did you know any of this, say, about 18 
months ago?
    Mr. Cutler. I do not believe that the Agency did.
    Chairman Shelby. You had no inkling?
    Mr. Cutler. I do not believe that the Agency knew that 
there was wrongdoing in the market timing and late trading 
area. That is my impression from where I sit.
    Chairman Shelby. But you are going to check the record and 
the examinations and share this information.
    Mr. Cutler. I think the examination people have gone back 
and checked their exams and this was something that--there are 
many things to examine for. There are many, many different 
areas.
    Chairman Shelby. We want to know. We should be able to know 
for sure, and I will ask Chairman Donaldson to furnish this 
information to us.
    Mr. Cutler. We will get you all the information you want, 
Mr. Chairman. I should also add that in the area of 
breakpoints, in the area of sales practices, those have been 
areas of acute focus by our examination staff, and they have 
helped develop the cases that you are now hearing about in 
those areas, the breakpoint cases, the fee disclosure cases.
    Chairman Shelby. I guess my point is, in an industry of $7 
trillion, $7 trillion is a little money, to say the least. If 
there were open secrets that all this was going on, it looks to 
me like somebody in Enforcement or Examination would have known 
something about it and would have acted on it. That is just a 
common sense question, is it not? Because as widespread as it 
looks like it is going to be in the industry, we are just 
trying to get to the facts.
    Mr. Cutler. I think it is a very fair question, and I can 
tell you, Senator, that we are determined to assure that going 
forward we have the tools to address just that question, that 
we are working proactively and we are working in concert. That 
is, that people from Enforcement, from our Division of 
Investment Management, and from our Office of Compliance 
Inspections and Examinations, have sat down together, have 
reviewed the examinations that have taken place, in particular, 
any examination that has raised, for example, any enforcement 
question, and figured out what to do with this and what it 
means to us, and thought about questions in a broad way. 
Because you are right in the sense that clearly market timing, 
and do not forget, market timing is not, per se, illegal, the 
practice of market timing was not a secret. What was a secret 
was that it was being used abusively, that it was being used in 
violation of law, and I think it is incumbent upon all of us 
to----
    Chairman Shelby. Was this investigated? If it was not a 
secret was it investigated by the SEC, and if not, why not?
    Mr. Cutler. I do not believe it was, and again, all I can 
tell you in that regard is I think that it was viewed as 
something that the industry was trying to stop, not something 
that the industry was actually complicit in facilitating.
    Chairman Shelby. I asked Chairman Donaldson a couple of 
days ago this question. I will just touch on it with you. We 
wanted to know for the Committee and the staff, the Members and 
the staff, how much in resources were expended by the 
Securities and Exchange Commission, say, in the last 5 years--
we will just use that as a calendar date--on the oversight of 
the mutual fund industry? You might want to do this for the 
record. I think the Chairman is trying to get this together. In 
other words, was this an area that was greatly neglected 
because there had not been any apparent scandals that were 
widespread in the public, or what was it?
    Mr. Cutler. I can tell you from an enforcement perspective 
it was not neglected.
    Chairman Shelby. Will you furnish this information for the 
Committee?
    Mr. Cutler. Yes, we certainly will. Certainly we have a 
broad mandate, and there have been lots of areas of focus, and 
I will tell you that in the last 3 to 4 years, I think the 
Agency has rightly been focused on the corporate scandals that 
we have read way too much about, the Enrons and the WorldComs. 
But we have to be 
everywhere----
    Chairman Shelby. You do not have to explain that to us who 
have been on the Banking Committee a long time. We know you 
have a broad mandate here, but we want to know what you are 
doing or what you did, if anything, in the scope of that 
mandate as far as these funds are concerned.
    My next question is how can the SEC, Mr. Cutler, modify its 
internal operations to perhaps prevent another such industry-
wide abuse from going unaddressed, neglected, by any of the 
SEC's internal division? In other words, how will Chairman 
Donaldson's risk management initiative affect a situation like 
this, if it will?
    Mr. Cutler. I think it will, in that he is looking from a 
30,000 foot perspective to ensure that we do not miss anything 
through whatever cracks might otherwise develop between 
divisions, and I think that is critical.
    At the same time, from my own parochial enforcement 
perspective, I too want us to be more proactive, and I have 
actually posted jobs to bring substantive expertise within the 
Enforcement Division, someone who knows trading and markets, 
someone who knows the investment company and investment adviser 
world, someone who knows corporate accounting and disclosure, 
so that they can help us from a strategic planning perspective 
where should we be putting our resources? What might we be 
missing? What should we take a flyer on and investigate even if 
we do not have a referral from our examination program?
    Chairman Shelby. And what if you did have a referral and 
you neglected it?
    Mr. Cutler. Well, I will not let that happen, and I will 
tell you we have already put into place a mechanism I hope that 
will ensure that does not happen. We have a working group 
consisting of my colleagues in those other divisions to review 
any exams that produce enforcement related issues.
    Chairman Shelby. Mr. Spitzer, you have been very involved 
and I thank you for your involvement in trying to bring 
investor confidence to the capital markets.
    You have been quoted as saying that you will not enter into 
any settlements until the mutual fund industry agrees to make 
significant structural changes such as reforms to fee 
structures, et cetera. Former SEC Chairman Arthur Levitt was 
quoted as stating the other day: ``As to the longer term 
question of fees, that issue should not be addressed in an 
enforcement action, but is an issue for the SEC Commission.'' 
What is your response to that statement and the contention that 
the SEC is a primary policymaker for the national market?
    Mr. Spitzer. Mr. Chairman, I am loathe to disagree with 
former Chairman Levitt, who is not only a friend and a 
colleague, but also somebody whom I respect enormously.
    Having said that, let me take a stab at it, and the answer 
I think is embedded in the testimony that I delivered today, 
that we see fund abuse as part and parcel of the violation of 
fiduciary obligation, one other evidence of which is late 
trading, market timing, failure to observe breakpoints, so that 
I would be loathe to enter a settlement which addressed the 
particular manifestations of fiduciary breach without 
confronting the larger issue itself.
    And I would note that Mr. Glauber referred to a very 
important point of failure to observe breakpoints is 
reflecting, in their conservative estimate, an $86 million 
loss.
    Chairman Shelby. How many firms did he----
    Mr. Spitzer. That was not----
    Mr. Glauber. I did not give the number, but we have looked 
at 650 firms.
    Chairman Shelby. Over 600 firms.
    Mr. Spitzer. But with respect merely to the differential 
between fees charged mutual funds and institutional investors, 
the 15 basis points at Putnam translated into $290 million net 
loss to those investors in one firm. Now, we have to massage 
those numbers. This is based on their delivery of numbers to 
us.
    The point is, the fee issue is so pervasive and cuts so 
deeply to the heart of whether or not these entities are living 
up to their 
fiduciary duty, that I do not want to settle with them unless 
and until we begin to address that issue.
    Chairman Shelby. I am not indicting you. I am just asking 
you a question.
    Mr. Spitzer. I am glad of that.
    [Laughter.]
    I would go back to the statute book to see if you could, 
but----
    [Laughter.]
    The issue I would point out is that Mr. Cutler and I have 
had a series of conversations about how, when, whether, and 
where to begin to undertake this discussion of fees, and I know 
that many of the Members of this Committee also are not only 
intrigued by it, but also believe that it is perhaps the 
essential point we have to address. So, I believe we are making 
real progress in moving that debate forward.
    Chairman Shelby. Attorney General Spitzer, how do you 
respond to the contention that State regulators who lack 
rulemaking authority are using the threat of prosecution to 
extract concessions that have nothing to do with the alleged 
violations of law, or on the other hand, are they all mixed 
together?
    Mr. Spitzer. First, I would reflect back on the cases we 
have brought over the last 2 years or so when we have tried to 
confront structural issues in the securities markets that we 
thought needed to be addressed that had not been addressed, and 
first was the failure of research, and more recently the 
failure of the mutual fund industry to govern itself within 
fair bounds of fiduciary duty. I think if you look at the 
remedies we have sought in each case, they flow directly from 
the nature of the wrongdoing that we have seen.
    Where we have verged into the area of rulemaking, we have 
done so only in concert with the SEC. I have been very 
conscious of that boundary line, and it is as a consequence of 
that that I early on, both last year with respect to research 
and this year the same day we began our post-Canary 
investigation, called Mr. Cutler and said we have to get into 
this together.
    Nobody, I would hope, at the State level has disputed or 
stated other than that the SEC is the primary regulator and has 
the final rulemaking authority. So, we are conscious of that 
divide and tried to reflect it.
    Chairman Shelby. But sometimes you have a situation where 
you have civil and criminal culpability, do you not?
    Mr. Spitzer. Oh, absolutely. The boundary line between 
those two is usually one of judgment calls rather than one of 
stark bright lines that can be defined.
    Chairman Shelby. Mr. Glauber, given the apparent failure of 
self-regulation in the context of the global settlement and of 
the 
recent mutual fund trading abuses, do you think now is an 
appropriate time to reconsider the structure of our regulatory 
structure and its reliance on self-regulatory organizations?
    Mr. Glauber. Well, I think it surely is worthwhile to ask 
the question.
    Chairman Shelby. Raise the level of debate on it.
    Mr. Glauber. Oh, absolutely. I believe that self-regulation 
has proven itself very effective in many, many areas. Indeed, 
in the areas of sales practices related to mutual funds, I 
think the history of self-regulation and of the NASD is one 
that is quite respectable.
    I recited what we have done on breakpoints, on sales 
contests, on inappropriate sale of Class B shares. So, I think 
really there has been a great benefit to the investing public 
from what is an organization in our case which is over 2,000 
people, with a budget of roughly $500 million that is geared 
and directed toward protecting investors. Do we catch 
everything? Of course not. But I think we really have made a 
very important contribution to the protection of investors and 
to the preservation of market integrity.
    Chairman Shelby. Absolutely.
    Mr. Spitzer, I understand that the scope of your 
investigations are continually expanding because one thing 
brings another, as we all know.
    Mr. Spitzer. Yes, sir.
    Chairman Shelby. What practices do you anticipate--or maybe 
you cannot say--investigating next? And when do you expect to 
complete your industry-wide probe? Or is it just too big to say 
at this point?
    Mr. Spitzer. Well, Mr. Cutler asked me that this morning, 
also.
    [Laughter.]
    Mr. Cutler. Do I get a chance to object?
    Mr. Spitzer. Mr. Chairman, I am not sure it is possible to 
say what is next. As you suggested, unfortunately, one 
investigation begets another, and what began with Canary has 
spawned a range of other abuses that have now been played out, 
some of them publicly, many of them not yet----
    Chairman Shelby. It runs right through the whole industry, 
maybe not every fund, but it is very widespread. It is going to 
take a while.
    Mr. Spitzer. It will take a long time. Let me just merely 
throw out one area that we are delving into, all of us 
collectively, that I think is highlighted by the case we filed 
this morning, the Pilgrim case, and that is the dual interest 
in a hedge fund and a mutual fund, simultaneous investment or 
management that creates very difficult and complex tensions 
that are often very difficult for people to mediate or 
temptations that they cannot resist or have been unable to 
resist. And we are seeing, where there are those simultaneous 
investments and interests, problems that emerge and that is an 
area that we are pursuing.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    Mr. Cutler, has the SEC studied the use of commissions by 
mutual funds to finance the marketing and distribution of fund 
shares?
    Mr. Cutler. I do believe that is an issue that has received 
a lot of attention and focus by our other divisions, so I 
cannot speak to it personally. But certainly if you look at the 
case we brought earlier this week, the case against Morgan 
Stanley, one aspect of that case is the use of commission 
dollars by mutual funds who are part of that Partners Program 
that Morgan Stanley had to pay Morgan Stanley for shelf space. 
And we certainly do not think that Morgan Stanley's customers 
understood that when they were buying a mutual fund share, that 
part of their own investment was going to be used by way of 
commission dollars to defray the obligations of the mutual fund 
family in which they were invested. I think it is a very 
important issue.
    Senator Sarbanes. These commission-generated payments that 
you have just referred to of marketing and distribution, as I 
understand it, are currently not itemized or disclosed to fund 
shareholders by their funds as a general proposition. Is that 
correct?
    Mr. Cutler. Senator, I do not believe they are in the 12b-1 
fees that are ordinarily disclosed.
    Senator Sarbanes. Isn't it a violation of 12b-1? As I 
understand 12b-1, it permits funds to use their assets, which 
is what is happening here, to pay for distribution only if such 
payments are made pursuant to a plan approved by fund 
shareholders and annually reviewed and approved by the fund's 
board. Apparently, that is not happening in these cases, is it?
    Mr. Cutler. Not that I am aware of. And then I think what 
the mutual funds would say is there is a difference between 
commission dollars and hard dollars, but I would take the 
different view. I agree with you, Senator, I think it is quite 
problematic when mutual funds are using commission dollars on 
fund portfolio transactions to defray expenses or obligations 
relating to distribution.
    Senator Sarbanes. Does either of the other panelists want 
to add anything on this issue? Mr. Glauber.
    Mr. Glauber. Thank you, Senator Sarbanes. The use of 
directed brokerage commission dollars actually does violate an 
NASD rule, and that is why we joined Mr. Cutler and the SEC in 
the case this week against Morgan Stanley.
    Mr. Spitzer. No, sir, I have nothing to add on that.
    Senator Sarbanes. Okay. Let me see how to phrase this. I am 
becoming increasingly concerned that a few firms, some of them, 
in a traditional view, leading firms, seem to be getting into 
trouble over and over again. And so, we read a case, the 
regulators come in, and they do a $50 million fine or 
something, and a strong admonition, and then there is another 
case where something has gone amiss and so they get punished 
there. But it all begins to smack a little bit of the cost of 
doing business.
    How do you propose to deal with these firms who seem to be 
repeat offenders? You know, there is a bad action and they get 
caught and admonished for it, and then they come along and 
something else happens, not too much later.
    Chairman Shelby. Something the next day.
    Senator Sarbanes. Yes.
    Mr. Spitzer. Senator, if I could take a shot at that, it is 
obviously a concern we all share, and I think we are all loathe 
to believe that there is some notion of a ``too big to fail'' 
protection that would extend to some of these entities and, 
therefore, almost an immunity that permits them to pay a fine, 
move on, and, as you say, build this into their cost of doing 
business.
    In my conversations with a certain number of the senior 
executives at these firms over the last few months, I have made 
it really quite clear to them that where there is recidivism, 
we will deal with them the way that we deal with recidivists, 
whether it is a robbery or any other street crime, and that is 
that there will be no second chance.
    I do not want to speak for anybody else. I am viewing this 
case as one where the penalties should be presumed to be 
significantly larger, sterner, perhaps even more draconian, 
than they were last year when we dealt with the research issue.
    To a certain extent, the rationale for that is that last 
year we did at the end of the day in our global settlement 
change the rules by which the investment houses were operating. 
This year, the violations we are seeing relate to rules that 
were reasonably clear, understood, and we have nothing more 
than new theories of larceny that are being played out by the 
malefactors.
    As a consequence, I think it is fair to presume that there 
will be criminal cases brought against institutions, and that 
may be the death penalty for those institutions. But, in my 
view, that is the only option which we are now left with.
    Senator Sarbanes. Mr. Glauber.
    Mr. Glauber. As I am sure you know, in the case generally 
of smaller firms, we have actually used our sanction of putting 
them out of the industry.
    In the case of larger firms, where I think sanction would 
be inappropriate, we are giving very serious consideration to 
requiring that they cease operation in certain lines of 
business for a fixed period of time, basically putting them in 
the penalty box, if you will, for that line of business for a 
period of time, which I think would be a very serious sanction, 
very serious economic sanctions, and in some cases appropriate.
    Senator Sarbanes. But is the culture within those firms 
such that the people who have been engaged in those practices 
have kind of an attitude, well, it is too bad you got caught, 
you were making a lot of money for us, and we know that, and we 
have to now adjust somehow to take this into account? Are they 
developing the kind of DNA that Donaldson talked about in terms 
of high standards?
    We had a witness here, the former head of Johnson and 
Johnson. This was when we were doing the corporate governance 
issues. And he was very good because he said they had a 
corporate culture that really came down very hard, it just did 
not tolerate the transgressions. You have a sense here that 
there is a tolerance for these transgressions, and people say, 
well, it is too bad and everything, but that is that. What is 
your sense of the corporate culture?
    Mr. Glauber. I think the best answer I can give you, 
Senator Sarbanes, is that cultures differ a great deal from one 
firm to another, and the DNA differs, as you have said. In some 
firms, I think sanctions of this sort really do change behavior 
and change it dramatically. In other cases, it may not.
    Senator Sarbanes. Obviously, you need to think of 
developing the kind of sanctions that will effectively change 
behavior everywhere; otherwise, you are still down this 
slippery slope.
    Mr. Glauber. I think that is a perfectly fair point.
    Senator Sarbanes. Do you have any observations to make 
about this, Mr. Cutler?
    Mr. Cutler. I think, Senator Sarbanes, that you have put 
your finger on exactly the right question, which is: What is 
the corporate culture? And is the problem that you saw 2 or 3 
years ago and the problem that you are seeing today reflective 
of a systemic failure, of a problem at the top, of a corporate 
culture that is sick? Or as can sometimes be the case, is it 
two separate problems? I think it is incumbent upon us to weigh 
that, to figure it out, and to ensure that we sanction 
appropriately, including determining whether higher sanctions 
are appropriate if the conduct reflects a problem that is 
systemic.
    Senator Sarbanes. Just one more?
    Chairman Shelby. Go ahead, Senator.
    Senator Sarbanes. Speaking of the culture of an 
institution, let me ask you: What can you tell us about the 
coordination between the Office of Compliance Inspections and 
Examinations, the Office of Investment Management, and the 
Office of Enforcement? And, particularly, has the Division of 
Enforcement been getting all the assistance it needs from other 
divisions and offices within the SEC, for example, the Office 
of Investment Management? If not, what can be done to improve 
the coordination between and amongst these offices?
    Mr. Cutler. I tried to address that a little bit earlier. 
We are concerned about our ability to coordinate, and we are 
addressing that and have actively addressed it in recent 
months. We are now ensuring that all referrals that raise 
enforcement-related issues connected to the mutual fund area 
are reviewed by a team that consists of enforcement, investment 
management, and the inspection program.
    We otherwise have gotten together or begun to get together 
on a regular basis to determine whether there are common issues 
that we should be addressing. And as you heard from Chairman 
Donaldson earlier this week, I think he has a risk assessment 
initiative that is designed to ensure that there is more and 
better coordination among the various offices at the 
Commission.
    Senator Sarbanes. What is the perception, Mr. Glauber, in 
the industry of the extent of or lack of coordination within 
the SEC in order to address these issues?
    Mr. Glauber. I really am at a loss to give you a good 
answer to that. The SEC, like our organization, is a large 
organization divided into divisions. It is a challenge to 
coordinate them. We work hard, and I know the SEC works very 
hard to do it.
    Senator Sarbanes. All right.
    Thank you, Mr. Chairman.
    Chairman Shelby. Thank you.
    I want to pick up on some of what Senator Sarbanes talked 
about. You found out or had reason to believe that people who 
look at this misconduct and so forth as just doing business, 
you know, a cost of doing business. Maybe they had not learned. 
They just figured they are going to maybe learn some other way 
to do it. And, Attorney General Spitzer, you referenced street 
crimes. You are the Attorney General, and you know a lot about 
street crimes, robberies, strong-arm robbery, thieving from the 
people and so forth, stealing. But, gosh, this is one of the 
big heists of the country. There are billions of dollars 
involved--millions, if not billions. We do not know how much 
now. But we do know the treasury is great, $7 trillion 
involved, about 100 million Americans involved in the funds. So 
the street crimes of America, which are bad, but as far as 
stealing and robbery and petty thievery, gosh, they would be 
pikers when they are compared to what we could see here or we 
will find out here. Do you agree?
    Mr. Spitzer. Yes, sir, I agree entirely. If I could just 
add one clarification. You suggested that because I was from 
New York, therefore, I knew a lot about crime.
    Chairman Shelby. I think that you know a lot about crime as 
a prosecutor.
    Mr. Spitzer. I just wanted to clarify that. We actually 
have among the lower crime rates in the Nation. I will be 
parochial and add that.
    Chairman Shelby. That is because you have been vigorously 
prosecuting it.
    Mr. Spitzer. Absolutely, sir.
    Senator Sarbanes. We will be sure that Senator Schumer gets 
a copy of this portion of the transcript.
    [Laughter.]
    Chairman Shelby. We will.
    Mr. Spitzer. Thank you, Senator. But I agree with the 
premise behind your question. Comparatively, the dollars 
involved here are exponentially greater than the economic harm 
that results from the larcenies committed on the street level. 
And that is why I made the point that the 15 basis points at 
Putnam in terms of the advisory services translates itself into 
a $290 million cost.
    Chairman Shelby. You do not need a gun to steal from 
people, do you?
    Mr. Spitzer. Well, somebody made the observation, Senator, 
that the smartest way to steal is one penny at a time from many 
people so that nobody really objects to that small incremental 
fee. Yet by the time you aggregate all that money, it is a vast 
sum of money. And that, unfortunately, is what we have seen in 
the financial services sector, incremental fees that are 
layered upon each other. I think it goes back to Senator 
Sarbanes' comment. It is that very difficult interface between 
the 90 million investors whom we have asked to come into the 
marketplace and the very few, the very large institutions who 
look at these individual accounts and see them as very small-
margin returns and, therefore, keep saying: How can we get more 
and more out of that customer? That is where this drive for 
fees comes from.
    Chairman Shelby. You quantify that and you have a lot in 
the aggregate, haven't you?
    Mr. Spitzer. Absolutely, sir.
    Chairman Shelby. Mr. Cutler, have you considered--and I 
know this is not a complete deal; I hope it is just beginning--
referring certain investigations to the Department of Justice 
for criminal investigation and prosecution? And if you have 
not, will you under the right circumstances?
    Mr. Cutler. Yes. I should add that my colleague to the 
right, Mr. Spitzer, has criminal authority. We are working very 
closely with him.
    Chairman Shelby. But so does the Justice Department.
    Mr. Cutler. That is right, but there probably can only be 
so many criminal prosecutions of the same person at the same 
time.
    Chairman Shelby. I understand that.
    Mr. Cutler. Actually, the two of us together have been 
coordinating with U.S. Attorney's Offices to the extent that 
they would be involved, but already Mr. Spitzer has brought 
criminal cases where we have brought companion civil cases. And 
I suspect that that will continue.
    Chairman Shelby. I have a letter here from John Snow, 
Secretary of the Treasury, and Alan Greenspan, Chairman of the 
Board of the Federal Reserve, to me as Chairman of the Banking 
Committee outlining a number of their thoughts on this, 
including criminals who use mutual funds to steal from 
investors or otherwise engage, as I read the letter, in fraud, 
and these must be apprehended and punished promptly in order to 
preserve the integrity of these financial institutions and 
preserve the trust placed in them. I want to put this letter in 
the record and share it with you, if I can.
    Chairman Shelby. Mr. Glauber, Chairman Donaldson, on 
Tuesday of this week, here in this Committee, called upon the 
NASD to lead a study examining the use of omnibus accounts.
    Mr. Glauber. Indeed so.
    Chairman Shelby. Would you elaborate on the problems 
created by omnibus accounts and the end goal of the study.
    Mr. Glauber. Certainly. The request came in conjunction 
with the study of the abuses of market timing, and the problem 
is this. In order to fully comprehend the abuses, it is 
necessary for investigators to be able to follow the trades of 
an individual investor, whether that is a person or, for 
example, a hedge fund. Omnibus accounts are a mechanism that 
brokerage firms use primarily to save money to aggregate trades 
from many investors into one aggregate account.
    In that aggregation process, it makes it difficult to 
follow the trail of individual market-timing trades, and I 
think that is the reason the Chairman asked us to put together 
a task force to work on that, and we, of course, said we would, 
and we are in the process of doing that.
    Chairman Shelby. Thank you.
    Attorney General Spitzer, one criticism of the global 
settlement was that the terms of the settlement permitted the 
firms involved to seek insurance payments for all monies other 
than those payments designated as fines and penalties. Are you 
crafting settlements, and I guess I should ask Mr. Cutler this, 
are you crafting settlements that do not simply permit 
defendants to pass through their costs to insurance companies? 
In other words, they do not feel it if somebody else pays it, 
do they?
    Mr. Spitzer. You are absolutely correct. If somebody can 
simply pass it through to an insurance carrier, then the fine/
penalty is less painful--perhaps not painful at all.
    Yes, we are very mindful of that as we move forward, and I 
would agree there were moments, as we look back on the global 
view of last year, that we wish we had been more refined in our 
language to prevent accessing insurance coverage to cover any 
of those costs. Frankly, it had been our view that under New 
York law that would not have been permitted.
    We have learned perhaps otherwise these issues are still 
being litigated by the insurance company and the claimants, but 
certainly we are very mindful of that as we move forward, and 
we will endeavor to ensure that insurance does not cover the 
fines and penalties that are imposed.
    Chairman Shelby. Mr. Cutler.
    Mr. Cutler. Yes, I would echo Mr. Spitzer's comments. We 
certainly want to make sure that penalties are felt and that 
the sting of penalties is felt, and along those lines, 
penalties and fines should not be insurable.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    Mr. Glauber, I want to put this question to you, but I want 
to quote the Enforcement Director Cutler first. In testimony 
here in the Senate, before the Subcommittee over in the 
Government Operations Committee, at the beginning of the month, 
he said: ``More than 25 percent--'' that was of firms 
responding to an SEC mutual fund inquiry report ``--said that 
customers have received 4 p.m. prices for orders placed or 
confirmed after 4 p.m. Fifty percent of responding fund groups 
appear to have had at least one arrangement allowing for market 
timing by an investor. Documents provided by almost 30 percent 
of responding brokerage firms indicate that they may have 
assisted market timers in some way such as by breaking up large 
orders or setting up special accounts to conceal their own or 
their clients' identities, a practice sometimes called 
`cloning' to avoid detection by mutual funds that sought to 
prevent abuse of market timing.''
    ``Almost 70 percent--70 percent--of responding brokerage 
firms reported being aware of timing activities by their 
customers.''
    Yet everyone, when they get asked about this, and we are 
not immune from it, I mean, we were constantly being told that 
everything was okay in the mutual fund industry; in fact, that 
it was unique to the--this arrived just in time. In a statement 
before the House Financial Services Committee, the Chairman of 
the ICI, Paul Haaga--this was in March of this year--said:
    ``The strict regulation that implements these objectives 
has allowed the industry to garner and maintain the confidence 
of investors and has also kept the industry free of the types 
of problems that have surfaced in other businesses in the 
recent past.''
    ``An examination of several of the regulatory measures that 
have been adopted are under consideration to address problems 
that led to the massive corporate and accounting scandals of 
the past few years, provides a strong endorsement for the 
system under which mutual funds already operate.''
    Now there is an element of Claude Raines in ``Casablanca'' 
about all of this, that he is shocked to learn that gambling is 
taking place in the back room of Rick's casino. How do we 
explain this?
    Some have said to us that it was an open secret that a lot 
of these practices were taking place. The trade group, the ICI, 
says, well, we did not know about it. In fact, they said they 
were, I think they actually used the word ``shocked'' to 
discover all of this, and now all of a sudden we are all 
operating on this premise--we were being told that everything 
was working very well, and now we are getting these incredible 
percentages here. There are not a few outriders engaging in 
this. It is very prevalent. How was all of this missed or what 
was happening?
    Mr. Glauber. Well, first, as regards the issue of market 
timing and late trading, we have been cooperating with the SEC 
in doing investigations of member firms. We have had, in fact, 
a larger number, although they tend to be smaller member firms, 
and thus far we have referred 30 cases, from the 160 firms we 
have been looking at, to our Enforcement Division, dealing with 
just these issues.
    How were they not seen? The fact is that market timing, the 
potential for market timing has been known for a long period of 
time. Indeed, the fund industry sought and put in place the so-
called fair value pricing mechanisms a number of years ago, in 
principle, to deal with this. What was not understood is that 
in a number of cases, with favored customers, they were looking 
the other way.
    And even perhaps more appalling, in cases inside the mutual 
funds themselves, portfolio managers were doing market timing 
and front-running their own customers or feeding, as the 
Chairman said in his introductory remarks, nonpublic 
information to favored customers.
    The issue of market timing has been around for a long time, 
but the level of abuses, I think you are quite correct were 
just never evident in the way they are now becoming so.
    Senator Sarbanes. Mr. Cutler or Mr. Spitzer, do either of 
you have any theories?
    Mr. Spitzer. Senator, if I could voice one general 
observation and one particular factual point. The general 
observation is that, over the last 2 years--I hate to say 
this--but my skepticism about the capacity of the SRO's to 
provide meaningful regulation has merely grown day-by-day as 
the magnitude and dramatic impact on investors of the abuses 
that ran rampant through the financial services industry have 
fallen out into the public's eye to observe.
    I share the same concerns that you just articulated--given 
the rampant abuse that we have seen, the percentage numbers 
that are just staggering on the part of fund companies, how 
could it possibly not have been observed either in the regular 
examinations or elsewhere.
    I would add one other data point, and this is a factual 
observation, there were, until quite recently, a very 
significant number of hedge funds--very significantly 
capitalized hedge funds--that very openly stated that their 
strategy was one of market timing, mutual fund timing. There is 
nothing wrong, of course, for the hedge fund to participate in 
timing if it can get away with it. That observation, observing 
the number of prospectuses and offering documents----
    Senator Sarbanes. Well, there is nothing illegal about them 
doing that.
    Mr. Spitzer. For the hedge fund.
    Senator Sarbanes. Yes.
    Mr. Spitzer. The illegality in the----
    Senator Sarbanes. It may be wrong in terms of the impact it 
is having on the workings of the market and the ordinary 
investor.
    Mr. Spitzer. Precisely. But for the hedge fund, there is 
nothing illegal about their trying to time the accounts. It is 
the burden that falls on the mutual fund because of its 
fiduciary duty to its shareholder. But anybody seeing the 
number of hedge funds whose prospectuses said we are going to 
be market timers, and the capital that was allocated to these 
hedge funds should have said, ``Where is that money going? It 
is landing somewhere.''
    Senator Sarbanes. I know that we are drawing to a close, 
Mr. Chairman.
    Chairman Shelby. That is okay. Go ahead.
    Senator Sarbanes. I want to just put a couple of quotes to 
you and get your reaction. One is Jack Bogle, the Vanguard 
founder, on November 14, in an op-ed piece in The Wall Street 
Journal said: There is a pervasive conflict between the 
interests of fund managers and fund shareholders that permeate 
the mutual fund industry and that the industry's bizarre 
structure has resulted in a total level of fund costs to 
investors that destroys any chance that the industry can 
provide to its fund shareholders their fair share of financial 
market returns.''
    Then because everyone now is focused on this, and we are 
getting lots of I think rather interesting observations, 
Business Week, in the November 17 issue, in an article 
entitled, ``Funds Need a Radical New Design,'' said: ``To 
retool fund governance to fit the reality of what the industry 
has become, Congress should scrap the fiction that each fund is 
a separate company. Instead, funds should be folded into the 
management company and funds and advisers should be under the 
authority of one board. That would give directors authority 
over managers, with the information, muscle, and responsibility 
to watch out for investors' interests.''
    I am interested in your reactions to these two comments. 
Mr. Glauber, why don't I start with you.
    Mr. Glauber. I should start by saying, as you know, NASD's 
jurisdiction does not extend to the structure of funds, of 
mutual funds or the relationship with their management 
companies. Having said that, I think, at a minimum, there needs 
to be a strengthening of the governance structure as it now 
exists. And Chairman Donaldson, before this Committee earlier 
this week, proposed an increase in the number of independent 
directors and the proposal that the chairman be independent, 
and I think those are both very sensible proposals.
    The Business Week notion is a very radically different 
approach to the whole governance structure of mutual funds, 
very different from the 1940 Act. And it is one thing I think 
that Congress should consider. It is quite a radical change, 
and I think should be considered as one of a range of possible 
alternatives.
    The first place I would look is where Chairman Donaldson 
talked about strengthening the structure that we have in place 
now.
    Senator Sarbanes. Mr. Cutler, do you want to add anything?
    Mr. Cutler. Sure. I guess I would say, first, that I do 
agree that conflict is endemic whenever you have someone 
managing someone else's money and getting paid for it. There is 
always going to be a conflict between the adviser and the 
advisee under those circumstances, and the question is how do 
you appropriately manage that conflict?
    This is really not my bailiwick, the policy on where we go 
from here, but I guess one thing I would caution is that the 
conflict will not disappear just because you take the funds and 
the fund management company and collapse them. We will still 
have to be worried about that conflict, and it will still have 
to be managed, even if we do change the structure. I know that 
nothing is off the table, as far as Chairman Donaldson is 
concerned, but he has put forward, I think, some very, very 
powerful proposals on how we can do better in the area of 
managing those conflicts.
    Senator Sarbanes. Mr. Spitzer.
    Mr. Spitzer. Yes, sir. The comment from Mr. Bogle is 
reminiscent of the comment that Paul Samuelson made several 
decades ago, when he looked at the 1940 Act structure and said, 
``The only place to invest, to make money in the mutual fund 
business was in the management companies,'' and he, from day 
one, said that is where they are going to be doing awfully 
well. Forget investing in the underlying shares--buy a 
management company. So, I think, for decades, people have 
observed this tension, and I think Jack Bogle is correct there, 
as he is in most cases.
    In terms of the Business Week notion, I think it is 
certainly something that should be thought through. I have said 
to a number of your colleagues, sir, that I do not pretend 
right now, as we sit here, to have the answer or anything more 
than a few ideas that are based upon the investigations we have 
done, but certainly, based upon what we have seen, this 
fiction, as Business Week called it, that there needs to be a 
division between the board and the management company is a 
fiction that does appear to be increasingly useless and raise 
the possibility that collapsing the two would be a sensible 
move as we restructure governance.
    Senator Sarbanes. Mr. Chairman, I know that you are drawing 
the hearing to a close. I just want to thank our panel, and I 
just want to say that, gentlemen, each of you is on the front 
line, as far as this is concerned. If the American investor 
were to ask us, ``Who are our champions? Who is there to be our 
gatekeepers and try to protect us in the current situation,'' 
it would be the people at the table.
    So, we encourage you on in your efforts. We appreciate what 
you are doing. I know there is a great deal of pressure and 
stress, and I know these offices are working to capacity or 
beyond capacity in terms of the demands they are making on 
their staff, but we appreciate what you are doing, and we 
encourage you to keep at it. That is the parting word I want to 
leave with you.
    Thank you.
    Chairman Shelby. I want to associate myself with Senator 
Sarbanes' remarks. You are on the front line, all three of you, 
and the American investor is looking for relief. They are 
looking for honest markets, and we are greatly challenged. And 
if we are greatly challenged, you are greatly challenged, but I 
think you are up to the challenge if we back you, and we will.
    Senator Sarbanes and I are committed to more hearings to 
find out what is the answer to this, from a regulatory 
standpoint, or perhaps a legislative standpoint. We do not want 
to rush to judgment in the waning days of a Congressional 
session. We might have you back, as we have had Chairman 
Donaldson.
    We thank you for your appearance, and we thank you for what 
you share with us.
    Thank you.
    [Whereupon, at 3:59 p.m., the hearing was adjourned.]
    [Prepared statements and additional material supplied for 
the record follow:]

                PREPARED STATEMENT OF STEPHEN M. CUTLER
                   Director, Division of Enforcement
                U.S. Securities and Exchange Commission
                           November 20, 2003

Introduction
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, thank you very much for inviting me to testify today on 
behalf of the Securities and Exchange Commission concerning alleged 
abuses relating to the sale of mutual funds. With more than 95 million 
Americans invested in mutual funds, representing approximately 54 
million U.S. households, and a combined $7 trillion in assets,
mutual funds are a vital part of this Nation's economy and millions of 
investors' financial security. For that reason, I share the outrage and 
disappointment of the Commission, Chairman Donaldson, the investing 
public, and so many others, at the misconduct that recently has come to 
light. It is intolerable when investment professionals--who have a duty 
to serve the best interests of their customers--instead put their own 
interests first. That way of thinking is antithetical to the 
responsibilities investment advisers, broker-dealers, and their 
employees owe to mutual fund investors. Mutual fund investors have a 
right to expect fair treatment, and when they do not receive it, we at 
the Commission will demand it on their behalf.
    Accordingly, the Commission has undertaken an aggressive agenda to 
identify and address problems in the mutual fund industry. That agenda 
has both an enforcement component, which I will discuss, and a 
regulatory component, which Chairman Donaldson discussed in his 
testimony before this Committee 2 days ago.
    The enforcement piece of the Commission's agenda relating to mutual 
funds currently is focused primarily on four types of misconduct, each 
of which may result in the interests of financial services firms or 
their employees being placed above the interests of investors. I will 
touch on each briefly, and then turn to the Commission's response to 
the recent revelations of serious misconduct relating to the trading of 
mutual funds.
    The first area of priority, which I will discuss in detail in a 
moment, is late trading and timing of mutual fund shares.
    Our second area of priority focuses on fee disclosure issues in 
connection with the sale of mutual funds. In particular, we are looking 
at what prospective mutual fund investors are--or are not--being told 
about revenue sharing arrangements and other incentives doled out by 
mutual fund companies to brokers selling their funds. Do customers 
understand that their broker is being paid to sell a particular fund? 
And when these payments are being made from fund assets, do customers 
understand that their own investment dollars are being used to foot the 
bill for the 
mutual funds' premium ``shelf space'' at the selling broker's office? 
Such fees may increase costs to investors, as well as create conflicts 
of interest between investors and the financial professionals with whom 
they deal.
    The Commission brought its first case in this area earlier this 
week. In that action, against Morgan Stanley DW (Morgan Stanley), the 
Commission found that the firm had not adequately disclosed that 
certain mutual funds Morgan Stanley offered to its customers were part 
of something it called the ``Partners Program.'' Under the Partners 
Program, a select group of mutual fund families paid Morgan Stanley 
substantial fees for preferred marketing of their funds. To incentivize 
its sales force to deliver the preferred marketing Morgan Stanley 
promised its partners, Morgan Stanley paid increased compensation to 
individual registered representatives and branch managers on sales of 
those funds' shares. But when Morgan Stanley's customers purchased the 
preferred mutual funds, they were not told about the Partners Program, 
and were therefore not in a position to understand the nature and 
extent of the conflicts of interest that may have affected their 
transactions. The Commission found Morgan Stanley also made inadequate 
disclosures in a second area, which I will discuss in a moment.
    Morgan Stanley agreed to settle this action by paying $25 million 
in disgorgement and prejudgment interest, and civil penalties totaling 
$25 million. All $50 million will be placed in a Fair Fund under the 
Sarbanes-Oxley Act and will be returned to investors. In addition, 
Morgan Stanley has undertaken to, among other things, place on its 
website disclosures regarding the Partners Program and provide 
customers with a disclosure document that will disclose specific 
information concerning the Partners Program.
    The abuses that are addressed in this case are significant and are 
not necessarily limited to Morgan Stanley. So-called shelf space 
payments have become popular with brokerage firms and the funds they 
are selling. Thus, the Commission is conducting an examination sweep of 
some 15 different broker-dealers to determine exactly what payments are 
being made by funds, the form of those payments, the ``shelf space'' 
benefits that broker-dealers provide, and most importantly, just what 
these firms tell their investors about these practices.
    The potential disclosure failures and breaches of trust spotlighted 
in the Morgan Stanley case are not limited to broker-dealers. We are 
also looking very closely at the role of mutual fund companies 
themselves. In that regard, I want to return to and finish with a point 
that I alluded to earlier. The aspect of the Morgan Stanley case that I 
find perhaps most troubling is this: Morgan Stanley said to the fund 
families that are part of the Partners Program: ``You can pay us in one 
of two ways--either the fund management company can pay us in cash; or 
the mutual funds you manage can defray the fund management company's 
obligation by giving us a multiple of that amount in the form of extra 
commission business on fund portfolio transactions.'' Faced with that 
choice, some fund companies--rather than reaching into their own pocket 
to pay what they owed--reached into the pockets of their mutual fund 
shareholders and paid in commission dollars instead. You can be certain 
that we are pursuing that issue, among others, as our investigation 
continues, and our exam sweep goes forward.
    Our third area of priority in the mutual fund arena is the sale of 
different classes of mutual fund shares. Many mutual funds offer 
multiple classes of shares in a single portfolio. For each class of 
shares, a mutual fund uses a different method to collect sales charges 
from investors. Class A fund shares are subject to an initial sales 
charge (front-end load); discounts on front-end loads are available for 
large purchases of Class A shares. Since the sales fee is paid up 
front, Class A shares incur lower (or no) ``Rule 12b -1 fees,'' fees 
the mutual fund pays for distribution costs, including payments to the 
broker-dealers and their registered representatives selling fund 
shares.
    Class B shares, by contrast, are not subject to an up-front sales 
charge. Instead, they become subject to a sales charge (a ``contingent 
deferred sales charge'' or ``CDSC'') only if they are redeemed before 
the end of a specified holding period. Because Class B share investors 
do not pay an up-front sales fee, the funds pay higher Rule 12b -1 fees 
on Class B shares to defray the associated distribution expenses. As a 
result, brokers typically earn larger payments on Class B shares than 
on Class A shares. In addition, long-term mutual fund shareholders may 
pay higher sales charges if they hold B shares rather than A shares, 
particularly when discounts, as discussed below, are available on the A 
shares.
    The Commission has brought three enforcement actions involving the 
sales of Class B shares to investors who were not made aware by their 
registered representatives that they could purchase Class A shares of 
the same mutual fund at a discount (sometimes called a ``breakpoint'' 
discount). Indeed, in this week's Morgan Stanley case, the Commission 
found that Morgan Stanley's disclosures to customers concerning B 
shares were inadequate. To address this violation, the relief we 
obtained in this case includes an agreement by Morgan Stanley to 
convert to Class A shares and otherwise make whole those customers who 
would have been entitled to a breakpoint discount had they purchased A 
shares in the first place. In addition, Morgan Stanley has agreed to 
retain an independent consultant to conduct a review of, and to provide 
recommendations concerning, its disclosures, policies, and procedures 
and its plan to offer to convert Class B shares to A shares. The firm 
is 
required to adopt the recommendations of the independent consultant.
    Earlier this year, the Commission brought an action against 
Prudential Securities for abuses in this area as well. In that case, 
filed in July, the Commission found that Prudential's supervisory 
system for overseeing practices in this area were inadequate. 
Prudential had in place policies and procedures requiring registered 
representatives to advise their clients of the availability of 
different classes of mutual funds and fully explain the terms of each. 
Prudential branch managers were also expected to approve all purchases 
greater than $100,000 and confirm the suitability of the choice of fund 
class. The Commission found, however, that Prudential failed to adopt a 
sufficient supervisory system to enable those above the branch manager 
to determine whether these policies and procedures were being followed. 
Under Prudential's system, branch office managers were solely 
responsible for ensuring that registered representatives followed the 
firm's mutual fund policies and procedures. As a result, when the 
registered representatives' branch manager failed to abide by and 
enforce Prudential's policies and procedures, the firm had no way of 
detecting the lapse. In resolving the Commission's action, Prudential 
was censured and agreed to pay disgorgement and a civil penalty. The 
Commission's action against the registered representative and branch 
manager, which charges them with fraud, is pending.
    The fourth priority area is to address the failure of firms to give 
their customers the discounts available on front-end loads for large 
purchases of Class A shares. Earlier this year, examiners at the SEC, 
NASD, and NYSE completed an examination sweep and outlined the results 
in a report, ``Joint SEC/NASD/NYSE Report of Examinations of Broker-
Dealers Regarding Discounts on Front-End Sales Charges on Mutual 
Funds.'' \1\ Together with the NASD, we have under active investigation 
instances in which it appears that investors were entitled to receive 
breakpoint discounts based on the size of their purchase of Class A 
shares, but where the firms failed to provide discounts.
---------------------------------------------------------------------------
    \1\ The report is available at: http://www.sec.gov/news/studies/
breakpointrep.htm.
---------------------------------------------------------------------------
    Before I turn to abuses that have more recently come to light, I 
will mention two types of misconduct, harmful to mutual fund investors, 
where the Commission has both an active and aggressive track record and 
a roster of current investigations. The first is the area of fund 
disclosures concerning the effect of hot IPO shares on fund 
performance; the second is pricing and valuation practices of mutual 
funds.
    The Commission has brought three actions in the last several years 
charging registered investment advisers with failing to disclose the 
substantial positive effect that holding or trading hot IPO shares had 
on their funds' performance, and, critically, the risk that such 
exceptional performance could not be sustained. In one case, the 
investment adviser also did not disclose that a portfolio manager, who 
managed multiple mutual funds, allocated securities purchased in 
initial public offerings-- especially ``hot'' IPO's--in a manner that 
had the overall effect of favoring one fund over three others he 
managed. The adviser did not disclose this practice, notwithstanding 
the fund's prospectus disclosure that investment opportunities would be 
allocated equitably among the fund complex's funds.
    These cases are an unfortunate part of an all-too-common theme--
mutual funds and their advisers often are reluctant or unwilling to 
disclose to investors important performance-related information to 
which they are not only entitled, but which they must have in order to 
make fair and reasoned investment decisions. With respect to valuation, 
the problem more typically is a failure on the part of funds and their 
advisers to adhere to the policies and procedures that they have 
disclosed. We are actively looking at two situations in which funds 
dramatically wrote down their Net Asset Values in a manner that raises 
serious questions about the funds' pricing methodologies.
    This brief overview of the Commission's enforcement agenda with 
respect to mutual funds is intended to give you a sense of the scope of 
our activities. I recognize, however, that today's hearing was prompted 
by recent revelations involving late trading and timing of mutual 
funds. Accordingly, I will now turn to that subject.
SEC Response to Misconduct Relating to Mutual Funds
    As you well know, the conduct of mutual funds and the financial 
intermediaries with and through which they do business, recently came 
to the public's attention when New York Attorney General Eliot Spitzer 
announced an action involving 
abusive mutual fund trading practices by a hedge fund, Canary Capital 
Partners, LLC. The Canary action identified two problematic practices--
late trading of mutual funds and timing of mutual funds. Late trading 
refers to the practice of placing 
orders to buy or sell mutual fund shares after the time at which the 
funds calculate their net asset value (NAV) -- typically 4 p.m. Eastern 
Time (ET) -- but receiving 
the price based upon the prior NAV already determined as of 4 p.m. Late 
trading 
violates a provision of the Federal securities laws that dictates the 
price at which mutual fund shares must be bought or sold and defrauds 
innocent investors in those mutual funds by giving to the late trader 
an advantage not available to any other investors.
    ``Timing'' abuses refer to excessive short-term trading in mutual 
funds in order to exploit inefficiencies in mutual fund pricing. 
Although market timing itself is not illegal, mutual fund advisers have 
an obligation to ensure that mutual fund shareholders are treated 
fairly, and they should not favor one group of shareholders (i.e., 
market timers) over another group of shareholders (i.e., long-term 
investors). In addition, when a fund states in its prospectus that it 
will act to curb market timing, it must meet that obligation.
    Abusive market timing can dilute the value of mutual fund shares to 
the extent that a trader may buy and sell shares rapidly and repeatedly 
to take advantage of inefficiencies in the way mutual funds prices are 
determined. Dilution could occur if fund shares are overpriced and 
redeeming shareholders receive proceeds based on the overvalued shares. 
In addition, short-term trading can raise transaction costs for the 
fund, it can disrupt the fund's stated portfolio management strategy, 
require a fund to maintain an elevated cash position, and result in 
lost opportunity costs and forced liquidations. Short-term trading can 
also result in unwanted taxable capital gains for fund shareholders and 
reduce the fund's long-term performance. In short, while individual 
shareholders may profit from engaging in short-term trading of mutual 
fund shares, the costs associated with such trading are borne by all 
fund shareholders.
    Following the announcement of the Canary Capital case, the 
Commission put in motion an action plan to vigorously investigate the 
matter, assess the scope of the problem, and hold any wrongdoers 
accountable. Specifically, the Commission is proceeding on three 
fronts, utilizing its enforcement authority, its examination authority, 
and its regulatory authority. I will address the first two areas of the 
Commission's efforts.
Recent Enforcement Efforts Relating to Mutual Fund Trading
    In the enforcement area, we are working aggressively to pursue 
wrongdoing, and are doing so in coordination with State regulators. 
Thus far, the Commission has brought actions against persons associated 
with three different types of entities--broker-dealers, hedge funds, 
and mutual funds--each of which can play a role in harming long-term 
mutual fund investors. Our actions to date address allegations of both 
late trading and market timing. I will briefly summarize those actions.
    On September 16, the Commission filed a civil action against 
Theodore Sihpol, a salesperson at Bank of America Securities (BOA), who was Canary Capital's primary contact at Bank of America. Specifically, the 
Commission issued an administrative order instituting proceedings in 
which the Division of Enforcement (the Division) alleges that Sihpol played a key role in enabling certain hedge fund customers of BOA to engage in late trading in shares of mutual funds offered by Bank of America, including the Nations Funds family of funds and other mutual funds. Based on the conduct alleged in the Commission's Order, the Division alleges that Sihpol violated, and aided and abetted and caused violations of, the antifraud, mutual fund 
pricing and broker-dealer record-keeping provisions of the Federal 
securities laws. In its action, the Division is seeking civil 
penalties, disgorgement, and other relief, which may include 
permanently barring Sihpol from the securities industry.\2\ 
Simultaneous with the issuance of the Commission's order, Sihpol 
surrendered in connection with Attorney General Spitzer's filing of a 
two-count complaint charging him with larceny and securities fraud.
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    \2\ In connection with the SEC's order, a hearing will be scheduled 
before an administrative law judge to determine whether the allegations 
contained in the order are true and to provide Sihpol an opportunity to 
respond to them.
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    Less than 3 weeks later, the Commission and the New York Attorney 
General announced criminal and civil actions against Steven B. 
Markovitz, formerly an executive and senior trader with the prominent 
hedge fund firm Millennium Partners, LP. In the New York Attorney 
General's criminal action, Markovitz pleaded guilty in State Supreme 
Court to a violation of New York's Martin Act. The SEC's administrative 
order finds that Markovitz committed securities fraud. In partial 
settlement of the SEC's action, without admitting or denying the SEC's 
findings, Markovitz consented to cease and desist from violations of 
certain provisions of the Federal securities laws, and to be 
permanently barred from associating with an investment adviser or from 
working in any capacity with or for a registered investment company. 
The SEC also is seeking disgorgement and civil penalties in amounts to 
be determined later.
    According to the criminal charges and the SEC findings, Markovitz 
engaged in late trading of mutual fund shares on behalf of Millennium, 
one of the Nation's largest hedge fund operators, with more than $4 
billion under management. With the assistance of certain registered 
broker-dealers, Markovitz placed mutual fund orders after 4 p.m. ET, 
but obtained the prices that had been set as of 4 p.m. ET. By SEC rule, 
Markovitz's post-4 p.m. orders should have received the prices set on 
the following day. This illegal trading allowed Millenium to take 
advantage of events that occurred after the markets closed.
    In its first action against a mutual fund executive for permitting 
market timing, on October 16, the Commission and the New York Attorney 
General announced the arrest, conviction, and lifetime industry bar of 
James P. Connelly, Jr., former Vice Chairman and Chief Mutual Fund 
Officer of Fred Alger & Company, Inc., a prominent mutual fund firm. 
Connelly pled guilty to the crime of Tampering with Physical Evidence. 
The criminal charges against Connelly stem from his repeated efforts to 
tamper with an ongoing investigation of illegal trading practices in 
the mutual fund industry, including by directing subordinates to delete 
emails called for by 
subpoenas.
    In its administrative order, the SEC found that Connelly approved 
agreements that permitted select investors to ``time'' certain mutual 
funds managed by Alger, a practice that violates an adviser's fiduciary 
duties and adversely affects the value of the fund being timed. In this 
case, the timing arrangements were also inconsistent with Alger's 
public disclosures in prospectuses and Statements of Additional 
Information filed with the SEC. According to the Commission's order, 
Connelly was involved in timing arrangements at Alger from the mid-
1990's until 2003. By early 2003, Connelly was requiring that investors 
seeking timing capacity agree to maintain at least 20 percent of their 
investment at Alger in buy-and-hold positions, sometimes referred to as 
``sticky assets.''
    Connelly has been ordered to cease and desist from future 
violations of various provisions of the Federal securities laws; has 
been barred from association with any broker, dealer, or investment 
adviser; has been barred from serving in various capacities with 
respect to any registered investment company; and is subject to a 
$400,000 civil penalty.
    On October 28, the Commission brought actions against Putnam 
Investment Management LLC (Putnam) and two former Putnam Managing 
Directors and portfolio managers, Justin M. Scott and Omid Kamshad, in 
connection with the personal trading by those Managing Directors in 
Putnam mutual funds. The Commission filed a civil injunctive action 
against Justin M. Scott and Omid Kamshad charging each of them with 
securities fraud. The complaint alleges that Scott and Kamshad, for 
their own personal accounts, engaged in excessive short-term trading of 
Putnam mutual funds for which they were portfolio managers. According 
to the complaint, Scott and Kamshad's investment decisionmaking 
responsibility for those funds 
afforded them access to nonpublic information about the funds, 
including current portfolio holdings, valuations, and transactions. The 
complaint further alleges that Scott and Kamshad's short-term trading 
violated their responsibilities to other fund shareholders, that Scott 
and Kamshad failed to disclose their trading and that, by their 
trading, they potentially harmed other fund shareholders. In this 
action, the Commission is seeking injunctive relief, disgorgement, 
penalties, and such equitable relief as the court deems appropriate.
    The Commission also issued an administrative order instituting 
proceedings against Putnam. Subsequently, on November 13, the 
Commission issued another order against Putnam reflecting a partial 
settlement with the firm. In connection with that agreement, Putnam 
committed to undertake significant and far-reaching reforms relating to 
excessive short-term and market timing trading by its employees. Putnam 
also agreed to a process for calculating and paying restitution to 
investors. The amount of civil penalty and other monetary relief to be 
paid by Putnam remains open and will be determined at a later date.
    In its Order against Putnam, the Commission found that Putnam 
committed securities fraud by failing to disclose potentially self-
dealing securities trading by several of its employees. The Commission 
also found that Putnam failed to take adequate steps to detect and 
deter such trading activity through its own internal controls and its 
supervision of investment management professionals. Putnam has agreed 
to admit these findings for purposes of the penalty phase of the 
administrative proceeding, which has not yet taken place.
    The reforms that Putnam agreed to implement, pursuant to the 
Commission's Order, are all designed to prevent the violations found by 
the Commission. They can be broken down into three important areas: (1) 
restrictions on employee trading; (2) enhancements of compliance 
policies, procedures, and staffing, including relating to employee 
trading; and (3) corporate governance, including fund board 
independence.
    Among the reforms Putnam will implement relating specifically to 
employee trading is a requirement that employees who invest in Putnam 
funds hold those investments for at least 90 days, and in some cases, 
as long as 1 year.
    In the compliance area, Putnam will:

 Require Putnam's Chief Compliance Officer to report to the 
    fund boards' independent trustees all breaches of fiduciary duty 
    and violations of the Federal securities laws.
 Maintain a Code of Ethics Oversight Committee to review 
    violations of the Code of Ethics and report breaches to the fund 
    boards of trustees.
 Create an Internal Compliance Controls Committee to review 
    compliance controls and report to the fund boards of trustees on 
    compliance matters.
 Retain an Independent Compliance Consultant to review Putnam's 
    policies and procedures designed to prevent and to detect breaches 
    of fiduciary duty, breaches 
    of the Code of Ethics, and Federal securities law violations by 
    Putnam and its 
    employees.
 At least once every 2 years, Putnam will have an independent, 
    third-party conduct a review of the firm's supervisory, compliance 
    and other policies and procedures in connection with the firm's 
    duties and activities on behalf of and related to the Putnam funds.

    In the area of corporate governance, Putnam agreed:

 That the fund boards of trustees will have an independent 
    chairman.
 That the fund boards of trustees will consist of at least 75 
    percent independent members.
 That no board action may be taken without approval by a 
    majority of the independent directors; and that Putnam will make 
    annual disclosure to fund shareholders of any action approved by a 
    majority of the fund board's independent trustees, but not approved 
    by the full board.
 That the fund boards of trustees will hold elections at least 
    once every 5 years, starting in 2004.
 That the fund boards of trustees will have their own, 
    independent staff member who will report to and assist the fund 
    boards in monitoring Putnam's compliance with the Federal 
    securities laws, its fiduciary duties to shareholders, and its Code 
    of Ethics.

    In sum, the reforms Putnam will undertake as part of the 
Commission's order are intended to provide real, substantial, and 
immediate protections for mutual fund 
investors. The required enhancements to the board oversight and 
compliance 
functions at Putnam should strengthen all aspects of Putnam's fund 
operations and provide investors with uncompromised representation by 
their fiduciaries in the boardroom and at the management company. In 
addition, the Division of Enforcement fully intends to seek substantial 
penalties and/or other monetary payments from Putnam, over and above 
the restitution Putnam already is bound by the Commission's order to 
make. And, of course, the Commission's investigation of Putnam and its 
employees is active and ongoing. If additional misconduct comes to 
light, the Commission will bring additional enforcement actions.
    On November 4, in conjunction with the Secretary of the 
Commonwealth of Massachusetts, the Commission announced still another 
enforcement action, this one against five Prudential Securities brokers 
and their branch manager. The Commission alleged in a civil action that 
the defendants defrauded mutual funds by misrepresenting or concealing 
their own identities or the identities of their customers so as to 
avoid detection by the funds' market timing police. This allowed them 
to enter thousands of market timing transactions after the funds had 
restricted or blocked the defendants or their customers from further 
trading in their funds. The Commission is seeking injunctive relief, 
disgorgement, penalties, and such equitable relief as the court deems 
appropriate.
The Commission's Use of Examination Authority
    As I noted, the Commission's response to the revelations of 
misconduct in the mutual fund area is multipronged. The second area of 
authority that we are utilizing aggressively is the Commission's 
examination authority, which entitles us to obtain promptly information 
and records from regulated entities. Accordingly, immediately following 
the Canary announcement, relying on the Commission's examination 
powers, the Commission's staff sent detailed requests for information 
and documents to 88 of the largest mutual fund complexes in the country 
and 34 broker-dealers, including prime brokerage firms and other large 
broker-dealers. These written requests sought information on each 
entity's policies and practices relating to market timing and late 
trading. In the case of mutual funds and broker-dealers, we have 
obtained information regarding their pricing of mutual fund orders and 
adherence to their stated policies regarding market timing. We also 
have sought information from mutual funds susceptible to market timing 
regarding their use of fair value pricing procedures to combat this 
type of activity.
    The examination staff is still analyzing the information received 
as a result of these requests, and in many cases has sought additional 
details. Nevertheless, some firms' responses have warranted aggressive 
follow-up, and thus, the Commission 
examiners have been dispatched to conduct onsite inspections and 
interviews at 
a number of firms. Responses from some other firms have already led to 
referrals 
to the enforcement staff for further investigation. All told, SEC staff 
across the country are looking at the activities and practices of 
dozens of mutual fund and broker-dealer firms.
    As I noted earlier, the Commission's examination and enforcement 
staff are examining and investigating other industry practices, such as 
the sale of B shares to 
investors, payments for ``shelf space,'' and the failure to give 
breakpoint discounts.
Conclusion
    The Commission's investigations of mutual fund trading and sales 
practices abuses are continuing on multiple fronts. I want to emphasize 
that we will aggressively pursue those who have violated the law and 
injured investors as a result of sales practice and related disclosure 
abuses, failure to give breakpoint discounts, 
improper valuation practices, illegal late-trading, market-timing, 
self-dealing, or any other illegal activity we uncover. Those 
responsible for these practices will be identified and will be held 
fully accountable.
    Wherever possible, the Commission also will seek recompense for 
investors in connection with mutual fund fraud. We will, of course, 
continue to work closely and cooperatively with State officials who 
also are taking steps to protect investors.
    I would be happy to answer any questions that you may have.

                               ----------
                PREPARED STATEMENT OF ROBERT R. GLAUBER
                  Chairman and Chief Executive Officer
               National Association of Securities Dealers
                           November 20, 2003

    Mr. Chairman and Members of the Committee, NASD would like to thank 
the Committee for the invitation to submit this written statement for 
the record.
NASD
    NASD, the world's largest securities self-regulatory organization, 
was established in 1939 under the authority granted by the 1938 Maloney 
Act Amendments to the Securities Exchange Act of 1934. Every broker-
dealer in the United States that conducts a securities business with 
the public is required by law to be a member of NASD. NASD's 
jurisdiction covers nearly 5,400 securities firms that operate more 
than 92,000 branch offices and employ more than 665,000 registered 
securities 
representatives.
    NASD writes rules that govern the behavior of securities firms, 
examines those firms for compliance with NASD rules, MSRB rules, and 
the Federal securities laws, and disciplines those who fail to comply. 
Last year, for example, we filed a record number of new enforcement 
actions (1,271) and barred or suspended more individuals from the 
securities industry than ever before (814). Our investor protection and 
market integrity responsibilities include examination, rulewriting and 
interpretation, professional training, licensing and registration, 
investigation and enforcement, dispute resolution, and investor 
education. We monitor all trading on the Nasdaq Stock Market--more than 
70 million orders, quotes, and trades per day. NASD has a nationwide 
staff of more than 2,000 and is governed by a Board of Governors at 
least half of whom are unaffiliated with the securities industry.
    NASD's involvement with mutual funds is predicated on our authority 
to regulate broker-dealers. NASD does not have any jurisdiction over 
investment companies 
or the fund's investment adviser; rather, we regulate the sales 
practices of broker- 
dealers who sell the funds to investors. Our investor education efforts 
also place special emphasis on mutual funds due to their widespread 
popularity with investors.
    The behavior that has been uncovered in the mutual fund industry 
has been reprehensible. The mutual fund industry was for years an 
example of a clean, disciplined industry. This reputation helped to 
foster growth in these products that
offered investors relatively low-cost professional management, 
diversification, and risk control to fit a wide range of investor 
needs. But now the industry has seriously undermined investor trust 
with a wide range of abuses--portfolio managers trading ahead of mutual 
fund investors, differential release of portfolio information, deals 
with preferred customers to permit market timing trades. Broker 
participation in illegal or unethical sales practices is very much a 
direct concern of NASD.
Disclosure
    This week during testimony before this Committee, Securities and 
Exchange Commission (SEC) Chairman Donaldson discussed a series of 
reforms in the realm of disclosure that he intends to seek. NASD 
supports these SEC efforts. Investors deserve clear and easy-to-read 
disclosure that tells them of all the costs associated with their 
mutual funds. Not just the load and fees that affect investor costs but 
also the other arrangements that affect the price--including Commission 
expenses and compensation arrangements between the broker and the fund. 
One of the bedrock principles of our free market system is that all 
participants have access to information about prices and costs that can 
influence their decisions. When this information is hidden or 
distorted, buyers are not able to make the best decisions about where 
to invest their money.
    In August, NASD proposed greatly expanded disclosure of mutual fund 
compensation arrangements. The proposal is designed to alert investors 
to the financial incentives that a brokerage firm or its registered 
representatives may have to recommend particular funds.
    The proposal would ensure that investors receive timely information 
about two types of compensation arrangements. The first consists of 
cash payments by fund sponsors to broker-dealers to induce fund sales. 
Typically, these payments are made in order to gain ``shelf space'' at 
the broker, or to secure a place for a fund on a preferred sales list. 
The second is the payment by a broker-dealer of a higher compensation 
rate to its own registered representatives for selling certain funds. 
The proposal would require firms to disclose these compensation 
arrangements in writing when the customer first opens an account or 
purchases mutual fund shares. The proposal also would require member 
firms to update this information twice a year and make it available on 
their websites, through a toll-free number, or in writing.
    The comment period on the proposal ended October 17, 2003. NASD has 
received approximately 40 comment letters on the proposal, which the 
staff is reviewing.
Recent Enforcement Efforts and Rule 2830
    To combat abuses in the realm of our regulatory authority, we have 
concentrated our examination and enforcement focus on five main areas: 
First, cash and noncash compensation practices and arrangements; 
second, the suitability of the mutual funds that brokers are selling, 
in particular B share abuses; third, whether brokers are delivering to 
their customers the benefits to which they are entitled, such as 
breakpoint discounts; and finally, market timing and late trading. All 
told, we have brought some 60 enforcement cases this year in the mutual 
fund area, and more than 200 over the last 3 years. We also have a 
large number of ongoing examinations and investigations involving these 
and other mutual fund issues.
Cash and Non-Cash Compensation Practices and Arrangements
    Just this week, NASD announced an enforcement action against Morgan 
Stanley for giving preferential treatment to certain mutual fund 
companies in return for millions of dollars in brokerage commissions. 
This is the second action brought by NASD against Morgan Stanley for 
mutual fund violations in the last 2 months and is part of our broader 
effort to crack down on sales practice abuses. In conjunction with a 
related action filed by the SEC, Morgan Stanley agreed to resolve the 
NASD and SEC actions by paying $50 million in civil penalties and 
surrendered profits, all of which will be returned to injured 
investors.
    In the Morgan Stanley case, NASD found that from January 2000 until 
2003, Morgan Stanley operated two programs which gave favorable 
treatment to products offered by as many as 16 mutual fund companies 
out of a total of over 115 fund complexes that could be sold by the 
firm's sales force. In return for these brokerage commissions and other 
payments, mutual fund companies received preferential treatment by 
Morgan Stanley, which included:

 Placement on a ``preferred list'' of funds that financial 
    advisors were to look to first in making recommendations of fund 
    products.
 Higher visibility on Morgan Stanley's sales systems and 
    workstations than nonpaying funds.
 Eligibility to participate in the firm's 401(k) programs and 
    to offer offshore fund products to Morgan Stanley customers.
 Better access to its sales force and branch managers.
 Payment of special sales incentives to Morgan Stanley 
    financial advisors.

    In addition, the participating mutual fund companies paid Morgan 
Stanley an extra 15 to 20 basis points on each sale. This was over and 
above the normal fees earned by the firm for selling the funds.
    This extra compensation paid to Morgan Stanley for the preferential 
treatment included millions of dollars paid by the mutual funds through 
commissions charged by the firm for trades it executed for the funds. 
These commissions were sufficiently large to pay for the special 
treatment, as well as the costs of trade execution. This conduct 
violated NASD's Conduct Rule 2830(k), one important purpose of which is 
to help eliminate conflicts of interest in the sale of mutual funds.
    NASD is also conducting an examination sweep where we are looking 
at more than a dozen broker-dealers, specifically with a view to 
determine how investment companies pay for inclusion on firms' featured 
mutual fund lists or why they receive favored promotional or selling 
efforts. Thousands of funds are presented to investors through discount 
and online broker-dealer ``supermarkets.'' We are looking at different 
types of firms, including full-service, discount, and online broker-
dealers. In addition, we are examining a similar number of mutual fund 
distributors, who are also our members. Mutual fund sponsors and 
distributors that once marketed exclusively through a single, 
traditional distribution channel often now compete head-to-head in the 
same distribution channels vying for visibility and valuable ``shelf 
space.'' We want to see what the distributors' role may be in these 
types of practices.
    As demonstrated in the recent case against Morgan Stanley, 
exchanging prominent placement of a fund or a family of funds on a 
firm's website or in the firm's marketing material or placing a fund on 
a ``featured'' or ``preferred'' list of funds in exchange for brokerage 
commissions from the funds constitutes a violation of the NASD rules.
    Another section of NASD Conduct Rule 2830 prohibits the award of 
noncash compensation, such as lavish trips and entertainment, to 
brokers for the sale of mutual fund shares. In September, we brought 
another case against Morgan Stanley that resulted in a $2 million fine 
against the firm. Morgan Stanley conducted prohibited sales contests 
for its brokers and managers to push the sale of Morgan Stanley's own 
proprietary mutual funds. In addition to censuring and fining the firm, 
NASD also censured and fined a senior member of the firm's management--
the head of 
retail sales.
    Between October 1999 and December 2002, the firm had conducted 29 
contests and offered or awarded various forms of noncash compensation 
to the winners, including tickets to Britney Spears and Rolling Stones 
concerts, tickets to the NBA finals, tuition for a high-performance 
automobile racing school, and trips to resorts.
    The obvious danger of such contests is that they give firm 
personnel a powerful incentive to recommend products that serve the 
broker's interest in receiving valuable prizes, rather than the 
investment needs of the customer. And one of the most troubling things 
about this case is Morgan Stanley's failure to have any systems or 
procedures in place that could detect or deter the misconduct.
    In January 2003, NASD censured and fined IF Distributor, Inc., and 
VESTAX Securities Corp. a total of $150,000 for failing to disclose 
special cash compensation they paid to their sales force in the sale of 
mutual fund shares. Prior to disclosing this special cash compensation, 
the brokers sold over $20 million in Class A shares to over 200 
customers. Brokers selling these shares received approximately $220,000 
in special cash compensation.
Suitability of Mutual Fund Sales--Class B Shares
    Many mutual funds offer different classes of the same investment 
portfolio. Each class is designed to provide brokers and their 
customers with a choice of fee structure. Class A mutual fund shares 
charge a sales load when the customer purchases shares. Class B shares 
do not impose such a sales charge. Instead, Class B shares typically 
impose higher expenses that investors are assessed over the lifetime of 
their investment. Class B shares also normally impose a contingent 
deferred sales charge (CDSC), which a customer pays if the customer 
sells the shares within a 
certain number of years. In addition, investors who purchase Class B 
shares cannot take advantage of breakpoint discounts available on large 
purchases of Class A shares.
    NASD has found that some brokers have unscrupulously recommended 
Class B shares in such large amounts that the customer would have 
qualified for breakpoint discounts had the broker recommended Class A 
shares instead. In this instance, the broker may receive higher 
compensation for the Class B recommendations. NASD has vigorously 
prosecuted these violations, and we are continuing a comprehensive 
review of Class B shares sales practices. Over the last 2 years, NASD 
has brought more than a dozen enforcement actions against firms and 
individual brokers for these types of violations. Presently, we have 
more than 50 open and active investigations in this area.
    For example, in May the SEC affirmed a disciplinary action NASD 
took against Wendell D. Belden, who was found to have violated NASD's 
suitability rule by recommending that a customer purchase Class B 
mutual fund shares in five different mutual funds within two fund 
families instead of Class A mutual fund shares. 
Because of the size of his customer's investment ($2.1 million) and the 
availability 
of breakpoint discounts for Class A shares, Belden's recommendations 
caused his customer to incur higher costs, including contingent 
deferred sales charges.
    Belden tried to justify his recommendations to customers that they 
purchase the Class B shares instead of the Class A shares because he 
received greater commissions on the sales of these shares. He stated 
that he ``could not stay in business'' with lower commissions. Belden 
was fined, suspended, and ordered to pay more than $50,000 back to his 
customers.
    In June, we announced a settled action against McLaughlin, Piven, 
Vogel for violations in this area. The firm was fined $100,000 and 
ordered to pay restitution of approximately $90,000 to 21 customers. In 
August, we announced five more actions for unsuitable sales of Class B 
shares.
Breakpoint Discounts
    Mutual funds typically offer discounts to the front-end sales load 
assessed on Class A shares at certain predetermined levels of 
investment, which are called ``breakpoints.'' The extent of the 
discount is based on the dollar size of the investor's investment in 
the mutual fund. For example, breakpoint discounts may begin at dollar 
levels of $25,000 (although, more typically, at $50,000) and increase 
at $100,000, $250,000, $500,000, and $1,000,000. At each higher level 
of investment, the discount increases, until the sales charge is 
eliminated.
    An investor can become entitled to a breakpoint discount to the 
front-end sales charge in a number of ways. First, an investor is 
entitled to a breakpoint discount if his single purchase is equal to or 
exceeds the specified ``breakpoint'' threshold. Second, mutual funds 
generally allow investors to count future purchases toward achieving a 
breakpoint if the investor executes a letter of intent that obligates 
him to purchase a specified amount of fund shares in the same fund or 
fund family 
within a defined period of time. Similarly, mutual funds generally 
grant investors ``rights of accumulation,'' which allow investors to 
aggregate their own prior purchases and the holdings of certain related 
parties toward achieving the breakpoint investment thresholds 
(including reaching investment thresholds necessary to satisfy letters 
of intent).
    Mutual fund families began to offer these breakpoint discounts to 
make their funds more attractive to investors. Over time, funds 
expanded the rights of accumulation they offered by expanding the 
categories of accounts that could be linked or aggregated for the 
purpose of obtaining breakpoint discounts. Mutual funds view their 
aggregation rules as important competitive features of their products. 
Accordingly, these rights of accumulation can vary from fund family to 
fund family, and many fund families define the related parties that can 
aggregate their holdings to determine breakpoint discount eligibility 
differently. For instance, one fund family may allow parents to link 
their accounts with a ``minor child,'' while another fund family may 
allow parents to link their accounts with any child residing at home.
    During routine examinations of broker-dealers by our Philadelphia 
District Office, NASD discovered that broker-dealers selling front-end 
load mutual funds were not properly delivering breakpoint discounts to 
investors. Following this discovery, in November and December 2002, the 
SEC and the New York Stock Exchange joined us for an examination sweep 
of 43 firms selling front-end load mutual funds. We found that most of 
those firms did not give investors all the breakpoint discounts they 
should. Failures to give the discounts stemmed from a variety of 
different operational problems, including a failure to link share 
classes and holdings in other funds in the same fund family and a 
failure to link accounts of family members.
    NASD issued a Notice to Members on December 23, 2002, reminding 
firms to 
explain and deliver breakpoints. And we issued in January 2003, an 
Investor Alert to advise customers of breakpoint opportunities.
    Also in January 2003, the SEC asked NASD to lead a task force to 
find breakpoint solutions. The task force had 24 members, including 
representatives from broker-dealers, mutual funds, transfer agents, 
clearing facilities, academia, the SEC staff, other SRO's, and trade 
associations.
    The Task Force issued its report in July 2003, in which it 
recommended a number of technological and operational changes, as well 
as modifications to mutual fund prospectus and other disclosure and 
sales practices, to ensure that customers are not overcharged. Working 
groups, consisting of knowledgeable representatives of 
the mutual fund and securities industries, are currently engaged in 
implementation of the Task Force recommendations. The NASD and the SEC 
receive periodic reports from these Working Groups and are monitoring 
progress as implementation moves forward.
    As for the transactions that should have received discounts, NASD 
supplemented its referenced examination effort with a survey of every 
NASD member to learn more about each member's overall mutual fund 
activities. The survey, in turn, provided NASD with information that 
helped us frame a self-assessment. Specifically, NASD directed firms to 
perform an assessment of their own of breakpoint discounts delivery. 
These self-assessments were carried out through use of a carefully 
constructed sample of transactions, which permitted NASD to extrapolate 
each firm's performance to its entire universe of transactions. NASD 
has concluded that, during the 2001 to 2002 period covered by the self-
assessments, investors were overcharged in about one out of every five 
transactions in which they were eligible for breakpoint discounts. 
Those overcharges, in our view, total at least $86 million, and the 
average overcharge was $243. When the assessments were complete, firms 
were directed to refund overcharges to investors, with interest. In 
addition, NASD will require that most of the firms involved undertake 
further action, including contacting their customers individually to 
alert them to possible overcharges. Disciplinary or enforcement 
proceedings will be brought against certain of the firms.
Late Trading and Market Timing
    Investment Company Act Rule 22(c)(1) generally requires that mutual 
fund shares be sold and redeemed at a price based on the net asset 
value (NAV) of the fund computed after the receipt of the order. In 
practice this requirement means that mutual fund shares are priced 
according to the value of their securities portfolio, computed at the 
next close of the national securities exchanges. For example, if a 
mutual fund receives an order to purchase shares before the close of 
the securities exchanges, 4 p.m., EST, the investor should receive a 
price based on that 4 p.m. close. If, however, a mutual fund receives 
an order to purchase shares after the 4 p.m. close, the investor should 
receive a price based on the next day's 4 p.m. close. This ``forward 
pricing'' requirement represents a fundamental principle of the 
Investment Company Act, for it prevents investors who might have access 
to the NAV of the portfolio from trading on that information.
    The failure to meet the forward pricing standard has become known 
as ``late trading.'' Late trading, however, should be distinguished 
from the practice, followed by many broker-dealers and other 
intermediaries, of transmitting orders after 4 p.m. because they 
require additional processing time. For example, some intermediaries 
may net out transactions by pension plan participants in order to 
simplify their order to the mutual fund company. In these instances, 
the participants entered their orders before 4 p.m., but the orders of 
the plan were not processed and transmitted until after 4 p.m.
    The frequent trading of mutual fund shares in order to take 
advantage of pricing inefficiencies or market movements has become 
known as ``market timing.'' Market timing is not per se illegal. Market 
timing activities become illegal when they violate the fiduciary duty 
of the fund's investment adviser; they also are problematic when they 
violate a stated policy of the fund as disclosed in the fund's 
prospectus. Many mutual funds police market timing by their 
shareholders, because market timing can increase fund expenses and can 
harm fund performance for the other shareholders. When a mutual fund 
has disclosed a policy of protecting investors from market timers, a 
broker-dealer may not knowingly or recklessly collude with the fund in 
order to effect a market timing transaction. Broker-dealers must have 
in place policies and procedures reasonably designed to detect and to 
prevent this collusion.
    In response to prevailing issues concerning mutual fund execution, 
in September NASD sought information from roughly 160 firms regarding 
late trading and impermissible market timing.
    As a preliminary matter, we have determined that numerous firms' 
conduct warranted a referral to NASD's Enforcement Department for 
further investigation and possible disciplinary action. Another group 
of firms is being examined by our Member Regulation Department for 
potential late trading and impermissible market timing misconduct. 
Specifically, a number of firms disclosed that they had, or probably 
had, received and entered mutual fund orders after U.S. markets closed 
for the day. Some of these firms disclosed specifically that they had 
accepted and entered late trades; other firms disclosed that they 
``probably'' accepted and entered late trades. This imprecision in the 
latter group indicates separate issues of poor internal controls and 
record keeping. These matters, too, have been referred to NASD's 
Enforcement Department for action.
    NASD also has identified a number of firms that were involved in 
market timing and it remains to be determined whether their activities 
were impermissible under our rules or applicable statutes. These firms 
appear to have facilitated a customer's market timing strategy in 
mutual funds or variable annuities, had employees who agreed with a 
mutual fund or variable annuity to market time the issuer's shares, or 
had an affiliate involved in some form of market timing of mutual funds 
or variable annuities. We are investigating any broker-dealer that made 
any of these disclosures in our investigations. We will investigate 
whether these firms simply allowed market timing, which is not per se 
illegal, or whether they colluded with the mutual fund companies to 
evade the fund's stated policies against market timing.
Investor Education
    Mutual funds have been a particular focus of NASD's investor 
education efforts. This year alone, we have issued Investor Alerts on:

 Mutual fund share classes
 Mutual fund breakpoints
 Principal-protected funds
 Class B mutual fund shares

    Each of these Investor Alerts educates investors about the wide 
variety of mutual fund fee structures that exist and urges investors to 
scrutinize mutual fund sales charges, fees, and expenses.
    Research has shown that many investors are unaware of how much they 
pay to own mutual funds and that even small differences in fees can 
result in thousands of dollars of costs over time that could have been 
avoided. To help investors make better decisions when purchasing mutual 
funds, we have unveiled an innovative ``Mutual Fund Expense Analyzer'' 
on our website. Unlike other such tools, the Expense Analyzer allows 
investors to compare the expenses of two funds or classes of funds at 
one time, tells the investor how the fees of a particular fund compare 
to industry averages, and highlights when investors should look for 
breakpoint discounts. To make this tool more widely available to 
investors, we are developing a version of the Expense Analyzer for 
broker-dealer websites.
Conclusion
    NASD will continue its vigorous examination and enforcement focus 
on the suitability of the mutual fund share classes that brokers are 
selling, the compensation practices between the funds and brokers, and 
the question of whether brokers are delivering to their customers the 
benefits offered to them, such as breakpoint discounts. And as we 
continue our examinations and investigations into late trading and 
market timing issues, we will enforce NASD rules with a full range of 
disciplinary options--which include stiff fines, restitution to 
customers, and the potential for suspension or expulsion from the 
industry. While NASD cannot alone solve all the problems revealed in 
recent months in the mutual fund industry, we have jurisdiction over 
all broker-dealers that sell these products to investors and will 
rigorously exercise our authority to take actions against violators as 
part of our overall efforts to protect investors and to restore 
investor confidence.



                    UNDERSTANDING THE FUND INDUSTRY
                    FROM THE INVESTOR'S PERSPECTIVE

                              ----------                              


                      WEDNESDAY, FEBRUARY 25, 2004

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10:03 a.m. in room SD-538 of the 
Dirksen Senate Office Building, Senator Richard C. Shelby 
(Chairman of the Committee) presiding.

          OPENING STATEMENT OF CHAIRMAN RICHARD SHELBY

    Chairman Shelby. The hearing will come to order.
    Today, the Banking Committee continues its examination of 
the mutual fund industry. In November, this Committee held the 
first two hearings in a series to consider the ongoing 
investigations,
enforcement proceedings, and regulatory actions concerning the 
mutual fund industry. Over the coming months, we will hold 
additional hearings as we examine the industry and consider 
whether legislative reform is needed. Although I have not yet 
determined the number of hearings, I expect the process to be 
comprehensive, deliberative, and informative.
    A number of my Senate colleagues and fellow Committee 
Members have introduced legislative reform packages. Although 
these proposals contain various reform measures, I expect a 
fully developed hearing record to guide the Committee's 
consideration of any potential legislation. With well over 95 
million investors and nearly $7 trillion in assets with that, 
mutual funds are the primary investment option for retail 
investors. Mutual funds have always been perceived as the safe, 
long-term investment option, but there is no doubt that recent 
revelations about self-dealing and preferential treatment have 
cast a shadow on the industry. Ordinary investors were shocked 
to learn the extent to which fund insiders, brokers, and 
privileged clients profit at the expense of the aver-
age investors.
    The ongoing enforcement actions concerning late trading, 
market timing, and selective portfolio disclosure suggest that 
too often funds and brokers disregarded their duties to protect 
investor assets and act in the investors' best interest. Many 
of these practices were open secrets on Wall Street, yet they 
continued unabated and undetected by the SEC. Frankly, the 
prevalence of these problems must necessarily raise questions 
about the SEC's compliance and examination programs.
    In addition to blatant malfeasance and compliance failures, 
this Committee will examine the transparency of mutual fund 
operations and the adequacy of current disclosure practices.
    Many of the questionable fund practices are not disclosed 
to most investors. Furthermore, we have already learned about 
instances in which firms act in direct violation of their 
stated disclosures.
    Therefore, this Committee, the Banking Committee, must take 
a comprehensive look at the industry to determine if the 
industry's practices are consistent with investors' interests. 
We may have to reemphasize the duty owed to investors to ensure 
that mutual funds are operating as efficiently and fairly as 
investors demand. In this regard, we will examine revenue 
sharing, directed brokerage and soft-dollar arrangements to 
determine how these practices have evolved and are currently 
used in the industry.
    We will also review a range of disclosure practices 
regarding fees and costs, portfolio holdings, the portfolio 
manager's compensation and fund holdings, and side-by-side 
management of mutual funds and hedge funds. We will also focus 
on fund sales practices to ensure that brokers provide adequate 
disclosure of any sales incentives and information about 
different classes of fund shares and give clients any 
breakpoint discounts to which they are entitled. Although it is 
critical that investors receive clear, concise, and complete 
disclosure regarding their investments, we must be mindful of 
the possibility that information overload could overwhelm the 
investor and impede decisionmaking. Although better 
transparency and disclosure practices are key components of 
reform, true reform will require changes in the boardroom. Fund 
shareholders rely on the board to aggressively police potential 
conflicts of interest and to vigorously protect shareholder 
interests.
    To some, the recent scandals suggest that many boards have 
abdicated their responsibilities. Whether boards were unaware 
of recent wrongdoings or turned a blind eye to such activities, 
I believe that either scenario calls for a serious review of 
board composition, decisionmaking, and responsibilities. I 
believe we must understand how changes to fund governance can 
minimize conflicts of interest and reinvigorate the boardroom 
culture to better protect shareholder interests. In our own 
ways, the regulators, industry participants, and Congress must 
collectively work to reform the mutual fund industry in order 
to restore investor confidence and integrity in the fund 
industry. State and Federal regulators must continue to 
vigorously prosecute wrongdoers in order to assure investors 
that fund executives and brokers who violate their duties and 
profit at the average investor's expense will be punished. 
Through enforcement actions, the regulators also help to define 
the full scope of transgressions, conflicts, and structural 
problems that are at the root of the misconduct in the fund 
industry.
    While this Committee examines the fund industry, the SEC is 
pursuing an aggressive rulemaking agenda aimed at improving the 
transparency of fund operations, strengthening fund governance, 
and halting abusive trading practices. Chairman Donaldson told 
this Committee that the SEC has the necessary statutory 
authority to reform the mutual fund industry, and he is 
executing his agenda for reform. Understanding the scope, 
application, and consequences of the SEC's rulemakings will be 
an important element of this Committee's process. Beyond rule 
proposals, the SEC must also demonstrate how it is revising its 
compliance and examination programs to ensure that brokers and 
funds comply with current law and to detect and halt future 
fund abuses.
    The fund industry and brokerage houses also have a vital 
role in this reform process. It would be impractical, I 
believe, to expect the regulators to detect every single fraud 
and manipulation in the industry. Therefore, fund executives 
and brokers must rededicate themselves to the fundamental 
principles of our securities markets--the principle that 
securities firms and mutual funds should not neglect investors' 
interests and knowingly profit at their expense. Until firms 
can reassert the ideal of investor protection and demonstrate 
an ability to abide by it, investors will not trust the 
industry, nor should they.
    Finally, Congress also has a critical role in the reform 
process. As this Committee examines the issues in the 
regulatory landscape, we must decide whether legislation is 
necessary. As we have learned in other contexts, however, 
additional legislation is not the only answer. While we 
consider various reform measures, we must be mindful of the 
cost of reform to investors and be wary of damaging the primary 
investment option for most Americans. We have an obligation to 
ensure that through either enforcement actions, regulation or 
legislation abuses are addressed and that transparency and fund 
governance improves. At the same time, we must ensure that 
funds and their fee structures remain subject to competitive 
market pressures and that reform measures truly benefit 
investors without having the primary effect of increasing costs 
and decreasing returns. The guiding principle of the overall 
reform process is investor protection--reassuring investors 
that mutual funds are a vehicle in which they can safely invest 
their money
and not have their return on investment take a back seat to 
Wall Street insiders.
    Building on this principle of investor protection, I hope 
that this reform process will give investors a better 
understanding of how the fund industry operates. Investing in 
mutual funds or any other investment vehicle is not a simple 
task as decisions require an understanding of risk and reward, 
and an awareness of potential conflicts of interest. To the 
extent that investors are more aware of their investment 
options and their inherent risks, our markets are better 
served. An educated investor is a better investor.
    Our panelists this morning will share their insights on the 
fund industry from an investor's perspective and will also 
discuss ways to improve investor education.
    With us this morning are Tim Berry, State Treasurer of 
Indiana and President of the National Association of State 
Treasurers; Jim Riepe, Vice Chairman of T. Rowe Price; Don 
Phillips, Managing Director of Morningstar Research; Gary 
Gensler, former Under Secretary of the Treasury for Domestic 
Finance, that we all know; and Jim Glassman, columnist for The 
Washington Post and Resident Scholar at the American Enterprise 
Institute. We look forward to your testimony.
    Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Mr. Chairman. I join 
with you in welcoming this very distinguished panel this 
morning.
    Again, I want to express my appreciation to you for the 
comprehensive approach you are taking to review the many issues 
surrounding the mutual fund industry.
    Last year, the Committee held two hearings on this subject 
and heard from, among others: SEC Chairman Donaldson, SEC 
Enforcement Director Cutler, New York State Attorney General 
Spitzer, NASD Chairman Glauber, as well as the Investment 
Company Institute President Matthew Fink, and Securities 
Industry President Lackritz.
    This is one of a series of hearings, and a number of 
additional hearings, as I understand it, have been scheduled on 
this important subject, which clearly merits the close 
attention that you are giving to it. As you mentioned, mutual 
funds are more than $7 trillion in assets and over 90 million 
Americans, half of all U.S. households, own mutual funds.
    We were proceeding along without any sense of trouble. But 
then we had September 2003 when New York Attorney General 
Spitzer announced that a hedge fund, Canary Partners, had 
engaged in improper late trading and market timing. He 
predicted, at the time, that more instances of mutual fund 
abuse would follow. Regrettably, they have, involving 
additional cases of market timing and late trading, as well as 
misconduct involving revenue sharing, selective portfolio 
disclosure, failure to deliver breakpoint discounts, and other 
practices.
    I think it is fair to say when we began our hearings last 
November, few of us anticipated the full dimensions of the 
problem. Since those hearings, almost every week, additional 
abuses have been revealed in many mutual fund families and 
securities broker-dealers, revealed by the SEC and by various 
State Attorneys General.
    For example, just last month, in January, the SEC's 
Director of Enforcement announced that the SEC had found fund 
abuses involving revenue sharing at 13 unnamed Wall Street 
brokerages. On February 12, just a few days ago, the SEC and 
the NASD announced actions against 15 firms for failure to 
deliver mutual fund breakpoint discounts.
    The proliferation of problems reflects, as the SEC said in 
a recent statement, ``a serious breakdown in management 
controls in more than just a few mutual fund complexes.''
    In response, the SEC is actively engaging in rulemaking, 
and I want to commend the SEC for the focus they have brought 
to this issue and the speed to which they are moving in trying 
to address it. The problem has also prompted a number of our 
colleagues in Congress to introduce legislation on this 
subject. We have a range of statutory proposals that have been 
placed before Congress.
    Questions have been raised about a wide range of issues: 
Sales practices, disclosure; how clearly and completely the 
types and amounts of fees and other important data are 
disclosed to investors; incentives that funds pay brokers to 
sell their shares; soft dollars; fund governance and structure; 
the performance of directors and their fiduciary duty to fund 
investors; the issues of firms that run hedge funds and mutual 
funds together; and the effectiveness of regulatory 
enforcement.
    I appreciate the quality of the panel that is here before 
us this morning. We are very pleased to have Tim Berry, the 
Treasurer of the State of Indiana representing the State 
Treasurers; Jim Riepe, Vice Chairman of the Board of Directors 
of T. Rowe Price Group, I think fair to say a venerable mutual 
fund institution, or at least we so think in Maryland; Don 
Phillips, Managing Director of Morningstar; Gary Gensler, who 
served with great distinction in the previous Administration as 
Treasury Under Secretary for Domestic Finance and is the co-
author, along with Gregory Baer, of a popular book on mutual 
funds, ``The Great Mutual Fund Trap,'' which makes for very 
interesting reading. You do not mind my giving a plug to your 
book here at the outset of the hearing.
    Senator Carper. What was the name of that book?
    [Laughter.]
    Senator Sarbanes. And James Glassman, Resident Fellow at 
the American Enterprise Institute. I look forward to hearing 
the panel.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Crapo.

                 COMMENTS OF SENATOR MIKE CRAPO

    Senator Crapo. Thank you very much, Mr. Chairman, and I 
will be brief because the two of you have both very adequately 
stated my concerns as well.
    I truly believe that without public trust and confidence, 
our markets cannot function efficiently and effectively. Recent 
revelations of wrongdoing, including the late trading and 
market timing contrary to fund prospectuses have undermined 
investor confidence.
    I support the approach that you have taken, Mr. Chairman, 
and that is to make it very clear that investor protection is 
the principle which we must utilize as we proceed here to make 
certain that the duty owed to the investors by the mutual 
funds, and frankly, by the system that we establish is solid, 
and that it is understood well and that it is followed, and 
that the concerns that have arisen about whether the mutual 
funds are being managed in such a way that they are following 
the law and are being implemented according to the contracts 
and the principles that we expect of them is occurring.
    At the same time, I appreciate the Chairman's comments that 
we also must look at whether new legislation is the best 
solution. The first principle we must follow, in my opinion, is 
to do no harm, and although there are certain serious problems 
that have been identified, I think it is also important for us 
to focus in this Committee, in our oversight role, on what the 
proper solutions should be. It is very possible that if we are 
not careful, we or others who are trying to address the issue, 
could actually raise costs and limit choices for investors 
which would be contrary to the very interests of those to whom 
this Committee and the entire mutual fund industry owe their 
highest duty, the investors.
    So, I will be looking here at this hearing and throughout 
the hearings that we hold to be sure that we identify exactly 
what the problem is, and to identify what the solution should 
be, to make certain that we achieve that ultimate goal of 
absolutely rock solid investor protection.
    Thank you.
    Chairman Shelby. Senator Carper.

              COMMENTS OF SENATOR THOMAS R. CARPER

    Senator Carper. Thanks, Mr. Chairman.
    To each of our witnesses this morning, welcome. Some of you 
have been before us before, and for those of you who have been 
before, welcome back. To our State Treasurer, I used to be a 
State Treasurer, and our own State Treasurer is now a fellow 
named Jack Markell, who is a very able guy, and who I think you 
actually may reference in your testimony. I always say to Jack 
that he is the best State Treasurer we have ever had in 
Delaware, and he and others are quick to agree.
    Mr. Gensler, we appreciate especially your service to our 
country and welcome you here today.
    I do not come into these hearing with any preconceived 
notion as to what course we need to follow. I come into it with 
an open mind, not an empty mind, but an open mind, and I look 
forward to this team here helping to fill the mind a little 
bit. I think this maybe is the ``A Team.'' Mr. Chairman, this 
is a good group and we look forward to their testimony.
    Thank you.
    Chairman Shelby. Senator Hagel.

                COMMENTS OF SENATOR CHUCK HAGEL

    Senator Hagel. Mr. Chairman, thank you. I would just add 
that I appreciate the distinguished witnesses appearing here 
this morning and that I look forward to their testimony.
    Thank you.
    Chairman Shelby. Senator Sununu.

               COMMENTS OF SENATOR JOHN E. SUNUNU

    Senator Sununu. Thank you, Mr. Chairman. And like Senator 
Carper, I do not have any preconceived notion of what we ought 
to do here other than be cautious. As Senator Crapo said, we 
want to make sure that any solutions that we are contemplating 
are grounded in good empirical evidence that will actually 
address the very problems that we say that we are concerned 
about.
    We should not be contemplating proposals that micromanage 
what is for the most part a very healthy and very vibrant 
industry simply because they sound good, simply because they 
have a nice rhetorical value or they make us feel like we 
passed legislation that dealt with the problem, because that 
ultimately can be counterproductive. I have emphasized this 
before in earlier hearings in this and other Committees, with 
regard to board structure, independent board members, 
independent board chairmen, if we pass legislation mandating 
the structure of the board, mandating a particular role and 
responsibility for an individual on the board, and then we say 
that that is dealing with this problem. There is no empirical 
evidence that boards of a particular composition are more or 
less prone to the kind of scandals we have heard about, then we 
are acting in a counterproductive way because we are creating 
in the public's mind the sense that we have dealt with a 
problem when we really have not, and in the long run that will 
only undermine public confidence and credibility of the 
marketplace.
    I think it is important that any proposals, ideas that we 
debate, discuss, and vet have some grounding in empirical 
evidence that they result in better governance, better 
management, and a better product for consumers in the long run.
    With that, I look forward to the testimony of our witnesses 
today.
    Thank you, Mr. Chairman.
    Chairman Shelby. All of the witnesses' written testimony 
will be made part of the Banking Committee's record without 
objection.
    We welcome, all of you, to the Committee again.
    Mr. Berry, we will start with you.

                     STATEMENT OF TIM BERRY

                  INDIANA STATE TREASURER AND

               PRESIDENT, NATIONAL ASSOCIATION OF

                        STATE TREASURERS

    Mr. Berry. Thank you, Mr. Chairman and Members of the 
Committee. Thank you for the opportunity to testify before you 
here today. As you said, I am Tim Berry, Treasurer of the State 
of Indiana, but also this year I am honored to serve as 
President of the National Association of State Treasurers, and 
it is in that role as well that I am here today.
    As State treasurers we directly oversee more than $1.5 
trillion in State funds. Additionally, many of us directly 
oversee or sit on boards that oversee our public pension funds, 
our State 401(k) and deferred compensation plans, and most 
importantly and significantly, State treasurers for the most 
part have direct oversight of the Section 529 College Savings 
Plans in our States, where citizens, families have invested 
more than $50 billion over the last few years in those plans.
    What is at stake here? Investor confidence, investor trust. 
It is imperative that all of us, large institutional investors 
as we are as State treasurers, regulators, as well as the 
mutual fund industry itself, place a priority upon the investor 
interests. Unfortunately, though, allegations, as you have 
discussed already, of wrongdoing go beyond just a ``few bad 
apples,'' but it appears to involve a significant number of 
mutual fund complexes. The National Association of State 
Treasurers and many of my State treasurer colleagues on their 
own have been on the forefront of calling for investor 
protection reforms. Much of the focus over the last year of the 
NAST activities, through the creation of a Special Corporate 
Governance Committee and through our own association work, has 
dealt with the issues that we are discussing here today.
    In recent months the Securities and Exchange Commission has 
taken a number of steps to address the issues that have been 
raised by State and Federal investigations into the mutual 
funds' sales and trading practices. There are several 
principles in which the treasurers and the Commission agree 
will bring about investor confidence and trust. I will address 
two of those here today in transparency of fees, and also fund 
board independence.
    Mutual fund shareholders, in order to better understand and 
gain comfort of their investments, should receive a statement 
of charges debited from their account for management, 12b-1 and 
other expenses. It is important that this billing information 
be both consistent and thorough and until this system of 
consistency has been developed, it is necessary that greater 
and clearer disclosure take place immediately. It is also 
recommended that only the independent directors may vote to 
approve board fees. They will base this decision on an 
itemization of expenditures associated with investment advisory 
services, marketing and advertising, operations and 
administration, and general overview.
    Also as it relates to the board structure, many of us 
believe that 75 percent of the mutual fund's board of directors 
shall be independent directors, along with an independent 
chair. This is a necessary component of providing increased 
investor confidence and trust. We also believe that it is 
important that these independent directors meet at least 
annually with their chief compliance officer and with the 
independent auditors without the presence of management to deal 
with the many issues that are at stake here. These are two of 
the important components of the mutual fund protec-
tion principles.
    We commend the Commission for their efforts and believe 
their actions will go a long way toward rectifying many of the 
abuses identified in recent allegations of the mutual fund 
industry. But in order to succeed in our dynamic American 
economy, we must
ensure that through these reforms, transparency, and greater 
understanding by the individual investor, will be achieved 
through greater financial literacy. Our citizens must be 
equipped with the skills, knowledge, and experience necessary 
to manage their personal finances, their college savings, and 
their personal retire-
ment needs.
    State treasurers have long been involved and recognize the 
importance of financial education. Through legislative process, 
State treasurers support public policy positions that promote 
savings and are actively educating our citizens on savings from 
birth to retirement. These financial literacy programs range 
across the board to a variety of target demographic groups, 
from school-age children, to women, to senior citizens, to our 
local public finance officers. Through these personal finance 
workshops citizens are learning how to take control of their 
own financial situations. Over a third of our State treasurers 
have implemented women and money conferences and continuing 
education seminars. Delaware State Treasurer Jack Markell has 
developed an innovative Delaware Money School, designed to 
bring community-based financial education to participants in a 
pressure free, no-selling environment.
    A few of the States, as we do in the State of Indiana, 
provide educational programs for our local public finance 
officials. These workshops provide participants, our county 
treasurers, city clerk treasurers, town officials, the school 
business officials, and tools to deal with the fiscal and 
ethical issues that they face when investing public resources.
    By bringing about more visibility to the corporate 
structure of funds and by enhancing the availability of 
usefulness of financial information disclosed by these firms, 
this Committee can demonstrate to the American investor that 
mutual funds will continue to operate as the cleanest, 
brightest investment method for all Americans.
    Chairman Shelby. Thank you so much.
    Mr. Riepe.

                  STATEMENT OF JAMES S. RIEPE

            VICE CHAIRMAN, T. ROWE PRICE GROUP, INC.

    Mr. Riepe. Thank you very much, Chairman Shelby, Ranking 
Member Sarbanes, and all the Members of the Committee. I am 
James Riepe, Vice Chairman of the T. Rowe Price Group, CEO of 
the Price Funds and Chairperson of all of those Price Fund 
Boards.
    T. Rowe Price is a Baltimore-based investment management 
organization, close to $190 billion in assets under management, 
about $120 billion of that is in mutual funds, and we have been 
managing investments for nearly 70 years now, and I personally 
have been in the business for about 35 years.
    I very much appreciate the opportunity to talk to you about 
my firm's efforts to respond to the challenges facing us today, 
investor reactions to these challenges, and to share my views 
on regulatory changes that I think will help funds move 
investors forward.
    Let me begin by saying that at T. Rowe Price we have always 
lived by the principle that the interests of our fund 
shareholders are paramount. As such, we have been deeply 
dismayed by certain abuse of mutual fund trading practices 
revealed during the last 6 months. On the heels of the 
corporate and Wall Street scandals and because mutual funds 
historically have been largely untainted by abuses in the 
conduct of their business, these revelations have attracted 
extensive attention from the regulators, the press, and the 
legislators.
    Although painful to those of us who are immersed in the 
task of stewarding investor assets, I believe this additional 
attention and scrutiny, excluding the hyperbole that has 
accompanied it, is healthy and will benefit most fund investors 
and those of us who serve them. I think your hearings, Mr. 
Chairman, should further enlighten that process.
    My firm, and I might add, my colleagues in this industry as 
well, support appropriate and decisive action by Government 
authorities to redress these abuses. We also support changes to 
bolster an already strong regulatory system. In my view, the 
SEC has responded to the recent abuses swiftly and with the 
most comprehensive mutual fund regulatory reform agenda in 
recent history, certainly in my history. I have stated many 
times that one of the key factors in the success of mutual 
funds is the regulatory scheme under which funds have operated 
for all these years.
    A little more than 11 years ago I sat in front of your 
Securities Subcommittee and argued that SEC's resources had not 
kept up with industry growth. I repeat again today that 
continued effective oversight by the SEC, as well as the 
successful implementation of any new reforms, cannot be 
achieved unless the SEC is adequately and consistently funded.
    Mr. Chairman, as your Committee reviews the current mutual 
fund situation and regulatory responses, we all need to 
understand that in the end ethical behavior cannot be 
regulated, no matter how extensive the compliance regulations. 
Ultimately, each one of us must create an environment within 
our organizations in which the right decisions are made by our 
employees consistent with our obligation to investors. Although 
we have seen very strong evidence that investors continue to 
recognize the fundamental benefits of investing in mutual 
funds, we also have witnessed several harsh examples of what 
can happen if damage is done to the implied bond of trust 
between investors and fund managers.
    Notwithstanding the improvements represented in some of the 
proposed reforms, we recognize that the challenge of 
maintaining investor trust falls primarily on those in the fund 
industry and its intermediaries and not on the Government. At 
T. Rowe Price, we take this responsibility very, very 
seriously. We have in place, for example, procedures and 
practices that seek to protect our fund shareholders against 
late trading, abusive short-term trade in
the mutual fund shares, and the selective disclosure of fund 
portfolio holdings.
    In light of the recent investigations and enforcement 
proceedings, we have conducted thorough reviews of all of these 
areas. We have confirmed that our policies and practices 
consider to be effective. We considered ways we might make them 
even stronger. As an example, we are expanding our annual 
compliance review meetings to include all of our employees 
instead of just our senior staff.
    During this review process, we have, as always, kept the 
fund boards fully informed, and they have played an active 
oversight role, including their decision to extend redemption 
fees to a number of additional funds.
    With respect to investor communications, we have sought to 
educate fund investors about these particular issues. We have 
used 
letters, newsletters, and our website to discuss the fund 
trading 
improprieties and how we seek to protect Price Fund 
shareholders from such abuses.
    Our internal efforts have been supplemented by a series of 
very substantive SEC regulatory initiatives. Today, I even 
understand that the SEC may be proposing a new rule that would 
impose mandatory redemption fees on transactions and certain 
types of fund shares where shares are held for 5 days or less. 
We strongly support most of these SEC initiatives and 
anticipated actions which are discussed in much more detail in 
my written testimony. And I believe that they will go a long 
way toward stamping out abuses and maintaining the confidence 
of investors which you all have talked about.
    I would also like to say a few words about fund governance. 
In my opinion, the recent disturbing revelations about mutual 
fund abuses do not evidence a failure of the fund governance 
system, as some industry critics have charged. These were 
failures of management, not fund governance. Fund directors 
cannot and should not be expected to oversee day-to-day 
management of the fund's activities. However, these failures 
have served to highlight that fund directors could benefit from 
being given additional tools to assist them in executing their 
oversight role more effectively. Most important of these new 
tools was a rule already adopted by the SEC in December that 
requires mutual funds to establish comprehensive compliance 
programs and to appoint a chief compliance officer who will 
report regularly and directly to the independent directors on 
all compliance matters. We strongly believe that this rule, 
probably more than any of the other proposed reforms, will have 
the most far-reaching effect on how fund managers conduct their 
day-to-day business, and it should significantly improve the 
directors' ability to oversee fund compliance.
    The Commission also has proposed certain new governance 
requirements, such as requiring that a fund's independent 
directors periodically meet in executive sessions, that fund 
boards conduct regular self-assessments, that the independent 
directors have the express authorization to retain experts and 
hire staff. Although ours and many other fund boards already 
adhere to these practices, formal requirements will emphasize 
their importance.
    Unfortunately, a few of the SEC governance proposals are, 
in my view, unwarranted, unrelated to the abuses that have been 
discovered, and in fact, could be counterproductive, as Senator 
Sununu pointed out. In particular, the idea of a Government 
mandate that all fund boards must have an independent chair 
makes no sense to me at all. Recent events demonstrate that 
having an independent chair is certainly no silver bullet. 
Since independent directors constitute at least a majority and 
typically a supermajority of fund boards, why should those 
directors not be allowed to determine who their chair should 
be? In the case of T. Rowe Price, we have had at least a two-
thirds supermajority of independent directors for many years, 
and they have appointed a lead director. They do not believe 
they need an independent chair to enhance their influence, but 
would name if they wanted to. For example, they have retained 
their own independent fund counsel for more than two decades, 
and several years ago they requested that the fund's advisor 
change its independent auditing firm because it was also the 
fund's auditor. Although changing auditors in a public company 
is a very big deal, as you all know, we made the change.
    Let me quickly mention two other SEC initiatives with 
respect to fund distribution. We support the SEC's recent 
proposal to ban the practice of directing fund brokerage 
transactions to reward broker-dealers who also sell fund 
shares. Further, we believe the Commission's decision to take a 
fresh look at Rule 12b -1 is both prudent and timely. The SEC 
has also proposed to require broker-dealers to give mutual fund 
investors a new point of sale disclosure document containing 
information about sales related fees and payments. This is 
consistent with a longstanding fund industry recommendation, I 
might add. If executed properly, and perhaps not limited to 
just sales related costs, I believe that this document could 
meaningfully enhance the investor awareness and understanding 
of a fund's investment program, its risks, costs, and fees 
associated with it.
    In closing, I would like to emphasize that T. Rowe Price 
has been and continues to be committed to acting in our fund 
shareholders' interest, and we believe most other fund managers 
seek to do the same. We understand very well the fiduciary 
relationship that exists between us and our investors. We also 
know that we operate in a highly competitive marketplace and we 
understand that over time, in order for us to be successful, 
our investors much be successful. The current challenges have 
presented those of us in the fund industry with an opportunity 
not only to improve the regulatory scheme under which we 
operate, but also to recommit ourselves to investor interests. 
I assure you, we will all take advantage of that opportunity.
    Thank you.
    Senator Sarbanes [presiding]. Thank you very much. I might 
note to my colleagues that there is a vote going on. The second 
bells have rung. Chairman Shelby went at the outset. He hopes 
to get back before we all have to depart to vote, in which case 
the hearing can continue. If not, I will recess at the 
appropriate time and we will flee the room in order to make the 
vote.
    Mr. Phillips, we would be happy to hear from you. Let me 
just note, though, that we very much appreciate the careful 
thought and effort that obviously went into the written 
statements. We have had a chance to review them, at least 
preliminarily, and I must say I am struck by the care and the 
comprehensiveness of many of the statements. It is enormously 
helpful to the Committee that this effort has been undertaken 
by the people who are on the panel today.
    Mr. Phillips.

                   STATEMENT OF DON PHILLIPS

              MANAGING DIRECTOR, MORNINGSTAR, INC.

    Mr. Phillips. Thank you for the opportunity to appear 
before this distinguished Committee. My name is Don Phillips 
and I am a Managing Director of Morningstar.
    As a leading provider of mutual fund information to both 
individual investors and their financial advisors, Morningstar 
has had a front-row seat to witness both the rapid rise and the 
recent missteps of this important industry. We have seen a 
generation of Americans embrace mutual funds for their 
compelling combination of convenience, instant diversification, 
and professional management. The industry's rise has not solely 
been due to these merits, however. The mutual fund industry has 
also been the beneficiary of considerable good fortune. 
Numerous legislative acts such as those allowing individual 
retirement accounts, 401(k) plans, and 529 plans have 
encouraged investors to place billions of dollars into funds, 
greatly enriching those companies that offer them. As a result, 
mutual funds now occupy a central position in the long-term 
savings plans of more than 90 million Americans.
    Given the privileged and highly important role that mutual 
funds now play, it would behoove the industry to redouble its 
commitment to the effective stewardship of the public's assets. 
Most 
individuals who work for mutual fund companies embrace this 
challenge, but the recent scandals make it abundantly clear 
that too many people in this industry were willing to forsake 
their responsibility in exchange for short-term personal 
profit. Investors are angered and confused by these scandals. 
While few question the inherent benefits of mutual funds, it is 
clear that the industry has foolishly jeopardized its greatest 
asset, the public's trust.
    Investors need reassurances that their trust will not be 
further betrayed. In particular, I believe they need to know 
that mutual funds operate on a fair and level playing field, 
that checks and balances exist to safeguard investor interest, 
that adequate information will be available to allow investors 
or their advisors to make intelligent decisions about their 
funds, and ultimately that mutual funds offer a reasonable 
value proposition.
    While market forces can and will do much of the work, the 
industry and regulators can take steps to ensure that mutual 
funds meet their obligations to the American public. 
Specifically, Morningstar endorses these 10 steps:
    (1) Close the door to timing and late trading abuses so 
that short-term traders do not undermine the returns of long-
term investors. (2) Eliminate directed brokerage and better 
disclose pay-to-play arrangements so investors know that the 
funds chosen for their portfolios are done so on the basis of 
investment merit, not on the willingness of the fund to pay for 
shelf space. (3) Eliminate soft-dollar payments so investors 
can see the full cost of investment management. (4) Eliminate 
or seriously reconsider the role of Rule 12b -1 fees, to make 
clear to the investor which costs go to pay for fund management 
and which costs go to pay for distribution. (5) Maintain 
vigilant and appropriately funded regulatory oversight. (6) 
Make fund directors more visible and more accountable to 
shareholders. While much has been made about the independence 
of directors, we think a much more important issue is the 
visibility. What is deeply alarming is in situations like 
Putnam, where there have been whistleblowers, the 
whistleblowers did not even think to go to the fund boards. If 
the fund boards are out of sight and out of mind, they cannot 
fulfill their responsibility to investors. (7) Disclose fund 
manager trading and their trades as a deterrent to the 
activities seen at Strong and Putnam where managers traded 
their funds aggressively while encouraging investors to hold on 
to theirs. (8) Disclose fund manager compensation. All 
investors have a right to see that their interests are aligned 
with management's. When it comes to equities and common stocks 
in the United States, investors have the ability to see how 
management is compensated and how they are incentivized. When 
it comes to mutual funds, investors do not have access to that 
same basic information. (9) Improve portfolio holdings 
disclosure so that investors can make better use of funds. Too 
often in the late 1990's we saw investors buying what they 
thought was a diversified fund, only to learn the hard way that 
those funds in practice had more than half of their assets in 
technology stocks. If investors do not know what is in their 
funds, they cannot use them wisely. (10) State fund costs in 
actual dollars like any other professional fee is stated, so 
that the market can work efficiently and there can be a true 
debate over whether it is good value brought for the cost that 
is charged.
    Mutual funds have a proud history, but the recent scandals 
have badly damaged the industry's credibility. Collectively, 
legislators, regulators, and industry leaders can rebuild the 
public's trust in mutual funds. Investors need assurances that 
the field is level, that safeguards exist, that their manager's 
interests are aligned with theirs, and ultimately that mutual 
funds represent good value. By addressing these concerns the 
industry can get back on track to helping investors meet their 
goals and secure a safer future for their families.
    Thank you very much.
    Senator Sarbanes. Thank you.
    We are going to suspend the hearing, we need to go vote. As 
soon as the Chairman returns, the hearing will resume.
    [Recess.]
    Chairman Shelby [presiding]. The hearing will return to 
order.
    Mr. Gensler, we have a vote going on as you know. I tried 
to get here for Senator Sarbanes. We will all be coming and 
going.
    Again, welcome to the Committee. You have spent a lot of 
time around us. Thank you.

                   STATEMENT OF GARY GENSLER

                     FORMER UNDER SECRETARY

                      FOR DOMESTIC FINANCE

                U.S. DEPARTMENT OF THE TREASURY

    Mr. Gensler. Thank you very much Mr. Chairman and Members 
of the Committee.
    Chairman Shelby. Other Committee Members are on their way.
    Mr. Gensler. Mr. Chairman, I believe that the scandals 
reveal the need for substantive reform in mutual funds 
governance. Only when independent directors act in the full 
interest of investors will we safeguard against the inherent 
conflicts that will always be there. These conflicts will not 
go away, lest we forget. But fund management companies, as 
distinct from the funds themselves, have their own shareholders 
and their own profits to consider. That is natural. That is 
good. Many of them will charge high fees even if this lowers 
investors' returns.
    The SEC has been very active addressing specifics of late 
trading, market timing, breakpoints, ethics officers, et 
cetera, compliance officers, and in many ways these are very 
good actions, but they in some ways treat the symptoms of a 
greater problem. To address that problem----
    Chairman Shelby. Explain. You are going to though, explain 
if treating the symptoms and not the real fundamentals.
    Mr. Gensler. I believe that the Congress will need, if they 
wish to address the core problems, to mandate that independent 
directors truly act as gatekeepers for the benefit of 
investors, not in name only, but in reality, and I believe that 
we simply have no choice but to do this as we prepare for the 
retirement of the baby-boom generation.
    I see this whole debate about mutual funds around preparing 
ourselves for this inevitable retirement of the baby-boom 
generation, and Congress will address itself to Social 
Security, Medicare, and so many other things, but this is a 
core of that same debate.
    Mutual funds operated in the best interest of investors 
would, in fact, lower costs and increase investor returns, and 
if that were the case, would increase retirement savings and 
ultimately lower the cost of capital for the overall economy. I 
think that is what is at the core of this debate.
    The SEC noted, just for instance, that a 1 percent increase 
in 
the funds' annual expenses can reduce investors' account 
balance 
in the fund 18 percent after 20 years. It is just arithmetic, 
but it is a critical factor. With costs totaling close to 3 
percent a year for the average investor, about half of that is 
the annual expense ratio, but then there is the portfolio 
trading costs, the triggering of short-term capital gains, and 
of course, half of funds have sales loads on top. It is about 
$100 billion a year for the overall industry.
    To accomplish these goals I believe that Congress should 
look at: First, strengthening fund governance; second, 
restricting payments under 12b -1 fees and soft dollars, and of 
course, third, enhancing certain disclosures.
    While the SEC has an important role to play, I do not 
believe that they can do it all by themselves. In terms of 
governance in particular, I think the most important thing to 
do is to clarify the duties of independent directors and the 
standards to which they are held. In practice, fund directors 
have a difficult time striking a proper balance between working 
with the advisor and pursuing investors' interest. Why is that? 
First, directors are recruited by the fund companies and serve 
on a multitude of fund family boards. They serve only part 
time, of course. They rely solely, and if not solely, largely 
on management company for all of their information. In 
addition, there is a landmark case that has proved 
to be somewhat insurmountable. It is called the Gartenberg 
case. 
The Second Circuit's Court of Appeals in 1982 ruled what? That 
``To be found excessive, the trustee's fee must be so 
disproportionately large that it bears no reasonable 
relationship to the services rendered and could not have been 
the product of arm's-length 
bargaining.''
    The result of that? Twenty years later not one shareholder 
has subsequently proved a violation of the Gartenberg standard 
and not once has the SEC sued a fund director for failing to 
review adequately the advisory agreement. I truly believe that 
there are many great firms in the mutual funds industry, but to 
think, with 9,000 funds and 20 years there have not been any 
bums that have failed to live up to a standard, tells us 
something about the standard.
    So in this environment, how many well-meaning directors 
would really make waves? What if mutual funds directors were 
actually vigorously negotiating fees and other costs? Would not 
retirement savings increase in America? While I am not 
suggesting, as some have, that we have mandated requests for 
proposals and changing fund advisors, I do believe that the 
1940 Act could be amended to include a general fiduciary duty 
for directors to act with loyalty and care in the best interest 
of shareholders. I believe it can mandate that the SEC 
promulgate rules for directors in carrying out these duties, 
requiring that independent directors formally meet without the 
interested parties, spell out the list, a small list of the 
major contracts that they have to really review and get their 
minds into. Maybe they should require true arm's-length 
negotiation. It is a tricky area. It is not without its pluses 
and minuses, and then, of course, I think amend or repeal the 
Gartenberg standard. The SEC cannot do that. Only the Congress 
can. It is another situation where the courts, albeit 20 years 
ago I think, took a step maybe too far.
    I do believe that it is important that the definition to 
independence be tightened, and how we recruit and select 
directors, and I also do support the SEC's proposal on board 
chairs and 75 percent independent directors. I would say though 
it is not a silver bullet. Current law already requires that 
independent directors review and make the key decisions, but 
legislation really should clarify how they make the decisions, 
and this earlier comment on the Gartenberg decision. But let me 
say anybody who doubts the importance of a chair, just think 
about all the energy, politics, and resources that goes to 
putting you, sir, in that chairmanship there. So, we all know 
there is some relevance to a chairmanship.
    Beyond governance, I believe that Congress should give 
serious consideration to restriction of 12b -1 fees and soft-
dollar agreements. Most importantly on 12b -1 fees, they were 
promulgated in another time, in another era, and I think their 
time has come. They have not served their useful purpose.
    On greater disclosure, while there is a series of things in 
my written testimony, I think most relates to disclosing 
portfolio trading costs; eats up about a half a percent to 
three-quarters a percent a year. It can be estimated. It can be 
disclosed. I think it is very relevant.
    In sum, again, I think this is all about retirement savings 
and promoting retirement savings, and within that window I 
think there is a call and a need for Congress to act beyond 
that which the SEC is doing.
    Thank you very much.
    Chairman Shelby. Thank you.
    Mr. Glassman.

                 STATEMENT OF JAMES K. GLASSMAN

         RESIDENT FELLOW, AMERICAN ENTERPRISE INSTITUTE

    Mr. Glassman. Thank you, Mr. Chairman, and thanks for 
inviting me today.
    In the wake of the scandals involving late trading and 
market timing in mutual funds, a flood of proposals both 
legislative and regulatory have been introduced to change the 
industry. My message to you today is that you should proceed 
extremely cautiously in making changes. I say this as someone 
who has written a
syndicated financial column for the past 10 years, as well as 
two books geared toward small investors. I fear that many of 
the proposals will hurt and not help small investors by adding 
costs and by reducing choices. I will review them briefly and 
recommend different approaches.
    But first let me say something as clearly as I can, the 
American mutual funds has been the most successful financial 
vehicle of all time. In 1970, there were 361 funds. Today, 
there are 8,124. In 1970, assets totaled $48 billion; today, $7 
trillion. The mutual funds is a very simple idea, a portfolio 
shared by thousands of shareholders, composed of stocks, bonds, 
or cash managed by a professional. In the past only the rich 
could afford this. Now about half of the households own mutual 
funds. They pay modest fees. For no-load equity funds, an 
average of about $125 a year for every $10,000 in assets, the 
most popular fund charges $18 a year, and investors have vast 
choices.
    This is a highly competitive industry, and it is getting 
more so. The top five fund houses account for only one-third of 
assets, and studies show that fees are falling. And I urge you, 
do not do damage to this success. You do so at the peril of the 
U.S. economy and the well-being of small investors. I agree 
with what Senator Crapo said earlier, ``first, do no harm.''
    Investors have already spoken in response to the scandals, 
and very forcefully. They have withdrawn money from the accused 
firms and they have rewarded untainted firms. Just as one 
example, $29 billion in assets was withdrawn in 2003 from 
Putnam, one of the miscreants, last year. Meanwhile, three 
untainted firms--American, Vanguard, and Fidelity--gained a 
total of $133 billion
in assets.
    Let me just move quickly to specific proposals. I oppose a 
hard 4 p.m. close on trading activity since it hurts small 
investors who will have to get their orders in many hours 
before the close or suffer stale pricing. I oppose a mandatory 
2 percent redemption fee because it serves as a kind of price 
fixing cartel for mutual funds, and impedes the exit of 
dissatisfied investors. Instead, you should encourage the exit 
of investors as a way to discipline poor funds. In that regard, 
I back a proposal by Bruce R. Bent to allow unlimited rollovers 
from one fund to another without incurring capital gains taxes. 
Currently, taxes prevent exit, helping a poor fund
keep customers.
    I oppose proposals to increase independent directors and 
have an independent chairman. Academic research and common 
sense show that this is no solution to bad governance. Enron 
had 11 independent directors who headed every single one of its 
board committees. Instead, I suggest a reexamination of the 
antiquated legal structure of funds set by a law 64 years ago. 
This kind of reexamination has been advocated by Amy Borrus and 
by Paula Dwyer 
of Business Week and many others. Why should 8,000 funds each 
be a separate company with a separate board? Funds should be 
treated in the law as what they are and what people think they 
are, investment vehicles offered by investment firms.
    The concern over the composition of fees is equally 
misguided. Investors do not care whether this or that charge is 
ascribed to 12b -1 or to management fees. Let every firm simply 
state charges without ascribing costs. When I buy a bicycle the 
company does not say that the price comprises this much in 
health care costs and this much in rubber.
    On disclosure, let us be serious. My readers do not pay any 
attention or pay very little attention to current disclosures. 
Why add a dozen more? No industry discloses more about its fees 
and performance. I would very much like to see competitive 
disclosure, absolutely, where companies brag about their best 
points including their low fees, but let the companies make 
these decisions in response to what investors really want.
    Now, my most important recommendation. Finance is rapidly 
becoming democratized in the United States, primarily by the 
mutual funds and the 401(k) plans. But too many Americans know 
too little about the basics of finance. Investor education is a job 
for Government, as well as the private sector. Current efforts are 
diffused and underfunded, and it is investor education, not 
more rules, that you should put your energy into.
    Finally, I want to congratulate Eliot Spitzer, William 
Donaldson, other regulators, law enforcement authorities, and 
the Congress, who have moved quickly to uncover and prosecute 
the miscreants in the current scandals. Illegal and fraudulent 
activity was found and perpetrators were punished. This is 
hugely beneficial, but this does not mean that major changes 
are necessary in the regulation of funds. I urge you to proceed 
with a yellow or even a red light, but not a green light.
    Thank you, Mr. Chairman.
    Chairman Shelby. Thank you, Mr. Glassman. I thank all of 
you.
    Mr. Riepe, some question the sincerity of recent efforts by 
funds to reach out to their investors. For many there seems to 
be a credibility gap between what the funds are doing now 
compared with what so many were doing before the recent 
revelations. How do you address this assertion and how can the 
investing public be sure that funds will continue on the 
straight and narrow once the current attention has shifted 
away?
    Mr. Riepe. Obviously, I cannot speak for the thousands of 
fund groups out there, Mr. Chairman, but I can tell you----
    Chairman Shelby. Speak for your own company.
    Mr. Riepe. As I said, in our particular case, we actually 
have had very few inquiries from investors about this. Just to 
take one, I had a review done of the hits to our website, and 
we have an icon up on our website that talks about the mutual 
funds abuses, and less than one-hundredth of 1 percent of the 
hits over the last 2 months went to that site.
    Chairman Shelby. Is that because they have confidence in T. 
Rowe Price?
    Mr. Riepe. We hope it is some of that, but obviously it is 
also in terms of what people's interests are, and what we have 
found is the people who are invested with someone whose name 
has been in the papers as being involved, has suffered a very 
big penalty and those people are very aware of it. The rest of 
the industry, which is the bulk, obviously, of the industry, 
that has not been tainted by that, those investors accept that. 
What that says to me is that the people are not worried about 
the underlying fund structure. They are not worried about 
mutual funds. It is not the S&L scandal where you worried about 
every S&L even though yours might not have been in the 
headlines. In this case it seems to me that investors are only 
worried about those that they have seen in the papers.
    I do think we are trying to communicate, and I do not think 
people are being duplicitous in terms of how they communicate. 
As Mr. Glassman pointed out, the penalty that has been exacted 
on those whose names have been in the paper under these 
allegations has been much, much more severe----
    Chairman Shelby. Comes in the market, does it not, 
sometimes?
    Mr. Riepe. Yes. The market takes care of those things, and 
much more so, frankly, then the penalties that the prosecutors 
have had. So anybody who is not watching that, and is not 
changing their 
behavior if, in fact, it has to be changed, I think is making a 
very big mistake.
    Chairman Shelby. Mr. Phillips, many investors are 
understandably concerned about the fund industry and are trying 
to understand the full scope of recent problems. What factors 
should investors monitor over the next few months as they 
evaluate their portfolios, and how would you advise the 
investing public to respond to the wrongdoing in the industry? 
Are they already responding?
    Mr. Phillips. I think clearly they are responding, and I 
think they are responding in an intelligent fashion. We have 
seen money go into the fund industry at a near record rate, 
which says that 
investors recognize that there is something very right about 
this industry at its core, and I would point out that----
    Chairman Shelby. Are the investors being a little selective 
on what funds to go into?
    Mr. Phillips. Absolutely, they are being more selective. 
First, they realize that there is a good value here. We track 
funds in 17 different countries, and nowhere else in the world 
is the value proposition of mutual funds as strong as it is in 
the United States. So there is something about the system, 
whether it is the corporate structure, the directors, the 
entire way that the industry is policed that is working for 
investors, but investors have radically been moving their money 
away from those groups that have been named and toward the 
others.
    But I would argue that what is really happening is an 
acceleration of a trend that was already in place. You see the 
major companies that are winning in this industry, firms like 
T. Rowe Price, firms like Fidelity, Vanguard, American Funds, 
these are firms that not only have not been involved in the 
scandals, but they are also firms that----
    Chairman Shelby. Integrity counts.
    Mr. Phillips. Integrity counts, and integrity shows itself 
in many ways. None of these firms offered Internet funds, 
whereas a lot of funds that were involved in the scandals were 
out offering the hot fund at the wrong time at the market peak. 
All of these funds have offered at below-market cost. Investors 
recognize integrity over time. The question is: Could you state 
costs more clearly so that investors do not have to suffer 
through 10 years of bad performance in a high-cost fund before 
they recognize the debilitating effect that high costs have on 
performance in the long-term.
    Chairman Shelby. I want to pose this next question to Mr. 
Glassman and Mr. Gensler. But I want to first tell Mr. 
Glassman, we are proceeding with caution because I think that 
if we are thorough in these hearings we learn more and we 
should not rush to judgment. This industry is too big. It is 
too complicated, it is too important to do otherwise, and we 
are pretty aware of that up here. I appreciate your remarks.
    Mr. Glassman and Mr. Gensler, some contend that the 
presence of so many high-cost funds is proof that competitive 
market forces, which should theoretically drive down prices, 
are not working in the fund industry. How would you respond to 
this assertion, Mr. Glassman? Why is it that some funds can 
attract billions in assets with relative poor performance and 
high fees? Should regulators mandate fees? That would be 
troubling to me.
    Mr. Glassman. That would be extremely troubling. Investors 
want and need help, and they are willing to pay for it. So that 
it is not simply the returns that a fund produces that should 
be the factor on which people make decisions about which funds 
to buy. People need hand-holding. People need the kind of 
advice you get from a third party, and usually these 
commissions, loads are being paid to funds that result through 
third parties. But they have choices, and they have massive 
choices, and they can go to a fund like Vanguard Index 500 for 
18 basis points, and get what they want with less hand-holding 
but lower returns.
    The second reason--and this I bring up in my testimony at 
the end--interesting new research, really is that investors are 
not as educated as they ought to be, especially investors who 
have entered the market recently. They really do need help. I 
just will give you an analogy. I mean if I were to go look for 
a tie at some mall in Washington, I would pretty much know 
where to find the best value at the lowest cost. But if you 
plunk me down in Morocco and tell me to find a tie, I would 
have a hard time doing it. Now, I might just go to a brand that 
I trust if I see a brand name somehow in the souk in Morocco 
that I trust, and that is the position that many investors are 
in, and we really need to help them.
    Chairman Shelby. Mr. Gensler.
    Mr. Gensler. I would say first, I do not think that 
Government, the SEC, the Congress should mandate fees.
    Chairman Shelby. Thank you.
    Mr. Gensler. I think that is just not my upbringing. I 
think markets do work well.
    But I do think that this overall market breaks down in a 
number of ways, and let me name five of them very quickly, and 
I detailed this more in my written testimony. One is investors. 
We Americans have a collective desire to rely on experts and in 
particular in that reliance on experts to chase past 
performance. Why is it that every January and February we see 
the financial magazines showing the hot funds of last year. It 
is not the magazines' fault. It is because we Americans want to 
read about the hot funds of last year. Two, I think that there 
is an effective advertising of the mutual funds industry. That 
is good business to promote the hot funds of last year, but 
every academic study shows the hot funds usually are not that 
good performing next year. Three is the inherent conflicts of 
brokers and financial planners. All of these things, their 
revenue-sharing arrangements, they come back to haunt us when a 
broker is pushing a fund that is not necessarily the best fund. 
Yet, many funds feel they have to engage in it. T. Rowe Price, 
which I think is one of the finest firms--but I have to admit a 
conflict here, Jim. My identical twin brother works for Jim--
but does not pay loads, but why do half the funds----
    Chairman Shelby. It does not help much.
    Mr. Gensler. You mean the twin brother? They do want to 
know why he cannot control his brother better.
    Chairman Shelby. That goes on in families.
    Mr. Gensler. That does go on in families.
    My point of this though is that half of all funds feel they 
have to pay loads to get access to that distribution. That 
pushes up costs. Four, is the unique way the industry charges 
for the fees. We are not going to change this, but it is just a 
reality that it is very convenient. It is just taken out. You 
do not have to write a check for it, and I am not suggesting 
changing it, but it is a reality.
    And last, there is a practical barrier to changing fund 
families. Many investors are invested through 401(k)'s, their 
corporation picks the fund, many investors find they want to 
keep a money market fund where they have other funds. So, they 
are just a practical reality. I think those five reasons make 
it more difficult for market forces to work as cleanly as we 
would like them to.
    Chairman Shelby. Senator Sununu.
    Senator Sununu. Thank you, Mr. Chairman.
    Mr. Gensler, in your testimony you state that there is no 
way a chair who also works for an investment advisor can 
satisfactorily serve two masters. What evidence is there to 
support that claim?
    Mr. Gensler. The evidence really is the history of high 
fees. As I said in the testimony as well, or in my oral 
statement, I believe that many of these scandals, the market 
timing, the late trading and so forth, will be addressed by the 
SEC and in many ways adequately addressed. But they are 
symptomatic of something other about governance, and it is a 
very difficult challenge that these fund directors, not one 
that I would wish to have for myself, being selected by the 
fund management company and then being put in a position to try 
to serve the best interest of investors.
    Senator Sununu. Are you suggesting evidence that funds with 
chairs that work for investment advisors historically have 
demonstrated higher fees than those funds that do not?
    Mr. Gensler. I have not seen data on that, but to be able 
to serve as a chair and both promote the highest profits for a 
fund company while at the same time trying to promote the 
highest investor returns is a conflict of two sets of fiduciary 
duties. It is a burden that really cannot be managed I believe. 
How do you maximize the profits of the fund company and rightly 
maximize the profits of the fund company, and at the same time 
maximize the returns to the investors.
    Senator Sununu. I mean it seems to me that history has 
shown that the way to maximize the returns of the fund is to 
ensure that investors have confidence in that fund and thereby 
are willing to invest money with that fund, and if recent 
history has shown us anything, it is that investor discipline 
against those funds that lose public confidence or credibility 
can be stunningly harsh. The folks at Putnam, I am sure, will 
attest to that.
    Mr Riepe, could you talk a little bit about the concept of 
an independent lead director? What does that mean? What is 
their role, and how do they interact with an interested 
chairman in the case where there is one?
    Mr. Riepe. Yes, Senator. In fact, in response to your 
question to Mr. Gensler, I think there is a lot of data, and 
the fact is that all of the very low-cost funds out there also 
have chairmen who are members of the advisors and come from the 
advisor. So the evidence is quite strong that the chair has 
nothing to do with the fees. Otherwise, we would have no low-
cost funds because most of the chairs are also involved with 
the advisor.
    Senator Sununu. I am sorry. I just want to be clear. You 
are suggesting that interested chairs that may also serve the 
advisory company actually understand that low fees attract 
customers and enable them to make more money?
    Mr. Riepe. I am saying that we have, for example, in T. 
Rowe Price's case, we have an interested chair who is chair of 
the fund boards, and our mutual fund fees, 100 percent of our 
funds below the average of all of their groups, and there are 
other fund groups with fees lower than ours, and they also have 
interested chairs. So the correlation between an interested 
chair and a disinterested chair seems to me to have very little 
to do with the cost of the fees. I also think that the ``high 
fees,'' the evidence would indicate that fees have come down 
over the last 25 years in a very material way, and so, I do not 
know where Mr. Gensler--what his basis is of the high fees.
    In our case with the lead director, I think it is very 
relevant because--and I will speak for our situation--it is a 
decision that the fund directors made on their own, and that 
is, they felt they wanted to have one of their people be the 
point person in effect working with the advisor, and in our 
case the lead director sees the agenda for the meetings 
beforehand, reviews that agenda, has comments, gets involved 
with some of our vendors, does various things that the other 
directors would want them to do, and performs in that function. 
He does not want to be chairman of the funds because--as the 
Chairman said--this is such a complicated business. He thinks 
it would be a bit of a charade to put a part-time independent 
director in the chair's seat and pretend, in effect--and I 
think you alluded to this in your opening comments--it gives an 
impression of a lot more authority and power and independence 
and knowledge than frankly exists. And that has been the 
reaction to all of the suggestions from our independent 
directors.
    Senator Sununu. Mr. Phillips, in your recommendations, I 
think you recommend disclosing fund manager compensation. I 
have not worked in the investment industry, but I am very 
pleased that I have some private sector experience working for 
a small manufacturing firm, so in theory, I am still employable 
after I serve in the U.S. Senate.
    [Laughter.]
    But it would seem to me that in the private sector 
disclosing key compensation beyond which is required in the 
10(k)'s, executive compensation but disclosing other key 
employee compensation, unless it is applied in a very, very 
broad and uniform way, would put funds at a tremendous 
competitive disadvantage relative to money managers and private 
banking, at hedge funds, and investment banking, that can just 
go right down the list and find those fund managers that they 
think have performed well or have unique sets of analytical or 
other skills, and on the basis of this information, pick them 
off.
    Mr. Phillips. Senator, it seems to me that there is an 
obvious template for this. Publicly traded companies, the key 
officers are--their full compensation is disclosed. We know to 
the penny what Michael Eisner is paid to----
    Senator Sununu. Executive compensation is disclosed in a 
10(k). I do not know if it is the top five paid or the top 10 
paid, but that is for all public companies 100 percent.
    Mr. Phillips. That is correct. And every day we talk with 
fund managers who say before they buy stock in a company they 
look and see how management incentivizes. They like to see how 
much is in base pay, how much is in bonus, how much is in stock 
compensation. In fact, I have spoken to fund managers who have 
commented on Mr. Riepe and said how much they like T. Rowe 
Price's bonus structure and where their senior executives have 
a low base salary and get most of their compensation in bonuses 
and have significant stock options.
    So, it seems to me, why shouldn't fund investors have that 
same kind of information to know whether a fund manager's 
compensation is linked to sales, new sales of the fund or 
simply to performance, or is his or her bonus tied to short-
term raw performance or longer-term risk-adjusted performance? 
Is it tied to pre-tax or post-tax returns? If you are an 
investor thinking about buying a mutual fund, and you are 
thinking about putting it into a taxable or a nontaxable 
account, would it not be significant to know if the fund 
manager's bonus is linked to pre-tax or post-tax returns?
    The notion that it would put the fund industry at a 
significant disadvantage to hedge funds and other types of 
money management, I think to buy into that argument you would 
have to say that publicly traded companies are at a significant 
disadvantage to privately managed ones, because all of the good 
managers want to go run privately managed companies so that 
their compensation would not be disclosed publicly, and I do 
not think anyone would buy that. Obviously, we are able to get 
very talented and good people to run publicly traded companies 
even though that comes with the burden of having your salary 
disclosed, the same way we can get people to run for the U.S. 
Senate, even though it comes with the burden of having a 
significant exposure to your personal income taxes.
    It seems to me that all investors have a right to know if 
their interests are aligned with management's interests. We 
have a great template for that with publicly traded stocks, 
ones that fund managers take advantage of, but then those 
managers turn around and do not give the same significant and 
valuable insights to their shareholders.
    Senator Sununu. If I am buying aluminum siding for my home, 
should the company be forced to publicly disclose the 
compensation package for the salesman who is selling me the 
aluminum siding?
    Mr. Phillips. I do not think that mutual funds are a 
product. There is not a fiduciary responsibility that goes with 
aluminum siding. There is a fiduciary responsibility that goes with the 
management of mutual funds.
    Senator Sununu. You talk about making directors more 
accountable to shareholders. Can you offer some specifics 
there, how that might be accomplished?
    Mr. Phillips. Yes, absolutely. To me, again, the visibility 
is the much more significant issue than the independence. As I 
mentioned in my oral testimony, one of the disturbing things 
that organizations like Putnam--which has a very visible board 
and a very strong board--is whether whistleblowers at Putnam, 
none of these whistleblowers thought to go to the board. My 
point is that mutual funds' boards have been out of sight and 
out of mind. In fact, you saw that in last Friday's Wall Street 
Journal, where there was a letter to the editor in response to 
Ned Johnson's editorial, looking for--stating that independent 
directors are good. The woman who wrote the letter back was 
clearly confused. She thought that a dependent director was one 
who owned shares in the mutual funds, not one who also owned 
the management company.
    What we have suggested is to have front and center the 
identity of the directors. Right now the identity and the role 
of the directors is in the statement of additional information. 
What we have asked for is to have a statement at the beginning 
of the mutual funds prospectus that says something along these 
lines: When you buy shares in a mutual fund you become a 
shareholder in an investment company. As an owner, you have 
certain rights and protections, chief amongst them an 
independent board of directors whose main role is to represent 
your interests. If you have comments or concerns about your 
investment, you may direct them to the board in the following 
ways.
    As I share in my testimony, I have met a number of 
independent directors over time, and they have very little 
contact with fund investors. I met one gentleman who was on the 
board of a number of mutual funds and also on the board of a 
Fortune 500 company. And he told me as a member of that Fortune 
500 company's board, he received about a dozen letters a month 
from shareholders, and he said he did not respond to every one, 
but he read every one. He said over time they made him a better 
director. But he said in 10 years of being an independent 
director at a mutual funds complex, he had never once received 
a single letter from shareholders.
    My simple question is: How can these people be the voice of 
shareholders if they do not hear from shareholders?
    The other thing that we would ask for is that the 
chairperson write back to investors in the annual report each 
year to simply discuss how they reviewed the management 
contract, what concerns they had, what actions they took on 
shareholders' behalf for that year to create some more 
visibility for the board so that the board can truly fulfill 
its function.
    Senator Sununu. Given that limited shareholder contact, are
you supportive of the idea of mandating a disinterested 
chairman for funds?
    Mr. Phillips. I think that is more of a superficial 
solution than anything else, but the superficial and the 
symbolic things count as well, and I think it would be a step 
that perhaps would give investors some assurances that at least 
one independent director will be fully engaged in working on 
these. To me, one of the most disturbing things I have heard 
through the years are the extraordinarily disparaging remarks 
that fund industry officials will make about the independent 
directors. I have been told repeatedly that the biggest 
challenge is keeping the independent directors awake at the 
meetings, and as long----
    Senator Sununu. I am sure that is not true.
    Mr. Phillips. You hear it regularly. We have to get these 
people engaged. I really believe that there is something about 
the corporate structure of funds that has made the mutual funds 
industry in the United States a better industry than the mutual 
funds industry anywhere else in the world. So the boards have 
done something right. If we are going to keep the boards, if we 
are going to have the cost of boards, let us make sure they are 
front and center in the public's mind so that they truly can 
fulfill that function.
    Senator Sununu. Thank you.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Carper.
    Senator Carper. I will yield to Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    I apologize to the panel if I ask questions which repeat 
testimony that has been given or other questions that have been 
asked, but since I was out of the room with the vote, I missed 
part of this.
    The first thing I want to focus on is the--because there is 
a tendency to, I think, concentrate on the abuses for obvious 
reasons, I mean the most manifest abuses, and late trading and 
things of that sort. But I want to get some sense of the amount 
of monies that are involved in the broad picture, and therefore 
the importance of the mutual funds industry and its proper 
governance and how it works, just in a broader social setting.
    Mr. Gensler, you say that the SEC noted the potential 
effects on retirement savings when they stated a 1 percent 
increase in a fund's annual expenses can reduce an investor's 
ending account balance in that fund by 18 percent after 20 
years. In other words, as I understand that, over a 20-year 
period, say if you were in a fund that had a 0.5 percent fee as 
opposed to a fund with 1.5 percent fee structure. I know the 
former is pretty low, but I think there are some that are even 
beneath that point. That the difference for the investor after 
20 years, it would be an 18 percent difference. Is that 
correct?
    Mr. Gensler. That is correct, sir.
    Senator Sarbanes. How much money are we talking about in 
the overall? Do we have any estimate of how much goes into the 
fees?
    Mr. Gensler. Senator, you ask a very good question. There 
are various estimates, as I outlined in the testimony. If you 
take the average fees, annual expense ratios, which if you just 
average is between 1 and 1\1/2\ percent, and I will even use 
the 1 percent to be at the low end, add in the burden of the 
constant trading of the portfolios with the typical fund--I 
will use the median fund--turns over their stock once every 18 
months. And to that add another half a percent if you add the 
commissions and trading costs and so forth. About half of all 
funds have sales loads, and if you take the average holding 
period that all of a sudden adds costs. Then in addition, 
believe it or not, we are triggering a lot of short-term 
capital gains taxes, and that may be good for the U.S. 
Treasury, but this hearing is about promoting savings in 
America, and mutual funds do, unfortunately, trigger a lot of 
short-term capital gains that add 1 or 2 percent to the cost 
instead of the long buy and hold strategy. So overall an 
investor can be looking at an additional 3 to 4 percent, not 
just on expenses directly to the mutual funds, but between the 
triggering of these additional costs and the trading costs and 
the like.
    Now, there are various estimates how much that means to the 
mutual funds industry. I estimated approximately $100 billion a 
year between the mutual fund industry and the brokers and 
financial planners. There have been other estimates, but these 
are significant dollars, and as I said in my oral statement, I 
think this hearing and why I am in the reform camp if I am, is 
to promote retirement savings in America. I think that is 
really why governance matters, is can we best promote 
retirement savings?
    Senator Sarbanes. Presumably, no one at the table is in 
favor of setting up some kind of mechanism to set fees, to 
regulate fees.
    Mr. Gensler. No. Again, I am not for that.
    Senator Sarbanes. I understand that. So, you have to think 
what structures in the industry would contribute toward lower 
fees rather than higher fees. Or let me put the question 
another way. Why is it that some very successful funds have low 
fees and other funds have very high fees, and what is missing 
in terms of addressing this discrepancy? I take it one 
position--I think this is yours, Mr. Glassman--is well, that is 
just how things are and it has to play itself out. Would you 
take that view?
    Mr. Glassman. Well, I would not say that. I would say that 
funds, especially load funds, which charge the higher fees or 
charge the up-front commission, are providing something to 
investors, especially kind of novice investors or investors who 
really do not have that much experience or who do not want to 
spend that much time making choices, they provide an extra 
service which people are willing to pay for. I think that is 
the best explanation.
    I would also say, as far as how to lower fees, I think that 
one thing that we have kind of lost sight of, Mr. Gensler was 
talking about independent directors setting--or independent 
chairmen setting fees. Fees are set by supply and demand. 
Prices are set by supply and demand, especially in a vigorously 
competitive industry like this. If you want to lower fees, what 
you need to do is increase supply. In other words, try to get 
more funds to participate, or you can lower demand, in which 
case make all the funds do a terrible job of providing service 
to people. Funds provide a good service so that is why people 
pay for it.
    Senator Sarbanes. Is there not a basic issue, right at the 
outset, of disclosure in terms of full information? How does an 
investor, a prospective investor, make a wise decision if they 
do not have full information? I think that was one of the 
points you were stressing.
    Mr. Gensler. I think there is one piece of information that 
is still absent, portfolio trading cost. This industry does 
have exhaustive disclosure and I would not be for a lot more, 
but that one piece would be critical. Just to clarify, Mr. 
Glassman, I do not believe that independent chairs should set 
fees, nor to Senator Sununu, I do not think it is a silver 
bullet. I think directionally it probably will change the tone 
in the boardroom. I think more fundamental is, we have a 
structure now, and do those boards weigh in to the negotiation 
of fees? I do not think there should be requests for proposals 
and changes----
    Mr. Glassman. But I mean you agree----
    Mr. Gensler. --weighing in to this negotiation----
    Mr. Glassman. --that any business wants to charge the 
highest price that it can possibly get. Let us not kid 
ourselves. That is what capitalism is all about. You are 
constrained in the price that you can charge basically by 
whether people like the product that you are selling and 
whether you have lots of competition. That is how prices occur. 
Information is tremendously important, Senator Sarbanes. You 
are absolutely right.
    Senator Sarbanes. Well, what do you think the role of the 
directors is?
    Mr. Glassman. I said earlier that I think it would be a 
good idea to take a look at whether the structure of the 1940 
Act really makes sense today. Senator Sununu was asking the 
question about aluminum siding, and I think Mr. Phillips said 
that mutual funds are not a product. I can tell you that my 
readers would be shocked to learn that. They think mutual funds 
are a product. They do not think that they are investing in a 
company and that there are directors and that there----
    Senator Sarbanes. Do you think that the directors have a 
fiduciary duty?
    Mr. Glassman. Absolutely.
    Senator Sarbanes. You do?
    Mr. Glassman. Absolutely.
    Senator Sarbanes. Do you think that the current fiduciary 
duty standard is adequate?
    Mr. Gensler. I do not think so.
    Senator Sarbanes. Mr. Glassman, do you think so?
    Mr. Glassman. I have to say that that is not an area where 
I really have any expertise, but absolutely it is----
    Senator Sarbanes. I mean that if you look at the standard 
established in the Gartenberg case, it is totally inadequate in 
terms of providing some rational standard of fiduciary duty, is 
it not?
    Mr. Glassman. I do not know that case, but I really do 
think that an examination of whether the current structure----
    Senator Sarbanes. But you do think they have a fiduciary 
duty?
    Mr. Glassman. Every director has a fiduciary duty to his 
shareholders.
    Senator Sarbanes. Then the standard of that fiduciary duty 
would become a highly relevant question, would it not? You 
could say, well, you have a fiduciary duty but you might have a 
court decision which defines that fiduciary duty at such a low 
level that it does not amount to a fiduciary duty compared with 
other prevailing standards for fiduciary duty. Would you 
concede that the standard at which the fiduciary duty is set 
is, of course, a very important and relevant question, is it 
not?
    Mr. Glassman. Absolutely, but I think the question is 
whether that duty is owed to individual shareholders in one of 
8,000 funds, that is 8,000 separate companies. Let us remember 
this. Or whether it should be owed to the shareholders in the 
management company that in real life actually runs the funds. 
We all know that. We are kind of pretending that something else 
is going on here. This is what investors think. When they buy a 
fund from T. Rowe price, they think they are buying it from T. 
Rowe Price.
    Senator Sarbanes. Therefore, you think that the fiduciary 
duty that the directors of a fund owe is not to the investors 
in the fund, but to the shareholders of the management company?
    Mr. Glassman. I think under the current structure, quite 
clearly it is to the investors of the fund. All that I would 
encourage this Committee to do is to look into whether that 
really is the best structure, the most rational structure, in 
fact, the kind of structure that investors need.
    Senator Sarbanes. If you are going to shift it to the 
shareholders in the management company, who is going to 
exercise fiduciary duty with respect to the investors in the 
fund?
    Mr. Glassman. I think that investors buy individual 
products, financial products, and they make the decision about 
the brand, the company that is selling them that product. All I 
am saying, I am raising this issue which others have raised 
about whether it makes sense to--I would call it certainly 
antiquated and it may even be kind of a fiction that these are 
individual companies. People do not look at it that way.
    Senator Sarbanes. I know my time is up.
    Mr. Phillips, Morningstar looks at all these funds. Do you 
have any comment on this issue?
    Mr. Phillips. I would say that people do not look at this 
that way because the industry has not treated them that way. 
The industry has lived perhaps by the letter of the 1940 Act, 
but not by the spirit of the Act, and the word ``product'' does 
not appear in the 1940 Act.
    I would say as far as fees, we have to engage investors at 
a level that they are going to be capable of participating in 
the debate. All other professional fees, even the taxes that 
you pay----
    Chairman Shelby. What is that?
    Mr. Phillips. To state these fees in dollars, all the other 
professional fees.
    Chairman Shelby. I mean what is the standard that they are 
going to be able to participate?
    Mr. Phillips. What I mean by that, sir, is that investors 
do not relate to percentages or to basis points, but they 
relate to dollars. Taxes may be calculated in percentages, but 
if you look at your paycheck, it is stated in dollars, the 
number of dollars that are deducted for Federal taxes, for 
State taxes, for Social Security, et cetera. That allows an 
informed debate over whether these are at a fair level.
    Investors are used to looking at dollar fees that they get 
from other professionals, from their accountant, from their 
dentist, from their doctor, and that allows an informed debate. 
But when it comes to mutual funds fees, these fees are never 
presented in dollars, and that keeps the investor disengaged 
from an active debate over whether they are getting good value.
    Chairman Shelby. Is this by design?
    Mr. Phillips. I do not know if it is by intent, but it 
certainly is by the way that the fees are collected, as Mr. 
Gensler pointed out, and my suggestion would be simply let us 
level the playing field here so you can engage investors to 
have an informed debate. I do think investors over time move to 
lower cost funds, but not because they have had a thorough 
examination of the cost, but simply because they have seen 
the----
    Chairman Shelby. They move to funds that may be lower cost, 
but they also move to funds that perform.
    Mr. Phillips. That is a very good point. At the end of the 
day investors do not simply want the lowest cost.
    Chairman Shelby. So the market will work if the people have 
choices maybe.
    Mr. Phillips. That is right. They want the best returns. I 
mean the way to pay the lowest taxes is to have no income. You 
do not want to look at one of these things in isolation, cost 
alone.
    Chairman Shelby. You could have a fee, a little more 
expensive fee, and you could have better managers and, gosh, if 
they produce, people will pay as long as the people know that. 
Would they not, Mr. Glassman?
    Mr. Glassman. Absolutely. I do not think there is a single 
reader that I have who would not rather pay a much higher 
percentage fee----
    Chairman Shelby. For performance.
    Mr. Glassman. For performance. And look at hedge funds. 
These are very sophisticated investors. They are willing to pay 
on average one percentage point plus 20 percent of the profits. 
Now that is a great deal higher in a year in which stocks 
perform, as well as they did let us say last year, than what 
individual investors pay. So it is not so unusual that people 
are willing to pay a lot. The problem is, obviously, that when 
you just look at short-term performance and extrapolate that 
out, then you could be making some very bad decisions as 
investors, and that is one of the great roles that Morningstar 
plays in providing that information to people so they do not 
make those decisions.
    Mr. Phillips. If I could point out one difference, 
investors see the benefits. They see the returns in dollars but 
they do not see the cost in dollars. If you see both in 
dollars, then you will have a more informed debate.
    Mr. Riepe. Actually, to answer your question directly, they 
are in percentages because returns are expressed in 
percentages, and that is how people look at returns. They look 
at was I up 12 percent last year, did I earn 6 percent, was I 
up 18 percent? So putting expenses in the same mode is why 
expenses have historically been expressed as an expense ratio.
    One of the big successes in mutual funds has been that it 
is an agency product, i.e., nothing is promised to the investor 
as it might be in an insurance product or a bank. It is 
transparent. You are going to get the return we earn minus X 
percent, and that is the way it is.
    Chairman Shelby. Well, could you perhaps come up with some 
solution that the fund would disclose a percentage and this 
percentage would equal so many dollars?
    Mr. Riepe. Yes, the SEC has proposed that.
    Chairman Shelby. That way you have some numbers.
    Mr. Riepe. Right. The SEC has proposed that. Certainly, we 
are all in support of it. And our only argument was don't put 
it in absolute dollars relative to your balance because then I 
as an investor can't compare it to anything. So, I open up my 
statement and it says, you know, it cost you $742.17 last 
month. I don't know what to compare that to. What the SEC has 
proposed, which I think is very reasonable, and what we have 
certainly supported is do it on a $10,000 payment.
    Chairman Shelby. What do you mean you couldn't compare it? 
You can compare costs to anything if you have the model.
    Mr. Riepe. Well, but not other funds. In other words, if I 
own three funds and I have $7,000 in this and $3,500 in this 
and $12,500 in this, I can't compare dollars. I can compare 
percentages. Of these three funds, if one has a 1.5 percent 
expense ratio, another has a 1 percent, and another has an 80-
basis-point expense ratio, I can compare the cost. But if you 
send them to me in dollars----
    Chairman Shelby. But if the factor is carried out into 
dollars from percentages, you could figure it.
    Mr. Riepe. I can tell you the absolute dollars. It is a 
question of you can't compare that to anything else in terms of 
comparing to other funds. And I think Don agrees with this as 
well.
    Chairman Shelby. But as a mutual fund owner, you would 
realize the cost, though, maybe in some way.
    Mr. Riepe. Yes.
    Chairman Shelby. I am just trying to learn.
    Senator Carper.
    Senator Carper. I did not have the benefit of hearing Mr. 
Gensler's or Mr. Glassman's testimony, and what I am going to 
ask each of you to do is take a minute apiece just to recap 
briefly what you most want us to take out of this hearing 
having heard.
    Mr. Gensler. Thank you, Senator. And it is good to see you, 
too, Senator Corzine. My former boss. He sent me to Japan.
    Senator Sarbanes. We will be very mindful of that as he 
asks questions and you give answers.
    [Laughter.]
    Mr. Gensler. I think that this entire debate about mutual 
funds really relates to retirement savings in America. We have 
so many debates about Social Security and Medicare and how we 
provide for the retirement of the baby boomers. Well, the good 
news is mutual funds are right at the center of that. They are 
a product that has served so many Americans so well. But if we 
can look at the policies around mutual funds to have them serve 
Americans even better, I think that is the challenge really 
moving forward. And in that light, I think at the core is we 
have a governance system that was put in place 64 years ago by 
Congress, recognizing inherent conflicts that are not going to 
go away. Those conflicts will be there again 65 years from now.
    Can we help the balance in that boardroom? It is not a 
silver bullet to have independent chairs, but that is 
directionally, I think, a positive step. I think more important 
is the fiduciary duty that those directors are held to. Are 
they engaged in representing the shareholders? As Chairman 
Donaldson said just 2 weeks ago, ``The fund board of directors 
serves as the shareholders' representatives in this 
negotiation.'' He was referring to the negotiation with the 
investment adviser. Can we really instill in them as 
gatekeepers to be involved in that negotiation? Not to go out 
and get requests for proposals and change fund managers, as 
some have said. I am not for that. But just to be really 
shifting that balance a bit in that boardroom.
    I also think it is worthy to look at restricting or even 
repealing 12b -1 fees. I think that they have served their 
length of time. They haven't really served the purpose they 
were first attributed to. Last, disclosing portfolio trading 
costs. Those would be my three key takeaways.
    Senator Carper. Thank you.
    Mr. Glassman.
    Mr. Glassman. Thank you, Senator Carper, for this 
opportunity. Just briefly, my main message is that I urge you 
to proceed extremely cautiously, which the Chairman said that 
he would be doing, you would be doing. I said that mutual----
    Senator Carper. He always says that.
    Mr. Glassman. He always says that.
    Senator Carper. You usually do.
    Chairman Shelby. Cautious but thorough.
    Mr. Glassman. Right. I reminded you that the mutual fund is 
the most successful financial vehicle of all time. In the last 
30 years, it has gone from $48 billion in assets to $7 trillion 
in assets. And we really shouldn't do damage to something that 
has been so successful for individual Americans and for the 
economy.
    I also talked about how investors have disciplined funds 
that misbehaved and have been accused in these scandals, as 
they should, and the discipline has been very harsh, as it 
should have been. Twenty-nine billion dollars in assets were 
withdrawn from Putnam. I have a table in my testimony. 
Meanwhile, untainted firms--American, Vanguard, Fidelity--
gained a total--some of the untainted firms, not mentioning all 
of them, gained a total of $133 billion in assets.
    Then I responded to specific proposals. I oppose the hard 4 
p.m. close because I think that hurts small investors. I oppose 
a mandatory redemption fee because I think that discourages 
exit, and you want exit from funds to discipline the funds. I 
oppose proposals on independent directors and instead urge an 
examination of the current legal structure of funds to see 
whether it really makes very much sense to have 8,000 separate 
boards of directors. And the same thing with the composition of 
fees. Why do we have to go into such great detail about whether 
this is ascribed to 12b -1 or this to management costs? Just 
simply make clear what the prices are and let individuals make 
those decisions.
    What else? And then I emphasized that really what is needed 
is investor education. I see that every day. I think most of my 
readers are fairly well-informed, but more and more Americans 
are entering the arena of investment, and that is great. Just 
as Mr. Gensler is saying, this is really a retirement issue, 
and they need better education. I think that is where a great 
deal of your emphasis should be directed.
    Thanks.
    Senator Carper. The panel before us today is a diverse 
panel with diverse views. Out of that diversity, our 
responsibility is to try to develop some consensus. It would be 
helpful to me to ask each of you--and we will start with our 
State Treasurer, but just to share with me maybe a thought or 
two, as it were, where you see some emerging consensus from 
among the disparate testimony that we have heard today.
    Mr. Berry. Well, I think certainly there is some 
consistency that this is an issue that we all must deal with. I 
think there is consistency that there are more and more people 
entering into the mutual fund arena. Because of tax advantages 
that have been provided for investments for retirement, et 
cetera, more individuals are in the mutual fund environment, 
and as a result, we need to make sure that we are able to 
provide clear, concise, consistent reporting to those investors 
of what they are seeing and what they are paying for. There is 
some inconsistency here as to how that is best achieved, but I 
think we all have the goals and desires to provide that clear, 
consistent reporting.
    Certainly, I think investor education is something that we 
have heard from several individuals, that because more 
individuals are participating in the marketplace, we need to 
make sure that those individuals have access and are obtaining 
the education necessary and are not more confused by the 
process, and that through this whole process we do not do more 
harm to our investors, that we ensure that we provide more 
clear, consistent disclosure.
    Senator Carper. Okay. Thanks.
    Mr. Riepe.
    Mr. Riepe. Senator, I would say, number one, that I think 
there is a very strong consensus that the mutual fund as an 
investment vehicle for Americans has proven to be a very 
successful and transparent--which is one of the reasons it has 
been successful--product for them. And it has given access to 
the markets in a very cost-effective way. I don't think you can 
fool 90 million Americans for all these decades. There is no 
question about that.
    Senator Carper. Some of us have tried.
    [Laughter.]
    Mr. Riepe. Yes, certainly.
    Senator Carper. Remember what Lincoln used to say? You can 
fool all the people some of the time.
    Mr. Riepe. Right, some of the time.
    Senator Carper. Some of the people all of the time.
    Mr. Riepe. I find it kind of interesting that most of the 
testimony and comments have stayed away from the abuses, which 
is comforting to me in the sense that I think there is a 
general sense that the abuses are being dealt with by the SEC, 
by the prosecutors, et cetera. This has now sort of opened up 
the opportunity to make broad comments on mutual funds 
generally that are really off the subject of the abuses. But I 
think the good news is that those abuses are being dealt with, 
number one; and, number two, the marketplace impact on those 
involved has been enormous, and that is the most powerful 
signal that you can send to all the others in the marketplace. 
Number three, I think there seems to be a general consensus 
that the SEC is doing what it should be doing, being very 
aggressive. Whether it got a late start or not, I wouldn't get 
into any of that, but certainly as a receiver of all these 
reforms and initiatives that they have put out, this is the 
broadest and most comprehensive I have ever seen.
    I think the disparity starts to come into a fundamental 
misunderstanding of funds, and I think in your future panels 
you will talk about this a little bit more, and so I won't get 
into it today. But somehow people are dealing with funds as if 
they are these independent entities that sit out there. But the 
fact is they have to be created, and they are created by an 
adviser--and I think Mr. Glassman alluded to this a little bit. 
They are created by an adviser. They are created by an adviser 
not for philanthropic purposes. They are created by an adviser 
as a way to package their investment skills and put out into 
the marketplace. If they are successful and they deliver a good 
performance, they grow. If they do not deliver good 
performance, they don't grow. Then when they do grow, somehow, 
because of this corporate structure the investment companies 
have been placed in, they now take on a life of their own. And 
that even leads to what Gary alluded to of some people 
suggesting that you should go out every year for RFP's, which I 
know he opposes.
    But I think one has to remember that you don't go to bed at 
night with a Chevy in your garage and expect six or seven or 
eight or ten directors whom you don't know to pick a Ford for 
you and there is a Ford there the next morning. That is just 
not the way the system works. People have hired T. Rowe Price, 
people have hired Fidelity, people have hired the American 
funds because they have done their homework and that is who 
they want to manage those funds. The system that we have to 
work around that is the system that most of the discussion has 
been about today, not about the abuses.
    Senator Carper. Mr. Phillips.
    Mr. Phillips. Thank you. I think there is agreement that 
mutual funds are a terrific investment vehicle. Even Jack 
Bogle, one of the harshest critics of the industry, was quoted 
in The New York Times recently as saying, ``There exists in the 
mind of man no better vehicle for long-term investing than the 
mutual fund.''
    I think there is also agreement that the fund industry 
occupies a privileged space, being the core vehicle for things 
like 401(k) plans, 529 plans, individual retirement accounts.
    I believe that there is also agreement that the industry 
has misstepped. Even the most senior people in the fund, 
members of the ICI, take the abuses that have happened at some 
fund companies extraordinarily seriously. And I have seen fund 
executives personally affronted by how serious some of these 
transgressions have been. So there is a sense that the industry 
has in some cases lost its way a bit.
    I think there is also a consensus that we should be looking 
forward to say how do you, like the framers of the 1940 Act, 
think about this industry in broader terms and put it on sound 
footing that it can be protected, not just for the next 6 
months but for the next 60 years? And I think that is what has 
opened up the dialogue beyond just dealing with the most recent 
abuses, but instead thinking mutual funds have become so 
central, as Gary has said, Mr. Gensler has said, to the 
retirement savings that we have to be thinking longer term. How 
do we protect this industry? How do we make a good thing even 
better? That is what has encouraged the debate on how to do 
that. I think everyone is in agreement that this is an 
important issue and it is one that we need to be thinking long-
term about. There is just disagreement to some extent over what 
is the right way to do that.
    Some, like Mr. Glassman, are saying let's get rid of the 
structure that has protected this industry for the last 60 
years. The corporate structure, in effect, is a farce. Let's 
treat these as products. To me, it seems that there is 
something about the corporate structure that has protected this 
industry. As I say, we track mutual funds in other countries 
where they are not organized as corporations. They are 
organized truly as products. They are organized contractually. 
There you see real abuses, and you can see why. If someone is 
writing the contract, giving it to someone else to sign, they 
are going to tilt that contract as much as possible in their 
favor.
    I think there is something about the corporate structure 
that works very well and has served investors well. And I think 
it would be wise to consider strengthening as opposed to 
abandoning the corporate structure of funds.
    Senator Carper. Again, Mr. Gensler and Mr. Glassman, my 
question is: Where do you see the consensus?
    Mr. Gensler. Consensus that this is critical and important 
to retirement savings. Consensus that there is a need for 
reform. And I applaud actually the industry, the ICI. Unlike 
some other industries, this industry actually is engaged in a 
constructive dialogue of reform. The distinctions are--and even 
agreement that governance matters. The distinctions are does 
Congress need to do more after the SEC completes its rule 
writing by the spring and whether we need to enhance what goes 
on in that boardroom around governance. And you know where we 
all stand, but I think those are the key differences.
    If you say no, then maybe Congress doesn't need to act. If 
you say yes, then Congress needs to go further because the SEC 
doesn't necessarily have the authority to address itself to 
those fiduciary duties in that boardroom.
    Senator Carper. Thank you.
    Mr. Glassman, the last word.
    Mr. Glassman. Just let me make a comment on an area where 
we do differ. Mr. Phillips was saying that I am in favor of 
throwing out the corporate structure. I am not. I am in favor 
of reexamining it. I refer the Committee to an excellent 
article in Business Week on November 17, called ``Funds Need a 
Radical New Design.'' I think we really need to look at that 
question.
    I want to just go back to where I think we all agree, and 
the most important thing, quite frankly, is investor education. 
Even in the current scandals, Morningstar took the lead in 
telling its--in elucidating this and telling its readers that 
perhaps they shouldn't be investing in some of these funds. I 
did the same a little bit later. I told my readers that they 
ought to specifically dump several of these funds.
    We need, however, much broader investor education. The SEC 
does it or is supposed to do it. The Treasury Department does 
it. The Labor Department does it. There is very little 
coordination, and there is very, very little money. The mutual 
fund industry had done, quite frankly, a fantastic job of 
educating a lot of newcomers to investing. But I really feel 
there is a major role for Government here, and it ought to be 
played, and I think the panelists agree with that.
    Senator Sarbanes. Mr. Chairman, at this very point I ought 
to interject that the issue of financial literacy has been a 
subject in which Members of this Committee have been extremely 
interested--Senator Enzi, Senator Corzine, Senator Stabenow, 
and myself, and, of course, the Chairman. In fact, we included 
in the Fair Credit Reporting Act reform legislation a financial 
literacy and education title that establishes a commission at 
the Federal level of all the interested agencies and 
departments to develop a national strategy with respect to 
financial literacy. They just had their first meeting 2 weeks 
ago. The chairman of that commission is the Secretary of the 
Treasury, and he was there. I think there were three or four 
Cabinet officials present at the initial meeting of that 
commission. And the Chairman of the Federal Reserve, Chairman 
Greenspan, was also there.
    I think it is important, just as you indicate, and I wanted 
to get on the record at this point, because I thought it was 
highly relevant, the action by this Committee and subsequent 
action by the Congress and the signature by the President and 
this commission is up and going.
    Now there is a vast field that has to be covered on 
financial literacy. You have payday lending and predatory 
lending and so forth and so on. But obviously we need to raise 
the standard of literacy amongst the American public.
    Chairman Shelby. That is good.
    Senator Corzine.

              STATEMENT OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you, Mr. Chairman, and I 
congratulate you and the Ranking Member for leading a most 
thoughtful discussion on this topic, which is at the heart of 
the savings function in this country and retirement function. 
And I am one that believes that the SEC is doing a terrific job 
in actually addressing a lot of the issues at hand. That does 
not lead me to believe that there is not room for legislation. 
I think capturing some of these reforms is really about 
revising the 1940 Act, and it is a wise piece of legislation, 
but I think terms and conditions of the marketplace have 
changed pretty dramatically, and we should really do a top-to-
bottom review.
    I apologize to the panel for being late. There are a number 
of hearings going on today. But this is as important a set of 
issues, I think, for savers in America that we can get to.
    Part of the discussion I hear, though, is trying to put 
things in either/or context. We are either going to have 
percentage fee disclosure or we are going to have absolute 
dollar disclosure. I don't really understand why you can't have 
both. I think people are smart enough to actually use all of 
that information.
    I don't fully understand why distribution fees and 
management fees are fair game and transactions costs aren't 
fair game, and people understanding whether their mutual fund 
is performing effectively. By the way, turnover in those 
accounts has a lot to do with the ultimate after-tax 
performance, so I think we are not serving the broadest public 
if there are 95 million folks. I wish I understood all of the 
tax implications of all the strategies that are going on in 
these mutual funds, but I don't think it is quite obvious to 
most people. And I would be concerned if we didn't address or 
at least the SEC didn't address some of these things, and I 
think full fee disclosure and transaction costs are something 
that need to be addressed. I haven't heard the words ``soft 
dollars'' mentioned since I have been here. Maybe they were 
talked about beforehand. But there are tremendous implications, 
I think, for a different cost structure and performance for 
individuals that should be understood, and it doesn't mean that 
people won't look at their total return over a period of time. 
You ought to have a right to understand what you are paying to 
get the results that you are.
    There is a serious issue that a lot of you have apparently 
pointed out on the legislation that Senator Dodd and I 
introduced earlier on the hard 4 o'clock close. I think 
actually we need to listen to the industry and figure out how 
we can get some facilitating device to have small investors be 
able to move through that process in a way that doesn't look at 
hard closes. I am curious whether anyone would want to comment 
on some of the intermediary devices, national clearing corp or 
some auditable outside vehicle being able to certify that we 
are not into late trading, market timing, and all the other 
kinds of things. Is that a practical solution? It seems to me 
that edging along those lines as opposed to either/or on the 
hard 
4 o'clock closes is a more appropriate response.
    Let's see. Also, I continue to be troubled--and I am 
absolutely not--absolute certainty about this governance issue 
with regard to whether you have a board of directors that 
governs the management company or each of the individual funds, 
because you can get a proliferation of boards that might be 
hard to imagine that you will be able to staff appropriately. 
But from my own point of view, I can't imagine that the board 
doesn't have a fiduciary responsibility to the investors. It 
strikes me that making sure we engineer our responses along on 
the governance issue are pretty important, and, again, I am not 
sure we want to put it in an either/or status.
    Finally, I have serious concerns about mixing up hedge 
funds and mutual fund managements. I understand these fee 
structures, and if my brain were trying to somehow sort out 
without ever verbalizing where my good trades go versus my bad 
trades go, no matter how perfect a human being I might be, I 
think that there is an enormous incentive that needs to be 
recognized in how we are managing, which is another one of the 
topics that need to be put forward here.
    I would love to hear your views on some of the things that 
I am talking about. I really don't understand why we are so 
either/or, particularly on fees and costs, which I think can be 
informative, ties into the financial literacy and investor 
education. People ought to understand what is actually 
transpiring, why they are paying to get the results that they 
are getting, and I don't know why more information clearly 
stated isn't a good idea.
    I guess I am making more of a statement--but I would love 
to hear comments about third-party verification on 401(k) 
investments. I would love to hear views about the debate about 
whether you have an independent board of directors at a fund 
management group or it has to be at each individual. I would 
like to hear about the hedge fund concept. I think we are all 
in agreement on this financial literacy or education effort. We 
ought to try to structure that in a way that is actually really 
practical for all of the various individuals. And anybody that 
wants to talk about soft dollars, I am always interested.
    Mr. Gensler. I will try to do it--knowing your list of 
seven, in 40 seconds. I think you can have dollars and 
percents. Some in the industry might be hesitant because the 
dollars could be a bit high.
    Congress already acted before you were a Senator, but 
unfortunately, the after-tax results are not in promotional 
material or on your statements.
    Soft dollars, I think there is some real problems of abuses 
there. I would restrict it. There is a legitimate question 
about independent research and whether you would ban it 
completely or you would find some way to narrow it to allow 
independent research, but really only independent research.
    I sense I am where you are. I think the hard 4 o'clock 
close is too hard, and it is probably the one place Mr. 
Glassman and I are in agreement.
    I don't have a problem with unitary boards, being that T. 
Rowe Price have one overall board with all these investors. 
That is efficient. It is a little awkward, maybe if you had a 
problem with one fund and not the other 80 funds. But I think 
governance is not about whether there is one. You can be 
efficient. Governance is about are they going to act in 
investors' interests.
    Then hedge funds and mutual funds, I think the real issue 
is allocation of shares. So if you could adequately assure that 
trades aren't going to be cherrypicked for the hedge fund, but 
if you can't, that is the real issue is the allocation of 
shares.
    Mr. Glassman. Can I comment on a few of them?
    Senator Corzine. Can I ask a follow-up question?
    Mr. Glassman. Sure.
    Senator Corzine. Does that mean that you think there needs 
to be more transparency with regard to hedge funds? How would 
we be able to assess that if we don't know what the heck is 
going on?
    Mr. Gensler. Well, I think it is a question of the 
allocation of shares within a mutual fund complex, and we 
already have that issue, Senator Corzine, even amongst the 
mutual funds.
    There is a benefit to allocate the hottest trades to the 
smaller funds because you can goose the performance of a new 
fund, an incubator fund, and then advertise it later in the 
year as hot. So this issue of allocation is not unique to hedge 
fund/mutual fund management. I think it is already in the 
mutual fund field, regardless of the hedge funds. It just adds 
to it and makes it harder for your hedge fund points.
    Senator Corzine. It is more complicated when you do not 
have transparency, however, with hedge funds.
    Mr. Gensler. If it is in the management of the same 
company. I didn't know if you were asking about general 
transparency of hedge funds that are not in the management of 
mutual funds.
    Senator Corzine. Multiple.
    Mr. Gensler. I don't think there is a need to bring 
nonaffiliated hedge funds into some global portfolio disclosure 
system. I think the market actually benefits from a very nimble 
group of investors, which we call hedge funds, and the economy 
benefits in a way that--and I haven't found a regulation that 
wouldn't hurt some of that on hedge funds.
    Mr. Glassman. Just three quick comments. On the hard 4 
o'clock close, I am worried about what happens to small 
investors who are put at a disadvantage, and the answer is a 
comprehensive clearing house with some kind of time stamping. I 
think that could be done, with tremendous responsibility placed 
on the funds and every other participant. People have been 
chastened, so that would work.
    On soft dollars, I am really worried about the whole 
research situation in the financial world in general. I think 
that as a result of previous legislation, we are getting less 
of it, and we ought to have more of it. Some of these proposals 
would really hurt independent research, and I don't think that 
is good.
    Finally, on the issue of dollars versus percentages----
    Senator Corzine. If the research were productive in helping 
get to returns, why people wouldn't pay for it for what the 
cost of it is that they think is impacting their performance. 
Why do we have to do it in a system that is opaque as opposed 
to here is the money I am paying to get this research that is 
going to help me do a better job?
    Mr. Glassman. I think the system could be more transparent. 
I agree with that. But I don't believe that companies should be 
prevented from doing transactions in soft dollars as opposed to 
hard cash. I think that the firms can simply say here is the 
soft-dollar amount and we will allocate it this way: This is 
for the trade, this is for the research. A lot of companies are 
already doing that, and I think that is fine. But whether they 
want to do it with soft dollars or not, I think that really 
should be their choice. But transparency is a good idea. It is 
necessary.
    Finally on transparency as far as percentages versus 
dollars, I agree, both is fine. But my worry is there is so 
much in the way of disclosure already. I know my readers are 
not paying very much attention. I agree with Mr. Riepe that to 
just get a specific amount of dollars on your statement is 
completely meaningless. You can't compare it.
    Morningstar does a fabulous job using both dollar amounts 
and percentage amounts. They also do a very good job of showing 
the tax efficiency of funds, the turnover in funds. I mean, you 
can get all the information that you as an investor really 
need. Maybe there are little odds and ends that you might need 
otherwise, but I think that funds themselves have an incentive 
to provide that information.
    The problem with requiring more and more disclosures is 
that I worry that people--first of all, I don't think anybody--
not that many people read them. Second, there is this tendency 
to believe that, well, we have done the disclosures, that is 
all we need to do, we as policymakers. I am not against 
disclosure, but I really don't think it is any kind of panacea, 
quite frankly.
    Mr. Phillips. I would say something on soft dollars. To me 
it seems like double-dipping. If you are paying a management 
fee, you assume that the investment research, the trading 
systems, the office furniture, all these things that a money 
manager needs, are being paid through the money management, not 
through an artificially high trading cost. As for the 
independent research, Morningstar is a provider of independent 
research, and so my stance may surprise you some. But it seems 
to me, as you say, if it has value, people will pay for it. To 
me this sounds like a $400 bottle of wine that you would 
happily purchase on an expense account but you wouldn't be 
willing to pay for out of your own pocket. It seems to me that 
if the research truly has value, then someone paying their own 
money should be willing to set the market price for that as 
opposed to people paying with other people's money, which is 
what is happening today.
    Mr. Riepe. Senator, on the either/or, certainly from my 
point of view, I don't think it is an either/or. I think it is 
both. And as I mentioned, the SEC has already approved 
disclosure and shareholder reports of a dollar, it is just a 
question of how we do that.
    The one complicating factor, which I think you are familiar 
with, is that more than half of mutual fund accounts are held 
in omnibus accounts. So the idea of moving from intention to 
execution in this area gets very complicated because a broker 
who has an account for somebody has all kinds of securities, 
plus four totally different mutual funds. And getting all that 
information and getting it personalized and into that thing is 
a very complex administrative task. I am not saying it cannot 
be done, but the devil is in the details on that one. There is 
no problem with either/or. I think that both are good.
    With respect to the hard close, I said in my testimony 
essentially what you said. The industry backed the hard close 
at the time because when one thinks about that moment in time 
when the abuses came out, we felt that we had to take a very 
strong position to make investors feel that they were being 
protected. We also felt that this was much more an intermediary 
problem than it was a fund manager problem. And so the hard 
close is sort of the heavy solution to that.
    I think an electronic solution, like a clearing corp 
solution, is the right solution. There are a lot of daily 
transactions in funds, but how long would it take to be 
developed? I think that ultimately has to be the solution, and 
that will avoid penalizing shareholders, 401(k) shareholders, 
and other people who come in. I think that
the NASD has one that tracks transactions from the very point 
it is delivered.
    Let me just say on the soft dollars, the industry has come 
out and said that we ought to clarify it, we ought to end 
third-party research. And the only thing I would point out to 
you, this is not just a mutual fund problem. All advisers have 
soft dollars, and we would not like to see just mutual funds 
regulated for soft dollars and all other advisers be left out 
of that.
    With respect to independent directors--we talked about 
this, and I think the Chairman spoke to this. Independent 
directors are being handed responsibilities far beyond what 
they are capable of executing as part-time overseers. Everybody 
is directing to them responsibilities that they are worried 
about, asking them to certify things that they can't certify. I 
think that has to come out of your review here, that we have to 
have a clearer idea of what they are. They are fiduciaries, but 
the question is: What is contained under their fiduciary 
responsibilities? What responsibilities do they have?
    Mr. Berry. As relates to funds, I think it is necessary 
that both be provided. Not only do investors look at their 
performance based on a percentage basis, but also they look at 
bottom-line dollars and what do they have in their account 
today. That is expressed in dollars, and as a result, fees 
expressed in dollars would also be meaningful to them as well.
    Senator Corzine. I thank you all. I think that personally I 
have a strong sense that we also need to think about how 
information is presented so that it is comprehensible. It ties 
together very much with the education issue, and I don't know 
whether that is a legislative approach or we need to do it in 
some other format. Not only making information available, but 
also making it presentable in a way that people can understand 
it I think is a key issue.
    Thank you, Mr. Chairman.
    Chairman Shelby. I have a couple more questions. I want to 
address them to Mr. Glassman and Mr. Gensler. I am not picking 
on them, though.
    As we consider reforms and possible legislation to protect 
investors, I agree with all of you that we have to be sensitive 
to the additional cost that will be borne by the investors. How 
do you do a cost/benefit analysis to determine when necessary 
reform becomes overregulation that costs investors? Mr. 
Gensler? That is something we have to weigh.
    Mr. Gensler. I think that it is a very difficult matter for 
policymakers and for Congress in all sectors of the economy.
    Chairman Shelby. Don't overkill, right?
    Mr. Gensler. Don't overkill. I mean, we do have a wonderful 
capital system in America, and it is part of our great success 
over the years.
    I do think that in this area what some of us are suggesting 
in terms of having stronger board governance, meaning that 
these individuals are doing exactly what Chairman Donaldson has 
said, being engaged in that negotiation or that fundamental 
relationship is critical.
    Might it add cost? Might these directors feel they need an 
adviser or something? It is possible. But when you are talking 
about $100 billion of costs, if they were to negotiate even 5 
percent better, it would, I believe, cover that.
    Chairman Shelby. So when you reference in the cost/benefit 
analysis, if it is a cost, somebody has to pay it. Ultimately, 
the investor will pay it, will he not? It will be part of the 
overall deal.
    Mr. Gensler. Oh, I think that there are two areas, and 
ultimately it would be the fund companies that would probably 
bear the crux of many of my recommendations and the Wall Street 
that I used to work for that would bear the crux. I mean, if 
the system was more efficient and investors had higher returns, 
in essence if we narrowed the gap between where corporations 
borrow money and investors get a return, that narrowing in 
economic terms helps the economy. But it is the 
intermediaries--Wall Street, mutual funds--that would probably 
have lower profit margins. That is why they would not 
necessarily endorse what I am saying--and rightly so, they 
would not endorse. They have shareholders as well.
    So, I think it is actually in narrowing that gap in the 
capital markets is where I would focus my attention.
    Chairman Shelby. Mr. Glassman.
    Mr. Glassman. I think if you raise the costs for everyone, 
then the costs to investors will rise. I think that is a pretty 
basic economic tenet. If you only raise it for certain 
companies, fine. They will go to the other companies.
    You raise a very important issue, Mr. Chairman. Even on 
disclosure, disclosure costs money. You have to have the 
accountants. You have to do the publishing. You have to have 
lawyers. And it is a very important issue----
    Chairman Shelby. You have to ask yourself, will this 
benefit? Is this worth what we are doing?
    Mr. Glassman. Right, what is the benefit? In fact, I think 
we need to define benefit here. To me, and to most of my 
readers, benefit is a higher return on their investment. That 
is what a benefit is. And will they get a higher return or a 
lower return through these disclosures? Well, it may be hard to 
say. My guess is they will probably end up with a lower return 
because they already have vast disclosures. This is just 
marginal disclosure that probably won't help.
    Chairman Shelby. Okay. Last, what do you believe is the 
most critical information for an investor to consider when 
purchasing a mutual fund? How can we make sure that investors 
get that information? Information is important.
    Mr. Riepe.
    Mr. Riepe. I think there is just a few--it was interesting. 
Don said something ought to be on page 1. Every time I get into 
disclosure discussions with people, everybody wants it on page 
1. You would have a page 1 that would fill up this room, 
probably. What we need to do is to make sure investors 
understand some fundamental things:
    Number one, the investment program that they are buying 
into of that fund. What is the investment strategy? What kind 
of fund is it? Number two, what are the risks that come along 
with that investment program? These two things will overwhelm 
costs, fees, everything else.
    Chairman Shelby. But should the risks be stated up front 
and not footnoted back somewhere where nobody is going to read 
it?
    Mr. Riepe. Absolutely. Now, the risks get stated in words, 
but they absolutely should be stated up front.
    Number three, what are the costs associated with buying 
into this investment? Then you get beyond that, and to me that 
is the top tier sort of--I am not saying that is all someone 
should know, but too many people don't even know those three 
things.
    Chairman Shelby. Anybody have any other comments? Mr. 
Gensler, what else should they know?
    Mr. Gensler. I would say on the risk aspect, there is a way 
that sophisticated investors look at risk, and it is called 
risk-adjusted return. I think that that would be the way to 
take those words, if somebody wanted to get it to page 1, and 
actually share with investors risk-adjusted returns.
    Chairman Shelby. Is that risk versus return?
    Mr. Gensler. Without getting into the calculus, it is a way 
to bring that return and adjust it for higher risk or lower 
risk.
    Chairman Shelby. What Mr. Glassman says, you know, we have 
a capitalist economy. You are investing for profit.
    Mr. Gensler. That is correct.
    Chairman Shelby. You have growth in there, so you know 
there is some risk--some risk everywhere when you put your 
money in.
    Mr. Gensler. Right, but there is----
    Chairman Shelby. Versus the return that they hope to make. 
Is that correct?
    Mr. Gensler. Right. But just in that one small place, there 
is a different risk of a Treasury bond than of an Internet 
stock. I think to your question, the most important thing for 
investors to do is first, on their own, without all of this 
information, decide how comfortable they are in stocks versus 
bonds versus cash. Eighty or 90 percent of the investment 
decision is really right there, your asset allocation. Then 
when you have picked stocks and bonds, how to best invest----
    Chairman Shelby. You have funds that specialize in bonds.
    Mr. Gensler. That is right.
    Chairman Shelby. You have some in stocks.
    Mr. Gensler. That is right.
    Chairman Shelby. Everything, don't you?
    Mr. Glassman. Yes, just in answer to your question, Mr. 
Chairman, it is kind of interesting that Mr. Berry and Mr. 
Gensler should really focus on some very simple ideas, very 
simple metrics. I really think those are the key. I completely 
agree with them. A lot of the discussion today has been about 
arcana, which, quite frankly, most investors just--I mean, they 
are either not interested in it or they don't have the time. 
They are doing other stuff with their time.
    What do they need to know? They need to know the past 
performance of the fund, the objective of the fund, the 
volatility, which is basically the way we define risk, and 
the----
    Chairman Shelby. The integrity of the fund.
    Mr. Glassman. Excuse me?
    Chairman Shelby. The integrity of the people running the 
fund.
    Mr. Glassman. Absolutely. That is a very difficult thing to 
find out, and that is one of the reasons that people go to 
third parties to make their decisions about funds. How are they 
going to judge the integrity of an individual fund manager? 
That is hard. The brand is important; a brand like T. Rowe 
Price or like Fidelity is important--and absolutely expenses. 
People need to know more about expenses. But they have tons of 
information as it stands right now about all these things, and 
I urge them to go to places like Morningstar to get probably 
much more than they want to know--maybe not more than they 
need--well, yes, I would also say probably more than they need 
to know, most of them.
    Chairman Shelby. They should get involved and know probably 
more than just glancing at something, because if we have mutual 
funds totally with trillions of dollars in it, this is big. It 
is big for the capital markets. It is big for the investor.
    Mr. Glassman. Yes. But I want to reemphasize something that 
Gary just said. Mutual funds are a way to meet specific 
investment aims. Asset allocation is much more important. That 
is how you 
divide up your assets among stocks, bonds, and cash--much more 
important than which individual mutual fund you pick. And so, 
we don't really want to lose sight of the forest for the trees 
here.
    Chairman Shelby. Mr. Phillips.
    Mr. Phillips. I think we should be careful about these 
arguments and say let's dumb down the information, let's keep 
it very simple because investors are overwhelmed, and realize 
that there are also a lot of forces in the market that work to 
help investors. Financial advisers, the majority of investors 
are going through an adviser, a professional. When a State 
treasurer chooses funds for a 529 plan, the stuff that we may 
say is arcane information that the investor doesn't want to see 
is very important to these people that have a fiduciary role to 
the investor. Academics study the 
industry, and the more disclosure they have, the more they can 
contribute to the aggregate body of knowledge that we have 
about mutual funds.
    So while this data may not be that important that every 
individual is going to read it, it will make an impact on the 
marketplace. Perhaps you don't put these things front and 
center, but more disclosure and more information about costs 
and whether management's interests are aligned with investors 
will make a difference to companies choosing funds for a 401(k) 
plan and other professionals that are helping the investor with 
their choices.
    Chairman Shelby. Gentlemen, thank you for your patience. 
Thank you for the information you have brought to the 
Committee, and we will continue our hearings in a thorough way 
and try to balance what is right here and without rushing to 
judgment.
    Thank you.
    [Whereupon, at 12:22 p.m., the hearing was adjourned.]
    [Prepared statements and additional material supplied for 
the record follow:]

             PREPARED STATEMENT OF SENATOR MICHAEL B. ENZI

    Thank you, Chairman Shelby, for the third in a series of oversight 
hearings on the mutual fund industry. It has been nearly 3 months since 
our last hearings on this issue were held and since that time many 
significant events have taken place.
    Back in November, I stated that virtually every day since the 
revelation of market timing and late trading abuses, the mutual fund 
industry appeared on the front pages of newspapers and was featured in 
television news segments and radio interviews. That situation does not 
appear to have changed. Just over a week ago, news surfaced of a mutual 
fund's employees permitting market timing of a mutual fund set up for 
young investors.
    Unfortunately, the bad actors in the mutual fund industry, who put 
their own interests ahead of their shareholders' and in the case I just 
cited ahead of children, have put a cloud over the entire industry. I 
have no doubt that the individuals in charge of preventing abuses to 
the system will be brought to justice. Their actions clearly violated 
the current regulatory scheme, and the SEC and State regulators already 
have commenced enforcement actions to rid the industry of them.
    It also is clear that the SEC has been extremely busy since our 
last set of hearings. The Commission has been putting together a series 
of rule proposals to clarify existing law and to ensure that the grey 
areas of a mutual funds' activities are clearly marked as black and 
white. Some of the proposals, including one on mutual fund compliance 
programs, have already been adopted. While I support many of the SEC's 
actions in this area, it is clear that there are many important areas 
that need to be fully and carefully examined before final action takes 
place.
    For example, the SEC proposed a ``hard 4 o'clock'' close for orders 
of mutual fund shares to reach the mutual funds. As I am a Member of 
the Committee on Health, Education, Labor, and Pensions, I have heard 
from many pension and benefit plan administrators, especially from the 
mountain and the western States that a hard 
4 o'clock close would place employees with pensions and with 401(k) 
plans at a disadvantage with investors who place orders for mutual fund 
shares directly with
mutual funds.
    Also, there are issues that appear ripe for a quick regulatory or 
legislative fix. However, upon closer examination, these issues are far 
more complex and intricate than they first appear. For example, certain 
industry members would institute a complete ban on so-called ``soft 
dollars'' which may be a misnomer in itself. Unfortunately, other 
industry members state that a complete ban would place independent 
research firms at a competitive disadvantage. These are the same 
research firms that were described as essential for investor confidence 
in last year's $1.4 billion SEC and State global settlement with Wall 
Street firms. We need to fully understand why these independent 
research firms would be placed at a disadvantage and what can be done 
so that they are not disproportionately affected by any proposed 
changes to the way the industry operates.
    Before us today, we have a diverse panel of mutual fund experts 
that will help us to understand better the operations and corporate 
governance policies of mutual funds from the perspective of investors. 
Their testimony is essential for us to have a clearer comprehension of 
the intricacies of the operations of the mutual fund industry, an 
industry structured unlike any other financial or corporate industry. 
We need their expertise to help us discern the true effects of proposed 
reforms that have been raised to date.
    For example, I have serious questions about the recent SEC proposal 
to require an independent chairman for a mutual fund even if the mutual 
fund's board is comprised of a super-majority of independent directors. 
Another proposal that the Commission is considering this morning would 
require a mandatory redemption fee for investors that trade within a 
short period of time. I am unclear as to whether this proposal will 
completely stop market timing abuses and I am concerned that the 
proposal may have unintended consequences for some individual 
investors. The witnesses' testimony is crucial for our understanding of 
issues like these.
    If legislation is necessary, I would like to see Congress 
thoroughly evaluate the problem to find the right solution. We should 
not rush to pass legislation as we may do undue harm to the industry. I 
applaud the Chairman for taking a similar approach that we used in the 
Sarbanes-Oxley Act.
    Typically, for every action, Congress has a tendency to overreact. 
In this situation, we need to thoroughly review the problems to find 
the appropriate solution. In addition, we still have a responsibility 
to make sure that whatever action is taken does not have a negative 
cascading effect on small entities and small investors.
    Several of our witnesses in their written testimony have cited a 
greater need for investor education and financial literacy. I wish to 
note that the Financial Literacy and Education Commission created by 
the Fair and Accurate Credit Transaction Act (FACT) of 2003, held its 
first meeting last month to coordinate the Federal Government's 
financial literacy and education efforts. Financial literacy has been a 
very important issue for Senator Sarbanes, our colleagues on the 
Committee, and I. I appreciate your efforts to have it included in the 
FACT Act.
    Thank you, Mr. Chairman, for holding this hearing. I appreciate the 
effort that you are taking to carefully analyze the problems with the 
mutual fund industry. I look forward to working with you on future 
Committee hearings highlighting this very important matter.

                               ----------
                    PREPARED STATEMENT OF TIM BERRY
                      Indiana State Treasurer and
          President, National Association of State Treasurers
                           February 25, 2004

Introduction
    Mr. Chairman, thank you for the opportunity to appear before this 
distinguished Committee. My name is Tim Berry and I am the Treasurer of 
the State of Indiana. I am honored this year to also serve as the 
President of the National Association of State Treasurers. We are very 
pleased to offer our comments relative to current mutual fund practices 
and their impact upon investors, including the States as investors. We 
are also pleased to provide you information on efforts to expand 
investor education, and the role such efforts play in building investor 
confidence in the financial markets.
    The National Association of State Treasurers, or NAST, is a 
bipartisan membership organization composed of all State treasurers, or 
State finance officials, from the United States, its commonwealths, 
territories, and the District of Columbia. As the elected chief 
financial officers of the States, the State treasurers directly oversee 
more than $1.5 trillion dollars in State funds. The treasurers are 
important daily participants in the domestic securities markets, 
investing State funds in U.S. corporations and small businesses. They 
have a direct stake in the health of the Nation's economy and 
diligently share their expertise in fiscal and investment matters with 
other Government officials and the general public. Based on this role, 
the State treasurers are in the forefront of addressing concerns about 
corporate business practices and governance, leading efforts to ensure 
investor confidence in the stock markets and to increase shareholder 
value for the citizens of their States.
    A great majority of State funds are invested in the domestic equity 
markets. Earnings from investments are an important source of revenue 
for State governments. These earnings are used to fund vital public 
services, to cover public employee retirement obligations, to help 
families save for college, and to fund beneficial economic development 
programs, among other uses. In contemporary financial markets, 
maximizing this source of revenue is a complex and time-consuming 
undertaking. To make the best use of investible public funds, investors 
like the State treasurers strive to earn the best returns possible 
without sacrificing the safety of their funds or subjecting their 
portfolios to undue risks. State treasurers and other public investors 
must achieve this goal within the constraints of applicable State and 
Federal laws, keeping in the forefront the overriding principles of 
safety, liquidity, and yield.
    The nature of State investments has made the State treasurers 
keenly aware of issues surrounding the mutual fund industry and its 
impact on investor confidence in the capital markets. We believe that 
accurate and reliable financial reporting lies at the heart of our 
financial market system and that investor confidence in such 
information is fundamental to the health of our markets. We further 
believe that expanding and strengthening the disclosure requirements of 
mutual fund companies will address concerns about investor confidence 
and enhance efforts to raise the level of understanding of the 
complexities and risks of mutual fund investing.
What is at Stake?
    The recent allegations of fraud in the mutual fund industry have 
fundamentally altered Americans' perceptions of these important 
investment vehicles. These allegations do not involve isolated 
instances of individual wrongdoing by low-level employees--the 
proverbially ``few bad apples,'' but rather appear to involve a large 
number of mutual fund complexes, and wrongdoing by a significant number 
of employees, including, in some cases, executives at the highest 
levels of management.
    Revelations regarding significant problems in mutual fund 
compliance have made regulatory reform a critical issue. The alleged 
frauds in these cases were open and notorious and violated express 
legal requirements. Fund stewards were on notice and failed to take 
action. Recently, the U.S. Securities and Exchange Commission surveyed 
most of the largest mutual fund complexes in the country and all of the 
Nation's registered prime brokers. Preliminary findings reveal the 
apparent prevalence with which mutual fund companies and brokerage 
firms had arrangements that allowed favored customers, including 
themselves, to exercise after-hours trading privileges and market 
timing options--as well as the ability to participate in other abusive 
practices.
    Investors have placed their trust in mutual funds with the 
understanding that they would be treated fairly--that fund managers 
would do their duty as fiduciaries. Unfortunately, there have been 
instances where the mutual fund industry has failed to live up to its 
fiduciary duty. The common theme running through all of the mutual fund 
issues that have been exposed in recent months is that certain 
participants in the mutual fund industry are putting their own interest 
ahead of mutual fund investors.
    These violations of the fiduciary duty owed to investors have 
caused real harm--particularly in confidence and in lost investment 
value. These frauds reflect a systemic compliance failure in the sense 
that the current structure of fund oversight is not resulting in fund 
shareholders receiving the most fundamental and obvious forms of 
protection from actual and potential abuses. If shareholders are not 
being protected from the most obvious frauds, they may not have any 
confidence that they are being protected from frauds that we have yet 
to or may never discover.
The Vital Role of State Treasurers
    The State treasurers have a direct stake in issues raised by mutual 
fund trading and sales practices. Twenty-five States utilize money 
market mutual funds to invest a portion of their general fund 
investments. Thirty-eight States use mutual fund companies as 
intermediaries for general fund investments. Many State treasurers also 
directly oversee or sit on the boards of State and local government 
pension plans, including supplemental pensions, 401(k) and deferred 
compensation plans, many of which are based on mutual fund investments. 
Most significantly, the State treasurers are directly involved in the 
oversight and management of Section 529 
college savings plans, the bulk of which are based on an investment 
model linked to the mutual fund market.\1\ Additionally, numerous 
mutual fund firms manage institutional portfolios for State and local 
government pension systems and other investment programs, but these 
operations are generally separate from the mutual fund's retail 
business. Mutual fund investments and mutual fund companies are a 
critical component of the treasurers' investment functions.
---------------------------------------------------------------------------
    \1\ The enactment of Economic Growth and Tax Relief Reconciliation 
Act in 2001 has enhanced the attractiveness of Section 529 plans by 
allowing greater contributions and flexibility in the plans. The 2001 
Act allows tax-free distributions from Section 529 savings plans for 
qualified higher-education expenses. Previously, withdrawals from these 
accounts were generally taxed at the rate of the beneficiary--usually a 
child or grandchild. In another change, contributors now will be able 
to move their 529 plan investments from one State's plan to another 
once a year without having to change beneficiaries. As a result, assets 
in Section 529 savings plans have more than quadrupled since 2001, 
increasing from $8.5 billion at year-end 2001 to $45.7 billion by 
December 31, 2003. The number of accounts rose to over 6 million, and 
the average account size was approximately $7,600.
---------------------------------------------------------------------------
    As fiduciaries of public investment funds, the State treasurers, 
their investment oversight boards, and their money managers maintain 
great responsibilities which bear directly on mutual fund company 
issues. First, as fiduciaries, they have a duty to act prudently and in 
the best interests of their plan participants and beneficiaries. 
Second, as investors, they have an opportunity and duty to speak out on 
the strategy, direction, and governance of the mutual funds in which 
they and their constituents invest. This is the essence of responsible 
investment management. State and local governments are among the 
Nation's most important institutional investors. Both singly and 
collectively, Government fund investments are frequently the most 
important shareholders a mutual fund has. Consequently, they are in a 
unique position to influence corporate policies and financial markets.
    Federal laws such as ERISA generally do not apply to State and 
local pension funds, which are governed by State and local regulatory 
structures that vary from jurisdiction to jurisdiction. In every 
jurisdiction, however, those who control State and local investment 
funds--State treasurers, pension boards and trustees, etc.--are 
considered fiduciaries. As fiduciaries, they are duty-bound to act in 
good faith and for the exclusive benefit of plan participants and 
beneficiaries. They must discharge their duties with the care, skill, 
and diligence that a prudent investor would exercise on his or her own 
behalf under like circumstances. To meet this high standard, they must 
demonstrate that the investment practices and policies they adopt on 
behalf of plan participants and beneficiaries are fundamentally sound.
    As fiduciaries, State treasurers must factor allegations of 
improper mutual fund practices into the fiduciary's determination of 
the continuing appropriateness of a fund. They must be attentive to 
activities that materially affect the plan's investment in the mutual 
fund or expose the plan to additional risk. They must have more active 
communication with mutual fund management in order to meet their 
obligations under State law.
    As competent and effective fiduciaries, individual State treasurers 
are demanding numerous changes to the manner in which corporations and 
mutual funds operate. These important activities have long been 
recognized as a fundamental function of our association, which last 
year established a standing committee on corporate governance. 
Currently chaired by Connecticut Treasurer Denise Nappier and Nevada 
Treasurer Brian Krolicki, the Corporate Governance Committee has taken 
a leading role in responding to issues raised by corporate behavior, 
including work on the proxy access issue, reforms to corporate board 
structure, composition and functions, and oversight of the stock 
exchanges. We have taken a number of strong positions on these matters 
and would be pleased to share them with the Committee.
    In a continuation of these efforts, North Carolina Treasurer 
Richard Moore, working with our Corporate Governance Committee, has 
implemented a series of ``mutual fund investor protection principles'' 
designed to provide greater transparency in mutual fund practices. The 
principles aim to stop late day trading by requiring the fund to hold 
all trades for 12 months. They require the fund to report how the 
managers are compensated and require at least two-thirds of the mutual 
fund board to be independent directors.
    These principles illustrate how the treasurers are acting in good 
faith on behalf of the citizens of their States. They are discharging 
their duties with care, skill, and due diligence. They are adopting 
fundamentally sound investment policies and implementing them within 
their States. They are attentive to fund activities that are affecting 
the health of their State's investments. And finally, they are active 
in their communication with mutual fund management, working to find 
equitable solutions to recent industry abuses. These actions have been 
taken with a fundamental goal in mind: To restore investor confidence, 
mutual fund companies need to provide timely and accurate information 
about costs and fees, performance and potential risks. The mutual fund 
companies should be required to provide investors access to timely and 
understandable information.

What Should Investors Do?
    Investors must actively research and monitor their fund investments 
to ensure that fund managers have their best interests in mind. At a 
minimum, investors should look to see that the mutual fund charges 
reasonable annual expenses; and that the fund management provides open 
and honest communication with investors.
    The fees charged for participation in a mutual fund are a key issue 
for investors. These fees can be substantial and may erode investment 
returns in mutual funds. Generally, investors do not pay enough 
attention to mutual fund expenses. Some funds charge investors upfront 
or back-end ``loads,'' or commissions, and all funds charge investors 
management fees, under the term ``expense ratio.'' Investors should be 
aware that even small fees may detract from growth in investments. In 
fact, fees mount over time because investors' total assets mount as 
well.
    These recommendations, of course, are predicated on investors 
having adequate access to timely and intelligible information on mutual 
fund fees and expenses. Equally important, particularly for the long-
term health of investors, and by extension to the whole economy, these 
investors need a strong education on how to 
approach and manage mutual fund investments. Thus, in considering 
regulatory reform, the Committee should also address the scope and adequacy of 
financial literacy training in the United States.

Policy Recommendation
    In recent months, the Securities and Exchange Commission has taken 
a number of steps to address issues raised by State and Federal 
investigations into mutual fund sales and trading practices. For 
example, to address late trading issues, the Commission adopted a new 
rule to require that an order to purchase or to redeem mutual fund 
shares be received by the mutual fund by the time that the fund 
establishes for calculating its net asset value in order to receive 
that day's price. We believe this rule would effectively eliminate the 
potential for late trading through intermediaries that sell fund 
shares.
    The Commission also recently proposed an amendment to Rule 12b -1 
under the Investment Company Act of 1940 that would prohibit mutual 
funds from directing commissions from their portfolio brokerage 
transactions to broker-dealers to compensate them for distributing fund 
shares. This would eliminate a large potential conflict of interest, 
aligning fund companies more directly with the interests of their 
shareholders.
    The Commission also recently adopted a compliance rule that will 
require these funds and advisers to have compliance policies and 
procedures, to annually review them and to designate a chief compliance 
officer who, for funds, must report to the board of directors. The 
designated compliance officers and written policies and procedures will 
have several benefits, including having a designated person charged 
with fund compliance who must answer to, and be accountable to, the 
fund's board of directors, thereby enhancing compliance oversight by 
directors, as well as allowing the SEC's examination staff to review 
the reports made to the board.
    In addition, the Commission proposed enhanced disclosure 
requirements. These enhancements would require funds to disclose market 
timing policies and procedures, practices regarding ``fair valuation'' 
of their portfolio securities and policies and procedures with respect 
to the disclosure of their portfolio holdings. This type of disclosure 
should shed light on market timing and selective disclosure of 
portfolio holdings so that investors could better understand the fund's 
policies and how funds manage the risks in these areas. Mutual fund 
boards of directors play an important role in protecting fund 
investors. They have overall responsibility for the fund, oversee the 
activities of the fund adviser, and negotiate the terms of the advisory 
contract, including the amount of the advisory fees and other fund 
expenses. In order to improve such governance, the Commission recently 
proposed amendments to its rules to enhance fund boards' independence 
and effectiveness and to improve their ability to protect the interests 
of the funds and fund shareholders they serve. First, independent 
directors would be required to constitute at least 75 percent of the 
fund's board. Second, the board would be required to appoint a chairman 
who is an independent director. Third, the board would be required to 
assess its own effectiveness at least once a year. Its assessment would 
have to include consideration of the board's committee structure and 
the number of funds on whose boards the directors serve. Fourth, 
independent directors would be required to meet in separate sessions at 
least once a quarter. Finally, the fund would be required to authorize 
the independent directors to hire their own staff.
    We commend the Commission for its efforts in this area. The new 
rules governing board composition and functions, as well as governing 
trading practices and expense disclosures, will go a long way toward 
rectifying many of the abuses identified in the recent investigations 
of the mutual fund industry.
    The implementation of these new rules confirm our opinion that the 
mutual fund industry is neither inherently corrupt nor in need of a 
major structural overhaul. While these rules properly clarified and 
strengthened, it is not necessary to undertake wholesale reform of the 
regulation of this industry. The vast majority of people in the fund 
management industry are honest and hard working. Collectively, they 
provide a valuable service to the American public. Moreover, the U.S. 
fund industry has a good long-term record of serving investors. This 
record reflects the strengths of the industry's structure and the 
emphasis placed on disclosure by its overseers and regulators. To the 
extent that the industry has lost its way in recent years, we believe 
that it is a function of its participants placing profit over the needs 
of mutual fund investors. The profitability of the fund company or its 
employees must never take precedence over the interests of fund 
shareholders.
    However, we remain concerned in particular about a practice that 
does great damage to investor confidence in the fairness and equity of 
mutual fund investments. Specifically, what are prospective mutual fund 
investors being told about revenue sharing arrangements and other 
incentives provided by mutual fund companies to brokers selling their 
funds? Do customers understand that their broker is being paid to sell 
a particular fund? And when these payments are being made from fund 
assets, do customers understand that their own investment dollars are 
being used to foot the bill for the mutual funds' premium ``shelf space'' at the selling broker's office? Such fees may increase costs to investors, as 
well as create conflicts of interest between investors and the 
financial professionals with whom they deal.
    Congress should act promptly to eliminate this gap in mutual fund 
fee disclosure. Current SEC rules and positions provide investors with 
a misleading picture of the incentives of brokers from whom they buy 
fund shares. If an investor buys shares of a particular company, his 
broker must send a confirm that shows how much the broker was paid in 
connection with the transaction. In contrast, if an investor buys 
shares in a mutual fund, the confirm is not required to provide this 
information. The Commission is considering possible solutions to this 
problem. But we believe this issue is so critical to restoring 
confidence in mutual funds, that Congress should require that all 
compensation received by brokers in connection with sales of fund 
shares be disclosed on fund confirmations, as well as any information 
necessary to direct investors' attention to incentives that a broker 
may have to prefer the sale of one fund over another. With America's 
investors experiencing a crisis in confidence in the mutual funds, fee 
disclosure reform is more important than ever.

Financial Literacy Programs
    In order to succeed in our dynamic American economy, our citizens 
must be equipped with the skills, knowledge, and experience necessary 
to manage their personal finances and retirement needs. All members of 
our society should have the financial knowledge necessary to make 
informed financial decisions. Despite the critical importance of 
financial literacy, many citizens lack the basic skills related to the 
management of personal financial affairs.
    The recent allegations of fraud in the mutual fund industry 
underscore the tremendous need for financial education in the United 
States. Improved financial education will help mutual fund investors 
better understand the costs associated with this form of investment, as 
well as the risks and rewards of mutual fund investing. A better 
educated class of investors would understand the industry, which would 
increase overall confidence in the capital markets.
    State treasurers have long recognized the need for improved 
financial education for all of our citizens. For many years, treasurers 
have taken a very active role in promoting financial literacy to the 
residents of their State. State treasurers strive to provide and 
promote financial education for the benefit of the citizens of the 
States, to improve their quality of life. State treasurers draw on 
their substantial expertise in the financial management of both 
personal and public funds to provide opportunities to educate the 
citizens of the States on savings, from birth to retirement. Members 
emphasize there is a critical need for personal savings to the citizens 
of the States. Through the legislative processes, State treasurers 
support public policy positions that promote savings, and seek changes 
of current policies which hinder and penalize savings.
    The financial literacy programs range across a variety of target 
demographic groups, from school age children, to women, to public 
officials. For example, State treasurers have developed an innovative 
personal finance workshop targeting women interested in learning how 
they can take control of their financial situations. Since that first 
Women and Money Conference, more than 15 treasurers have implemented 
this program in their States. The treasurers in Delaware, Maine, 
Massachusetts, Ohio, and many other States have developed strategic 
partnerships with local, regional, and national organizations and they 
continue to provide Women and Money Conferences for residents of their 
States.
    Alabama Treasurer Kay Ivey, who has worked on financial education 
matters for 30 years, works closely with local boys and girls clubs to 
teach financial basics to the young people in her State. In another 
example, Delaware Treasurer Jack Markell has developed an innovative 
program called the Delaware Money School designed to bring community-
based financial education to participants in a pressure free learning 
environment. Topics covered in the Money School include basic money 
management, investing, and retirement planning. Specialized classes are 
also offered at the request of churches, senior citizen centers, or 
community groups.
    In the Delaware Money School, a coalition of financial 
professionals--from the financial service industry, nonprofit organizations, and government--volunteer to teach the classes. The Money School is a collaborative undertaking with various community and public organizations, it can also be structured to fit the specific needs of a group of people or provide educational opportunities as they arise.
    Many of us take the lead in providing education programs for State 
and municipal employees charged with managing public finances. These 
workshops present participants with tools to deal with the fiscal and 
ethical issues they face when investing public resources. In some 
States, continuing education is mandated for public fund managers, and 
the treasurers' programs satisfy this requirement. In other States, the 
treasurers initiate the workshops on their own. In California and Ohio, 
where the programs are mandated, more than a dozen workshops on topics, 
ranging from investment management to innovative financing techniques, 
are held each year. In Illinois and Indiana, where the programs are not 
required by law, the treasurers hold annual conferences for local 
public finance officials.
    In addition to the programs administered by the States, the 
National Association of State Treasurers has taken an active role in 
providing educational opportunities to members and other public 
officials responsible for the management of public funds. For 8 years, 
NAST has sponsored the National Institute for Public Finance, a 
comprehensive curriculum designed to enhance participants' 
understanding of public financial management and increase their 
abilities to make independent financial decisions. We also recently 
established the NAST Foundation, a not-for-profit organization, to 
promote and improve the educational initiatives of the organization and 
individual State treasurers.
    The common theme among these programs is the vital need to provide 
all citizens, and the public officials who serve them, the tools and 
information to understand and negotiate our complex financial markets. 
The issues raised by the recent developments in the mutual fund 
industry amplify this need. Financially literate investors, supplied 
with clear and understandable information, are better able to make 
informed investment decisions, which is critical to their and the 
Nation's financial health and well-being.

Conclusion
    Collectively, legislators, regulators, and the industry can rebuild 
and preserve the public's trust in mutual funds by implementing 
stronger disclosure requirements in order to better align fund 
management company interests with those of fund shareholders. This will 
give current and prospective investors access to the type of 
information to enable them to make fully informed decisions about their 
investments.
    By bringing more visibility to the corporate structure of funds and 
by enhancing the availability and usefulness of financial information 
disclosed by the firms, this Committee can demonstrate to American 
investors that mutual funds will continue to operate as the cleanest, 
brightest investment method for all Americans. The industry does not 
need a wholly new set of operational rules or new oversight groups, it 
simply needs to be held accountable to both the letter and the spirit 
of the rules that have guided it well for decades. We believe the 
simple improvements suggested here can help keep the industry focused 
on its ultimate mission--helping investors meet their goals and secure 
a safer future for their families.

                               ----------
                  PREPARED STATEMENT OF JAMES S. RIEPE
                Vice Chairman, T. Rowe Price Group, Inc.
                           February 25, 2004

Introduction
    My name is James S. Riepe. I am Vice Chairman of T. Rowe Price 
Group, Inc., a Baltimore-based firm that, through its affiliates, 
provides investment management services to the T. Rowe Price family of 
no-load mutual funds and to individual and institutional clients. In 
addition, I am Chief Executive Officer of each of the Price Funds and 
the Chairperson of all the Price Fund Boards. T. Rowe Price acts as 
sponsor, investment adviser and distributor of 108 mutual funds and 
variable annuity portfolios which, as of the end of 2003, exceeded $120 
billion in assets. In total, T. Rowe Price manages approximately $190 
billion in assets.
    I appreciate the opportunity to appear before the Committee today 
to discuss the ongoing efforts of my firm, and the mutual fund industry 
as a whole, to respond to abusive mutual fund trading practices by 
taking concrete and far-reaching actions to protect investors' 
interests and prevent future abuses. I also note that my comments come 
from the perspective of having been engaged in the mutual fund business 
for the last thirty-five years.

Executive Summary
    T. Rowe Price Group operates its mutual fund business in accordance 
with the fundamental principle that the interests of our fund 
shareholders are paramount. Consequently, we have been deeply dismayed 
by the recent revelations of abusive mutual fund trading practices.
    We support appropriate action by Government authorities to redress 
these abuses, and we commend the SEC for its swift and comprehensive 
regulatory response. As we have urged for a number of years, it is 
critically important that the SEC receive increased funding to develop 
appropriate regulatory initiatives and to carry out its mutual fund 
oversight and inspection duties.
    We also recognize that the challenge of restoring and maintaining 
investor trust falls not on the regulators but on those of us in the 
business of managing and distributing funds. T. Rowe Price takes this 
responsibility very seriously.
    T. Rowe Price has policies, procedures, and practices in place that 
seek to protect Price Fund shareholders against late trading, abusive 
short-term trading of mutual fund shares, and selective disclosure of 
fund portfolio holdings. In response to the recent investigations and 
enforcement proceedings, we have conducted thorough 
reviews of our policies, procedures, and practices in these areas, 
which has allowed us to confirm their continuing effectiveness and to 
implement or consider certain 
enhancements.
    We have, as always, kept the Price Fund Boards fully informed of 
our actions and they have played an active oversight role. We have also 
sought to educate fund investors--through communications on our 
website, in our newsletter, and in fund shareholder reports--about the 
alleged improprieties and how we protect Price Fund shareholders from 
these types of abuses.
    The efforts of individual firms such as T. Rowe Price to address 
the concerns raised by the scandal have been significant and are being 
supplemented by a series of regulatory initiatives.

Late Trading
    To protect against the possibility of late trading, the SEC has 
proposed rule amendments that would mandate that all purchase and 
redemption orders be received by a fund, its transfer agent, or a 
registered clearing agency before the time the fund prices its shares 
(e.g., 4 p.m. Eastern time). T. Rowe Price supports the SEC's proposed 
approach, until such time as an electronic trade monitoring process is 
available that would allow other entities to receive fund orders on 
behalf of a fund for pricing purposes.

Excessive Short-Term Trading
    T. Rowe Price also supports the various regulatory measures that 
the SEC has proposed and/or adopted to address abusive market timing 
activities, including: (1) requiring funds to have more formalized 
short-term trading policies and procedures and to explicitly disclose 
those policies and procedures, (2) emphasizing the obligation funds 
have to fair value their securities under appropriate circumstances, 
and (3) providing a more effective mechanism for board oversight of 
market timing policies and procedures.
    With respect to personal trading activities of senior fund 
personnel, the SEC has recently proposed new code of ethics 
requirements for registered investment advisers, which T. Rowe Price 
supports.
    Funds and their shareholders also would benefit if funds had 
additional ``tools'' to combat harmful market timing activity, such as 
a minimum 2 percent redemption fee on fund shares redeemed within a 
minimum of 5 days of their purchase. The SEC is expected to propose 
requiring such minimums for certain categories of funds and we support 
this approach, but note the need to provide a sufficient time period 
for implementation.

Fund Governance
    The recent disturbing revelations do not evidence a failure of the 
fund governance system but they do indicate that fund directors would 
benefit from additional tools to assist them in serving effectively in 
their oversight role. The mutual fund compliance program rule recently 
adopted by the SEC will have a significant and far-reaching impact on 
improving the compliance environment and enable fund directors to more 
readily oversee this important activity. Certain proposals to 
``improve'' fund governance are, however, unwarranted, unrelated to the 
abuses that have been revealed and counterproductive, such as mandating 
that all fund boards have an independent chair and requiring 
independent directors to make certifications relating to matters 
outside the scope of what they could reasonably be expected to know.

Other Initiatives
    In addition to internal measures and regulatory changes to protect 
investors against the abusive mutual fund trading practices that have 
been the subject of recent investigations and enforcement proceedings, 
it is appropriate to consider other ways to reinforce the protection 
and confidence of mutual fund investors. In this vein, the SEC recently 
proposed, and T. Rowe Price supports, rule amendments to ban the 
practice of directing fund brokerage transactions to reward broker-
dealers who also sell fund shares. In addition, the SEC has embarked on 
a prudent and timely reevaluation of Rule 12b -1. Finally, the SEC has 
proposed to require broker-dealers to provide a separate document to 
mutual fund investors at the point of sale that will help inform them 
about sales-related fees and payments and alert them to possible 
conflicts of interest.
    T. Rowe Price is committed to protecting our fund shareholders 
against abusive mutual fund trading activities. We support those 
Government and industry efforts which are designed to address these 
issues and other initiatives that will promote investors' interests. We 
are fortunate that investor confidence in mutual funds generally 
remains very high, but we must take advantage of the current problems 
to make improvements that will guard against future breaches of trust 
and allow our fund shareholders to be confident that their interests 
come first.

Introduction
    My name is James S. Riepe. I am Vice Chairman of T. Rowe Price 
Group, Inc., a Baltimore-based firm that, through its affiliates, 
provides investment management services to the T. Rowe Price family of 
no-load mutual funds and to individual and institutional clients. In 
addition, I am Chief Executive Officer of each of the Price Funds and 
the Chairperson of all the Price Fund Boards. T. Rowe Price acts as 
sponsor, investment adviser, and distributor of 108 mutual funds and 
variable annuity portfolios which, as of the end of 2003, exceeded $120 
billion in assets. In total, T. Rowe Price manages approximately $190 
billion in assets.
    I appreciate the opportunity to appear before the Committee today 
to discuss the ongoing efforts of my firm, and the mutual fund industry 
as a whole, to respond to abusive mutual fund trading practices by 
taking concrete and far-reaching actions to protect investors' 
interests and prevent future abuses. I also note that my comments come 
from the perspective of having been engaged in the mutual fund business 
for the last 35 years.
    T. Rowe Price operates its mutual fund business in accordance with 
the fundamental principle that the interests of our fund shareholders 
are paramount. Our fundamental thesis is a simple one: If shareholders 
prosper then we, as managers, will do likewise; if they do not see 
value in an investment relationship with us, then our business will do 
poorly. This principle is applied through formal, documented policies, 
including a comprehensive Code of Ethics, but, perhaps more 
importantly, it is also deeply ingrained within the firm's culture. In 
this context, it is important to understand that one cannot regulate 
ethical behavior, no matter how extensive the compliance regulations. 
Ultimately, each of us must create an environment in which the right 
decisions are made by our employees. Given our culture, and the 
industry's previously clean record, my colleagues and I were shocked 
and deeply dismayed by the allegations of late trading and short-term 
trading in the New York Attorney General's complaint in the Canary case 
\1\ and subsequent allegations of these and other abusive mutual fund 
trading practices. It is difficult to fathom that persons associated 
with our industry--fund managers and intermediaries--would knowingly 
permit the blatantly illegal buying and selling of fund shares after 4 
p.m. It is equally troubling that some fund companies allegedly entered 
into arrangements that authorized short-term market timing in apparent 
contravention of stated policies in exchange for promises of other 
benefits to the fund manager. Perhaps most disturbing of all are the 
revelations that a few fund insiders may have engaged in short-term 
trading for their own personal benefit, again in contravention of 
stated policies and potentially at the expense of other fund 
shareholders.
---------------------------------------------------------------------------
    \1\ State of New York v. Canary Capital Partners, LLC, Canary 
Investment Management, LLC, Canary Capital Partners, Ltd., and Edward 
J. Stern (NY S. Ct. filed September 3, 2003) (undocketed complaint).
---------------------------------------------------------------------------
    I commend the Securities and Exchange Commission and the New York 
Attorney General's office for their investigative efforts and forceful 
responses to these practices. However, the marketplace impact on the 
fund companies involved, caused by the disclosure of abuses, has been 
so severe that it far exceeds the regulatory penalties. This has been a 
reminder to all of us how important is the implied bond of trust 
between the investor and the fund manager.
    I also commend the SEC for taking swift and sweeping actions on the 
rulemaking front to address the abusive practices that have been 
discovered, and to otherwise strengthen mutual fund regulation. I 
believe the SEC's current far-reaching and aggressive mutual fund 
regulatory reform agenda is unprecedented.
    Of course, in order for the SEC to develop appropriate regulatory 
initiatives to respond to the trading abuses that have occurred, and to 
successfully carry out its oversight and inspection duties with respect 
to mutual funds, it is critically important that the SEC have 
sufficient resources. Consistent with this, I strongly support the Bush 
Administration's proposed fiscal year 2005 budget for the SEC, which 
would provide a significant and necessary increase over the record 
amount appropriated for the current fiscal year. I note that T. Rowe 
Price, and the fund industry generally, has argued for increased SEC 
resources for many years. Funds have 
historically generated SEC registration fees far in excess of the 
monies spent on 
regulating and examining fund companies and related entities.
    In addition to the important work of the SEC and other Government 
authorities in redressing mutual fund abuses, however, the challenge of 
restoring and maintaining investor trust falls squarely on the 
shoulders of the industry itself. T. Rowe Price and other mutual fund 
firms take this responsibility very seriously. In this regard, we are 
heartened by the fact that investors have not found fault with the 
fundamental features of funds--convenience, low-cost, diversification, 
and professional management. This is evident in our thousands of 
conversations with investors each day and by the continued flow of tens 
of billions of dollars into equity, bond, and money market funds.
    The remainder of my testimony will: (1) describe what T. Rowe Price 
has done to protect its fund shareholders' interests against late 
trading, abusive short-term trading of mutual fund shares, and the 
practice of selectively disclosing information about fund portfolio 
holdings to shareholders; and (2) discuss regulatory initiatives in 
these areas. I will also comment on hedge fund oversight and fund 
governance issues, as well as certain other current initiatives to 
reinforce the protection and confidence of mutual fund investors.

Response to Mutual Fund Trading Abuses
    Since news of the mutual fund trading abuses first broke, T. Rowe 
Price, like most other firms, has conducted thorough reviews of our 
firm's policies, procedures, and practices in the principal areas that 
have been implicated in the various enforcement proceedings and 
investigations that have been announced to date. This has
allowed us both to confirm the continuing effectiveness of our existing 
policies, procedures, and practices and to make or consider certain enhancements. Throughout this process, we have kept the Price Fund Boards fully informed of our actions and they have played an active oversight role. 
Indeed, since the initial revelations, we have held three meetings of 
the Fund Boards in addition to our regularly scheduled meetings.
    In addition to keeping the Fund Boards informed and involved in 
this process, we believe it is important for investors to understand 
these improprieties and how we protect Price Fund shareholders from 
these types of abuses. To this end, we posted a statement on our 
website last fall emphatically condemning the practices and additional 
abuses that have been revealed or alleged in these investigations. The 
statement, which has been continually updated, includes questions and 
answers about the practices that are under investigation and T. Rowe 
Price's policies in these areas. We have also updated shareholders on 
these issues in our newsletter and in the Chairman's letter included in 
the funds' most recent annual reports to shareholders. Based on what I 
have seen and heard, it is my impression that most industry 
participants have developed communications for their investors.

Late Trading
    Consistent with existing legal requirements, our mutual fund 
trading policy, delineated in our fund prospectuses, requires that fund 
transaction orders received prior to 4 p.m. Eastern time (the time as 
of which we price our funds) be executed at that day's share price. 
Orders received after 4 p.m. Eastern time are executed at the following 
day's price. This policy also applies to shareholders who place their 
orders through intermediaries such as brokers and retirement plan 
recordkeepers (i.e., orders received by intermediaries before 4 p.m. 
will get that day's price). Under current law, these intermediaries are 
authorized to transmit their customer orders to T. Rowe Price after 4 
p.m. for processing at that day's closing price, provided that the 
intermediary received the orders before that time. Our firm has not and 
will not enter into any arrangements with investors or intermediaries 
that authorize post-4 p.m. trading.
    In light of recent revelations of ``late trading'' of mutual fund 
shares, our Internal Audit Department conducted a review of our 
established policies, procedures, and practices with respect to the 
timely receipt of orders to purchase or redeem fund shares and 
determined that they are sound. This review and the findings were 
discussed with the Price Fund Boards.
    In addition, given the alleged instances of late trading involving 
transactions conducted through intermediaries, we have taken steps to 
improve our oversight of intermediaries with whom we conduct business. 
In particular, we formed an Intermediary Oversight Committee which is 
charged with:

 Overseeing the relationships with intermediaries.
 Maintaining and enforcing our policies regarding 
    intermediaries.
 Resolving any material issues relating to intermediaries.
 Taking action to terminate intermediaries that have failed to 
    meet our compliance standards.

    T. Rowe Price has also required each intermediary with whom we have 
trading agreements (currently over 200) to sign and return a 
certification that it is complying with all relevant rules and 
regulations regarding the handling of orders for the Price Funds on a 
timely basis.
    The SEC, for its part, has proposed to address late trading through 
rule amendments that would tighten existing regulations to require that 
all purchase and redemption orders be received by a fund, its transfer 
agent, or a registered clearing agency before the time of pricing 
(e.g., 4 p.m. Eastern time).\2\ T. Rowe Price supports the SEC's 
proposal. Although this approach could have a significant impact on 
many investors who own fund shares through financial intermediaries, 
the recent abuses indicate that strong measures are necessary to ensure 
investor protection. However, it is our expectation that an electronic 
trade monitoring mechanism will be developed in the near future that 
will permit trades to be accepted from intermediaries after the closing 
time. Such a system would create an audit trail that could verify that 
trade orders were received timely by the intermediaries from customers.
---------------------------------------------------------------------------
    \2\ See SEC Release No. IC-26288 (December 11, 2003).
---------------------------------------------------------------------------
    My own view is that, if the SEC expands the list of entities that 
would be permitted to receive orders on behalf of a fund for pricing 
purposes under its proposal, it should consider requiring periodic 
reviews of those entities' internal controls and reports of any 
material inadequacies (similar to the SAS 70 control review).

Market Timing/Excessive Trading
    For many years, T. Rowe Price has taken an active role in 
minimizing the potential negative impacts from short-term trading by 
fund investors on our funds and their long-term shareholders. Our firm 
has not and will not enter into any arrangements with investors or 
intermediaries that authorize harmful short-term trading in any of our 
funds.
    Frequent trades driven by short-term market timing have the 
potential to disrupt the management of a fund and raise its transaction 
costs. For those investors for whom we maintain individual accounts, we 
review daily trading activity across the complex at a retail, 
retirement, and institutional level, and we analyze purchases and sales 
in the funds to determine if the transactions are within the excessive
trading guidelines contained in the prospectus. If we determine that a 
shareholder has violated our guidelines, action is taken to restrict 
future excessive trading activity. Over the years, this monitoring 
process has resulted in actions up to and including the suspension of 
purchase privileges for many individuals and a number of 
intermediaries.
    In addition, to discourage excessive trading, a number of Price 
Funds impose redemption fees ranging from 0.5 percent to 2.0 percent. 
The required holding periods vary and can be as long as 2 years.
    In the wake of the recent scandals, our Internal Audit Department 
reviewed our established policies, procedures, and practices concerning 
excessive trading, including the imposition of redemption fees, and 
determined that they remain sound. The review and its findings were 
discussed with the Price Fund Boards. As a result of this review, we 
have augmented our monitoring methodologies and will be expanding the 
number of funds subject to redemption fees.
    One issue that the recent trading abuses have highlighted is the 
difficulty of ensuring that fund policies regarding excessive trading, 
including the imposition of redemption fees, will be appropriately and 
consistently applied in the case of investors who own fund shares 
through intermediaries. With respect to intermediaries, the monitoring 
process is based on aggregate activity for each intermediary and relies 
on that entity to provide us with specific sub-account information when 
excessive trading is suspected. As noted above, we have formed an 
Intermediary Oversight Committee to help ensure, among other things, 
that intermediaries meet our compliance standards on an ongoing basis. 
We are also seeking written certification from intermediaries that they 
are collecting redemption fees in compliance with the funds' policies.
    Last fall, SEC Chairman Donaldson outlined various regulatory 
measures that the SEC staff was considering to address abusive market 
timing activities.\3\ These measures included new rules and form 
amendments to: (1) require explicit disclosure in fund offering 
documents of market timing policies and procedures, and (2) require 
funds to have procedures to comply with representations regarding 
market timing policies and procedures. Chairman Donaldson also 
indicated that the SEC would consider measures to reinforce board 
oversight of market timing policies and procedures. The SEC has 
recently taken formal action in these areas.\4\
---------------------------------------------------------------------------
    \3\ SEC Chairman Donaldson Releases Statement Regarding Initiatives 
to Combat Late Trading and Market Timing of Mutual Funds, SEC Press 
Release No. 2003-136 (October 9, 2003).
    \4\ See SEC Release No. IC-26287 (December 11, 2003) (proposing 
amendments to require
mutual funds to disclose in their prospectuses both the risks to 
shareholders of the frequent purchase and redemption of fund shares, 
and fund policies and procedures with respect to such frequent 
purchases and redemptions) (``SEC Disclosure Proposals'') and SEC 
Release No. IC-26299 (December 17, 2003) (adopting Rule 38a-1 under the 
Investment Company Act of 1940 concerning the mutual fund compliance 
programs) (``SEC Compliance Rule Release''). New Rule 
38a-1 requires mutual funds to adopt and implement written policies and 
procedures reasonably designed to prevent violation of the Federal 
securities laws, including procedures reasonably designed to ensure 
compliance with disclosed policies regarding market timing. In 
addition, it requires a fund's chief compliance officer to provide a 
written report to the fund's board, no less frequently than annually, 
that addresses, among other things, the operation of the fund's 
compliance policies and procedures and material compliance matters that 
occurred since the date of the last report.
---------------------------------------------------------------------------
    T. Rowe Price supports these measures. While our funds and many 
others already have market timing policies and procedures, requiring 
funds to adopt formal and detailed policies and procedures in this area 
and specifically providing for board oversight will ensure that all 
funds have systems in place to address abusive activity. Such a 
requirement should also provide a more effective mechanism for boards 
and regulators to police compliance because more formal policies likely 
will limit discretion in dealing with short-term traders. Fund 
shareholders also will benefit from additional prospectus disclosure 
about a fund's policies on short-term trading by gaining an 
understanding of how the fund will protect their interests from 
potentially abusive activity. Requiring that such disclosure be in a 
fund's prospectus could serve to enhance compliance with the policies. 
The disclosure also could have a deterrent effect by alerting potential 
abusers to the fund's policies. Of course, it will be important for any 
new disclosure requirements to allow funds to achieve an appropriate 
balance between providing disclosure that would have these beneficial 
effects and providing overly specific disclosure that inadvertently 
could serve as a roadmap for potential abusers to circumvent fund 
policies.
    Steps also clearly need to be taken to enable mutual funds to 
better enforce the restrictions they establish on short-term trading 
when such trading takes place through omnibus accounts held by 
intermediaries. One approach would be to require intermediaries to 
provide information about trading activity in individual accounts to 
funds upon request (a practice that some intermediaries already have in 
place). And an additional approach would be to require most types of 
long-term funds, at a minimum, to impose a 2 percent redemption fee on 
any redemption of fund shares within 5 days of purchasing them.\5\ If 
funds had a standardized minimum redemption fee along these lines, it 
should be easier for intermediaries to establish and maintain the 
requisite systems to enforce payment of those fees.\6\ It is 
encouraging that the SEC appears willing to consider proposing such a 
requirement.\7\ The administrative implications for recordkeepers of 
such broad-based redemption fees are significant and would have to be 
examined by the SEC before final approval.
---------------------------------------------------------------------------
    \5\ Funds should retain the flexibility to impose more stringent 
redemption fee standards, either in the form of higher redemption fees 
and/or longer minimum holding periods. Flexibility is 
important because different types of funds are affected differently by 
short-term trading. In addition, certain types of funds (e.g., money 
market funds and funds that are designed specifically for short-term 
trading) should not be required to assess redemption fees.
    \6\ At the SEC's request, the NASD formed an Omnibus Account Task 
Force to consider issues raised by the implementation of mandatory 
redemption fees in the omnibus account context. See NASD, Report of the 
Omnibus Account Task Force (January 2004), available at http://www. 
nasd.com/pdf--text/omnibus--report.pdf.
    \7\ See SEC News Digest, February 18, 2004. At the meeting, the SEC 
also will consider any pertinent recommendations from the NASD's 
Omnibus Account Task Force.
---------------------------------------------------------------------------
Employee Trading in Fund Shares
    In addition to our review of policies, procedures, and practices 
related to excessive trading by fund shareholders, the firm's Internal 
Audit Department, its Director of Compliance, and our Ethics Committee 
(which is chaired by the firm's Chief Legal Counsel and oversees the 
administration of the firm's Code of Ethics) have reviewed trading by 
T. Rowe Price personnel in the Price Funds over the last several years. 
This review did not uncover the existence of any of the abusive trading 
practices described in recent enforcement actions relating to fund 
portfolio managers and senior fund executives. The review and its findings were discussed with the Price Fund Boards.
    Although our review did not uncover any such abusive trading, we 
are exploring how to enhance protections against such conduct at T. 
Rowe Price. The firm has maintained a comprehensive Code of Ethics 
since 1973. Each employee must annually sign a compliance verification 
form attesting to his or her compliance with the Code. We are 
considering the possibility of instituting additional trading controls 
relating to employee transactions in Price Fund shares that may be 
similar to the controls in place for many years for employee trading in 
stocks and bonds. In addition, each year, we conduct Code of Ethics 
compliance meetings with all employees at the vice president level and 
above. These meetings will be expanded to include all employees in 
2004.
    Consistent with the actions we have been considering on a voluntary 
basis, the SEC recently proposed to require registered investment 
advisers to adopt codes of ethics that, among other things, set forth 
conduct expected of advisory personnel and also require such personnel 
to report their personal securities transactions, including 
transactions in any mutual funds managed by the adviser.\8\ We support 
this proposal.
---------------------------------------------------------------------------
    \8\ See SEC Release Nos. IA-2209; and IC-26337 (January 20, 2004) 
(``SEC Code of Ethics 
Proposal'').
---------------------------------------------------------------------------
Fair Value Pricing
    Short-term trading activity, it appears, is often motivated by a 
desire to take advantage of fund share prices that are based on closing 
market prices established some time before a fund's net asset value is 
set. All mutual funds are required to have pricing procedures in place 
to establish a share price each business day based on the current 
market values of their portfolio securities. When market prices for 
portfolio securities are not readily available or are not reliable, 
funds must determine the fair value of those securities. In accordance 
with policies and procedures approved by the Fund Boards, T. Rowe Price 
has utilized fair value pricing for many years, and on many occasions 
to address events affecting the value of a fund's portfolio securities.
    We recently conducted a detailed review of our valuation policies 
and procedures, and determined that such policies and procedures are 
appropriate and are being followed. We have also reviewed our policies 
and procedures with the Fund Boards.
    The SEC has recently taken steps to minimize the possibility that 
long-term fund shareholders' interests will be harmed by the activities 
of arbitrageurs seeking to take advantage of stale prices. The SEC 
issued a statement regarding fair value pricing requirements in its 
release adopting the mutual fund compliance program rule.\9\ In 
addition to describing the SEC's position on when funds must use fair 
value pricing, the release states that the compliance program rule 
requires funds to adopt policies and procedures that require the fund 
to monitor for circumstances that may necessitate the use of fair value 
prices; establish criteria for determining when market quotations are 
no longer reliable for a particular portfolio security; provide a 
methodology or methodologies by which the fund determines the current 
fair value of the portfolio security; and regularly review the 
appropriateness and 
accuracy of the method used in valuing securities, and make any 
necessary adjustments.\10\ SEC examinations of funds will provide the 
opportunity to further reinforce and monitor the implementation of 
applicable requirements in this area.\11\
---------------------------------------------------------------------------
    \9\ See SEC Compliance Rule Release, supra note 4.
    \10\ Id. at 16 -17.
    \11\ The SEC also has proposed revisions to clarify prospectus 
disclosure requirements concerning fair value pricing. The proposal is 
intended to make clear that all funds (other than money market funds) 
are required to explain briefly in their prospectuses both the 
circumstances under which they will use fair value pricing and the 
effects of using fair value pricing. In addition, the proposed 
revisions are intended to clearly reflect that funds are required to 
use fair value prices any time that market quotations for their 
portfolio securities are not readily available (including when they are 
not reliable). See SEC Disclosure Proposals, supra note 4. The proposed 
revisions should serve as a useful complement to the requirements 
articulated in the SEC Compliance Rule Release and the proposed 
disclosure of market timing policies and procedures discussed above. As 
in the case of market timing, however, too much specificity about a 
fund's fair value pricing policies could prove counterproductive by 
tipping off arbitrageurs and allowing them to circumvent the policies. 
Thus, it is equally important that new disclosure requirements 
concerning fair value policies call for disclosure that will be 
informative to investors but is not so specific as to invite abusive 
practices.
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    It is important to note that, while fair valuation can reduce the 
impact of harmful short-term market timing activity, it cannot by 
itself completely eliminate such trading. Accordingly, funds (including 
Price Funds) often employ additional methods to deter market timing 
activity, such as the redemption fees discussed above.

Dissemination of Portfolio Holdings Information
    It appears that several fund managers may have provided information 
about fund portfolio holdings to certain investors in order to enable 
them or their clients to trade ahead of the fund, to the potential 
detriment of fund shareholders. For years, the Price Funds have 
maintained a formal policy relating to providing information about fund 
portfolio holdings to clients, shareholders, prospective clients, 
consultants, and the public. The policy is intended to ensure that all 
the shareholders are treated in a fair and consistent manner and that 
the information is not used in inappropriate ways. The policy lists the 
many pieces of information that may be of interest to shareholders and 
others (for example, a fund's top 10 holdings) and then indicates when 
that information will be made available (for example, 7 days after 
month end). The policy has been very helpful in managing requests for 
portfolio holdings information. We have reviewed important aspects of 
the policy with the Price Fund Boards and are considering modest 
revisions to ensure that it remains responsive to those with a genuine 
need for the information while also being protective of shareholders' 
interests.
    The SEC has taken several actions to put in place additional, more 
specific regulatory requirements in this area. First, the SEC 
Compliance Rule Release states that a fund's compliance policies and 
procedures under the rule should address potential misuses of nonpublic 
information, including the disclosure to third parties of material 
information about the fund's portfolio.\12\ Second, the SEC has 
proposed to require funds to disclose their policies and procedures 
with respect to the disclosure of portfolio securities, and any ongoing 
arrangements to make available information about their portfolio 
securities.\13\ Third, as indicated above, the SEC has proposed to 
require investment advisers to adopt codes of ethics that, among other 
things, set forth standards of conduct expected of advisory personnel 
and safeguard material nonpublic information about client 
transactions.\14\
---------------------------------------------------------------------------
    \12\ See SEC Compliance Rule Release, supra note 4, at 19. The rule 
requires that the fund's board approve the policies and procedures. In 
addition, it provides for regular reporting to the board on the 
effectiveness of the policies and procedures, any changes thereto, and 
material compliance matters.
    \13\ See SEC Disclosure Proposals, supra note 4.
    \14\ See SEC Code of Ethics Proposal, supra note 8.
---------------------------------------------------------------------------
    Similar to market timing, requiring funds to adopt formal policies 
should ensure that they have a system to prevent disclosure that is not 
in the best interests of shareholders and to police compliance. Board 
oversight and public disclosure will further enhance compliance with 
the policies. At the same time, the approach proposed by the SEC 
appropriately would preserve some flexibility in how funds release 
information. T. Rowe Price supports the SEC's initiatives.

Hedge Fund Oversight
    The action brought by the New York Attorney General against Canary 
Capital also underscores the need for some SEC oversight of hedge fund 
advisers. Last fall, the SEC issued a Staff Report on hedge funds \15\ 
that included a recommendation to require hedge fund advisers to 
register under the Investment Advisers Act of 1940. As the Staff Report 
indicates, by requiring hedge fund advisers to register, the SEC would 
be able to observe the trading activities of the funds managed by such 
advisers and be in a better position to detect improper or illegal 
trading practices.\16\ T. Rowe Price supports the SEC recommendation to 
require those advisers to hedge funds that are not otherwise already 
registered to register under the Investment Advisers Act.
---------------------------------------------------------------------------
    \15\ Staff Report to the U.S. Securities and Exchange Commission, 
Implications of the Growth of Hedge Funds (September 2003) (``Staff 
Report'').
    \16\ Id. at 92-95.
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Fund Governance
    The recent disturbing revelations about mutual fund abuses have 
caused some to question the effectiveness of the fund governance 
system. However, blaming directors, especially independent directors, 
for failing to uncover the wrongdoing that has occurred is unfair. Independent directors cannot--and should not--be responsible for the day-to-day management of a fund's, adviser's, distributor's, or recordkeeper's activities. Indeed, in several cases, the problematic conduct took place at unrelated entities.
    The recent incidents do indicate that directors would benefit from 
additional tools to assist them in serving effectively in their 
oversight role. The SEC's mutual fund compliance program rule, 
discussed above, should serve as a useful vehicle for this purpose by 
requiring funds to have compliance policies and procedures reasonably 
designed to prevent violation of the Federal securities laws and by 
improving the flow of information about the policies and procedures, as 
well as significant compliance issues, to the directors. In addition, 
the SEC has proposed several new fund governance requirements that 
should help enhance the independence and effectiveness of fund 
boards.\17\ However, certain other proposals to ``improve'' fund 
governance in the wake of the recent scandals are unwarranted, 
counterproductive, and would not improve the substantive oversight of 
the board.
---------------------------------------------------------------------------
    \17\ The SEC has proposed to require, among other things: That the 
board perform an annual self-assessment that would include 
consideration of the board's committee structure and the number of 
boards on which the directors sit; that the independent directors meet 
in separate sessions at least once each quarter; and that funds 
authorize the independent directors to hire their own staff. See SEC 
Release No. IC-26323 (January 15, 2004) (``SEC Fund Governance 
Proposals''). T. Rowe Price supports these measures, although our fund 
directors view themselves as already having authority to hire staff if 
appropriate. In addition, the SEC has proposed to require that 
independent directors constitute at least 75 percent of each fund 
board. While we support requiring a supermajority of independent 
directors, we question whether the marginal benefits, if any, of a 75 
percent requirement would outweigh the disruption involved in imposing 
that standard rather than codifying the two-thirds supermajority that 
most fund boards have. The SEC also has proposed to require fund boards 
to appoint an independent chair which, as discussed in more detail 
below, T. Rowe Price believes should not be mandated for all fund 
boards. We recently sent a letter to the SEC staff setting forth T. 
Rowe Price's views on these important matters. See Letter from Henry H. 
Hopkins, Chief Legal Counsel, T. Rowe Price Associates, Inc., to Mr. 
Paul F. Roye, Director, Division of Investment Management, Securities 
and Exchange Commission, dated January 13, 2004.
---------------------------------------------------------------------------
    One such proposal would require mutual fund boards to have an 
independent chair. While some fund boards may choose to have an 
independent chair--as a number now have--not all fund boards may find 
that this structure works well for them.\18\ It seems counterintuitive 
to mandate such a requirement, instead of allowing the directors to 
determine in their best judgment who is the most appropriate person to 
serve as the board's chair. This reasoning is reinforced by the fact 
that the SEC (and applicable law) already relies heavily on the 
independent directors' judgment with respect to protecting the 
interests of shareholders. Furthermore, the independent directors 
already constitute at least a majority (and in most cases a 
supermajority) of a mutual fund's board, and therefore have full power 
to appoint an independent chair if they wish to do so. In the case of 
T. Rowe Price, fund directors some years ago appointed a ``lead 
independent director'' and believe that approach has served them and 
the funds' shareholders well. With a supermajority of independents, 
they believe they are able to take any action needed.\19\
---------------------------------------------------------------------------
    \18\ For example, some funds have found that having an interested 
director serve as board chair is beneficial in that it promotes 
administrative efficiencies.
    \19\ For example, several years ago the T. Rowe Price funds' audit 
committee expressed a desire, for reason of the appearance of a 
conflict, to have different independent accountants than those who 
served the funds' adviser. The full boards supported this 
recommendation and, as a result, the adviser replaced its auditors.
---------------------------------------------------------------------------
    Also, it is far from clear why mutual fund boards, alone among all 
corporate boards, should be deprived of the discretion to choose their 
chairperson. Existing regulatory requirements and industry practices, 
as well as the other new fund governance requirements recently proposed 
by the SEC, make a requirement to have an independent chair 
unnecessary.\20\ Finally, it bears noting that some of the funds 
involved in the recent scandals have independent board chairmen. Thus, 
it would be folly to suggest that requiring all fund boards to have 
independent chairs is in any way an answer to the current problems.
---------------------------------------------------------------------------
    \20\ For example, the Investment Company Act requires a separate 
vote of the independent directors on virtually all important decisions, 
such as approval of the fund's investment advisory and underwriting 
agreements, and the use of fund assets to support the distribution of 
fund shares under a Rule 12b -1 plan. Existing practices in the fund 
industry--such as a supermajority of independent directors, the 
appointment of lead independent directors and regular meetings of 
independent directors in executive session--further reinforce the 
independence and authority of the independent directors. The Price Fund 
Boards follow all of these practices. In addition, as noted above, the 
SEC recently issued a proposal that would require, among other things, 
that independent directors constitute at least 75 percent of fund 
boards and that the independent directors meet in separate sessions at 
least once each quarter. See SEC Fund Governance Proposals, supra note 
17.
---------------------------------------------------------------------------
    Another misguided ``solution'' to the abusive trading practices 
that we have seen would require independent directors, or an 
independent chair, to make a series of certifications, many of which 
relate to matters that are outside the scope of what an independent 
director--who serves in an oversight capacity--could reasonably be 
expected to know (e.g., that the fund ``is in compliance'' with certain 
policies and procedures, such as fund share pricing policies and 
procedures).\21\ Not only would this potentially expose those 
certifying directors to increased liability, but also it would not 
serve the best interests of fund shareholders. Independent directors 
(or the independent chair) would be faced with the Hobson's choice of 
either: (1) seeking to secure and being forced to rely on a series of 
sub-certifications from those directly involved in the various matters 
to be certified (because the directors themselves would not be in a 
position to have personal knowledge of what they are certifying), or 
(2) immersing themselves in the day-to-day intricacies of fund 
operations, thereby inappropriately transforming their role from 
``oversight'' to ``management.'' Both of these results would place the 
independent directors in an awkward and/or inappropriate position and 
neither would improve investor protection. On the contrary, an 
independent director certification requirement could give investors a 
false sense of security. It most assuredly would also discourage many 
qualified persons from serving as independent directors of mutual 
funds.
---------------------------------------------------------------------------
    \21\ See, e.g., Section 201 of H.R. 2420, the ``Mutual Funds 
Integrity and Fee Transparency Act of 2003,'' as passed by the U.S. 
House of Representatives on November 19, 2003; Section 204 of S. 1971, 
the ``Mutual Fund Investor Confidence Restoration Act of 2003,'' as 
introduced by Senators Corzine and Dodd on November 25, 2003.
---------------------------------------------------------------------------
Other Initiatives to Promote Investor Confidence
    In addition to internal measures and regulatory changes to protect 
investors against the abusive mutual fund trading practices that have 
been the subject of the recent investigations and enforcement actions, 
it is appropriate to consider other ways to reinforce the protection 
and confidence of mutual fund investors. Certain current initiatives 
are discussed below.

Directed Brokerage
    Under current law, a mutual fund manager is permitted to take sales 
of fund shares into account in allocating brokerage, subject to various 
conditions including that the broker must provide best execution. As a 
directly marketed fund complex, T. Rowe Price has never engaged in this 
practice for its own mutual funds. Although such ``directed brokerage'' 
is strictly regulated, prohibiting this practice may be the most 
effective way to address the conflict of interest issues it raises. The 
industry, through the Investment Company Institute, recently urged the 
SEC (and/or NASD) to adopt new rules for this purpose.\22\ Consistent 
with the Institute's recommendation, the SEC recently proposed 
amendments to Rule 12b -1 under the Investment Company Act that would 
prohibit funds from using brokerage commissions to pay broker-dealers 
for selling fund shares.\23\
---------------------------------------------------------------------------
    \22\ Letter to The Honorable William H. Donaldson, Chairman, U.S. 
Securities and Exchange Commission, from Matthew P. Fink, President, 
Investment Company Institute, dated December 16, 2003. The Institute 
urged the SEC to curtail the use of soft dollars by all investment 
advisers, including mutual fund managers. T. Rowe Price supports the 
Institute's recommendations.
    \23\ See SEC Press Release 2004 -16 (February 11, 2004), available 
at http://www.sec.gov/news/press/2004-16.htm.
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Rule 12b -1
    In addition to proposing amendments to Rule 12b -1 to prohibit the 
use of fund brokerage commissions to pay broker-dealers for selling 
fund shares, the SEC is soliciting comments on whether it should make 
other changes to Rule 12 -1. Given the many developments in fund 
distribution practices since the rule was adopted in 1980, a 
reevaluation of the rule is appropriate and timely. Due to the 
significance of the rule, its widespread use and related issues, it is 
important to solicit and consider the views of all interested parties 
before determining whether further changes to the rule should be 
proposed. Intermediaries who are selected by investors to assist them 
in making decisions about fund investments, and monitoring those 
investments, deserve to be compensated. The amounts and methods of 
compensation, and the disclosure of such to the investor, should all be 
part of this review. T. Rowe Price looks forward to studying the SEC's 
release and participating in this process.

Point-of-Sale Disclosure of Broker Incentives
    Another issue that has been the focus of much attention recently 
involves the so-called ``revenue sharing'' arrangements in which a fund's investment adviser or principal underwriter makes payments out of its own 
resources to compensate intermediaries who sell fund shares. The 
principal investor protection concern raised by these payments is 
whether they have the potential for influencing the recommendations of 
the financial intermediary that is receiving them. Disclosure 
concerning
certain types of revenue sharing arrangements already is required in 
fund prospectuses, and the industry has long advocated additional, 
point-of-sale disclosure by broker-dealers to help investors assess and 
evaluate recommendations to purchase fund shares.\24\ Both the SEC and 
the NASD have recently proposed new point-of-sale disclosure 
requirements in this area.\25\
---------------------------------------------------------------------------
    \24\ See, e.g., Letter from Craig S. Tyle, General Counsel, 
Investment Company Institute, to Ms. Joan Conley, Office of the 
Corporate Secretary, NASD Regulation, Inc., dated October 15, 1997.
    \25\ See SEC Release Nos. 33-8358; 34-49148; IC-26341 (January 29, 
2004) and NASD Notice to Members 03-54 (September 2003). Both proposals 
also would require disclosure concerning differential compensation paid 
to salespersons that could provide an incentive to favor one fund over 
another.
---------------------------------------------------------------------------
    The SEC's proposal also would encompass other sales-related fees 
and payments, such as front-end and deferred sales charges and 12b -1 
fees. T. Rowe Price strongly supports requiring point-of-sale 
disclosure concerning such fees and payments (as well as revenue 
sharing and differential compensation). Requiring broker-dealers to 
provide to investors who are considering purchasing mutual funds a 
separate disclosure document at the point of sale (as contemplated by 
the SEC's proposal) would help educate investors about the costs they 
are incurring in connection with the use of the broker who is assisting 
them, while also alerting them to any potential conflicts of interest.

Conclusion
    T. Rowe Price has been and continues to be committed to acting in 
our fund shareholders' interests. We believe most fund companies seek 
to do the same. The recent revelations of fund trading problems have 
highlighted to us and others responsible for fund investor assets the 
risks of doing otherwise. Many of the far-reaching regulatory changes 
proposed by the SEC and industry will assist fund managers, 
distributors, recordkeepers, and directors in fulfilling their 
objective of serving investor interests. At the same time, they will 
help eradicate inappropriate or illegal practices.
    We are fortunate that investor confidence in mutual funds generally 
remains very high. But we must take advantage of the current problems 
to improve our policies and procedures so that we do not experience 
similar breaches of trust in the future. Our fund shareholders need to 
be confident that their interests do indeed come first.

                               ----------
                   PREPARED STATEMENT OF DON PHILLIPS
                  Managing Director, Morningstar, Inc.
                           February 25, 2004

    Thank you for the opportunity to appear before this distinguished 
Committee. My name is Don Phillips, and I am a Managing Director of 
Morningstar, Inc., an independent investment research firm that 
provides data and analysis on mutual funds and other investments. 
Morningstar was founded in 1984, and today we cover more than 100,000 
investments worldwide. Over 150,000 individual investors and 80,000 
financial planners subscribe to our services. In addition, there are 
more than 2 million registered users of our investment website, 
Morningstar.com.
    As the leading provider of mutual fund information to both 
individual investors and their financial advisors, Morningstar has had 
a front-row seat to witness both the rapid rise and the recent missteps 
of this important industry. We have seen a generation of American 
investors embrace mutual funds for their compelling combination of 
convenience, instant diversification, and professional management. The 
industry's rise has not solely been due to these merits, however. The 
mutual fund industry has also been the beneficiary of considerable good 
fortune. Numerous legislative acts, such as those allowing Individual 
Retirement Accounts, 401(k) plans, and 529 college savings plans, have 
encouraged investors to place billions of dollars into funds, greatly 
enriching those companies that offer them. As a result, mutual funds 
now occupy a central position in the long-term savings plans of more 
than 90 million Americans.
    Given the privileged and highly important role that mutual funds 
now play, it would behoove the industry to redouble its commitment to 
the effective stewardship of the public's assets. Most individuals who 
work for mutual fund companies embrace this challenge, but the recent 
scandals make it abundantly clear that too many people in this industry 
were willing to forsake their responsibility in exchange for short-term 
personal profit. Sadly, these were not the acts of a few, low-level 
employees, but instead were violations of trust that took place at the 
highest levels, including company founders, CEO's, portfolio managers, 
and several current or former members of the Investment Company 
Institute's Board of Governors.
    Investors are angered and confused by these scandals. Moreover, 
those institutions, such as pension plans, the financial press, and 
even the U.S. Congress, who steered investors toward funds have reason 
to feel betrayed. While few question the inherent benefits of mutual 
funds, it is clear that the industry has foolishly jeopardized its 
greatest asset--the public's trust. Investors need reassurances that 
their trust will not be further betrayed. In particular, they need to 
know: (A) That mutual funds operate on a fair and level playing field. 
(B) That checks and balances exist to safeguard investor interests. (C) 
That adequate information will be available to allow investors or their 
advisors to make intelligent decisions about their funds. (D) That 
mutual funds offer a reasonable value proposition
    While market forces can and will do much of the work, the industry 
and regulators can take steps to ensure that mutual funds meet their 
obligations to the American public. Here are Morningstar's suggestions 
on each of these fronts:

Mutual Funds Must Operate on a Fair and Level Playing Field
    One of the most disturbing aspects of the recent scandals has been 
the revelation that not all fund shareholders have been playing by the 
same set of rules. Too often, rules imposed upon ordinary investors 
have been ignored by insiders or waived for high rollers, such as hedge 
funds. These breaches violate the core democratic promise of funds, 
which, after all, are designed to be mutual. Moreover, the loosening of 
these rules allowed for rapid trading of fund shares that created 
economic penalties for shareholders who played by the rules. It is time 
for the industry to define what constitutes abusive market-timing and 
then take meaningful steps to eliminate it. It goes without saying that 
whatever standards are set must be applied 
uniformly to all shareholders in a fund. It is also essential that late 
trading and the possibility of time-zone arbitrage in mutual funds be 
curbed immediately. We suggest a combination of redemption fees, fair-
value pricing standards, and, until a better solution can be 
determined, a hard 4 p.m. close that would require all fund 
transactions to be at the fund company by 4 p.m. Eastern time in order 
to be transacted at that day's price.
    Compounding the problems of mutual fund trading abuses has been 
disturbing evidence surrounding fund sales practices. When brokerage 
houses demand special payments or directed brokerage arrangements in 
exchange for including a fund
on their preferred lists, they tilt the playing field, and they raise 
questions about the objectivity of the advice their brokers give. 
Investors deserve to know that the funds chosen for their portfolios 
are done so on the basis of their investment merit, not on their 
willingness to pay for shelf space at the brokerage house. It is time 
to eliminate directed brokerage deals and, at a minimum, better 
disclose pay-to-play arrangements.
    Another area that warps the playing field is how different fund 
companies account for basic fund expenses. Investors currently pay a 
management fee to the fund management company to cover the cost of 
investment research. In addition, a host of operational expenses, such 
as custodial costs or the cost of trading securities, are charged 
directly to the fund. Two activities muddy the water. First, soft-
dollar arrangements allow the fund's manager to dip into shareholder 
assets to pay for
research, trading systems, office furniture, or other services. While 
funds clearly need these things, one would assume that these expenses 
would be included in the fund's management fee, not embedded in 
artificially high trading costs. Simply put, soft dollars provide a 
bigger profit margin for the fund's manager made possible by a hidden 
charge to shareholders. The opportunity for such double-dipping should
be eliminated.
    Rule 12b -1 fees further muddy the waters. Fund companies use these 
charges in part to promote the sale of new fund shares. Investors may 
benefit to a small extent from fund asset growth, but the advantages of 
a bigger fund are typically far greater for the asset manager. To the 
extent that 12b -1 fees compensate brokers for selling funds or for the 
services of fund supermarkets, we concur that these services help 
investors, but feel that the charge would be more properly paid 
directly to those parties, rather than through the expense ratio where all investors, not just those receiving the benefits of an advisor or a discount brokerage house, foot the bill.
    While industry advocates will praise 12b -1 fees as a means of 
allowing investors greater choice in how (but not necessarily how much) 
they pay for advice, there is a danger to these fees that goes 
unspoken. When distribution costs are bundled into a fund's expense 
ratio, they begin to affect fund manager thinking. Unlike upfront sales 
charges, which are not included in the performance calculations 
investors see in places like The Wall Street Journal, the costs of 
12b -1 fees directly lower a fund's total return and its yield. 
Managers who are saddled with high 12b -1 fees on their funds are at a 
distinct disadvantage to those who are not. If they simply buy the same 
securities as their lower-cost competitors, they are guaranteed to 
trail their rivals. Because fund managers are competitive people, it is 
not surprising that managers of higher-cost funds adjust their behavior 
in order to avoid this fate. Morningstar studies have shown that 
managers of funds saddled with high 12b -1 fees systematically take on 
greater risk than do managers of funds with lower expense ratios. For 
bond fund investors, this often means lower-quality bonds or added 
exposure to the risk of rising interest rates. For investors in equity 
funds, it may mean more concentrated portfolios or more speculative 
stock choices. In short, Rule 12b -1 fees offer investors both insult 
and injury--the illusion of cost savings and the likelihood of added 
risk.
    At Morningstar, we think it is time to eliminate soft-dollar 
payments and to eliminate or seriously reconsider the role of 12b -1 fees in funds. Investors deserve a clear account of how their money is being spent. 
Allowing fund managers to dip into shareholder assets to promote asset 
growth or to offset research costs distorts the picture and makes it 
difficult for investors to align costs and benefits. Let's keep things 
clean and clear: Costs whose benefits flow primarily to the fund's 
advisor should be on the advisor's tab, not passed off as an investor 
expense. Moreover, 
distribution costs should be paid directly to distributors, not run 
through the fund's expense ratio where they tempt managers to take 
risks they otherwise would avoid. Pricing schemes should not compromise 
the integrity of the investment management process.

Checks and Balances Must Be in Place to Safeguard Investors
    It is not just the venality of the misdeeds in mutual funds, but 
the sheer number of offenses that is so disturbing to investors. It 
seems that every day another fund company is drawn into this mess. It 
is hard to fathom how so much wrongdoing could go undetected for so 
long. Sadly, these scandals raise obvious questions about the 
regulators who are supposed to safeguard investors. We support the 
increased funding for the Securities and Exchange Commission and would 
urge the Commission to continue to prioritize mutual fund regulation 
among the numerous important tasks it handles. Mutual funds are too 
important to the country's savings to be a back-burner issue with 
regulators.
    Moves to put all fund regulation under the SEC strike us as 
inappropriate. The New York Attorney General's Office has demonstrated 
the significant benefits of a fresh set of eyes looking at the 
industry. We support the continued ability of individual States to 
bring actions against mutual fund companies when they see abuses. 
Mutual funds have been embedded into Government-sponsored savings plans 
for both retirement and college savings. It is valuable to have 
multiple agencies serving as checks and balances to safeguard investor 
interests, but we would ask that these groups coordinate their efforts. 
The public bickering between agencies in the recent investigations does 
nothing to reassure investors that their interests are paramount.
    Ultimately, much of the burden of fund oversight must fall to the 
funds themselves, particularly to the fund directors. Much has been 
made of the importance of independent directors and an independent 
chairman. While these moves may be largely superficial, we think they 
are potentially beneficial. While in U.S. operating companies the 
chairman and the CEO are often the same person, such an arrangement 
presents a conflict of interest in funds that does not exist in 
operating companies. In an operating company there is only one party to 
which directors, be they independent or not, owe their loyalty--the 
firm's stockholders. In a mutual fund there are two parties to which 
the nonindependent directors owe their allegiance--one is the fund 
shareholder, the other is the stockholder in the fund management 
company. Only independent fund directors have a singular fiduciary 
responsibility to fund shareholders. Accordingly, we believe that fund 
shareholders may be better served when an independent chairman oversees 
their fund.
    Of course, independence alone is no guarantee of good governance. 
We think a far more important issue is the visibility of the board. The 
typical fund investor is largely unaware of the corporate structure of 
funds. Few investors in, say, Fidelity Magellan think of themselves as 
the owners (alongside their fellow shareholders) of the fund. Instead, 
they think that Fidelity owns Magellan and they merely purchase its 
services. It is a notion that the fund industry doesn't discourage. 
Indeed, funds do little to draw attention to their corporate structure 
or the role of the board of directors, often relegating the names and 
biographical data of fund directors to the seldom-read statement of 
additional information.
    To remedy this situation, Morningstar suggests that each fund 
prospectus begin with an explanation of the fund's corporate structure, 
such as the following:

          When you buy shares in a mutual fund, you become a 
        shareholder in an investment company. As an owner, you have 
        certain rights and protections, chief among them an independent 
        board of directors, whose main role is to represent your 
        interests. If you have comments or concerns about your 
        investment, you may direct them to the board in the following 
        ways . . .

    By bringing more visibility to the fund's directors and by alerting 
shareholders to their role in negotiating an annual contract with the 
fund management company, the balance of power may begin to shift from 
the fund management company executives, where it now resides, to the 
shareholders, where it belongs.
    If directors are to represent shareholders, they need to hear from 
them. However, most fund directors have far more contact with the 
fund's manager than they do with fund shareholders. Several years ago I 
met a director who served on the board of many funds at a large fund 
complex. He also served on the board of a Fortune 500 company. He told 
me that while he received a dozen or so letters a month from 
shareholders concerning the public company, he had never in more than 
10 years received a letter from a fund shareholder. Fund boards have 
been out of sight and out of mind. It is telling that the 
whistleblowers at groups like Putnam did not even think to go to the 
fund boards. Fund boards must be more visible if they are to be an 
effective check for shareholders.
    They must also be accountable. We suggest that the independent 
chairman be 
responsible for writing to fund shareholders in the fund's annual 
report to address the steps the board takes each year in reviewing the 
manager's performance and the contract that the fund has with the 
management company. By bringing to light these important review 
functions, one assures that the structural safeguards of the investment 
company will work in practice, as well as in theory. We would also 
advocate a stronger role for fund directors in reviewing all 
communication between the fund management firm and fund shareholders, 
including marketing materials designed to attract new investors. The 
fund's communications should effectively explain the fund's investment 
strategy and the potential risks it may incur. By helping to establish 
rational performance expectations, fund boards would do a real service 
for both current and future shareholders.

Investors Must Have the Information to Make Intelligent
Decisions About Funds
    Transparency is the hallmark of the American financial system and 
one of the reasons that U.S. investors have put so much trust in mutual 
funds. Indeed, the amount of disclosure on funds in the United States 
is superior to that of any other country. Yet, at the same time, the 
disclosure requirements for funds fall well behind the standards set by 
publicly traded stocks in the United States. Given the rising 
importance of funds to so many Americans' financial security, we think 
it would benefit the industry to strive for the highest standards 
possible. While transparency can be a burden, it is also a tremendous 
asset in establishing and retaining trust, the very quality upon which 
mutual funds are based.
    All investors deserve to know if their interests are aligned with 
management's. Every week, we speak with mutual fund portfolio managers 
who tell us that before they buy stock in a company, they look to see 
how management is compensated. They want managers who ``eat their own 
cooking'' and whose interests are aligned with theirs. That is why 
institutional equity managers have long demanded and received detailed 
information about senior corporate executives' compensation and their 
holdings of company stock. In fact, stock investors would protest 
loudly if this information were denied to them. Why, then, are fund 
shareholders not given the same insights into their investments?
    Consider the case of a manager's holdings or trades in his or her 
fund. An equity investor has access to detailed information on the 
purchases, sales, and aggregate holdings of senior executives and other 
insiders at an operating company. Stunningly, fund investors are denied 
access to the very same data about the managers of their funds. While 
it is easy to appreciate why management might not wish to provide such 
data, it is hard to argue why an investor shouldn't have the right to 
see it. Indeed, such sunlight might well have been beneficial in the 
recent cases of several Putnam portfolio managers or Strong Funds' 
Chairman Richard Strong, who have been accused of market-timing their 
own funds. Can you imagine these executives engaging in such actions if 
they knew their inappropriate trading activities would become public 
information? Disclosure can be a powerful deterrent.
    Even the aggregate investment that managers have in their funds is 
shielded from fund shareholders' view. While any equity investor can 
see exactly how many shares of Microsoft Bill Gates owns, there is no 
way for a fund investor to see if his or her manager has any ``skin in 
the game.'' In the wake of the recent fund scandals, several mutual 
fund portfolio managers have stated publicly that because they invest 
heavily in their own funds, the kinds of trading abuses seen in other 
shops would not happen at theirs. This statement is a virtue that any 
fund manager can claim, but none has to prove. Why would such 
information that has long been disclosed about corporate insiders not 
be available about fund insiders?
    The same principle applies to management compensation and the 
incentives it creates. Disney shareholders know to the penny what 
Michael Eisner is paid to run their company. Like all holders of 
publicly traded stocks, they receive a statement from the compensation 
committee with their annual proxy materials outlining how the committee 
has structured the CEO's pay and on which metrics his or her bonus is 
based. It is not uncommon for these materials to include a CEO's entire 
employment agreement. Given the high level of disclosure on operating 
companies, it is hard to reconcile why no disclosure whatsoever is 
provided on fund manager 
compensation.
    Fund investors do not know if their manager's bonus is tied to 
short-term returns or to rolling 5-year returns, to pretax or to 
aftertax profits. If the manager's pay is linked to pretax returns, 
surely a manager will be less concerned about the tax consequences of 
his or her decisions. How can this not be material information to an 
investor considering placing a fund in either a taxable account or an 
IRA? In addition, one would hope that a fund manager's compensation is 
tied to fund performance, rather than to the fund's asset growth. A 
manager's incentive should be to manage, not to sell. But, with no 
compensation disclosure, how can a fund investor be sure? If mutual 
funds are indeed investment companies, let's treat them as companies 
and give fund investors the same level of disclosure that stock 
investors have long enjoyed.
    Finally, there is the issue of funds disclosing their portfolio 
holdings in a uniform and timely fashion. Such disclosure allows 
investors to see how their money is being managed and to more 
intelligently deploy funds within their portfolio. Many of the funds 
sold to the public as ``diversified'' growth funds during the late 
1990's held more than half their assets in technology stocks. An 
investor who thinks he has a diversified portfolio, but who, in fact, 
has a massive sector bet, is a disaster waiting to happen--a fate that 
too many fund investors learned the hard way when the tech bubble burst 
in 2000.
    The only way to intelligently troubleshoot a portfolio of funds is 
to have accurate and timely data on the securities within the funds. 
While most investors won't sort through detailed lists of fund 
holdings, there are financial advisors and research companies who will. 
In addition, the press and academics would be better able to research 
the fund management industry if they had access to such information. We 
see no need for instantaneous disclosure of fund holdings, but full 
portfolio disclosure at monthly intervals with an appropriate lag time 
to protect the manager's trading would greatly facilitate the research 
process and increase the odds that the right investor ends up in the right fund. If funds are not deployed wisely, they cannot possibly meet their obligations to investors. Barriers to quality research that would help investors make better use of their funds need to be removed whereever possible.

Mutual Funds Must Show that They Offer a Compelling Value Proposition
    Ultimately, mutual funds must demonstrate to investors that they 
offer a compelling value proposition. While the market will be the 
final arbitrator, fund companies can and should disclose fund costs in 
a fashion comparable to other professional fees, so that investors can 
make informed choices and the market can operate efficiently. Investors 
have moved their assets toward lower-cost funds over time, but they 
have done so not because funds clearly disclose costs, but because 
investors ultimately see the debilitating effect of high costs on long-
term performance. Why should we continue to subject investors to these 
damages when there are easy steps that can be taken to alert investors 
up front to the true cost of their funds?
    Funds currently state their costs in percentage terms, not dollars, 
and they state them as a percentage of assets entrusted to the manager, 
not in terms of the percentage of the investor's likely gain-
potentially a far more relevant number. For
example, an investor with $300,000 in a bond fund is told that his fund 
has an expense ratio of 1.5 percent. However, if an investor expects 
bonds to return 5 percent per year over the course of his investment 
horizon, that 1.5 percent expense ratio in reality reflects a 30 
percent annual toll on the likely returns he will receive from his 
investment. While establishing expected returns for asset classes is 
problematic, it is clear that the way fees are currently reported to 
shareholders dramatically understates their impact on returns (1.5 
percent versus 30 percent).
    The U.S. Government has established a fine precedent for the fund 
industry to follow in how it states, in dollars, the exact amount that 
a worker has deducted from his paycheck for Federal taxes, State and 
local taxes, Social Security, and Medicare. Workers can decide for 
themselves if they think the payments they make represent reasonable 
value for the services provided because they are allowed to see the 
exact cost in dollars of the services. Wouldn't the same basic level of 
disclosure be helpful to investors making decisions about funds?
    For many middle-class Americans, mutual fund management fees are 
now one of their 10 biggest household costs, yet the same individual 
who routinely shuts off every light in his house to shave a few pennies 
from his electric bill is apt to let these far greater fund costs go 
completely unexamined. Stating these fees in a dollar level that 
corresponds with an investor's account size is an important first step. 
We have truth-in-lending laws that detail to the penny the amount a 
homeowner will pay in interest on his mortgage. It is time for truth-in-investing rules that would bring the same common-sense solution to mutual funds. And of course, in fairness to mutual funds, the same standards should 
be applied to all investment services, including exchange-traded funds, 
variable annuities, and separately managed accounts.

Conclusions
    Given the central role funds now play in the retirement savings of 
our country, it makes sense to debate the rules governing this 
industry. At the same time, we do not believe that legislative 
solutions alone can safeguard investors. Public scrutiny and market 
forces also play a crucial role. In the wake of the recent fund 
scandals, we have seen Larry Lasser, Putnam's longstanding CEO, resign 
his position in disgrace. We have seen Strong Funds' Chairman Richard 
Strong forced to sell his business for a price possibly less than half 
what he had been offered just 4 years ago. And, finally, we have seen 
James Connelly of the Alger Funds sentenced to prison for his role in 
covering up evidence surrounding these scandals. The message to every 
fund executive is clear: If you violate the public's trust you can lose 
your reputation, your fortune, and your freedom. That is a lesson that 
will guide this industry for years to come.
    Still, we believe that there are additional steps that can be taken 
to protect the investing public. Specifically, we endorse these 10 
steps:

 Close the door to timing and late-trading abuses.
 Eliminate directed brokerage deals and better disclose pay-to-
    play arrangements.
 Eliminate soft-dollar payments.
 Eliminate or seriously reconsider the role of 12b -1 fees.
 Maintain vigilant and appropriately funded regulatory 
    oversight.
 Make fund directors more visible and accountable to 
    shareholders.
 Disclose fund manager trading in their funds.
 Disclose fund manager compensation.
 Improve portfolio holdings disclosure.
 State actual fund costs in dollars, so the market can work 
    more efficiently.

    Mutual funds have a proud history, but the recent scandals have 
badly damaged the industry's credibility. Collectively, legislators, 
regulators, and industry leaders must rebuild the public's trust in 
mutual funds. Investors need assurances that the playing field is 
level, that safeguards exist, that their manager's interests are 
aligned with theirs, and, ultimately, that funds represent good value. 
By addressing these concerns, the industry can get back on track to 
helping investors meet their goals and secure a safer future for their 
families.

                               ----------
                   PREPARED STATEMENT OF GARY GENSLER
              Former Under Secretary for Domestic Finance
                    U.S. Department of the Treasury
                           February 25, 2004

Introduction
    Chairman Shelby, Ranking Member Sarbanes, Members of the Committee, 
thank you for the opportunity to testify today on how to better align 
the mutual fund industry with the interests of investors. Since I last 
appeared here during my tenure as Under Secretary of the Treasury, I 
co-authored a book, The Great Mutual Fund Trap, to present common sense 
investing advice to middle-income Americans.
    The recent mutual fund scandals have shaken the confidence of these 
very investors. They are now asking: What went wrong? How do they best 
protect their savings? What can their Government do to better protect 
investors in the future?
    I believe that, at its core, the scandals have revealed the need 
for substantive reform regarding how mutual funds are governed and 
operated in America.
    In today's global economy, we simply have no choice but to ensure 
that America has the fairest and most efficient capital markets in the 
world. Mutual funds are a dominant factor for a majority of American 
families trying to save for retirement. They are amongst the largest 
sources of capital for corporate America. If mutual funds were to truly 
operate in the best interest of investors it would increase investors' 
returns, increase retirement savings, and lower the cost of capital for 
the
overall economy. This is ever more critical as we prepare for the 
retirement of the baby-boom generation.
    Congress long ago recognized the inherent conflicts of interest 
that exist between investors and those who mange investors' money. 
Responding to an earlier era's financial scandals, Congress passed the 
Investment Company Act of 1940 (1940 Act). The 1940 Act set up a system 
of mutual fund governance whereby noninterested mutual fund directors 
(independent directors) must independently review and approve all of 
the contractual relationships with the management company and the 
financial community. Congress understood that these relationships 
presented unavoidable conflicts and could significantly affect 
investors' overall returns.
    It is largely that system--independent mutual fund directors acting 
as gatekeepers for the benefit of investors--which we have in place 
today. It is that system that I believe deserves serious review and 
reconsideration.
    Only Congress can adequately address these issues through reform 
legislation. While the Securities and Exchange Commission (SEC) is 
pursuing an active agenda of reform, it cannot act alone on all of the 
necessary reforms to best align the interests of mutual funds with 
those of the investors they are supposed to serve.

Background
    The whole idea of a mutual fund is, as the name suggests, 
mutuality. Funds allow investors to share the costs of professional 
money management, in the nature of a cooperative. Mutual funds offer 
investors a chance at the superior long-term performance of equity 
investing, and a convenient way to buy bonds. They offer risk reduction 
through diversification as most funds own a broad spectrum of the 
market. Finally, when compared with the full-service brokerage 
commissions of the time, at first mutual funds' costs were relatively 
attractive. Legally, investors actually have collective control over 
their mutual funds. The company managing the 
assets is distinct from--and legally simply a contractor hired by--a 
mutual fund. Investors are represented by a board of directors which 
has a fiduciary duty to oversee their investments and hire the money 
management company (known as an ``adviser'') to invest it. In theory, 
the adviser works for investors to get the best returns for the lowest 
costs and risks. That is, at least in theory.
    Mutual fund companies, as distinct from the funds themselves, 
however, have their own shareholders and profits to consider. They have 
a primary responsibility to their shareholders above any duties to the 
investors in the many funds they manage. They charge high management 
fees even though those fees come directly from investors' returns. They 
generally are willing to take added risks in an effort to 
attract assets in rising markets. And they trade frequently, even if 
that increases trading costs and investors' short-term capital gains 
taxes.
    In practice, mutual fund investors have very little power over 
``their'' company. Mutual funds are set up by advisers, not by 
individual investors. Funds have no employees of their own. All of the 
research, trading, money management, and customer support staff 
actually work for the adviser.
    Mutual fund directors serve part-time and rely on the adviser for 
information. The adviser initially selects directors for new funds and 
often recruits new directors for established funds. Approximately 80 
percent of mutual fund boards are even chaired by someone affiliated 
with the adviser. Furthermore, fund companies generally set up a pooled 
structure, whereby fund directors serve on groups of boards for a fund 
family. The Investment Company Institute (ICI) recommends use of such 
``unitary boards'' or similar ``cluster boards'' in the name of 
efficiency. Not surprisingly, mutual fund boards fire their advisers 
with about the same frequency that race horses fire their jockeys.

The Role of Fund Directors
    The 1940 Act establishes specific roles for mutual fund directors. 
In particular, Section 36 of the 1940 Act imposes a fiduciary duty on 
directors with respect to fees paid to advisers. Section 15 of the 1940 
Act requires that the independent directors annually review and approve 
the contracts with the investment adviser and the principal 
underwriters. Rule 12b -1 requires a similar review of the distribution 

contracts. According to the late U.S. Supreme Court Justice William 
Brennan, the 1940 Act was designed to place unaffiliated fund directors 
in the role of independent watchdogs, to furnish an ``independent check 
upon the management of investment companies.'' \1\
---------------------------------------------------------------------------
    \1\ Burks v. Lasker, 441 U.S. 471, 484 (1979).
---------------------------------------------------------------------------
    In speaking to the inherent conflicts and potential for abuse and 
overreaching, SEC Chairman Donaldson said just 2 weeks ago:

          This problem is nowhere more in evidence than in the 
        negotiations over the advisory contract between the manager and 
        the fund. The money manager wants to maximize its profits 
        through the fees the fund pays. The fund's shareholders want to 
        maximize their profits by paying as little as they can for the 
        highest level of service. The fund's board of directors serves 
        as the shareholders' representative in this negotiation.\2\
---------------------------------------------------------------------------
    \2\ SEC hearing (February 11, 2004).

    This duty, however, has never been interpreted very stringently. In 
the landmark case on the matter, the second circuit court of appeals 
---------------------------------------------------------------------------
ruled in 1982 that:

          To be found excessive, the trustee's fee must be so 
        disproportionately large that it bears no reasonable 
        relationship to the services rendered and could not have been 
        the product of arm's-length bargaining.\3\
---------------------------------------------------------------------------
    \3\ Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 
923 (2d Cir. 1982), cert. denied, 461 U.S. 906 (1983).

    Over the subsequent years, the Gartenberg standard has proved to be 
insurmountable. No shareholder has subsequently proved a violation of 
the Gartenberg standard. And while it was initially found with regard 
to the fiduciary duty of the adviser (under Section 36(b) ) courts have 
allowed its use as the standard for directors as well. The SEC also has 
never sued a fund director for failing to review adequately an advisory 
agreement.
    In practice, fund directors have a difficult time striking a proper 
balance between working with the adviser and vigorously pursuing 
investors' interests. Directors, in essence, are recruited by the fund 
companies. Directors generally serve on a multitude of the fund 
family's boards. They naturally serve only part time and rely 
solely on the management company for all of their information. There 
are not even any direct employees of the fund or the board. The 
directors also have been informed of the legal standards and that until 
recently there has been only limited actions by the SEC and the courts. 
How many well-meaning directors would wish to make waves in this 
environment?

Why Governance Matters--Excess Costs Lower Retirement Savings
    High mutual fund costs take a serious bite out of Americans' 
retirement savings. The SEC noted the potential effects on retirement 
savings when they stated: ``A 1 percent increase in a fund's annual 
expenses can reduce an investor's ending 
account balance in that fund by 18 percent after 20 years.'' \4\
---------------------------------------------------------------------------
    \4\ SEC Report of the Division of Investment Management of Mutual 
Fund Fees and Expenses, (January 2001): 5.
---------------------------------------------------------------------------
    Over a lifetime, results can be even more dramatic when compared 
with low-cost passive index investing. Investing in low-cost index 
funds can lead to nearly twice as much savings by retirement than with 
the same amount actively invested (based upon just 2 percent more 
earnings per year).\5\
---------------------------------------------------------------------------
    \5\ For example, if a worker saves just $100 per month over a 40-
year career and earns 8 percent annually, they can retire with a 
$348,000 nest egg. Invest in actively managed funds and the likely nest 
egg--$199,000--fully 43 percent less money available for retirement.
---------------------------------------------------------------------------
    In total, investors can expect costs totaling close to 3 percent to 
disappear each year in an actively managed stock fund. Those investors 
who invest in a fund with sales loads (close to one half of all 
investors) can expect costs averaging over 4 percent per year. While 
fees for bond funds are modestly lower, they still overwhelm the 
expected returns on bonds, particular in today's low-interest rate 
environment.
    Mutual fund companies impose costs on investors approaching $100 
billion annually. These mutual fund costs are disclosed to investors:

 Monthly management, administrative, and distribution fees 
    averaging well over 1 percent per year. A review of the 2,297 
    actively managed stock funds in the Morningstar database shows an 
    average expense ratio of 1.49 percent.\6\
---------------------------------------------------------------------------
    \6\ Morningstar Principia Pro as of December 31, 2003.
---------------------------------------------------------------------------
 Sales loads, charged by half of all actively managed mutual 
    funds, averaging 3.9 percent.\7\ With an average holding period of 
    just over 3 years, investors can pay an additional 1.2 percent per 
    year.
---------------------------------------------------------------------------
    \7\ Morningstar Principia Pro as of December 31, 2003. Search was 
for all U.S. equity mutual fund share classes charging a sales load, 
excluding index funds, exchange-traded funds, and institutional funds--
3,996 funds in all. The 3.9 percent came from adding the average front-
end and back-end load.

    While investors may not pay particular attention to these costs, at 
least they are disclosed. Also, fund directors are legally required to 
pay attention to them.
    There are some very important costs, though, which go undisclosed. 
They are hard for investors to measure and they do not show up on any 
statement. Mutual fund directors also have a more limited legal role in 
these costs. As investors' representatives, however, I believe, they 
actually should be very engaged in these costs.

 Portfolio trading costs--the typical active equity fund 
    manager turns over their entire portfolio once every 18 months, 
    incurring brokerage costs and bid/ask spreads approximating \1/2\ 
    to \3/4\ percent of assets each year.
 Excess capital gains taxes--adding costs of 1 to 2 percent of 
    assets per year--are incurred as portfolios are rapidly traded. 
    While helpful to the U.S. Treasury, this pervasive triggering of 
    short-term capital gains tax is particularly costly for investors 
    in the new 15 percent long-term capital gains rate environment.
 The opportunity cost of holding idle cash lowers returns about 
    0.4 percent each year, on average, during the last 10 years. 
    (Though even more during the strong market of last year.)
Why Governance Matters--Soft Dollars
    Hidden within portfolio trading costs is something Wall Street 
calls ``soft dollars.'' This is where an adviser, with the acquiescence 
of the funds' directors, benefits itself at investors' expense.
    The mutual fund industry's educational material on the role of 
directors has this to say about ``soft dollars.'' [Emphasis added]:

          Directors also review a fund's use of ``soft dollars,'' a 
        practice by which some money managers, including mutual fund 
        advisers, use brokerage commissions generated by their clients' 
        securities transactions to obtain research and related services 
        from broker-dealers for the clients' benefit. Directors review 
        their fund adviser's soft-dollar practices as part of their 
        review of the advisory contract. They do this because services 
        received from soft-dollar arrangements might otherwise have to 
        be paid for by the adviser.\8\
---------------------------------------------------------------------------
    \8\ The Investment Company Institute, ``Understanding the Role of 
Mutual Fund Directors'' (1999): 16.

    What is hard to figure out is how soft-dollar payments can ever be 
``for the clients' benefits'' when they ``might otherwise have to be 
paid for by the adviser.'' A portion of every commission will be 
retained by the broker as payment for research advice or other services 
normally paid for by the fund company. Basically, any expense that the 
fund company can direct to the fund's broker adds to the fund 
companies' profits at the expense of individual funds and their 
investors.

Why Governance Matters--The Sad Averages
    All of these costs have their effect. Looking at the results over 
the last 10 years, Morningstar data shows that the average actively 
managed diversified U.S. equity mutual fund fell short of the market by 
1.4 percent annually. Annual fund returns of 9.2 percent compared to 
the overall market return of 10.6 percent annually, as measured by the 
Wilshire 5000.
    Furthermore, currently reported performance results include only 
those funds that survived the entire period. The many funds which have 
been routinely merged or liquidated are not still included in industry 
statistics. Looking at 10-year returns of currently active funds in 
2004 will by definition exclude all the unfit funds that closed up shop 
during the last 10 years.
    This phenomenon is known as survivorship bias. It is like judging 
the contestants on a reality TV show simply by looking at the last few 
people left on the island. If someone asked a viewer how interesting 
the contestants were, they would probably forget the ones who were 
voted off in the first few weeks. What were their names again?
    The most comprehensive look at survivorship bias was conducted by 
Burton Malkiel, who concluded that such bias was considerably more 
significant than previous studies had suggested. For the 10-year period 
of 1982-1991, survivorship 
bias inflated average industry returns by 1.4 percent per year.\9\ 
Furthermore, the number of liquidating funds is rising. With 4 to 5 
percent of all funds disappearing each year, survivorship bias today is 
likely to be even greater than during this 
earlier period.
---------------------------------------------------------------------------
    \9\ Malkiel, Burton G., ``Returns from Investing in Equity Mutual 
Funds 1971 to 1991,'' Journal of Finance 50 (June 1995): 549.
---------------------------------------------------------------------------
Why Governance Matters--Distribution & Revenue Sharing Arrangements
    The mutual fund industry increasingly relies on others--brokers, 
insurance companies, and financial planners--to sell its products. So 
while initially hesitant to promote a competitor's products, brokers 
later developed ``revenue sharing arrangements'' whereby they would get 
paid for every new sale they made. Most mutual fund families feel that 
they have to pay, lest they lose access to new assets and market share.
    Mutual fund companies do not eat the cost of paying these sales 
forces. They pass that cost along to investors, either through a 12b -1 
fee, a sales load, or in the form of directed brokerage commissions. In 
certain recent cases, these arrangements have been in direct conflict 
with current SEC rules. In aggregate, 12b -1 fees cost investors 
approximately $10 billion per year while sales loads are in excess of 
$20 billion per year.
    There is absolutely no reason, however, for investors to pay loads 
or 12b -1 fees. They are not like brokerage commissions, which are 
necessary to execute a trade on an exchange. Mutual funds are charging 
investors loads and part of 12b -1 fees to issue them new fund shares. 
The other part of 12b -1 fees goes to advertising. Brokers like both 
because they get to share in the action as additional compensation. 
Sales loads do not even help offset other costs. Expense ratios for 
load funds are higher than for no-load funds, with an average of 1.89 
percent per year.\10\ And as a group, load funds actually earn lower 
average returns than no-load funds . . . even without taking the loads 
into account.
---------------------------------------------------------------------------
    \10\ Morningstar Principia Pro as of December 31, 2003.
---------------------------------------------------------------------------
Why Governance Matters--Recent Scandals
    Mutual fund investors have had a series of wake up calls this past 
year. The series of scandals has helped to highlight the potential for investors to take a back seat to the inherent conflicts of interest lurking 
within the industry.
    In a pursuit of assets, many mutual fund companies entered into 
questionable activities. Some sophisticated investors, such as certain 
hedge funds, were allowed to invest in mutual funds based upon stale 
prices. These practices, known as ``late trading'' and ``market 
timing'' were not readily available to the general public. With ``late 
trading,'' intuitional investors were allowed to invest after the 
legally mandated 4 p.m. close, thus getting the benefit of further 
market developments while still paying the price as of 4 p.m. In 
``market timing'' sophisticated investors were allowed to trade in and 
out of funds on very short holding periods in an effort
to take advantage of stale prices related to international stocks. Most 
of these funds had actually publicly stated to their investors that 
they forbade such activity.
To allow this for the privileged few was disadvantageous to the vast 
majority of retail investors.
    Another set of problems arose around brokers incorrectly charging 
investors when purchasing load funds. In many of these funds, discounts 
are advertised for larger purchases. Unfortunately, many brokers were 
lax in recognizing these discounts or ``breakpoints.''
    There also have been questionable practices which have gotten less 
public attention, but are no less troubling. In particular, many mutual 
fund companies use ``incubator'' funds and the allocation of initial 
public offerings (IPO's) and other hot stocks to boost the reported 
results of new funds. Other fund advisers also have been advising hedge 
funds and potentially favoring those funds internally.

Market Breakdown
    The mutual fund industry is certainly competitive, with significant 
disclosure of its costs. So why haven't markets worked better to 
protect investors?
    I believe that this is due to a number of factors, including: (i) 
investors' collective willingness to put their faith in experts while 
chasing after recent performance; (ii) the effective advertising of the 
financial industry; (iii) the unique way the industry charges for its 
services; (iv) the many conflicts of brokers and financial planners; 
and (v) the practical day-to-day barriers in switching mutual fund 
families.
    There are thousands of funds and hundreds of fund companies 
competing in the market. That does not mean, however, that the mutual 
fund industry competes on cost. There are hundreds of casinos in Las 
Vegas, but that doesn't mean that you will find one where the odds are 
in your favor.
    Mutual funds compete on service and the expectation of earnings 
performance. Most Americans tend to pick actively managed funds in the 
hope of relying on the experts to beat the market. Worse, they pick 
funds based upon last year's best 
performers or ``hot'' funds--expecting them to out perform the market 
once again next year.
    Winning funds of the past, however, are unlikely to be the winning 
funds of the future. In perhaps the most important study of the factors 
affecting mutual fund performance, it was found that, basically, past 
performance does not predict future performance.\11\ If you take the 
top 10 percent of funds in a given year, by the next year, 80 percent 
of those funds have dropped out of that top 10 percent ranking. For the 
top 20 percent of funds, 73 percent drop out the next year. For the top 
50 percent of funds, roughly 45 percent fall out the next year. That is 
not much different from what you would expect from random chance.
---------------------------------------------------------------------------
    \11\ Carhart, Mark M., ``On Persistence in Mutual Fund 
Performance,'' Journal of Finance 52 (March 1997): 57.
---------------------------------------------------------------------------
    Regardless, mutual fund companies spend significant advertising 
dollars luring investors to this loosing strategy. Advertisements are a 
poor guide, however, for investors trying to decide on a mutual fund. 
Researchers examined 2 years of mutual fund advertising in Barron's and 
Money magazine.\12\
---------------------------------------------------------------------------
    \12\ Jaij, Prem C., and Joanna Shuang Wu, ``Truth in Mutual Fund 
Advertising: Evidence on Future Performance and Fund Flows,'' Journal 
of Finance 15 (April 2000): 937.
---------------------------------------------------------------------------
    The study reached three conclusions:

 First, not surprisingly, the advertised funds had performed 
    well in the year before the advertisement was run. The pre-
    advertisement returns of those funds over the past year were 1.8 
    percentage points better than the S&P 500 Index.

 Second, the advertisements were extremely effective in 
    attracting new money to the funds. Compared to a control group, 
    advertising appeared to increase inflows 20 percent over what one 
    would otherwise have expected.

 Third, and most significantly, the post-advertisement 
    performance of the funds was quite poor. The funds' post-
    advertisement performance over the next year trailed the S&P 500 by 
    7.9 percentage points.

    Mutual fund advertising is a classic example of closing the barn 
door once the horse has left. Mutual funds also have constructed a 
unique system whereby costs are practically invisible--another reason 
why traditional market forces break down. We all have to write a check 
to our utility or mortgage company, but we never pay a bill for mutual 
fund management. Such costs are simply deducted from our monthly 
returns, or taken off the top if we buy a load fund. Other significant 
costs are not even adequately disclosed, such as portfolio trading 
costs. In addition, markets are volatile while trending up. This leaves 
most investors focused on total returns rather than how costs affect 
those returns.
    Investors also are faced with brokers and financial planners 
touting suggestions and advice which often have the added benefit of 
lining that broker's or planner's pocket. When investors do consider 
changing mutual funds, they generally turn to these same brokers and 
financial planners. There are some practical barriers to switching 
funds, as well. A significant portion of mutual fund investors now have 
some savings in 401(k) plans or 403(b) plans. These plans and the fund 
options 
are selected by their employers. Many other investors are hesitant to 
make investments with a fund family other than where they might have a 
linked money market account.

Policy Recommendations
    To promote retirement savings and the markets, I believe that 
Congress and the SEC should enact significant mutual fund reforms. 
While the SEC and other law enforcement agencies may be the first line 
of defense, I think that there is an important role for Congress to 
play. The SEC may go only so far under current statute. In addition, 
Congress can bolster the actions the SEC might take on their own.
    In this regard, I recommend that this Committee give serious 
consideration to: (a) strengthening fund governance; (b) restricting 
payments of soft dollars and 12b -1 fees; (c) enhancing fund 
disclosures; and (d) adopting certain fixes directly raised by the 
recent scandals.

Mutual Fund Governance
    The 1940 Act sought to address inherent conflicts of interest by 
relying upon independent directors to promote investors' best 
interests. The recent scandals and the persistence of high fees and 
other costs have revealed fundamental weaknesses in this system of 
governance. I believe that Congress and the SEC should now vigorously 
address these weaknesses by: (i) clarifying the duties of independent 
directors and the standards to which they are held; (ii) tightening the 
definition of independence; (iii) prescribing how independent directors 
are selected; and (iv) increasing their numbers and requiring the chair 
to be independent.

Governance--Duties & Standards
    I believe that the most important thing that Congress can do in 
promoting reform is to make clear--in statute--the duties which 
independent directors hold to investors and tighten the standards to 
which they will be held. In essence, I believe that directors should 
act on behalf of the investors as if they were owners.
    While the 1940 Act is specific as to the many duties of directors, 
until the recent scandals, the mood in the boardroom has been all too 
accommodating. In particular, there is significant evidence suggesting 
that fund directors do not actively pursue cost reductions or 
vigorously negotiate major contracts related to advisers, brokers, or 
portfolio trading. These are the largest controllable costs of a mutual 
fund.
    What if mutual fund directors were to vigorously negotiate fees and 
other costs? Could they not confer far more significant benefits to 
investors than they do under the current governance system? Would not 
retirement savings increase in America?
    While I am not suggesting mandating ``request for proposals'' by 
mutual funds, I do believe that the 1940 Act should be amended to 
include a general fiduciary duty for directors to act with loyalty and 
care and in the best interests of the shareholders. It may be 
appropriate, as well, to mandate that the SEC promulgate rules for 
directors in carrying out these fiduciary duties. This would provide 
impetus for independent directors trying to balance their relationships 
with the investment adviser and others with inherent conflicts of interest. For instance, the Act could require that the independent directors formally meet without interested parties while reviewing and discussing the material contracts. It could also spell out a list of issues which must be considered when approving contracts. Most significantly, the 1940 Act could require true arm's-length negotiations. Imagine any other board of directors fulfilling 
its fiduciary duties without requiring similar efforts related to its 
principal supply contracts.
    I also believe that Congress should amend or repeal the Gartenberg 
Standard. This legal standard is at the very heart of the loose 
oversight currently evidenced by mutual fund boards.
    Finally, I believe that independent directors should be required to 
ask for and receive more relevant information prior to entering into 
major contracts, not just the advisory contract. Section 15 of the 1940 
Act could be expanded, requiring that the SEC promulgate rules from 
time-to-time to best accomplish this. In particular, the SEC should 
require independent directors to consider the amounts that advisers 
charge pension plans and other parties for similar advisory services.
    A study conducted in 2001 showed that the largest mutual funds pay 
twice the amount to their advisers than public-employee pension plans 
do for the same services.\13\ In some cases, mutual fund advisory fees 
were 3 to 4 times higher than those of pension funds. While challenged 
by the ICI, the study still raises legitimate questions for 
policymakers and independent fund directors. Pension funds negotiate 
for lower fees, while mutual fund shareholders can only rely on their 
directors to do so. Trustees of public pension plans and corporate 
retirement plans switch asset managers on a regular basis, due to fee, 
performance or service issues. Mutual fund directors should at least 
benefit from the best direct comparisons on fees. I have no doubt that 
they could be made available, if required in law.
---------------------------------------------------------------------------
    \13\ Brown, Stewart, and John Freeman, ``Mutual Fund Advisory Fees: 
The Cost of Conflicts of Interest,'' University of Iowa Journal of 
Corporation Law (August 2001): 609 -73.
---------------------------------------------------------------------------
Governance--Definition of Independence & Selection Process
    While the 1940 Act currently contains a definition of an 
independent director, I believe that it is prudent to tighten that 
definition and provide for an independent mechanism for the recruitment 
and selection of such directors. Sections 10 (and its related 
definitions) of the 1940 Act could be amended to assure that 
noninterested directors not have any material employment, business or 
family relationship with the investment adviser, significant service 
providers, or any entity controlling, controlled by, or under common 
control with such companies. In addition, the recruitment and selection 
of such directors should be by the independent directors or by an 
independent nominating committee.

Governance--Independent Chair & Percentage of Independent Directors
    The 1940 Act currently mandates that at least 40 percent of mutual 
fund directors be independent. The SEC, in 2001, required mutual funds 
operating under a series of SEC exemptions to have at least 50 percent 
of their directors be independent. The SEC, in response to the recent 
scandals has proposed rules to move this percentage to 75 percent and 
require that the board chair be independent, as well. I support these 
changes as they should change the dynamics in the board-
room. In particular, the chair sets the agenda and tone of board 
deliberations. There is no way that a chair who also works for the 
investment adviser can satisfactorily serve two masters. By way of 
analogy, for those who might doubt the impor-
tance of the chair, think of all the energy that goes into securing the 
chairs of Senate Committees.
    I do believe, however, that it would be far better to incorporate 
these requirements directly in the 1940 Act. It is better for Congress 
to act on such a material provision of law, rather than have the SEC, a 
regulatory agency, to mandate its adoption particularly through 
indirect means. In addition, in a moment of future confrontation 
between an independent board and a fund company, the fund may avoid the 
SEC rule by declining the various exemptions.
    To assure the necessary change in behavior of boards, however, more 
is needed than simply changing the number of independent directors and 
mandating an independent chair. The great majority of funds already 
have a substantial majority of independent directors. In fact, 
approximately 20 percent already have independent chairs, including 
some of those funds caught up in the recent scandals. While it would be 
a positive step, current law already requires that independent 
directors review and make the key decisions of the board. That is why I 
believe that the most important governance reform is to clarify the 
duties of independent directors and tighten the standards to which they 
are held.

Restricting Soft Dollars & 12b -1 Fees
    Beyond changes to encourage better mutual fund governance, I 
believe that Congress should give serious consideration to restrictions 
on soft-dollar arrangements and 12b -1 fees. Both of these practices 
exist as they do as a result of specific SEC actions. Both of these 
practices also have been associated with a long history of conflicts of 
interest, and may have outlived their purposes.
    The use of soft dollars was significantly broadened under an SEC 
release in 1986 (interpreting Section 28(e) of the Securities Exchange 
Act of 1934, which allows paying more than the lowest available 
commission). Mutual fund companies enter into soft-dollar arrangements 
with brokers at the expense of the mutual funds which they manage. 
While soft-dollar arrangements can be used to support independent 
research efforts, they are often used for other expenses as well. They 
also diminish fund managers' pursuit of best execution for portfolio 
transactions.
    The SEC has put out a concept release seeking comments on soft-
dollar arrangements, but the Congress may wish to significantly 
restrict or possibly prohibit the current practice. Short of an 
outright prohibition, mutual funds should be required to disclose the 
amount by which any soft-dollar arrangement are picking up costs for 
the fund company and this amount should be added to expense ratios.
    Rule 12b -1 was promulgated in 1980 in an effort to bring the 
benefits of economies of scale to investors. The theory originally was 
that by helping fund companies generate cash for marketing, funds could 
grow faster and share economies with investors. Unfortunately, 
investors have seen few benefits from scale in these funds. The 
evidence clearly shows that funds with 12b -1 plans simply have higher 
expense ratios and poorer performance than non-12b -1 funds. The time 
has come to look seriously at repealing Rule 12b -1. The SEC proposed 
an amendment to Rule 12b -1 this month which would ban the practice by 
mutual funds of directing commissions from their portfolio brokerage 
transactions to broker-dealers to compensate them for distributing fund 
shares. I agree with these changes but would add that Congress might 
want to consider the effects of other revenue sharing arrangements, as 
well. These arrangements call into question the ability of investors to 
receive unbiased financial advice from their financial planners or 
brokers. By analogy, patients do not wish to see their doctors receive 
direct commissions when deciding on the appropriate medicine to 
prescribe.

Greater Disclosure
    The mutual fund industry currently provides a considerable amount 
of disclosure to the investing public. Additional disclosures, however, 
may assist investors and further guard against inherent conflicts. 
While I think that the most important reforms relate directly to governance, I offer the following thoughts on additional possible disclosures to benefit investors.
    First, while the direct costs of management fees and sales loads 
are disclosed, many of the indirect costs are not. In particular, 
portfolio trading costs are generally not disclosed. This is somewhat 
remarkable given their significance to investor returns. They are also 
one of the largest controllable costs of mutual funds. I believe that 
it would be beneficial to disclose total transactions costs, 
commissions as well as an estimate of the costs of bid/offer spreads. 
If pursued, this would be most helpful if disclosed along with 
management fees as a percentage of average assets.
    Second, the mutual fund industry relies heavily on others--brokers, 
insurance companies, and financial advisers--to sell its products. 
Additionally, fund companies actively compete to win 401(k) and 403(b) 
plans from large corporations and institutions. Recognizing their 
commercial leverage, brokers have developed revenue sharing agreements 
whereby they get paid handsomely for new sales. Large corporations and 
institutions have developed somewhat similar arrangements whereby they 
receive part of the mutual fund fees on plan assets. Consideration is 
appropriate to greater disclosure of these revenue sharing 
arrangements.
    Third, bringing greater transparency in the area of governance may 
bring greater discipline. The SEC has this month proposed a rule to 
require improved disclosures regarding the reasons for a fund board's 
approval of investment advisory contracts. I believe that this rule 
could be extended--by statute--both as it relates to the negotiations 
with the adviser and to include other major contracts. In addition, 
disclosure of portfolio manager compensation and fund ownership would 
be helpful.
    Fourth, given the natural desire of fund companies to ignore the 
poor results of liquidated or merged funds, it would be helpful to 
require fund companies to maintain such disclosure on their websites. 
Survivorship bias has a perfectly innocent explanation. When investors 
are trying to decide with which mutual fund family to invest, however, 
they could benefit by seeing a firm's entire track record. Many outside 
services and publications would also summarize the information, once it 
was made publicly available.
    Fifth, there is a significant relationship between risk and 
returns. Many observers focus on risk adjusted returns to compare 
investments. Based upon modern theories of investing, risk adjusted 
returns are a way of comparing investments of different risks. There 
are many services that compute such statistics. It may be worthwhile 
considering requiring fund companies to readily disclose such 
information on their web sites or with promotional material.
    Sixth, while Congress took steps several years ago to require the 
disclosure of after-tax returns, the SEC does not require inclusion of 
this information in sales and promotional material unless a fund is 
claiming to be tax efficient. Investors wishing to know a fund's after-
tax performance currently need to review the prospectus--something they 
should be doing, but generally are not. It may be appropriate to 
mandate broader use of after-tax performance data.

Recent Scandals
    The SEC has had an active agenda addressing the specifics of ``late 
trading,'' ``market timing,'' and ``breakpoint discounts.'' In 
particular, the SEC proposed a rule requiring that fund orders be 
received by 4 p.m. to address ``late trading.'' To address ``market 
timing'' problems, the SEC proposed a rule requiring enhanced 
disclosures including: (1) ``market timing'' policies and procedures, 
(2) ``fair valuation'' practices, and (3) portfolio disclosure policies 
and procedures. Regarding ``breakpoints,'' the SEC proposed enhanced 
disclosure regarding breakpoint discounts. In addition, the SEC adopted 
a rule on fund compliance policies and compliance officers and has 
proposed a rule on fund codes of ethics.
    While the SEC has been able to move forward with these rules under 
the current authorities, Congress could include in any comprehensive 
reform package an endorsement or enhancement of these rules.

Conclusion
    In conclusion, I believe that the recent mutual fund scandals have 
revealed the need for substantive reform regarding how mutual funds are 
governed and operated. Most importantly, it is the system of 
governance--whereby independent mutual fund directors act as 
gatekeepers for the benefit of investors--which deserves serious review 
and reconsideration.
    Mutual funds now play a central role in America's capital markets. 
As we, as a Nation, face increasing global competition and prepare for 
the retirement of the baby-boom generation, I believe that we simply 
have no choice but to ensure that America has the fairest and most 
efficient capital markets in the world. Even small annual savings can 
lead to enormous differences upon retirement. Thus, mutual fund 
reforms, with the goal to promote greater retirement savings and lower 
the cost of capital, are ever more critical.
    Thank you. I would be happy to answer any of your questions.

                               ----------
                PREPARED STATEMENT OF JAMES K. GLASSMAN
             Resident Fellow, American Enterprise Institute
                           February 25, 2004

    Mr. Chairman and Members of the Committee, my name is James K. 
Glassman. I am a Resident Fellow at the American Enterprise Institute, 
where my focus is economic and financial issues. I am also host of the 
website TechCentralStation.com, which concentrates on matters of 
technology, finance, and public policy. In addition, for the past 10 
years, I have written a weekly syndicated column for The Washington 
Post on investing. I have also written two books geared to small 
investors and have published numerous articles on investing topics in 
publications ranging from The Reader's Digest to The Wall Street 
Journal. Thank you for inviting me to testify at this important hearing 
on mutual funds from the point of view of the investor, especially the 
small investor, who is my main concern. I testify as an individual. The 
views are mine, not those of any institution with which I am connected.

The Mutual Fund Scandals
    In early September of last year, the Attorney General of New York, 
Eliot Spitzer, announced that several mutual fund firms had allowed 
large investors to profit from practices that were either illegal or 
actively discouraged by their own published policies. One of those 
investors, Canary Capital Partners, LLC, a hedge fund, agreed to pay a 
fine of $40 million to settle civil charges. Since then, two dozen 
mutual fund houses, including several of the largest, have been 
implicated in the scandal, which, by the end of January, had led to 
civil or criminal complaints against at least 10 companies by attorneys 
general, the U.S. Securities and Exchange Commission, and the Justice 
Department; the dismissal or resignation of 60 executives, including 
the president of Alliance Capital and the CEO's of Pilgrim, Baxter & 
Associates, Putnam Investments, and Strong Capital; and the imposition 
of more than $640 million in penalties.\1\
---------------------------------------------------------------------------
    \1\ ``Putnam Led Industry With $28.9 Billon of Withdrawals,'' 
Bloomberg, January 28, 2004.
---------------------------------------------------------------------------
    Specifically, the charges concern two practices:
    Late trading, by which an investor purchases shares in a mutual 
fund after the 4 p.m. deadline but pays the price at that day's close, 
rather than the next day's. This practice, which typically requires the 
collusion of a broker or mutual fund employee, is illegal.
    Market timing, by which an investor makes quick trades in a mutual 
fund's shares. Most mutual funds discourage market timing--and so 
officially state to investors--because it can add costs for other 
shareholders in the fund.
    Both practices attempt to capitalize on ``stale prices''--usually 
in international stocks. Trading in Europe and Japan, for example, ends 
many hours before the 4 p.m. deadline and, in the interim, events may 
occur that could lift prices the next day. Through stale-price 
arbitrage, an investor can, to paraphrase Spitzer, bet on a horse after 
the outcome of the race is known.
    These practices dilute the holdings of the other shareholders in 
the fund. According to research by Eric W. Zitzewitz, ``In 2001, a 
shareholder in the average international fund in my sample lost 1.1 
percent of assets to stale-price arbitrage trading and 0.05 percent of 
assets to late trading. Losses are smaller, but still economically 
significant, in funds holding small-cap equities or illiquid bonds.'' 
\2\ Large-cap U.S. stock funds are generally unaffected.
---------------------------------------------------------------------------
    \2\ Eric W. Zitzewitz, Assistant Professor of Economics, Stanford 
University, testimony before the Subcommittee on Capital Markets, 
Insurance and Government-Sponsored Enterprises, Committee on Financial 
Services, U.S. House of Representatives, November 6, 2003.
---------------------------------------------------------------------------
    The scandal is by far the most extensive to afflict the mutual fund 
industry, which, since its founding 80 years ago,\3\ has been 
relatively free of impropriety and broadly respected by investors. Even 
before Eliot Spitzer filed his initial charges, however, the Congress 
and the SEC had been examining major changes in the structure and 
regulation of mutual funds, and, after the scandals, a flood of 
legislation was introduced, including three major bills in the Senate 
in the space of 20 days in November.\4\
---------------------------------------------------------------------------
    \3\ The Massachusetts Financial Services (MFS) is generally 
credited with launching the first mutual fund in the Spring of 1924. 
MFS, the eleventh largest mutual fund firm, reached an agreement on 
February 5, to pay $225 million and reduce fees in a settlement with 
regulatory authorities after charges of permitting market timing. In 
addition, the CEO and President of MFS have stepped down. (Letter to 
clients from Robert Manning of MFS, February 17, 2004, at http://
www.mfs.com/about/index.jhtml; $sessionid$5MJVUBMKDMDCBTXTQYUBFD4O4O 
DCSESS.)
    \4\ S. 1822, S. 1958, and S. 1971. These three, along with H.R. 
2420, passed by the House on November 19, 2003, are examined at length 
in a CRS Report (RL32157), ``Mutual Fund Reform Bills: A Side-by-Side 
Comparison,'' updated December 9, 2003.
---------------------------------------------------------------------------
    But is the rush to regulate the proper response to the scandals? 
Judging from the perspective of the investor, as this hearing requests, 
I have serious doubts.
    While steps need to be taken to ensure that some investors do not 
exploit stale pricing at the expense of others, the mutual fund 
industry is basically sound. It is highly decentralized and 
competitive, and, despite the scandals and the 3-year bear market in 
stocks, it continues to attract savings at a remarkable rate. The 
largest firms--including Fidelity Investments, which offers more than 
300 funds; Vanguard Group, whose Index 500 Fund is the largest mutual 
fund with $77 billion in assets; and American Funds, which runs four of 
the top biggest funds, with assets totaling $200 billion--have not been 
tainted by the scandal.
    A greater worry is that, by rushing to increase regulations in 
areas such as fees, board composition, and disclosure, policymakers run 
the risk of limiting choices and raising costs for small investors. The 
mutual fund industry is a great American success story. It has 
democratized finance. It has both provided capital for businesses and 
increased the net worth of families. But weighed down by dozens of new 
counterproductive rules, it could lose its robust character.

Popularity of Mutual Funds
    The most striking characteristic of mutual funds is how popular 
they have become in such a short time. In a free economy with abundant 
selections, people buy what they want, and their investment of choice 
in the past three decades has been mutual funds. In 1970, for example, 
there were 361 funds with a total of $48 billion in assets. At the end 
of 2003, there were 8,124 funds with $7.2 trillion in assets. Mutual 
funds are owned by 91 million investors in 53 million U.S. households--
roughly half the Nation.\5\
---------------------------------------------------------------------------
    \5\ 2003 Mutual Fund Factbook, 43rd edition, Investment Company 
Institute, May 2003; updated information from the ICI website, 
www.ici.org.
---------------------------------------------------------------------------
    Even in the wake of the scandals, Americans have continued to 
invest in mutual funds. In 2003, a total of $152 billion in net new 
money (after redemptions) flowed into stock mutual funds, including $30 
billion in November and December, at the height of the revelations by 
Spitzer and the SEC.
    In his history of popular finance in America, Joseph Nocera, 
Editorial Director of Fortune magazine, wrote:

          Mutual funds became the investment vehicle of the middle 
        class because they . . . struck people as making a good deal of 
        sense. If anything, mutual funds made more sense than ever 
        after the crash [of October 19, 1987, when the Dow Jones 
        Industrial Average lost 22 percent of its value in one day]. 
        For one thing, even the most aggressive mutual funds 
        outperformed the market on Black Monday, and in so doing 
        provided at least a little comfort to small investors. More 
        importantly, as the financial life of the middle class became 
        ever more complicated, connected irrevocably to such arcane as 
        the state of the Japanese market and the shape of the yield 
        curve, Americans took increasing solace in the central notion 
        behind mutual funds--that by putting money in a fund, they were 
        hiring a professional to make market decisions they felt 
        increasingly incapable of making themselves.\6\
---------------------------------------------------------------------------
    \6\ Joseph Nocera, A Piece of the Action: How the Middle Class 
Joined the Money Class, Simon & Schuster, 1994, p. 369.

    Mutual funds created a revolution in investing by providing average 
Americans with the same professional management and financial reporting 
enjoyed by the rich--and at roughly the same cost. Because of private 
research institutions like Morningstar Mutual Funds, investors can 
easily compare the performance and the fees of thousands of funds. 
Nocera quotes Don Phillips of Morningstar as saying, ``One of the 
hidden advantages of the fund industry is that by packaging investments 
in consumer wrapping, mutual funds tap into the consumption skills baby 
boomers have spent their lifetimes refining. . . . Funds make investing 
very much like shopping.'' \7\
---------------------------------------------------------------------------
    \7\ Ibid.
---------------------------------------------------------------------------
    One of the many problems with proposals for mutual fund reforms is 
that the shopping will become much more difficult--with a profusion of 
new requirements that will mainly serve to confuse investors and add 
costs that will be borne by fund shareholders or taxpayers. The SEC 
alone has approved or is considering 17 separate rules changes \8\ and 
these are in addition to those that may be enacted by other regulators 
or through legislation.
---------------------------------------------------------------------------
    \8\ ``Taking a Closer Look: The SEC's Fund To-Do List,'' Ian 
McDonald, The Wall Street Journal Online, January 14, 2004, at http://
online.wsj.com.
---------------------------------------------------------------------------
    A better approach is to increase incentives of investors to 
discipline funds through their own choices--and to increase incentives 
of funds to communicate forcefully and clearly to investors and of 
Government to educate.
Investor Discipline is Harsh
    The discipline of investors is far more harsh than anything 
regulators can dream up. Consider the new inflows and outflows of new 
money into major mutual funds during 2003 \9\:
---------------------------------------------------------------------------
    \9\ ``Putnam Led Industry,'' Bloomberg, January 28, 2004, op. cit., 
and ``American Funds Get Highest Inflows in United States, Report 
Says,'' Bloomberg, January 29, 2004. Both articles use the Financial 
Research Corporation of Boston as their main source for data in the 
table that I have compiled.


------------------------------------------------------------------------
                                                         Net Inflow or
                                                           (Outflow)
           Fund Company               Allegations of  ------------------
                                       Impropriety?     In billions  of
                                                            dollars
------------------------------------------------------------------------
American..........................         No                66
Vanguard..........................         No                36
Fidelity..........................         No                31
Putnam............................         Yes               (29)
Janus Capital.....................         Yes               (15)
Amvescap (Invesco)................         Yes                (8)
Alliance Capital..................         Yes                (2)
------------------------------------------------------------------------


    Putnam, for example, charges an annual expense ratio of between 1 
percent and 1.55 percent for its equity funds, in addition to a 5.25 
percent load, or up-front fee.\10\ Imagine that Putnam merely loses 1 
percent on the foregone assets each year. Based on an asset decline of 
$29 billion in 2003, that's a loss of $290 million in revenues--with 
much of it dropping straight to the bottom line--in the first year 
alone. Assume that a typical client who redeems her shares would have 
kept an account for 5 years; the total loss (assuming no more new 
redemptions in subsequent years but growth in assets of about 8 percent 
annually) is well over $2 billion.
---------------------------------------------------------------------------
    \10\ These figures and all others regarding the individual expense 
ratios, loads and returns of mutual funds come from Morningstar Mutual 
Funds, at www.morningstar.com.
---------------------------------------------------------------------------
    The business of mutual funds is asset-gathering. Investors are 
willing to entrust their money to fund companies for many reasons: High 
historic returns, low expenses, good service, and confidence in the 
fund's integrity and safety.
    When confidence is shaken--as it has been in the cases of Putnam, 
Janus, Amvescap (specifically, its subsidiary Invesco Funds Group, 
which is accused of allowing favored clients to make short-term 
trades), and Alliance--investors take appropriate action. They were 
encouraged in that action by analysts and commentators, including 
me.\11\
---------------------------------------------------------------------------
    \11\ ``Don't Panic, But Start Selling,'' James K. Glassman, The 
Washington Post, November 9, 2003. I wrote, ``It's time to dump Putnam, 
Strong, and Alger funds, unless you have a very good reason to keep 
them, such as avoiding a big tax bill or wanting to hold on to a fund 
that has been a superb performer. . . . In my view, it is reckless to 
entrust your money to institutions that have proved rotten at the top, 
no matter what their intentions for the future.'' Morningstar's more 
sweeping admonition to investors preceded mine and was certainly more 
influential.
---------------------------------------------------------------------------
    Instead of adding rules, policymakers could perform a more useful 
service by using the bully pulpit to condemn executives and firms who 
abuse their clients' trust and to laud those that act responsibly. That 
would encourage investors themselves to take action. Such statements 
should be part of a strategic program of investor education. There are 
other steps as well that would enhance competition and give mutual 
funds stronger incentives to communicate vigorously with the public.
Response and Recommendations
    Let me now comment on specific recommendations and offer some of my 
own.

Late Trading
    A rule that would require a hard 4 p.m. market close on all trading 
activity, including reconciling trades from financial intermediaries, 
would hurt small investors. It would, in practical terms, require small 
investors to make decisions to buy or sell shares in a fund well before 
the 4 p.m. close--without knowledge of late-day market events. The 
change ``would require deadlines several hours earlier [than 4 p.m.] at 
intermediaries such as brokerage firms and 401(k) plans. Thus 
participants would have less flexibility.'' \12\ Large professional 
investors, which either trade securities directly themselves or place 
their orders directly with fund companies, would have an advantage over 
small investors. The rule should state that all orders must be placed 
by buyers and sellers before 4 p.m. and time-stamped accordingly, with 
the understanding that the execution of those orders may not occur 
until after that time. A stronger national clearinghouse should be 
responsible for verifying the 
orders were placed before the closing time.
---------------------------------------------------------------------------
    \12\ ``Mutual Funds Vow to Fix Their Clocks,'' Karen Damato and Tom 
Lauricella, The Wall Street Journal, October 31, 2003.
---------------------------------------------------------------------------
    Fund companies have been chastened. Further illegal late-trading 
activity is unlikely, considering the high costs already imposed on the 
miscreants. At any rate, regulators should hold funds responsible for 
late trading in their funds, no matter who participates in the 
practice. Fidelity Investments has properly called the shortened 
deadline an overly simplistic approach that ``ends up hurting the 
shareholders, not helping.'' \13\ A new rule is not needed. Proper 
compliance with the current rule is needed.
---------------------------------------------------------------------------
    \13\ Robert Reynolds, Chief Operating Officer of Fidelity, quoted 
in ``Mutual Funds Vow to Fix Their Clocks,'' op. cit.
---------------------------------------------------------------------------
Market Timing
    If a fund states in its prospectus and other written materials that 
it discourages market timing, then it must adhere to that policy for 
all investors, large and small. But funds should be free to adopt 
policies that allow, or even encourage, short-term trading. The choice 
should be that of the fund itself, but it must be clearly communicated 
to investors.
    Why do funds allow market timing in the first place? In order to 
gain more assets, which in turn can lower costs for the fund and its 
smaller shareholders. As D. Bruce Johnsen, Professor of Law at George 
Mason University, put it:

          According to the SEC's own findings, large accounts 
        contribute far more than the average to scale economies in 
        management. It is therefore no
        surprise that the SEC's perplexing rules prohibiting lower fees 
        for larger accounts would lead fund advisers to compete for 
        hedge fund dollars by tolerating large-scale internal timing. 
        It is by no means clear that this reflects a breach of trust. 
        Quite the contrary, fund advisers may have done nothing worse 
        than cut loss-minimizing deals with hedge funds. By allowing 
        the adviser to keep hedge fund money in the complex, all 
        investors are likely to be better off compared to the 
        alternative.\14\
---------------------------------------------------------------------------
    \14\ ``An Economic Defense of Mutual Fund Timing,'' D. Bruce 
Johnsen, unpublished paper presented as a draft at a conference at the 
American Enterprise Institute on January 28, 2004, titled, ``Mutual 
Fund Regulation and Litigation: Is the Cure Worse Than the Disease?''

    Funds should be free to charge investors different fees according 
to the size of their investments, and the scheme for such pricing 
should be left to the mutual fund itself. Discriminatory pricing helps, 
rather than hurts, small investors, since it draws more large investors 
into the fund to share the costs.
    The SEC is also expected to propose a mandatory fee of at least 2 
percent on shares that investors sell within days or even weeks of 
purchase. Unfortunately, this rule, like the hard 4 p.m. deadline, has 
been endorsed by the Investment Company Institute, the mutual fund 
trade group.\15\ This misguided rule will merely penalize small 
investors who need to move their funds in an emergency--or some other 
valid reason, such as poor performance by a fund or the revelations 
that the fund has been engaged in unsavory ethical practices.
---------------------------------------------------------------------------
    \15\ ``Mutual Funds Vow to Fix Their Clocks,'' op. cit.
---------------------------------------------------------------------------
    It is perfectly valid for a fund to charge a high exit fee in an 
effort to keep shareholders invested--thus avoiding pressure on the 
fund manager to sell stock at importune times in order to raise cash. 
But, again, the choice must be that of the fund management itself. 
Investors, in turn, can choose whether they want to own a fund with a 
high redemption fee (perhaps adding stability to the fund's holdings) 
or a low or nonexistent redemption fee (to give the investors 
themselves some flexibility).
    By mandating the high redemption fee, the SEC would be dampening 
competition among funds and providing all of them with serendipitous 
income in case of emergency withdrawals. A bad idea.
Independent Directors
    The proposals have been advanced that would require each fund to 
have an independent chairman and for funds to increase the proportion 
of their independent directors from a majority to at least 75 percent. 
The reasoning here is that directors without an ownership stake or 
other financial interest will protect shareholders' interests. That may 
or may not be true. Enron Corporation had 11 independent directors (out 
of 15), but they failed to stop fraud and misrepresentation.\16\
---------------------------------------------------------------------------
    \16\ A Senate subcommittee found, ``The Enron Board of Directors 
failed to safeguard Enron shareholders and contributed to the collapse 
of the seventh largest public company in the United States.'' (``The 
Role of the Board of Directors in Enron's Collapse,'' a report prepared 
by the 
Permanent Subcommittee on Investigations of the Committee on 
Governmental Affairs, U.S. Senate, July 8, 2002.) The chairmen of 
Enron's executive committee, finance committee, audit committee, and 
compensation committee were all independent (and, by any conventional 
observation, distinguished) independent directors.
---------------------------------------------------------------------------
    Mark Hulbert, Editor of The Hulbert Financial Digest, the respected 
scorekeeper for financial newsletters, wrote in The New York Times, 
``Almost all of the several dozen academic studies on board 
independence have found [either] that it has no correlation with 
company performance or that companies generally perform worse when they 
have more outsiders on their boards.'' \17\ Why worse? Probably because 
the directors with a direct personal stake in a firm put more time and 
effort into governance.
---------------------------------------------------------------------------
    \17\ ``Outside Directors Don't Mean Outside Returns,'' Mark 
Hulbert, The New York Times, June 15, 2003.
---------------------------------------------------------------------------
    Requirements like this one present a moral hazard problem for 
investors. Regulators are sending the signal: ``We will require lots of 
independent directors on mutual funds, so investors won't have to worry 
about good corporate governance.'' In fact, investors should worry, 
and, if they do, mutual fund companies will have an enormous incentive 
to reassure them. Perhaps having lots of independent directors provides 
that assurance. If it does, the funds will advertise the fact. That is 
the proper dynamic to ensure integrity.
Disclosure and Fees
    It is hard to be against disclosure, but the absurd amount of 
detail that the SEC is now requiring--and is proposing to require--may 
do more harm than good. Most disclosure involves expenses. My 
experience with readers is that their main interest in choosing a 
mutual fund is not the expenses, but the return. Ask any investor, and 
you will get the same answer: He would rather pay $100 in expenses to 
get a net return of $300 then pay $2 in expenses to get a net return of 
$299. In this judgment, small investors in mutual funds are no 
different from sophisticated investors in hedge funds. A typical hedge 
fund charges a 1 percent annual fee plus 20 percent of the profits. 
That can amount to far more than a mutual fund investor pays. In a year 
when the market is up 30 percent, a hedge fund investor pays about 7 
percent in expenses, compared with an average of about 1.5 percent for 
a mutual fund investor.
    The problem for all investors, however, is that past performance is 
no guarantee (or, in most cases, even indication) of future 
performance. Since markets tend to be efficient, most funds, over time, 
will produce returns that are close to those of the market as a whole, 
reflected, for example, by the Standard & Poor's 500 Stock Index. If 
funds tend to perform alike, then the fund with the lowest expenses 
will produce the highest net returns.
    Life isn't quite so simple. Last year, for example, the top 
quartile of diversified stock mutual funds produced returns that 
averaged about 10 percentage points higher than the average fund, and 
there are gifted fund managers whose long-term records seem to show 
they have the ability to beat the market with some consistency. Still, 
expenses count, and it is difficult to get investors to believe that 
fact.
    Despite the urging of practically every writer on the subject, 
despite the clear statement of fees at the start of every mutual fund 
prospectus, despite the detail on expenses in every Morningstar write-
up, despite the industry's outreach,\18\ despite the fact that about 
three-quarters of fund purchases are made through advisors whom 
investors can simply ask about fees, and despite the SEC's own 
excellent online fee calculator,\19\ many--perhaps most--investors 
don't even know the fees that their funds charge. Since expenses are 
netted out of returns (that is, investors do not have to hand over a 
check for a fund's services), they are largely invisible.
---------------------------------------------------------------------------
    \18\ For example, ``Frequently Asked Questions About Mutual Fund 
Fees,'' booklet, Investment Company Institute, 2003.
    \19\ At www.sec.gov/mfcc/mfcc-int.htm
---------------------------------------------------------------------------
    Will more disclosures help? I doubt it. ``Mutual fund fees are 
subject to more 
exacting regulatory standards and disclosure requirements than any 
comparable 
financial product offered to investors,'' says the Investment Company 
Institute, which is obviously an interested party but which is speaking 
here with accuracy.
    Beyond the basics that are required today and are explained at 
length in the prospectus and ``Statement of Additional Information'' 
and are summarized by services like Morningstar, disclosure--in its 
extent and presentation--should be left to the funds themselves. They 
know how to communicate best with consumers. The job of the regulators 
is to ensure that the disclosure is accurate and that companies do what 
they say they will do. Companies and individuals that commit fraud 
should be vigorously prosecuted, as they have been--appropriately--in 
recent cases involving late trading and market timing.
    Funds already have an incentive to advertise low fees, just as 
grocery stores have an incentive to advertise low prices on bananas. 
The paucity of such advertising indicates that investors don't care 
about fees as much as they care, for example, about returns, and no 
amount of disclosure will change that fact. Additional disclosures will 
simply cause additional confusion and may lead policymakers to think 
they have done their job. One mutual fund CEO told me that only two 
people, out of the many thousands that are shareholders in his fund, 
request the Statement of Additional Information annually, and the CEO 
assumes that the two are ``competitors rather than investors.''
    The SEC is also considering a requirement to disclose ``incentives 
and conflicts that broker-dealers have in offering mutual fund shares 
to investors.'' \20\ Disclosure would come through a confirmation form. 
I have examined this form and find it
so complicated as to be unusable. It includes a complete page, in dense 
type, of
``explanations and definitions,'' and it requires ``comparison 
ranges,'' but it is un-
clear what is being compared with what: Small-cap funds, all funds, 
equity funds? The SEC should drop the disclosure approach and instead 
adopt an education approach (following).
---------------------------------------------------------------------------
    \20\ Testimony of William H. Donaldson, Chairman of the SEC, before 
the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, 
September 30, 2003, at www.sec.gov/news/testimony/ts093003whd.htm.
---------------------------------------------------------------------------
Structure
    Much of the confusion and problems related to mutual fund 
governance can be traced back to 1940, when a law established the 
industry's current legal structure, characterized recently by Business 
Week as an ``antiquated set-up,'' \21\ and that is putting it mildly. 
Under the law, each mutual fund (and there are more than 8,000 today) 
is a separate company, ``but it's essentially a shell, with directors 
but no employees. The fund board contracts out for all key services, 
from stockpicking to recordkeeping. In theory, the board can choose any 
adviser, but in reality, a fund company usually sets up a fund, 
appoints a board, and the board then hires the management company that 
founded the fund.'' \22\
---------------------------------------------------------------------------
    \21\ ``Funds Need a Radical New Design,'' Amy Borrus and Paula 
Dwyer, Business Week, November 17, 2003, p. 47.
    \22\ Ibid.
---------------------------------------------------------------------------
    It is doubtful that many investors understand this structure. They 
believe that the fund adviser owns the fund. The way to rationalize and 
modernize the current system is to treat mutual funds as investment 
products instead of companies. ``It might make sense to permit funds to 
structure themselves the way people actually think of them--as services 
bought based on performance and cost,'' says Steven M.H. Wallman, a 
former SEC Commissioner who now runs the investment firm FOLIOfn.\23\ 
The board that runs the funds, then, would be the board of the asset 
management company that is now the funds' adviser.
---------------------------------------------------------------------------
    \23\ Ibid.
---------------------------------------------------------------------------
Competition Enhancement
    Rather than adding rules, policymakers should seek ways to enhance 
competition. Already, the mutual fund industry is fiercely 
competitive--and getting more so. The five largest fund houses 
accounted for just 33 percent of mutual fund assets in 2002, down from 
37 percent in 1990. The 10 largest fund houses accounted for 46 percent 
of assets, down from 56 percent in 1990. With 4,700 equity mutual 
funds, investors have vast choices.\24\ Some funds charge commissions, 
or loads, at the time of purchase; others at the time of sale. Others 
impose no loads at all, instead getting all their investor income from 
annual fees, charged as a percentage of total assets.
---------------------------------------------------------------------------
    \24\ These figures and subsequent industry are from the 2003 Mutual 
Fund Factbook.
---------------------------------------------------------------------------
    The most popular mutual fund, Vanguard Index 500, carries no load 
and charges just 18 basis points in annual expenses. The second 
largest, Fidelity Magellan,
also imposes no load and charges only 76 basis points. There are 
abundant low-cost choices.
    ``The actual costs borne by average stock mutual fund shareholders 
have dropped 45 percent since 1980,'' said Brian Reid, Deputy Chief 
Economist for the Investment Company Institute, reporting on a recent 
study by Peter Tufano of Harvard and Erik Sirri of Babson College. The 
study found that 60 percent of shareholder assets are invested in funds 
with total expense ratios under 1 percent.\25\ An extensive study of 
fees found a decline in the weighted-average annual expense ratio for 
stock mutual funds from 2.26 percent in 1980 to 1.28 percent in 2001; 
for bond funds, from 1.53 percent in 1980 to 0.9 percent in 2001.\26\ 
Fidelity recently did away with its 3 percent loads on sector funds. 
Fees don't fall, of course, because fund company executives are nice 
guys. They fall because costs drop through economies of scale and, more 
important, because competition puts pressure on prices.
---------------------------------------------------------------------------
    \25\ ``ICI Economist Reports that `Total Shareholder Cost' of 
Investing in Stock Mutual Funds Has Declined 45 Percent Since 1980,'' 
Press Release, Investment Company Institute, February 18, 2004.
    \26\ ``Frequently Asked Questions,'' op. cit., p. 13.
---------------------------------------------------------------------------
    Investors do not, however, opt for low costs alone. Nor should 
they. They consider financial returns and service as well. PIMCO Total 
Return, a bond fund, has accumulated $74 billion in assets despite a 
4.5 percent front load plus annual expenses of 0.9 percent. The reason 
is simply that the fund's manager, Bill Gross, has compiled such a 
spectacular record in recent years. Similarly, Legg Mason Value Trust, 
with a lofty expense ratio of 1.72 percent, has increased its assets 
from less than $1 billion in 1993 to $14 billion today largely because 
its manager, William Miller, has beaten the benchmark Standard & Poor's 
500 Stock Index in each of those years (plus two more), an astounding 
record.
    Last December, two top Republicans on the House Financial Services 
issued a Press Release stating, ``All mutual fund shareholders deserve 
lower fees. Not just shareholders who invested in funds that engaged in 
questionable trading practices; not just shareholders invested in one 
fund family; but all mutual fund shareholders deserve relief from fees 
that continue to rise.'' \27\ First, it appears that fees are not 
rising; but, second, in a competitive market, with few supply 
constraints, higher fees (if they did arise) would be a reflection of 
higher demand. The concept that any consumer ``deserves'' a particular 
price is an artifact of poor economic thinking. Efforts to push down 
costs by Government fiat or intimidation (an approach of Spitzer) are 
misguided and misinformed. It is competition that holds down prices.
---------------------------------------------------------------------------
    \27\ ``Oxley, Baker: All Mutual Fund Investors Deserve Lower 
Fees,'' Press Release, House Committee on Financial Services, December 
17, 2003. The Press Release is quoted in my article, ``Spitzer vs. the 
SEC,'' James K. Glassman, TechCentralStation.com, December 19, 2003 
(http://www.techcentralstation.com/121903G.html), which contains a 
discussion of the competitive 
nature of the mutual fund industry.
---------------------------------------------------------------------------
    A good way to enhance competition and get the lower fees that some 
policymakers seek is to increase the supply of funds--that is, the 
choices of investors.\28\ But adding new regulations-- even disclosure 
requirements that appear innocuous--will have the opposite effect. Some 
funds will simply not be able to afford the added legal, accounting, 
research and publishing costs. They will either close down, merge, or 
boost expenses beyond the reach of small investors.
---------------------------------------------------------------------------
    \28\ Another way to lower expenses would be to decrease the demand 
for funds, which would best be accomplished if funds did not perform a 
service that consumers wanted. In other words, if funds would only do a 
worse job, prices would fall.
---------------------------------------------------------------------------
    An attraction of mutual funds is that they offer small investors 
much the same professional services that well-off investors have 
enjoyed for years. Recently in New Orleans, I visited the firm St. 
Denis J. Villere & Co., founded in 1911 to manage the money of 
institutions and wealthy investors--a task it has performed 
exceptionally well. Villere requires a minimum starting account of 
$500,000 for its advisory clients. In 1999, after requests from smaller 
investors, the firm launched a public mutual fund, Villere Balanced, 
which requires an initial investment of just $2,000. The fund, which 
combines stocks and bonds, has been an exceptional performer, beating 
the S&P by an annual average of 7 percentage points over the past 3 
years. But it remains small: Just $17 million in assets.
    Such a fund--and there are many--will bear a heavy burden if the 
regulatory wish list goes into effect. More important, small investors 
could lose choices like Villere Balanced. Calamos Growth, by some 
accounts the top diversified stock fund in America, had only $12 
million in assets in 1998 and now has $5 billion. It won those assets 
through impressive performance (returning an annual average of 21 
percent for the past 5 years), but, with heavy regulatory expenses, it 
might have been killed in the cradle. By the way, Calamos charges a 
front load of 4.75 percent and annual expenses of 1.4 percent. Is that 
too much? Evidently not for the investors who have piled into the fund 
to benefit from the talents of the Calamos family, who last year 
produced returns of 42 percent of their shareholders.
    Another way to enhance competition--and improve the governance of 
funds--is by making it easier for investors to exit funds that have 
failed to meet financial or ethical expectations. A major obstacle to 
redemption of fund shares is the capital gains tax. Investors are 
reluctant to leave a fund they have held for a long time if they have 
to pay Federal taxes of 15 percent on their profits.
    Mr. Bruce R. Bent, who invented the money-market fund in 1972, 
proposes that ``investors be permitted to sell shares of a mutual fund 
for any reason . . . without incurring tax, provided that the proceeds 
are reinvested in a similar fund . . . within 30 days.'' \29\ In this 
rollover plan, Bent would require investors who sell shares in a small-
cap fund, for example, to buy shares in another small-cap fund. This 
seems to me needlessly complicated; I would allow purchases of shares 
in any fund, or in individual stocks and bonds, for that matter. But 
either way, Bent has the right approach. Public policy should be 
directed at intensifying competition and increasing the anxiety of 
funds that, if they betray their customers, they will lose a great deal 
of business.
---------------------------------------------------------------------------
    \29\ Bruce R. Bent, private correspondence, January 30, 2004.
---------------------------------------------------------------------------
Investor Education
    As boring as it may sound, the most important step that 
policymakers can take to improve governance of mutual funds and to help 
small investors is to focus on investor education. Today, lip service 
is paid and a small amount of money is spent. Far more effort is 
required, and it needs to be centralized. The SEC, the Treasury 
Department, and the Labor Department all have investor education 
programs. Instead, there should be a single office, with sufficient 
funding and dynamic, marketing-oriented leadership.
    Let me close on a disturbing paper by Ali Hortacsu and Chad 
Syverson.\30\ The two University of Chicago economists looked at 85 
retail index funds geared to the S&P 500 (an index fund is constructed 
to mimic the performance of a popular stock or bond index; the S&P 500 
is the most popular such index, in part because it reflects about 85 
percent of the total U.S. stock market capitalization in only 500 
stocks). The number of S&P index funds has quintupled since 1992, so, 
clearly, investors have wide choices.
---------------------------------------------------------------------------
    \30\ ``Product Differentiation, Search Costs, and Competition in 
the Mutual Fund Industry: A Case Study of S&P 500 Index Funds,'' 
October 2003.
---------------------------------------------------------------------------
    What is disturbing is that ``the highest price S&P 500 index fund 
in 2000 imposed annualized investor fees nearly 30 times as great as 
those of the lowest-cost fund: 268 vs. 9.5 basis points'' (a basis 
point is one one-hundredth of a percentage point, so 268 bp equals 2.68 
percent). The authors continue, ``This striking divergence is not 
restricted to the far ends of the distribution; the seventy-fifth/
twenty-fifth and ninetieth/tenth percentile price ratios are 3.1 and 
8.2, respectively.'' \31\
---------------------------------------------------------------------------
    \31\ Ibid, pp. 2-3.
---------------------------------------------------------------------------
    The authors ask, ``How can so many firms, charging such diffuse 
prices, operate in a sector where funds are financially homogeneous?'' 
\32\ In other words, why do funds that return the same (that is, they 
all pretty much return, before expenses, what the S&P 500 returns) 
charge fees that are so different?
---------------------------------------------------------------------------
    \32\ Ibid., p. 3.
---------------------------------------------------------------------------
    The principal answer they give is that there has been an ``influx 
of high-information-cost novice investors.'' \33\ Very simply, many 
investors are unsure about the investments they are purchasing. The 
costs--that is, the value of the time spent--in investigating the 
expenses of one index fund over another are so high that these 
investors just pick a name they know, or rely on the suggestions of 
friends or advisors. ``While average search costs were declining, costs 
for those at the upper percentiles of the distribution actually tended 
to increase through our sample years.'' \34\ Again, to translate: Most 
investors have learned a great deal over the years about investing, so 
the costs to them of picking a fund are falling, but costs (again, in 
time) are still high for new investors.
---------------------------------------------------------------------------
    \33\ Ibid., frontispiece.
    \34\ Ibid., p. 32.
---------------------------------------------------------------------------
    This study shows, with glaring illumination, just how much 
education is needed, especially for novices. Not disclosure, not new 
rules, not onerous requirements, but simple education. Much of that 
education has been provided by mutual fund companies themselves and, of 
course, by journalists and research firms. But more education is 
urgently required, and here the Government has a significant role to 
play.
    Thank you.

    
    


                     FUND OPERATIONS AND GOVERNANCE

                              ----------                              


                      THURSDAY, FEBRUARY 26, 2004

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 2:03 p.m. in room SD-538 of the 
Dirksen Senate Office Building, Senator Richard C. Shelby 
(Chairman of the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order.
    This afternoon, the Banking Committee continues its 
examination of the mutual fund industry. Specifically, we will 
focus on fund operations and governance.
    Before I get started, I want to tell the panelists, you 
have been here twice for one panel, one chance to testify. We 
appreciate that. We did not bring the ice and the snow earlier 
when we cancelled everything in the Senate, and we did not 
bring trouble here either. But we appreciate your patience and 
your willingness to come again today.
    Under the operating structure created by the Investment 
Company Act of 1940, fund boards contract with service 
providers for the daily management of the fund. As a result, 
the typical mutual fund maintains a variety of relationships 
with investment advisers, transfer agents, and underwriters. 
Over the course of time, fund operations have become 
increasingly complex and the need for outside expertise has 
grown. For instance, the expanded role of intermediaries in the 
sale and distribution of mutual fund shares that has led to new 
fees, compensation arrangements, and conflicts of interests.
    The recent revelations concerning the fund industry raise 
serious questions about the transparency of fund operations and 
the adequacy of current disclosure practices. It seems as if 
most investors lack a basic understanding of how funds operate 
and are unaware of the risks, and potential conflicts of 
interest, that accompany fund operations. Currently, mutual 
funds are required to disclose a significant amount of 
information to investors. Many contend these disclosures are 
confusing and omit useful information. We will consider various 
operational issues and compensation arrangements to evaluate 
how these practices serve investors today. We will also 
evaluate how the SEC's disclosure regime might be revised to 
ensure that investors receive clear, concise, and meaningful 
disclosure that enhances decisionmaking rather than impede it.
    Given the complex operating structure of funds, 
shareholders must rely on fund boards to police conflicts of 
interest and protect shareholder interests. With such an 
important responsibility to shareholders, I believe it is 
critical that boards exercise strong and active leadership and 
sound judgment. Some contend that the recent scandals are 
evidence of an erosion of fund governance. We will review the 
role of independent directors and examine how changes to fund 
governance can better minimize conflicts of interest and 
reinvigorate the boardroom culture to better protect 
shareholder interests.
    To discuss these issues with us today, we have a 
distinguished panel. No stranger to the Banking Committee, 
Chairman Dave Ruder. Professor Ruder was the Chairman of the 
SEC when we spent a lot of time here together. He is also the 
Chairman of the Independent Directors Forum; David Pottruck, 
President, Charles Schwab; Mellody Hobson, President, Ariel 
Capital Management; and John Bogle, founder of Vanguard Funds.
    I look forward to all of your testimony here today. Your 
written testimony will be made part of the hearing record in 
its entirety. Chairman Ruder, we will start with you, and 
welcome you again to the Banking Committee, where you have 
appeared many times.

                  STATEMENT OF DAVID S. RUDER

                        FORMER CHAIRMAN

            U.S. SECURITIES AND EXCHANGE COMMISSION

          WILLIAM W. GURLEY MEMORIAL PROFESSOR OF LAW

             NORTHWESTERN UNIVERSITY SCHOOL OF LAW

             CHAIRMAN, MUTUAL FUND DIRECTORS FORUM

    Mr. Ruder. Thank you, Chairman Shelby. I well remember the 
days of following the market crash of 1987, when I had the 
pleasure of appearing before this Committee.
    Chairman Shelby. That was one of yours and then Chairman 
Greenspan and Mr. McDonough's finest hours and days.
    Mr. Ruder. I thank you for asking me to testify on the 
important question of mutual fund reform. I am currently a 
Professor of Law at Northwestern University School of Law, 
where I teach securities law, and as you said, I was Chairman 
of the U.S. Securities and Exchange Commission from 1987 to 
1989.
    Currently, I serve as the Chairman of the Mutual Fund 
Directors Forum, a not-for-profit corporation, whose mission is 
to improve fund governance by promoting the development of 
vigilant and well-informed directors. We do so by offering 
continuing education programs to independent directors, 
providing opportunities for independent directors to discuss 
matters of common interest, and serving as advocates on behalf 
of independent directors.
    Although I am Chairman of the Forum, these remarks are my 
own and not made on behalf of the Forum, its members, or any 
other groups of persons. That is similar to an SEC disclaimer, 
and I give it gladly.
    My written statement contains my suggestions for 
improvement in mutual fund----
    Chairman Shelby. Speaking for yourself and not for your 
other members, right?
    Mr. Ruder. That is right. My statement deals with corporate 
governance and identifies several problem areas in mutual fund 
administration that need special attention.
    The most important approach toward increasing protections 
of mutual fund investors is to enhance the power of independent 
fund directors and to motivate them to perform their duties 
responsibly. In seeking these goals and reforms in adviser 
activities, I believe Congress should rely upon the Securities 
and Exchange Commission and should refrain from extensive 
legislation.
    In deciding what corporate governance structure is 
desirable, the Congress and the SEC need to understand that 
most fund directors are well-informed, dedicated, and active in 
their supervision of
mutual fund advisers. But to say that most fund directors are 
well-informed, dedicated, and active does not mean that all 
fund directors share those qualities.
    Historically, the mutual funds have been created by 
investment advisers that are extremely knowledgeable about the 
securities industry and the intricacies of mutual fund 
management. Some fund directors who are charged with 
supervising an adviser may at times be unwilling to challenge 
the adviser who has the advantage of superior knowledge and 
resources.
    There are some important corporate governance improvements 
that should be made, many of which have already been proposed 
or adopted by the SEC.
    First, regarding independence, I agree that at least three-
fourths of each fund board of directors should be independent 
of the adviser. I also believe that the chairman of the board 
of each fund should be independent of the adviser. An 
independent chairman can control the board agenda, and can 
control the conduct of board meetings so that important 
discussions are not truncated, and can provide important and 
direct liaison with the adviser between board meetings. And 
both of these reforms have been suggested by the SEC.
    Second, regarding fund board operations, the fund boards in 
the larger complexes should function with committees composed 
solely of independent directors, including a nominating 
committee, an audit committee, a compliance committee, and an 
investment committee. Since most funds are externally managed 
by the adviser, it is also important that boards of directors 
have access to their own consultants and advisers. I believe 
that all independent directors should have independent legal 
counsel, that mutual fund boards should be able to hire an 
independent staff on a permanent basis or on an as-needed 
basis, and that fund boards should be able to hire independent 
advisers to advise the board in areas such as fund fees and 
costs, the quality of portfolio executions, and the valuation 
of fund securities.
    Third, regarding compliance, which I regard as all 
important, I strongly endorse recent SEC actions to improve 
compliance. Each investment adviser should be required to have 
a chief compliance officer charged with supervising the 
compliance functions of the adviser and the service providers 
to the funds. Although paid by the adviser, the chief 
compliance officer should report to the fund board, as well as 
to the adviser. The fund boards should have the right to set 
the compensation and to hire and fire the chief compliance 
officer.
    Chairman Shelby. Chairman Ruder, do any of the funds have a 
chief compliance officer that you know of today?
    Mr. Ruder. A few do.
    Chairman Shelby. A few do.
    Mr. Ruder. A few do, but not many.
    Chairman Shelby. Okay.
    Mr. Ruder. But there is a growing movement in that regard.
    Chairman Shelby. Absolutely.
    Mr. Ruder. Advisers and funds should adopt and implement 
written compliance policies and procedures. The SEC's recently 
adopted Investment Advisers Act rule will require the adviser 
to adopt and to implement written policies and procedures 
reasonably designed to prevent violation of the Advisers Act by 
the adviser. Its Investment Company Act rule requires fund 
boards to adopt written policies and procedures reasonably 
designed to prevent violations of the securities laws.
    I believe these compliance requirements will be extremely 
helpful in achieving better fund governance. But I believe 
there are two areas in which no action should be taken. Some 
have suggested that fund directors or the board chairman should 
be required to certify to shareholders regarding their 
oversight activities. I do not believe that such a 
certification requirement is needed or advisable. Such a 
requirement is not needed because fund boards are increasingly 
becoming more active in supervising advisers and service 
providers, and they will become even more active under new SEC 
rules. Such a requirement is not advisable because it could 
deter qualified individuals from serving on boards.
    Even under the Sarbanes-Oxley Act, the certification 
requirement does not reach the board level.
    Some also have suggested that a mutual fund oversight board 
be established for the purpose of overseeing the mutual fund 
industry in a manner similar to which the Public Company 
Accounting Oversight Board oversees accountants. I do not 
believe that such a mutual fund oversight board is necessary. 
The PCAOB was established in the accounting area because of a 
lack of power to oversee the accounting industry. In contrast, 
the SEC has the authority to oversee the mutual fund industry. 
It is increasing its oversight and rulemaking activities and, 
thanks to the Congress, has recently been given badly needed 
additional resources that will help it to perform its oversight 
functions.
    My written statement contains some comments regarding 
technical areas of fund administration. I want to point to four 
of them.
    First, in my opinion, neither the U.S. Government nor the 
State governments should attempt to set mutual fund advisory 
fees. This is a very complex industry and very competitive, and 
I think----
    Chairman Shelby. Shouldn't the market set the fees?
    Mr. Ruder. I believe the market should set the fees, but--
--
    Chairman Shelby. Does anybody have any disagreement with 
that on the panel?
    Mr. Bogle. Yes, sir.
    Chairman Shelby. You do? Okay. I will let you continue.
    Mr. Ruder. I think that the fees should be set by the 
directors bargaining in a very vigorous way with the adviser, 
and there are many subsets of that negotiation which are very 
important.
    Second, I believe that the SEC should mandate that all 
directed brokerage revenues--those are the revenues that come 
from portfolio transactions--including soft-dollar payments, 
should be used for the benefit of the funds and not for the 
fund advisers.
    Third, I believe Congress should enact legislation in one 
area. It should repeal Section 28(e) of the Securities and 
Exchange Act, which protects soft-dollar practices, and lets 
the SEC, by rule, deal with those soft-dollar payment problems.
    Fourth, since the SEC is addressing late trading and market 
timing, no legislation is needed in those areas.
    The SEC may be criticized for its failure to engage in 
earlier action regarding the problems that have emerged in the 
mutual fund industry. But I regard its recent actions and 
proposals to be effective in correcting the problems in this 
very highly complex industry. I believe Congress should rely on 
the SEC and fund directors to provide effective oversight of 
the industry and should not seek a legislative solution other 
than the repeal of Section 28(e).
    If Congress should, nevertheless, decide to act, I believe 
it should limit its action to structural areas, such as having 
an independent chairman and three-fourths of the board being 
independent, and possibly to clarifying the powers of the 
Commission to oversee the industry. But the important thing is 
that this is such a complex and highly difficult industry to 
understand that the SEC is the right agency to take action.
    Thank you.
    Chairman Shelby. Mr. Pottruck, welcome to the Committee.

                 STATEMENT OF DAVID S. POTTRUCK

                    CHIEF EXECUTIVE OFFICER

                 THE CHARLES SCHWAB CORPORATION

    Mr. Pottruck. Thank you, Chairman Shelby, Ranking Member 
Sarbanes--who is not here at the moment--distinguished Members 
of the Committee. My name is David Pottruck, and I am the CEO 
of Charles Schwab Corporation. Mutual funds are at the core of 
our business, and we at Schwab share the Committee's 
disappointment over the recent events that have propelled 
mutual funds to the front pages. I am delighted to be here and 
applaud this Committee's efforts to identify needed reforms.
    Schwab is certainly no stranger to the needs of mutual fund 
investors. We serve more than 8 million individual accounts and 
more than 2 million 401(k) plan investors with nearly $1 
trillion in assets. And perhaps most important from the point 
of view of individual investors, we pioneered the first no-load 
mutual fund 
supermarket.
    Before the launch of our no-load, no-transaction-fee mutual 
fund supermarket in 1992, our clients held about $6 billion in 
mutual funds at Schwab. Today, our clients have more than $278 
billion invested through our company in more than 5,000 funds. 
Moreover, nearly 90 percent of mutual funds traded today, 
including many 401(k) plans, are executed via an intermediary, 
whether Schwab or a competitor of ours.
    I do not think I am being too bold when I say that mutual 
fund supermarkets helped democratize investing for millions of 
Americans. Supermarkets protect investors from being held 
captive by a single fund company by providing an array of 
investment choices. They empower investors by facilitating 
comparison shopping among funds; they increase competition by 
allowing investors to move easily from one fund family to 
another; and they simplify investing by consolidating 
statements, thereby driving down costs.
    In a time of growing consolidation in all of the financial 
services industry, mutual funds stand out as an admirable 
exception. Since our supermarket launch, competition has 
increased, and the number of mutual funds has nearly tripled. 
Many of these new funds are managed by smaller fund companies 
that did not even exist a decade ago and could not exist or 
blossom without the supermarket infrastructure, such as the 
Ariel funds, represented on today's panel by Mellody Hobson.
    As you consider reform, I strongly urge the Committee to 
remember the very qualities that make mutual fund supermarkets 
so valuable to investors: Choice, simplicity, disclosure, 
competition, and convenience.
    I would like to briefly outline a few suggestions for the 
Committee's consideration to underscore these principles.
    Number one, investors deserve choice without conflict. 
Their broker's representative should never have a financial 
incentive to push one mutual fund over another, and no one at 
Schwab does.
    Number two, all investors need disclosure. They should 
know, for example, whether a fund company has paid a fee to be 
on a broker's preferred list.
    Number three, having said that, it is important that we 
focus on the quality, not just the quantity of disclosure. 
Mutual fund documents are already too complex. There is a 
danger that additional disclosure will further overwhelm 
investors. The SEC has made 
important progress in recent years in its plain-English 
initiatives. It must apply those principles here as well, or we 
are just fooling ourselves about helping investors.
    Number four, finally, to boost competition and drive down 
prices, Congress should un-fix sales loads and force broker-
dealers to disclose and compete on cost. Mutual funds should be 
allowed to set a maximum load, but not a minimum, as they do 
now. Today, Schwab is prevented from selling load funds at 
reduced charges to the consumer. Moreover, if Congress un-fixes 
sales loads, the SEC should do away with the confusing 
proliferation of the load share classes which leave many 
investors confused. At Schwab, we only offer the same low-cost 
share class that fund companies offer to investors directly.
    This brings us to the issues of choice, convenience, and 
fairness. One of the highest profile proposals to emerge from 
the SEC is known as the ``Hard 4 p.m. Close.'' We fully support 
the intended result. But without further development, this 
proposal would unnecessarily decrease investor choice, 
convenience, and fairness. The highway through mutual fund 
supermarkets and intermediaries, the preferred route for nearly 
90 percent of mutual fund purchases, would have a 10-foot-tall 
speed bump.
    Under the SEC's proposal, different investors would face 
different cutoff times. Imagine three investors who want to buy 
or to sell $5,000 worth of the same mutual fund, one through a 
401(k) plan, one through a brokerage account, and one through 
an account held directly with the mutual fund. Each investor 
would have a different cutoff time and potentially a different 
price for the same transaction. Ironically, it is this kind of 
disparate treatment of investors that has been the source of 
concern for the American people and this Committee.
    Mr. Chairman, the ``Hard 4'' needs to become the ``Smart 
4,'' which takes the ``Hard 4'' and goes beyond it to embrace 
the services investors want. And this further evolved proposal 
absolutely achieves the goal of preventing orders from being 
placed after the market closes but without creating inequities 
among different investors. It requires that preapproved 
intermediaries utilize the best technology, enhanced compliance 
and audit requirements, and vigorous enforcement to stamp out 
illegal late trading.
    I provide more details about the ``Smart 4'' proposal in my 
written testimony, which I ask to be included in the record.
    Chairman Shelby. Without objection, your entire testimony, 
all the testimony will be made part of the hearing record.
    Mr. Pottruck. Thank you.
    Finally, Mr. Chairman, let me conclude by saying that we in 
the mutual fund industry bear the ultimate responsibility for 
acting in the best interest of our clients. Legislation and 
regulation can only do so much. Most of the failures that have 
been publicized were 
already illegal. They were not a result of inadequate rules 
but, 
rather, a failure to follow the letter and the spirit of the 
rules that we have.
    I appreciate the opportunity to share our views on this 
critical issue, and I look forward to answering any questions 
that any of you may have.
    Chairman Shelby. Thank you.
    Ms. Hobson.

                  STATEMENT OF MELLODY HOBSON

           PRESIDENT, ARIEL CAPITAL MANAGEMENT, LLC/

                       ARIEL MUTUAL FUNDS

    Ms. Hobson. Thank you, Chairman Shelby, Ranking Member 
Sarbanes, and all of the Members of the Committee. I am honored 
to be here.
    I am President of Ariel Capital Management, the investment 
adviser to the Ariel Mutual Funds, a small mutual fund company 
based in Chicago. Our firm's Chairman, John Rogers, founded our 
firm in 1983 when he was just 24 years old. John began 
investing at the early age of 12 when his father started buying 
him stocks every birthday and every Christmas instead of toys. 
Ultimately, his childhood hobby evolved into a passion that led 
to the creation of our firm.
    At the time of our inception, Ariel was the first minority-
owned money management firm in the Nation, in my view a 
testament to the American Dream. Given our pioneering status, 
it is part of Ariel's corporate mission to make the stock 
market the subject of dinner-table conversation in the black 
community.
    With nearly $5.5 billion in assets, Ariel's four no-load 
mutual funds invest for 280,000 investors. So, our 
responsibilities are indeed quite large. But in comparison to 
the largest mutual fund firms in the country, with just 74 
employees, we are quite small as a company.
    As a small mutual fund company, we are the norm in our 
industry, not the exception. More than 370 mutual fund 
companies manage $5 billion or less. As such, I welcome the 
chance to speak on behalf of small mutual fund companies and 
our shareholders.
    Clearly, there are important ways in which Ariel and other 
small, entrepreneurial fund firms stand apart from the giants 
in our industry. Yet, because of our vision and hard work, and 
because of regulatory innovations like the SEC's Rule 12b -1, 
we are able to compete fiercely and quite often successfully 
with larger fund companies every single day.
    A breach of trust involving mutual funds has raised doubts 
about my industry's commitment to integrity, a commitment that 
tens of thousands of mutual fund employees have spent more than 
60 years building. Recent disturbing revelations have led some 
to conclude that fund companies are ignoring their fiduciary 
obligations, have lost their connection to shareholders, and 
have abandoned the basic principles of sound investment 
management. Nothing could be further from the truth. As a 
mutual fund company executive, I know my future, my 
credibility, and my livelihood are inextricably linked to that 
of our shareholders and their success.
    First, I would like to address the issue of mutual fund 
fees. Federal regulation of prices can be appropriate when 
there are few competitors and little choice that the 
opportunity for monopolistic practices is a threat to the 
consumer. This is not the case in our industry. Notwithstanding 
some heated rhetoric to the contrary, mutual fund competition 
is powerful, vibrant, and growing. Capitalism is working and 
price regulation, as some have proposed, is both uncalled for 
and potentially disastrous.
    Second, mutual funds are one of the only products I know 
where price increases are actually rare. To raise management 
fees, a majority of our fund companies' directors must vote 
that an increase is needed. Then a majority of the fund's 
independent directors must separately vote for a higher fee. 
After that, the ultimate decision rests with the fund's 
shareholders, a majority of whom must also vote in favor of any 
increase before it can take effect.
    While some critics claim mutual funds charge higher fees 
than pension funds and other institutional accounts, their 
analysis is seriously flawed. The fact is mutual fund investors 
receive a litany of services not commonly offered to 
institutional investors. They 
include phone centers, websites, compliance, accounting, and 
legal oversight, as well as prospectuses, educational 
brochures, and shareholder letters.
    Contrary to some claims, fund fees have declined steadily 
for more than 20 years. ICI research shows since 1980, the 
average cost of owning stock mutual funds has decreased 45 
percent. Additionally, the SEC, GAO, and ICI have all concluded 
most mutual funds reduce fees as they grow. While one of my 
fellow witnesses appears to believe otherwise, it is undeniable 
that this is the very definition of economies of scale. 
Industries generally do not produce scale economies. Companies 
do. If any of us wanted to start manufacturing automobiles 
tomorrow, the huge scale enjoyed by Ford and General Motors 
would be of relatively little help to us. It would still cost 
us a fortune to produce new cars.
    Some question if mutual fund fees are understood. Fund 
prospectuses are required to have an SEC-designed table showing 
fees in place, English-based upon strict formulas. A key part 
of this table is the standardized example illustrating the cost 
of a $10,000 investment. Beyond the prospectus, the SEC 
recently ruled reports must illustrate the exact cost in 
dollars of a $1,000 investment over a 5-year period. That is in 
the shareholder report now. These guidelines enable investors 
to compare the total fees of 8,000 mutual funds competing for 
their business.
    A significant mutual fund fee issue that has been 
frequently misunderstood relates to a portion of fund expenses 
called the 12b -1 fee. The issue is of great import to small 
mutual fund companies like Ariel because it impacts our ability 
to reach investors. The easiest way to think about mutual fund 
distribution is to equate it to the film industry. You can make 
a great movie, but if you do not have a distributor, no one 
will see it. Similarly, you can have a terrific fund with an 
excellent track record. But if the fund company does not have 
access to effective sources of third-party distribution, it 
will be a fund more in theory than in practice because it will 
have so few investors.
    Distribution costs money. Without the means to pay for 
access to these far-reaching channels, the smaller fund 
companies that lack scale, a recognizable brand name, and huge 
advertising budgets will be disproportionately disadvantaged. 
Ultimately, mutual fund investors will have fewer and much 
lesser first choices. We have seen many instances where 
industries came to be dominated by a few large firms. Does 
anyone believe that is good for consumers, for competition, and 
for economic growth? I do not think so.
    Let me now turn to fund governance. Should Congress mandate 
an independent chair? In my view, an across-the-board rule is 
unwarranted. The Chairman's status is far less relevant than a 
strong majority of independent directors who make all the key 
decisions. For example, Ariel's board has an independent chair 
and a majority of independent directors advised by their own 
independent counsel. Among other things, these members have the 
exclusive responsibility to renew our advisory contract each 
and every year. In fact, our board does not even allow us to be 
present in the room during their annual contract renewal 
discussion. So, the idea that we as inside directors are active 
participants in our own contract assignment and in some ways 
self-dealing is just not true.
    Additionally, independent directors are solely represented 
on all board nominating committees, leaving insiders like me no 
say in the board's ultimate composition. Most important of all, 
an independent board can at any time decide its own chair.
    Another governance issue of note is the SEC requirement for 
the hiring of a compliance officer reporting to independent 
directors. I understand why the SEC and the ICI have advanced 
this rule in response to recent abuses. But such mandates 
disproportionately impact smaller fund companies, seriously 
affecting our cost structure, as well as our ability to compete 
against industry giants.
    Finally, regarding disclosure, I agree with Federal Reserve 
Chairman Greenspan who said, ``In our laudable efforts to 
improve public disclosure, we too often appear to be mistaking 
more extensive disclosure for greater transparency.''
    Former SEC Chairman Levitt appears to share the concern. He 
said, ``The law of unintended consequences has come into play. 
Our passion for full disclosure has created fact-bloated 
reports, and prospectuses that are more redundant than 
revealing.''
    Notwithstanding these observations, the SEC reported last 
June that it adopted 40 new investment company rules, including 
many disclosure requirements, since 1998. That is an average of 
one every 7 weeks. The impact of new proposals on small mutual 
fund companies is perhaps understandably not always at the 
forefront of regulators' thinking, but I urge the Committee to 
think about this. As some of you have suggested over the last 
few years, the Nation would benefit substantially from finding 
ways to improve our comprehension of the information already 
disclosed. Financial literacy is the only real way to empower 
investors to make the right choices that will secure their 
futures.
    At Ariel, an inner-city Chicago public school bearing our 
name has an innovative saving and investment curriculum. 
Similarly, the ICI has developed its own financial literacy 
initiative. Education programs like these will help replace 
both confusion and fear with knowledge and confidence.
    My colleagues at Ariel and so many others in the fund 
industry are grateful for your efforts. By effectively 
reinforcing investor protections and supporting the integrity 
of our markets, we know you are helping our business and our 
shareholders. That said, recent events notwithstanding, it 
would be deeply regrettable if attempts to heighten fund 
company oversight eroded the competitive position of small 
firms that represent the dynamic, entrepreneurial spirit of the 
mutual fund industry.
    Again, many thanks for allowing me to testify.
    Chairman Shelby. Thank you.
    Mr. Bogle.

                   STATEMENT OF JOHN C. BOGLE

               FOUNDER AND FORMER CHIEF EXECUTIVE

                         VANGUARD GROUP

               PRESIDENT, BOGLE FINANCIAL MARKETS

                        RESEARCH CENTER

    Mr. Bogle. Thank you very much, Chairman Shelby, Ranking 
Member Sarbanes, and Members of the Committee. You honor me by 
inviting me to be with you today.
    I have a unique perspective, and it is based on a 53-year 
career in the mutual fund field. I was inspired by an article 
in the December 1949 issue of Fortune magazine, wrote my 
Princeton University thesis on mutual funds, and joined 
Wellington Management Company in July 1951, and served with 
this industry leader until 1974. Then I took what you might 
call the road less traveled by, if I may say so, and founded 
Vanguard as a truly mutual mutual fund complex. It is unique.
    At Vanguard we broke unprecedented ground by having our 
management company owned not by outside owners, but by the 
shareholders of the mutual funds it managed. We called it the 
Vanguard experiment in mutual fund self-governance, and from 
the outset we have operated on an at-cost basis. Shortly after 
we began, we eliminated all sales charges, and we have operated 
as a no-load business for almost the last 30 years.
    I think it is fair to say--I hope it is not self-serving to 
say--that the experiment seems to have worked. Our fund assets 
then were $1.4 billion, and they now total $725 billion. Our 
funds are owned by 17 million Americans. During the three 
decades in which the 
average expense ratio of the average mutual fund has risen by 
50 percent--and that is the fact--our expense ratio has fallen 
by 60 percent. At 0.26 of 1 percent, it is fully 1.10 
percentage points below the industry norm of 1.36 percent. That 
differential resulted in a savings to our shareholders, 
Vanguard shareholders, of more than $6 billion in 2003 alone. 
Partly and very importantly by reason of those low costs, our 
mutual funds have been recognized almost everywhere, if not 
everywhere, for earning returns that are superior to those of 
their peers. And our market share of industry assets has risen 
unremittingly, year after year after year, from 1 percent of 
industry assets in 1981 to 9 percent of industry assets today. 
Delivering maximum shareholder value, it turns out, is a 
winning business strategy.
    Vanguard's structure was designed to honor the basic 
principles set forth in the Investment Company Act. Mutual 
funds must be ``organized, operated, and managed'' in the 
interests of their shareholders and not in the interests of 
their investment advisers and distributors. The Act is 
completely clear on that. And it says nothing, by the way, 
about letting the marketplace set management fees out there, 
nor does it say anything about charging fees that traffic can 
bear. It says directors have the obligation to organize in the 
interests of shareholders. Yet, by and large, I am sorry to say 
that the conduct of this industry in general has honored that 
principle more in the breach than in the observance.
    The recent scandals have clearly reflected the serious 
nature of that breach, but these scandals are, in fact, 
gentlemen, the tip of the iceberg, reflecting the conflicts 
that exist between the interests of shareholders and the 
interests of managers. These scandals have been terrible, but 
the conflicts have been far more costly to investors in two 
other areas: One, the setting of mutual fund fees at levels 
that are highly profitable to managers, even as they severely 
erode the returns the funds deliver to investors; and, two, 
asset gathering has overtaken prudent management in importance, 
exemplified by aggressive marketing practices, the asset-
gathering practices, marketing practices focused on bringing 
out new funds to meet each new market fad, recent technology in 
the new economy, and advertising our highest performing funds. 
Both of these actions have cost investors hundreds of billions 
of dollars.
    This is a vastly different industry than the industry I 
described in that ancient Princeton thesis. Trusteeship has 
been superseded by asset building. Stewardship has been 
superseded by salesmanship. As my prepared statement makes 
clear, the costs imposed on fund shareholders have soared, and 
the returns earned by fund shareholders have tumbled. And if 
you do not believe that, just look at Chart 10b--``The Stock 
Market, Funds, & Fund Owners'' of my written testimony.
    Equity mutual funds today are measurably riskier than they 
were then, and today picking funds is akin to picking stocks. 
The six-fold increase in our portfolio turnover to 110 percent 
a year 
reflects a strategy that has moved from the wisdom of long-term 
investing to the folly of short-term speculation. Fund 
managers, once almost entirely small, privately-held 
professional organizations--and I salute those that remain that 
way today--are now overwhelmingly owned by giant United States 
and foreign financial conglomerates, who are in this business, 
to state the obvious, to earn not only a high return on your 
capital but also a high return on their capital.
    Of course, we need regulatory action to prevent a 
recurrence of the ethically unconscionable conduct that we have 
seen in the scandals, but we need something more. We need to 
strengthen governance so that funds put the interests of their 
shareholders ahead of the interests of their managers, just as 
the Act demands, at least for the large fund complexes. I 
believe that we need an independent fund chairman, a board on 
which the manager has no more than a single representative, an 
independent staff that
provides the board with objective information, and an express 
statutory standard of fiduciary duty to assure that the funds 
are, indeed, organized, operated, and managed in the sole 
interest of their shareholders, just as the statute demands. 
These changes are not a panacea, make no mistake about that. 
But they are a beginning.
    We also need statutory language that encourages directors 
of funds and fund complexes, once they reach a certain size, to 
consider moving to a mutual structure, of all things, in which 
shareholders, not the managers, control the funds, a structure 
that has served Vanguard shareholders so very well. It is a 
curious irony noted in the addendum to my remarks today that 
U.S. Senators, of all people, and all other officials and 
employees of the Federal Government have precisely such a 
program, a mutual fund group available to all of you in the 
Federal Employees Thrift Savings Plan, operating at a tiny 
cost, 7 basis points a year--even lower than Vanguard's 37 
basis points for our equity funds, which has $130 billion worth 
of assets. In fact, the Federal plan is the 13th largest mutual 
fund complex, and they run it just the way we do.
    Public fund investors deserve to have their funds operated 
under those principles, too, or at least have the opportunity 
to. What investors deserve, gentlemen, is fund companies that 
are truly of the shareholder, by the shareholder, and for the 
shareholder.
    Thank you very much for your attention. I am looking 
forward to responding to your questions.
    Chairman Shelby. I want to thank all of you on the panel.
    Mr. Pottruck and Mr. Bogle, I will address this question to 
you. There is no doubt that costs matter and that investors 
should have access to cost information as they make investment 
decisions. Many people contend that mutual fund fees are 
excessive and that there are insufficient market pressures and 
incentives for funds to minimize costs. How do you respond to 
this assertion? Shouldn't informed investors be able to make 
their own investment decisions? Mr. Pottruck, do you want to 
take that first?
    Mr. Pottruck. Sure. Thank you, Chairman Shelby.
    I think that we would say in the mutual fund industry that 
costs vary all over the board.
    Chairman Shelby. But they matter, don't they?
    Mr. Pottruck. They certainly matter. Absolutely they 
matter. But investors are most motivated by the return they get 
net of fees. Many investors are willing to pay more to get 
something more than the lowest-cost fund. Sometimes that is in 
the performance of the fund----
    Chairman Shelby. So pay more for quality advice or for 
quality investment?
    Mr. Pottruck. Sure. It is all of the above. Sometimes they 
pay more because they do not want to be put on hold when they 
call a call center, or they want a superior website. Or perhaps 
they want to be able to sit down and have someone explain 
mutual funds to them, because they have never invested before 
and it is a little frightening to put their money at risk when 
it is their retirement that they are talking about. And they 
need someone to walk them through the difference between a bond 
fund and an
equity fund.
    Chairman Shelby. To most Americans, this is part of their 
nest egg, or whatever you want to call it, is it not?
    Mr. Pottruck. Absolutely. It is the primary saving vehicle 
for most Americans who are trying to save for their retirement. 
So a little advice and a little counsel is often a very 
important part of that process.
    An example is we distribute the Vanguard funds at Schwab, 
and we have $20 billion of our $1 trillion at Schwab has gone 
into the Vanguard funds. They are a terrific fund company and 
very, very competitive. But what is interesting is that 
everybody who buys the Vanguard funds at Schwab pays a little 
extra, pays a transaction fee, a brokerage commission, if you 
will, to buy the Vanguard funds. They pay more to buy the 
Vanguard funds from Schwab--and they know that at the point of 
purchase--than they would pay to go to Vanguard directly. So 
lowest price is not always the only thing people care about. 
They care about the whole range of services and things that 
come with the product, and you see that virtually in every 
industry.
    Chairman Shelby. Well, trust is an important component of 
all this, too, isn't it?
    Mr. Pottruck. No question.
    Chairman Shelby. Integrity.
    Mr. Bogle, do you want to comment?
    Mr. Bogle. Yes. Obviously price is extremely important, and 
investors, truth told, do not pay very much attention to it, 
partly 
because they chase past performance. And it is wonderful for us 
to say, ``Wouldn't you pay a few extra percentage points for a 
few more points of performance?''
    The problem with that analogy is that cost goes on forever 
and performance comes and goes. And we know by looking at the 
record that the low-cost quartile of funds provides a return 
over a decade, any decade you want to look at, that is 
something like 3 percentage points a year--an astonishing 
amount--over the high-cost quartile. And it happens in every 
single Morningstar style box, large cap growth and small cap 
value, et cetera. But people do not pay much attention to cost. 
Another reason they do not is because they are much too short-
term in their investment horizons. You know, a difference of 1 
or 2 percentage points in return over an investment lifetime is 
half of your capital. When you lose 2 or 3 percentage points of 
return over 30 years, you have put up 100 percent of the 
capital, you have taken 100 percent of the risk, and you have 
gotten 50 percent of the return. And the intermediaries put up 
0 percent of the capital, took 0 percent of the risk, and got 
50 percent of the return. It is not a good deal, sir.
    Chairman Shelby. Good answer.
    This next question is for all of you. Some contend that the 
current scandals are exposing a fundamental weakness in the 
structure of the fund industry. This weakness is the legal 
construct that each fund is a separate company with its own 
board. Many contend that in reality boards are totally reliant 
on the adviser who creates and manages the fund because boards 
have no independent operational authority.
    Some people contend that the current fund structure should 
be eliminated and funds should be combined with the adviser so 
that funds and advisers are under the authority of one board 
and are accountable to one set of shareholders.
    Chairman Ruder.
    Mr. Ruder. I do not think there is any need to change the 
fundamental structure of the fund industry. We have had 
scandals in the industrial community, as Senator Sarbanes 
knows, in which the 
directors and officers were not doing their jobs.
    The important thing is to instill into the directors the 
obligation to oversee the adviser and the service providers, 
both in terms of quality and in terms of fees. It is a hard 
thing to say that directors have to perform their jobs better, 
but we need to motivate them to do that.
    Chairman Shelby. Mr. Pottruck.
    Mr. Pottruck. I would agree with Mr. Ruder. I do not think 
we have to dismantle the governance structure of mutual funds. 
Effectively, the single shareholder proposal is more like some 
of the other products that are already offered in the 
investment industry, separate accounts and such. Mutual funds 
have stood the test of time. They have made investing in equity 
markets and participation in the capital formation of America a 
possibility for millions of Americans who otherwise could not 
in any way participate.
    I think that while it is easy to look at the recent 
scandals and think that the whole mutual fund industry does not 
work, I would argue that there is so much more good than bad. 
We should focus on the kinds of things that would prevent 
future problems. Shame on us if we allow those things to 
continue to happen or happen again. But I would urge the 
Committee to consider the broad range of what mutual funds have 
accomplished for America. More Americans are participating in 
capital formation and in the power of capitalism than ever 
before.
    Chairman Shelby. Ms. Hobson.
    Ms. Hobson. I do not necessarily see, in thinking through 
how our board meetings actually work in the structure of our 
firm, what that would change. At the end of the day, this 
wholesale change to consolidate the fund company and the 
adviser and the fund to me seems, again, like it sounds good in 
theory, but in practice nothing would be different. And the 
reason that I say that is that when I think about who we are 
accountable to every single day, we know we are accountable to 
those shareholders, and we know that the board at any time can 
just----
    Chairman Shelby. But haven't some people forgotten that in 
the industry?
    Ms. Hobson. I think that some people, in terms of how they 
have treated their shareholders, have put themselves first. But 
I do not think that that is everyone in the industry.
    Chairman Shelby. I agree with you. Mr. Bogle.
    Mr. Bogle. Believe it or not, I would not require the 
compulsory mutualization of the entire mutual fund industry. I 
do believe this: We need a governance structure that puts funds 
in a position to do that, if funds reach a size where that is a 
feasible option. You know, if everyone had that kind of a 
structure, there would be no entrepreneurship in the business. 
There may be too much of it now, but every business needs some 
of it. New funds would not be started, and the established 
firms would be dug in and we would have an oligopoly situation. 
However, I do not think that is healthy for anybody.
    But we need to put directors in the position where they can 
mutualize once the funds reach a certain size and standing. It 
would not apply to small funds. The example I like to use is 
when a fund is born, of course it needs a parent. When the fund 
gets to 21 years old and $100 billion of assets, maybe it can 
strike out on its own and make its own decisions in its own 
best interest. And, my gosh, the oldest fund is 80 now. It 
really must be time for them to think about it. That is pretty 
old for not being able to make any decisions of your own.
    I do think that that structure can best be done not only by 
the governance changes I have suggested, giving some heft to 
the weight of the fund board and the fund operation on the 
decision, but I also believe that would be substantially 
enhanced--and this is exactly, by the way, the way Vanguard 
began; we did not begin as a full-fledged mutual fund complex--
by having the funds take over operational control over the 
things that we do not usually associate with advisers, like the 
administration, the shareholder recordkeeping, the legal 
compliance. All of those would be fund functions under this 
structure, and the adviser would provide advice and the 
distributor would provide distribution. And if you had that 
structure, then the funds could say to the adviser we think we 
should do a little fee negotiation here. You have gotten big. 
Let's talk about it. Or we think maybe we should use a 
different distributor instead of you. Or maybe the fund manager 
has failed, and we say we are going to bring in another 
manager.
    We do that at Vanguard, not frequently--but more frequently 
than we would like because we hope to hire a manager forever. 
But that sometimes does not work out.
    We have the flexibility to deal with the funds' managers on 
an arm's-length basis. So, I think in that little scenario lies 
the ingredients for a much better industry.
    Chairman Shelby. Senator Bayh.

                 COMMENTS OF SENATOR EVAN BAYH

    Senator Bayh. Thank you, Mr. Chairman.
    First of all, I would like to thank all of our panelists 
for being here today. We very much appreciate your time.
    Mr. Bogle, you--and I apologize, Mr. Ruder, I was not able 
to be present for your testimony--describe a situation in which 
market imperfections keep what some of the other panelists have 
described as the normal competitive forces from working in the 
best interests of shareholders. Why, in your opinion, does the 
competitive marketplace not function as it should in this 
context?
    Mr. Bogle. I think that part of the answer is investors are 
very unaware of the importance of independent representation, 
very unaware of the importance of cost, and all too aware of 
how the fund did yesterday, last week, month, and year. Also do 
not forget that the mutual fund industry, like the life 
insurance industry, spends huge amounts of its resources on 
marketing and distribution. In other words, this is a sales-
driven industry and not a buyer-driven industry. The selling 
power is what basically drives most of this industry, what the 
brokers are selling, what the advisers are selling. So those 
things are an important part of it.
    But the reason it should not be that way is we have a 
fiduciary duty. It is established in the common law going back, 
I guess, thousands of years. It says that funds are different. 
Other people's money is a sacred trust that requires a 
fiduciary duty of those who are overseeing it. And it is that 
we have moved too far away from this idea--not entirely away 
from in all firms, but too far away in too many firms.
    Senator Bayh. So in your view, it is the retrospective view 
of 
investors and focusing on that rather than costs, which, to 
use, I think, your phrase, you said costs are perpetual but 
performance varies. Is that in a nutshell? And I would like to 
give Ms. Hobson and Mr. Pottruck----
    Mr. Bogle. Well, just let me add one thing quickly to that, 
and that is what I said, but I do not want to understate the 
tremendous power of a sales force. I mean, that is the way the 
life insurance industry got the way it is.
    Senator Bayh. Mr. Pottruck and Ms. Hobson, would you like 
to respond to that? Why, in your view, do the market 
imperfections that Mr. Bogle focuses on not exist?
    Ms. Hobson. One thing is that there is competition. This is 
very important. It is probably the most important theme that I 
could stress. There are 500 mutual fund companies, 8,000 
choices. People can select from a wide, broad range, and the 
market in basic capitalist terms, what we learn in economics in 
school, allows the customer to make their own choice, and it 
bears--there is supply and demand there. Where there is demand, 
people go. People vote with their feet in this business, and it 
is very interesting that Mr. Bogle talked specifically about 
how the funds get marketed and the cost. But at the end of the 
day, the investors are buying the lower-cost mutual funds. That 
is one of the reasons Vanguard has been so successful, as well 
as lots of other mutual fund companies around this country.
    This idea that sales and marketing become a four-letter 
word, a bad thing, is something I just absolutely reject, 
because when you are a small mutual fund company, you have to 
do everything you can to think of ways to sell and market when 
the top 10 mutual fund companies in this country, of the $7 
trillion in assets, control $3 trillion of them, spend lots of 
money in advertising, lots of money in promotion. So sales and 
marketing is very important.
    Senator Bayh. Forgive me for interrupting, Ms. Hobson, but 
in your view, consumers have access to adequate information to 
make informed decisions?
    Ms. Hobson. I certainly believe that there is a lot of 
information that consumers are hit with, and the question is: 
Is there a way this information can be given to them so they 
can understand it?
    I talked about my role on TV and the types of questions 
that I get there. The question is not that there is too little 
information. It is that it is too much. Tell me what is 
important because I am trying to sift through too much and I 
cannot understand.
    Senator Bayh. Well, that gets to the advisory component 
that Mr. Pottruck was referring to. To both of you, again, Mr. 
Bogle referred to the fiduciary duty component of this. Let me 
ask you for your response about what appears to be a tradeoff 
between--with so many members of boards serving the whole 
family of mutual funds, and I gather the argument is that that 
in itself creates efficiencies for the shareholders. But at 
some point you reach a tipping point at which you serve on so 
many boards, it is more efficient, but doesn't it also create 
some difficulty in adequately overseeing--carrying out your 
fiduciary duty? Do you have a response to that criticism that 
has been raised? I think one fund family has a director serving 
on as many as 277 boards. How is it possible to exert effective 
oversight on that many funds?
    Ms. Hobson. In our situation, we have four mutual funds and 
our directors serve on all four, and I see a lot of benefit to 
them being there for the discussion of all four mutual funds 
and the issues that are affected. I also see a benefit to the 
funds splitting the cost of flying them to Chicago and dealing 
with all the expenses that relate to them. I think that is 
something that is important.
    Also when I think about just the logistics--if you have a 
mutual fund company that has several hundred mutual funds, and 
you have four to six to eight board meetings a year, and you 
start to break apart the number of funds that one director can 
serve on, you would be having mutual fund board meetings every 
single day. That is what the company would be in the business 
of doing.
    So, there is to me some realistic number that is right that 
will allow for the efficiencies and at the same time allow 
people to run a business and not spend all of their time in 
board meetings. I do not know how you do that if you limit that 
fund company to two or three boards. You know, when you think 
about how many directors they are going to need and how many 
mutual fund board meetings they are going to have, it will be--
--
    Senator Bayh. Well, four certainly is reasonable. I would 
say to the layman when you get up to 277, you do kind of 
wonder, you know, how is that possible?

              COMMENTS OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Do you think 277 is too many?
    Ms. Hobson. I do not know how they run their structure, so 
it would be impossible for me to comment.
    Senator Sarbanes. No matter how they run their structure, 
is it too many?
    Ms. Hobson. If they have board meetings for a week, is it 
reasonable to think that you could cover 277 boards if you were 
working from 9 to 5, over 5 days, six or eight times a year----
    Senator Sarbanes. Is that reasonable?
    Ms. Hobson. It is possible, sure.
    Senator Sarbanes. Forty-five hours for 277 boards?
    Ms. Hobson. It is absolutely possible.
    Senator Sarbanes. Do you think that is reasonable?
    Ms. Hobson. The thing is, you would have to look at the 
board.
    Senator Sarbanes. I took your figures, 9 to 5, 5 days a 
week--actually that is 40 hours, not 45 hours, for 277 funds. 
So is that reasonable?
    Ms. Hobson. I think that it depends on the boards and it 
depends on the type of funds. If you had a hundred index funds 
on that list out of 277, there is not going to be a lot of 
detail that you are going to get into on performance, which is 
a big part of the board meeting. So, it is impossible for me to 
answer that question without having a better sense of the 
actual funds that are being overseen.
    Senator Sarbanes. That is 14 minutes a fund.
    [Laughter.]
    Ms. Hobson. But the thing is that a lot of the discussion 
is in common, so you are going to have a discussion about 
distribution, compliance, and legal issues that is going to 
happen across all of those funds, and then there will be 
independent discussions about the actual fund performance 
itself.
    Senator Bayh. I see my time has expired. Thank you, Mr. 
Chairman. Again, thanks to our witnesses for your testimony 
today.
    Chairman Shelby. Senator Sununu.

               COMMENTS OF SENATOR JOHN E. SUNUNU

    Senator Sununu. Thank you, Mr. Chairman.
    I think that was a great answer. You talked, Ms. Hobson, 
about information and that there is a concern perhaps among 
some consumers that they have a lot of information, but maybe 
it is too much, maybe it is not quite the right information, 
maybe they do not know what to do with that information. Are 
there any specific ideas that are out there that you have come 
up with, that you have heard the SEC discussing that might help 
improve transparency for investors, help clarify the 
information, help improve the disclosure rules that we have?
    Ms. Hobson. I think there are a number of things that I 
have seen suggested, I have heard the ICI talk about, and some 
of your colleagues mention. I think issues related to portfolio 
turnover, prominent discussions of that will capture some of 
the issues that are very hard to define around transaction 
costs, since there is no agreed-upon methodology there.
    Some of the discussion about the $10,000 example that the 
SEC has imposed now in the shareholder letter is not a bad 
thing. That shows the expense ratio and the actual cost that 
you will pay. I think that that is very good. People, if they 
do not read their prospectus, maybe they would catch that 
information in their shareholder letter.
    I think that the issue is: Can we be smarter about all of 
this thick document that we are giving shareholders? We have 
gone to the plain-English prospectus a few years ago that I 
think helps a lot, not having the legalese. And I am sure we 
could be more creative about some of these other ideas that 
would help investors.
    Certainly some of the new advertising rules are very, very 
good, where the standardized periods, the performance 
discussion, after-tax I think is very good. So there is 
information there that is helping the investor get a clearer 
view of what they are paying.
    Senator Sununu. So, Mr. Bogle, you talked about the 
predicted performance of costs. Low-cost funds historically 
have performed better than high-cost funds. That seems to me to 
be a strong argument for good transparency, good disclosure, 
along the lines just described by Ms. Hobson, maybe some of the 
other proposals that are out there. Do you also, however, 
advocate a capping or Government regulation of those fees?
    Mr. Bogle. No, I do not.
    Senator Sununu. You do not. Excellent.
    Mr. Ruder, you talked about the proposal for independent 
board members and for a disinterested chairman. I think it was 
yesterday, it may have been the day before that we had a 
hearing--we have had a number of important hearings in this 
Committee--but we had a hearing where specific studies were 
referenced that showed no correlation between having a 
disinterested chairman and the quality, the overall performance 
of the company, or the overall performance of a mutual fund. 
What is the purpose of proposing a standard mandate or 
requirement that every fund have a disinterested chairman?
    Mr. Ruder. In most cases, when the fund board meets, the 
adviser presents the agenda. The adviser, with its own 
chairman, will run the meeting and will have control of the 
meeting. That is a situation which does not allow the 
independent directors to act in a forceful manner.
    We have a situation now in which, within the last 3 years, 
the SEC has required that the independent directors be a 
majority of the fund boards. And we are only moving into a 
situation where these directors are going to have to fulfill 
their responsibilities, and I think that directors are going to 
be much more able to fulfill their responsibilities if they 
have power. If you allow an adviser to be the chairman, he can 
cut off discussion, he can control the agenda, and he can force 
his or her attitudes on the independent directors. I think that 
is wrong.
    Senator Sununu. If, in fact, the board structure you 
describe resulted in limitation on directors from being able to 
fulfill their responsibilities or act as they should--your 
words--or their ability to make good decisions, would not an 
evaluation of 50 or 100 or 1,000 boards be able to identify 
that that board structure results in poor performance, bad 
decisionmaking or, in the case of recent history, the scandals 
that we have read about being correlated to the lack of an 
independent chairman?
    Mr. Ruder. I know of no studies which have reached that 
conclusion. On the other hand, I do not believe there have been 
very many studies about this topic. What I am talking about is 
essentially a sea change in the way the boards work. I think 
that our investors need to have the opportunity to see what 
will happen in this industry if we have a responsible 
governance mechanism.
    Senator Sununu. I will certainly submit for the record that 
the study that was described in the hearings earlier this week 
was an evaluation of approximately 1,000 different public 
companies, certainly not all of them financial services or 
mutual fund related, but fortunately or unfortunately, there 
wasn't a correlation shown. I have no opposition to boards 
having independent chairmen.
    Ms. Hobson has an independent chairman, correct? I am sure 
it is a perfectly effective and workable structure, and there 
are some independent chairs and independent board members that 
I think do an outstanding job. There are others, as was also 
testified to at the hearing, that have a great deal of trouble 
staying awake in the meetings.
    I think it is pretty clear which ones you would want to 
have on your board, but it is also clear that the fact that 
they carry the label ``independent'' does not necessarily mean 
that they are delivering a superior level of oversight, 
decisionmaking, or responsibility on behalf of mutual fund 
investors or shareholders.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    First of all, I want to express my appreciation to the 
panel, not only for their oral presentations, but also for 
their written statements. Obviously, a lot of work and effort 
have gone into them.
    Mr. Chairman, I would be remiss if I did not, at the 
outset, thank David Ruder for his contributions when we were 
working on the corporate governance and accounting oversight 
issue. Mr. Ruder was on the initial lead-off panel when we had 
the five former Chairmen of the SEC. We received absolutely 
splendid testimony from all, extremely thoughtful, 
knowledgeable testimony, from all five Chairmen. And Mr. Ruder, 
in subsequent weeks, was of help in counsel to the Committee, 
and I want to express my appreciation.
    Mr. Ruder. Thank you, Senator.
    Chairman Shelby. If I may interject, that was unprecedented 
when you were chairing the Committee, and we had five, 
including you, Chairman Ruder, former Chairmen of the 
Securities and Exchange Commission, all of which had spent 
months collectively in this Committee all in one panel. I 
commend you for that.
    Mr. Ruder. I found them to be very opinionated, aggressive, 
and wonderful.
    Chairman Shelby. Quite opinionated, but wonderful too.
    Senator Sarbanes. Ms. Hobson, I have been looking at your 
statement, and maybe I missed it, but I am trying to find what 
changes, if any, you think should be made. A quick reading of 
your statement would lead me to the conclusion that you do not 
really think anything should be changed. Am I right in that 
impression?
    Ms. Hobson. No, you are not right in that impression.
    Senator Sarbanes. Now did I miss it in your statement or is 
it not here?
    Ms. Hobson. No, in my statement, I really wanted to focus 
on some of the possible repercussions to the changes that are 
being suggested for small mutual fund companies and ask----
    Senator Sarbanes. I think it would have been helpful to us 
if you had also focused on what changes we might consider as 
being necessary, since most people seem to think some changes 
are necessary. I know Mr. Pottruck has a section outlining some 
changes that he thinks should be made.
    Ms. Hobson. I would be happy to comment on those changes in 
writing to you that I think are appropriate. One of them that I 
think is terrific that has been suggested is no longer allowing 
directed brokerage for the selling of mutual funds. I think 
that makes a lot of sense and eliminates conflicts of interest 
at the brokerage level. That would be one simple one I could 
point to very quickly.
    I think the two-thirds majority board that the SEC adopted 
was a good idea. We already had that, but again I recommended 
and stated that I thought a strong independent board was the 
most important thing that could be done to offset some of the 
problems that have existed. So those would just be two of them.
    Senator Sarbanes. Why don't you submit something to us in 
writing. It would be helpful----
    Ms. Hobson. Sure, I would be happy to do that. Thank you.
    Senator Sarbanes. It would be helpful to us in our 
deliberations.
    Mr. Pottruck, Fortune magazine, dated December 8, 2003, 
contained an article, ``When Bad Things Happen to Good 
Companies,'' and this is what the article says: ``When WorldCom 
blew up, Pottruck had a fit. `How could this be? Where the hell 
are the goddamn accountants? How could the board of directors 
and the auditors let this happen? I just could not believe 
it.' '' That is the end of the quote from the article. Now, how 
accurate they are in quoting you, I do not know. I am just 
quoting the article.
    Since then, starting in September of 2003, with Attorney 
General Spitzer's case against Canary Fund, a series of 
scandals have rocked the mutual fund industry. In your view, 
how could the board of directors let this happen? And to use 
your words, I could not believe it when I heard it, but there 
we are.
    Mr. Pottruck. I think what we have learned is that there 
are lots of opportunities in an industry made up of tens of 
thousands of people for individual acts of failure to happen 
that can go undetected when they are as subtle as they 
sometimes are. We in the mutual fund industry, in many cases, 
never even conceived of some of the problems and practices that 
we have now learned were going on. So this has been an eye-
opener, an embarrassing eye-opener to our entire industry.
    In many, many cases boards rely on management to fulfill 
fiduciary responsibilities, and I believe that management makes 
every effort to do that. But sometimes individual acts of 
compromised 
behavior, where people are not fulfilling their legal and 
fiduciary responsibilities, can go undetected if you do not 
have sufficient oversight detection.
    Senator Sarbanes. Who should do the oversight detection?
    Mr. Pottruck. Sometimes it is beyond the capability of a 
fund company to do it for themselves, and they have to 
outsource it to another firm who might have the technology. 
They might have to rent somebody's computer technology to do 
the artificial intelligence kind of work that detects patterns 
of behavior or other signals that indicate that more 
investigation needs to happen.
    We are trying to look at the thousands of transactions that 
go on and see if there are patterns that suggest some kind of 
abuse. Then we send people in to investigate whether something 
real is going on here that we should be concerned about. But 
ultimately management owns the responsibility and the 
accountability to make sure that those kinds of things are 
happening.
    Senator Sarbanes. Are you supportive of compliance officers 
and strengthening that whole concept in order to have that 
watchdog at work?
    Mr. Pottruck. I think the idea of having a chief compliance 

officer who reports to the board is not very different than 
public companies having a head of audit who has a reporting 
responsibility to the audit committee. So, I am supportive of 
that idea.
    Ms. Hobson. If I could just add one thing, Senator?
    Senator Sarbanes. Yes, you don't like that idea, as I 
understand your statement.
    Ms. Hobson. I am concerned about the cost. So if the small 
fund company has to bear the cost, does it create a scenario 
where they cannot compete in the same way as the big fund 
companies. If you are a Fidelity and you have a floor full of 
lawyers, and you are Ariel and you have two, does that change 
the game for you when you are then being told you have to bring 
someone in? And then, of course, the price of those people will 
be very clearly set by the demand that we will all have at the 
exact same time for those 
individuals.
    Senator Sarbanes. If there are abuses going on, and if a 
compliance officer is adjudged would be of use in curbing those 
abuses, should we forgo that change because the smaller funds 
present the position that there is a cost inherent in the 
compliance officer?
    Ms. Hobson. I guess the answer would be, from my 
perspective, that we want to do anything that will make our 
industry better, and if it costs money, and it makes sense, and 
it can prevent abuses and make us better, we want to do it. But 
this is the issue that I think is hard.
    When we were thinking about all of the scandals and how 
they unfolded, I remember one day waking up, when I read the 
stories about portfolio managers timing their own funds, and I 
said to the chairman of our firm, not the board chairman, but 
the chairman of our company: How would we have known to catch 
this? How would we have figured this out? Even with the best of 
intentions, trying to run our business in the best possible 
way, would I have thought about looking at the transactions of 
our employees on the mutual funds when that, in terms of our 
personal securities reporting, is an exempted category by the 
SEC? We report the stock trades that our individual employees 
make, but we never had them report their mutual fund trades.
    Well, that was, with best of intentions, I would not have 
thought of it. Now, you better believe, after the story broke, 
I said, ``I want to see everyone's trades for the past 5 years, 
every single quarter, every trade and double check and see if 
there was anything there.'' And with some pleasure, I was glad 
to see that we did not have any problem.
    But running the company as effectively as I can think of, 
and trying to put the shareholder first, I would not have had a 
way to think about some junior analyst that maybe was timing 
our fund, nor would there have been a policy for it.
    Chairman Shelby. Ms. Hobson, what size firm do you have? 
You say you are a small mutual fund. What are you managing?
    Ms. Hobson. In mutual fund assets, we manage $5.5 billion, 
and then we have----
    Chairman Shelby. What is Charles Schwab managing, Mr. 
Pottruck?
    Mr. Pottruck. We manage approximately $280 billion in 
mutual fund assets.
    Chairman Shelby. So $280 billion compared to that.
    Mr. Pottruck. Right.
    Chairman Shelby. Mr. Bogle, what is Vanguard managing now?
    Mr. Bogle. Well, $725 billion.
    Chairman Shelby. Okay, $725 billion.
    So, she is making the point, although $5 billion is a lot 
of money to several of us up here, it is not a lot of money 
compared to the giants in the mutual fund industry; is that 
your point, Ms. Hobson?
    Ms. Hobson. That is my point, but also the point that I was 
trying to make is, if we do hire the compliance officer, we 
then need to----
    Chairman Shelby. Sure, I see your point.
    Ms. Hobson. How will we know that they can check in a way 
that is even more effective than what is being done, when some 
of these things, you just cannot even contemplate?
    Senator Sarbanes. Well, I think--if I could just close, Mr. 
Chairman--that the industry needs to come to grips with this 
challenge.
    In March 2003, the Chairman of the ICI, testifying before 
the House Financial Services Committee said, ``The strict 
regulation that implements these objectives has allowed the 
industry to garner and maintain the confidence of investors and 
also has kept the industry free of the types of problems that 
have surfaced in other businesses in the recent past. An 
examination of several of the regulatory measures that have 
been adopted or under consideration to address problems that 
led to the massive corporate and accounting scandals of the 
past few years provides a strong endorsement for the system 
under which mutual funds already operate.''
    In effect, we took that and gave credibility to it. Then, 
subsequently, beginning last fall, we see the unfolding of all 
of these problems. Now, you know, it came I think, in effect, 
as something as a surprise to a lot of people, and it seems to 
me at this point we need to address what can we do to bring 
about changes in the workings of the system that would make it 
less likely that these abuses would occur. The SEC is working 
at it, of course, and they have a prime responsibility in that 
area, and I recognize that, but of course at the same time we 
are holding these sets of hearings and trying to see what the 
lay of the landscape is. But I do not think we can just let 
things go on as they had gone on before, before we had 
experienced these problems.
    Chairman Shelby. Plus, it affects about 100 million people 
and $7 trillion in money--$7 trillion.
    Senator Allard, we thank you for your indulgence. You take 
what time you want.

                COMMENTS OF SENATOR WAYNE ALLARD

    Senator Allard. Thank you, Mr. Chairman. This is a very 
interesting hearing. I can take all of the time I want?
    Chairman Shelby. Whatever you want.
    [Laughter.]
    But we think you will be judicious.
    Senator Allard. I had better be careful here. I will try 
and use discretion with the Chairman's generosity.
    Let's suppose that I am an American that picked up $10,000, 
and I am trying to decide where I want to invest this money. 
Why would I invest in a mutual fund? Maybe in just 1 or 2 
minutes, a couple or three of you can give me some good reasons 
why I would want to invest in a mutual fund.
    Mr. Bogle. The reason you invest in a mutual fund of any 
kind, and this is a very diverse industry, as we have stock 
funds, bond funds, and money market funds, but the reason you 
invest in a 
mutual fund is, at their best--at their best--they give you 
broad diversification, very consistent investment policies, and 
very low costs. So it gives you a chance to capture the returns 
of American industry, to own the stock market, if you will, for 
your lifetime. Whatever returns American business gives, you 
will share in. And if you do it at low enough cost, you will 
get almost 100 percent of that return, whether it is the stock 
market or the bond market.
    Where this industry messes it up is giving you such costs 
that it, over 30 or 40 years as a long-term investor, you do 
not have a fighting chance, truth told. Our average portfolio 
manager only lasts for 5 years. So mutual funds, in their great 
diversity, give you opportunities which are there for the 
taking, but we have complicated it all a lot. But it is the 
best way to buy stocks, it is the best way to buy bonds, and it 
is the best way to buy money market instruments.
    Ms. Hobson. If I could add, you also get low barriers to 
entry.
    Senator Allard. You get what?
    Ms. Hobson. Low barriers to entry. So, you can invest at 
Ariel for no minimum investment, as long as you agree to invest 
$50 a month. You cannot necessarily do that and go and buy 
General 
Motors stock in that way, and so you get that opportunity.
    I do think you get low costs. You get professional money 
management. You are not trying to figure out what individual 
stock or bond to buy on your own. And then last, but not least, 
you get simplicity, and simplicity meaning that you get your 
tax statements prepared for you at the end of the year, you get 
a statement showing how your investments have done every 
quarter, and you get confirmations on your investments when you 
make them.
    Those things are all very, very helpful to the investor in 
managing their financial life and their account, not to 
mention, of course, Mr. Bogle's point about diversification is 
very important. You are not putting all of your eggs in one 
basket, so if one stock is down and another is up, you have 
averaged out a better return.
    Mr. Pottruck. I would certainly agree with what Mr. Bogle 
and Ms. Hobson have said, but let me offer a little bit broader 
perspective, if I may. First of all, if you have this $10,000, 
and you are not a reader of financial publications and a 
watcher of CNBC, you might take that $10,000 and stick it in a 
CD or a money market fund because you do not fully understand 
how the stock market works, and you do not have someone who is 
helping you. So for many Americans, one reason to go into 
mutual funds is to be able to rely upon someone who helps them 
understand investing and reassures them of the long-term 
paybacks of participating in capitalism with some of their nest 
egg.
    Another reason to invest in mutual funds is that it really 
is an easy thing to do. You could go to a firm like ours, which 
offers more than 4,000 funds, use our website and scan down the 
array of choices. You can screen for funds with certain levels 
of performance, or that have low fees, or by many other 
parameters. There are many different ways to participate in 
this industry, which is part of what makes it so vibrant and 
successful.
    Senator Allard. Now, you have all given me a sales job. 
Where do I go now to check on what you told me? You have this 
capability of catering to the uninformed investor. You may be 
an investor who does not want to take the time to study or 
maybe he says, well, great, I do not understand all of these 
individual funds, and I like to spread my risk out. That all 
makes sense. Where can I go to confirm what you just told me is 
legitimate? Where can I check on you and confirm that they told 
me this. Now, can I check on performance and compare that to 
other companies? Where can I go for that information.
    Mr. Pottruck. There is considerable reporting on the mutual 
fund industry. There are quarterly publications that show the 
performance of all mutual funds in newspapers----
    Senator Allard. So, I have to buy quarterly magazines on 
the mutual funds or----
    Mr. Pottruck. You get monthly statements, you get quarterly 
statements, which provide performance updates.
    Senator Allard. I get that from individual mutual fund 
companies, but where can I go to get a comparison? Is there 
anywhere I can go as a consumer and get a comparison, maybe 
someplace on the Internet. Is there an agency out there that 
can give us the oversight that we need and do a comparison? 
Where do we go?
    Mr. Bogle. You could go to the library and get Morningstar 
Mutual Funds. They have a full page on every mutual fund 
practically in the business, every one of any serious size. It 
tells you more really than you want to know or need to know. It 
is presented in an attractive format. It makes recommendations. 
Alas, however, Senator, I have to inform you that all of these 
choices we give investors basically have put us in the same 
position as selling stocks.
    There is a big risk in buying an individual stock, and we 
now have such a diversity of mutual funds in this industry, 
doing all of these very odd things, that offer nowhere near the 
full diversification of owning the whole stock market, and so 
there is a premium on choosing the right mutual funds, the 
right objectives, the right costs, the right sales charges, the 
right managements.
    We have made what should be a nice simple game, where the 
typical investor can just go on in and do what he wants to do, 
into a very complicated one involving complicated choices that 
are made almost always on the basis of past performance, which, 
alas, does not repeat itself.
    Senator Allard. So disclosure is important.
    Mr. Bogle. Disclosure is very important.
    Senator Allard. And that leads to my next question. So if 
disclosure is very important, what are the key things in 
disclosure that would be most helpful for the consumer--
disclosure of the various costs in the funds by disclosure of 
the dollar breakdown of costs in the purchase of the funds; or 
what is the percentage of return on their investment based on 
what kind of funds they are investing in? These are all things 
that get discussed in regard to disclosure. Is it appropriate 
to go ahead and have full disclosure? Is it appropriate for the 
Federal Government to insist that we have this full disclosure 
or are there some areas that are proper?
    I happen to be someone that feels like we need to invest, 
and that we have to disclose necessary information for the 
consumer to make informed decisions. I want to know what kind 
of disclosure that requires.
    Mr. Ruder. Sir, you should know that the Securities and 
Exchange Commission has over the years tried to increase the 
amount of disclosure which the mutual funds are making. It has 
greatly increased that amount of disclosure, and continues to 
do so.
    My experience was that that increase in disclosure was 
quite frequently resisted by the industry, and I think it is 
not a good thing that they did that. I think that the industry 
should be telling us what kinds of disclosure should be made, 
and the Commission should continue to try to increase the kinds 
and amounts of disclosures, and to have it be done in a very 
understandable way.
    Senator Allard. Why would they want to resist disclosure?
    Mr. Ruder. I have never understood exactly why. They talk 
about costs, for one thing. I know that. There is a proposal 
out now that each individual be given an exact dollar-for-
dollar discussion of what happened to his or her individual 
account. That proposal is being resisted by the industry on the 
grounds that it will cost a lot of money.
    Mr. Pottruck. That is correct.
    Senator Allard. So there is a cost with disclosure, but 
then Ms. Hobson also said, ``You know, I would never have 
dreamed of doing this in my company, but I find out some other 
company got caught doing this, and so I checked back with my 
company to make sure we were not doing it.'' Does disclosure 
not help the whole industry so you all know what is going on? 
And what is the right balance?
    Mr. Pottruck. I think that disclosure can help, and it can 
hurt. I mean, there is probably not a person in this room who 
has not refinanced their mortgage in the last 2 or 3 years and 
signed 50 documents without having the time to read any of 
them.
    Senator Allard. That sounds like closing----
    Mr. Pottruck. That is disclosure run amuck. The design of 
disclosure has to be done in a way that balances the importance 
of a few things being very visible with other things being 
available and somewhere findable so the press, and analysts, 
and others can hold the industry accountable. That works very 
well.
    At the point of purchase, there are only a few things the 
investor needs to know. There is probably more they want to see 
on their monthly or quarterly statements, more still that 
should be in a prospectus. There is a tremendous amount written 
about the mutual fund industry, and the press plays an 
important role in giving bad publicity to those funds that are 
doing a very bad job for consumers, and money follows that 
information.
    Chairman Shelby. They should play that role.
    Mr. Pottruck. Exactly.
    Senator Allard. Are they doing that now?
    Mr. Pottruck. Yes, absolutely they are. Absolutely they 
are.
    Mr. Bogle. Information is really a tricky thing in our 
business because the markets are so efficient that it is very 
hard to gain an edge, and in the long run, buying individual 
stocks is a loser's game compared to the market itself, as is 
buying individual mutual funds. You cannot beat the market. It 
is nearly impossible over time. Look at the record.
    Then you look at what is being disclosed and look at, say, 
Money magazine, and what they give you here are the 100 best 
mutual funds. They have been giving this list for 5 years, and 
I will bet there are not 30 funds in this most recent list that 
were in the
first list.
    So, you are supposed to be buying each year on the basis of 
that? It does not make any sense. We should work much harder on 
simplifying and giving more diversification. This is an asset-
gathering business. The reason is that is what the asset 
managers do. They want to get more assets and get more fees, 
and that is not illegitimate, except it does not help the 
shareholders. It says create this kind of a fund when everybody 
wants to buy it, so that money will come in and add to our 
management fees.
    It has taken this nice, simple business of owning America 
and holding it forever, and turned it into this complex thing 
where we need these reams of disclosure, and I am not sure it 
is going to be productive. We turn over our portfolios at 100 
percent a year. People want information, but I don't know what 
they conclude from it.
    Senator Allard. Thank you, Mr. Chairman.
    Chairman Shelby. It sounds like I would buy the 500 index 
fund from what you have just said.
    Mr. Bogle. Well, I think there are worse recommendations, 
sir.
    Chairman Shelby. I know it. I agree with you.
    Mr. Bogle, you founded Vanguard probably with a little 
money, and I do not know how much, not probably millions or 
billions, but now your firm, Vanguard, has over $700 billion; 
is that correct?
    Mr. Bogle. Yes, sir.
    Chairman Shelby. You are the second-largest fund at this 
moment, is this correct?
    Mr. Bogle. Yes, sir.
    Chairman Shelby. Gosh, we would like to have that money to 
close the deficit, wouldn't we.
    [Laughter.]
    Mr. Bogle. Our shareholders would be reluctant to part with 
it.
    Chairman Shelby. We would, but we do know better than that, 
don't we?
    Senator Allard. The Government is not a good investment.
    Chairman Shelby. Yes, the shareholders would revolt.
    Mr. Bogle, some contend that it is inappropriate for a 
portfolio manager to simultaneously manage both institutional 
accounts, like hedge funds and a mutual fund, because the 
manager will favor the hedge fund at the expense of the mutual 
fund. What is your perspective on this and has the side-by-side 
management of hedge funds and mutual funds been at the center 
of any of the recent fund scandals? Further, how would a ban on 
side-by-side management impact, if at all, the mutual fund 
industry?
    Mr. Bogle. Those are very, very good questions and very, 
very tough questions. It is hard to see that the financial 
incentives in favor of running hedge funds are not so 
overpoweringly large, relative to the fees in running mutual 
funds, even the high fees in running mutual funds, for that 
matter, that the temptation to put the best ideas in the hedge 
fund would be very strong, not necessarily irresistible, but 
very strong.
    Chairman Shelby. There is a lot of temptation.
    Mr. Bogle. There is a lot of temptation.
    In general, mutual funds, particularly the large fund 
complexes, do not run hedge funds, and I think it is the kind 
of split that one should think long and hard about. We need to 
think about what kind of regulations might reduce that 
conflict, and realize that one of the unfortunate, unintended 
consequences of such a law would likely be that every hedge 
fund manager who ran a mutual fund would give up the mutual 
fund business, and therefore his clients would have to find 
other funds.
    So, I do not like the idea of conflicts of interest in this 
business, but I think we should be a little clearer about what 
we are giving up when we eliminate them.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. I want to follow up on Chairman Shelby's 
question. When you start out on these hearings you start 
receiving communications from everywhere, so to speak. We 
received a communication that came in that said the following. 
I want to quote it to you and ask for comment.

    Many asset management firms have started hedge funds in the 
last few years due to the much higher fees and less stringent 
regulations, but run them side-by-side with mutual funds. They 
are often even run by the same portfolio managers. The main 
reason mutual funds firms start hedge funds is to keep star 
portfolio managers from leaving to set up their own fund. Some 
of the biggest mutual funds companies in the country are doing 
this. This presents incredible conflicts. Some firms have been 
known to short a stock in the hedge fund, hold onto it in the 
mutual funds because they are not allowed to sell short, and 
then sell the mutual funds position at a later date, thus 
causing downward pressure on the stock price and making the 
short position more valuable.

    If that kind of thing is going on, as it is asserted here, 
do we not need to do something about it?
    Mr. Bogle. Absolutely. That is shocking, I would say. I am 
not an attorney, but I would say that is almost criminal 
behavior.
    Senator Sarbanes. We need to prosecute those people.
    Mr. Bogle. Yes. Just to make the record clear, we do not 
run any hedge funds at Vanguard. I have to say, maybe 
editorialize it a little bit, that this business about star 
managers is a little bit odd. I have seen a lot of these stars 
come and I have seen a lot of these stars go, and it occurs to 
me that there are far more comets that burn themselves out than 
there are stars in the mutual fund business--think of portfolio 
managers that have really been good over 25 years, and we can 
all name Warren Buffett, and we can all name--well, there is 
somebody else out there I am sure. I just cannot think of 
another top portfolio manager for 25 years. They do not come to 
mind, so it is a short-term game, and that is another thing we 
should try and get away from.
    I think it is disgraceful if what you describe is going on, 
but I have no knowledge that it goes on anywhere, however.
    Chairman Shelby. Chairman Ruder, we know you are an 
attorney, but would you describe the fiduciary duties that a 
fund board owes to the shareholders? Would you describe the 
fiduciary duties that a fund board owes to the shareholders?
    Mr. Ruder. Most of the fund boards are organized either as 
a corporation or as trust, and the fund board shareholders or 
trustees owe obligations to be loyal, to act with care----
    Chairman Shelby. Honest.
    Mr. Ruder. And to be honest. These are duties which occur 
in all organizations, but to me, to call these fiduciary duties 
does not nearly describe the obligations of these directors. I 
think in the mutual fund industry today the directors have to 
be alert, aggressive, and informed, and they should assume 
their responsibilities in a way that befits their special 
responsibilities. I think their obligations are greater than 
they are in a normal company when management is reporting to 
the board on a regular basis.
    Here we have a separation of the directors from the 
adviser. You can call these duties fiduciary if you want, but 
these are duties and obligations that the directors need to 
perform in special ways.
    Chairman Shelby. Is not integrity central to the running of 
a mutual funds industry or to any business, but especially one 
that is so important to our capital markets involving $7 
trillion?
    Mr. Ruder. I could not agree with you more, Senator, that 
the concept of integrity is vital. To my mind the problem with 
these scandals has been at the adviser level, where the levels 
of integrity have not been as great as they should have been. 
The SEC is trying to develop a system in which the advisers can 
be controlled to make sure that they act properly.
    Chairman Shelby. It was mentioned earlier about a sales-
driven industry, but I do not know how you take marketing out 
of a market driven economy, whether it is mutual funds or 
anything else. It is just part and parcel.
    With that in mind, Mr. Pottruck and Ms. Hobson, this 
question I will address to you two. Broker-dealers play a large 
role in the distribution and sale of fund products. Could you 
describe how 12b -1 fees and revenue sharing arrangements are 
currently used and how these practices benefit fund 
shareholders? Also, do we need to reassess these practices in 
light of recent revelations?
    Mr. Pottruck.
    Mr. Pottruck. Sure. The 12b -1 fees in many cases are used 
to reimburse distributors for the time and energy spent talking 
to shareholders or potential shareholders in explaining the 
pluses and minuses.
    Chairman Shelby. It is part of the marketing, is it not?
    Mr. Pottruck. Correct, it is part of the marketing and the 
service. When you come to Schwab, the people who talk to 
clients have no financial interest in which investment choice 
the client makes. So, they are just trying to help find out 
what the client wants, what their tolerance for risk looks 
like. There are many different kinds of mutual funds, and this 
conversation can take some time. For example, there are mutual 
funds that have underperformed the stock market over the years, 
but have been exceptional performers in down markets. They lose 
less during down markets and they make less during up markets. 
Maybe over time they might underperform, but some investors 
want the stability during a downturn.
    Chairman Shelby. Are those bond funds?
    Mr. Pottruck. No, equity funds. Equity funds that are 
managed on a very, very conservative basis, attended by very 
conservative investments. There are other funds that have much 
higher betas, much higher volatility, and there are those 
people who love the idea of being more aggressive. Those would 
be funds that would be more heavily invested in technology, for 
example. People might think, ``Gee, this is a great time for 
that kind of investment. Companies are going to go back into 
technology. I want to own technology funds.''
    About 20 percent of our investors describe themselves as 
``self- 
directed'' investors. They come to our website every day. They 
scan all the 4,000 funds and they make their choices. Fifty 
percent of investors describe themselves as ``validators.'' 
That is a term we use for people who do not want to turn over 
the management of their money to someone else, but they want to 
work with an adviser who helps them navigate all these choices 
while they maintain an active involvement. That takes time and 
energy.
    Chairman Shelby. At least they are watching you.
    Mr. Pottruck. The 12b -1 fees are one of the ways for a 
fund like Ariel to help reimburse Schwab for the time and 
energy we spend explaining to investors about the Ariel funds 
so that they can make an informed investment choice.
    Chairman Shelby. Ms. Hobson.
    Ms. Hobson. I think that David answered it very well. The 
do-it-yourselfers are a small group, and then there is the 
validators and the designators, the people who want their 
decision confirmed and those who want someone else to make it 
for them. And the 12b -1 fees help us to pay those people who 
offer that advice and counsel.
    As we have all noted, because this can be a very confusing 
area for American investors and because you do not learn about 
investing in school in America, we need a lot of help in making 
these decisions and discerning what is important, and I do 
believe that the payment for those services is also important. 
Ninety percent of our assets right now are coming from mutual 
funds supermarkets, Schwab and Fidelity, 90 percent for our 
company.
    What is the benefit to the investor besides being able to 
talk to an informed person on the phone at Schwab, being able 
to get all of their investments on one statement at Schwab, 
having access to a terrific website? Beyond that, as we grow, 
they get the benefits of the scale. One simple example of that, 
I looked back in 1998, the Ariel Fund, our flagship mutual fund 
had an expense ratio of 1.19 percent. Five years later, because 
the fund has grown because of the sources like Schwab and 
Fidelity, our expense ratio as of today is 1.02 percent. I am 
sorry. In 1998, it was 1.25 percent. It is 1.02 today, and so 
that is a 20 percent drop in 5 years. Because we have grown----
    Chairman Shelby. Because you have more to manage in economy 
of scale, is that it?
    Ms. Hobson. We have the economies of scale through Schwab 
and Fidelity.
    Chairman Shelby. Mr. Pottruck, you have testified that 
although the SEC's proposal for a ``Hard 4 p.m. Close'' would 
deter later trading, it will have unintended adverse 
consequences for some investors and will be particularly unfair 
to investors that 
invest through 401(k) plans which are important to all of us. 
We 
understand the need to halt late trading, but I also appreciate 
the concern about unintended consequences for investors. A 
number of the proposed alternatives to the ``Hard 4 p.m. 
Close'' rely on technological fixes. How feasible are these 
alternatives, and does the required technology exist or is that 
on the drawing board?
    Mr. Pottruck. We and others are suggesting that, since 90 
percent of mutual fund trades come through an intermediary on 
behalf of the fund, that intermediaries be able to apply to be 
a designated agent of the funds, and that when the intermediary 
takes the trade by 4 o'clock, that is considered to be an 
adherence to the ``Hard 4 p.m. Close.'' We at Schwab take 
50,000 mutual funds trades a day, and we have to aggregate all 
these trades before placing them. It takes us a little time to 
aggregate the trades and send the money and the information to 
the various funds so that they can manage their investing.
    The technology to have hard-coded, unalterable time stamps 
as to when these trades came into the system exists, but it is 
not all implemented. It never occurred to us, frankly, that we 
had to make the field with a time stamp something that someone 
could not go in later on and override. Now, we have learned the 
importance of those kinds of protections. So those technologies 
need to be added, but they are not a technological challenge, 
it is just some time and money for us to put those in place.
    Chairman Shelby. Mr. Bogle, do you have a comment on that?
    Mr. Bogle. Yes. I think, first of all, the idea that you 
should make an investment decision based on what the market is 
going to do in the last 2 hours of the day if you are investing 
for a lifetime, strikes me as, for the want of a better word, 
nuts. Second, even a 4 p.m. close is not adequate for the 
proper conduct of this industry's affairs. It should be 
something like 2:30 so the money is known to be in there when 
the portfolio manager can invest it by the close of the day. In 
other words, the idea is to have the purchases the portfolio 
manager makes be made at the same price that reflects what the 
net asset value is, but that is a parity there, a linking, and 
at 4 o'clock it is too late to do that, so I would go for a 
2:30 close. And as absurd as that might sound to you, that is 
actually the way we do our index funds, because there the 
pressure to match is so heavy that you just have to close at 
2:30 so the portfolio manager can buy that future at 4 p.m. and 
the fund is priced the same way.
    But I think it is a good idea to have a hard close, and I 
am sure no one is going to agree with me. I do not think very 
many people are going to agree with me for a 2:30 close, it may 
be a tough medicine for everybody to swallow, but the abuses 
were worse, so we have just got to do something about it.
    Chairman Shelby. How much of the mutual fund money of 
Vanguard roughly is in index funds?
    Mr. Bogle. Order of magnitude, probably about $280 billion 
something like that, index stock and bond funds.
    Chairman Shelby. Ms. Hobson, do you have a comment on that?
    Ms. Hobson. I do not have anything to add to that.
    Chairman Shelby. Mr. Ruder, Chairman Ruder, we always 
addressed him as.
    Mr. Ruder. Thank you, sir.
    Chairman Shelby. The SEC has not mandated a maximum number 
of fund boards on which independent directors can serve, at 
least not yet. What are the implications of directors serving 
on over 100 boards? We talked about that a little earlier. 
Further, what are the considerations for determining the 
appropriate number of boards on which a director serves, and 
who should make that determination?
    Mr. Ruder. That is a very good question. When I first 
learned that directors were directors of 30, 40, 50, or 100 
boards at the same time, I was astounded. Then I learned more 
about the industry. As Ms. Hobson said, there are similar 
aspects in funds which fund boards can examine at the same 
time, the governance functions, the compliance functions, and 
other functions. So it is quite appropriate to have a large 
number of funds with the same boards.
    The boards can also look at the performance characteristics 
of the various funds. There must be a point, however, at which 
you want to say 100 is enough or 80 is enough or 250 is enough, 
and I think the SEC should look at the multiple board 
phenomonon very carefully. I cannot imagine Congress making 
that kind of decision, but someone should.
    Chairman Shelby. Ms. Hobson had some comments on that 
earlier, on the time I think Senator Sarbanes asked her a 
question about how much time they would spend on the board. You 
want to comment on this again?
    Ms. Hobson. No.
    Chairman Shelby. No.
    Ms. Hobson. I think I said enough on that one.
    [Laughter.]
    Chairman Shelby. Mr. Bogle.
    Mr. Bogle. In any abstract sense it is absolutely absurd 
for a 
director to serve on 330 or 340 boards or even 100. I used to 
say 
a fiduciary duty test was whether they name each fund they were 

director of. Nobody could pass with 100 funds. I am absolutely 
confident of that.
    Chairman Shelby. I would hate to have the responsibility if 
something went wrong on one of those boards, the legal 
liability.
    Mr. Bogle. On the other hand, if I may add, sir, doing it 
the other way and having--if you have 330 funds, which I 
believe is a Fidelity number--having 33 boards would make Mr. 
Johnson, who is the king or the emperor now, it would make him 
into the Pope. I mean he would have no limits. His power would 
be absolutely unchecked if he had 10 different boards to deal 
with, all doing different things.
    So my idea for balancing those interests is to require that 
no director could serve on more than, say, 10 fund boards 
unless the funds had an independent staff to assist the 
directors--an independent, objective staff on the fund's 
payroll to enable the directors to fulfill their fiduciary 
duty. I think that would be the best balance of interest.
    Chairman Shelby. Mr. Pottruck.
    Mr. Ruder. Could I just comment once more on this?
    Chairman Shelby. Let me call on Mr. Pottruck first.
    Mr. Pottruck. Thank you, Chairman Shelby. I think this is a 
very complicated issue. We have 40 or 45 mutual funds that are 
proprietary Schwab funds, where we have our own board that is 
in charge of these funds. The vast majority of what the boards 
look at relative to these funds is exactly the same, fund to 
fund to fund. There is an enormous economy of scale. Issues 
having to do with individual performances of individual funds 
are primarily dealt with on an exception basis. There is an 
expected benchmark for every fund. If the funds are within 
their benchmarks, there is not a lot of discussion that is 
necessary about their performance. So it is done on an 
exception basis.
    But I would liken the issue of a board of funds where there 
are 100 or 150 funds, to the same question of whether boards of 
companies like Citigroup, one of the largest corporations in 
the world, can effectively oversee 500 operating subsidiaries? 
The main issue to me is how independent is the board? I would 
urge the Committee and the SEC to focus on the issue of 
independence by setting rules around, (a) what percentage of 
the board must be independent, and (b) what qualifies as 
independent? I think if you get strong independent board 
management, they will set their own agenda to do the right 
thing for the shareholders of the funds.
    Chairman Shelby. Mr. Ruder.
    Mr. Ruder. If you have 100 boards in a complex, and you 
split those boards into 10 funds each so you have 10 boards, my 
guess is that the adviser would be much more powerful dealing 
with each of these 10 boards one at a time than if it had to 
deal with, say, two boards managing 50 funds. In the later case 
those boards would be able to assert their independence with 
regard to the adviser. This is a very competitive situation 
between the adviser and the funds, and you need to give those 
directors power.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. I take it you all would agree with the 
propositions that the directors have a fiduciary duty? To whom 
do they owe the fiduciary duty?
    Ms. Hobson. Shareholders.
    Mr. Bogle. That is actually a wonderful question because of 
course they owe the fiduciary duty to the shareholders of the 
funds. But think about it a minute, Senator, the directors of 
the management company that are on that board also owe a 
fiduciary duty to the shareholders of the management company. 
There can be no question about that. How do they serve those 
two fiduciary duties? How do they observe those two standards 
of loyalty to two completely different companies? I do not 
believe it can be done.
    Chairman Shelby. You have a bifurcated situation.
    Mr. Bogle. Well, no man can serve two masters. I read that 
somewhere.
    Senator Sarbanes. We had Glassman in here yesterday who was 
very close to arguing that they owed their fiduciary duty to 
the shareholders of the management company and not the 
shareholders of the mutual funds.
    Mr. Bogle. He had better not get into this industry.
    Ms. Hobson. If I could just add one thing to that point, at 
the end of the day when the system works--and I do not in any 
way suggest that we did not have some failures--all of those 
interests are in line because the management company knows very 
clearly that the only way that they can be successful is to 
have a successful and competitive fund that has good 
performance for the shareholders, that will attract and retain 
shareholders. So in situations where there is a sense that 
people are not thinking through--``people'' meaning those of us 
who are on the management side and sitting on a board--how 
these funds affect our everyday business is not really 
realistic.
    Senator Sarbanes. That may be, but it seems to me that 
there is almost an inherent conflict of interest there because 
if you go one way, one side benefits, if you go the other way 
the other side benefits.
    Ms. Hobson. But not over any period of time because at the 
end of the day serving your shareholders well is the only way 
you are going to have a successful business in our industry. 
The investors vote with their feet. That is the one thing we 
have been able to see very clearly, be it their 401(k) plan, be 
it their IRA, their children's college account, or whatever it 
might be. When they become dissatisfied with that management 
company, with performance which has put them in more of a 
short-term performance derby, performance discussion, which I 
do agree with Mr. Bogle on, when they become dissatisfied, that 
leaves, and that hurts us as the management company.
    Senator Sarbanes. Would you say that there is a range in 
there where you as a very smart, knowledgeable investor might 
march with your feet, but most people would have to be pushed 
out to a point further along the spectrum before they would 
march with their feet?
    Ms. Hobson. That is not what the data is showing right now. 
I have read that the typical time that an investor invests in a 
mutual fund now has dropped to 3.5 years, and that is down from 
7 years in the late 1990's.
    Senator Sarbanes. Do you think that is good or bad?
    Ms. Hobson. I think that is very bad. I am a company that 
has a turtle as a logo, so our motto is slow and steady wins 
the race. I think that is very bad. We call ourselves the 
patient investors.
    Senator Sarbanes. Then something is wrong with the way the 
rewards and punishments----
    Ms. Hobson. Because we used to pay so much to get those 
customers and worked so hard to get them, you have no incentive 
to have them leave.
    Senator Sarbanes. You do not want to lose them, do you?
    Ms. Hobson. Right. The customer you have is the one that 
you want most of all.
    Senator Sarbanes. Yesterday, we had testimony on the 
standard for the fiduciary duty, referencing the Gartenberg 
decision in the Second Circuit, which established a very loose, 
in my view, standard of fiduciary duty. In fact, the court said 
to be found excessive, the trustee's fee must be so 
disproportionately large that it bears no reasonable 
relationship to the services rendered and could not have been 
the product of arm's-length bargaining. This, since then, has 
been insurmountable. No shareholder has subsequently proved a 
violation of the Gartenberg standard that was initially found 
with regard to the fiduciary duty of the adviser, but the 
courts have now extended it to the standard for directors as 
well. So there is some thinking that we need to address this 
question of what the standard of duty is, of fiduciary duty 
that the directors have. Would you all agree with that?
    Mr. Bogle. I would like to say, if I may, Senator Sarbanes, 
that I actually have been doing a little work on that and spoke 
about it this morning in a different venue, and that is the 
Gartenberg standards and almost all the standards we see have a 
terrible flaw, and that is they look at basis points, the 
number of percentage points that you charge, and you compare 
one fund charging 60 basis points and one fund charging 40. 
They say, well, 20 basis points doesn't seem to be that big of 
a difference, so there is no problem there.
    I think what we have to do--and I will just give you a 
couple of numbers--is talk about dollars and dollars as a waste 
of corporate assets. It will open the eyes of the world. I have 
looked at the California PERS, the California Public Employees 
Retirement System, and found that mutual fund shareholders 
typically pay their fund managers 100 to 150 times as much as 
CalPERS pays for the same manager providing the same service. 
The mutual funds' fees in basis points are only like 5 times 
higher, but in terms of dollars, the fees paid to the mutual 
funds are 100 to 150 times higher than what the manager charges 
an outside party with only a fraction of the assets. I believe 
that to be a complete waste of corporate assets.
    I will give you two specific examples in the mutual fund 
field. There is a large money market fund which has done us a 
wonderful favor by separating their fee for distribution and 
their fee for administration and their fee for investment 
management. You put all of that together and you can therefore 
pull out how much is actually paid for investment management. 
That money market fund, just 2 years ago, paid $257 million for 
the money managers who pick A-1, P-1, and Treasury CDs. That is 
all there is to it, A-1 paper and P-1 paper, CDs and Treasury 
bills, $257 million. If the cost of those three or four people 
at the desk is a million dollars, I would eat my hat, which I 
am not wearing today.
    Another example. There is a very large mutual fund that 
once had a very good record. It got so large that it could 
never duplicate that record again, and in the last 10 years it 
failed to do so. It became essentially an index fund. It 
correlates with the index at about .97 or .98. But its huge 
size was great for its management in that decade, and despite 
its loss to the stock market, the management was paid $3.6 
billion for investment management, $3.6 billion for managing 
what is, in fact, an index fund. Sure, they are going to tell 
you the rate is only 80 basis points, but $3.6 billion, sir, is 
$3.6 billion, and it is not right.
    Ms. Hobson. I think the issue about the difference between 
the institutional accounts and the mutual fund accounts is a 
very important issue. I address that in my testimony and in my 
written testimony as well. I think that there are some things 
that are getting lost there that are very important. We manage 
institutional accounts and we manage mutual funds, and I 
mentioned we had $5.5 billion in mutual funds, but we have lots 
of large institutional accounts around the country. There is a 
fundamental difference in what we do in those two businesses.
    In both situations we are the investment manager, and we 
are providing our investment strategy in a very clear and 
disciplined way. However, on the mutual fund side of our 
business we have to have licensed professionals talking on the 
phone to the shareholders. When working for CalSTRS, which we 
do, we do not have millions of California employees calling 
directly to Ariel about their institutional account that we 
manage for them that is several hundred million dollars. It 
just does not happen. We have to have a 24-hour website that 
gives the individuals access to their account, up-to-date 
information performance. Millions of institutional employees 
pension fund people do not call our firm and ask us for that 
same opportunity. We have to have legal accounting compliance. 
A lot of times the legal in the institutional accounts is done 
by the plan sponsor. Last but not least, we have to put 
together shareholder letters and special brochures and things 
like that to keep the customers informed. I never communicate 
directly with the pensioneer with Ford Motor Company, which is 
one of our clients.
    So there is a fundamental difference in those businesses. 
Investment management is just one piece of the business as it 
relates to the mutual fund side.
    Chairman Shelby. Chairman Ruder.
    Mr. Ruder. I have spent my life worrying about corporate 
governance in one way or the other, and I find it very hard to 
deal with the problem of what some would call excessive fees in 
this industry. I do not think that the Government should be 
addressing the fee question directly to say fees are too high 
or they should be capped. Nor do I think the problem should be 
addressed by setting fiduciary standards to say there is some 
level at which we are going to penalize the directors or the 
managers of these funds because they have not met the standard 
we have set. I do not see the fiduciary duty approach as a way 
to get to this problem, because it is an indirect way of 
setting fees in an industry which is highly complex, very 
difficult, and as Ms. Hobson has told us, in which it is very 
hard to know what the right answer is.
    I can only say that I think compliance and transparency, 
both to the investors and to the boards, and good management 
are going to give us the results that we need.
    Senator Sarbanes. Don Phillips, Managing Director of 
Morningstar, testified before us yesterday, and he said:

    At Morningstar we think it is time to eliminate soft-dollar 
payments and to eliminate or seriously reconsider the role of 
12b -1 fees in funds. Investors deserve a clear account of how 
their money is being spent. Allowing fund managers to dip into 
shareholder assets to promote asset growth or to offset 
research costs distorts the picture, makes it difficult for 
investors to align costs and benefits. Let us keep thing clean 
and clear. Costs whose benefits flow primarily to the fund's 
adviser should 
be on the adviser's tab, not passed off as investor expense. 
Moreover, distribution 
costs should be paid directly to distributors, not run through 
the fund's expense 
ratio where they tempt managers to take risks they otherwise 
would avoid. 
Pricing schemes should not compromise the integrity of the 
investment management process.

    What is your take on that?
    Mr. Ruder. Sir, if you look at my prepared statement, I 
have agreed with all of those positions. I think the adviser 
should pay distribution costs and management costs out of its 
own budget, and those costs should be very transparent to the 
board. We should eliminate soft dollars and directed brokerage 
for the use of the advisers, and as I have said, eliminate the 
protection of Section 28(e). Those are all wonderful 
suggestions.
    Senator Sarbanes. Mr. Pottruck.
    Mr. Pottruck. There are a lot of different things that 
different mutual fund companies do on behalf of their clients. 
The key, to my way of thinking, is that there is effective 
disclosure and that on at least an annual if not quarterly 
basis, mutual funds must disclose in great detail where money 
goes and what money pays for in these different fund complexes.
    We are in the business of institutional brokerage so some 
of our research is paid for with soft dollars. However, having 
said that, I think a study of that practice is very much in 
order. I think that mutual fund advisers should be able to buy 
research and charge that to the fund as a separate line item 
and a separate expense. It is on behalf of the funds. It helps 
the fund shareholders when they have more research information. 
Paying for it with the brokerage commissions is probably the 
least good way of doing that. It should be broken out and be 
more specific so we can see if it seems to be excessive. It 
gives investors more information.
    Effective disclosure will be the simplest tool to help 
investors, rather than lots of rules and regulations on exactly 
how much is a reasonable level of fees for different kinds of 
things. The intensity of competition in this industry should 
not be underestimated. I think many people underestimate how 
intense the competition is. We worry about the problems of 
investors who move on, the turnover. Indeed, the time duration 
of people holding onto a mutual fund has come down. All of that 
argues for the intense competition in our industry. If you do 
not perform for the client, people vote with their feet. They 
vote with their wallets every day.
    Ms. Hobson. The only thing I would add to the discussion 
is--and Don Phillips' quote I think is appropriate, that 
pricing schemes should not compromise the integrity of the 
investment management process. No investment manager wants 
their performance compromised by high fees, I can tell you 
that, because typically they are very competitive people who 
want to win and show up as being one of the high performers or 
the best performers.
    But I do think one thing that is missing there is that the 
investment manager, in many cases, firms like Ariel, we are 
paying for part of the distribution out of our pocket. Our 
12b -1 fee on our funds is 0.25 percent. However, Schwab and 
Fidelity charge us 40 basis points, 0.40 percent. So in those 
situations, in order to get the access to distribution that we 
think is very valuable and valid, we have to pay out of our 
pocket the difference.
    So this idea that it is totally being passed on to the 
shareholder just based upon the way the costs work is not 
necessarily the case. In some of the 401(k) situations that we 
are in, if we are in a 401(k) plan where the provider is a 
Merrill Lynch or a Vanguard or others, in order to have another 
fund come in, the provider, the company that has the whole kit 
and caboodle to the plan, the administration, enrolling the 
employees, providing the investment management options, in 
those situations sometimes they will make the barrier for us to 
come in as high as 50 basis points just to be on the list 
alongside of the other mutual funds. So, we would say, okay, we 
have to pay for that right, but if that means--which did happen 
for us last year--we can now be on the Wal-Mart 401(k) plan 
list, which we are, and 1.4 million employees now have access 
to Ariel through their relationship with Merrill Lynch that 
they have at Wal-Mart. We think that that is not only good for 
us, as people are working hard to grow our business, but it is 
also good for the shareholders as the assets go up and the 
expenses on the funds go down, as we have been able to 
demonstrate.
    Senator Sarbanes. Mr. Bogle.
    Mr. Bogle. Nothing makes it more clear that we are in a 
marketing business, an asset gathering business, than when we 
hear phrases like ``point of sale'' and ``shelf space'' and all 
of that, and that is fine as far as it goes. Every industry 
needs some of that. But all those costs, which are staggering, 
are a dead weight on the returns that are earned by mutual fund 
shareholders. There is no way around it. And research does not 
bail you out. It is not at all clear that research has any 
value at all. How could it have any value when everybody is 
sharing it together and the stock you buy with Merrill Lynch's 
research is the stock someone else sold because of Merrill 
Lynch's research? If there was ever a zero-sum game, that is 
it, except for Merrill Lynch, who does very well because people 
buy this research with their shareholders' money, and, of 
course, everything is very cheap when you are buying it with 
other people's money.
    It is all part of this idea that we just cannot simply get 
through our heads that mutual funds lose to the market by the 
amount of their cost year after year, and those costs are 
something like $125 billion. There is no way around that 
equation because we cannot all be smarter than all the rest of 
us. We really should be thinking much more about simplifying 
the business and taking some--I would not argue all--of the 
marketing costs out of the business, and certainly getting rid 
of soft dollars is something that is going to have to happen. 
It is going to be a very difficult adjustment for this industry 
and for Wall Street, but it is going to happen. I mean if you 
want to get on the right side of history, do away with it 
gradually. And 12b -1 the same thing. It can be held together 
with bailing wire and thumbtacks for a while but not forever. 
We know where it is all going to come out because the investor 
finally will be served.
    The problem with this is that time is money, and huge money 
when you talk about compounding, and the longer we let these 
ills go on the more we disserve the American investor, in my 
judgment.
    Ms. Hobson. I think it is easy to have that perspective 
when you have $750 billion in assets and terms like 
``marketing'' and ``shelf space.'' You just feel differently 
about them when you are like the 370 mutual fund companies that 
are like Ariel that have $5 billion or less in assets. It is 
just a different discussion.
    Chairman Shelby. We appreciate all of you here today. It 
has been a lively discussion, distinguished panel. We have a 
vote on the floor of the Senate. Thank you for the 
contributions you have made today. We will continue these 
hearings to see what we need to do from a legislative 
standpoint. Thank you.
    The hearing is adjourned.
    [Whereupon, at 4:12 p.m., the hearing was adjourned.]
    [Prepared statements and additional material supplied for 
the record follow:]

                  PREPARED STATEMENT OF DAVID S. RUDER
        Former Chairman, U.S. Securities and Exchange Commission
              William W. Gurley Memorial Professor of Law
                 Northwestern University School of Law
                 Chairman, Mutual Fund Directors Forum
                           February 26, 2004

Introduction and Background
    Thank you for asking me to testify on the important question of 
mutual fund reform. My views are my own and not those of any group or 
entity. I am currently a Professor of Law at Northwestern University 
School of Law, where I teach securities law. I was Chairman of the U.S. 
Securities and Exchange Commission from 1987 to 1989 and was a member 
of the Board of Governors of the National Association of Securities 
Dealers, Inc. from 1990 to 1993. While a member of the NASD Board, I 
was chairman of a committee that reviewed securities industry practices 
in and promulgated a report on the topic ``Inducements for Order 
Flow,'' \1\ sometimes known as ``payment for order flow.''
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    \1\ National Association of Securities Dealers, Inc. (1994).
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    Currently, I serve as Chairman of the Mutual Fund Directors Forum, 
a not-for-profit corporation, whose mission is to improve fund 
governance by promoting the development of vigilant and well-informed 
directors. We do so by offering continuing education programs to 
independent directors, providing opportunities for independent 
directors to discuss matters of common interest, and serving as 
advocates on behalf of independent directors.
    The Forum is a membership corporation whose members are all 
independent directors of mutual funds. Their dues are paid by their funds, but 
their memberships are individual. The Forum is entirely independent of the mutual fund advisory industry.
    In November 2003, the Securities and Exchange Commission Chairman 
William H. Donaldson asked the Forum to develop guidance and best 
practices in five areas where directors oversight and decisions are 
critical for the protection of fund shareholders. In our view, Chairman 
Donaldson's choice of the Forum to develop guidance and best practices 
in critical mutual fund areas demonstrates the SEC's confidence in the 
Forum's capability and independence.
    Finally, by way of background, I am currently serving as the 
Independent Compliance Consultant for the Strong Financial Corporation, 
which manages approximately $37 billion in assets and is the adviser to 
more than 50 mutual funds. My task is to recommend compliance 
procedures at Strong, including the areas of market timing, late 
trading, portfolio valuation, and disclosure of portfolio holdings.

The Role of the Mutual Fund
    A mutual fund provides a vehicle through which the pooled resources 
of investors can be managed by professional money managers (investment 
advisers or advisers). Though mutual funds' investors are able to 
achieve the benefits of diversification and to seek above average 
returns by investing in funds with special characteristics, such as 
growth funds, income funds, or sector funds.
    In addition to offering diversification and special investment 
vehicles, mutual funds provide other advantages to investors. 
Individual investors are unlikely to be able to gather the information 
necessary to make good investment decisions, and they do not have the 
experience or judgment enabling them to outperform professional 
managers. Mutual funds provide them with the opportunity to compete 
with the professionals.
    Equally important, the discipline of regular investing in mutual 
funds, with an expectation of long-term investment profit, creates 
saving habits that are beneficial to investors.

Directors as Monitors
    When a mutual fund investor entrusts funds to an investment 
adviser, conflicts inevitably arise. The adviser seeks to maximize their profits, while the fund shareholders want the adviser to charge the lowest fees possible. Conflicts also exist because the adviser who has control over investors' money may engage in transactions with the fund that are to the advantage of the adviser and to the detriment of investors.
    The Investment Company Act of 1940, as administered by the SEC, 
recognizes these conflicts by laws and rules designed to prevent 
conflicts of interest and by placing special governance 
responsibilities on mutual fund boards of directors.
    The most important approach to increasing the protection of mutual 
fund investors is to enhance the power of independent fund directors 
and to motivate those directors to perform their duties responsibly.
The Unique Form of Mutual Fund Organization
    As presently constituted, the mutual fund industry has a unique 
form of organization. In an industrial corporation, the primary 
function of the board of directors is to supervise the management of 
the corporation. The board has the ability to hire and fire the 
corporate chief executive officer, as well as other officers, and has 
the power to set corporate policy. The board has the power to tell the 
corporate officers how to manage the business.
    In contrast, in the typical mutual fund, the board of directors is 
not dealing with a CEO or other officers charged with management of the 
corporation, but with an entity--a mutual fund adviser whose 
obligations to the fund are determined by contract. Typically the fund 
board does not have a separate office or a staff. The CEO of the fund 
will be an employee of the adviser, and the CEO's allegiance typically 
will lie primarily with the adviser.
    Given the separation between the fund board and the adviser, the 
important question to be asked is: What organization and powers will 
best assist a fund board in protecting the interests of the fund and 
its shareholders?
    I will examine this question, and will also examine some specific 
current areas of concern in the mutual fund area.
    In deciding what corporate governance structure is desirable, the 
Congress and the SEC need to understand that for the most part fund 
directors are well-informed, dedicated, and active in their supervision 
of the adviser. Any reform in the mutual fund governance area should be 
aimed toward improving the powers of fund directors to perform their 
supervisory functions.
    To say that most fund directors are well-informed, dedicated, and 
active does not mean that all fund directors share these qualities. 
Historically mutual funds have been created by investment advisers that 
are extremely knowledgeable about the securities industry and the 
intricacies of mutual fund management. In many cases, the independent 
fund directors have been chosen by the adviser. Some fund directors 
charged with supervising the adviser may at times be unwilling to 
challenge an adviser who has the advantage of superior knowledge and 
resources. The SEC has stated:

          Our concern is that in many fund groups the fund adviser 
        exerts a dominant influence over the board. Because of its 
        monopoly over information about the fund and its frequent 
        ability to control the board's agenda, the adviser is in a 
        position to attempt to impede the directors from exercising 
        their oversight rule. In some cases, boards may have simply 
        abdicated their responsibilities, or failed to ask the tough 
        questions of advisers; in other cases, boards may have lacked 
        the information or organizational structure necessary to play 
        their proper role.\2\
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    \2\ Proposed Rule: Investment Company Governance, Rel. IC-26323 
(January 15, 2003) p. 3.

    There are some directors who are not meeting high standards as 
supervisors of fund activities, because they are new to a complex 
industry, because they have not taken the time to become fully 
informed, or because they are friendly to the adviser. Some directors 
do not meet supervisory standards because they are not sufficiently 
assertive in carrying out their duties.
    Our primary tasks at the Mutual Fund Directors Forum are to assist 
independent directors to become better educated and to be more active 
in overseeing management of their funds by advisers.
    In assessing director performance, it is important to recognize 
that the mutual fund industry is complex. Mutual fund boards are 
ultimately responsible for supervising many fund functions, including:

 Advisory fees and fees of other entities providing services;
 Compliance with representations made in documents distributed 
    to prospective 
    investors and fund shareholders;
 Performance of the fund portfolio;
 Quality and cost of portfolio executions;
 The manner and cost of the distribution of fund shares;
 The custody of the fund's securities; and
 Administration of individual investor accounts.

    These functions will be carried out by the adviser and by other 
entities, sometimes collectively called ``service providers.'' The term 
``service providers'' includes not only advisers and sub-advisers who 
manage fund portfolios, but also underwriters who sell fund shares, 
administrators of customer accounts, and transfer agents who record 
transfers of shares in customer accounts. Custodians who hold fund 
portfolio securities both in the United States and abroad, fund 
accountants, and third-party pricing services may also be considered to 
be ``service providers.'' \3\
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    \3\ See Note 28 in SEC Releases IA-2204 and IC-26299 (December 17, 
2003).
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    In order to monitor the adviser, the fund directors need to 
understand the fund's operations, have the power to assure that the 
fund operations are being carried out honestly and efficiently, and 
have the will to exercise these powers for the protections of 
shareholders. They must bargain with the adviser regarding the costs of 
its services and regarding the cost of arrangements made by the adviser 
to have others perform services.

An Overview of Needed Regulation
    Recent events have revealed that there are serious problems in the 
mutual fund industry. Advisers have facilitated late trading, market 
timing, and improper disclosure of mutual fund portfolio holdings. 
Advisers have used fund portfolio execution revenues and their own 
resources to pay brokers to advocate purchase of funds 
managed by the adviser, without adequate disclosure to investors.
    The recent problems are being addressed by both State regulatory 
authorities and the Securities and Exchange Commission. The SEC has 
been charged by Congress with regulating the complicated investment 
company industry since 1940, and it has performed that regulation well, 
given its limited resources. Nonetheless, some of the recent scandals 
have caught the Commission by surprise. In reaction, the Commission has 
recently been vigorous in its enforcement activities, has imposed 
numerous reforms through new rules governing the activities of funds 
and advisers, and is preparing additional rules.\4\
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    \4\ See, e.g., SEC Proposed Rule: Confirmation Requirements and 
Point of Sale Disclosure Requirements for Transactions in Certain 
Mutual Funds and Other Securities, and Other Confirmation Requirement 
Amendments, and Amendments to the Registration Form for Mutual Funds. 
Releases 33-8358; 34-49148; IC-26341 (January 29, 2004).
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    As noted earlier, the mutual fund industry is highly complex. 
Detailed regulation is best left to the discretion of the agency that 
has expertise regarding the mutual fund industry and can regulate in a 
manner that will reflect changing industry patterns and technology in 
both the mutual fund industry and in the securities industry generally. 
I believe Congress should be very cautious in addressing mutual fund 
reform by legislation. I urge Congress to recognize that for the most 
part needed regulatory steps are being taken by the SEC through its 
rulemaking and enforcement powers under the Investment Company Act, the 
Investment Advisers Act, the Securities Act, and the Securities and 
Exchange Act.

Corporate Governance Reforms
    The Mutual Fund Directors Forum recently conducted a policy 
conference on the Critical Issues for Mutual Fund Directors. At that 
conference it was my pleasure to listen to numerous independent 
directors express their desire to increase their oversight of the 
advisers. My recommendations for reform are designed to increase the 
oversight powers of fund directors and to help independent directors be 
more assertive when they deal with fund advisers.

Independence
    The first criteria for exercise of independent oversight is that a 
sufficient number of directors be independent of the adviser.
    1. At least three-fourths of each fund board of directors should be 
independent of the adviser. The SEC has proposed this requirement.\5\
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    \5\ Proposed Rule: Investment Company Governance, Rel. IC-26323 
(January 15, 2003).
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    2. Director independence standards should be tightened by the SEC. 
The Investment Company Act's definition of ``interested person'' does 
not sufficiently address problems of indirect relationships, such as 
former employment with the adviser, family relationships, and other 
matters.

An Independent Chairman of the Fund Board
    The chairman of the board of each fund should be independent of the 
adviser. An independent chairman can control the board agenda, can 
control the conduct of board meetings so that important discussions are 
not truncated, and can provide important and direct liaison with the 
adviser between board meetings. The SEC has proposed this 
requirement.\6\
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    \6\ Id.
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An Independent Committee Structure
    At the urging of the SEC, the New York Stock Exchange and the 
Nasdaq Stock Market now require that the Board Nominating, 
Compensation, and Audit Committees be composed entirely of independent 
directors. Similar committees and other committees composed entirely of 
independent directors are important to assuring good fund governance. 
The SEC should urge or perhaps mandate that various committees exist, 
taking into account that funds are different in size and objectives. 
Some fund boards, particularly in smaller funds, may choose to deal 
with some matters solely at the board level.
    I recommend that fund boards in the larger complexes function with 
the following committees.

A Nominating Committee
    A Nominating Committee composed entirely of independent directors 
should have exclusive power to nominate directors, thereby helping to 
assure that new independent directors of each fund will not be chosen 
by the adviser.

An Audit Committee
    An Audit Committee composed entirely of independent directors 
should have responsibility to oversee the audit function and the power 
to hire, terminate, and set the compensation of the auditor.

A Compliance Committee
    A fund board may wish to create a Compliance Committee composed 
entirely of independent directors. The Committee should have the 
primary responsibility for overseeing the compliance policies and 
procedures of advisers and service providers, and should be responsible 
for overseeing the content of their ethics codes. The Committee should 
monitor the fund's compliance functions, including the activities of 
the chief compliance officer.

An Investment Committee
    Although practices in each fund complex may differ, some funds may 
choose to create an Investment Committee composed entirely of 
independent directors, charged with the review of investment 
performance and fund fees and costs.

Other Committees
    Other committees, such as a valuation committee, should be 
established as deemed desirable by the fund board.

Independent Counsel and Staff
    Since most mutual funds are ``externally'' managed by the adviser, 
it is important that the board of directors have independent counsel 
and staff.

Independent Counsel
    In 2001, the SEC required any legal counsel to the independent 
directors of funds relying on certain exemptions to be independent from 
the adviser.\7\ As a result, many independent fund directors now have 
legal counsel who can provide independent advice to the fund board 
regarding board governance matters and the entire range of fund 
operations. A fund board should be sure that its counsel is, in fact, 
independent and is acting independently. The SEC should require that 
the independent directors have an independent legal counsel. In the 
absence of SEC action, all independent directors should strongly 
consider retaining their own independent counsel.
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    \7\ Role of Independent Directors of Investment Companies, Rel. IC-
24816 (January 2, 2001).
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Independent Staff
    The Sarbanes-Oxley Act mandated that the Audit Committee of each 
company registered with the SEC have the power to hire independent 
staff. The stock exchanges have recommended that the nomination and 
compensation committees be empowered to hire independent staffs. Mutual 
fund boards should be able to hire an independent staff on a permanent 
basis or on an as needed basis. They should be able to hire independent 
advisers to advise the board in areas such as fund fees and costs, the 
quality of portfolio executions, and the valuation of fund securities.

A Chief Compliance Officer
    Each investment adviser should be required to hire a chief 
compliance officer (CCO), charged with supervising the compliance 
functions of the adviser and its service providers. The CCO should 
report to the fund board, as well as to the adviser. The fund boards 
should have the right to hire, fire, and set the compensation for the 
chief compliance officer. Mutual fund advisers typically provide 
investment advice not only to mutual funds, but also to other clients, 
such as high net worth individuals, 401(k) retirement plan advisers, 
and institutions such as pension plan sponsors. The adviser's chief 
compliance officer should report to the fund board regarding adviser 
compliance in all aspects of the adviser's operations that are likely 
to impact the fund's operations, including the adviser's supervision of 
sub-advisers and service providers. The chief compliance officer should 
be well paid, have high ranking officer status within the adviser, and 
have his or her own staff.
    My recommendations are not new. The SEC has adopted rules requiring 
chief compliance officers at both advisers and funds.\8\ Rules under 
the Investment Advisers Act will require each adviser to have a chief 
compliance officer, meeting the criteria I have set forth. Similar 
rules under the Investment Company Act will require mutual funds to 
have a chief compliance officer. The SEC's new Investment Company Act 
rule adds important additional levels of detail:
---------------------------------------------------------------------------
    \8\ Investment Advisers Act Rule 206(4)-7 and Investment Company 
Act Rule 38a-1. Final Rule: Compliance Programs of Investment Companies 
and Investment Advisers, Rel. IA-2204; Rel. IC-26299 (December 17, 
2003).

 The chief compliance officer must annually provide a written 
    report to the fund board regarding operation of the fund's policies 
    and procedures, as well as those of the fund's service providers.
 The chief compliance officer must meet with the fund board in 
    executive session as least once each year.
 The chief compliance officer must oversee the fund's service 
    providers, including their compliance officers, and should keep the 
    fund board aware of compliance matters and needed changes at the 
    service providers.\9\
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    \9\ Rule 38a-1, Id.
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Policies and Procedures
    Advisers and funds should adopt and implement written compliance 
policies and procedures. The SEC's recently adopted Investment Advisers 
Act rule \10\ will require the adviser to adopt and implement written 
policies and procedures reasonably designed to prevent violation of the 
Advisers Act by the adviser. The rule specifies a number of areas that 
should be addressed, including portfolio management, trading practices, 
proprietary trading, the accuracy of disclosures, the safeguarding of 
client assets, and portfolio valuation procedures.
---------------------------------------------------------------------------
    \10\ Investment Advisers Act Rule 206(4)-7, Id.
---------------------------------------------------------------------------
    The SEC has also adopted a similar rule under the Investment 
Company Act \11\ requiring fund boards to adopt written policies and 
procedures reasonably designed to prevent the funds from violating the 
Federal securities laws. As with the adviser rule, the Investment 
Company Act rule also specifies a number of areas that must be 
addressed. In the corporate governance area, the SEC's investment 
company rules require funds to have policies and procedures designed to 
oversee compliance by the adviser and the service providers, including 
principal underwriters, administrators of shareholder accounts and 
transfer agents. The rule specifies areas that should be addressed, 
including the areas identified for fund advisers, as well as
pricing of portfolio securities and fund shares, processing of fund 
shares, and compliance with fund governance requirements. The latter requirements include board approval of the fund's advisory contracts, underwriting agreements, and distribution plans.
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    \11\ Investment Company Act Rule 270.38a-1, Id.
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Certification
    The Sarbanes-Oxley Act and SEC rules now require chief executive 
officers and chief financial officers of industrial corporations to 
certify in disclosure documents that the issuer's financial statement 
fairly present the company's financial condition and that the company's 
internal controls and procedures are effective.
    Some have suggested that fund directors or the fund board chairman 
be required to certify to shareholders regarding oversight activities. 
I do not believe that such a certification requirement is needed or 
advisable. Such a requirement is not needed because fund board's are 
increasingly becoming more active in supervising advisers and service 
providers and will be even more active under new SEC rules. A 
certification requirement for fund directors is not advisable because 
it would deter qualified individuals from serving as directors.

A Mutual Fund Oversight Board
    Some have suggested a mutual fund oversight board be established 
for the purpose of overseeing the mutual fund industry in a manner 
similar to the oversight regarding the activities of accountants now 
being performed by the Public Company Accounting Oversight Board. I do 
not believe such a mutual fund oversight board is necessary. The SEC 
has full authority to exercise such oversight, is increasing its 
oversight and rulemaking activities, and has recently been given 
additional resources that will help it to perform its oversight 
functions.

Areas Needing Attention
    In evaluating possible legislation Congress should be aware of the 
complexity of the issues faced by mutual fund directors in monitoring 
the activities of advisers and the funds service providers. I will 
address several areas of particular current concern.

Advisory Fees
    As noted earlier, a fundamental conflict exists between the mutual 
fund directors, who should be seeking the lowest fees from advisers 
consistent with good performance and the adviser, who will be seeking 
the highest profits for its services.
    In reviewing advisory fees, the fund board should consider 
portfolio performance, the quality of the adviser oversight of service 
providers, the levels of volume breakpoints that provide reduced fees 
to the funds based upon fund size, compensation received by the adviser 
through its affiliates or from directing portfolio brokerage, and other 
factors.
    Criticisms of mutual fund fee levels have been made by a number of 
well-informed persons. These critics contend that mutual fund boards 
have too readily acceded to management's recommendations. They also 
challenge fee levels in index funds and some debt funds that do not 
require judgments regarding the likely future value of particular 
securities.
    Accepting the proposition that fund directors can be more active in 
attempting to reduce advisory fees, I believe the proper way to achieve 
better control over advisory fees is to improve the corporate 
governance environment for independent directors, to increase director 
education as we are attempting to do through the Mutual Fund Directors 
Forum, to encourage directors to be more assertive and energetic in 
challenging adviser recommendations, and to mandate increased 
disclosure regarding the fee setting process.\12\
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    \12\ See SEC Proposed Rule: Disclosure Regarding Approval of 
Investment Advisory Contracts by Directors of Investment Companies. 
Rel. IC-26350 (February 11, 2004).
---------------------------------------------------------------------------
    I strongly believe that neither the U.S. Government nor State 
governments should attempt to set mutual fund advisory fees. Government 
price setting is inadvisable and wrong in the exceedingly complex and 
competitive mutual fund industry.

Best Execution and Directed Brokerage
    One difficult task for a fund board is to assure that the fund is 
receiving best execution in fund portfolio transactions. All fund 
boards are concerned with execution practices and will normally insist 
that the adviser demonstrate that it is achieving best execution in 
portfolio transactions. The adviser will present details and 
comparisons regarding best execution to fund boards on a regular basis. 
Statistical analysis by third-party consultants is sometimes provided.
    Although best execution is a goal, the definition of best execution 
is highly subjective. The definition is frequently said to mean the 
achievement of the most favorable price under the circumstances, 
including commissions, market conditions, and the desire for prompt 
execution.
    Mutual fund portfolio transactions almost always involve 
transactions in large numbers of shares. In highly liquid markets, some 
large transactions can be accomplished without causing market price 
movements. However, mutual fund transactions are frequently so large in 
size that the execution must be accomplished
confidentially and carefully so that the transaction does not unduly 
affect price. Some of the more difficult transactions are conducted by 
brokers who are highly skilled at executing large size transactions 
without revealing the size of the order or by electronic communications 
networks that have the ability to use computers to execute orders in 
stages without revealing size.
    Substantial competition exists among executing brokers for the 
right to execute transactions. These brokers will be compensated based 
primarily upon a per share commission charge, which now is said to vary 
between approximately 3 and 6 cents per share for large transactions.
    The competitive environment for portfolio execution commissions has 
caused many executing brokers to offer cash payments or equivalent 
payments in kind for the execution privilege. These payments are 
sometimes called ``directed brokerage'' payments and are sometimes used 
to pay for the costs of adviser research, to pay distribution costs 
incurred by advisers for fund shares, and to pay service providers for 
costs owed to entities providing services for funds.
    I believe that directed brokerage is the property of the funds, who 
should receive the benefit of these payments. I believe payment to 
service providers on behalf of the funds meets this objective, but that 
payments that benefit advisers, such as soft-dollar payments and 
payment for distribution costs do not, unless these payments are 
quantified and utilized by fund boards to reduce advisory fees. I 
believe the SEC should adopt a rule requiring all directed brokerage to 
be used for the benefit of funds, not the benefit of fund advisers.

Soft Dollars
    Directed brokerage payments used to pay research or brokerage costs 
of fund advisers are called ``soft dollars.'' Section 28(e) of the 
Securities and Exchange Act protects the adviser against liability or 
administrative action for payment of an excess amount of commissions 
for effecting a securities transaction if the adviser ``determined in 
good faith that such amount of commission was reasonable in relation to 
the value of the brokerage or research services received'' by the 
adviser.\13\
---------------------------------------------------------------------------
    \13\ Securities and Exchange Act, Section 28(e).
---------------------------------------------------------------------------
    The value of research services received for soft dollars is often 
difficult to measure, so that soft-dollar payments often lack 
transparency. Additionally, as soft-dollar practices have developed, 
the SEC has by release expanded the allowable use of soft dollars to 
pay for services that seem to me to be far removed from research or 
brokerage.\14\ For instance, services sometimes include costs of 
computers. Provision of these and other services often creates 
recordkeeping problems because of the need to separate services 
applicable to research and brokerage from services that are not 
applicable to these functions. It is also important to monitor soft-
dollar payments to see that the funds generating commission dollars are 
receiving appropriate credit. Even if allocated properly, the amount of 
soft-dollar payments made to the adviser should be revealed to and 
approved by the fund directors.
---------------------------------------------------------------------------
    \14\ SEC Rel. 34-23170 (April 23, 1986).
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    I believe that protection given to soft-dollar payments by Section 
28(e) is wrong and creates unnecessary complications. Congress should 
repeal Section 28(e), and the SEC should deal with soft-dollar payments 
by rule.

Use of Directed Brokerage for Distribution
    Recently the SEC brought and settled administrative proceedings 
with Morgan Stanley DW, Inc.\15\ based upon alleged violations of SEC 
rules by Morgan Stanley when it accepted payments from mutual fund 
advisers in return for rewarding its sales personnel for selling shares 
of funds sponsored by those advisers rather than the shares of funds 
sponsored by nonpaying advisers. The advisers' motive in paying Morgan 
Stanley was to increase the amount of assets under management and 
therefore their advisory fees. The Commission asserted that by 
accepting these payments for ``shelf space'' without disclosing them to 
investors Morgan Stanley violated SEC antifraud rules prohibiting 
misrepresentations to investors.
---------------------------------------------------------------------------
    \15\ In the Matter of Morgan Stanley DW, Inc. Securities and 
Exchange Act Rel. 48789 (November 17, 2003).
---------------------------------------------------------------------------
    The Commission's action also noted that a portion of the payments 
to Morgan Stanley amounted to the use of directed brokerage by the 
investment advisers to pay for distribution costs. This practice of 
using revenues from fund brokerage to pay third parties for the benefit 
of the adviser is similar to the advisers' receipt of soft dollars from 
directed brokerage. Unless the use of directed brokerage by the adviser 
to pay for the distribution of fund shares is revealed to and approved 
by fund directors, this practice is unacceptable. Adviser acceptance of 
directed brokerage to pay for its distribution costs is not protected 
by Section 28(e).
    I believe the Commission should adopt a rule requiring the adviser 
to use all directed brokerage revenues for the benefit of the funds. It 
may be that if the adviser chooses to forgo all directed brokerage 
revenue, best execution of fund shares will be improved.

Rule 12b -1
    In 1980, the Commission promulgated Investment Company Act Rule 
12b -1 \16\ which permits mutual fund assets to be used to pay for the 
distribution of fund shares. The theory underlying the rule is that the 
use of fund assets to pay for distribution is justified because as 
assets increase, advisory fees as a percentage of assets will decrease. 
The assertion is that when certain levels, called break points, are 
reached, advisory fee levels will decrease.
---------------------------------------------------------------------------
    \16\ SEC Inv. Co. Act Rel. 16431 (1980).
---------------------------------------------------------------------------
    Rule 12b -1 requires fund board approval for the use of fund assets 
to pay for fund distribution costs. Some have suggested that at the 
very least the use of directed brokerage revenues to pay for fund 
distribution costs should be included as a
12b -1 fee, which must be approved by the fund directors. My view is 
that the advisers should pay all of the costs of fund distribution and, 
therefore, Rule 12b -1 should be repealed by the SEC. If that rule is 
not repealed, use of directed brokerage to pay for fund distribution 
costs should be included as part of 12b -1 fees, subject to approval by 
the fund directors.
    With regard to inclusion of directed brokerage in 12b -1 fees, as 
with other aspects of directed brokerage revenues, I believe Congress 
should refrain from legislation, and await SEC action.

Late Trading and Market Timing
    New York Attorney General Spitzer's investigation involving the 
Canary Hedge Fund and subsequent SEC inquires and actions have raised 
important concerns in the areas of late trading and market timing.

Late Trading
    Late trading is the practice by which a fund allows orders to buy 
or sell fund shares to be placed after the time at which the fund 
determines its net asset value (NAV), which in turn determines the per 
share net asset value used to price purchases and sales of fund shares. 
Late trading allows an investor to buy or sell shares at prices that 
will differ from the next day's prices to the advantage of the 
investor. The investor may profit if it is in possession of information 
that will cause the NAV to change on the following day. The practice of 
late trading is unlawful under SEC Investment Company Act Rule 22c -1, 
which prohibits an investment company from selling or redeeming fund 
securities except at a price based on the current net asset value of 
the security next computed after the order is placed. Late trading has 
the effect of allowing securities to be valued at a NAV computed before 
the order is placed.
    Late trading activities have been aided by fund transfer agent 
practices allowing submission of orders by third-party fund 
distributors after the NAV pricing time. The distributors are usually 
brokerage firms that receive customer fund orders during the day and 
submit so called omnibus orders aggregating smaller customer orders 
into large buy and sell orders. Industry practice has been to allow 
these orders to be submitted as late as 7 p.m. or 9 p.m. Eastern time, 
or even later. Use of these omnibus accounts raises the possibility 
that the orders were actually received after the NAV pricing time in 
violation of the late trading prohibitions.
    The SEC has attempted to meet the late submission problem by 
proposing a ``hard close'' of 4 p.m. Eastern time, requiring that all 
purchase and redemption orders be received by the fund no later than 
the time the fund prices it securities.\17\ Since late trading is 
already illegal and since the SEC is addressing late trading practices, 
no legislation is needed.
---------------------------------------------------------------------------
    \17\ Proposed Rule: Amendments to Rules Governing Pricing of Mutual 
Fund Shares. Release IC-26288 (December 11, 2003).
---------------------------------------------------------------------------
Market Timing
    Market timing is the practice of engaging in short-term trading of 
fund shares in order to take advantage of situations in which the 
fund's net asset values will not reflect the real value of the fund's 
shares. This practice allows the market timers to take advantage of 
information learned prior to the time at which the fund values its 
assets at the end of the day, but which will not be reflected in the 
NAV. The most frequently used illustration of this practice involves 
the pricing of foreign securities when foreign markets have closed many 
hours before NAV pricing. If events occur during the intervening period 
that will be likely to cause changes in the prices of the foreign 
securities, the market timer can buy or sell the fund shares on the day 
the events occur, taking advantage of the fact that the fund shares 
will not reflect the changed values of the foreign securities. Market 
timing is not illegal, but a fund allowing market timing to exist may 
be violating representations in the fund's prospectus that market 
timing will not be allowed.
    Both late trading and market timing activities injure the funds and 
their investors because the funds lose money to the arbitrage 
activities of the traders and because the funds often will have to 
retain additional cash in order to be able to pay these traders when 
they sell their shares.
    The SEC has urged funds to enhance their compliance procedures 
regarding market timing, and is pursuing market timing enforcement 
actions.\18\ It has proposed amendments to the registration form used 
by mutual funds to register securities for sale that would require 
funds to disclose risks to them of market timing and to disclose fund 
policies and procedures designed to prevent market timing.\19\ It has 
also recently required funds to adopt policies and procedures dealing 
with market timing.\20\ Some funds are attempting to meet market timing 
problems by adopting special valuation procedures for foreign 
securities, and the SEC has proposed that funds disclose their fair 
value procedures.\21\ No legislation is needed in the market timing 
area at this time. The SEC should adopt its proposed disclosure rules 
and should consider rules requiring third-party distributors to monitor 
market timing practices.
---------------------------------------------------------------------------
    \18\ E.g., In the matter of Putnam Investment Management, LLC. 
Investment Advisers Act Rel. 2192 (November 13, 2003).
    \19\ Proposed Rule: Disclosure Regarding Market Timing and 
Selective Disclosure of Portfolio Holdings, Release 33-8343, IC-26287 
(December 11, 2003).
    \20\ Final Rule: Compliance Programs of Investment Companies and 
Investment Advisers. Rel. IC-26299 (December 17, 2003).
    \21\ Proposed Rule: Disclosure Regarding Market Timing and 
Selective Disclosures of Portfolio Holdings. Rel. 33-8343, IC-26287 
(December 11, 2003).
---------------------------------------------------------------------------
Prospectus Disclosures
    Sales of fund shares to investors are regulated by the Securities 
Act of 1933, which mandates disclosures when selling securities to 
investors. Since sales of mutual fund shares are continually being 
made, the SEC allows the fund prospectuses to be amended on a 
continuous basis, so that they are always current.
    Prospectus disclosures must be complete and truthful. By describing 
the types of portfolio securities that will be purchased by the fund, 
the use of leverage, the methods of distributions of fund shares, and 
costs to investors the funds are essentially making a series of 
promises to investors regarding fund operations.
    Oversight of the adviser by the fund directors includes oversight 
of the adviser's responsibility to see that its activities conform to 
the representations made in each fund's prospectus. The SEC's recent 
rules requiring compliance policies and procedures and emphasizing the 
enhanced role of the chief compliance officer will provide the fund 
boards with tools for meeting these responsibilities.
Conclusion
    In conclusion, I believe that Congress should rely upon the 
Securities and Exchange Commission to remedy problems in the mutual 
fund industry, particularly by measures designed to enhance the power 
of independent fund directors. Congress should not take any legislative 
action, except for repealing Section 28(e) of the Securities and 
Exchange Act.

                               ----------
                PREPARED STATEMENT OF DAVID S. POTTRUCK
        Chief Executive Officer, The Charles Schwab Corporation
                           February 26, 2004

    Chairman Shelby, Ranking Member Sarbanes, distinguished Members of 
the Committee: My name is David S. Pottruck, and I am the Chief 
Executive Officer of The Charles Schwab Corporation, one of the 
Nation's largest financial services firms. Schwab was founded more than 
30 years ago as a pioneer in discount brokerage. Today, we are a full-
service firm serving more than 8 million client accounts with nearly $1 
trillion in client assets. Through Schwab Corporate Services, we serve 
more than 2 million 401(k) plan investors.
    I appreciate the opportunity to provide my thoughts this morning on 
the vitally-needed reforms to the mutual fund industry. Let me begin by 
assuring you that we stand ready to help the Committee move forward in 
any way we can. We at Schwab share the Committee's disappointment over 
the recent events that have propelled mutual funds to the front pages. 
We fully support many of the reforms already undertaken by the SEC. But 
we also believe that more can and should be done. I applaud this 
Committee's efforts to put the interests of investors--not insiders--
first.

Introduction--The Importance of Mutual Fund Supermarkets
    Schwab is certainly no stranger to the needs of mutual fund 
investors--mutual funds have long been at the core of our business. We 
launched the first mutual fund supermarket to focus on no-load funds 
some 20 years ago, and in 1992 we launched the first no-load, no-
transaction fee supermarket, OneSource'. Today, Schwab 
clients can choose from among nearly 5,000 mutual funds from 430 fund 
families, including nearly 2,000 funds that have no loads and no 
transaction fees.
    Our heritage is one of innovation, and I don't think I am being too 
bold when I say that mutual fund supermarkets have revolutionized 
investing for millions of Americans. Supermarkets have helped provide 
investors with an array of investment choices unimaginable a decade or 
two ago, when investors were essentially held captive by their fund 
company. Supermarkets empower investors by facilitating comparison 
shopping among funds; they simplify investing by consolidating 
statements and allowing investors to move easily from one fund family 
to another; and they increase competition, driving down costs for 
individual investors.
    We made the decision early on to focus our supermarket on no-load, 
no-transaction fee funds because we felt that investors should not be 
forced to bear these costs, and that they deserved access to funds 
without them. But in response to client demand, we also make available 
more than 2,600 mutual funds that do carry either transaction fees or 
loads, or both. The goal of our supermarket is to make available to our 
clients the widest array of funds, and our customers have demanded the 
option of funds that carry additional costs. No two investors are the 
same. While the majority of our clients prefer funds without loads or 
transaction fees, that is a determination for each individual investor 
to make on his or her own, based on his or her own investment strategy, 
needs, and long-term goals. If a load fund offers superior service or 
performance, investors may determine that paying the load is worth 
those benefits. But fewer than 1 percent of all mutual fund purchases 
made at Schwab involve paying a load.
    Our mutual fund supermarket is designed to make comparison shopping 
among funds as easy as possible. On our website, Schwab.com, investors 
can compare literally thousands of mutual funds in a wide array of 
categories to find the one that best meets their investment goals. They 
can compare the performance of a no-load fund with that of a load fund, 
to determine whether loads help or hinder market performance. They can 
compare funds that have transaction fees with funds that don't have 
transaction fees. They can compare multiple funds across any number of 
key data points--past performance, fee structure, portfolio turnover 
rates, the tenure of the fund manager, risk, amount of assets in the 
fund, even the percentage of holdings that are from a particular sector 
of the economy. All of these tools are designed with the idea that what 
is most important to one investor may be least important to the next. 
At Schwab, we strive to make as much information as possible available 
to the investor prior to the transaction to help him or her make the 
most educated decision.
    It is clear to us that our supermarket strategy was the right one. 
Our clients love this kind of freedom, convenience, and flexibility, 
and they have voted with their wallets. Before the launch of our no-
load, no-transaction fee marketplace, our clients held about $6 billion 
in mutual funds. Today, our clients have more than $235 
billion invested in literally thousands of mutual funds from more than 
400 fund companies. We are proud to be one of the largest mutual fund 
supermarkets in the world.
    And it's not just Schwab's supermarket that investors have 
responded to. The vast majority of mutual fund trades today are 
executed via a supermarket, whether it be Schwab's, or Fidelity's, or 
another competitor's. Only about 12 percent of mutual fund assets are 
purchased directly from a fund company. And, in the retirement plan 
context, an estimated 80 or more percent of all 401(k) investors have 
access to a fund supermarket that allows them to compare hundreds or 
even thousands of funds across hundreds of fund families to find the 
one that best meets their individual needs, goals, and style.
    Mutual fund supermarkets have also helped the industry remain 
extraordinarily competitive. In a time of growing consolidation in the 
financial services industry that has resulted in less consumer choice, 
mutual funds stand out as an admirable exception. Since 1990, the 
number of mutual funds available to investors has nearly tripled--from 
3,000 to over 8,000. Many of these new funds are managed by smaller 
fund companies that didn't even exist a decade ago--and could not exist 
without the infrastructure provided by mutual fund supermarkets that 
helps them reach large numbers of individual investors.
    In short, supermarkets are a crucial innovation that provide the 
link between millions of Americans and our equity markets. They are an 
indispensable tool that must be preserved and strengthened--not 
weakened by reform proposals, no matter how well-intentioned. As the 
Committee considers reform, I urge it to remember the very qualities 
that make mutual fund supermarkets so valuable to investors: Choice, 
simplicity, convenience, transparency, and competition.

Reforms Must Preserve the Strength of Supermarkets
    Let me briefly outline a few suggestions for the Committee's 
consideration that underscore these principles.
    First of all, it is clear that there is not enough transparency in 
the mutual fund business. Schwab supports many of the proposals under 
consideration in Congress and at the SEC to enhance disclosure to fund 
investors, but I think we can go further. There are three areas that I 
would recommend for additional disclosure:

 Investors have a right to know if their broker's 
    representative has a financial 
    incentive to push one mutual fund over another. No one at Schwab 
    does. We voluntarily provide information on our website today to 
    investors about how our
    representatives are paid and rewarded. All investors deserve this 
    transparency.

 Investors need to know whether a fund company has paid a fee 
    to be on a broker's preferred list. At Schwab, our OneSource Select 
    List tm features the best performing no-load, no-
    transaction fee funds available through Schwab's supermarket. No 
    fund can pay us for inclusion on the list, and we tell investors 
    that. More light needs to be shed on how these lists are created.

 To bolster competition and lower prices, Congress should unfix 
    sales loads, so that broker-dealers are forced to compete, just 
    like back in 1974, when commissions were deregulated. Mutual funds 
    should be allowed to set a maximum load, but not a minimum. This 
    would put the burden on the broker to determine, disclose, and 
    defend their commissions. Investors could then shop around for the 
    best price. Mutual funds already compete vigorously on the fees 
    they charge investors; there is no reason that broker-dealers 
    should not do so as well.
    Moreover, in 1992 the SEC's Division of Investment Management 
    recommended that the Commission seek legislation to amend Section 
    22(d) of the Investment Company Act, which mandates retail price 
    maintenance on mutual fund sales loads.\1\ That recommendation was 
    never adopted, and as a result, investors are faced today with a 
    confusing array of load share classes that prevent too many 
    investors from understanding how they are paying for their sales 
    commission--via a front-end load, a back-end load, or level load. 
    The proliferation of Class
    A, B, and C shares leads to conflicts, as brokers could push 
    investors into a
    class that may not be appropriate for their situation. If Congress 
    acted to unfix sales loads, the SEC should do away with the 
    confusing proliferation of load share classes.
---------------------------------------------------------------------------
    \1\ See Protecting Investors: A Half Century of Investment Company 
Regulation, Division of Investment Management, SEC, at page 297.

    All of these steps would put investors in the driver's seat--
helping them better understand what they are paying for and giving them 
better tools for making informed investment decisions.
    It is critically important, though, that we focus on the quality 
not just the quantity of these disclosures. Mutual fund documents are 
already too complex. They are littered with legalese and fine print 
that too few investors can understand, when they bother to read it at 
all. There is a danger that additional disclosure will further 
overwhelm investors. The SEC has made important progress in recent 
years in its plain English initiatives--it should apply those 
principles here as well, ensuring that new disclosures are presented as 
simply and as conspicuously as possible, and that they facilitate 
comparability and clarity.

``Hard 4 p.m. Close'' Will Harm Investors
    Unfortunately, Mr. Chairman, one of the highest-profile proposals 
to emerge from the SEC would undermine all of these efforts. The so-
called ``Hard 4 p.m. Close'' represents a step backward for investors. 
While well-intentioned, it does nothing to increase transparency, 
minimize conflicts, or maximize convenience. Instead, it undermines the 
goal of competition and would deprive investors of choice.
    The SEC proposal would require all fund orders to be received by 
fund companies by Market Close, generally 4 p.m. Eastern time, to 
receive that day's price. To accomplish that, intermediaries, such as Schwab, would have to impose an earlier cut-off time, perhaps at 2:30 or 3 p.m., to process, verify, and aggregate those orders before submitting them to the fund company. Furthermore, because of the additional regulatory requirements 
surrounding the processing of retirement plan trades, an even earlier 
cut-off time would have to be imposed for retirement plan participants. 
The result is a confusing array of different rules depending on how the 
individual invests.
    In considering the impact of the ``Hard 4,'' it is important first 
to understand how mutual funds transactions currently work. At Schwab, 
we receive mutual fund orders throughout the day and night from 
individual investors, registered investment advisers, clearing firms, 
and retirement plan administrators. Those orders come in to live 
representatives, via our website, over the telephone, even via wireless 
communication devices. Close to 90 percent of our orders are received 
through the electronic channels with minimal or no human intervention. 
Whenever and however those orders are placed, they are promptly entered 
into our system and electronically time-stamped. Our system 
automatically and in real time aggregates the order for the appropriate 
day's price. Orders received up until Market Close automatically 
receive today's price; orders received after Market Close automatically 
receive the next day's price.
    Once the market closes, Schwab engages in a review process to 
ensure the accuracy and integrity of our aggregate omnibus orders prior 
to sending them to the funds. For the majority of our mutual fund 
business, orders are aggregated by order type and are transmitted as a 
single omnibus level order to the fund. Aggregating the orders provides 
real economic value and minimizes the expenses to us and the funds. We 
also use this small window of time to proactively notify fund companies 
of any large purchase and redemption orders from clients. This gives 
fund companies the time needed to contact their portfolio managers and 
make an informed decision regarding the order (taking into account 
client trading behavior, fund flows, and market conditions) and 
communicate back to Schwab. Schwab also needs time to cancel the 
order(s) if the fund elects to reject the purchase. Since a rejected 
order may involve multiple orders for hundreds of accounts managed by a 
registered investment adviser, the process of canceling a rejected 
order may take upwards of 30 minutes. This is important since we do not 
want to transmit orders that have been rejected by the fund. This 
ultimately protects the funds (and Schwab) from the operational and 
financial risks associated with canceling orders that have been 
rejected after they were transmitted to the funds.
    Typically, this entire review process is completed within 60 to 90 
minutes and our omnibus orders are submitted to the various fund 
companies between 5 and 5:30 p.m., Eastern time. For many 
intermediaries, the process takes much longer, and orders are submitted 
to fund companies well into the night. It is, of course, this gap in 
time, between 4 p.m., when the market closes, and the time when orders 
are submitted to the fund company, that the SEC has identified as the 
period some have taken advantage of to engage in the prohibited 
activity known as ``late trading.'' The ``Hard 4'' solution proposed by 
the SEC is an attempt to deal with this problem.
    We at Schwab share the Committee's disappointment at the illegal 
late trading activity that has been uncovered in the industry, and we 
strongly support regulatory and legislative steps to ensure that this 
kind of activity is eliminated. We have a proposal, which we call the 
``Smart 4'' solution, that I outline below. It is a solution that 
cracks down on late trading without disadvantaging different groups of 
investors. Before I detail that proposal, which we believe is the best 
solution, let me take a moment to walk the Committee through the impact 
of the SEC's ``Hard 4'' proposal on various groups of investors:

 Impact on Individual Investors. As the SEC acknowledges in its 
    rule proposal, substantial changes would be required in the way 
    fund intermediaries process fund purchase and redemption orders. 
    Today, a mutual fund may accept an order after Market Close, 
    provided the order was received by an intermediary prior to Market 
    Close. However, under the Proposed Rules, investors investing 
    through intermediaries would be required to submit purchase orders 
    prior to an earlier cut-off time, such as 2 p.m., to allow the 
    intermediary sufficient time to process the purchase and the 
    redemption orders before submitting them to the fund, its 
    designated transfer agent, or a registered clearing agency by the 4 
    p.m. deadline. Significantly, that earlier cut-off time would 
    likely be different for different intermediaries, depending on the 
    business model and systems capabilities of the particular firm. In 
    other words, an investor who uses Schwab might have a deadline of 
    2:30 p.m., but an investor that uses Firm ABC as an intermediary 
    might have a cut-off time of an hour earlier. Of course, an 
    investor would be able to place an order directly with a fund 
    company right up until 4 p.m. Yet approximately 88 percent of 
    mutual fund purchases today are executed via an intermediary. 
    Undoubtedly, this variety of cut-off times would be confusing to 
    investors, and it would create different classes of investors 
    depending on which firms they used to execute their trades.
    Moreover, earlier cut-off times would particularly disadvantage 
    investors on the West Coast and in Hawaii. For example, West Coast 
    investors might be required to submit their mutual fund orders to 
    the intermediary by 11 a.m. Pacific Time (and as early as 8 a.m. in 
    Hawaii) to receive that day's current price (assuming a 2 p.m. 
    Eastern time early cut-off time).
    Let me also make an observation about the nature of pricing mutual 
    funds. Forward pricing in the fund industry has been necessary to 
    protect existing shareholders, but the reality is that it is not a 
    particularly consumer-friendly feature. Where else does a consumer 
    make a decision to buy something without knowing the exact price 
    he/she will pay? Mutual fund investors are promised only that they 
    will get the appropriate price at the next calculated time. 
    Investors don't like this uncertainty, and they take steps to 
    minimize it by placing orders later in the day when there is less 
    time between when their order is entered and the pricing time. In 
    fact, over 40 percent of mutual fund orders are received by Schwab 
    during the last 2 hours prior to market close. Sadly, the Hard 4 
    p.m. Close will create increased investor dissatisfaction by 
    increasing the time between order placement and pricing. We owe it 
    to investors to do better, not worse.

 Impact on Retirement Plan Participants. More significantly, 
    retirement plan participants, because of the increased complexity 
    of aggregating and pricing orders at the individual and plan 
    levels, would have even earlier, less convenient cut-offs than 
    ordinary retail investors. The latest order cut-off a retirement 
    plan could administer likely would be 12 p.m. Eastern time. In 
    practice then, as acknowledged by the SEC in its proposal, almost 
    all retirement plan participants would as a result receive next-day 
    pricing, not same-day pricing.
    The proposal would have other unfortunate consequences for 
    retirement plans. Under the proposed rules, retirement plans will 
    face strong pressure to offer choices only from a single fund 
    family, which would allow orders to be placed up until the market 
    closes. In this way, retirement plans will be able to take 
    participant orders later than if the orders were first routed 
    through an intermediary such as a broker-dealer. However, limiting 
    plan participants to a single fund family will be a detriment for 
    401(k) plan participants. It will reduce choice and the ability to 
    diversify retirement assets across multiple fund families. Reducing 
    participant choice will encourage higher operating expense ratios 
    and other costs. As a result of reduced choice and increased costs, 
    plan participants could face increased risk and decreased returns.
    Forcing retirement plan participants to get next-day pricing would 
    also raise 
    serious fiduciary issues for retirement plan sponsors as to whether 
    they should
    offer mutual funds as an investment option at all, when other 
    pooled investment vehicles (such as bank collective trust funds and 
    insurance company separate accounts) with same-day pricing are 
    available as alternatives. It would be unfortunate if the ``Hard 
    4'' proposal created an incentive for 401(k) plan participants, who 
    include less sophisticated investors, to receive investment choices 
    with a lower level of investor protection.
    One of the issues that frustrates me most in this context is the 
    claim that retirement plan participants are, or at least should be, 
    long-term investors, for whom the price of a mutual fund on a 
    particular day is not that important. While the effect of next-day 
    pricing on a single investor may be small, the aggregate effect on 
    all investors is large. SEC statements over time on best execution 
    (in the equities context), for example, make clear the SEC's view 
    that it is a serious breach of fiduciary duty to short-change 
    investors by a few pennies per share. In the aggregate, especially 
    over long periods of time, pennies matter.\2\ Long-term investors 
    should be fully invested; systematically having money uninvested 
    for a day will increase long-term tracking error and disadvantage 
    investors (especially since significant market events will occur on 
    some of the uninvested days). Furthermore, it will undermine 401(k) 
    plan participants' confidence in mutual funds if they are forced to 
    wait an extra day to sell in a falling market, or to buy in a 
    rising market. The Government should not be in the business of 
    determining what is and is not an ``appropriate'' investing 
    strategy for a retirement plan
    participant.
---------------------------------------------------------------------------
    \2\ See Remarks of Chairman Arthur Levitt, Best Execution: Promise 
of Integrity, Guardian of Competition (November 4, 1999); Order 
Execution Obligations, Securities Exchange Act Release No. 37619A 
(September 6, 1996).

 Impact of an Early Order Cut-Off on Investors' Use of 
    Intermediaries. Another disadvantage of the ``Hard 4'' proposal is 
    that it will create a strong disincentive to invest in mutual funds 
    through intermediaries, which benefit investors in many ways. As I 
    have already detailed, intermediaries are more convenient for 
    investors. They allow clients to see all of types of assets, 
    including mutual funds from different fund families, equities, 
    bonds, and other investments, on a single web page and/or a single 
    statement; enhance clients' ability to comparison shop among 
    different fund families and make more informed decisions; foster 
    more robust competition in the industry; and allow investors to 
    move money more easily from one fund family to another. The SEC 
    staff has repeatedly noted the benefits to investors of fund 
    supermarkets, as recently as in a letter to the House Financial 
    Services Committee last summer. \3\
---------------------------------------------------------------------------
    \3\ See Memorandum from Paul F. Roye Re: Correspondence from 
Chairman Richard H. Baker, House Subcommittee on Capital Markets, 
Insurance, and Government Sponsored Enterprises, June 9, 2003, at 73; 
Investment Company Institute, 1998 SEC No-Act LEXIS 976 at *6 (publicly 
available October 30, 1998).

 Impact of Early Order Cut-Off on Funds--Cost and Competition. 
    By discouraging the use of intermediaries and encouraging direct 
    investment with funds, the proposed ``Hard 4'' would result in all 
    funds having to build more infrastructure for handling customer 
    service and orders. Today, most fund companies receive a relatively 
    small number of orders--the work of aggregating thousands of 
    customer orders (and doing all of the attendant sub-accounting) 
    occurs at the broker-dealer, not at the fund company. Many 
    intermediaries, such as broker-dealers, find it more efficient to 
    build this infrastructure, where they can leverage the 
    infrastructure they already have for handling orders for other 
    types of securities.
    Requiring an early order cut-off for mutual fund orders through 
    intermediaries will create additional competitive distortions. 
    Newer, smaller, more entrepreneurial mutual funds primarily reach 
    clients through intermediaries and typically do not have the scale 
    to reach clients directly. If the SEC adopts regulations that 
    discourage the use of intermediaries, the result may be higher 
    barriers to entry for new funds and fewer choices for investors. As 
    a result, the mutual fund industry will move toward an oligopoly of 
    large fund complexes with the size and scale to be able to reach 
    investors directly. The inevitable result of lessened competition 
    will be higher costs and fewer choices for investors.
    Moreover, mutual funds are just one choice among many other types 
    of investments. An earlier cut-off time that applies only to mutual 
    funds would disadvantage these funds compared to investors in 
    competing products that will continue to have later cut-off times. 
    Equities, exchange-traded funds (ETF's), closed-end funds, bank 
    collective trust funds, insurance company separate accounts, and 
    managed accounts will continue to accept orders up until 4 p.m. A 
    ``Hard 4'' for mutual funds would encourage investors to prefer 
    those products to mutual funds. Many of these other products are 
    less regulated and have less robust disclosure.
``Smart 4''--A Strong Alternative That Will Protect, Not Harm Investors
    Mr. Chairman, the term ``Hard 4'' is accurate--it will make 
investing harder. We prefer an alternative, a ``Smart 4,'' if you will. 
It would utilize the best technology, enhanced compliance and audit 
requirements, and vigorous enforcement to stamp out late trading. The 
SEC included in its recent rule proposals an alternative proposal that 
incorporates several of our suggestions, but we would recommend going 
even further. Our ``Smart 4'' proposal would allow a fund intermediary 
to submit orders after Market Close, provided that the intermediary 
adopts certain protections designed to prevent late trading:

 Immediate electronic or physical time-stamping of orders in a 
    manner that cannot be altered or discarded once the order is 
    entered into the trading system.

 Annual certification that the intermediary and the fund has 
    policies and procedures in place designed to prevent late trades, 
    and that no late trades were submitted to the fund or its 
    designated transfer agent during the period.

 Submission of the intermediary to an annual audit of its 
    controls conducted by an independent public accountant who would 
    submit their report to the fund's chief compliance officer.

 SEC inspection authority over any intermediary that seeks to 
    submit orders it has received prior to 4 p.m. to the fund company 
    after the market closes.

 Enhanced compliance surveillance policies and procedures that 
    would ensure that orders were in fact received prior to 4 p.m.

    We believe that any intermediary that seeks to submit orders that 
it received from its customers prior to 4 p.m. to the fund company 
after that hour should be required to adopt the five protections set 
forth above. Intermediaries should have the option, however, to avoid 
adopting these protections if they elect to submit their orders to the 
fund company prior to 4 p.m. This approach will be more effective in 
preventing instances of late order trades, while avoiding the many 
hardships that forcing an earlier cut-off time would impose on millions 
of mutual fund investors.
    Schwab believes that the most effective way to stop late trading at 
both the fund level and the intermediary level is to make the time that 
a customer submits an order transparent to the fund, its independent 
auditors, and SEC examiners, and subject the order process to strict 
compliance controls, certification requirements, and independent audit 
and examination. This verifiable, ``Smart 4 p.m. Close,'' provides a 
greater level of protection because it applies to all mutual fund 
orders, while avoiding the hardship on individual investors imposed by 
the ``Hard 4 p.m. Close.'' Let me set forth further details about each 
of the five elements of this plan:

 Electronic Audit Trail. The mutual fund industry should work 
    together to establish an enhanced electronic audit trail for mutual 
    fund orders. Ideally, this audit trail should document the time of 
    receipt of the order from the client, the time of transmittal 
    within a firm (for example, from a branch or call center to a 
    mutual funds operations group), the time of transmission among 
    intermediaries (for example, from a retirement plan third-party 
    administrator to a broker-dealer), and the time of transmission 
    from the intermediary to the fund or its transfer agent. At an 
    absolute minimum, however, the time of receipt of the order from 
    the client should be captured electronically with the order secured 
    from being altered. In addition, the time stamping should be 
    accompanied by information about the actual individual who handled 
    or observed that step in the process. Material modifications would 
    require the cancellation of the original order and the entry of a 
    new order with a new and updated time stamp.

 Annual Certification of Procedures. Entities that handle 
    mutual fund orders--including fund companies and their transfer 
    agents, as well as intermediaries such as brokerage firms and 
    retirement plan third-party administrators--should issue annual 
    certifications that they have procedures reasonably designed to 
    prevent or detect late trading, and that those procedures have been 
    implemented and are working as designed. Intermediaries would make 
    these certifications available to any mutual fund on behalf of 
    which it accepts orders for purchase or sale of shares of the fund. 
    As is typically the case for certifications under the Sarbanes-
    Oxley Act of 2002, each entity would be responsible for designing a 
    process to give the individuals signing the certification a 
    reasonable basis for believing it to be correct. As with the SEC's 
    recent proposal for investment company and investment adviser 
    compliance programs, the annual certification process would address 
    whether changes are needed to assure the continued effectiveness of 
    the late-trading procedures.

 Enhanced Auditor Review. All entities that handle mutual fund 
    orders should be required to conduct an annual auditor review of 
    their late-trade prevention and detection procedures. For 
    registered intermediaries such as broker-dealers or banks, we 
    suggest, at a minimum, a standardized SAS 70 or similar review by 
    independent auditors. An audit review would be based in part on the 
    annual written compliance certification by the intermediary's 
    management discussed above, which would in this context serve as 
    the equivalent of a management representation letter for an auditor 
    review. Both the management certification and the results of the 
    auditor review should be provided to the funds on behalf of which 
    the intermediary accepts orders. Further, if the auditors discover 
    any material control weaknesses, and management does not promptly 
    correct those weaknesses, the auditor should be required to 
    escalate that information to the SEC, similar to the requirement 
    for independent audit escalation under Section 10A of the 
    Securities Exchange Act of 1934.

 Consent to SEC Inspection Jurisdiction. The SEC should be able 
    to inspect any intermediary to review whether its late-trade 
    prevention and detection procedures are adequate and are working as 
    designed. The SEC already has jurisdiction to inspect broker-
    dealers who process mutual fund orders; but there should be 
    consistency in oversight. The SEC should require banks and trust 
    companies to ``push out'' mutual fund order processing activities 
    to an affiliated broker-dealer registered with the SEC. The Gramm-
    Leach-Bliley Act contemplated that these types of securities 
    processing activities (a core part of the definition of broker-
    dealer 
    activity in the Exchange Act) would be handled by broker-dealer 
    affiliates; however, regulations implementing this portion of 
    Gramm-Leach-Bliley do not exist. Alternatively, the SEC could 
    require that banks register as transfer agents to
    engage in this type of mutual fund order aggregation and 
    processing.
    Unregistered intermediaries should consent to SEC inspection on the 
    grounds that they are acting as an agent of an SEC-registered 
    mutual fund when they
    accept orders for that fund. Indeed, some third-party 
    administrators are already subject to SEC jurisdiction as 
    registered sub-transfer agents for fund companies. To the extent 
    intermediaries decline to consent to SEC jurisdiction for 
    inspections, they should be required to submit all trades to a 
    registered intermediary (or directly to the fund or transfer agent) 
    prior to Market Close.

 Enhanced Compliance Surveillance. Even with an electronic 
    order audit trail, there may be situations where the electronic 
    version of the order is entered 
    shortly after the market closes (for example, when a client calls 
    just before 4 p.m. but the registered representative does not 
    finish inputting the order until shortly after 4 p.m., or when a 
    computer systems problem delays electronic input of the order). A 
    robust compliance surveillance process can address the potential 
    for abuse of this process. Firms should require surveillance for 
    suspicious patterns of potential late orders by a single client, 
    orders entered by related clients (such as clients of a single 
    adviser), or orders entered by a single registered representative. 
    Where suspicious patterns exist without adequate contemporaneous 
    explanations, firms should take prompt actions to investigate and 
    respond appropriately.

    In addition, each intermediary's handling of late orders should be 
transparent to the regulators. Funds and intermediaries who accept 
customer orders up until 4 p.m. should file annually with the SEC a 
report of trade activities including reporting of any ``late trades'' 
with explanations. This reporting would allow visibility and oversight 
by the SEC without overwhelming the Agency with the need to inspect or 
examine each firm: The SEC could target firms where the late trading 
filings indicate unusual activity. This process already exists for 
transfer agents in the current TA-2 filing. Finally, funds and 
intermediaries should be required to review late trading policies and 
procedures with their employees in their annual compliance continuing 
education meetings.
    Mr. Chairman, this ``Smart 4'' proposal is, we believe, the most 
effective way to combat the pernicious problem of late trading. It is a 
tough and sensible solution 
that will prevent illegal activity but without disadvantaging 
legitimate investors who want nothing more than to make very sound 
investment decisions on a level playing field.
Other Issues
    With the Committee's indulgence, I would like to conclude by 
offering specific comments on two other issues that have been under the 
spotlight recently.
Fees
    There has been considerable discussion in the media and at the 
Senate Governmental Affairs hearing last month about the subject of 
mutual fund fees. Some believe that the Government should be mandating 
fee rates or capping fee rates. I strongly disagree. This is an 
extraordinarily competitive industry, which puts tremendous pressure on 
companies to keep fees low. As an investor, if you believe the fees a 
particular fund charges are too high, you have literally thousands of 
other funds to choose from. Every investor is different and should be 
allowed to make his or her own choices--if a particular fund has a high 
fee but offers tremendous performance and tremendous service, then an 
investor can make the decision to pay for that. Neither Congress nor 
the regulators should be in the business of mandating fee levels in 
such a competitive environment.
    The other point I want to raise is the issue of how best to 
disclose fees. In both the legislative and the regulatory context over 
the past few months, there has been considerable discussion of what 
kind of disclosure is most appropriate and useful to investors. One 
idea under consideration is mandating personalized, actual-dollar 
disclosure of the fees each unique investor pays. I am not convinced 
that this kind of individualized disclosure is actually helpful to 
investors. First of all, it would be enormously expensive, and firms 
would just pass that cost on to investors, increasing the fees. More 
importantly, I do not believe individualized disclosure facilitates the 
kind of apples-to-apples comparisons that investors need. Apparently, 
the SEC agrees, for Commissioners approved a rule earlier this month 
requiring that funds disclosure, via a standardized example, what the 
fees are on an investment of $1,000. This was a sensible decision by 
the Commission, as it allows for quick side-by-side comparison of 
different funds, would be a much better solution. We applaud the 
Commission for moving so quickly on this rule.

Mutual Fund Governance
    On the issue of mutual fund governance, we support the SEC's 
proposal for mutual fund boards to have a 75 percent majority of 
independent directors. We have concerns, however, about mandating an 
independent chairman. We believe the independent directors should be 
empowered to choose whomever they want as a chairman, and that person 
can be independent or interested. There does not seem to be a 
correlation between behavior and having an independent chairman. 
Indeed, many of the funds that have had the worst problems over the 
last few months had an independent chairman. Finally, let me say that 
Charles R. Schwab is the Chairman of our mutual fund board. We believe 
the expertise and experience he brings to the table is unparalleled. 
Moreover, we believe his integrity cannot be questioned, and that his 
long history of championing the individual investor speaks for itself.

Conclusion
    As we move forward we must remember the lessons we have learned 
from the evolution of mutual fund supermarkets. We must empower 
investors by promoting competition and choice; requiring clear, simple 
disclosure; and minimizing conflicts. Investors have given us a roadmap 
that should guide our reform efforts. We should also look ahead to 
solutions that may be further down the road, such as examining ways to 
use technology to improve pricing and, perhaps ultimately, to get to 
more frequent, even real-time, pricing.
    I applaud this Committee for its deliberate approach on this issue. 
Mutual funds are the great democratizing force in our markets. They are 
the vehicle that allows millions of Americans to participate fully in 
our Nation's economic prosperity. However, any reform that confuses 
investors or erects new barriers for those who want to participate in 
mutual funds--including well-intentioned proposals such as the ``Hard 4 
p.m. Close''--will be a step backward, not forward.
    Finally, Mr. Chairman, let me conclude by saying that we in the 
mutual fund industry bear the ultimate responsibility for acting in the 
best interest of our clients. Legislation and regulation can only do so 
much. Most of the failures that have been publicized were not about 
inadequate rules, but a failure to follow the letter and spirit of the 
rules we have. At Schwab, we are committed to living by the principles 
I have outlined for you today.
    I appreciate the opportunity to share my views on this critical 
issue and I would be happy to answer in writing any follow-up questions 
Members of the Committee may have. Thank you.

                               ----------
                  PREPARED STATEMENT OF MELLODY HOBSON
      President, Ariel Capital Management, LLC/Ariel Mutual Funds
                           February 26, 2004

    Thank you, Chairman Shelby, Ranking Member Sarbanes, and Members of 
the Committee. I am honored to be here today. The issues facing mutual 
fund companies demand serious and thoughtful attention from industry 
leaders, mutual fund regulators, and from the Members of this 
Committee. An appalling breach of trust by some in the fund industry 
has raised doubts about the industry's commitment to integrity--a 
commitment that hundreds of mutual fund companies and tens of thousands 
of fund employees have spent more than 60 years building. As such, I 
sincerely thank you for allowing me the opportunity to testify.
    I particularly welcome the chance to speak on behalf of hundreds of 
small mutual fund companies, and applaud the Committee for its 
thoughtful consideration of our special concerns.
    I am the President of Ariel Capital Management, LLC, which serves 
as the investment adviser to the Ariel Mutual Funds, a small mutual 
fund company based in Chicago. By way of background, our firm's 
Chairman, John W. Rogers, Jr., founded Ariel over 21 years ago at the 
young age of 24. John's exposure to the stock market began when his 
father started buying him stocks every birthday and every Christmas 
instead of toys starting when he was just 12 years old. Ultimately, his 
childhood hobby evolved into his life's work--a passion that led to the 
creation of
our firm.
    It is also worth noting that at the time of our inception in 1983, 
Ariel was the first minority-owned money management firm in the United 
States. In many ways, you can say we are a testament to the American 
Dream. John and I certainly feel that way.
    In part because of our pioneering status, we work particularly hard 
to reach out to those who have not experienced firsthand the wonders of 
long-term investing, compound growth, and the creation of enduring 
wealth. To this end, I also serve as the financial contributor for a 
national network news program. Besides educating all investors, our 
unique mission is also to make the stock market a regular part of 
dinner table conversation in the Black community.
    Ariel's four no-load mutual funds hold about $5.5 billion in assets 
and serve approximately 280,000 investors. So clearly, our 
responsibilities to investors are quite large. But it should be just as 
clear that as a company, in comparison to the largest mutual fund 
firms, we are quite small. Ariel has a total of 74 employees.
    I think it is important for the Committee to be aware that small 
mutual fund companies are the norm in our industry, not the exception. 
In fact, more than 370 mutual fund companies in the United States 
manage $5 billion or less. Perhaps the point is stronger if you 
consider it from a different perspective. If you combined all the 
assets of these 370 smaller mutual fund companies that manage $5 
billion or less into a single firm, we would still be a little less 
than half the size of the Nation's largest mutual fund company.
    Clearly, there are important ways in which Ariel and other small, 
entrepreneurial mutual fund firms stand far apart from the giants in 
our industry. Yet, because of our vision and hard work--and because of 
regulatory innovations like the SEC's Rule 12b -1--we are able to 
compete fiercely and often quite successfully with larger fund 
companies every single day. In this way too, you can say Ariel is a 
testament to the American Dream.
    The revelations about trading abuses involving mutual funds are 
extremely painful. I am, of course, profoundly disappointed about the 
abuses that have occurred at mutual funds. Ariel is 100 percent 
committed to supporting effective reforms that ensure these abuses will 
not happen again. I am greatly concerned that mutual fund investors 
have had their confidence shaken and my life's work has been threatened 
by individuals motivated by their selfish, shortsighted interests.
    Nevertheless, I think it is important to tell you that I still take 
enormous pride in being part of a great industry. I do not believe that 
most mutual fund companies ignore their fiduciary obligations, have 
lost their connection to their customers or abandoned the basic 
principles of sound investment management. In fact, I believe nothing 
could be further from the truth. As a mutual fund executive, I know my 
future, my credibility, and my livelihood are inextricably linked to 
the success of Ariel shareholders.
    The fundamental obligation of a mutual fund company is to provide 
dependable, cost-effective, long-term investment products. This is no 
small feat considering the destinies of average Americans and the 
capitalist system itself is at stake. Each day, my firm, Ariel, strives 
to do just that. I strongly believe the overwhelming majority of the 
Nation's mutual fund companies work to do the same.
    Regarding the three areas I have been asked to address today, I 
would like to emphasize the potential affects on small mutual fund 
companies like Ariel.

Fees
    First, I would like to address the costs and fees borne by mutual 
fund shareholders. In order to adequately discuss this issue, it is 
important for policymakers to understand not just the sum of mutual 
fund fees, but also the parts.
    A shareholder in a mutual fund is unique. No matter how much is 
invested, each receives equal access to all of the benefits the mutual 
fund offers--diversification, professional management, liquidity, and 
simplicity. For example, Ariel investors who invest $50 per month are 
afforded the same benefits as those who have multimillion accounts.
    Industry critics claim mutual fund fees are excessive when compared 
to management fees of pension funds and other institutional accounts. 
This argument is incomplete and wrong. Comparing the fee structure of 
an institutional account to a mutual fund is like comparing an apple to 
an orange. In fact, despite some surface similarities--mainly the 
offering of investment management services--the organizational, 
operational, legal and regulatory frameworks for mutual funds versus 
institutional accounts could not be more different.
    More specifically, total costs for a mutual fund investor include a 
litany of services that are not commonly offered to institutional 
investors. These services have been developed to increase shareholder 
access and knowledge. They include phone centers with licensed service 
representatives made available to answer any questions; websites that 
often provide 24-hour account access; compliance, accounting, and legal 
oversight; as well as development of everything from the prospectus to 
the shareholder letter that keep investors informed about how their 
funds are performing.
    In contrast, the management of an institutional account generally 
only calls for portfolio management and a letter detailing performance. 
As opposed to the investment manager, the pension plan sponsor 
generally is responsible for legal, regulatory, and participant 
communication. The ICI recently completed an excellent study of this 
question. I have attached a copy of it to my testimony as Appendix 1, 
and commend its key findings to you. Among the most important is the 
fact that, when you adjust for the substantial differences between 
managing mutual funds and pension plan portfolios, the costs of the two 
are essentially identical.
    Fee differences aside, the total amount mutual fund shareholders 
are being charged, contrary to what some claim, has decreased. The SEC, 
GAO, and ICI have all found that substantial majorities of mutual funds 
lower their fee levels as they grow, which is the very essence of 
economies of scale.
    In addition, the ICI has found that since 1980, the average cost of 
owning stock mutual funds has decreased by 45 percent; bond funds, 42 
percent; and money market funds, 38 percent.\1\ Not to mention, because 
of the great deal of competition in our industry, investors can, and 
do, vote with their feet. This is clear from the fact that 87 percent 
of the assets shareholders have invested in stock mutual funds are in 
funds whose fees are lower than the industry average. Stated 
differently, the typical investor's equity mutual funds have total 
annual expenses of just 1 percent, which is nearly 40 percent less than 
the fees charged by the average fund. The SEC reached similar 
conclusions in the mutual fund fee study they completed in 2000.
---------------------------------------------------------------------------
    \1\ ``The Cost of Buying and Owning Mutual Funds,'' Investment 
Company Institute, Volume 13, No. 1, February 2004.
---------------------------------------------------------------------------
    When an investor buys a fund, they receive a prospectus with a fee 
table listed within the first pages which details total cost. A 
critically important part of the fee table is the mandatory, 
standardized example it includes that illustrates the costs an investor 
can expect to pay over a 1-, 3-, and 5-year period given a $10,000 
investment. This example enables investors to make exact apples-to-
apples comparisons of the total costs of any of the 8,000 mutual funds 
in the country.
    It is for some reason neglected in many of the media reports I see 
on mutual fund fees, but the fact is that the fee table was redesigned 
by the SEC in 1998 following the most extensive testing with investors 
ever undertaken by the Agency. Multiple focus groups were sponsored to 
determine how to make the fee table as accessible and useful as 
possible. And both the SEC and GAO have since testified before Congress 
that the fee table is an extremely useful and accurate way to compare 
the costs of competing mutual fund investments. The SEC has made the 
further point, which again is frequently overlooked, that the fee table 
provides a form of disclosure to investors that is superior to what is 
offered by all other financial services.
    A significant mutual fund fee issue that has been frequently 
misunderstood relates to a component of the fund expense ratio called 
the Rule 12b -1 fee. This issue is of great importance to small mutual 
fund companies like Ariel, and impacts our ability to distribute funds 
to investors. The easiest way to think about mutual fund distribution 
is to equate it to distribution in the film industry. You may be an 
inspired director and have made a great movie, but if you do not have a 
distributor, no movie theaters will get copies of your film and most 
individuals will never have a chance to see it.
    The same is true of mutual funds. You can have a terrific, well-
managed mutual fund with an excellent track record. But if the fund 
company does not have access to wide sources of third-party 
distribution, it will most likely be a fund without investors. Third-
party firms with the scale to offer small mutual funds access to broad 
distribution channels obviously must be paid for their services. Rule 
12b -1 fees have been absolutely critical to our effort to expose many 
small mutual fund companies like Ariel to millions of potential 
investors around the country.
    Finally, on the subject of fees, the mutual fund industry is the 
only industry I know of where price increases are rare. In order to 
raise its management fee, a fund company must first get a majority of 
all fund directors to agree. They must then get a majority of the 
independent directors to separately vote in favor of the increase. 
Those steps alone are insufficient: The fund company must ask its 
shareholders to vote on the increase, and a majority is required for 
the proposed increase to take effect.
    For this reason and others, price regulation of mutual funds would 
be directly counter to the principles of capitalism. With over 500 
mutual funds companies and nearly 8,000 mutual funds, investors have 
choice. Federal regulation of prices is often necessitated when there 
are few competitors and so little choice that the opportunity for 
monopolistic practices is a threat to the consumer. This is not the 
case in our industry.

Governance
    Second, the issue of board governance is worthy of some discussion 
given the recent push to mandate independent chairs for mutual fund 
boards. While we do have an independent board chairman at Ariel Mutual 
Funds, I would argue the designation is irrelevant based upon the 
unique way in which mutual funds are governed. More specifically, 
independent directors already make all of the major decisions affecting 
the funds they oversee. For example, independent directors have the 
exclusive ability to renew the investment manager's advisory contract, 
which is clearly one of every mutual fund's largest annual expenses. A 
full review and renewal of this contract must take place each and every 
year. Independent directors also have extensive authority with respect 
to hiring and retaining firms that provide key services to the fund, 
such as the fund's outside auditor. Additionally, independent directors 
are solely represented on board nominating committees--leaving 
affiliated or inside directors little say in the board's ultimate 
composition. Finally, as both the SEC and GAO testified in June of last 
year, once boards are composed of a majority or super-majority of 
independent directors--as most funds already are--the independent 
directors are fully empowered to dictate who the chairman of the board 
will be.
    Another governance-related point worthy of discussion is the newly 
enacted requirement pertaining to fund company boards and the hiring of 
a compliance officer. I certainly understand why the SEC and others--
including the ICI--have looked to such a requirement in response to the 
abuses revealed in recent months. ICI President Matt Fink has said that 
he views this particular requirement as one of the changes most likely 
to have enduring benefits for funds and their shareholders.
    We will defer to policy experts with respect to the likelihood that 
the compliance officer requirement will produce the hoped for benefits. 
But we urge everyone involved to also recognize the substantial 
disproportionate cost that requirements like this--and many others 
currently on the table or being discussed--will pose for smaller mutual 
fund companies. We obviously have much more limited resources than the 
small number of very large fund companies. Therefore, we hope you and 
the other policymakers are aware of the serious impact such 
requirements will have on our cost structure and on our competitive 
position within the industry. While
obviously well-intended, rules of this nature could create a barrier to 
entry for
future entrepreneurs--like my colleague John Rogers--interested in 
starting a
fund company.

Disclosure
    Federal Reserve Chairman Alan Greenspan recently observed, ``[I]n 
our laudable efforts to improve public disclosure, we too often appear 
to be mistaking more extensive disclosure for greater transparency.'' 
\2\
---------------------------------------------------------------------------
    \2\ ``Corporate Governance,'' Remarks by The Honorable Alan 
Greenspan, Chairman, U.S. Federal Reserve Board, May 8, 2003.
---------------------------------------------------------------------------
    Chairman Greenspan said that improved transparency is more 
important--but harder to achieve--than improved disclosure. 
``Transparency challenges market participants not only to provide 
information but also to place that information in a context that makes 
it meaningful.'' \3\ Former SEC Chairman Levitt once expressed a 
similar concern, ``[t]he law of unintended results has come into play: 
Our passion for full disclosure has created fact-bloated reports, and 
prospectuses that are more redundant than revealing.'' \4\
---------------------------------------------------------------------------
    \3\ Id.
    \4\ ``Taking the Mystery Out of the Marketplace: The SEC's Consumer 
Education Campaign,'' Remarks by The Honorable Arthur Levitt, Chairman, 
U.S. Securities and Exchange Commission, October 13, 1994.
---------------------------------------------------------------------------
    In a report to the House Financial Services Committee last June, 
the SEC reported that it had adopted 40 new investment company rules 
since 1998, averaging one every 7 weeks. The list the SEC developed is 
attached as Appendix 2. At the time this represented the busiest period 
of the SEC's mutual fund rulemaking in its history.
    Since the first revelation of trading abuses on September 3 last 
year, the SEC has averaged one new regulatory action every 2 weeks. 
During this time, the SEC has adopted two additional mutual fund rule 
requirements, proposed nine new regulatory initiatives, and issued a 
concept release about whether to require a new form of cost disclosure.
    I believe that in responding to new concerns and problems by simply 
calling for more disclosure, we risk impeding rather than enhancing 
decisionmaking by individuals. It is worth remembering that when the 
SEC overhauled mutual fund prospectuses 6 years ago, the simplified 
plain English prospectus was hailed as the most beneficial SEC change 
to disclosure requirements in the industry's 60-year history. At the 
time they adopted the new prospectus requirements, the SEC urged great 
caution about succumbing to the future temptations to add new 
disclosure requirements, noting that they had learned that too much 
information ``discourages investors'' from further reading or 
``obscures essential information'' about the fund.\5\
---------------------------------------------------------------------------
    \5\ Id.
---------------------------------------------------------------------------
    Earlier, I mentioned I serve as an on-air financial contributor to 
a television network news program. I also author a bi-monthly column to 
aid investors. In these roles, I have literally received thousands of 
questions and requests for guidance. The recurring theme in these 
appeals for help is that people feel overwhelmed. Young, old, married, 
single, Black, white, working, or retired, investors want insight, 
timesavers, and ways to cut through the noise to get to the most 
important information that will help them make the best investment 
decisions. Rarely do I hear complaints about too little information. 
Instead, it is nearly always the opposite--investors drowning in data 
and in paper with no ability to assess what really matters. 
Interestingly, I have received many fairly sophisticated inquiries, but 
I have never received a question about some of the more esoteric fund 
company matters currently under review.
    For these reasons, I respectfully suggest that the Committee 
concentrate a considerable part of its efforts in the weeks ahead on 
how we could clarify and increase understanding of the critical mutual 
fund information that is already disclosed to individuals. This 
Committee clearly recognizes from its past work that financial literacy 
is fundamental to any serious effort to empower investors to make the 
right choices that will secure their futures, as well as those of 
future generations.
    At Ariel, we take financial literacy very seriously. We have 
partnered with Nuveen Investments to create an investment and financial 
literacy program at a Chicago Public School bearing our name. Through 
this effort, we award each first grade class a $20,000 gift that 
follows them through their grade school career. As the students 
progress through the school's unique investment curriculum, so does 
their involvement in the portfolio process and the management of their 
class fund.
    The ICI has developed a major initiative with similar goals. 
Through its Education Foundation--the ICI created a program called 
Investing for Success Program. The program is a partnership with the 
National Urban League, the Coalition of Black Investors Investment 
Education Fund, and the Hispanic College Fund. Carefully designed 
programs have been presented in conferences and workshops across the 
country, on the Internet, and at historically Black colleges and 
universities.
    We believe educational programs like these will help diminish the 
confusion and fear that shrouds the investment decisionmaking process 
and replace it with a culture of knowledge and confidence.

Conclusion
    My colleagues at Ariel and in the fund industry are grateful for 
the Committee's efforts. When you find effective ways to reinforce 
investor protections and support the integrity of our markets, you help 
our business and our shareholders.
    Recent events notwithstanding, it would be deeply regrettable if 
attempts to heighten mutual fund company oversight eroded the 
competitive position of small firms, one of the most dynamic and 
entrepreneurial parts of the fund business. For fund companies such as 
Ariel, it could seriously impair any efforts to enter and even remain 
actively engaged in this marketplace.
    Similarly, I urge you to bear in mind the consequences for mutual 
funds overall if regulatory burdens increase so much that companies 
determine it is more attractive to them to market far less regulated 
investment products and services. I know that groups like Fund 
Democracy and the Consumer Federation of America share this concern, 
and I too think it merits your serious study.
    Thank you again for the privilege of testifying. I look forward to 
your questions and appreciate your patience.



                  PREPARED STATEMENT OF JOHN C. BOGLE*
---------------------------------------------------------------------------
    *Note: Much of the material in this statement was included in a 
presentation before the Boston Society of Security Analysts on January 
14, 2003.
---------------------------------------------------------------------------
        Founder and Former Chief Executive of the Vanguard Group
        President of the Bogle Financial Markets Research Center
                           February 26, 2004

    Good morning, Chairman Shelby and Members of the Committee. Thank 
you for inviting me to speak today.
    I hope that my experience in the mutual fund industry will be 
helpful in considering the issues before you. I have been both a 
student of, and an active participant in, the mutual fund industry for 
more than half a century. My interest began with an article in the 
December 1949 issue of Fortune magazine (``Big Money in Boston'') that 
inspired me to write my Princeton University senior thesis (``The 
Economic Role of the Investment Company'') on this subject. Upon 
graduation in 1951, I joined Wellington Management Company, one of the 
industry pioneers, and served as its Chief Executive from 1967 through 
January 1974. In September 1974, I founded the Vanguard Group of 
Investment Companies, heading the organization until February 1996, and 
remaining as Senior Chairman and Director until January 2000. Since 
then I have served as President of Vanguard's Bogle Financial Markets 
Research Center. The views I express today do not necessarily represent 
those of Vanguard's present management.
    The recent market timing scandals that have thrust the mutual fund 
industry into the limelight have illustrated, in a most shocking way, 
this industry's profile. But these scandals are but the tip of the 
iceberg. For they have also illuminated the fact that too far, too 
great an extent, this industry has focused on the financial interests 
of its managers at the cost of the 95 million citizens who have 
entrusted their hard-earned assets to us. While the damage done to our 
shareholders by allowing selected investors to do market timing at the 
expense of their fellow fund shareholders has been estimated at some $5 
billion, excessive management fees and fund expenses can easily be 
siphoning off many times that amount, year after year. And our focus on 
marketing speculative funds that pander to the public tastes probably 
cost the investing public hundreds of billions of dollars in the recent 
market crash.
    As discouraging as the scandals are to someone like me, who has 
dedicated his life to the mutual fund industry, they also have a good 
side, in that they bring to light all of the nibbling around the edges 
of ethical behavior that has been happening for decades. In that 
respect, the scandals present us a wonderful opportunity to finally get 
it right, and I hope that, with the help of Congress and our 
regulators, we seize that opportunity. Toward that end, it is high time 
that we carefully examine how the fund industry works today, and the 
extent to which it is serving the national public interest and the 
interest of investors. The preamble to the Investment Company Act of 
1940 demands that funds be ``organized, operated, and managed'' in the 
interests of their shareholders rather than in the interests of their
``investment advisers and underwriters.'' But that sound principle has, 
I fear, been turned upside down.
    Let me begin with the conclusion I reached in my thesis, all those 
years ago. My extensive study of the industry led me to four 
conclusions: One, that mutual funds should be managed ``in the most 
efficient, honest, and economical way possible,'' and that fund sales 
charges and management should be reduced. Two, mutual funds should not 
lead the public to the ``expectation of miracles from management,'' 
since funds could ``make no claim to superiority over the (unmanaged) 
market averages.'' Three, that ``the principal function (of funds) is 
the management of their investment portfolios''--the trusteeship of 
investor assets--focusing ``on the performance of the corporation . . . 
(not on) the short-term public appraisal of the value of a share (of 
stock).'' And four, that ``the prime responsibility'' of funds ``must 
be to their shareholders,'' to serve the individual investor and the 
institutional investor alike.
    In retrospect, the industry described in my thesis is barely 
recognizable today. Not just in size, for, as I predicted, an era of 
growth lay ahead for this industry, although I don't think anyone could 
have anticipated that mutual funds would grow from $2 billion in assets 
then to over $7 trillion today. If my thesis described a tiny industry, 
I'm not sure what adjective would be adequate to describe today's 
giant.
    But the real difference between funds past and funds present, the 
principal theme of my statement, is not that dramatic change in size, 
but the change in the very character of the industry. A half-century 
ago, the mutual fund industry was one in which the idea was to sell 
what we made: Funds provided a prudently diversified list of 
investments, and offered the small investor peace of mind. It was an 
industry that focused primarily on stewardship. By contrast, the 
industry we see today is one focused primarily on salesmanship, an 
industry in which marketing calls the tune in which we make what will 
sell, and in which short-term performance is the name of the game.
    This change in character is not an illusion. Since I entered this 
industry slightly over a half-century ago, there are specific, 
quantifiable ways in which this industry has changed. Today, I will 
examine nine of them, and then conclude with an appraisal their impact 
on the effectiveness with which mutual funds serve their shareholders, 
and some suggestions on returning this industry to its roots. I will be 
using industry averages to measure these changes. Of course some fund 
firms--not nearly enough in my view--have strived to retain their 
original character. But be clear that the mutual fund industry has 
changed radically. Let me count the ways:
1. Funds are Far Bigger, More Varied, and More Numerous
    The mutual fund industry has become a giant. From its 1949 base of 
$2 billion, fund assets soared to $7.2 trillion at the outset of 2004, 
a compound growth rate of 16 percent. Then, 90 percent of industry 
assets were represented by stock funds and stock-oriented balanced 
funds. Today, such funds compose just over half of industry assets (54 
percent). Bond funds now represent 17 percent of assets, and money 
market funds--dating back only to 1970--constitute the remaining 29 
percent. Once an equity fund industry, we now span the universe of 
major financial instruments--stocks, bonds, and savings reserves--a 
change that has been a boon not only to fund investors, but also to 
fund managers as well.
    So too has the number of funds exploded. Those 137 mutual funds of 
yesteryear have soared to today's total of 8,200. More relevantly, the 
total number of common stock funds has risen from just 75 to 4,600.\1\ 
The investor today has more mutual funds to choose among than common 
stocks listed on the New York Stock Exchange (2,800). It is not clear, 
however, that the nature of this increase has created investor 
benefits, for in retrospect, ``choice'' has done more harm than good.
---------------------------------------------------------------------------
    \1\ Sixty-six of these original diversified funds, constituting 90 
percent of equity fund assets, were broadly diversified ``blue chip'' 
funds. The remaining nine funds (10 percent of assets) were largely 
``single industry'' funds that were soon to vanish.



2. Stock Funds: From the Middle-of-the-Road to the
   Four Corners of the Earth
    As the number of stock funds soared, so did the variety of 
objectives and policies they follow. In 1950, the stock fund sector was 
dominated by funds that invested largely in highly diversified 
portfolios of U.S. corporations with large market capitalizations, with 
volatility roughly commensurate that of the Standard & Poor's 500 Stock 
Index. And today such middle-of-the-road funds represent a distinct 
minority of the total. While 2,524 of the 3,599 equity funds measured 
by Morningstar are considered diversified U.S. stock funds, only 572 
funds now closely resemble their blue-chip ancestors.\2\
---------------------------------------------------------------------------
    \2\ The accepted terminology in equity funds reflects this change. 
We have come to accept a nine-box matrix of funds arranged by market 
capitalization (large, medium, or small) on one axis, and by investment 
style (growth, value, or a blend of the two) on the other. Yesteryear's 
middle-of-the-road funds would today find themselves in the ``large-cap 
blend'' box, constituting just 23 percent of the funds in the 
diversified U.S. fund category, and 14 percent of the Morningstar all-
equity fund total.
---------------------------------------------------------------------------
    In addition to the diversified U.S. funds, there are 381 
specialized funds focused on narrow industry segments, from technology 
to telecommunications (particular favorites during the late bubble), 
and 694 international funds, running the gamut from diversified funds 
owning shares of companies all over the globe to highly specialized 
funds focusing on particular Nations, from China to Russia to Israel. 
We offer a fund for every purpose under heaven.
    Paradoxically, the major new entrant in the stock fund derby since 
1950--the stock market index fund--represents a throwback to a simpler 
age. The first index fund was created in 1975. It holds the 500 stocks 
in the S&P 500 Index and seeks to match its return (before costs). With 
its first cousin, the total stock market index fund (owning essentially 
all publicly held U.S. stocks), introduced in 1987, these consummate 
middle-of-the-road funds now account for 8 percent of equity fund 
assets. On the other hand, there are also market segment index funds 
(matching, for example, a technology stock index or an index of 
Austrian stocks), the antithesis of their diversified forebears.
    In substance, a half-century ago investors could have thrown a dart 
at a list of stock funds and had nine chances out of ten to pick a fund 
whose return was apt to closely parallel that of the market averages. 
Today, they have just one chance out of eight! The 1949 Fortune article 
noted the allegation that Massachusetts Investors Trust (M.I.T.), the 
first and then-largest mutual fund, did no more than give investors ``a 
piece of the Dow Jones Average.'' But the author was right when he 
presciently added, ``the average is not a bad thing to own.'' In any 
event, selecting mutual funds has, for better or worse, become an art 
form.


3. From Investment Committee to Broadway Stardom
    These vast changes in fund objectives have led to equally vast 
changes in how mutual funds are managed. In 1950, the major funds were 
managed almost entirely by investment committees, and that original 
Fortune article pictured the M.I.T. trustees and their advisory board 
as they made their investment decisions. There they are--not quite as 
dour as the famous Grant Wood portrait of the Iowa couple in ``American 
Gothic,'' but pretty close--distinguished of mien, serious of visage, 
doleful of countenance. The picture almost shrieks: We are 
conservative!
    But the demonstrated wisdom of the collective was soon overwhelmed 
by the perceived brilliance of the individual. The ``Go-Go'' era of the 
mid-1960's introduced both the concept of far more aggressive 
``performance funds'' and the notion of a ``portfolio manager.'' That 
era had much in common with the recent bubble, as fund sponsors 
introduced hot funds with supercharged returns (often based on cooked-
up numbers), aggressively marketed through stock brokerages. The new 
game seemed to call for free-wheeling individual talent, and the 
portfolio manager gradually became the prevailing standard. Today, the 
term ``investment committee'' has vanished, apparently replaced by 
``management team.'' But ``portfolio manager'' is the advisory model 
for some 3,400 funds of the 4,094 stock funds listed in Morningstar.
    The coming of the age of portfolio managers who serve as long as 
they produce performance moved fund management from the stodgy old 
consensus-oriented investment committee to a more entrepreneurial, 
free-form, and far less risk-averse approach. Before long, moreover, 
the managers with the hottest short-term records had been transformed 
by their employers' vigorous public relations efforts, and the 
enthusiastic cooperation of the media, into ``stars,'' and a full-
fledged star-system gradually came to pass. A few portfolio managers 
actually were stars--Fidelity's Peter Lynch, Vanguard's John Neff, Legg 
Mason's Bill Miller, for example--but most proved to be comets, 
illuminating the fund firmament for a moment in time and then flaming 
out, their ashes floating gently down to earth. Even after the 
devastation of the recent bear market, and the stunning fact that the 
tenure of the average portfolio manager is just 5 years, the system 
remains largely intact.
4. Turnover Goes Through the Roof
    Together, the coming of more aggressive funds, the burgeoning 
emphasis on short-term performance, and the move from investment 
committees to portfolio managers had a profound impact on mutual fund 
investment strategies--most obviously in soaring portfolio turnover. At 
M.I.T. and the other funds described in that Fortune article, they 
didn't even talk about long-term investing. They just did it, simply 
because that is what trusteeship is all about. But over the next half-
century that 
basic tenet was turned on its head, and short-term speculation became 
the order of the day.
    Not that the long-term focus didn't resist change. Indeed, between 
1950 and 1965, it was a rare year when fund portfolio turnover much 
exceeded 16 percent, meaning that the average fund held its average 
stock for an average of about 6 years. In the Go-Go era, that figure 
nearly tripled, to 48 percent (a 2-year holding period), only to fall 
back to an average of 37 percent (a 3-year holding period) after the 
1973-1974 market crash. But that was just the beginning.
    With the elimination of fixed commissions on stocks in 1975 and the 
later burgeoning of electronic trading networks, the unit costs of 
buying and selling plunged. Turnover rose accordingly, averaging about 
80 percent from the early 1980's through 1999. And it has risen even 
further since then, with fund managers turning their portfolios over at 
an astonishing average annual rate of 110 percent(!). Result: Compared 
to that earlier 6-year standard that prevailed for so long, the average 
stock is now held for just 11 months.
    The contrast is stunning. At 16 percent turnover, a $1 billion fund 
sells $160 million of stocks in a given year and then reinvests the 
$160 million in other stocks, $320 million in all. At 110 percent, a $1 
billion fund sells and then buys a total of $2.2 billion of stocks each 
year--nearly seven times as much. Even with lower unit transaction 
costs, it's hard to imagine that such turnover levels aren't a major 
drain on shareholder assets.
    When I say that this industry has moved from investment to 
speculation, I do not use the word speculation lightly. Indeed, in my 
thesis I used Lord Keynes' terminology, contrasting speculation 
(forecasting the psychology of the market) with enterprise (forecasting 
the prospective yield of an asset). I concluded that as funds grew they 
would move away from speculation and toward enterprise (which I called 
``investment''), focusing, not on the price of the share but on the 
value of the corporation. As a result, I concluded, fund managers would 
supply the stock market ``with a demand for securities that is steady, 
sophisticated, enlightened, and analytic.'' I was dead wrong. Mutual 
fund managers are no longer stock owners. They are stock traders, as 
far away as we can possibly be from investing for investment icon 
Warren Buffett's favorite holding period: Forever.


5. High Stock Turnover Leads to Low Corporate Responsibility
    Whatever the consequences of this high portfolio turnover are for 
the shareholders of the funds, it has had dire consequences for the 
governance of our Nation's 
corporations. In 1949, Fortune wrote, ``one of the pet ideas (of 
M.I.T.'s Chairman Merrill Griswold) is that the mutual fund is the 
ideal champion of . . . the small stockholder in conversations with 
corporate management, needling corporations on dividend policies, 
blocking mergers, and pitching in on proxy fights.'' And in my ancient 
thesis that examined the economic role of mutual funds, I devoted a 
full chapter to their role ``as an influence on corporate management.'' 
Mr. Griswold was not alone in his activism, and I noted with approval 
the SEC's 1940 call on mutual funds to serve as ``the useful role of 
representatives of the great number of inarticulate and ineffective 
individual investors in corporations in which funds are interested.'' 
By appraising corporate management critically and expertly, the SEC 
added, funds can ``not only serve their own interests, but also the 
interests of other public stockholders.''
    It was not to be. Just as my early hope that funds would continue 
to invest for the long-term went aborning, so did my hope that funds 
would observe their responsibilities of corporate citizenship. Of 
course, the two are hardly unrelated: A fund that acts as a trader, 
focusing on the price of a share and holding a stock for but 11 months, 
may not even own the shares when the time comes to vote them at the 
corporation's next annual meeting. By contrast, a fund that acts as an 
owner, focusing on the long-term value of the enterprise, has little 
choice but to regard the 
governance of the corporation as of surpassing importance.
    A half-century ago, funds owned but 2 percent of the shares of all 
U.S. corporations. Today, funds own some 23 percent of all stocks. They 
could wield a potent ``big stick,'' but with few exceptions, they have 
failed to do so. As a result of their long passivity and lassitude on 
corporate governance issues, fund managers bear no small share of the 
responsibility for the failures in corporate governance and accounting 
oversight that were among the major forces creating the recent stock 
market bubble and the bear market that followed. It is hard to see 
anything but good arising when this industry at last returns to its 
roots and assumes its responsibilities of corporate citizenship.
6. The Fund Shareholders Get the (Wrong) Idea
    The change in this industry's character has radically affected the 
behavior of the mutual fund shareholder. In the industry described in 
the Fortune article as having ``tastes in common stocks that run to the 
seasoned issues of blue-chip corporations,'' shareholders bought fund 
shares and held them. In the 1950's, and for a dozen years thereafter, 
fund redemptions (liquidations of fund shares) averaged 6 percent of 
assets annually, suggesting that the average fund investor held his or 
her shares for 16 years. Like the managers of the funds they held, fund 
owners were investing for the long pull.
    But as the industry brought out funds that were more and more 
performance- 
oriented, often speculative, specialized, and concentrated--funds that 
behaved increasingly like individual stocks--it attracted more and more 
investors for whom the long-term didn't seem to be relevant. Indeed, in 
the 1970's the industry added a not-so-subtle temptation to investors 
to trade among funds, an ``exchange privilege'' that facilitated swaps 
between funds in a given family. Up, up, up went the redemption rate, 
actually reaching 62 percent in the year of the 1987 market crash. Last 
year, the redemption rate (including exchanges out of funds) totaled 31 
percent, an average holding period of slightly more than 3 years. The 
time horizon for the typical fund investors had tumbled by fully 80 
percent .
    This change in behavior has forced a change in the delivery 
mechanism for fund shares. As ``buy and hold'' turned to ``pick and 
choose,'' the average fund owner who once held a single equity fund 
came to hold four. Freedom of choice became the industry watchword, and 
``fund supermarkets,'' with their ``open architecture,'' made it easy 
to quickly move money around in no-load funds. Trading costs are hidden 
in the form of access fees for the shelf-space offered by these 
supermarkets, paid for by the funds themselves, so that swapping funds 
seemed to be ``free,'' tacitly encouraging fund shareholders to trade 
from one to another. But while picking tomorrow's winners based on 
yesterday's performance is theoretically attractive, in practice it is 
a strategy that is doomed to failure.


7. The Modern Mutual Funds . . . Made to be Sold
    It is easy to lay the responsibility for this astonishing 
telescoping of holding periods on gullible, flighty, and emotional fund 
investors, or on the change in the character of our financial markets. 
After all, the investment climate was relatively peaceful during the 
1950's and early 1960's, while the boom and bust in the stock market 
bubble of 1997-2002 was clearly a mania driven by the madness of 
crowds.
    But the fund industry was a major contributor to that bubble. 
Departing from our time-honored tenet, ``we sell what we make,'' we 
jumped on the ``we make what will sell'' bandwagon, creating new funds 
to match the market mania of the moment. First, it was during the Go-Go 
era when ``concept stocks'' were the rage, and at least one-half of the 
new funds we formed were ``performance funds,'' sold not on the 
soundness of their policies and strategies, but on the glitter of their 
often illusory and sometimes fraudulent records. Then, during the 
recent market bubble, when technology and telecom stocks led the way, 
we formed 494 new technology, telecom, and Internet funds, and 
aggressive growth funds favoring these sectors. It was not just the 
industry opportunists who sought to capitalize on this foolishness. As 
the prices of ``new economy'' stocks moved relentlessly upward, many of 
the most respected firms in the industry--to their later 
embarrassment--abandoned their investment discipline, formed 
speculative funds, and offered them to their clients.
    But in the recent mania it was considerably easier to bring the 
investor sheep into the new-fund fold. Why? Because funds were now 
permitted to advertise their returns, and advertise them they did. 
Consider just one issue of a single magazine: In the March 2000 issue 
of Money, right at the market peak, 44 mutual funds advertised their 
performance. Their average return over the previous 12 exuberant months 
came to +85.6 percent! Small wonder that this industry took in $555 
billion of new money--more than a half-trillion dollars--during 1998 -
2000, overwhelmingly invested in the new breed of speculative high-
performance funds.
    And just as those winners of yesteryear led the market upward and 
attracted all that money, so they led the market on the way down and 
saw it vanish. In 1998-1999, the hottest 10 funds provided a cumulative 
average return of 332 percent, only to decline by 75 percent in 2000-
2002. While the resultant net gain of 8 percent for the shareholder of 
the fund throughout the period, the overwhelming majority came in late, 
garnering little if any of the upside, and most, if not all, of the 
downside. The industry's cash flow, of course, traced the same up-then-
down pattern. Eternally a trailing indicator in this ever-market-
sensitive business, the gushing equity cash flow of the boom actually 
turned negative in the bust--an $18 billion outflow as the market 
reached its low in 2002. Today, it is not irrational exuberance but 
rational disenchantment that permeates the community of fund owners.
    In another astonishing reversal, this flagrant formation of new 
funds soon began to unwind. Fund deaths began to match, and will surely 
soon exceed, fund births. But it is not the old middle-of-the-road 
funds that are dying; it is largely the new breed of funds--those that 
sought out the exciting stocks of the new economy and hyped their 
records. Most of those stodgy funds of 1950 remain survivors. M.I.T. 
and the other 10 largest funds of a half-century ago ($75 million or 
more in assets!) remain in business today.
    Those early funds were, as the saying goes, ``built to last.'' 
Typically, 99 percent of the funds in business at the beginning of each 
year were still around at its end, and nearly 90 percent still in 
business after a decade, with some 10 percent liquidating or merging 
with another fund. But as ``built to last'' turned to ``born to die'' 
during the Go-Go era, that decade-long failure rate then rose to 60 
percent in the 1970's, only to fall back to 18 percent in the 1980's. 
Then, in the 1990's, the failure rate soared to 50 percent. The 
acceleration continued in 2000 -2002, with nearly 900 funds giving up 
the ghost--an annual failure rate averaging 7 percent. If that rate 
continues (and there is reason to believe it may accelerate), half of 
today's funds won't be around a decade hence.


8. The Costs of Fund Ownership
    When ``Big Money in Boston'' featured Massachusetts Investors 
Trust, it was not only the oldest and largest mutual fund, but also the 
least costly. The Fortune article reported that its annual management 
and operating expenses, paid at the rate of just 3.20 percent of its 
investment income, amounted to just $827,000. In 1951, its ``expense 
ratio'' (expenses as a percentage of fund assets) was just 0.29 
percent, the lowest in the industry, and the average expense ratio for 
the 25 largest funds, with aggregate assets of but $2.2 billion, was 
only 0.64 percent.
    What a difference five decades makes! In 2002, M.I.T.'s expense 
ratio had risen to 1.20 percent, and its $126 million of expenses 
consumed 80 percent(!) of its investment income. The average expense 
ratio for the equity funds managed by the 25 largest fund complexes has 
risen 139 percent to 1.53 percent despite the fact that assets have 
soared 1,070-fold, to nearly $2.4 trillion. The dollar amount of direct 
fund expenses borne by shareholders of all equity funds has risen from 
an estimated $15 million in 1950 to something like $35 billion in 2003. 
There are staggering economies of scale in mutual fund management, but 
it is obvious that fund investors have not only not shared in these 
economies, but have also been victims of far 
higher costs.
    Of course, the expense ratio is only part of the cost of fund 
ownership. And in those olden days, the industry's no-load (no sales 
commission) segment represented less than 3 percent of industry assets. 
The predominant form of distribution was the independent broker-dealer, 
and the fund buyer typically paid a sales charge averaging perhaps 6 
percent on each purchase. Spread over a then-holding period of perhaps 
15 years, that additional cost of about 0.4 percent per year brought 
the all-in direct costs of fund ownership to, say, 1.00 percent 
annually.
    The distribution mechanism has changed. Now, no-load funds are a 
powerful force in the industry, accounting for some 40 percent of 
equity fund assets. And for load funds, the traditional front-end sales 
charge has been largely supplanted by a host of ``alphabet'' shares, 
usually with no front-end commission. Rather, the sales charge is paid 
in annual installments of 1 percent a year or so, usually aggregating 
about 6 percent. When this ``distribution fee'' is included in the 
fund's expense ratio, there are significant conceptual differences in 
comparing today's fund expense ratios with those of a half-century 
earlier.
    The fund industry reports that the costs of fund ownership have 
steadily declined, but it is difficult to take that allegation 
seriously when total fund operating expenses have, as stated earlier, 
risen more than 3,000-fold(!) since 1950. While the ratio of fund 
expenses to fund assets may be lower, such a decline arises only 
because investors are increasingly choosing no-load funds and low-cost 
funds, not because of substantial management fee reductions. Stripped 
of statistical legerdemain, recent industry data show that direct all-
in equity fund expenses amount to 1.46 percent of assets, not far from 
the crude unweighted 1.66 percent expense ratio reported for the 
average equity fund.
    The industry data on what it calls ``the cost of mutual fund 
ownership'' is shockingly understated. Why? Because it omits one of the 
largest costs of fund ownership. Portfolio transaction costs--an 
inseparable part of owning most funds--are ignored, yet they add 
something like 0.8 percent per year to that 1.66 percent expense ratio, 
bringing the cost to 2.4 percent. Out-of-pocket costs paid by fund 
investors are also ignored. Fees paid to financial advisers to select 
funds (partly replacing those front-end loads) are also ignored. 
Opportunity cost--the long-term shortfall in the returns engendered by 
the cash reserves that nearly all equity funds maintain--is ignored. 
Put them all together and it is fair to estimate that the all-in annual 
costs of mutual fund ownership now runs in the range of 2\1/2\ percent 
to 3 percent of assets.
    What does that mean? While 2\1/2\ percent may look like small 
potatoes compared to the value of a typical fund investment, such a 
cost could cut deeply into the 
so-called ``equity-premium'' by which investors expect stock returns to 
exceed bond 
returns, giving the average equity fund investor a return little more 
than a bondholder, despite the extra risk. Looked at another way, 2\1/
2\ percent would consume 25 percent of an annual stock market return of 
10 percent. Over the long-term, $1 compounded in a 10 percent stock 
market would grow to $17.50 over 30 years; compounded at 7\1/2\ 
percent--a fund's return after such costs return--would reduce that 
value by exactly one-half, to $8.75. Costs matter!
    The astonishing rise in equity fund costs since 1950--despite the 
truly flabbergasting leap in fund assets, not just on new speculative 
funds but on old conservative funds--is one more indication that the 
fund industry has veered from its roots as an investment profession, 
moving ever closer to being just another consumer products business. 
Further disclosure of the total costs incurred by fund investors would 
be a much-needed first step in the long process of reversing this 
trend.
9. The March of the Entrepreneur
    That the line between a business and a profession is an obscure one 
does not mean that it does not exist. We think of a business as an 
undertaking in which the principal purpose is to earn a profit for the 
owner, and a profession as an undertaking in which the provider's 
purpose is to serve clients. Nonetheless, it must be clear that every 
business must entertain some idea of service to others. (Without that 
element, the customers would go elsewhere.) And that every profession 
must also, in some sense, make a profit. (Doctors and lawyers, after 
all, should earn a good living.)
    But the industry that Fortune described all those years ago clearly 
placed the emphasis on fund management as a profession--the trusteeship 
of other people's money. The article is peppered with the words 
``trust'' and ``trustee,'' and frequently refers to the ``investment-
trust industry.'' Funds were largely middle-of-the-road in focus, 
diversified in investments, and built to last. Management fees were 
used to pay for, of all things, management. Costs were low, and 
distribution costs were paid not by the funds, but by the investors, as 
they purchased their shares. (M.I.T., for example, had its own 
employees (28!), no management company, and no economic or ownership 
interest in the company that distributed its shares.)
    Today, it seems clear that marketing has superseded management as 
our industry's prime focus, the exact opposite of what I called for in 
my thesis. The industry spends, I would estimate, at least five times 
as much on selling as on supervision, contributing heavily to those 
soaring expense ratios. Advertising has gone from virtually nonexistent 
to pervasive (or at least it was until the onset of the great bear 
market). We have put aside our professional judgment and formed new 
funds when the investing public demanded then, and, when they outlive 
their usefulness or lose their performance luster, we give them a 
decent burial, happily consigning their records to the dustbin of 
history.
    What caused the sea change in our industry? Perhaps it is that 
stewardship was essential for an industry whose birth in 1924 was 
quickly followed by tough times--the Depression, and then World War II. 
Perhaps it is that salesmanship that became the winning strategy in the 
easy times thereafter, an era of almost unremitting economic 
prosperity. Perhaps it is because as we became the investment of choice 
for American families fund shareholders, with no more efficient way to 
own stocks, bonds, and saving reserves, became less discriminating. 
Perhaps it was the very genetics of the capitalistic system that drives 
companies to compete and win. But I believe that the most powerful 
force behind the change was that mutual fund management emerged as one 
of the most profitable businesses in our
Nation, with pretax profit margins that average 40 percent to 50 
percent or more. Entrepreneurs could make big money managing mutual 
funds.
    The fact is that, only a few years after ``Big Money in Boston'' 
appeared, the whole dynamic of entrepreneurship in the fund industry 
changed. In 1958, it became possible not only to make a tidy profit in 
managing money, but also to capitalize that profit by selling shares of 
a management company to outside investors. Up until then, the SEC had 
successfully defended its position that the sale of a management 
company represented the payment for the sale of a fiduciary office, an 
illegal appropriation of fund assets. Why? Because by allocating future 
advisory fees to whomever the manager might wish, a sale of the 
trustee's office would have taken place. If such sales were allowed, 
the SEC feared it would lend to ``trafficking'' in advisory contracts, 
leading to a gross abuse of the trust of fund shareholders.
    But in 1954, a California management company, in effect challenging 
the SEC's position, sold its shares to an outside investor. The SEC 
went to court, and lost. As 1958 ended, the gates that had prevented 
public ownership for 34 years came tumbling down. Apres moi, le deluge! 
The rush of public offerings began. Within 2 years, the shares of a 
dozen management companies, including some of the industry 
pioneers, were brought to market via initial public offerings. Over 
subsequent 
years, many others followed. Investors bought management company shares 
for the same reasons that they bought Microsoft and IBM and, for that 
matter, Enron,
because they thought their earnings would grow and their stock prices 
would rise
accordingly.
    But the IPO's were just the beginning. Most of the companies that 
went public were ultimately acquired by other financial companies. 
Giant banks and insurance companies also acquired privately held 
management companies, taking the newly found opportunity to buy into 
the burgeoning fund business at a healthy premium--averaging 10 times 
book value or more. ``Trafficking'' wasn't far off the mark; there have 
been at least 40 such acquisitions during the past decade, and the 
ownership of some firms has been transferred several times. Today, 
among the 50 largest fund managers, only six(!) are privately held, 
largely by their executives.\3\ Thirty-six are owned by giant financial 
conglomerates, including bank, stock brokers, insurance companies, and 
foreign financial firms. (In 1982, even the executives of M.I.T. and 
its associated funds sold the management company to Sun Life of 
Canada.) The seven remaining firms are publicly held.
---------------------------------------------------------------------------
    \3\ While Vanguard is not included in this list, it is owned by the 
mutual funds it manages.
---------------------------------------------------------------------------
    It must be clear that when a corporation buys a business--whether a 
fund manager or not--it expects to earn a hurdle rate of, say, 12 
percent on its capital. So if the acquisition cost were $1 billion, the 
acquirer would likely defy hell and high water in order to earn at 
least $120 million per year. In a bull market, that may be an easy 
goal. But when the bear market comes, we can expect some combination 
of: (1) slashing management costs; (2) adding new types of fees 
(distribution fees, for example); (3) maintaining, or even increasing, 
management fee rates; or even (4) indeed, the overreaching by managers 
in the recent fund scandals was often done to enrich fund managers at 
the expense of fund shareholders. (The SEC's ``trafficking'' in 
advisory contracts writ large!)
    It is not possible to assess with precision the impact of this 
shift in control of the mutual fund industry from private to public 
hands, largely those of giant financial conglomerates, and the change 
in the industry from profession to business. But such a staggering 
aggregation of managed assets--often hundreds of billions of dollars--
under a single roof, much as it may serve to enhance the development, 
to whatever avail, of fund complex's ``brand name'' in the consumer 
goods market, seems unlikely to make the money management process more 
effective, nor to drive investor costs down, nor to enhance this 
industry's original notion of stewardship and service.


10. A Half-Century of Change: For Better or Worse?
    In short, this industry is a long, long way from the industry 
described in ``Big Money in Boston'' all those years ago. While my 
characterization of the changes that have taken place may be 
subjective, the factual situation I have described is beyond challenge. 
This is an infinitely larger industry. The variety of funds has raised 
the industry's risk profile. The management mode was largely by 
committee but is overwhelmingly by portfolio manager. Fund turnover has 
taken a great upward leap. Fund investors do hold their shares for far 
shorter periods. Marketing is a much more important portion of fund 
activities. Fund costs, by any measure, have increased, and sharply. 
And those closely held private companies that were once the industry's 
sole modus operandi are an endangered species.
    All this change has clearly been great for fund managers. The 
aggregate market capitalization of all fund managers 50 years ago could 
be fairly estimated at $40 million. Today, $240 billion would be more 
like it. Way back in 1967, Nobel Laureate Paul Samuelson was smarter 
than he imagined when he said, ``there was only one place to make money 
in the mutual fund business--as there is only one place for a temperate 
man to be in a saloon, behind the bar and not in front of it . . . so, 
I invested in a management company.''
    At the start of this statement, I asked whether these nine changes 
have served the interests of mutual fund investors. Clearly the answer 
is a resounding no. It is a simple statistical matter to determine, 
using Dr. Samuelson's formulation, how well those on the other side of 
the bar in that saloon have been served, first by the old industry, 
then by the new.

 During the first two decades of the period I have covered 
    today (1950 -1970), the annual rate of return of the average equity 
    fund was 10.5 percent, compared to 12.1 percent for Standard & 
    Poor's 500 Stock Corporate Index, a shortfall of 1.6 percentage 
    points, doubtless largely accounted for by the then-moderate costs 
    of fund ownership. The average fund delivered 87 percent of the 
    market's annual
    return.

 During the past 20 years (1983-2003), the annual rate of 
    return of the average equity fund was 10.3 percent, compared to 13 
    percent for the S&P 500 Index, a shortfall of 2.7 percentage 
    points--69 percent greater than the prior period's--largely 
    accounted for by the now-far-higher levels of fund operating and 
    transaction costs. The average fund delivered just 79 percent of 
    the market's annual return.
    
    
    It is the increase in costs, largely alone, that has led to that 
substantial reduction in the share of the stock market's return that 
the average fund has earned. But it is the change in the industry's 
character that has caused the average fund shareholder to earn far less 
than the average fund. Why? First, because shareholders have paid a 
heavy timing penalty, investing too little of their savings in equity 
funds when stocks represented good values during the 1980's and early 
1990's. Then enticed by the great bull market and the wiles of mutual 
fund marketers as the bull market neared its peak, they invested too 
much of their savings. Second, because they have paid a selection 
penalty, pouring money into ``new economy'' stocks and withdrawing it 
from ``old economy'' stocks during the bubble, at what proved to be 
precisely the wrong moment.
    The result of these two penalties: While the stock market provided 
an annual return of 13 percent during the past 20 years, and the 
average equity fund earned an annual return of 10.3 percent, I estimate 
that the average fund investor earned just 3 percent per year. It may 
not surprise you to know that, compounded over two decades, the nearly 
3 percent penalty of costs is huge. But the penalty of character is 
even larger--another 8 percentage points. One dollar compounded at 13 
percent grows to $11.50; at 10 percent, to $7.10; and at 3 percent, to 
just $1.80. A profit of just eighty cents!


    The point of this exercise is not precision, but direction. It is 
impossible to argue that the totality of human beings who have 
entrusted their hard-earned dollars to the care of mutual fund managers 
has been well-served by the myriad changes that have taken place from 
mutual funds past to mutual funds present. What about 
mutual funds yet to come? My answer will not surprise you. It is time 
to go back to our roots; to put mutual fund shareholders back in the 
driver's seat, to put the interests of shareholders ahead of the 
interests of managers and distributions, just as the 1940 Investment 
Company Act demands.
It Is Time For Change
    It is time for change in the mutual fund industry. We need to 
rebalance the scale on which the respective interests of fund managers 
and fund shareholders are weighed. Despite the express language of the 
1940 Act that arguably calls for all of the weight to be on the side of 
fund shareholders, it is the managers' side of the scale that is 
virtually touching the ground. To get a preponderance of the weight on 
the shareholders' side, we need Congress to mandate: (1) an independent 
fund board chairman; (2) no more than a single management company 
director; (3) a fund staff or independent consultant that provides 
objective information to the board; (4) a Federal standard that, using 
the Act's present formulation, provides that directors have a fiduciary 
duty to assure that ``funds are organized, operated, and managed in the 
interests of their shareholders'' rather than in the interests of 
``their advisers and distributors;'' (The italicized language would be 
added to the statute.) (5) that boards of directors consider a mutual 
structure once a fund complex reaches a
certain size.
    In addition to legislation that will begin the process of reforming 
fund governance in the interests of fund owners, we also need better 
information for mutual fund shareholders, including: (1) annual 
statements that show the actual dollar amount of annualized fund 
expenses and portfolio transaction costs paid by each investor; (2) 
mandatory reporting, not only of the standard returns of an investment 
in a single share of the fund (``time-weighted'' returns), but also the 
returns actually earned on the fund's total assets (``dollar-weighted'' 
returns); (3) an economic study of the fund industry by the Securities 
and Exchange Commission showing all of the costs assumed by fund 
owners, and the itemized list of expenses incurred by their managers, 
as well as the managers' profits; (4) complete disclosure of all 
compensation paid to mutual fund executives, including total 
compensation paid to senior executives and portfolio managers, 
including their share of the management company's profits; and (5) an 
express requirement that compels advisers to provide, and fund 
directors to consider, the amount and structure of fees paid to the 
adviser by institutional clients. The disparities in these fees are 
shocking.
    As I wrote 5 years ago in Common Sense on Mutual Funds, changes 
such as these would at long last allow independent directors ``to 
become ferocious advocates for the rights and interests of the mutual 
fund shareholders they represent . . . they would negotiate 
aggressively with the fund adviser . . . they would demand performance-
related fees that enrich managers only as fund investors are themselves 
enriched. . . . They would challenge the use of 12b -1 distribution 
fees . . . and no longer rubber-stamp gimmick funds cooked-up by 
marketing executives . . . becoming the 
fiduciaries they are supposed to be under the law.''
    Alternatively, and perhaps even more desirably, I then argued, the 
industry may require ``a radical restructuring--the mutualization of at 
least part of the mutual fund industry. . . . Funds-- or at least large 
fund families--would run themselves; and the huge profits now earned by 
external managers would be diverted to the shareholders . . . they 
wouldn't waste money on costly marketing companies designed to bring in 
new investors at the expense of existing investors. With lower costs, 
they would produce higher returns and/or assume lower risks. But 
regardless of the exact structure --(a new) conventional form or a 
truly mutual form--an arrangement in which fund shareholders and their 
directors are in working control of a fund will lead . . . to an 
industry that will enhance economic value for fund shareholders.'' And 
it is in that direction that this industry must at last move.
                              *    *    *
Addendum: A Fair Shake for Federal Government Employees
    It is a curious irony that the ``radical restructuring'' I called 
for in the final paragraph of my regular testimony is already in place 
for the employees of the Federal Government. The Thrift Savings Plan 
(TSP), established by Congress in 1986, is a defined contribution plan 
governed by their Federal Retirement Thrift Plan Board, an independent 
Government agency. The members of the Board are required by law to 
manage the Plan prudently and solely in the interests of the 
participants and their beneficiaries.
    In effect, the TSP joins Vanguard as the second mutual mutual fund 
organization, operated on an ``at cost'' basis and managed for the 
benefit of its participants. TSP invests in fixed-income securities, 
stocks of large companies, small capitalization stocks, and 
international stocks, all ``indexed'' to track appropriate market 
benchmarks (for example, the Standard & Poor's 500 Stock Index). TSP 
has negotiated with Barclays the fees paid for those indexing services, 
which last year came to $4,270,000, equal to 0.005 percent, or just 
one-half of one basis point. (A basis point equals one-tenth of 1 
percent.) Including administrative expenses, the Plan's ``expense 
ratio''--expenses as a percentage of average assets--was 0.07 percent 
(seven basis points).
    As the attached table shows, TSP would have by far the lowest costs 
of the equity funds managed by the 25 largest equity fund managers--
roughly 95 percent lower(!) than the average manager's expense ratio of 
1.60 percent, and even 30 basis points below Vanguard's industry-low 
0.37 percent equity fund expense ratio. (Vanguard's equity funds are 
both indexed and actively managed.) The TSP has been a remarkable 
success. Were it a conventional fund complex, its $129 billion of 
assets at the beginning of 2004 would mark it as the 13th largest firm 
in the industry.
    TSP has provided enormous benefits to Federal employees, has 
operated in the way that Vanguard operates, has been totally immune to 
scandal or to any of the nine baneful trends described in my statement, 
and has served its owners well. The TSP large cap stock fund, for 
example, delivered an annual return of 9.29 percent to its investors 
during 1993-2002, after all administrative expenses, management fees, 
and trading costs, compared to the return of 9.34 percent of the (cost-
free) Standard & Poor's 500 Index, a shortfall of just five basis 
points. The average equity fund, on the other hand, (see chart 10b) has 
tended to fall some 270 basis points per year behind the Index, 
creating a staggering shortfall in investment returns.
    General mutual fund investors deserve to be as well-served as 
Federal Government employees. I believe the optimal way to encourage 
the industry to move in that direction is to enforce the objective of 
the Investment Company Act of 1940 that requires that funds be 
``organized, operated, and managed,'' not in the interests of their 
managers and distributors, but solely in the interests of their 
shareholders, just as is the Federal Employees Thrift Savings Plan. I 
recommend that the Act be amended to include: (1) imposing upon fund 
directors an express statutory Federal standard of fiduciary duty to 
fund shareholders; (2) a requirement that no more than a single 
management company executive be eligible for membership on the fund's 
board of directors; (3) a requirement that the fund's chairman be an 
independent director; and (4) a provision empowering and encouraging 
fund directors to employ their own staff to evaluate the costs and 
returns achieved by their managers relative to other alternatives.





                     FUND OPERATIONS AND GOVERNANCE

                              ----------                              


                         TUESDAY, MARCH 2, 2004

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10:01 a.m. in room SD-538 of the 
Dirksen Senate Office Building, Senator Richard C. Shelby 
(Chairman of the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order.
    Today, this Committee holds its fifth hearing on reforming 
the mutual fund industry. We have two panels this morning.
    On the first panel, we have Senator William Armstrong, my 
former colleague and the current Independent Director and 
Chairman of the Oppenheimer Funds; Marvin Mann, Chairman of the 
Independent Trustees of the Fidelity Funds; and Vanessa Chang, 
who is an Independent Director for the New Perspective Fund.
    I expect the witnesses to further our understanding of fund 
governance practices and principles as we seek to ensure that 
mutual fund boards are properly armed to protect shareholder 
interests.
    We will also hear from Michael Miller, who is Managing 
Director for The Vanguard Funds. Mr. Miller will discuss the 
issues surrounding the simultaneous management of mutual funds 
and other institutional accounts, such as hedge funds, by 
portfolio managers.
    I am sensitive to the potential for conflicts that can 
arise through the side-by-side management of mutual funds and 
hedge funds. Like all potential conflict situations, these 
side-by-side arrangements must be subjected to close scrutiny 
under strong and active compliance programs.
    I look forward to hearing whether, and how, fund advisers 
go about ensuring that fund shareholders are treated fairly and 
receive equitable share allocations.
    The second panel will address the SEC's recent rule 
proposal aimed at halting late trading. As we learned from the 
recent scandals, late trading was all too common in the 
industry. In an effort to shut the window for late trading, the 
SEC proposed a rule that would essentially require all mutual 
fund trades to be reported to the fund or a registered clearing 
agency by 4 p.m. Eastern Standard Time.
    This proposal is known as a ``Hard 4 p.m. Close.'' Many 
contend that although the ``Hard 4 p.m. Close'' would deter 
late trading, it will have the unintended adverse consequence 
of limiting investors' access to their mutual fund investments. 
This unintended consequence will be particularly unfair to 
401(k) investors.
    The witnesses will discuss how the ``Hard 4 p.m. Close'' 
will impact investors and will hopefully offer alternatives 
that deter late trading without unintentionally harming 
investors.
    On the second panel, we will hear from Ms. Ann Bergin, 
Managing Director of the National Securities Clearing 
Corporation; Mr. William Bridy, President of Financial Data 
Services, a subsidiary of Merrill Lynch; Mr. Raymond McCulloch, 
Executive Vice President, BB&T Trust; and Mr. David Wray, 
President, Profit Sharing/401(k) Council of America. I look 
forward to your testimony.
    Now, I want to recognize Senator Allard for a special 
recognition.

                COMMENTS OF SENATOR WAYNE ALLARD

    Senator Allard. Thank you, Mr. Chairman. I just want to 
take a moment to welcome the panel here and particularly one 
member on the panel, former Senator Bill Armstrong. Bill 
represented my State of Colorado--in fact, he represented the 
seat that I now hold here in the Senate--from 1979 to 1991. He 
spent 10 years of that time right here on the Banking 
Committee.
    Chairman Shelby. Some of it with me.
    [Laughter.]
    Senator Allard. He is recognized as somebody who is very 
thoughtful and who was extremely effective while he was here.
    I also know he has not been particularly anxious to come 
back. It has been over a decade since he has testified before a 
committee or even had his words put on any kind of public 
record around here. He has certainly been a strong advocate of 
the free enterprise system, and I know that he recommends this 
Committee to new Members that come into the Senate. I had a 
discussion with him when I came to the U.S. Senate, and he 
recommended that I get on this Committee--that was a very good 
recommendation. I have never regretted that and have thoroughly 
enjoyed serving with you, Mr. Chairman, and serving on this 
particular Committee.
    I just wanted to give him my special welcome. I am not 
going to be able to stay long because I am on the Budget 
Committee, so I won't be able to hear all your words this 
morning.
    Mr. Chairman, I also have some comments I would like to 
have in the record.
    Chairman Shelby. Without objection, they will be made part 
of the record.
    Senator Allard. Thank you very much.
    Chairman Shelby. Before I recognize the panel, I do want to 
add something else about Senator Armstrong. He served on this 
Committee. He was a senior Member of this Committee when I was 
a freshman Member, and my first 2 years on the Committee were 
your last 2 years in the Senate. He left by choice not by 
force. I told him the other day that if he had stayed here, he 
would be Chairman of the Committee and I would be one of his 
lieutenants. And I would gladly be so.
    We have just been joined by Senator Hagel. Do you have any 
opening comments?

                COMMENTS OF SENATOR CHUCK HAGEL

    Senator Hagel. The only comment I would make, Mr. Chairman, 
is to welcome our witnesses and, as you have noted, our former 
colleague and dear friend, Bill Armstrong. I might add that one 
of the reasons he is so smart and wise, he is a Nebraskan.
    [Laughter.]
    As is his wife.
    Chairman Shelby. You are all probably cousins in some way.
    [Laughter.]
    I could not resist.
    Senator Hagel. Mr. Chairman, thank you.
    Chairman Shelby. Senator Hagel, I think that both of you 
understand the business model and market forces.
    Senator Armstrong, we will start with you. If you have 
written testimony it will be made part of the record. You know 
the Committee. Proceed as you wish.

               STATEMENT OF WILLIAM L. ARMSTRONG

              INDEPENDENT MUTUAL FUND DIRECTOR AND

                  CHAIRMAN, OPPENHEIMER FUNDS

                FORMER U.S. SENATOR (1979-1991)

    Senator Armstrong. Mr. Chairman, thanks very much. Thanks 
for the opportunity to be here. Thank you for your gracious 
comments. The financial services industry and thoughtful people 
all over the world are glad that I retired and you became the 
Chairman of this Committee. And I compliment you for your 
leadership.
    Chairman Shelby. Maybe I should retire and you would be the 
Chairman, if you would show me how the market forces work.
    Senator Armstrong. Mr. Chairman, I do not want to take too 
much time to say so, but I left because of illness and fatigue. 
I was afraid if I stayed too long, my constituents would get 
sick and tired of me.
    [Laughter.]
    I particularly want to thank my dear friend, Wayne Allard, 
for his comments. It just reminds me how much I appreciate his 
friendship and his service to the people of our State and 
country. And to Chuck Hagel, who has been a friend for, I 
guess, three decades and a person whom I have admired and 
appreciated, I thank Senator Hagel for his comments as well.
    Mr. Chairman, I am an Independent Mutual Fund Director. I 
am the Chairman of 38 Denver-based mutual funds with about 5 
million shareholder accounts and $75 billion in assets.
    My colleagues and I on these fund boards have learned with 
mounting indignation that some people in this industry have 
betrayed the trust placed in them by shareholders. These people 
must be called to account. It seems to me that people who have 
violated their trust must be punished. And, in fact, as far as 
I am concerned, we should throw the book at them.
    Having said that, it is important to keep in mind that all 
of the wrongdoing has been discovered and can readily be 
punished under existing statutes. What has happened does not, 
in my opinion, call for sweeping new legislation. In fact, some 
of the proposals which have been suggested--and I have reviewed 
106 specific proposals contained in various legislative 
initiatives and regulatory proposals--some of these actually 
end up punishing the shareholders. What an irony it would be 
if, as a result of the wrongdoing, we somehow ended up 
punishing the victims instead of the violators.
    Now this is not to say that we should do nothing. 
Obviously, there is some action called for, and I take it for 
granted that Congress should and will act. I think the 
important thing, though, is to separate out what will help the 
shareholders because they should be, it seems to me, the 
paramount interest of this Committee and certainly the 
paramount interest of directors.
    Mr. Chairman, broadly speaking, the things that will be 
good for shareholders are governance and disclosure, and I 
would like to just quickly address two or three items.
    First of all, my colleagues and I in the fund industry--and 
I do not speak for all of them, but I must say, I have talked 
to a great many, probably the chairmen or directors of maybe 25 
different fund families over the last few months. Most of us 
believe that independent directors are a good idea. We favor 
the concept of two-thirds or 75 percent of directors being 
independent, though I would urge caution in how this is 
implemented. In one case that I know of, an 11 member board has 
10 members who are independent under present law, but if the 
definition was changed in accordance with some suggestions, 
suddenly people who are now considered independent would not 
be. And to get into conformity, it would require discharging a 
number of the present directors or actually adding 13 new 
directors to the board, which would produce a board too large 
to govern effectively; it would be unwieldy and not a desirable 
outcome.
    We favor the independence requirement, but we want it 
either phased in or leave the definition alone just to avoid 
unintended consequences and either the loss of expertise or 
creating boards that are too large.
    Many people in the industry favor the concept of an 
independent chairman. I am an independent chairman. I generally 
think that is a good idea. In fact, I happen to think 
independent chairmen are a good idea for most business 
corporations, not just mutual funds. But I cannot help but 
wondering: Why should this be mandated by law? Why shouldn't 
this be left up to individual boards of independent directors 
to decide whether they want to elect someone who is an 
executive or somebody who is an independent trustee? Why can't 
that just be left up to everybody?
    Now, for example, if Mr. Mann's fund finds that he wants to 
have an executive chairman and our fund at Oppenheimer has an 
independent chairman, if that is fully disclosed, shareholders 
can make that decision. And if they decide that they do not 
like an executive chairman, fine, let them sell their Fidelity 
shares and buy Oppenheimer shares and vice versa. In other 
words, if the people know, they will work it out for 
themselves.
    Which brings me to the whole topic of disclosure. We think 
truth is our friend, and with one exception which I want to 
mention, we favor disclosing everything, only to the extent 
that it does not 
become confusing to investors, but basically we think sunshine 
is great. We think that regulation is probably to the 
disadvantage of shareholders.
    The one exception, the one place where I personally and my 
colleagues have some concern about disclosure is when it comes 
to disclosing the exact salary of a portfolio manager, which 
just puts such people on a shopping list for headhunters and 
will end up having people recruited out of the industry into 
hedge funds and other financial institutions.
    Mr. Chairman, let me just close by saying this: In my 
written statement I have submitted commentary on a number of 
the issues that are pending, including things that have to do 
with the next panel. I will not go into them now, but I do want 
to say that my colleagues and I wish the Committee much success 
in your deliberations. The mutual fund industry is enormously 
important to America. Fifty-four million Americans have mutual 
fund accounts, with $7 trillion invested. It has been perhaps 
the most important, the most significant engine of wealth 
creation for most American families, particularly middle-income 
families who do not have the financial resources or access to 
hedge fund managers, separate 
accounts, or all of the investment vehicles that are available 
to the wealthy. They do not have that. But the mutual fund 
industry has made it possible through 8,200 funds for them to 
have a chance to create significant wealth, much to their 
advantage, but also to the advantage of the whole country 
because such people do not tend to become dependent upon the 
Government for help.
    Mr. Chairman, we do wish you well, and needless to say, if 
my colleagues or I can ever be of help, we are eager to do so.
    Thanks again for the opportunity to be here.
    Chairman Shelby. Thank you.
    Ms. Chang.

                STATEMENT OF VANESSA C.L. CHANG

                      INDEPENDENT DIRECTOR

                      NEW PERSPECTIVE FUND

    Ms. Chang. Thank you and good morning.
    Chairman Shelby. Pull the mike up to you a little bit, 
please.
    Ms. Chang. Okay.
    My name is Vanessa Chee Ling Chang. I serve as an 
Independent Director, Chair of the Audit Committee, and a 
member of the Contracts Committee of New Perspective Fund, also 
known as NPF, a member of the American Funds family. The fund 
is advised by Capital Research and Management Company, and it 
has in excess of $30 billion in assets and is sold through 
third parties.
    I appreciate the opportunity to appear before this 
Committee this morning to discuss mutual fund governance and my 
perspective as an independent director.
    I am greatly dismayed by the abuses that have come to light 
in this industry over the last couple of months. In particular, 
I am distressed, like my colleague Mr. Armstrong, about the 
abuses that some industry participants have chosen to benefit 
themselves unfortunately at the expense of fund investors, 
causing the current crisis of confidence. Their behavior is so 
contrary to my experience with my fellow directors at American 
Funds, with the associates at Capital Research, and in 
particular, independent directors of other funds whom I have 
gotten to know and with whom I have had industry discussions.
    I commend Congress' and the regulators' interest, 
especially the SEC, in restoring investor confidence and faith 
in our capital markets. Clearly, some regulatory response is 
necessary. I thank this Committee for your thoughtful 
consideration to determine what legislative response may be 
necessary.
    My testimony this morning will focus on two areas: First, I 
will discuss the operation of a fund board and my experience in 
carrying out my duties and responsibilities as an independent 
director. Second, I will address some of the pending reform 
proposals that could affect the duties of an independent 
director on fund boards and provide my views on whether they 
could enhance or hinder our oversight role.
    A shareholder invests in a mutual fund because the 
investment strategy and process of the adviser is attractive to 
that individual investor. In fact, the investment adviser 
created the mutual fund to offer its services on a pooled basis 
to the investing public who otherwise could not possibly afford 
the services of a professional money manager.
    Fund directors are subject to State law duties of loyalty 
and care. We are also subject to additional specific duties 
under the Investment Company Act of 1940 and the SEC. These 
responsibilities typically include monitoring for conflicts of 
interest between the fund and its adviser and other service 
providers. One prominent example of the independence role in 
protecting against conflicts is the annual renewal of the 
adviser's contract.
    A mutual fund has no employees and, therefore, contracts 
out for all its services. Accordingly, the mutual fund board 
must continually focus on the quality of those services and 
determine whether the fund has received fair value. The adviser 
and service providers manage its operations and provide staff. 
As fund directors, we are not charged with managing any of the 
fund operations. We serve, however, the interests of fund 
shareholders through our oversight of the fund's operations and 
of the fund's service providers such as the adviser, the 
auditors, lawyers, and the like.
    At NPF, active oversight of the fund's investment adviser 
is the heart of our work. We receive monthly briefings that 
address the business, industry, and regulatory developments 
amongst other items of interest, and especially in connection 
with the annual contract renewal. We review and discuss 
information provided by the adviser over two board meetings. I 
have never felt inhibited in asking questions or raising issues 
that were either not on the agenda or not in the book.
    Only the independent directors, together with our 
independent counsel, meet in executive session to discuss all 
of the information in connection with this contract renewal. 
Only after we are all satisfied do we vote on the advisory 
contracts. All independent directors sit on the Contracts 
Committees, and only we vote on the contract matters.
    My duty as a director is to feel comfortable not just at 
one point in time. As a result, throughout the year, I look for 
or request information that satisfies me that the controls, 
systems, policies, and procedures necessary to protect the 
fund's investors continue to be in place. Our board regularly 
takes the initiative to identify matters for the adviser to 
report on at the board meetings or in special sessions. 
Management is always responsive to our requests.
    Attendance at our board meetings and committee meetings is 
almost always 100 percent. My fellow directors diligently do 
their homework, as evidenced by the tough and probing 
questions. Independent directors are nominated by the 
Nominating Committee that consists of only independent 
directors. We have a separate committee consisting of one 
independent director from each of
the nine clusters to oversee the shareholder operations 
performed by a subsidiary of Capital Research. This committee 
meets biannually with at least one meeting taking place at one 
of the four service centers.
    Now, I would like to mention a couple of examples of the 
reforms that I consider beneficial and most likely will have an 
impact on how I discharge my duties as an independent director.
    I support broadening the definition of ``interested 
person,'' requiring 75 percent of the board be independent, 
self-assessing the board performance annually, separate 
independent director meetings at least four times a year, and 
requiring the chief compliance officer to report directly to 
the independent directors.
    On the matter of the independent chair, I do not support 
the proposal that every mutual fund board must have an 
independent chair. In fact, I support choice. Other 
alternatives that would strengthen the board equally well, for 
example, use of a lead director, combined with 75 percent 
independent directors, independent nominating committees, and 
the ability to contribute to the agenda and control the board 
discussion.
    American funds have nine clusters ranging from 1 to 12 
funds per cluster. For example, the Fixed-Income funds consist 
of 12 funds, while my cluster has only one fund. I serve on 
only one board, but our board meetings coincide with two other 
global equity funds--EuroPacific Growth Fund and New World 
Fund. We meet quarterly over consecutive days, and we 
oftentimes have joint board and Audit Committee meetings.
    I like the efficiency and economies of scale provided by 
these joint meetings. It is my impression that directors 
serving on multiple boards benefit in much the same way. I do 
not believe the Congress or the SEC should dictate the number 
of boards an independent director can sit on. There are too 
many subjective influences, subjective factors to influence 
this. Instead, I think that the annual review of the board's 
performance will oversee this matter in an effective way.
    With the matter on certification requirements, I understand 
that the independent directors or an independent chair is 
proposed to certify on a number of matters. I strongly believe 
an independent director should not be required to certify 
matters about which directors have no direct knowledge.
    In particular, I am troubled by proposals that will require 
independent directors to certify that a fund is in compliance 
with its policies and procedures to calculate daily net asset 
values and oversee the flow of funds into and out of the fund.
    I inquire and am satisfied that there are controls, 
procedures, and policies in place to calculate net asset values 
and oversee those fund flows. But neither I nor my fellow 
directors would be able to certify that that fund is in 
compliance with those procedures on a daily basis. It is my 
view that these certifications, if required, should be directed 
to those persons who are responsible for managing the 
operations.
    Putting this responsibility on directors would confuse our 
role as overseers with day-to-day managers. Moreover, should 
these certifications come to pass, it would be difficult to 
retain and to attract responsible, conscientious people to 
serve as board members.
    I have found these people, independent board members of 
other funds and my fellow directors, to be smart, 
conscientious, inquisitive, and outspoken.
    Thank you, Mr. Chairman.
    Chairman Shelby. Mr. Mann.

                  STATEMENT OF MARVIN L. MANN

              CHAIRMAN OF THE INDEPENDENT TRUSTEES

                       THE FIDELITY FUNDS

    Mr. Mann. Thank you very much, Chairman Shelby, Ranking 
Member Sarbanes, and Senator Hagel. I am Marvin Mann, Chairman 
of the Independent Trustees of the Fidelity Funds. I appreciate 
this opportunity to appear before you today to discuss mutual 
fund governance and how the Fidelity Funds Board does its job. 
It is a challenge to do this in 5 minutes.
    Today, I am speaking on behalf of the Governance and 
Nominating Committee of the Fidelity Funds. First, I would like 
to touch on recent proposals, including those of the SEC, 
designed to improve fund governance, and I will do that 
briefly.
    The SEC's proposal contains several requirements, most of 
which I support. Three of the more significant would require 
that independent trustees constitute 75 percent of a fund's 
board, undertake an annual self-evaluation, and meet separately 
from management at least quarterly.
    One proposal that I do not support is a requirement that 
the board chairman be an independent trustee. A fund's 
independent trustees should, however, have the authority to 
elect and remove the chairman.
    There are also legislative proposals that would require 
independent trustees to certify as to certain matters, such as 
the existence of certain procedures. I would not support such a 
requirement. For public companies' certifications are the 
responsibility of management, not directors. A certification 
requirement would create uncertainty as to the trustee's duties 
and potential liabilities.
    I do believe that there are measures that should be taken 
to improve mutual fund regulation. In my written statement, I 
outline three proposals that address fund expense disclosure, 
soft-dollar arrangements, and arrangements for distributing 
fund shares. Frankly, I think that these could be very 
meaningful actions if carefully considered. And if time 
permits, I would be happy to discuss these proposals further.
    Now, I would like to turn to how the Fidelity Funds Board 
exercises our fiduciary duties in our oversight of the 292 
funds that we are responsible for.
    First, we accomplish this through five attributes that 
characterize well-functioning boards: The right people, 
spending the amount of time that is required, the time 
commitment, the authority to set the agenda, access to 
information, and the right organizational approach.
    Having the right people is critical. Ten of the 14 trustees 
of the Fidelity Funds, or over 70 percent, are independent. The 
Governance and Nominating Committee, which is composed 
exclusively of independent trustees, is responsible for all 
aspects of independent trustee recruitment. We recruit people 
who are highly experienced at managing large, complex 
organizations, who are independent in fact and are prepared to 
be adversarial, who have the highest personal integrity, and 
who are able to meet the significant time 
commitment.
    Let me pause a moment on this last point. The Fidelity 
Funds Board has regular meetings 11 times a year. Meetings take 
two long and very full days. A significant amount of time is 
required to prepare for these meetings.
    Independent trustees must have a strong voice in setting 
the agenda for board and committee meetings. We approve an 
annual calendar that lays out the essential agenda items for 
the entire year. Then each month we add additional matters to 
the agenda for that month's meeting.
    Information and organization are critical. The Fidelity 
Funds Board has a well-defined committee structure that is a 
key factor in our ability to oversee the Fidelity Funds and 
obtain the information we need to carry out our duties. The 
structure, mission, and membership of each board committee are 
decided solely by the independent trustees. These committees 
are chaired by and consist exclusively of independent trustees.
    We have 10 committees that address the numerous 
responsibilities that require our attention. For example, we 
have three fund oversight committees, each of which oversees a 
specific category of funds and focuses primarily on fund 
performance. These fund oversight committees provide a good 
illustration of how our committee structure works.
    The independent trustees receive monthly reports on the 
performance of all funds. Now these are graphs and charts, so 
it is easy to quickly identify funds that are not performing as 
they should be. This includes information comparing the 
performance of each Fidelity fund to a peer group of funds and 
to appropriate securities indices.
    Each fund oversight committee conducts regularly scheduled, 
in-depth reviews of the funds it is responsible for. Prior to 
each fund review meeting, the board receives written reports 
and analyses from the portfolio manager. This material provides 
the independent trustees with essentially the same information 
that Fidelity management uses in its periodic review of its 
portfolio managers.
    At a typical fund review meeting, the Oversight Committee 
discusses this data and other aspects of fund performance in-
depth with the portfolio managers and their supervisors. Topics 
include the fund's compliance with its investment objectives 
and its performance, and the highlights of these meetings are 
reported to and discussed by the full board.
    The fund oversight committees focus on matters unique to 
each fund. In contrast, there are a number of operational 
elements that are generally common to all funds, such as 
processes related to brokerage allocation, fund operations, 
accounting, and compliance, and so on. Several of our 
committees focus on these common elements.
    Given the limits of time, I regret that I cannot provide a 
more complete overview of how we do our job, but I have 
described one process that gives you some insight into how we 
exercise our fiduciary duties for the benefit of shareholders.
    I appreciate the opportunity to share my views, and I would 
be happy to respond to your questions about these and any other 
issues. And I respectfully request that my entire written 
statement be included in the record.
    Chairman Shelby. Without objection, it will be made part of 
the record, Mr. Mann.
    Mr. Miller.

                 STATEMENT OF MICHAEL S. MILLER

          MANAGING DIRECTOR, THE VANGUARD GROUP, INC.

    Mr. Miller. Chairman Shelby, Ranking Member Sarbanes, and 
Senator Hagel, my name is Mike Miller. I am a Managing Director 
at The Vanguard Group, where my responsibilities include 
selecting and overseeing third-party investment advisory firms 
that manage assets for our funds, as well as for our corporate 
compliance function.
    Vanguard understands that in the wake of fund trading 
scandals there is some interest in imposing a direct ban on the 
ability of an individual to manage both hedge funds and mutual 
funds, sometimes referred to as side-by-side management. 
Congress is properly considering this and other issues relating 
to the operation and the regulation of mutual funds. Vanguard 
appreciates the opportunity to testify today.
    Although Vanguard does not manage or offer hedge funds, we 
are very concerned that a ban on side-by-side management will 
eliminate a substantial number of investment professionals that 
would ordinarily be available to our shareholders. Like 
Congress, Vanguard is concerned about protecting the interests 
of mutual fund shareholders. We believe that there are ways to 
effectively protect the interests of mutual fund clients 
without taking the extraordinary and potentially damaging step 
of an outright ban on managing both hedge funds and mutual 
funds.
    Let me provide just a quick background on Vanguard. We are 
the world's second-largest mutual fund family with more than 17 
million shareholder accounts and approximately $725 billion in 
our 126 U.S. mutual funds. Investment professionals on our own 
staff manage about 70 percent of Vanguard's assets. The 
remaining $220 billion or so are in portfolios managed by 
third-party investment advisory firms, which are hired and 
overseen by the funds' boards of trustees with substantial 
assistance from Vanguard's professional staff. In all, 37 of 
our funds receive portfolio management services from 21 
independent advisory firms. We have been selecting and 
overseeing independent advisers for more than 25 years.
    At many investment advisory firms, including Vanguard, 
other mutual fund companies, and all the third-party advisers 
we use, individual portfolio managers run multiple accounts for 
multiple clients. Besides mutual funds, these may include 
separate accounts, bank common trust accounts, collective 
trusts, and in some cases hedge funds. Managing money for 
multiple clients has always been an inherent feature of 
successful asset management firms. None of the sub-advisers we 
have hired manages money solely for Vanguard. Importantly, any 
firm that manages mutual fund assets is a registered investment 
adviser and as such should have in place policies and 
procedures that help ensure that the investment 
professionals manage multiple accounts in the interest of all 
of their clients.
    Mutual fund shareholders are protected by a number of 
practices today including internal controls and Federal 
regulation. At Vanguard, the protections for fund shareholders 
start, of course, with careful selection of advisers in the 
first place. Once an adviser is hired, we continually review 
the performance and portfolio characteristics of the funds, as 
well as the investment practices and compliance policies of the 
adviser.
    All of our third-party managers are subject to periodic 
audits by Vanguard. Every firm that manages mutual fund assets 
must be registered under the Investment Advisers Act and is a 
fiduciary under both State and Federal law. Simply stated, this 
means the adviser has a duty to recognize and disclose 
potential investment conflicts and to manage them 
appropriately. These potential conflicts are not unique to 
advisers who provide investment management to mutual funds and 
hedge funds. They exist whenever a portfolio manager advises 
two accounts that differ in any way, potentially even two 
different mutual funds.
    Investment firms typically manage potential conflicts 
through allocation policies and procedures, internal review 
processes, and oversight by directors and independent third 
parties. Trade allocation systems and controls ensure that no 
one client is intentionally favored at the expense of another.
    In addition, the SEC has very recently enacted new rules 
that will raise industry-wide standards for addressing 
potential conflicts for the protection of all investors. These 
changes are discussed in my written testimony.
    Banning individual portfolio managers from managing mutual 
funds and hedge funds would disadvantage and fail to fully 
protect mutual fund shareholders.
    Allowing side-by-side management of mutual funds and other 
accounts, including hedge funds, affords mutual fund investors 
access to top investment firms and professionals. The supply of 
exceptional investment professionals is limited. It is 
important that all investors, including mutual fund 
shareholders and 401(k) plan participants, who largely invest 
in mutual funds, have access to the same universe of investment 
expertise available to large institutions or wealthy 
individuals.
    Many mutual funds with strong long-term performance records 
are managed by portfolio managers who also invest for other 
accounts, which may include hedge funds. These managers can 
choose where to commit their time and their talent. Hedge funds 
can be an attractive option because they allow the use of a 
broader range of investment techniques and provide an 
opportunity to earn higher fees based on performance.
    To the extent that a ban causes investment professionals to 
move on to accounts not subject to the ban, mutual fund 
investors would experience higher portfolio manager turnover. 
Continuity and stability benefit mutual fund investors. In our 
experience, they are among the key determinants of long-term 
investment success.
    A better way, in our opinion, to address concerns about 
conflicts of interest is to strengthen compliance procedures, 
reporting, and oversight. For example, mutual fund directors 
should be required to review and approve stringent procedures 
to address conflicts of interest and to review an adviser's 
performance under those procedures. Advisers should be required 
to demonstrate to mutual fund boards that they have 
successfully followed their procedures.
    Congress and regulators have responded to recent events by 
demanding more specific protections. The SEC recently 
strengthened the position of fund directors in this regard by 
requiring that every mutual fund have a chief compliance 
officer reporting to the directors. Each investment adviser 
must now have written policies and procedures for a number of 
matters, including allocation of trades among multiple clients. 
Fund boards must approve the policies and procedures of their 
advisers. In addition, the SEC has recently proposed that 
mutual funds explicitly authorize their independent directors 
to hire employees or other experts to help them fulfill their 
fiduciary duties. We support requiring this authority for 
directors.
    We believe that the combined effect of enhanced compliance 
obligations and additional support for independent directors 
will protect investors. An outright ban would be a drastic 
solution in our opinion, especially in light of recent efforts 
to impose more stringent requirements.
    Thank you, Mr. Chairman. Vanguard does very much appreciate 
the opportunity to testify today, and we would ask that our 
written testimony be included in the record.
    Chairman Shelby. Thank you, Mr. Miller.
    My first question is for the directors. Many people contend 
that an independent chairman is critical to facilitating a 
vigorous and challenging boardroom culture. The chairman of any 
board controls the agenda, as you well know, and information 
flow. Would you describe your experiences with either insider 
or independent fund chairmen? What are the benefits and the 
negatives? Also, how do you address the assertion that an 
independent chairman requirement is a justified safeguard in 
light of the inherent conflict of 
interest between the adviser and the fund?
    Senator Armstrong.
    Senator Armstrong. Well, Mr. Chairman, I happen to think 
that in most cases an independent chairman is a good idea. The 
chairman does set the agenda----
    Chairman Shelby. You are an independent chairman.
    Senator Armstrong. I am an independent chairman, and I will 
just note for the record that I was elected chairman long 
before that became a battle cry because of recent developments.
    Chairman Shelby. How large a fund is Oppenheimer?
    Senator Armstrong. The funds that I am Chairman of are 38 
funds with about $75 billion under management. We are not one 
of the biggest, but we are certainly not one of the smallest 
either. And there is no doubt that the Chairman has----
    Chairman Shelby. You have not been involved in the problems 
either, have you?
    Senator Armstrong. No. And thank you for noting that, Mr. 
Chairman.
    Chairman Shelby. Okay.
    [Laughter.]
    Senator Armstrong. Happily, we have escaped that notoriety.
    I think the issue, however, is not whether I happen to 
think it is a good idea. I happen to like strawberry and 
vanilla, but I do not think we should outlaw chocolate.
    Chairman Shelby. I agree.
    Senator Armstrong. And if there are some people who 
strongly feel that an executive chairman, a member of the 
management team, is a better choice for a particular fund under 
particular circumstances, and if that is well disclosed, then I 
say let the investors decide that.
    Chairman Shelby. Mr. Miller.
    Mr. Miller. Vanguard would fully support Mr. Armstrong's 
position. We today have seven directors on our board--one of 
whom is an interested director, our Chairman and CEO Jack 
Brennan; the other six are independent directors. So about 85 
percent of our directors are independent. We feel very strongly 
that when the rules require that there be a supermajority of 
independent directors, then one should let those directors 
decide and use their judgment and their discretion to decide 
who is best to serve as chairman of the board. And so we very 
much believe that the fund boards should make that 
determination.
    Chairman Shelby. Mr. Mann.
    Mr. Mann. Mr. Chairman, I would perhaps make the comment 
that the independent trustees should be able to select the 
individual that they feel is most qualified to do the job, 
whether it be an insider or an independent trustee.
    The major considerations I find are whether you are able to 
have control over the agenda, whether you are able to structure 
the board the way it needs to be structured to get your job 
done, whether you have the ability to have independent trustee 
meetings so that you can resolve issues where there are 
conflicts with management, and whether you have an organization 
and a staff that is open and willing to provide all of the 
information you require to be able to make the judgments that 
you have to make. That information must be provided in a format 
that is requested and is efficient to use. And if you have 
those things, I do not think it really matters whether the 
board has an independent chairman or not.
    You see, the board meeting itself is not where the work 
gets done. I suspect it is a little like the work here. The 
work gets done in committees, and the committees are 
independent trustees.
    Chairman Shelby. But doesn't the board set the agenda in a 
sense, the broad agenda?
    Mr. Mann. The board sets the agenda, and I can tell you 
specifically how it works at Fidelity. We have this annual 
calendar that I mentioned that prescribes the required things 
that we must do. Then on a monthly basis, early in the month, 
prior to the board meeting, we work out specific topics that we 
want to include in the next meeting. The Fidelity people put 
that agenda together because their staff does the work. They 
contact me. I get input from the chairmen of the committees. 
And whatever we suggest gets on the agenda. There is no debate 
about it.
    Chairman Shelby. Thank you.
    Mr. Miller, the dramatic compensation differences between 
the mutual funds and hedge funds create an incentive for 
portfolio managers to favor hedge funds, or they seemingly 
would. If this is true, how do you ensure that in your case 
Vanguard's shareholders receive fair treatment? Are there 
processes to manage the conflict of interest and ensure 
equitable share allocations here? If so, how do you do it?
    Mr. Miller. Mr. Chairman, there are clearly conflicts, 
potential conflicts of interest between hedge fund managers and 
mutual fund managers when they are the same individual, as 
there are with other kinds of accounts, not just hedge funds, 
separate accounts--I mentioned some in my oral statement.
    We work judiciously to ensure that our outside managers 
that may run hedge funds, as well as money for Vanguard 
shareholders adhere to compliance procedures, policies, written 
guidelines, and codes of ethics. Under the law itself, there is 
a fiduciary duty that requires that you manage money in a way 
that does not disadvantage any client over another. And so it 
is a combination of using the professional staff of Vanguard--
for example, at Vanguard we have a group called the Portfolio 
Review Group, which is about 25 individuals, mostly MBAs, CFAs, 
and CFPs. They work closely with the outside advisers. They 
help, you know, in the selection, the monitoring of what those 
advisers do for our fund shareholders, performance issues, 
things of that sort. Then we meet with our outside managers on 
a regular basis. They come to Vanguard and meet with senior 
management. They come to Vanguard periodically to meet with our 
board of directors. We go to their shops. We monitor their own 
procedures, their own policies, to ensure compliance, to ensure 
that there is no favoritism of one client over another.
    We have long-term relationships with our managers. We are 
confident that they understand the protocol, the rules, the 
procedures, what is required by law. We go beyond our 
confidence to inspect, to enforce, to audit. And they know as a 
manager for Vanguard that at any time they are subject to our 
inspection and our audit activities to ensure they are managing 
money correctly on behalf of all investors fairly.
    Chairman Shelby. Senator Sarbanes.

              COMMENTS OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you, Mr. Chairman. I want to join 
with you in welcoming the panel and, in particular, our former 
colleague Bill Armstrong. It is very good to see him back in 
the Committee room, although at this time on the other side of 
the table.
    I am interested in this issue of the independent directors 
and the independent chairman and how that decision is made. The 
SEC has put out a rule proposing that 75 percent of the 
directors be independent. What is your reaction to that, very 
quickly?
    Senator Armstrong. Mr. Chairman, our board supports that, I 
think most directors do, but with this caveat: That if the 
definition is simultaneously changed, that is, the definition 
of interested or independent directors is changed, it could 
have some unforeseen consequences.
    In one case I know of, it would literally--in order to meet 
the 75 percent requirement instantaneously, the board would 
have to discharge several of its existing members who are 
presently considered to be independent, or add 13 new members 
to an 11 member board, creating a board so large that it would 
not be functional.
    So if Congress decides, as I expect they will, to require 
two-thirds or 75 percent, which we favor, we would ask that 
there be a long phase-in period to accommodate the natural 
retirement of members who would otherwise be lost to the 
process, lose their expertise.
    Senator Sarbanes. Ms. Chang.
    Ms. Chang. I do support the 75 percent independent director 
proposal. In fact, on our fund, we exceed that.
    With respect to the definition of interested director, I 
actually like that proposal. I like the definition to make it 
clearer of what an independent director is and their prior 
relationships with service providers.
    Senator Sarbanes. Mr. Mann.
    Mr. Mann. The tightening up of the definition of 
independent 
director we think is very good. At Fidelity, 70 percent of the 
directors--or 71 percent, to be precise, are independent, truly 
independent trustees. The additional 5 percent, the 75 percent, 
would require us to either add independent directors or drop 
one insider off the board, who we would not be excited to lose 
from the board because they make contributions to the board. 
But at the next board meeting, we would probably comply after 
we were told that that was the rule, and we would be okay with 
that.
    Senator Sarbanes. Mr. Miller.
    Mr. Miller. Senator Sarbanes, we also at Vanguard would 
support the SEC's proposal. As you know, the law has long 
required that there be a majority of independent directors on 
the board. The SEC now says let's take that to 75 percent. We 
would be very much in favor of that. As I noted, we do not 
favor the chairman necessarily being independent, but we do 
believe that the 75 percent proposal makes sense. We do at 
Vanguard favor a strict definition of independence and would 
not be in favor of permitting close relationships to fall 
within the definition.
    Senator Sarbanes. Let me ask all of you this question, 
because I am interested in your answers, which, of course, 
range a bit. We have established the Securities and Exchange 
Commission. It has five Commissioners. They have to be 
appointed by the President and confirmed by the Senate. We 
think we look for quality in picking Commissioners, and at the 
moment I think most of us think we have quite a good Commission 
at work.
    Traditionally, the SEC has had a very good reputation, 
although it has had its ups and downs. It has a highly 
professional staff, a lot of expertise and a lot of technical 
competence.
    Should we make these decisions we are talking about by 
statute in the Congress as opposed to the SEC making them by 
regulation? The SEC has a broad grant of authority, as 
witnessed by the fact that they are proposing various rules and 
regulations now to address some of the problems in the mutual 
fund industry. They have a staff that is looking into it. We 
are giving them more money. They are going to have an upgraded 
staff. Suppose the SEC were to decide two-thirds. Should we 
pass a statute requiring three-fourths? Why not?
    Mr. Mann. I would say broadly that of all of the things 
that we are discussing here, my counsel has been that all of 
these, perhaps with one exception, one of the things I am 
recommending, could be done by the SEC. The SEC has a very good 
process of putting out a proposal and asking for comments. 
There is a lot of back and forth and a lot of debate, a lot of 
enlightenment in the process that assures that the implications 
of those rules are well understood and that there will be a 
proper transition period during which it can be implemented, et 
cetera. And I think it works very well.
    So, I think the Senate Banking Committee should give its 
direction and its ideas to the SEC and then encourage the SEC 
to act.
    Senator Sarbanes. Does anyone want to add to that?
    Senator Armstrong. Well, Senator Sarbanes, I agree with the 
implication of your question that the Senate would be wise to 
set the policy but leave the detailed regulation to the SEC, 
for all the reasons that you mentioned in your question. But on 
that same topic, there is floating around an idea of an 
oversight board which would be a separate and new regulatory 
body. Personally, I think that would be the worst outcome 
because if you put the regulation of the mutual fund industry 
in a new board and leave the regulation of the securities 
industry and the brokerage industry in a board over here, we 
end up fragmenting the process rather than integrating it and 
making it strong.
    I have met recently with the Chairman of the SEC and 
members of his staff, and I sense a great vigor, a great 
enthusiasm for the task, and I believe that in most cases, as 
your question suggests, in most cases Congress can look to the 
SEC with confidence for the solution. Where that cannot happen, 
where there is doubt about their authority, then, of course, 
you would want to act or clarify their authority in some way.
    Senator Sarbanes. But where they have authority, you think 
we should defer to it as the expert body?
    Senator Armstrong. I do, and I think----
    Senator Sarbanes. Now would you all take that position with 

respect to the independent chairman?
    Mr. Miller. I will jump in here, because I do agree with 
what my colleagues have said, Senator, with respect to your 
question about legislation versus regulation. The SEC has 
proposed an independent chairman.
    Senator Sarbanes. They have proposed it. But they have not 
adopted it yet, and you all presumably are commenting about it.
    Mr. Miller. Yes, sir, we will be commenting.
    Senator Sarbanes. What is our role here? Should Congress 
move in now and start legislating all these various standards, 
or should the Congress say, ``well, you know, this is why we 
set up the SEC, this is why we have jumped their budget, just 
shy of doubling it in 3 fiscal years.'' We have this expertise 
and professionalism. But there are some times, I say, ``I might 
have not made that decision that way myself, but there are 
enough pros and cons on both sides that if the expert body 
makes the decision that way, I am prepared to accede to it and 
to give them their role.'' It is not only the SEC we have set 
up this way, but we also have set up the Financial Accounting 
Standards Board to set accounting standards.
    Then the issue becomes, is the Congress going to legislate 
accounting standards if the board seems to be moving in a 
direction that people do not like? So there is a one-stage-
removed dimension to all of this, and I want to get from you 
what you see. Do you want us in there doing all of these 
things? Or do you want us sort of holding back and giving the 
Commission the chance to do its job? They have, I think, by and 
large, a very good process worked out for reaching the 
decisions, by proposing rules, taking comments, and reviewing 
the comments, it has struck me as being a thoughtful process. I 
think the industry generally agrees with that.
    Mr. Miller.
    Mr. Miller. Senator, absolutely, I believe you have summed 
up quite nicely the position this Committee and Congress should 
take. The SEC is there, and it has been there for a long time. 
It works closely with the industry. At times, the SEC may 
propose a rule that the industry or members of the industry 
would disagree with, but that is the process.
    I believe it is highly appropriate for the Congress, for 
this Committee, to weigh in with the SEC in terms of your 
beliefs, your judgments, your opinions. But I would defer to 
the expertise of the SEC and allow them to be the body that 
governs our industry, the rulemaking body.
    Mr. Mann. I agree.
    Ms. Chang. I agree, too. In addition, with respect to the 
independent chairman issue, just as your question was the 
legislative versus the regulatory process, there needs to be a 
balance. On the independent chairman issue, there are funds out 
there whose shareholders may not be well-served. In our 
situation, we have an interested chairman, and it is because of 
his or her day-to-day knowledge, they are able to anticipate 
problems and to deal with them well in advance because of their 
day-to-day knowledge.
    Thank you, Senator Sarbanes.
    Senator Sarbanes. Thank you.
    Chairman Shelby. Senator Bennett.

             COMMENTS OF SENATOR ROBERT F. BENNETT

    Senator Bennett. Thank you very much, Mr. Chairman.
    I am delighted to have Senator Sarbanes go down the road he 
is because we are----
    Senator Sarbanes. I am just asking hypothetically.
    [Laughter.]
    Getting the benefit of the witnesses' wisdom here.
    Senator Bennett. Particularly in this session of Congress, 
the idea that we do not have to do something is quite 
appealing.
    But I do think we have a role to play in these hearings as 
we set a record and get the combined wisdom of our witnesses. 
And while I agree with Senator Sarbanes on FASB and the SEC and 
so on, I do ultimately reserve the right as a Member of 
Congress to yank their chain a little, pull back their 
authority a little. They are, in fact, creatures of the 
Congress, that is the Congress created them. And the Congress 
createth, the Congress can taketh away. I would hope that we do 
not put ourselves in the position of saying we will never, ever 
take a position here.
    I think that the role of this Committee in this situation 
is to
hold hearings of this kind, get your comments on the record, 
and,
frankly, I think they have more impact on the record before the 
Banking Committee and our comments on those comments than they 
do in the dry filing being sent over to the SEC.
    I am perfectly willing to leave this one to the SEC. I 
agree that they are competent to do it. I do have some concerns 
about potential rigidity of an independent chairman and the 
definition of what is an independent chairman.
    So in the spirit of what I have just said, to get it on the 
record with our reactions, can you describe for me the 
difference between an independent chairman and an interested 
chairman? I do know the difference between uninterested and 
disinterested.
    [Laughter.]
    But I do not know the difference between independent and 
interested in this context, and I think it would be good for 
the record to have that discussed. Yes, sir?
    Senator Armstrong. Senator, so far as I know, the term 
``independent'' does not appear in the statute. The term that 
appears is ``interested.'' But they mean the same thing in 
everyday usage, so far as I am aware.
    By the way, I agree with everything you just said.
    Senator Bennett. Well, I thought that ``independent'' meant
``disinterested.''
    Senator Armstrong. Pardon me?
    Senator Bennett. I have always thought that ``independent'' 
meant ``disinterested.''
    Senator Armstrong. Yes, that is correct.
    Senator Bennett. But this is interested, so by definition, 
it is not the same thing as disinterested?
    Senator Armstrong. I apologize. I jumped to a conclusion I 
should not have. ``Interested'' is what I understand to be 
described in the statute, and a person who is independent is 
said to be ``disinterested.''
    Senator Bennett. I see.
    Senator Armstrong. Perhaps I am not responding to the 
question that you are asking.
    Senator Bennett. No, no. This is helpful. You are. So, you 
are saying the current statute says you have to have an 
interested chairman?
    Senator Armstrong. No. The current statute is silent on 
that.
    Senator Bennett. Is silent, so the proposed rule says you 
have to have an interested chairman.
    Senator Armstrong. Yes.
    Senator Bennett. A disinterested chairman.
    Senator Armstrong. I beg your pardon.
    Senator Bennett. Okay.
    Senator Armstrong. The point that you made which I thought 
was very significant was the idea of retaining authority in 
this Committee and in the Senate, and the Congress, to 
supervise the process, but deferring, as Senator Sarbanes had 
suggested, to their expertise and also to the fact that they 
have the time to do a thoughtful job. I think that is a very 
significant point, and forgive me for leading you into an 
intellectual cul-de-sac on the distinction.
    Senator Bennett. No, you are helping to clarify.
    Ms. Chang.
    Ms. Chang. Senator Bennett, ``independent,'' or 
``disinterested,'' and ``interested'' is really two things. 
They are independent and disinterested in fact as well as in 
mind. And as I said in my oral earlier, I do not support a 
mandate for an independent chairman.
    However, we have an interested chairman, but the individual 
allows us to control the agenda, to add items to that, and he 
allows us to control the discussions. So although he may be 
interested in fact, he is actually allowing the board the 
freedom to discuss what we want to discuss and the freedom to 
request the information we need in order to protect the fund's 
investors.
    Senator Bennett. Well, I know how majorities are formed, 
and it seems to me if independence controls 75 percent of the 
seats, even if the chairman says I want this on the agenda, a 
quick motion and vote and the agenda gets changed. So, I am not 
quite sure how essential it is that the chairman be an 
independent chairman.
    Ms. Chang. I agree with you.
    Senator Bennett. Okay. Any other comment?
    Mr. Miller. At Vanguard, Senator, we have as our Chairman 
of the Board our CEO. He is clearly not independent under the 
standard that the SEC uses. He is clearly affiliated with 
Vanguard. He runs our company. He is our CEO.
    There are standards that govern how independent directors, 
disinterested directors, not-interested directors, however you 
want to say it, are defined. Things that, for example, if you 
formerly worked with a fund complex and retire, and then the 
next week go onto the board, you would not be considered an 
independent director. There has to be a passage of a certain 
amount of time. And there are proposals in some quarters that 
there be a tightening up of that definition to make it a 
stricter definition so that there would not be close 
relationships allowed to be independent directors. As I said 
earlier, Vanguard would favor those proposals and the 
tightening up of the standard.
    But today at many fund companies, there is an independent 
chairman. At some fund companies, there is a nonindependent 
chairman. I think many complexes--Vanguard would be one of 
them, although we have as the chairman of our board our CEO, we 
have a lead outside director, a lead independent director that 
works closely with our chairman and CEO, and obviously 
represents the interest of the supermajority of directors that 
we have on the board who are independent.
    Senator Bennett. I want to make one more comment if I 
could, Mr. Chairman. There is a trend in industrial 
corporations, as opposed to the kinds of corporations you run, 
to move toward a chairman who is not the CEO. But it is not 
necessarily a chairman who is ``disinterested.'' For example, 
Bill Gates is no longer the CEO of Microsoft, but you could not 
say that Bill Gates was not very much interested in every way 
in what goes on in Microsoft. The same thing is true, Andy 
Grove is the Chairman of Intel, but he is no longer the CEO of 
Intel. So the CEO is put in a position where he clearly is 
reporting to the board, and that I think is the important issue 
here rather than whether or not the board chairman knows 
anything about the business, because there is always the fear 
if you get an independent chairman, he is so independent that 
he does not really understand. And in many ways my experience 
is you get such an independent chairman, you run the risk of 
increasing the possibility that the CEO can pull the wool over 
his eyes rather than decreasing it, because he is so 
independent he is divorced from the day-to-day operations and 
can be conned.
    Nobody is going to con Bill Gates as to what is really 
going on in Microsoft or Andy Grove as to what is really going 
on in Intel. And I would think it might well be if the decision 
is made that it cannot be the CEO, it nonetheless must be 
somebody--can be, not must be, but nonetheless can be somebody 
who has a very big financial stake in the organization and a 
history of dealing with it. There is a kind of separation there 
between the chairmanship and the CEO that does not fit the 
legal definition of ``disinterested,'' but might as a practical 
matter make a little more sense.
    But having put that on the record, I will leave it up to 
the SEC to read the record. I am not necessarily looking for a 
response, but if you feel you have to, by all means.
    Senator Armstrong. Well, Mr. Chairman, the point you have 
made, which I agree with completely, illustrates----
    Senator Bennett. This is the Chairman [pointing to Chairman 
Shelby]. I am not.
    Senator Armstrong. I am sorry. Senator Bennett, the point 
you have made----
    Senator Sarbanes. We are very sensitive to that sort of 
thing.
    [Laughter.]
    Senator Armstrong. Yes, I understand that.
    [Laughter.]
    You are exactly right, but what that illustrates is 
precisely why it should be left to the boards of the 8,256 
funds to make that decision. They will not all make the same 
decision based on a different set of circumstances. And if it 
is disclosed, it feels to me like that is a great outcome. Then 
investors can decide what they think the right answer is and 
they will have before them what the fund boards have decided as 
well.
    Senator Bennett. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Carper.

              COMMENTS OF SENATOR THOMAS R. CARPER

    Senator Carper. Thanks very much. I apologize for missing 
all of your testimonies. We have some interesting issues on the 
floor today, as you may know: Gun control legislation and 
assault weapons bans and gun show loopholes. I have been 
involved in some of that debate, and I apologize for missing 
what you had to say.
    I would just like to start off by asking each of you what 
role, if any, do you believe that the Congress should play with 
respect to the governance issues that you are discussing and 
that we are discussing here this morning. I would be interested 
in hearing what your thoughts--not disinterested, but I would 
be interested in hearing what you have to say.
    I want to say, that exchange between you and Senator 
Bennett a little bit earlier, Senator Armstrong, was just a 
classic.
    [Laughter.]
    I wish we could have videotaped that one and shown that 
one, say, at orientation for new Senators. It would have been 
good comic relief, and maybe instructive, too.
    Mr. Miller, do you want to lead off ?
    Mr. Miller. Sure. Senator, I believe that--we have 
discussed this a little bit this morning, and I believe that it 
makes very much sense for Congress, this Committee, to weigh in 
with their opinions, their judgments, express their policy 
concerns to the SEC or whatever agency might be involved. In 
this case, it is obviously the SEC that is more involved.
    I do believe that the expertise, by and large, rests with 
the SEC. I believe that they take the pulse of Congress. I 
think that they are smart in that regard. But at the end of the 
day, probably because they have the expertise--this is what 
they do on a full-time basis and have been doing it for many 
years. I think because the industry tries to work in 
conjunction with the SEC to express our issues, our concerns, 
to express whether we oppose or favor, you know, there is a 
dialogue that goes on. And I think properly it is at the SEC 
level that there should be the rulemaking that governs the 
governance issues that we are here discussing this morning.
    Senator Carper. So if I understand what you are saying, you 
are saying our role is to really have our pulse taken and to 
share our sense with the regulators, at least in this instance, 
and to convey those beliefs.
    Mr. Miller. I certainly would think that Congress, this 
Committee, could make its role whatever it wanted to make its 
role. But I believe that probably from a prudent standpoint, 
from the standpoint of expertise and familiarity, deferring to 
some extent to the SEC, again, weighing in very much with your 
judgments and your opinions and expressing your beliefs, but 
looking to the SEC to set the rulemaking that governs the 
industry, including these corporate governance issues, would 
probably make sense.
    Senator Carper. Thank you.
    Mr. Mann.
    Mr. Mann. Well, I would say that I think there is 
significant risk for Congress to legislate details of corporate 
governance. That is what a board of directors is in place to 
do--to figure out what needs to be done in a given situation. I 
believe that most boards do what they should do.
    That does not mean to say that you should not give lots of 
direction, gather lots of information, and try to influence the 
process. But it seems to me that legislation in this particular 
area would not be something that you should rush to do.
    Senator Carper. All right. Thanks.
    Ms. Chang.
    Ms. Chang. Senator Carper, I agree that Congress should 
have a balance here in that having these hearings, you are 
hearing from the industry. What is very important here is to 
make sure that we restore investors' confidence and that there 
is appropriate governance. But as to the actual implementation, 
it should be left to the SEC. They have an excellent process. 
They listen to the industry. They give us time to comment. But 
the fund board uses their judgment, their experience, to be 
able to ask the right questions, follow-up questions, 
challenging questions. And if there were legislation, I am 
concerned that it might take away the board's judgment and 
their use of the experience just in order to meet those laws.
    So, I support leaving it up to the SEC, but with your 
direction and the fact that you have shown concern. By having 
these hearings, I think it has gotten front and center with 
respect to the SEC.
    Senator Carper. Thank you.
    Mr. Armstrong, did you serve in the House of 
Representatives?
    Senator Armstrong. I did, indeed.
    Senator Carper. Did you ever serve in the U.S. Senate?
    Senator Armstrong. I did.
    Senator Carper. Well, I have always wondered: Is there life 
after politics?
    [Laughter.]
    Senator Armstrong. Yes, sir, there is.
    Senator Carper. Is it pretty good?
    Senator Armstrong. It is not bad.
    Senator Sarbanes. That is very reassuring to all of us.
    [Laughter.]
    Senator Carper. You are in an interesting position because 
you have sat in our seats, and maybe even served as a chairman. 
I do not know if you were independent.
    Chairman Shelby. He would be Chairman if he had stayed, but 
I am glad he left.
    [Laughter.]
    With all due respect to my friend.
    Senator Carper. Anyway, I think that we would have turned 
out okay. But you served here.
    Senator Armstrong. I did.
    Senator Carper. Now, you have an interesting perspective 
from within the industry. And just take a minute or two and 
using both of those hats, just tell me what you feel we should 
be doing here.
    Senator Armstrong. Thank you, Senator. In fact, I think the 
Committee is doing exactly what it should do. In light of the 
disclosures of wrongdoing by a handful, relatively speaking, of 
the 456,000 people that work in the mutual fund industry, a 
handful have stepped across the line and violated shareholder 
trust in an ethical or even in a legal manner. I do not think 
this Committee or the Senate would or should fail to take that 
seriously.
    The hearings that this Committee is having, which are 
really a very ambitious schedule of hearings, are completely 
appropriate. And there may be some legislation needed. But it 
is my impression that the Securities and Exchange Commission 
has undertaken a very, very fast-track, ambitious schedule of 
reform proposals. I believe that this Committee will be 
generally well pleased with the outcome, and I think most of us 
in the industry are going to be pleased, at least with some of 
it. There will be some give and take as to whether the outcome 
is satisfactory. I am personally convinced that unless there 
are areas where we really need to clarify the authority of the 
SEC or where Congress wishes to give very specific direction 
that it thinks that the SEC needs, then I see no reason not to 
leave the responsibility with the SEC, but to make it clear 
that this Committee intends to hold the Commission fully 
accountable for the outcome. But my impression is they are 
moving rapidly with a very ambitious agenda.
    Senator Carper. One last quick question, if I could. I am 
sure you have said this already earlier in your testimony 
before, but with respect to the proposed rules promulgated by 
the SEC, I think in January, as they pertain to independent 
chairmen, what were your views on that?
    Senator Armstrong. Senator, I am an independent chairman.
    Senator Carper. I thought so.
    Senator Armstrong. I am generally sympathetic to that idea, 
not only for mutual funds but actually for other kinds of 
boards. I am a director of several public corporations as well, 
at least one of which, partly because I lobbied for it, has an 
independent chairman. I think there are many times when that is 
a great idea. But I do not think it should be mandated by law 
or by regulation. I think that is a proper decision for the 
directors to make, and in turn, for shareholders to make. If a 
shareholder thinks that is a significant issue, then they can, 
in effect, vote with their feet. They can put their money in 
funds that have their preferred form of organization, but I 
think a one-size-fits-all approach is probably not a good 
answer.
    Senator Carper. Why does it work well for the fund for 
which you are the independent chairman? Why does it work well?
    Senator Armstrong. To have an independent chairman? Well, I 
am not sure that I was elected because I was independent. I was 
elected because my predecessor, who had been in the job 30 
years, decided it was time to retire, and we could well have 
elected someone else who was not technically an independent 
director. But I am just convinced that these decisions 
generally are better left to each board to decide on a case-by-
case basis.
    I personally tend to favor independent directors, but I can 
certainly imagine situations, such as those that are 
represented at this table, where that is not the best answer in 
the shareholders' interests.
    Senator Carper. All right. Thanks. Thanks to all of you.
    Chairman Shelby. Senator Armstrong, just briefly, if you 
would, you serve as chairman of a mutual fund board. You are a 
director, of course. So how does this differ from serving on a 
public company board? You have done both and there is a 
difference, isn't there?
    Senator Armstrong. Oh, there is a tremendous difference.
    Chairman Shelby. Just briefly.
    Senator Armstrong. Mr. Chairman, the difference in brief is 
that a mutual fund board is an oversight responsibility. We do 
not run the company. A corporate board, for example, sets the 
salary of the CEO----
    Chairman Shelby. You serve on corporate boards.
    Senator Armstrong. I do serve on several corporate boards 
and have served on seven or eight public corporate boards at 
one time or another, where we set the salary of the CEO, the 
salary of individual corporate officers at the senior level, 
where we establish the budget, where we decide when to borrow 
money, where we decide what products to do, whether to merge or 
not--none of which are matters that properly come before a 
mutual fund board.
    Chairman Shelby. A mutual fund board.
    Senator Armstrong. A very different issue.
    Chairman Shelby. Mr. Miller, would you elaborate on how 
fund shareholders would be impacted by a ban on side-by-side 
management of hedge funds and mutual funds? Also if we were to 
ban side-by-side management of hedge funds and mutual funds, 
then would we also have to ban the simultaneous management of 
mutual funds and all other institutional accounts? I think 
there are unintended consequences here.
    Mr. Miller. Yes, Mr. Chairman, I would say that there are 
unintended consequences with that ban. I believe that if there 
were to be a ban of mutual fund and hedge fund management 
simultaneously, then at least consistency would suggest that 
there should be also a ban of ever managing multiple accounts 
involving multiple clients. I cannot see how that could work in 
the best interest of shareholders. I believe in my statement. I 
talked a lot about the fact that there is a relatively scarce 
commodity of really exceptional investment talent. I do believe 
mutual fund shareholders should have access to that talent, 
just like wealthy individuals or institutions. I believe 401(k) 
plan participants, who largely invest in mutual funds, should 
have access to that talent. And a ban, in my opinion, would 
clearly lead to at least some managers choosing the hedge fund 
over the mutual fund, in part because they can make more money 
running hedge funds.
    Chairman Shelby. Sure. What is the scope of the SEC's 
authority over portfolio managers who manage both hedge funds 
and mutual funds? Does the SEC have increased oversight 
authority over a hedge fund in a situation where a portfolio 
manager manages both of them?
    Mr. Miller. Hedge funds, Mr. Chairman, tend to be 
unregistered and, therefore, not per se subject to the SEC's 
jurisdiction. In the case of side-by-side management----
    Chairman Shelby. Well, Hedge funds are basically private,
aren't they?
    Mr. Miller. Yes, sir. But in the case of side-by-side 
management involving a mutual fund, the SEC has access and 
jurisdiction because of that mutual fund management, and, 
therefore, because of that mutual fund management, have access 
and enforcement and inspection authority over the activities of 
the same person managing the hedge funds.
    Chairman Shelby. Would you quickly describe the fiduciary 
duties--I think this is important to the integrity of the 
mutual fund industry--that a board owes to the fund 
shareholders? Do you think that the current fiduciary standards 
are sufficient to protect investors? We will start with you, 
Senator Armstrong?
    Senator Armstrong. Yes, sir, I do. I personally think that 
they are extraordinarily high, properly so.
    Chairman Shelby. Ms. Chang.
    Ms. Chang. Yes, I agree. In fact, if I could come back to 
your question earlier of my colleague, Mr. Armstrong, with 
respect to the comparison of corporate boards, there are also a 
lot of similarities, and this also speaks to your question on 
fiduciary duties. Board members at both corporate level and at 
the mutual fund level--and I also serve on a corporate board--
the quality of the board members who serve is very important. 
They must hold management accountable. They must look at the 
performance of the business, be it a corporate board or a 
mutual fund, and they must have an independent mind. They must 
be inquisitive.
    The fiduciary duties, in terms of the standards, I believe 
are adequate, and I believe we have board members, both in the 
mutual fund industry and in the corporate world, who take their 
responsibilities very seriously.
    Thank you, Mr. Chairman.
    Chairman Shelby. Mr. Mann.
    Mr. Mann. I think the fiduciary standards are very high, 
and I think they are adequate.
    Mr. Miller. I would agree, Mr. Chairman. I think satisfying 
one's fiduciary duty requires the highest possible standard of 
care and fair dealing. I think those standards are adequate. 
They obviously need to be enforced.
    Chairman Shelby. But that is one of the challenges in the 
industry, maybe not with particular funds but with some funds 
today.
    Mr. Miller. I would say that is a fair statement, Mr. 
Chairman.
    Chairman Shelby. Mr. Miller, many contend that fund 
investors should receive more disclosure regarding the 
portfolio's manager compensation and fund holdings. How would 
this information benefit investors and how would it impact fund 
operations? I think this is being discussed up here, as you 
know.
    Mr. Miller. Vanguard is, generally as you know, Mr. 
Chairman, I believe in favor of additional disclosure. We think 
disclosure is good. I believe that when it comes to--if the 
proposal would be to actually disclose the dollar amount of the 
compensation of a portfolio manager or a senior executive of 
the fund complex, for that matter, that is not something 
Vanguard would favor. If there are proposals to disclose the 
structure of compensation, we believe that could make sense.
    There is disclosure today of the fees that are paid to 
firms that manage money, and those fees should be properly 
disclosed, perhaps disclosed better than they are today. There 
is a difference, I think, between disclosure of the advisory 
fees paid to the firm and the particular compensation, dollar 
amount compensation of an individual. There we think that there 
is a common sense of privacy, just like we treat our 
shareholders and their information as private. It is a very 
serious commitment by Vanguard. In some respects you wonder 
what is the relevance to the investment decision to know what 
an individual is making. Someone mentioned earlier that could 
open up that individual to every headhunter out there. I think 
that would be a real concern. I think that basically----
    Chairman Shelby. That might not necessarily help the fund 
holders at all, right?
    Mr. Miller. I think that would not help the fund 
shareholders because you might then have that individual leave 
the management of mutual funds.
    Chairman Shelby. Senator Armstrong, you have a comment?
    Senator Armstrong. I think my colleague summed it up very 
well. Let us not put a bull's eye on the chest of these 
portfolio managers and send headhunters after them.
    Chairman Shelby. You agree, Ms. Chang?
    Ms. Chang. Yes, I do, and it also goes to the SEC's 
proposal where the board should determine the compensation of 
the compliance officer. I disagree there because the fund board 
hires outside contractors. An analogy is when I hire the audit 
firm, I do not require, nor do I set the salary of that 
partner. So, I would be more interested in the structure of the 
compensation.
    Chairman Shelby. Mr. Mann.
    Mr. Mann. Mr. Chairman, I would like to make a comment 
about disclosure. One of my recommendations is that we should 
significantly improve the disclosure of fees and expenses. I 
think, to be very direct----
    Chairman Shelby. To the shareholders.
    Mr. Mann. To the shareholders. To be very direct, I think 
that a confirmation statement should be given to the investor 
when an investment is made that spells out the mutual fund and 
brokerage fees and expenses in dollars and cents. Also in a 
quarterly or semiannual statement, the same thing, for each 
investment, what the expense is in dollars and cents and in 
percentage terms, so every investor can see what it is costing 
to manage their investments.
    Chairman Shelby. It should be done in unvarnished language 
too, should it not?
    Mr. Mann. In just dollars and cents on their investment. 
The SEC has taken a step in that direction to show what the 
fees are per $1,000, but if you went through the details, what 
it would require an individual to really figure out how much 
money they are paying in expenses, it is very complicated and 
very difficult.
    On your point specifically, I think it would be a drastic 
mistake to disclose the compensation of individual portfolio 
managers. I think perhaps disclosing the general structure of 
compensation could be worthwhile, and not even the details of 
that because that gives out information that would be a 
competitive problem.
    Chairman Shelby. This question has come up before here. 
Many people contend that fund directors are over committed and 
serve on too many boards. What are the considerations for 
determining the appropriate number of boards on which a 
director serves, and who should make that determination?
    Senator Armstrong, I will start with you and then move 
over.
    Senator Armstrong. Interestingly, Mr. Chairman, when I was 
elected to be Chairman of the Mutual Fund Boards of which I am 
Chairman, that is one of the issues which was put to me by my 
colleagues before they voted to elect me, and what I told them 
was that if they chose to elect me, I would commit to shuck off 
anything that proved to be an impediment. I am busy. I have 
companies of my own to run, and I am a director of some other 
public companies. So, I think it varies with the individual, 
but clearly, anybody who is the chairman or a director of a 
mutual fund has to be prepared to devote the time and energy to 
do it. The right people to make that decision of whether that 
is happening are the other directors.
    Chairman Shelby. Ms. Chang.
    Ms. Chang. I do not know what the right number is, but I 
think there should be balance, and I agree with Mr. Armstrong 
in that it really depends on that individual's own time 
commitment as long as that individual is responsible, and they 
are doing their homework. I do not think the number of boards 
should be legislated.
    As I mentioned in my oral comments, I can see the 
efficiencies and economies of scale of people sitting on 
multiple boards.
    Chairman Shelby. Mr. Mann.
    Mr. Mann. I guess I would probably be able to speak to this 
as well as anyone. We oversee 292 mutual funds at Fidelity.
    Chairman Shelby. How much total money roughly?
    Mr. Mann. Over $900 billion.
    Chairman Shelby. Getting toward $1 trillion.
    Mr. Mann. Yes.
    Chairman Shelby. Vanguard is right behind you, right?
    Mr. Mann. Yes, sir, they are.
    [Laughter.]
    Chairman Shelby. Not on your back, but looking at you.
    Mr. Mann. We are watching them closely.
    Senator Sarbanes. You are looking over your shoulder there.
    Chairman Shelby. Go ahead, Mr. Mann.
    Mr. Mann. I would say this, that over the 10 years that I 
have been an independent trustee, the workload has increased 
dramatically, not just because of the number of funds that are 
overseen, but also because of a lot of other issues that have 
arisen over the last 2 or 3 years that have increased the 
amount of time that one must spend.
    I would say to you that fortunately there is a lot of 
commonality of issues in overseeing mutual funds, and you focus 
on those one time if you are overseeing 10 funds or 100 or 200 
funds, and then you have to review the individual funds. You 
review the funds, frequently on an exception basis, and then 
you have in-depth reviews periodically as required to make sure 
that things are going well, and that proper actions are taken.
    Chairman Shelby. Mr. Miller.
    Mr. Miller. Mr. Chairman, we have at Vanguard a common or a 
single board. We think that is highly appropriate. I will give 
you just briefly two reasons why: The commonality of the issues 
that cut across the various funds of the fund complex, and 
frankly, the consistency of the decisionmaking. It helps very 
much that these directors oversee all of the complex of the 
funds because you do get consistency in the way they look at 
the issues and they render their opinions and judgments.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you, Mr. Chairman.
    There is a line of thought that the standard for the 
fiduciary duties of the directors on these boards is inadequate 
in light of the Gartenberg decision in the Second Circuit in 
1982. I am not going to take the time now to press you on that, 
but I would like you all to go back and look at that, and let 
us have the benefit of your comments. Just to take the example 
of trustees' fees, which after all the board is supposed to 
actively negotiate on behalf of its shareholders, this is what 
the Court said: ``To be found excessive, the trustee's fee must 
be so disproportionately large that it bears no reasonable 
relationship to the services rendered and could not have been 
the product of arm's-length bargaining.''
    That is a pretty low standard for a fiduciary duty in my 
judgment. I have some concern about that, and I know that all 
of you said that you thought the standard was appropriate, but 
I have difficulty drawing that conclusion looking at this 
language, the Second Circuit opinion for which the Supreme 
Court did not give cert 20 years ago.
    Mr. Miller, I want to ask you about the hedge fund and the 
mutual funds, and having individual investment managers 
managing both. Now, I take it your position is that if you do 
not do that, you are going to lose a lot of talent because 
people will go off and do the hedge fund instead of the mutual 
fund. Is that right, that is one of the problems?
    Mr. Miller. That is part of the issue, Senator, yes.
    Senator Sarbanes. As I understand it, Vanguard does not 
manage hedge funds; is that right?
    Mr. Miller. Vanguard does not manage or offer hedge funds, 
but we do use, as I mentioned earlier, a number of outside 
investment advisory firms, some of which run mutual funds--
hedge funds in addition to mutual funds.
    Senator Sarbanes. As I understand it, 70 percent of your 
assets are managed by your own people; is that correct?
    Mr. Miller. That is correct, sir.
    Senator Sarbanes. So, they are excluded from the hedge 
funds, is that right?
    Mr. Miller. We do not run hedge funds at Vanguard, so they 
do not run hedge funds.
    Senator Sarbanes. Do you feel you have a talent deficiency 
with respect to this 70 percent of the funds you manage, 
because you do not do hedge funds, and your people cannot do 
them? What are you saying about your own operation by your 
earlier testimony?
    Mr. Miller. Senator, I would make it very clear that we do 
not believe we have a talent deficiency at Vanguard. Frankly, 
we do not offer hedge funds. I am sure our people have the 
talent to do it, but we----
    Senator Sarbanes. I take it your position is that even not 
doing it, you can still get very good talent at Vanguard, 
right?
    Mr. Miller. We believe so, yes sir.
    Senator Sarbanes. Why do you then advance the general 
proposition that if people cannot do hedge funds and mutual 
funds you are not going to be able to get talent?
    Mr. Miller. What we are saying, Senator, is that at 
Vanguard we do not offer hedge funds because it does not fit 
our business model. You cannot offer--I have never seen one at 
least--a low-cost hedge fund. That is our business model. We 
have the talent in house to do hedge funds if we chose to do 
that. We just do not choose to do that.
    We do believe that when you go outside to look for 
investment talent, it is a limited commodity, it is a scarce 
commodity, and to put people, individual managers of money in 
the position where they have to choose between a mutual fund or 
a hedge fund, we believe could lead to unintended consequences 
of those hedge fund managers deciding to pursue the hedge funds 
because, frankly, they can do different things from investment 
techniques and they can earn more money.
    Senator Sarbanes. Do you think hedge funds should be 
registered and that the SEC should move in to exercise more 
oversight over hedge funds?
    Mr. Miller. My position on that, Senator, would be to what 
purpose would you request to require the registration of hedge 
funds? I believe the SEC today has ample jurisdiction, 
depending on the circumstances of the particular money manager. 
For example, we have talked to you about side-by-side 
management, so again, if you have a person managing a mutual 
fund and a hedge fund simultaneously, the SEC has ample 
jurisdiction to go in to inspect and to enforce, to ensure that 
all clients are being treated fairly.
    Senator Sarbanes. What about the separate hedge fund?
    Mr. Miller. Some believe--and I am not an expert----
    Senator Sarbanes. Do you think it is a good thing, where it 
is side-by-side, that the SEC is able to do that with respect 
to the hedge fund?
    Mr. Miller. I think it does provide an additional degree of 
oversight and insurance, and perhaps comfort level that the SEC 
does have that ability to go in and look and enforce if there 
is side-by-side management of these funds.
    Senator Sarbanes. When there is not side-by-side 
management, why wouldn't the same argument apply with respect 
to the hedge fund alone?
    Mr. Miller. I think partly, Senator, it goes to the 
clientele of the hedge fund manager. In that circumstance, 
typically the clientele tends to be institutional money, very 
high net worth individual money----
    Senator Sarbanes. There is some concern that arrangements 
are now being set up that in effect allow what amounts to 
retail participation in hedge funds; is that not correct?
    Mr. Miller. There is some movement in that direction.
    Senator Sarbanes. What do you think about that? And if that 
is the case, what does it do to the proposition you just put to 
me? It makes it hollow and empty, does it not?
    Mr. Miller. I suspect, Senator, to the extent that the 
concern is retail--traditionally to find retail investors 
moving into hedge fund accounts because hedge fund managers are 
moving downstream, there would be some more legitimacy to the 
registration of hedge funds. In the typical model where hedge 
funds are doing the money management for the institutional and 
high net worth individuals, I think that is one of the reasons 
why there has not been registration required in the past.
    Senator Sarbanes. Thank you.
    Chairman Shelby. I want to thank the panel. It has been 
very informative, we appreciate your candor. Thank you all very 
much.
    We are going to call up the second panel although we are on 
the verge of having three stacked votes on the Senate floor.
    Ms. Ann Bergin, Managing Director of the National 
Securities Clearing Corporation; Mr. William Bridy, President, 
Financial Data Services, Inc., a subsidiary of Merrill Lynch; 
he will testify on behalf of the Securities Industry 
Association, SIA; Mr. Raymond McCulloch, Executive Vice 
President, BB&T Trust, testifying on behalf of the American 
Bankers Association; and Mr. David Wray, President, Profit 
Sharing/401(k) Council of America.
    We welcome our second panel and we appreciate your patience 
here this morning in waiting for the first panel, which has 
been more than interesting. All of your written testimony will 
be made part of the Banking Committee's hearing record in its 
entirety.
    We will start with Ms. Bergin. If you will sum up your 
testimony, we will go from here. Thank you, Ms. Bergin.

                   STATEMENT OF ANN E. BERGIN

                       MANAGING DIRECTOR

            NATIONAL SECURITIES CLEARING CORPORATION

    Ms. Bergin. Chairman Shelby, I appreciate the opportunity 
to discuss the recent SEC's proposal to amend Rule 22(c)(1) of 
the Investment Company Act of 1940. With your permission, I 
would like to have two documents previously provided to 
Committee staff, included in the record.
    Chairman Shelby. Without objection, it will be made part of 
the hearing record.
    Ms. Bergin. Thank you. The February 6, comment letter to 
the SEC on the proposed amendment, and a brochure that 
describes how Fund/SERV, which is our fund processing system, 
works.
    NSCC and its affiliated clearing agencies play a 
significant role in supporting the U.S. financial markets. We 
provide post trade clearance, settlement and information 
services, not only for mutual funds, but for equities, fixed 
income and other securities as well.
    I have been asked today to speak about one aspect of the 
SEC's proposal which provides that in order to purchase or 
redeem shares in a mutual fund, it be received by the fund, its 
transfer agent or a registered clearing agency prior to 4 p.m. 
in order to receive the current day's price.
    NSCC is currently the only registered clearing agency 
providing services to the mutual fund industry. We are 
registered with the SEC and subject to comprehensive regulation 
and oversight by the Commission. As such, our Fund/SERV system 
was directly reference in the rule proposal. NSCC is owned and 
governed by our users. Our revenues are generated by the fees 
paid by our users and excess revenues are refunded to them.
    Our participation in the mutual fund industry began in 1986 
at the request of market participants looking for a way to 
address market inefficiencies. Our Fund/SERV system provides a 
central automated process for broker-dealers and other 
distribution intermediaries to transmit purchase, redemption 
and exchange orders through a single standard process and 
communications link. Like all of our fund services, 
participation in Fund/SERV is optional, but it has become the 
industry standard for processing fund and defined contribution 
transactions at the wholesale level.
    We estimate today that Fund/SERV processes the vast 
majority of these wholesale transactions. Last year Fund/SERV 
handled 87 million fund transactions, roughly 350,000 on the 
average day. Fund/SERV is used by----
    Chairman Shelby. How many on the average day?
    Ms. Bergin. On the average day 350,000. Fund/SERV is used 
by about 650 mutual fund companies, offering 30,000 different 
funds and more than 430 distribution intermediaries. Fund/SERV 
has had a tremendous impact on the efficiency of the industry 
over the years by greatly reducing operational errors and 
processing costs. It has established broadly adopted standards 
and introduced order into the marketplace. By acting as a 
central conduit, Fund/SERV allows intermediaries to offer a 
much broader range of funds than before at a much lower cost.
    Under current regulation, as long as a broker-dealer is in 
receipt of a mutual fund order by 4 p.m., the order is given 
that day's closing price regardless of what time the trade is 
processed through Fund/SERV, which today could be up until 
midnight or in some circumstances the following morning. Under 
the proposed regulation, even if the order is received by the 
broker-dealer before 4 p.m., unless it is transmitted to the 
NSCC, the fund or its transfer agent by 4 p.m., the purchase 
would not be made at that day's price.
    Although we anticipate that this would dramatically change 
the current trade flow and result in a significant increase in 
the number of trades received at NSCC in the half hour just 
prior to 4 p.m., we believe our current system's capacity is 
sufficient to handle a concentration of orders in that time 
frame. However, we will need to make some enhancements to our 
services. To date we have identified three.
    First, we would need to create a uniform methodology to 
record the time of receipt of each file and each order within 
that file before transmission to the fund. Second, our system 
would need to recognize the elements of a complete and valid 
order so that the order is final and unalterable as of 4 p.m. 
Those elements would include the name of the fund, the specific 
number of shares or dollar amount of the trade and whether the 
order is a purchase, redemption, or exchange. Third, we would 
need to build functionality to allow intermediaries to 
communicate additional information about a valid order after 4 
p.m. An example of that would be breakpoint discounts to which 
a shareholder would be entitled, as long as the information 
would not alter any of the essential elements of the order.
    We believe we can complete these enhancements within the 1 
year following adoption of the amendment as was proposed by the 
SEC at an estimated cost of approximately $5 million, which as 
I indicated earlier, would be funded by our users. It does not 
include costs that would be incurred by our users in making 
conforming changes to their own systems.
    We do recognize that migrating the time-stamping function 
from the intermediary to NSCC will impose some limitations on 
the flexibility that fund investors currently have. We feel 
very strongly, however, that applying a hard 4 o'clock close at 
NSCC is far bet-
ter for investors than applying that close at the fund or the 
transfer agent.
    The SEC, in their proposal, offered an alternative solution 
which would leave the responsibility for time-stamping at the 
intermediary level with the adoption of new safeguards to 
prevent late-trading abuses. In our comment letter to the SEC, 
we advised that implementing this alternative would preserve 
the flexibility of the current system. Whatever the 
Commission's final determination, NSCC is committed to working 
with the industry to facilitate compliance with the new 
regulations.
    That would complete my prepared remarks.
    Chairman Shelby. Thank you.
    Mr. Bridy.

                 STATEMENT OF WILLIAM A. BRIDY

            PRESIDENT, FINANCIAL DATA SERVICES, INC.

                        ON BEHALF OF THE

                SECURITIES INDUSTRY ASSOCIATION

    Mr. Bridy. Good morning and thank you very much, Chairman 
Shelby, Ranking Member Sarbanes, and Members of the Banking 
Committee.
    I am Bill Bridy. I am President of Financial Data Services, 
Inc., a wholly-owned subsidiary of Merrill Lynch. My business 
unit is responsible for the prompt and accurate processing of 
mutual fund orders placed through our firm. I am honored to 
appear before the Committee today on behalf of the Securities 
Industry Association, and I commend the Committee for your many 
contributions to the efforts to protect investors.
    We agree that the practice of late trading is unequivocally 
illegal, and its very existence threatens to undermine the 
public's trust and confidence in mutual funds. For this reason 
we applaud the strong enforcement actions the SEC and other 
authorities are taking to punish wrongdoers.
    My testimony today will focus on the ``hard close'' 
solution at the intermediary level. The intermediary level 
includes broker-dealers, banks, trust companies, insurance 
companies, and third-party administrators supporting the 401(k) 
marketplace. Such a solution will entitle the mutual fund 
orders to receive current day pricing as long as the order is 
received by a broker-dealer or other intermediary by the time 
the subject mutual fund determines its net asset value or NAV, 
which is generally 4 p.m. Eastern Time.
    This solution would benefit 88 percent of the 95 million 
investors in mutual funds. The solution is predicated on two 
core principles. The first, that a critical factor is not where 
an order is physically located at the time a fund's net asset 
value is determined, but 
rather whether the receipt of such time can be verified with a 
high degree of certainty. Second, and most importantly, the 
available hard close solution must not be detrimental to or in 
any way disadvantage the tens of millions of honest mutual fund 
shareholders who are not trying to game the system.
    The Securities and Exchange Commission recently made a 
proposal that would essentially allow for hard close solutions 
only at the fund or the registered clearing agency level. In 
the proposing release, the Securities and Exchange Commission 
recognize that requiring a hard close at the fund level would 
require that intermediaries establish an earlier preclose 
cutoff time for investors to submit fund orders and obtain 
current day pricing with respect to 401(k) plans. The SEC 
acknowledged that investors may not be able to receive same-day 
pricing at all.
    The net result of the earlier cutoff time is that the vast 
majority of fund shareholders who deal through intermediaries, 
some 88 percent of fund share investors, would be unavailable 
to effect fund purchases at current day prices for at least a 
portion, and possibly the entirety, of the trading day. The 
hard close at the fund remedy also fails to provide for an 
effective tamper-proof electronic order capture time-stamping 
system. The proposed remedy merely carries over the current 
time-stamping requirement, which is shown to be prone to abuse 
both at the fund and the intermediary levels.
    We advocate adoption of the Securities Industry 
Association's electronic order capture time-stamping approach 
for funds, brokers and 401(k) intermediaries to cure the 
shortcomings. The Securities Industry Association's hard close 
of the intermediary solution would require broker-dealers to 
use an electronic order capture and routing system, which 
assigns a verifiable order entry time aligned with the atomic 
clock currently used for equity order time-stamping. Other 
regulated and nonregulated entities would have to use a system 
certified to be functionally equivalent. It is noteworthy that 
House bill H.R. 2420 and several of the bills introduced in the 
Senate propose a similar approach.
    Importantly, the SIA recommendation contemplates that 
orders not accepted into the intermediary system by the hard 
close, even where the lack of timely receipt was due to 
legitimate errors, would, without exception, receive next-day 
pricing. Thus, corrections would have to be effected through an 
error account and essentially they, not the fund shareholders, 
would bear the economic risk of loss with respect to any orders 
processed after the hard close.
    So the Securities Industry Association's proposal would 
impose stringent additional requirements on the use of time-
stamping methodologies that would make it extremely difficult 
to game the system. And the Securities Industry Association 
recommendation, which could be implemented expeditiously, would 
eliminate the inadequacies of the current time-stamping system 
and would create a readily auditable order trail, while 
avoiding the significant adverse consequences of early order 
cut-off times. Electronic and auditable electronic time-
stamping systems are critical components to any effective hard 
close rulemaking solution. This approach would place the vast 
majority of investors holding their fund investments through 
intermediaries on a more level playing field with other 
investors.
    While imposing a hard close at the fund or registered 
securities clearing agency should be among the available 
alternatives, these measures should not be the exclusive 
solution.
    We are really looking forward to working with your 
Committee to swiftly and effectively eliminate late trading in 
a way that protects all investors and does not create 
competitive advantages for some. We believe such measures are 
essential to maintaining the integrity of our capital markets 
and retaining the public trust of the 95 million Americans for 
whom mutual funds are a core investment vehicle.
    Thank you.
    Chairman Shelby. Thank you. We are going to recess the 
hearing. We have the first vote coming up immediately. We will 
recess for about 30 minutes. If you will stick around, we will 
get on with the rest of the panel.
    [Recess from 11:49 a.m. to 12:36 p.m.]
    Chairman Shelby. The hearing will come to order.
    I know that was a long 30 minutes, but that is in the 
tradition of the Senate and the way it is managed. I apologize, 
but this is the way we operate up here as you well know.
    Mr. McCulloch, you proceed.

               STATEMENT OF RAYMOND K. McCULLOCH

              EXECUTIVE VICE PRESIDENT, BB&T TRUST

                        ON BEHALF OF THE

                  AMERICAN BANKERS ASSOCIATION

    Mr. McCulloch. Thank you, Mr. Chairman.
    I am Ray McCulloch. I am the Executive Vice President for 
BB&T Trust. I have over 26 years of banking experience with the 
last 12 focused on trusts and employee benefits.
    BB&T Trust administers over 2,200 employee benefit plans 
with total assets equaling $5.2 billion. Our parent, BB&T 
Corporation, is the Nation's 13th largest bank, and I am 
pleased to testify on behalf of the American Bankers 
Association.
    As investors and intermediaries of mutual funds, ABA 
members are quite concerned about the issue of late trading. 
Let me be very clear. ABA members emphatically believe that 
late trading has no place in mutual funds. This practice is 
illegal under current law, and we applaud the SEC for punishing 
those at fault.
    The SEC's proposal, however, often referred to as the 4 
o'clock hard close, is unworkable and will have a detrimental 
effect on investors, particularly the millions of people who 
have trusted their retirement and trust accounts to banks like 
mine to manage. While the SEC's proposal seems to be a simple 
solution to the problem of late trading in practice, it would 
result in different cut-off times for mutual fund companies and 
for intermediaries that sell shares of funds of those 
companies.
    This occurs because the processing, particularly for 401(k) 
plans is operationally complex and time consuming. Unlike the 
mutual fund companies that can perform all the processing tasks 
after 4 o'clock, all other providers must complete the 
processing before 4 o'clock. Processing trade orders involves 
as many as five steps using four separate systems, as discussed 
in my written statement.
    For BB&T Trust it generally takes 3 hours to complete the 
processing. For other ABA member banks, it can take much 
longer. This would mean that an investor making a decision at 3 
p.m. would get today's price if he or she dealt with the mutual 
fund directly, but tomorrow's price if the order was placed 
through us. It makes no sense for the SEC to create a system 
that discriminates against investors based upon the choice of 
one distribution channel over another.
    Fortunately, alternatives to the SEC's proposal exist. The 
key is a tamper proof order system where the entry time of an 
order can be verified with a high degree of certainty. This 
would allow fund intermediaries to receive orders up to the 
time of the net asset value calculation. The time-stamping, 
whether done by an outside company or internally, must be 
subject to audit. Annual audit of controls and certification of 
policies and procedures would be appropriate. Time-stamping 
processes are already available, and companies are working to 
make the electronic signing of documents, using digital 
certification, as simple as signing a piece of paper with a 
pen.
    And technological solutions can be expensive to implement. 
Thus, it is very important that the SEC's approach be flexible 
and sensitive to the cost and provide an implementation period 
of at least 1 year.
    Finally, Mr. Chairman, the ABA appreciates efforts by 
Senators to assure that solutions to late trading do not 
disadvantage investors. We are hopeful that, with your strong 
encouragement, the final SEC regulations will recognize this as 
well. Should it not, it may become necessary to address this 
through legislation.
    Thank you for the opportunity to present the views of the 
ABA.
    Chairman Shelby. Thank you.
    Mr. Wray.

                   STATEMENT OF DAVID L. WRAY

                 PRESIDENT, PROFIT SHARING/401K

                       COUNCIL OF AMERICA

                          ON BEHALF OF

             ASPA, ASSOCIATION FOR FINANCIAL PROFESSIONALS,

             AUTOMATIC DATA PROCESSING, INC., COMMITTEE ON

            INVESTMENT OF EMPLOYEE BENEFIT ASSETS, THE ERISA

           INDUSTRY COMMITTEE, FLINT INK CORPORATION, FLORIDA

             POWER & LIGHT COMPANY, HEWITT ASSOCIATES, ICMA

               RETIREMENT CORPORATION, INTEL CORPORATION,

            PROCTER & GAMBLE, PROFIT SHARING/401K COUNCIL OF

            AMERICA, SMALL BUSINESS COUNCIL OF AMERICA, AND

                             SUNGARD CORBEL

    Mr. Wray. Good afternoon, Mr. Chairman. I am David Wray, 
President of the Profit Sharing/401K Council of America, an 
association of employers that provide profit sharing and 401(k) 
plans for their workers.
    Thank you for this opportunity to share the views of the 
employer-provided retirement plan system with the Committee. My 
comments reflect the views of the companies and of the 
organizations listed on the transcript of my statement.
    As we all know, mutual funds play a key role in the 
employer-based system. According to Investment Company 
Institute, 36 million U.S. households invest one-third of all 
mutual fund assets through employer-provided retirement plans. 
Like this Committee, we are concerned by the breaches of trust 
that have occurred recently, and we applaud the efforts under 
way in the Congress to restore confidence in our Nation's 
financial institutions.
    Late trading must be eliminated. At the same time it is 
important that we preserve a level playing field for the 
ability to make investment decisions using same-day pricing. In 
most employer-provided plans, investors can make trading 
decisions up to or very close to a fund's closing time, 
generally, 4 p.m. Eastern Time. Some have questioned if plan 
participants value same-day pricing. I can assure you that they 
do, as evidenced by the predominance of this feature in 401(k) 
plans. Like all investors, plan participants adopt a long-term 
saving strategy, and only infrequently make changes in their 
investment decisions. However, when plan participants do make 
investment change decisions, they highly value same-day 
pricing. This is particularly true for distribution decisions 
upon retirement.
    Same-day pricing in employer-provided retirement plans is 
possible because intermediaries are permitted to process 
participant trades and forward the final aggregated trades to 
the funds or a clearing agency after 4 p.m. This late 
processing is necessary to 
ensure that all the requirements surrounding the operation of a 
qualified retirement plan are met, including satisfying plan 
features and the highly complex rules issued by the Departments 
of Labor and Treasury. On a more basic level, fund trade 
processing is always delayed to reflect the fund's net asset 
value for the current day, an event that does not occur until 
well after 4 p.m.
    Congress understands the need to preserve same-day pricing 
in employer-provided plans when addressing late trading. The 
House overwhelmingly passed H.R. 2420 last November. It 
instructs the SEC to issue rules to address late-day trading 
that permit late processing by retirement plan and other 
intermediaries if procedures exist to prevent late trading and 
such procedures are subject to independent audit. Similar 
provisions are found in S. 1971, cosponsored by Senators 
Corzine, Dodd, and Lieberman; and S. 2059, cosponsored by 
Senators Fitzgerald, Levin, and Collins. I applaud these 
Members for all of their efforts, and I urge this Committee to 
move forward on this important legislative provision if the 
final SEC rule on late trading fails to preserve equal 
opportunities for all investors.
    Under the SEC's proposed rule, to offer same-day pricing an 
order must be received by the fund, its designated transfer 
agent or a registered securities clearing agency by the fund's 
closing time. This means that a retirement plan participant's 
ability to enjoy full same-day pricing will be based on the 
employer's selection of a plan intermediary and investment 
choices. Employers will be pressured to adopt service provider 
arrangements that favor same-day pricing over an open 
architecture design with offerings from several fund complexes. 
Participants could be influenced to invest in proprietary funds 
of the intermediary when also offered funds from other fund 
complexes. Intermediaries will incur significant initial and 
recurring systems cost that will be borne by participants.
    I commend Ann Bergin and the NSSC staff for their valiant 
efforts to develop a viable process to meet the SEC's clearing 
agency proposal. Although the clearing agency approach will 
provide some relief to retirement plan participants that do not 
trade in a bundled provider environment, it will not create 
parity among investors. It will not accommodate all plan 
transactions, and it will result in additional costs for many 
plan participants.
    There is a preferable way to address late trading. The SEC 
has requested comments on an alternative approach. And this 
would include tamperproof time-stamping, certification 
policies, and independent audits. This approach is very similar 
to that in the legislation I mentioned earlier in my comments. 
A large majority of SEC commenters, including leading consumer 
organizations support inclusion of this approach in their final 
rule. Several technology companies have confirmed their ability 
to provide the technological safeguards sought by the SEC.
    I hope that the SEC final rule will include this 
alternative approach that preserves the opportunity for same-
day pricing for all retirement plan participants. I repeat my 
request for this Committee to intercede legislatively if that 
does not occur.
    Thank you very much for this opportunity. I look forward to 
your questions.
    Chairman Shelby. The goal of the ``Hard 4 p.m. Close'' is 
to stop illegal late trading. Without a hard 4 p.m. on order 
delivery to the funds, how do we ensure that the late trading 
window has been shut? Are there solutions--you alluded to 
something--that can be immediately implemented that address the 
problem? Ms. Bergin, we will start with you.
    Ms. Bergin. I think, Chairman, there are probably several 
solutions that could be workable. The question is: At what 
point can we certify or determine that a shareholder's intent 
to make a trade is determined prior to 4 p.m. Today that 
determination is made at the intermediary level, and for the 
most part, I would say, is preserved there, even though the 
processing happens after 4 p.m.
    I think that the SEC is certainly looking for some greater 
validation of that going forward and has suggested several 
alternatives, though they do still preserve the opportunity for 
the intermediary.
    Chairman Shelby. Could you describe the technology that 
would be needed to support the NSSC's proposal? Is the 
technology currently available? If not, how long would it take 
to develop and to implement a new system?
    Ms. Bergin. Some of that technology is available. It would 
require additional technology to actually stamp a file that 
contains trades, and stamp each of those trades within that 
file, and transmit that information.
    We have estimated that it would take us the better part of 
the year that the SEC has proposed.
    Chairman Shelby. All that will be subject to audit, of 
course, would it not?
    Ms. Bergin. Exactly, yes.
    Chairman Shelby. Are you talking about maybe software of a 
year or so ahead or what?
    Ms. Bergin. It would take about a year to develop and 
implement that, yes.
    Chairman Shelby. Mr. Bridy, many contend that in place of 
the ``Hard 4 p.m. Close,'' the industry could implement an 
audit trail and time-stamping system at the intermediate level. 
How would a system work like that? How will you authenticate a 
mutual fund transaction and prevent people from altering 
records? This is important to have an auditing trail that would 
be hard to alter.
    Mr. Bridy. Within the broker-dealer community, there is a 
platform today that we use for equities which is referred to as 
OATS. That provides a hard and a verifiable time-stamp on every 
single security.
    Within our firm, being Merrill Lynch, we have a hard clock, 
and you cannot enter a trade after 4 o'clock for that day's 
execution. If so, our system will automatically process that 
trade entered after 4 p.m. on the next day for execution. Also, 
not only is our retail broker-dealer business within the 
broker-dealer entity, but also our 401(k) business is within 
the construct of the broker-dealer. Both of our trading 
platforms have the capability to ensure that a hard clock is 
implemented within the structure of the broker-dealer 
intermediary.
    I think what is critical is that there are technologies 
that exist today that can ensure a hard close is implemented at 
the intermediary level. The need to transmit a transaction to 
either the fund or to a clearing organization prior to 4 p.m., 
in effect, in our view, will substantially disadvantage about 
88 percent of the fund investor marketplace. Eighty-eight 
percent of the marketplace conducts their business through an 
intermediary today. So how do we sit there and say we are going 
to disadvantage 88 percent of the marketplace because of the 
channel they use to execute a trade?
    Chairman Shelby. Sure. Mr. McCulloch, go ahead and compare 
how you currently monitor late trading with how you would do it 
under your proposal. Why should the regulators have confidence 
that your proposal will be accurate? How do you ensure the 
integrity of the information which goes to the crux of it?
    Mr. McCulloch. Today, we cannot accept post- 4 o'clock 
trading on our current systems. I, like my colleague from 
Merrill, have systems that shut down and flip to the next day 
automatically.
    What we do not have today that would make the audit trail 
much easier for our internal auditors, external auditors, and 
the FDIC and Fed to come in and check would be the electronic 
stamping. Knowing that this was coming, we have already had 
discussions with our software provider about this technology so 
that we can--as the 1-year time frame has been put forward, 
would give us time to put that in. Then if, in fact, my 
customers, being those participants out in the country and 
their employers, call me--as some have already done--and ask me 
at BB&T, ``How are you protecting this from happening?'' Not 
only can I tell them that my current systems will stop it, but 
I can also turn to them and say that my regulators and my 
auditors now can follow my pattern of behavior electronically.
    Chairman Shelby. Okay.
    Mr. Wray, would you elaborate on your concerns with the 
NSCC's proposal? Why doesn't the designation of the NSCC as a 
national clearinghouse work for the plan administrators?
    Mr. Wray. The regulatory compliance requirements of 401(k) 
plans are much more complicated than a typical order 
processing. For example, for a plan loan, you can only borrow 
up to 50 percent of your account balance, and that does require 
a transaction if you request a plan loan. You have to know the 
NAV in order to run the test to make sure that the person has 
not asked to withdraw more than 50 percent of their account 
balance. And so you have to hold back that processing until you 
get this other information. That is an example, and there are a 
lot of cases like that.
    So the special compliance requirements that are imposed on 
the 401(k) system really make it impossible to utilize that 
kind of process. The people that we----
    Chairman Shelby. Is it too simple for 401(k)s?
    Mr. Wray. Pardon?
    Chairman Shelby. Is that process too simple for 401(k)s?
    Mr. Wray. Right. We have talked to the recordkeepers that 
we work with, and they say that they would have to impose a 
cutoff approximately 4 hours earlier in order to run all their 
evaluations and things, and then they could get it over by 4 
o'clock to the clearing agency. But they could not still 
provide equivalent treatment compared to a 401(k) participant 
who is in a bundled investment product who can still trade 
right up to 4 o'clock, because the direct relationship with a 
mutual fund permits that in that case.
    So what we are trying to do is have a level playing field. 
We do not want to see plan sponsors and participants making 
plan design decisions or investment decisions based on how 
processing works or trade handling works. It should be based on 
other things.
    Chairman Shelby. Basically it is your concern that the 
proposal to have the NSCC serve as a clearinghouse for trades 
does not take into account all the trades made by the 401(k) 
participants. Is that correct?
    Mr. Wray. That is correct.
    Chairman Shelby. And, of course, we have a challenge of how 
to resolve the problem, right?
    Mr. Wray. Correct. We are with the other members of the 
panel.
    Chairman Shelby. Sure.
    Mr. Wray. If you look at the 401(k) system, nowhere in the 
401(k) system is there any evidence or even allegation that 
there was any wrongdoing in this area. And it is a huge system.
    Chairman Shelby. So how much money, roughly, is invested 
through the 401(k) system?
    Mr. Wray. Probably, if you include all of the 401(k) 
products, such as 403(b)'s, it is probably $2 trillion.
    Chairman Shelby. Two trillion dollars.
    Mr. Wray. Right.
    Chairman Shelby. That is not pocket change.
    Mr. Wray. No, it is not. And there is no allegation that 
there was any wrongdoing in the system, and yet we are imposing 
a solution or talking about a solution that would harm this 
innocent group of people.
    Chairman Shelby. But we have to protect, see what we can 
do, and the SEC has to see what they can do to protect the 
whole shed and everything under it.
    Mr. Wray, some contend that the ``Hard 4 p.m. Close''--we 
keep talking about that--is not a real hardship for 401(k) 
investors 
because they are long-term investors. How would you respond to 
the assertion that 1 day's price really does not matter for 
401(k) investors because they are in it for the long haul?
    Mr. Wray. Well, there is no question that 401(k) 
participants do not trade their accounts.
    Chairman Shelby. I know.
    Mr. Wray. I mean in the normal cases. But they do make 
transactions that are very important, and I will use an 
example.
    Chairman Shelby. Sure.
    Mr. Wray. In 1987, on Friday afternoon, there was an 
anticipation that the market would do certain things, and on 
Monday, the market lost 25 percent of its account value. If I 
am in the process of converting my assets from equity assets to 
fixed assets in order to buy an annuity when I retire----
    Chairman Shelby. What if you went to cash?
    Mr. Wray. But you have to sell to go to cash.
    Chairman Shelby. I know.
    Mr. Wray. Then you convert the cash to an annuity. I mean, 
this person needs to have a high degree of certainty.
    Chairman Shelby. The market was going to drop 25 percent. 
You better do something, shouldn't you?
    Mr. Wray. Right. And you want some degree of certainty. 
Kicking the trade over to the end of the next day, who knows 
what might happen between that decision and the next. We need 
the highest degree of precision and predictability that we can 
get. That is the reason the system is moving to daily 
evaluation. This is how the system should work.
    So it is very important in those cases when the employee 
does make changes in their account balance.
    Chairman Shelby. Ms. Bergin, do you want to comment on 
that? Do you have any comment?
    Ms. Bergin. I would comment insofar as NSCC does 
acknowledge that the 401(k) market is significantly more 
complex than the retail market.
    Chairman Shelby. Than ordinary transactions.
    Ms. Bergin. Absolutely. We have worked with many of our 
clients who are 401(k) recordkeepers, and we have carved out--
--
    Chairman Shelby. Well, how do we work it out?
    Ms. Bergin. I am sorry?
    Chairman Shelby. How do we work it out?
    Ms. Bergin. I think, Mr. Chairman, some of the 
transactions----
    Chairman Shelby. Or how does the SEC work it out?
    Ms. Bergin. Our system would recognize the transaction 
coming through as a retail--it looks to us like a retail trade 
in the new 4 o'clock world. There are some certain transactions 
that the trade record could not be built at the recordkeeper 
until after the NAV is known at 4 p.m. So unless there is a 
carveout for those kinds of transactions----
    Chairman Shelby. What is the harm here? There has to be a 
downside to something here. What is the uptick and what is the 
downside? Obviously, Mr. Wray is concerned about certain 
things.
    Ms. Bergin. I think I would share his concern for the 
401(k) investor, that he is going to have less ability to move 
his money in the same way a retail investor would, you know, on 
that same-day time frame.
    Chairman Shelby. But how do we resolve it?
    Mr. McCulloch.
    Mr. McCulloch. I would like to make two points.
    First of all, I go back a long way in this business and 
remember the days of common trust funds where you could only 
submit transactions quarterly. And the business has evolved 
really to a 24/7
environment where you can do things through Internet and voice 
response. If we move backward from that, our investors not only 
will be harmed, but they also will be terribly disappointed 
they do not have prompt access.
    We are in a very regulated business as a bank. We have 
multiple regulators in our shop. To have them look at our 
policies, our procedures, and our audit trail and have that 
certified annually, I am more than happy to do that if that 
solves the problem the SEC has concern about, that we at BB&T 
and other banks we are not processing past 4 o'clock.
    The technology exists today to do that, and to me it is 
common sense that we would take that approach to ensure that 
when I am selling these services and supporting these services 
that I, in fact, am living within the law.
    Chairman Shelby. Mr. Bridy.
    Mr. Bridy. I think there is one other thing we want to 
mention. Not only do we have a problem in the 401(k) arena, but 
we also have problems in the retail arena, because 
intermediaries are going to have to back up their closing 
process to calculate trades and distribute those trades. A lot 
of trades are linked trades where you are selling one security 
and purchasing with the proceeds from another and you need 
pricing for execution. So, we would have challenges within that 
arena.
    I think that the other significant disadvantage is that the 
whole world does not reside on the East Coast, so if we are 
going to start backing things up and we are going to close off 
retail at 2 o'clock, well, then we are going to be shutting 
down the West Coast at 11 o'clock in the morning, and it 
becomes even more exaggerated as one moves west.
    Chairman Shelby. Four o'clock Eastern Time might have 
worked at one time, or seemingly so, but with the 24/7 
investment syndrome, worldwide, internationally, we have 
challenges. Isn't that what your message is?
    Mr. McCulloch. Exactly. But, again, getting back to audit 
and verification, we are more than willing to do that to ensure 
our investors that we are not processing past 4 o'clock. We 
hire external auditors. We have the FDIC audit. We have DOL. 
There are enough bodies to oversee this, but obviously not to 
raise the cost dramatically. Electronically, we could provide 
that information, as an intermediary.
    Chairman Shelby. Well, we have a lot of work to do. We have 
a number of hearings left on the mutual fund industry, where we 
will be looking at it.
    We appreciate your patience today and appreciate your input 
for the record. Thank you so much. It is getting late in the 
day. The hearing is adjourned.
    [Whereupon, at 1:02 p.m., the hearing was adjourned.]
    [Prepared statements supplied for the record follow:]
               PREPARED STATEMENT OF SENATOR WAYNE ALLARD
    Thank you, Chairman Shelby, for holding this hearing to discuss the 
operations and governance of mutual funds. This is the fifth hearing 
the Committee has convened to discuss mutual funds, and I feel that we 
have gained a great deal of knowledge. I appreciate your special 
attention to this matter as revelations of late trading and market 
timing abuses have signaled the need for closer scrutiny of the mutual 
fund industry. In particular, I appreciate the balanced and cautious 
approach you have taken in examining such a critical part of the U.S. 
economy.
    Mutual funds are a unique investment vehicle, allowing middle-
income Americans the ability to invest responsibly and save for the 
future. While many invest in mutual funds to save for college or a 
house, much of the saving by Americans is done in retirement accounts 
and 401(k) plans. Whatever the ultimate reason for investing in mutual 
funds, Americans deserve to be confident about the decisions they are 
making. Congress plays a critical role in seeing that the necessary 
steps are taken so that investors remain confident, and the industry 
remains vibrant.
    The late-trading and market-timing abuses that have been brought to 
light are disturbing, and those who are guilty of these wrongdoings 
must be punished. However, as we move forward in examining the mutual 
fund industry and its investors, it is essential that we are as prudent 
and as deliberative as necessary. As Congress, it is our job to ensure 
that existing law is vigorously enforced. Furthermore, we must see to 
it that we do not overreach our authority.
    Today, we will discuss how funds actually operate, and who is 
involved in that process. I am pleased to welcome my good friend and 
colleague, Senator Armstrong, to the Committee today. Senator Armstrong 
is no stranger to this room as he served on this very Committee, as 
well as the Senate Finance and Budget Committees. He is currently the 
Independent Chairman of Oppenheimer Funds, and serves as a Director of 
Helmerich & Payne--a leading oil and gas-drilling contractor, and UNUM 
Provident--the world's leading disability insurer. His extensive 
understanding of the legislative process coupled with his experience in 
fund governance will undoubtedly provide the Committee with valuable 
insight and wisdom in our examination of fund operations and 
governance. Welcome, Senator.
    I would also like to welcome the other witnesses to the Committee 
today. You all have very busy lives and we appreciate you taking the 
time to come and share your experience and expertise with us. I look 
forward to your testimony.
                               ----------
               PREPARED STATEMENT OF WILLIAM L. ARMSTRONG
     Independent Mutual Fund Director & Chairman, Oppenheimer Funds
                    Former U.S. Senator (1979-1991)
                             March 2, 2004
     Mr. Chairman and Members of the Committee, thank you for the 
opportunity to appear before you this morning. I am an Independent 
Mutual Fund Director and Chairman of the Denver-based Oppenheimer 
Funds. Our 38 funds manage $75 billion for 5 million shareholder 
accounts.
    During the past few months, my colleagues and I on these fund 
boards have learned with mounting indignation that some mutual fund 
industry executives have violated the trust placed in them by 
shareholders. In my opinion, we should throw the book at those who have 
done so.
    But let's keep one thing in mind--the wrongdoing has been 
discovered--and can be readily punished--under the existing statutes 
and regulations. Nothing has happened which calls for sweeping new 
legislation.
    The fund industry is already heavily regulated. So, I urge Senators 
to go slow in considering costly and burdensome new requirements and 
regulations that could end up costing shareholders more than the abuses 
they are intended to correct. If that were to happen, it would be 
tantamount to punishing the victims instead of the violators, punishing 
shareholders instead of those who betrayed them.
    Does this mean Congress should do nothing?
    Absolutely not. I have reviewed 106 specific proposals contained in 
pending legislation and regulations. All are undoubtedly well-intended. 
And some, particularly recommendations for enhanced disclosure, are 
highly desirable. I recommend such measures for your approval.
    But other proposals do not take into account the unique nature of 
funds and the role of mutual fund directors. In contrast with corporate 
directors, our role is one of oversight. The adviser created the fund, 
and investors have chosen to invest in it. Fund investors do not expect 
or want us to take control of the fund, nor be deeply involved in day-
to-day management, as would become inevitable under some of the pending 
proposals.
    Based on my experience as an independent fund Director, I believe 
Congress should evaluate proposed legislation based on the following 
considerations:

    1. More than 54 million American families own mutual funds in 95 
million accounts. These shareholders are invested in eight thousand 
funds with assets totaling approximately $7 trillion.
    2. Mutual funds have been and continue to be a powerful engine for 
economic growth and wealth creation for American families.
    3. Mutual funds are the primary investment vehicle for middle- and 
low-income families. Wealthy investors have access to many different 
kinds of investments and a wide range of financial advice. But for most 
families, mutual funds provide skilled, professional investment 
management that would not otherwise be readily available to them or 
would be available only at a significantly higher cost.
    4. Although instances of misconduct by people managing or dealing 
with mutual funds have been widely publicized, recent sensational news 
reports should not obscure the tradition of honorable dealing and high 
ethical standards for which the industry has long been recognized. 
Almost all of the 456 thousand men and women who work in the mutual 
fund industry are decent, hard working, and honorable. They have served 
shareholders with dedication and expertise.
    5. The mutual fund industry is already heavily regulated.
    6. Proposed reforms should be carefully vetted to weigh costs 
against benefits and to avoid unintended consequences. Although I do 
not know the extent of investor losses as a result of misconduct by 
these wrongdoers, various estimates run from tens to hundreds of 
millions of dollars.
    Nor do I know the exact cost to shareholders of pending 
legislation, but some news articles have estimated that cost at more 
than $1 billion in one report, and 5 to 10 basis points (a basis point 
is \1/100\th of 1 percent) of the total assets in another article. I 
cannot vouch for these numbers, but my experience as Chairman or 
Director of several private and public companies convinces me there is 
a real risk that proposed ``reforms'' will prove to be more burdensome 
and costly to shareholders than the abuses they were intended to 
correct.
    7. Traditionally, U.S. regulation of investments and securities has 
focused on disclosure, leaving actual investment and operational 
decisions to investors, financial advisers, brokers, fund boards, 
managers, etc. In general, Congress and the SEC have upheld the idea 
that sunshine is the best investor protection, and that it is rarely 
advisable to impose operational requirements on business corporations 
or 
mutual funds. The stunning economic record of the American economy 
strongly 
validates the wisdom of this approach.
    8. The Securities & Exchange Commission is the appropriate agency 
to monitor and supervise the mutual fund industry. My colleagues and I 
favor additional funding for the SEC so it will have adequate resources 
to perform this role.
    9. Finally, I note that all good ideas need not be enacted into 
law.

    Many interesting and worthwhile proposals have been advanced for 
improving governance and operational reform in the mutual fund 
industry. Some of these are well-suited for some funds, less so for 
others. Ultimately, consideration of many of these reforms may be 
better left to the discretion of fund boards and management. Along with 
proper disclosure, competition among funds is likely to give 
shareholders a fairer and more efficient outcome than imposing 
additional unnecessary supervision on an industry that is already 
heavily regulated.
    With these considerations in mind, and with concurrence of many, 
though not all, of my colleagues in the industry, I offer the following 
comments and recommendations. I have been asked to particularly discuss 
issues of governance and director independence. So let me start there.
Governance
    In general, we agree with the idea that a super-majority of fund 
directors should be independent. Most of us, therefore, favor the 
requirement that two-thirds or 75 percent of fund boards be 
independent. (H.R. 2420, S. 1822, S. 1971, S. 1958)
    It is important to understand, however, that if such a requirement 
is imposed and, at the same time, the definition of independent (or not 
``interested'') director is changed, the results could be quite 
drastic.
    Take the example of one particular board with which I am familiar. 
The board has 11 directors, 10 of whom are independent under existing 
law. The most extreme proposed definition (calling for a 10 year 
cooling off period for former adviser employees) would create a 
Hobson's Choice for the board. It could discharge several directors and 
lose the expertise of experienced board members. Or it could reach the 
new standard by adding 13 new directors and, thereby, creating an 
unworkably large board. Neither of these outcomes is good for 
shareholders.
    So, Congress should be cautious in amending the definition of an 
``interested'' director. If Congress wishes to increase the cooling-off 
period, it should also permit a phase-in period of sufficient length to 
accommodate turnover in a natural manner as present directors retire.
    We favor the proposal (S. 1822, S. 1971, S. 1958) that fund board 
nominating committees be composed of independent directors. This issue 
is already largely addressed by SEC rules adopted in 2001 that require 
that, for virtually all funds, the independent directors must nominate 
and select the independent directors. There is also some agreement 
among us that it is usually a good idea for a fund board chairman to be 
independent. Accordingly, some of us favor such a requirement.
    But others of us wonder whether this is always the best 
arrangement. Are there not some circumstances in which a chairman who 
is part of fund management better serves shareholders? And, in any 
case, why must this be mandated by law? Why can't this matter, if 
properly disclosed, be left to the discretion of investors themselves? 
If they think an independent chairman is a better approach, they will 
have many funds from which to choose. But if they are indifferent to 
this issue or, for some reason, think some other arrangement is 
preferable, why should they not be permitted to invest as they choose?
Financial Expert
    We oppose the requirement that each board include at least one 
``financial expert,'' a provision that will impose a serious hardship 
on small funds.
    Even for large fund groups, such as ours, this requirement will 
adversely affect our ability to attract ``experts'' to serve on our 
boards because of the implication of additional liability attributed to 
persons so designated. Frankly, when someone is designated as such an 
``expert,'' it is like painting a bull's eye on his or her chest. That 
person will automatically be subject to more scrutiny, more criticism 
and, potentially, more liability.
    I know from firsthand experience as a corporate director, and as 
one who has been responsible for corporate director searches, that this 
requirement will make it a lot harder to attract and retain highly 
qualified board members.
    We favor instead the current Sarbanes-Oxley standards, which 
require disclosure of whether a fund has a financial expert on its 
Audit Committee.
Other Audit Committee Requirements
    We believe that additional audit committee requirements, if needed, 
should be provided by SEC rule. Many of the Sarbanes-Oxley requirements 
have already been imposed on fund audit committees by the SEC. If there 
is remaining doubt about the authority of the SEC to do so, it would be 
appropriate for Congress to explicitly grant such rulemaking power to 
the Commission.
Chief Compliance Officer
    We favor requiring the Chief Compliance Officer to report directly 
to the board, as provided by H.R. 2420 and S. 1971. I note, however, 
SEC Rule 38a-1 already substantially requires this.
Director Review of Soft Dollar, Revenue Sharing & Directed Brokerage
    Three pending bills establish a fiduciary duty for boards to review 
the soft dollar, revenue sharing, and directed brokerage arrangements. 
We see no need for legislation on this matter since, in our view, the 
law currently imposes the duty on a
fund board to carefully monitor the use of fund assets. I should also 
note that directed brokerage and certain aspects of revenue sharing are 
the subject of the SEC's rulemaking.
Certifications by Independent Chairman and/or Independent Director
    We are against proposals to require various certifications by the 
fund board chairman and/or independent directors. Such requirements 
entail too much director involvement in fund management and adversely 
affect the independence of directors. We believe such certifications 
should be made to the board, not by the board itself.
    If the most extreme proposed independent director certification 
requirements were adopted, several things would quickly happen:
    First, many independent directors would throw in the towel. They 
would just 
resign. Second, the remaining directors would have to get so deeply 
entangled in day-to-day operations of the company that they would no 
longer, as a practical matter, be independent. Third, the cost of D & O 
insurance would skyrocket.
    So, we believe such certifications should be made to the board, not 
by the board. If the board is going to continue its historic role as an 
independent watchdog, it should receive, not prepare, such 
certifications.
Ethics Code
    Our board has a well-established code of ethics (as required by 
Rule 17j-1 of the Investment Company Act) and regularly reviews 
compliance by board members and management company personnel.
    But we are skeptical of requiring that ethics violations be posted 
on fund websites (S. 1971). Doing so would raise questions of fairness, 
libel, and administrative practicality, and entails so many ``due 
process'' issues that the result would be to scuttle an otherwise 
worthy process.
Disclosures
    In general, we favor disclosure. Truth is user-friendly for our 
shareholders, and we support giving the public all the facts needed to 
make good investment decisions.
    In reviewing the numerous proposed disclosure requirements, we note 
that many of the matters included in pending legislation are already 
required by current SEC and NASD rules, and are likely to be enhanced 
by proposed rules.
    Four pending bills require disclosure of the structure and method 
for determining portfolio manager compensation and the ownership 
interest of managers. We have no objection to making such disclosures.
    We are troubled, however, by the requirement of S. 1971 to disclose 
the exact amount of manager compensation. This unnecessarily intrudes 
on the privacy of portfolio managers and creates a competitive 
disadvantage for mutual fund companies in attracting and holding 
managers.
    We have no objection to additional disclosure of share ownership by 
directors, as already contained in the Statement of Additional 
Information. But the proposal to report if a director ``does not'' own 
shares seems to us awkward. On balance, we prefer affirmative, rather 
than negative, disclosure.
    We also wish to point out that increasingly complex disclosure 
tends to make various required documents difficult to understand and, 
if carried too far, the purpose of informing investors is actually 
undermined, rather than enhanced.
Mutual Fund Oversight Board
    There has been some discussion of establishing a new Mutual Fund 
Oversight Board. We are against this idea because the SEC already has 
invaluable regulatory expertise that any new agency could acquire only 
over a long period of time.
    Moreover, we believe splitting mutual fund regulation from exchange 
and brokerage regulation will weaken the regulatory framework and 
result in confusion and fragmentation.
    It is our strong view that Congress should instead provide 
additional funding so that the SEC can properly enforce statutory and 
regulatory requirements. This seems a more practical and direct 
approach.
4:00 P.M. Closing
    We favor the so-called ``soft close'' concept (H.R. 2420, S. 1971), 
which requires strict monitoring of intermediaries to assure that all 
buy/sell orders are received 
either by the fund or the intermediary prior to the time funds 
calculate their net asset value (usually 4 p.m.).
    The ``hard close'' alternative (S. 1958) would require that all 
transactions be received by the fund itself (or its transfer agent or a 
registered clearing agency) prior to 4 p.m. This means orders placed 
through brokers or other intermediaries would have to be cut off 
several hours earlier to assure receipt prior to 4 p.m.
    The practical result might be that Pacific Time zone brokers would 
be forced to put all orders received after 9 or 10 o'clock into the 
following day's business. So, for some investors, order execution would 
be delayed for more than an entire business day, hardly fair to such 
investors.
    In our funds, a majority of shareholders place their transactions 
through intermediaries. So the ``hard close'' concept would be to the 
disadvantage of millions of our accounts.
    In our opinion, the ``soft close,'' with strict monitoring of 
intermediaries, assures a level playing field for all investors without 
implementing the more draconian ``hard close.''
Market Timing
    We favor forthright disclosure by funds of how frequently investors 
will be permitted to trade in fund shares. And we favor disclosure of 
the penalty to be invoked by the fund on those who violate the 
guidelines.
    But we are against mandatory restrictions or a one-size-fits-all 
prohibition on quick turnaround trading. The overwhelming majority of 
mutual funds are designed for long-term investors with a time horizon 
of years, not months and certainly not days or hours. Many funds also 
permit controlled asset allocation programs. But if a particular fund 
or complex wishes to offer itself to market timers, we see no reason 
why this should be prohibited, if properly disclosed.
    We also favor full disclosure of any trading restrictions that 
funds may place on adviser personnel to limit the frequency of their 
trades. In general, however, we think such personnel should be subject 
to the same limitations as other investors.
RICO
    One pending bill, S. 1958, proposes to apply RICO to the mutual 
fund industry. We are strongly opposed to this concept and feel that it 
is completely inappropriate for the mutual fund industry.
Other Issues
    Mr. Chairman, again let me express my appreciation to you and 
Members of the Committee for the opportunity to be here today. I hope 
you and your staff will call on my colleagues and me for help as you 
consider legislation regarding the mutual fund industry. Thank you.

                               ----------
                PREPARED STATEMENT OF VANESSA C.L. CHANG
               Independent Director, New Perspective Fund
                             March 2, 2004

Introduction
    My name is Vanessa Chee Ling Chang. I serve as an Independent 
Director and Chair of the Audit Committee and member of the Contracts 
Committee for the New Perspective Fund, a member of the American Funds 
family. The fund, whose board I joined in March 2000, is advised by 
Capital Research and Management Company, has assets in excess of $30 
billion and is sold through third parties. I also serve 
as an Independent Director, Audit Committee and Governance and 
Nominating Committee member for Inveresk Research Group, Inc., a 
Nasdaq-listed company providing contract research services for drug 
development to biotechnology and pharmaceutical companies. I am a 
Certified Public Accountant and worked for Peat Marwick, now KPMG, in 
the Audit Department and later in Corporate Finance. I was a partner 
from 1986 to 1997.
    I appreciate the opportunity to appear before the Committee to 
discuss mutual fund operations and governance from my perspective as an 
independent director.
    I am greatly dismayed by the abuses that have come to light in the 
mutual fund industry over the past few months. In particular, I am 
distressed that some industry participants apparently chose to benefit 
themselves at the expense of fund investors, resulting in the current 
crisis of confidence. Their behavior is so contrary to my experience 
with my fellow directors at the American Funds family, the associates 
at Capital Research and Management Company and independent directors of 
other funds whom I have had the opportunity to know and with whom I 
have discussed industry issues. I have found these individuals to be 
smart, responsible,
conscientious, inquisitive, and outspoken. I commend Congress' and the 
regulators' interest, especially the Securities and Exchange 
Commission, in restoring investor confidence and faith in our capital 
markets. Clearly, some regulatory response to the recent events is 
necessary but it must be well considered and practical. I thank this 
Committee for its thoughtful consideration to determine what 
legislative response may be necessary.
    I will discuss:

 the organization of our boards and how we work;

 service on a single versus multiple boards;

 the independent chair proposal; and

 the independent director certification proposals.
Duties and Responsibilities of Fund Boards of Directors
    In evaluating proposals that would reform fund governance, it is 
important to understand how investment companies operate and, in 
particular, the role of independent directors. Today, I will share with 
you how I go about discharging my 
duties and responsibilities in the shareholders' best interests.
    Before I joined the board of New Perspective Fund, my experience 
had been with traditional public corporations. Therefore, I had to 
learn very quickly the distinctions between my role as an independent 
director of a mutual fund versus that of a corporate director. A 
shareholder invests in a mutual fund because the investment strategy 
and process of the investment adviser is attractive. In fact, the 
investment adviser created the mutual fund to offer its services on a 
pooled basis to the investing public who could not otherwise afford the 
services of a professional money manager. A fund has no employees--the 
adviser and service providers manage its operations and provide staff. 
As fund directors, we are not charged with managing any of the fund 
operations. We serve the interests of fund shareholders through our 
oversight of the fund's operations and of the fund's service providers 
such as the adviser, auditors, and the like.
    Under the Investment Company Act and SEC rules, independent 
directors have particular responsibilities to protect fund shareholders 
against conflicts of interest between the fund and its adviser and 
other service providers. One prominent example of the independent 
directors' role in protecting against conflicts of interest is the 
renewal of a fund's advisory contracts. At New Perspective Fund, we 
receive substantial education from the adviser throughout the year, 
especially in connection with the annual contract renewal. In advance 
of the first of two board meetings during which we will be discussing 
the contracts, we receive extensive information from the adviser that 
we review carefully and compare some of the information with that of 
the prior year. The first meeting is devoted to asking questions of the 
adviser and/or requesting additional information. I have never felt 
inhibited in asking questions or raising issues that may not be on the 
agenda or in the book. After questioning management, the independent 
directors and our independent counsel meet in executive session to 
discuss the information in connection with the renewal of the contract. 
At the second board meeting we receive the additional information and 
discuss any further issues. Only after we are all satisfied do we vote 
on the advisory contracts. All independent directors sit on the 
Contracts Committees and they vote separately on contract matters.
    My duty as a Director is to feel comfortable not just at one point 
in time. As a result, throughout the year I look for or request 
information that satisfies me that the controls, systems, and 
procedures continue to be in place. Our board regularly takes the 
initiative to identify matters for the adviser to report on at board 
meetings or in special sessions. Management is always responsive to our 
requests.
    We meet in clusters. American Funds have nine clusters ranging from 
one to twelve funds per cluster. For example, the Fixed-Income funds 
may meet in a cluster that consists of 12 funds, while my cluster has 
only one fund. Although I only serve on New Perspective Fund's Board, 
our meetings coincide with board meetings of two other global equity 
funds, EuroPacific Growth Fund and New World Fund. We meet quarterly 
over consecutive days. We often have joint board or Audit Committee 
meetings to discuss issues common to us all, such as discussion of a 
particular industry or country or the internal control review (SAS 70) 
performed by an independent audit firm. After the joint meetings, each 
Board then meets separately, including our executive sessions.
    Independent directors are nominated by the Nominating Committees 
that consist solely of independent directors. We have a separate 
committee consisting of one independent director from each of the nine 
clusters to oversee the shareholder operations performed by a 
subsidiary of Capital Research and Management Company. This committee 
meets bi-annually with at least one meeting taking place at one of the 
four service centers.
    Finally, we are encouraged to attend independent educational 
seminars and hold biennial 2-day seminars for all American Fund 
directors at which we discuss various topics outside the context of 
regular board and committee meetings.
Service on Multiple Fund Boards
    The proposed reforms for fund governance include questions 
concerning service by independent directors on multiple boards. 
Although I serve on a single board, I believe there are efficiencies 
and economies of scale to be achieved from service on multiple boards. 
I have experienced these efficiencies as a result of the joint board 
and/or Audit Committee meetings in which I have participated.
    While our ``cluster'' arrangement works for us, I can appreciate 
that different complexes may find other structures preferable. I do not 
believe that Congress or the SEC should dictate the number of boards on 
which an independent director can sit. The factors affecting a 
director's ability to serve on multiple boards are quite varied and 
subjective. I think that the SEC's proposal to require directors to 
evaluate, annually, their ability to serve the shareholders of the 
funds they oversee is an effective way to address this issue.

Fund Governance Reforms
    As an American by choice and not by birth, I have great faith in 
this committee and the legislative process that any actions will be for 
the benefit of the individual investor/shareholder. Some of the reforms 
suggested will, in my opinion, improve the governance system, yet 
others threaten to add more cost and burdens on boards and fund 
shareholders without any benefit.
    As I mentioned, I believe certain of the proposed reforms would be 
beneficial and most likely to have an impact on how I discharge my 
duties as an independent director. For example, I support:

 broadening the definition of ``interested person'' to draw a 
    clearer line between independent directors and persons with ties to 
    the fund's adviser or other service providers;

 requiring 75 percent of the board to be independent;
 self-assessing annually the board's performance;

 meeting separately with only independent directors at least 
    four times a year;

 implementing nominating committees consisting only of 
    independent directors; and

 requiring a fund's chief compliance officer to report directly 
    to the independent directors.

Independent Chair
    I do not support the proposal that every mutual fund board must 
have an independent chair. Although our Board does not have an 
independent chair, we have never been prevented from adding items to 
the agenda or discussing issues that are not on the agenda. I also 
believe that the quality of our Board meeting agendas is a function of 
the input from the independent directors, as well as the interested 
chair, the officers of the adviser, independent legal counsel, and the 
fund's auditors. They reflect an open and challenging dialogue between 
the adviser and the independent directors. While some funds may benefit 
from an independent chair, I do not agree that the chair should be an 
independent director in every case because:

 An independent chair would not have the day-to-day exposure to 
    the fund's operations to understand and raise current issues or 
    anticipate potential problems 
    before they become ``problems.'' In order to gain that kind of 
    knowledge, the 
    independent chair may find himself / herself with a full time job, 
    thereby negating his / her independence from the fund's adviser. 
    This also would increase the cost to shareholders.

 No two-fund families and advisers have the same culture; 
    accordingly, one size does not fit all.

    My recommendation would be to allow boards to decide whether to 
have an independent chair or lead director. Independent boards should 
vote and appoint either an independent chair or lead director, 
whichever they believe would best benefit shareholders of their funds.

Certification Requirements
    Pending legislative proposals would require that independent 
directors or an independent chair certify to a number of matters. These 
include whether there are certain policies and procedures in place, as 
well as whether those policies and procedures have been followed. I 
strongly believe that an independent director should not be required to 
certify to matters about which directors could have no direct 
knowledge. I am particularly troubled by proposals that would require 
independent directors to certify that a fund is in compliance with its 
policies and procedures to calculate daily net asset values and oversee 
the flow of funds into and out of the fund. I inquire and am satisfied 
that there are controls, procedures, and policies in place to calculate 
net asset values and oversee fund flows. While we receive reports on 
these issues at board meetings, directors do not and should not have 
the obligation to monitor compliance on a day-to-day basis. Some of 
these certifications also appear to confuse the role of an independent 
director of a mutual fund with the role of 
the distributor/financial adviser in serving the ultimate investor/
shareholder. For 
example, while I can be satisfied that all the fund's share classes 
bear appropriate fees and expenses, I have no way to determine whether 
a given share class is appropriate for a particular investor without 
knowing that investor's investment 
objectives, holding period, etc. That is not my role as an independent 
director of a 
mutual fund.
    I also am concerned about the implications of independent director 
certifications. Do these certifications expose us to additional 
liability or remove our business judgment? As an independent director, 
do I add value if I must rely on sub-certifications from the people who 
really are in a position to monitor day-to-day compliance with these 
operations? Am I suggesting to fund shareholders that additional 
protections are in place, protections that I could offer only if I were 
to immerse myself in the day-to-day operations of the fund? If I did 
take it upon myself to become so immersed, am I now performing the role 
of management, and am I still independent? The whole area of 
certifications, as proposed, crosses the line from oversight to day-to-
day management, and sometimes may cross the line from investment 
adviser to distributor. I also believe that the certification could 
cause a problem for funds attracting and retaining qualified persons as 
fund directors, which certainly would not be in the best interest of 
shareholders.
    It is my view that these kinds of certifications, if required, 
should be redirected to those persons who are responsible for managing 
the operations of a fund or its distribution, as appropriate. This 
would place the responsibility directly on the persons who are capable 
of conducting the types of review necessary to verify compliance. To 
place this responsibility on directors would badly confuse our 
oversight responsibilities with the operating responsibilities of 
management.

Conclusion
    I appreciate the opportunity to address the Committee and to share 
my perspective as an Independent Director with you. I trust that I have 
given you a better understanding of independent directors' roles in the 
fund industry. I also hope that you take into consideration that the 
vast majority of independent directors take their responsibilities 
seriously as you evaluate the numerous proposals relating to fund 
governance.

                               ----------
                  PREPARED STATEMENT OF MARVIN L. MANN
        Chairman of the Independent Trustees, the Fidelity Funds
                             March 2, 2004

I. Introduction
    Chairman Shelby, Ranking Member Sarbanes, and distinguished Members 
of the Committee, my name is Marvin Mann. I am Chairman of the 
independent trustees of the Fidelity Funds. I appreciate this 
opportunity to appear before you today to discuss mutual fund 
governance and to describe how the Fidelity Funds Board does its job.
    The Fidelity Funds are the largest mutual fund family in the United 
States, with assets of over $900 billion and about 19 million 
shareholders as of December 31, 2003. As an Independent Trustee, it is 
my job to oversee the Fidelity Funds and to help protect the interests 
of the many shareholders of the Fidelity Funds. In that capacity, I 
have had the good fortune to work with a group of independent trustees 
who are dedicated to acting independently in pursuing the best 
interests of the Fidelity Funds and their shareholders. The way in 
which we go about our job may be instructive.
    Before I begin, I want to applaud this Committee for the leadership 
it demonstrated in connection with the enactment of the Sarbanes-Oxley 
Act of 2002. This Act recognized that corporate governance generally 
could best be improved by enhancing the role of independent directors, 
strengthening auditor independence, subjecting internal controls to 
more rigorous scrutiny and reinforcing the process by which information 
gets ``reported up'' through a corporation--ultimately, when necessary, 
to the board of directors. Without this type of system, corporate 
boards, including fund boards, cannot do their job. These types of 
reforms, rather than efforts to mandate a specific ``one-size-fits-
all'' board of trustees model for all mutual funds, are the most 
effective means to improve mutual fund governance, compliance, and 
accountability.
    Today, I would like to address mutual fund governance matters. In 
addressing these matters, specifically in Parts II, III, and IV of this 
testimony, I am expressing not only my own views but also those of the 
Governance and Nominating Committee of the Fidelity Funds, all of the 
members which are independent trustees.\1\
---------------------------------------------------------------------------
    \1\ The views expressed in this testimony may not represent the 
views of Fidelity Management & Research Company. The views expressed in 
Part V of this testimony reflect my own views.
---------------------------------------------------------------------------
    In addition, stepping from my role as an Independent Trustee of the 
Fidelity Funds and speaking more broadly about public policy issues 
affecting the entire fund industry, I would also like to address three 
proposals that I believe will improve mutual fund regulation and 
benefit investors in a meaningful way. I encourage Congress and the SEC 
to give these proposals serious consideration.
II. Characteristics of Effective Boards of Trustees
    I know that you are interested in how fund boards oversee a large 
number of funds in an effective manner. An engaged and well-functioning 
board of trustees can undertake this responsibility and do the job 
well. To describe how this can be done, I would like to identify what I 
believe are the five general characteristics of a well-functioning 
board. Having been an Independent Trustee for approximately 10 years 
and a member of corporate boards for many more, I have had ample 
opportunity to observe and think about the characteristics of a well-
functioning board and to put my thoughts into practice. The Fidelity 
Funds Board incorporates these characteristics. It is important to 
understand the role of a board of directors in the corporate governance 
of mutual funds and, for that matter, of companies generally. The role 
of a board of directors is primarily one of oversight. A board of 
directors typically is not, and should not be, involved in the day-to-
day management affairs of the company. With this in mind, I would now 
like to address the five characteristics of a well-functioning board.
    First, a well-functioning board recruits high quality, highly 
experienced people, who are independent, to serve as trustees. In the 
case of the Fidelity Funds Board, the independent trustees have 
established criteria that are aimed at recruiting such people who also 
have the time, the commitment, the expertise, the judgment and, most 
importantly, the values to serve as independent trustees. One of the 
most important values, in addition to integrity, is the disposition to 
act independently in fact. We expect that the independent trustees, as 
fiduciaries, will play an active role and, as necessary, an adversarial 
role in pursuing the best interests of the funds and their 
shareholders.
    We also focus our Trustee recruiting efforts on people who are 
highly experienced in overseeing large, complex organizations. Trustees 
with this type of experience have the expertise, disposition, and the 
instincts to guide the formulation of processes that enable them to: 
(i) oversee many complex issues in an effective manner, (ii) identify 
areas that require detailed board attention, and (iii) establish 
reporting mechanisms that provide assurance that appropriate actions 
are promptly taken.
    We make an effort to recruit senior executives from a variety of 
fields, including business operations, finance and accounting, 
marketing, investment management, and Government service. Trustees with 
diverse backgrounds bring complementary skills, strengths, experiences 
and insights that enhance our ability to provide effective oversight.
    The process of recruiting independent trustees is crucial. It 
requires a lot of effort, because 10 of the 14 trustees of the Fidelity 
Funds, or over 70 percent, are independent. Substantially more effort 
would be required if a limit were to be imposed on the number of funds 
that a single board could oversee. As the number of boards overseeing 
funds increases, there would be more board seats to be filled without 
any increase in the number of suitable candidates.
    Responsibility for all aspects of the Independent Trustee 
identification and recruitment process is vested in the Governance and 
Nominating Committee, which I chair and which is composed exclusively 
of independent trustees. More recently, in order to assure that we 
consider a broader range of qualified candidates, the Governance and 
Nominating Committee has retained an executive search firm to assist us 
in canvassing for qualified people.
    The Governance and Nominating Committee consults with the other 
independent trustees throughout the selection process. The decision to 
select an independent trustee for our board is made by all of the 
independent trustees. Of course, ultimately our selections must be 
approved by fund shareholders.
    The second characteristic of a well-functioning board is time 
commitment. Trustees must make the significant time commitment 
necessary to prepare for and fully participate in board meetings. The 
Fidelity Funds' Board has regular meetings 11 times a year, almost 
always in person. Special board and committee meetings are not 
infrequent. Regular meetings generally take the better part of 2 days. 
Board members are expected to review an extensive amount of material 
prior to each meeting. Preparation time can span several days prior to 
the meeting. In order to contribute meaningfully to board discussions 
and meetings, trustees therefore must be in a position to make a real 
commitment of their time. Often, potential candidates who would 
otherwise be extremely capable independent trustees have been 
eliminated from consideration due to their inability to make this 
commitment.
    The third important characteristic is the ability to exercise a 
strong voice in setting the agenda for board and committee meetings. 
The Fidelity Funds independent trustees pay a great deal of attention 
to structuring the agenda. First, we establish an annual calendar to 
schedule all of the matters that require board action and review over 
the course of the year, including individual fund portfolio reviews. 
Each month we consider whether additional matters should be added to 
the agenda for that month's meeting. At every board meeting, we reserve 
a substantial amount of time for executive sessions limited to 
independent trustees. At these meetings we discuss the agenda, the 
agendas for future meetings and other matters relating to our oversight 
of the Fidelity Funds.
    This process ensures that issues important to fund shareholders are 
considered. As Chairman of the independent trustees of the Fidelity 
Funds, I not only approve meeting agendas, but I also make sure that 
they reflect my input, as well as the input of committee chairs and the 
other independent trustees.
    The fourth characteristic of a well-functioning board is access to 
information and resources. Trustees cannot exercise oversight and 
fulfill their fiduciary duties in a vacuum. The independent trustees of 
the Fidelity Funds have our own legal counsel. We need and receive 
regular reports and detailed presentations from Fidelity on a broad 
range of matters related to our oversight of the funds. Our requests 
for information are promptly addressed. As necessary, we schedule 
tutorials to address additional questions and provide additional 
analytical data that we may need to support the Board's decisionmaking 
process. Importantly, Fidelity has the resources and commitment to keep 
the board of trustees fully informed.
    The fifth and final characteristic is organization. A well-
functioning board needs to have effective and flexible structures and 
processes that govern the board and its committees. These structures 
and processes must be designed to ensure that all necessary work is 
completed, based on the right mix of information.
    The Fidelity Funds Board has developed a well-defined committee 
structure that is a critical factor in our ability to oversee the 
funds. The structure, mission, and membership of each board committee 
are decided solely by the independent trustees. These committees are 
chaired by, and consist exclusively of, independent trustees. This 
assures that the committee agendas and decisions are controlled by the 
independent trustees.
    We have a Nominating and Governance Committee, an Audit Committee, 
an Operations Committee, a Fair Value Oversight Committee and a 
committee that focuses on brokerage, distribution and shareholder 
services. We also have divided the universe of Fidelity Funds into 
three categories, based largely on investment focus, and we have 
established a separate committee to oversee each category. We also have 
committees that lead the board's review and negotiation of the fund's 
investment advisory contracts.
    The committee structure, coupled with the other elements that I 
have described, make it possible for the independent trustees to 
consider the issues faced by all of the Fidelity Funds in an effective 
manner.
    It may be much more difficult for a board to oversee a large number 
of operating companies in diverse businesses, each with different 
groups of shareholders. But there are important differences between 
operating companies and mutual funds. Funds within the same fund 
complex share a substantial number of common elements. These common 
elements include distribution, fair value pricing procedures, brokerage 
allocation processes, administrative and operational processes (such as 
transfer agency, custody, and IT issues), audit, internal control and 
compliance processes, and many investment management processes. And, 
unlike operating companies, funds do not have separate employees or 
substantial physical assets and operating facilities. Rather, mutual 
fund boards generally oversee a relatively limited number of service 
providers that furnish specified services to each of the funds in the 
complex. While there may be variations in the specific services that 
each fund receives, they are generally variations of the common 
services that each fund must receive. Issues arising in connection with 
these common elements often must be resolved in a uniform way--a 
resolution that can most readily be achieved by a single unified board.
    The time and effort involved in overseeing a large number of funds 
with common elements is, therefore, not the same as would be required 
to serve on separate boards of the same number of unaffiliated 
operating companies. A well-functioning unified fund board can leverage 
its knowledge of the common elements, address them in an efficient 
manner and in the process do a superior job in exercising its fiduciary 
duties and looking after the best interests of fund shareholders.
    Our committee structure comes into play here and really makes it 
possible for the independent trustees to oversee all of the Fidelity 
Funds. The common elements of fund operation, such as fair value 
procedures, internal controls and audit functions, brokerage 
allocation, shareholder services and distribution, are addressed by 
committees that have oversight responsibilities for these areas across 
all funds in the complex.
    We also have processes that allow us to identify issues that are 
unique to specific funds. The Board of Trustees' oversight of fund 
performance provides a good example. The independent trustees receive 
monthly reports on the performance of all of the funds. This includes 
information comparing the performance of each Fidelity Fund to a peer 
group of funds and an appropriate securities index or combination of 
indices. Unusual performance that may require attention is immediately 
obvious to all of us. The Fund Oversight Committees also conduct 
regularly scheduled in-depth reviews of the funds they oversee. Prior 
to each fund review meeting, the board receives written reports and 
analyses from the portfolio manager to assist the oversight committee's 
preparation for the meeting. This material provides the independent 
trustees with essentially the same information that Fidelity management 
uses in its periodic reviews of portfolio performance. At the meeting, 
the oversight committee discusses this data and other aspects of fund 
performance in depth with the portfolio managers and their supervisors. 
The highlights of these meetings are reported to and discussed by the 
full Board. In this manner, all of the independent trustees are made 
aware of the significant issues faced by each of the Fidelity Funds and 
any actions required to remedy them.
    Another good example of the process that allows us to identify 
issues that are unique to specific funds relates to our review of the 
funds' investment management agreements with Fidelity. I will discuss 
this in the next section of my testimony.
    To sum up, the five characteristics of a well-functioning board are 
people, time commitment, the authority to set the agenda, access to 
information and organization. When all five of these elements are 
present, a board should be able to effectively fulfill its oversight 
and supervisory responsibilities. This certainly is the case with the 
Fidelity Funds Board.
    You will note that one characteristic that I did not include is 
having an independent chairman.
    A well-functioning board can, and in the case of the Fidelity Funds 
Board does, act independently and effectively without having an 
independent trustee serve as chairman. Independent trustees should have 
the authority to select an independent chairman, and the independent 
trustees of the Fidelity Funds have that authority now. I believe that 
the key structural component of assuring that independent trustees are 
in a position to control the board is to assure that they constitute a 
substantial majority of the board, as the SEC has proposed. The 
independent trustees of the Fidelity Funds further reinforce their 
independence by setting their own compensation. The investment adviser 
and management trustees are not involved in this determination.
    I am sure that there are some fund boards where governance might be 
improved if a particular individual, who also happened to be an 
independent trustee, served as chairman. In the case of many funds, 
that may not be the case. In each case, the independent trustees are 
the parties in the best position to make this decision.
    The SEC and the Investment Company Act entrust to independent 
trustees a number of important decisions with respect to various 
matters, including the approval of investment advisory contracts, 
underwriting agreements and determinations under various rules that 
address conflicts of interest. Removing from our discretion the 
election of the board chairman seems to me to be in basic conflict with 
that approach, particularly when, as a practical matter, the 
independent trustees must be at least a majority of the board. The 
Sarbanes-Oxley Act strengthened corporate governance for public 
operating companies. Wisely, it did not require corporate boards to 
have independent chairs. I do not believe that the case has been made 
that an independent chairman is essential to improving mutual fund 
governance. I therefore feel strongly that mandating a governance 
structure that requires an independent chairman is not in the best 
interests of all funds or all shareholders. It may be appropriate, 
however, to require that a majority of the independent 
trustees of a fund have the authority to elect and remove the board 
chairman.
III. Consideration of Investment Management Contracts
    One of the most important functions of a mutual fund board of 
trustees is its annual consideration of the investment management 
contract between the mutual fund and its investment adviser. The 
approval and annual renewal of the investment management contract 
requires the approval of a majority of the independent trustees. The 
Fidelity Funds Board of Trustees receives an enormous amount of 
information in connection with our review of the funds' investment 
management contracts with Fidelity and any affiliates of Fidelity that 
serve as sub-advisers (who, for purposes of this testimony, I refer to 
collectively as ``Fidelity'').
    First, however, I want to dispel any notion that all of the issues 
relating to investment advisory contracts are considered at a single 
meeting. The formal contract reviews occur over a series of meetings. 
Moreover, we receive data and information relevant to that review 
throughout the year, including the fund reviews that I discussed above.
    In reviewing the contracts, the Board of Trustees considers a 
number of factors. We receive data and information from Fidelity to 
support our consideration of these factors, including comparative data 
relating to peer groups of funds. I should also emphasize that the 
management fees paid by a large number of the Fidelity Funds include a 
performance-based adjustment, which can increase or decrease the fee. 
Thus, we receive information on the impact of performance adjustments 
to the management fees.
    The factors that we consider typically include the following:

 Benefits to Shareholders. We consider the benefit to 
    shareholders of investing in a fund that is part of a large family 
    of funds offering a variety of investment disciplines and providing 
    for a large variety of fund and shareholder services.

 Investment Compliance and Performance. We consider whether 
    each fund has operated within its investment objective and its 
    record of compliance with its investment restrictions. We also 
    review each fund's investment performance as well as the 
    performance of a peer group of mutual funds, and the performance of 
    an appropriate index or combination of indices (approved by the 
    independent trustees).

 The Investment Advisers' Personnel and Methods. As discussed 
    above, we have annual meetings with each fund's portfolio manager. 
    We review each fund's investment objective and discipline. The 
    independent trustees also have discussions with senior management 
    of Fidelity responsible for investment operations and the 
    investment discipline of each fund. Among other things that we 
    consider are the size, education, and experience of Fidelity's 
    investment staff, their use of technology, and Fidelity's approach 
    to recruiting, training, and retaining portfolio managers and other 
    research, advisory, and management personnel.

 Nature and Quality of Other Services. We consider the nature, 
    quality, cost, and extent of administrative and shareholder 
    services performed by Fidelity and its affiliates, under the 
    investment management contracts and under separate agreements 
    covering transfer agency functions and pricing, bookkeeping and 
    securities lending services, if any. We also consider the nature 
    and the extent of Fidelity's supervision of the third-party service 
    providers, principally custodians and sub- custodians.

 Expenses. We consider each fund's expense ratio, and expense 
    ratios of a peer group of funds. We also consider the amount and 
    the nature of fees paid by the shareholders.

 Profitability. We consider the level of Fidelity's profits in 
    respect of the management of the Fidelity Funds, including each 
    fund. This consideration includes an extensive review of Fidelity's 
    methodology in allocating its costs to the management of a fund. We 
    consider the profits realized by Fidelity in connection with the 
    operation of a fund and whether the amount of profit is a fair 
    entrepreneurial profit for the management of a fund. We also 
    consider Fidelity's profits from non-fund businesses that may 
    benefit from or be related to a fund's business. We also consider 
    Fidelity's profit margins in comparison with available industry 
    data.

 Economies of Scale. We consider whether there have been 
    economies of scale in respect of the management of the Fidelity 
    Funds, whether the Fidelity Funds (including each fund) have 
    appropriately benefited from any economies of scale, and whether 
    there is potential for realization of any further economies of 
    scale.

 Other Benefits to Fidelity. We consider the character and 
    amount of fees paid by each fund and each fund's shareholders for 
    services provided by Fidelity and its affiliates, including fees 
    for services like transfer agency, fund accounting and direct 
    shareholder services. We also consider the allocation of fund 
    brokerage to brokers affiliated with Fidelity, the receipt of sales 
    loads and payments under Rule 12b -1 plans in respect of certain of 
    the Fidelity Funds and benefits to Fidelity from the use of soft-
    dollar commissions to pay for research and other similar services. 
    We also consider the revenues and profitability of Fidelity's 
    businesses other than its mutual fund business, including 
    Fidelity's retail brokerage, correspondent brokerage, capital 
    markets, trust, investment advisory, pension record keeping, 
    insurance, publishing, real estate, international research and 
    investment funds, and others. We also consider the intangible 
    benefits that accrue to Fidelity and its affiliates by virtue of 
    their relationship with each fund.

    I have outlined a significant number of factors and, as you can 
imagine, that means we review a significant amount of information. As I 
have just discussed, our committee structure makes our review of this 
information more efficient. The independent trustees and Fidelity also 
spend a great deal of time in developing formats for the presentation 
of this information that facilitate our review of the data applicable 
to each fund. As I discussed earlier, a well-functioning board of 
trustees can
and, in the case of the Fidelity Funds, does have the capabilities 
required to consider all of the factors relevant to the review of each 
fund's investment management contract.
IV. Independent Director Certifications
    Certain legislative proposals would require independent trustees, 
or an independent board chairman, to certify as to certain matters, 
such as, depending on the bill, the existence of procedures for 
verifying a fund's net asset value, the oversight of the flow of assets 
into and out of the fund, the adoption of codes of ethics, the accuracy 
of disclosure documents and certain other matters.
    The fundamental role of a mutual fund board, and particularly of 
the independent trustees, is to provide oversight. It is important that 
the fundamental oversight role of independent trustees not be confused 
with the operating responsibilities of fund management. Certification 
is a proper function for entities that manage the fund on a day-to-day 
basis since it is they, not the board, that must carry out the 
appropriate risk assessment, compliance, and internal audit 
responsibilities.
    Proper oversight may require a board to review and approve various 
policies and procedures and receive reports on their implementation. A 
certification requirement is not necessary to assure that these actions 
are taken by the board. It would be relatively simple for a regulator 
to confirm that required procedures have been adopted from a review of 
the board's minutes and to take appropriate action if the board had 
failed to adopt required procedures.
    Certification requirements would go beyond the requirements imposed 
on independent directors of other public companies and would not serve 
any practical purpose. They would only blur the line between the 
oversight function of the board and the day-to-day management and 
operational responsibilities of various entities, such as the 
investment adviser. This is likely to create uncertainty as to the 
board's 
duties and potential liabilities. It would have a chilling effect on a 
board's ability to recruit and retain independent trustees.
    For these reasons, I do not support trustee certification 
requirements.
V. Three Proposals to Improve Regulation
    The existing regulatory frame work under which mutual funds operate 
has served investors well. It continues to accomplish its primary goal 
of investor protection. There is always room for improvement, however. 
In that spirit, I would like to take off my Fidelity Funds trustee hat, 
and instead speak more broadly about issues that affect the fund 
industry as a whole. In particular, I would like to discuss three 
proposals that would improve the regulation of mutual funds and the 
financial markets generally, to the benefit of all investors.
    These proposals relate to fund expense disclosure, the use of fund 
brokerage to acquire certain types of goods and services (sometimes 
referred to as ``soft-dollar'' arrangements) and fund distribution 
costs. I cannot take credit for these proposals because they appear, in 
one form or another, in various bills that have been introduced to 
reform the mutual fund industry.
    I want to emphasize that these proposals reflect systemic and 
competitive issues that can only meaningfully be addressed on an 
industry-wide basis. I raise them today in the hope that my voice will 
encourage their consideration.
Expense Disclosure
    Mutual fund investors could benefit from being told, in dollars and 
cents, exactly how much it costs for them to invest in their fund. 
Current rules, which require that fee disclosures be presented in fund 
prospectuses as a generic percentage of fund assets and a dollar-based 
hypothetical may be helpful, but they lack precision and specificity. 
An investor who is interested in getting the full picture of the 
expenses related to his or her investment would be required to collect 
data concerning commissions, fees, expenses (to the extent that the 
data is available) and performance from multiple sources (such as 
account statements, confirmations and prospectuses). The investor would 
also be required to keep track of changing account balances and then 
would have to attempt to make computations of the expenses and net 
performance on each investment. Investors, even reasonably 
sophisticated investors, would find this time consuming and difficult. 
Investors could receive more useful information regarding the costs 
associated with their investments, and that information could be 
presented in a better way.
    It may be useful for investors to receive information on actual 
expenses applied to a hypothetical investment amount that would be the 
same for all funds, so that investors could compare expenses among 
funds. This type of disclosure requirement was recently adopted by the 
SEC. I would have liked the SEC to have gone further.
    The regulations should require that when an investor buys shares in 
a fund he or she receive from the fund or the broker a statement 
setting forth the expenses that the investor will incur. This 
information should be set forth as a percentage of his or her 
investment and in actual dollars. The statement would detail all sales 
charges and itemize all of the fees and expenses that will be paid by 
the investor either directly or indirectly. The disclosure would be 
presented so that the investor would not need to search for it in the 
prospectus or other documents that the investor may receive.
    Thereafter, on a quarterly basis, the investor would receive as 
part of his or her account statement the amount of fees and expenses 
that the investor actually paid with respect to his or her investment 
in each fund during the period and, on a cumulative basis, since the 
beginning of the year. The gross and net returns of the fund 
investment, in dollars, would also be shown. The goal would be to allow 
investors who are interested in expense information to receive it in a 
manner that is readily accessible, easy to understand and, more 
importantly, in the context of a report that shows what they really 
earned on their investment.
    I believe that this approach should be required for all investment 
vehicles and accounts. There will be some costs in implementing it, 
some of which may be borne by investors. But I firmly believe that 
improved expense disclosure will result in greater investor awareness 
of expenses. I believe that this increased awareness will, over time, 
bring competitive pressures to bear on some funds with higher fees. I 
hope that the SEC will be encouraged to continue to actively pursue the 
type of 
expense disclosure that I suggest.
Fund Brokerage and Soft Dollars
    Broker-dealers often provide investment advisers with research 
products and services in exchange for the direction by the adviser of 
mutual fund and other client brokerage transactions to the broker-
dealer. A portion of the commission paid by a client, sometimes 
substantial, may, in effect be used to pay for these research products 
and services. In other words, the additional services are bundled with 
execution and their costs are reflected in commission rates.
    These arrangements, known as soft dollars, are specifically 
permitted under current law. Section 28(e) of the Securities Exchange 
Act of 1934 provides, in effect, that an investment adviser shall not 
be deemed to have breached a fiduciary duty solely by reason of having 
caused the client to pay more than the lowest available commission. The 
adviser must determine in good faith that the amount of the commission 
is reasonable in relation to the value of the brokerage and research 
services provided. The research need not have any relationship to the 
client that generated the commission; the investment adviser can 
conclude that the value of the research was reasonable when viewed in 
terms of its overall responsibilities with respect to clients for whom 
it has investment discretion.
    Brokerage commissions are not reported as fund expenses. Thus, 
while the use of fund brokerage in connection with soft-dollar 
arrangements is disclosed in mutual fund disclosure documents, the real 
costs of the services provided under soft-dollar arrangements are not 
obvious to investors.
    I believe that regulatory action should be taken to ``unbundle'' 
fund portfolio brokerage. Specifically, mutual fund brokerage 
commissions should reflect execution costs and nothing else. I support 
the recent SEC rule proposal to prohibit the use of fund commissions to 
reward brokers for sales of fund shares as a step in the right 
direction. But more needs to be done.
    Section 28(e) should be repealed. I acknowledge that repeal of 
Section 28(e) could result in some significant changes in the way in 
which brokerage firms and others conduct business. I believe that the 
SEC should develop a transition plan to allow the repeal of Section 
28(e) to take effect on a date certain without inordinate disruptions 
to market participants.
    If an adviser wants to purchase research products or other services 
such as data terminals, or other nonexecution services, or pay a dealer 
compensation for fund sales (to the extent currently permitted by law), 
it would pay for those in hard dollars from its own resources, not from 
fund commissions. Once soft-dollar arrangements are eliminated, the 
receipt of research would no longer be a factor in allocating portfolio 
brokerage.
    The end of soft-dollar arrangements may result in pressure to 
increase investment advisory fees, since investment advisers will need 
to pay for certain research products and services out of their own 
pocket. If that is a result, it is a matter that would be considered by 
fund boards as part of their advisory contract review process. I would 
expect that any increased advisory fees will in the long run be more 
than offset by reduced brokerage costs. In any event, the cost of the 
services, if they continued to be purchased by the fund or through 
increased advisory fees, would be reported to investors. Investors 
would have a much better understanding of the expenses of investing in 
a mutual fund and would be able to make better-informed investment 
decisions. At the very least, the cost of research and other services 
to fund investors would be transparent.
Distribution Costs
    The third area where change is called for relates to the way in 
which the costs of distributing fund shares are paid.
    Investors who purchase fund shares through intermediaries pay for 
the distribution of fund shares in a number of ways. The investor may 
be charged a commission or sales load at the time they purchase their 
shares. The investor may also have the option to pay for the services 
of the intermediaries on a deferred basis through an annual asset-based 
fee imposed in accordance with Rule 12b -1 under the Investment Company 
Act. The Rule 12b -1 fees provide for the payment over time of 
distribution and marketing expenses from fund assets. The investor, of 
course, bears these expenses through his or her investment in the fund 
and, in certain circumstances, through a contingent deferred sales 
load.
    Sales loads and Rule 12b -1 fees also have been supplemented, in 
some cases, by fund brokerage commissions, which may be allocated to 
sellers of fund shares under certain circumstances. In other words, a 
portion of the fund brokerage commissions may actually pay for 
distribution costs.
    In addition, the investment adviser also may supplement sales loads 
and Rule 12b -1 fees by paying for marketing and distribution costs 
from its own resources. These payments may be for services such as 
advertisements in newspapers or cash payments to dealers. The latter 
type of payments, have come to be characterized as ``revenue sharing.'' 
Revenue sharing payments may cover some of the broker's costs in 
selling the funds. They may also, in effect, be payments for ``shelf-
space'' or being placed on ``preferred lists'' at the broker-dealer.
    The complexity of these different methods for paying sales charges 
may make it difficult for investors to fully comprehend the cost of 
investing in a mutual fund. Certain practices, such as revenue sharing, 
may create conflicts of interest for the broker that, even when fully 
disclosed, may be difficult to understand.
    I have a three-element proposal that would bring greater clarity to 
this area. First, sales charges for the services of the broker-dealers 
or other intermediaries, whether up front or paid in installments, 
should be paid directly by the investor. A Rule 12b-1 fee should not be 
used as a substitute for sales loads. The compensation of 
intermediaries should generally be limited to their receipt of sales 
loads (whether paid up front or over time) paid by the investors that 
choose to utilize their services. If brokers want to give investors the 
option of paying their sales loads over time, they should collect them 
in installments as is specifically permitted by the rules.
    There is no reason why such installment payments should be a fund 
expense--they can and should be deducted from the shareholder's 
account. Thus, if a dealer charges a deferred asset-based sales fee in 
lieu of a front-end load for its distribution efforts, it should be 
collected by the broker or by the fund complex either by imposing a 
direct charge on the investor or by deducting the amount from the 
shareholder's account. These charges would, of course, be fully 
disclosed and agreed to by the investor.
    The SEC recently requested comment on whether Rule 12b -1 should be 
amended to require this approach. I hope that, after reviewing the 
comments that it receives, the SEC embraces this approach.
    The second element would be to prohibit intermediaries from 
collecting any additional cash payments (including brokerage 
commissions) from the fund, its adviser or the adviser's affiliates for 
distribution efforts. In other words, revenue sharing and other similar 
practices that involve cash payments to dealers would be prohibited. 
Accommodation may have to be made for the provision of training and due 
diligence services by the fund adviser to the dealer sales force.
    The third element would recognize that fund complexes themselves 
have marketing and other unique costs, whether the funds are sold 
directly to investors or through intermediaries. These fund expenses, 
which reflect the cost of gathering and servicing assets from tens of 
thousands of investors, as well as the administrative and regulatory 
compliance costs, differ greatly from the expenses incurred by 
investment advisers to pension plans and other large institutional 
investors. The investment adviser should be permitted to collect a 
reasonable fee from fund assets to pay for these costs. The fee could 
be approved by the independent trustees (subject to their fiduciary 
duty to approve only reasonable fees). The fee could be used to pay for 
marketing, administrative and shareholder servicing expenses. This
fee could not be used to make cash payments to intermediaries (although 
it could
be used, subject to the NASD rules, to pay for marketing activities 
directed at
intermediaries).
    This fee would be separate and unbundled from the investment 
advisory fee. The investment advisory fee would only represent the 
charges for portfolio management services and thus would be more 
directly comparable to the investment management fees paid by pension 
funds and other large institutional investors.
    This three-element approach would have several benefits. First, the 
amount that the investor pays an intermediary for its selling efforts 
would be clear and obvious. The amounts would be paid by the investor 
directly. There would be little need for the complex multiclass fund 
structures that have been developed to accommodate different 
distribution arrangements, since the payments would not pass through 
the fund. The amount would be totally transparent.
    Second, eliminating revenue sharing payments would reduce conflicts 
of interest. Revenue sharing creates potential conflict of interest 
situations for broker-dealers and other recipients, and has presented 
significant regulatory issues and resulted in SEC enforcement actions. 
And I do not believe that the way to address these conflicts is more 
disclosure--the disclosure simply becomes too complicated even for the 
more sophisticated investor. I believe that the conflicts created by 
these practices can best be addressed through prohibition rather than 
disclosure.
    Third, my proposal would recognize the reality that mutual fund 
sponsors have marketing and other costs. The approach would provide 
investors with a basis for differentiating between the expenses borne 
by the fund for these efforts and the 
expenses borne by the fund for pure portfolio management. This may 
provide better disclosure for certain investors.
    Greater transparency, reduced conflicts, and better disclosure: I 
think that these are worthwhile objectives.
    I appreciate that implementing this approach would create complex 
transition issues for mutual funds and intermediaries that have been 
relying on the current system. I believe that these issues could be 
effectively addressed once the basic concepts are understood.
                                *  *  *
    These proposals must be implemented on an industry-wide basis. 
These are not issues that each fund family can choose to address as it 
sees fit; it would simply not be feasible for a board of trustees to 
attempt to implement these changes on its own. I have been advised that 
substantially all of these proposals could be implemented by the SEC. 
Therefore, in order to ensure industry-wide change, Congress and the 
SEC should give these proposals serious consideration.
    I am certain that you will hear lots of arguments from all sides 
against these three proposals. If implemented, they will result in some 
dislocations. They will also result in some up-front costs, mostly for 
systems development, as well as some ongoing costs, mainly in the 
reporting area. But we should view these costs in the context of the 
trillions of dollars invested in mutual funds and the billions of 
dollars of trading commissions mutual funds generate. Improving market 
forces through greater transparency and reducing opportunities for 
conflicts of interest should offset these costs many times over.
Conclusion
    The series of hearings on mutual fund regulation being held by this 
Committee is a great service. These hearings serve to demonstrate, 
above all, that the issues facing mutual fund investors do not present 
simple problems or solutions. I believe that this Committee should 
consider other proposals to help investors better understand their 
mutual fund investments and the costs associated with them.
    Thank you for this opportunity to share my views.

                               ----------
                PREPARED STATEMENT OF MICHAEL S. MILLER
              Managing Director, The Vanguard Group, Inc.
                             March 2, 2004

    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, my name is Michael Miller. I am a Managing Director at The 
Vanguard Group, based in Valley Forge, Pennsylvania, where I am 
responsible for Planning and Development. An important part of my 
responsibilities is managing our Portfolio Review Group, which selects 
and oversees third-party investment advisory firms that manage assets 
for our funds.
    Vanguard understands that in the wake of fund trading scandals 
there is some interest in imposing a direct ban on the ability of an 
individual to manage both hedge funds and mutual funds. Congress is 
properly considering this and other issues relating to the operation 
and regulation of mutual funds. Vanguard appreciates the opportunity to 
testify on the issue of joint management of mutual funds and other 
accounts.
    While Vanguard does not manage or offer hedge funds, Vanguard is 
very concerned that a ban on side-by-side management will eliminate a 
substantial number of investment professionals and investment advisory 
firms that would ordinarily be available to its mutual fund 
shareholders. Like Congress, Vanguard is concerned about protecting the 
interests of mutual fund shareholders. We believe there are ways to 
effectively protect the interests of multiple clients without taking 
the extraordinary, and potentially damaging, step of an outright ban on 
managing both hedge funds and mutual funds.
The Vanguard Group
    The Vanguard Group is the world's second largest mutual fund 
family, with more than 17 million shareholder accounts and 
approximately $725 billion of investments in our U.S. mutual funds. 
Vanguard offers 126 funds to U.S. investors and over 35 additional 
funds in foreign markets. The Vanguard Group has a unique structure 
within the mutual fund industry. At Vanguard, the mutual funds, and 
therefore indirectly the fund shareholders, own The Vanguard Group, 
Inc., which provides the funds with all management services ``at 
cost.'' Under this structure, all ``profits''
of The Vanguard Group are returned to our fund shareholders in the form 
of reduced expenses.
    Given Vanguard's mutual ownership structure, all of our management 
policies, practices, and personal incentives are designed to ensure the 
growth, safety, and well-being of our fund shareholders' assets. In 
addition, Vanguard has long maintained a philosophy of fair dealing 
with our shareholders, and we believe our current investment, business, 
and disclosure practices are designed to protect their 
interests. As an industry leader, we are pleased to contribute to the 
discussions about proposed fund initiatives, and we support appropriate 
and meaningful reforms at the Federal level to restore investor trust 
in mutual funds.
    Approximately 70 percent of Vanguard's assets are managed by 
investment professionals employed by The Vanguard Group, Inc. These 
professionals manage 
equity index funds, actively managed quantitative equity funds, 
actively managed and indexed bond funds, and money market funds. The 
remaining 30 percent of Vanguard's assets, or roughly $220 billion, 
include actively managed equity and fixed-income portfolios that are 
managed by third-party investment advisory firms, which are hired and 
overseen by the funds' boards of trustees with substantial assistance 
from Vanguard's professional investment staff. In all, 37 of our funds 
receive portfolio management services from 21 independent advisory 
firms. We have been selecting and overseeing independent advisory firms 
for more than 25 years. There are substantial benefits for investors 
from our approach of using both internal and outside managers:

 Diversity of Thought. Vanguard funds and shareholders benefit 
    from the diversity of thought that a variety of external advisers 
    bring to the asset management process. We are able to engage 
    portfolio managers with distinct investment strategies and cultures 
    that would not otherwise be available to mutual fund investors. 
    Investment styles and strategies in fund offerings across the 
    Vanguard complex are distinct.

 Larger Pool of Investment Talent. Vanguard funds and 
    shareholders benefit from the additional investment talent that 
    outside managers represent. Vanguard is able to consider a wider 
    range of potential managers for a specific investment mandate and 
    is not limited by geographic or other constraints.

 Capacity to Grow. Vanguard funds and shareholders benefit from 
    the flexibility to absorb new investments by engaging additional 
    sub-advisers, without a fund's larger size diluting the 
    effectiveness of existing managers. Introducing new managers can 
    increase a fund's capacity to grow and provide greater economies of 
    scale without diminishing potential investment returns.

 Diverse Investment Offerings with Consistent Compliance and 
    Service Standards. Vanguard funds offer diverse investment styles 
    and strategies by using independent advisory firms. Importantly, 
    Vanguard fund shareholders also benefit from a consistent level of 
    compliance oversight and service that a single management company 
    can provide.
Side-by-Side Management
    At many investment advisory firms, including Vanguard and all of 
the third-party advisers we use, individual portfolio managers manage 
multiple accounts for multiple clients. In addition to mutual funds, 
these other accounts may include separate accounts (assets managed on 
behalf of institutions such as pension funds, insurance companies, 
endowments, and foundations), bank common trust accounts, collective 
trusts, and other unregistered investment companies. Although, as 
stated earlier, Vanguard does not manage or offer hedge funds, many 
asset management firms, including a number of our sub-advisory firms, 
do. A growing number of mutual fund families hire independent sub-
advisers to manage one or more funds. These sub-advisers have other 
clients, including, in some cases, hedge funds.
    While the structure of asset management firms may vary widely, 
managing money for multiple clients is, and has always been, an 
inherent feature of a successful asset management firm. Vanguard, for 
example, has never had a sub-adviser that managed money solely for 
Vanguard. Importantly, any firm that manages mutual fund assets is a 
registered investment adviser and, as such, should have substantive 
policies and procedures that help ensure that the investment 
professionals manage multiple accounts in the interest of all clients. 
The law and an adviser's role as a fiduciary demand no less.
Current Practices to Protect Mutual Fund Shareholders
Vanguard's Approach
    Vanguard's external investment advisers are subject to multiple 
controls and regulations to help ensure that Vanguard fund shareholders 
are protected. Among these are:

 Careful Selection. In the selection of fund advisers, Vanguard 
    carefully evaluates the people, philosophy, process, and 
    performance of a prospective investment management firm. In our 
    view, the integrity and ethics of an advisory firm's investment 
    professionals are as critical as experience and talent.

 Close Supervision. Vanguard works closely with our advisers to 
    ensure that they are employing talented and experienced investment 
    personnel, as well as devoting the necessary research and 
    compliance resources in the management of our funds. In addition, 
    the investment professionals in our Portfolio Review Group 
    continually review the performance and portfolio characteristics of 
    our funds. The practices and policies of our advisers are also 
    subject to periodic audits by Vanguard.

 Federal Regulation and Fiduciary Obligation. Under the 
    Investment Advisers Act of 1940, all investment advisers are 
    required to perform as fiduciaries and must place the interests of 
    their clients above their own at all times. Advisers also have a 
    fiduciary obligation to treat all clients fairly and equitably.

 Codes of Ethics. Each of our advisers has long maintained a 
    strict code of ethics that requires them to conduct their business 
    in a completely ethical manner and adhere to the highest standards 
    of professional behavior. Accordingly, all managers representing 
    Vanguard are expected to act for the benefit of fund shareholders. 
    Vanguard regularly reviews each adviser's code of ethics and its 
    procedures and efforts to assure compliance with its code.

 Internal Compliance Policies and Procedures. In addition to 
    the various laws and regulations that govern investment management 
    firms, our advisers maintain formal compliance procedures and 
    policies that are consistent with SEC regulations and designed to 
    address potential conflicts of interest. These safeguards help to 
    assure us that Vanguard funds are not being disadvantaged by any of 
    the firm's other investment activities.
Federal Regulation
    All of the investment advisers who manage mutual funds are required 
by law to be registered with the Securities and Exchange Commission 
under the Investment Advisers Act. Therefore, all investment advisers 
whose business models include side-by-side management of mutual funds 
and other accounts are also required to be registered under the 
Advisers Act. All registered investment advisers are subject to the 
SEC's jurisdiction, inspection, and enforcement powers for all of their 
business, including the side-by-side management of mutual funds and 
hedge funds. The SEC's oversight of the investment adviser extends to 
all of its management activities, regardless of whether the investment 
activity is otherwise regulated. This provides the SEC with enhanced 
insight into unregulated investment activity, a degree of transparency 
that is not present when the unregulated funds or accounts are not 
managed jointly with mutual funds.
    Under the Advisers Act, a registered investment adviser has a 
fiduciary duty to recognize and disclose potential investment conflicts 
and carefully manage them through appropriate policies and oversight. 
For example, a portfolio manager might hypothetically have an incentive 
to allocate well-priced trades to a client paying higher fees and more 
expensive trades to a client paying lower fees. As another 
example, a manager might hypothetically have an incentive to benefit 
one client by ``trading ahead'' of the trading strategies of another 
client. As noted previously, these potential conflicts are not unique 
to advisers who provide investment management to a mutual fund and a 
hedge fund. They exist whenever a portfolio manager advises two 
accounts that differ in any way, potentially even when a manager runs 
two different mutual funds simultaneously.
Compliance Policies and Procedures
    Investment firms typically manage potential conflicts, whether 
involving hedge funds or other types of accounts, through allocation 
policies and procedures, internal review processes, and oversight by 
directors and independent third parties. Investment advisers develop 
trade allocation systems and controls to ensure that no one client--
regardless of type--is intentionally favored at the expense of another. 
Allocation policies are designed to address potential conflicts in 
situations where two or more clients' accounts participate in 
investment decisions involving the same securities, which happens 
frequently. In our experience, there are four core elements of a strong 
compliance program.\1\ These elements are:
---------------------------------------------------------------------------
    \1\ A detailed list of compliance procedures is included in the 
Appendix.

 assigning one average price per security for all trades in 
---------------------------------------------------------------------------
    that security executed for multiple clients;

 when supply of a security is insufficient to satisfy all 
    clients, apportioning the available supply according to equitable, 
    predetermined rules;

 periodic reviews of the trading activity of portfolio managers 
    for anomalous trading patterns involving multiple accounts; and

 independent review of the internal controls relating to the 
    management of accounts, including controls on trade allocation.

    These systems can also be, and typically are, examined by the SEC 
staff during their inspections of registered investment advisers.
    The SEC has very recently adopted new rules that will raise 
industry-wide standards for addressing these potential conflicts for 
the protection of all investors.\2\ The new rules require each mutual 
fund, and each registered investment adviser, to have written 
compliance policies and programs administered by a designated chief 
compliance officer. Fund boards must approve not only the policies and 
programs of the fund but also of the fund's adviser. Fund chief 
compliance officers will report directly to fund directors. These 
changes will enhance the transparency and accountability of fund 
investment advisers and also require fund directors to review these 
activities very closely to determine that fair and equitable allocation 
policies are in place and are being followed.
---------------------------------------------------------------------------
    \2\ SEC Rel. No. IA-2204, ``Final Rule: Compliance Programs of 
Investment Companies and Investment Advisers'' (December 17, 2003).
---------------------------------------------------------------------------
Fiduciary Duties of Investment Advisers
    Many investment advisers have adopted practices such as those 
described previously regarding joint management in order to meet the 
fiduciary duties that have been required of them by Congress. All 
investment advisers (whether registered or not) are subject to Section 
206 of the Advisers Act, which generally makes it unlawful for an 
investment adviser to engage in fraudulent, deceptive, or manipulative 
conduct. Congress enacted the Advisers Act upon declaring that the 
public interest was adversely affected ``when the business of 
investment advisers is so conducted as to defraud or mislead investors, 
or to enable such advisers to relieve themselves of their fiduciary 
obligations to their clients.'' \3\
---------------------------------------------------------------------------
    \3\ Investment Trusts and Investment Companies: Hearings on S. 3580 
Before the Subcommittee of the Committee on Banking and Currency, 76th 
Congress, 3d Sess. 202 (1940).
---------------------------------------------------------------------------
    An investment adviser has a fiduciary duty to exercise good faith 
and to disclose all material facts fully and fairly, as well as an 
affirmative obligation ``to employ reasonable care to avoid 
misleading'' its clients.\4\ As a fiduciary, an adviser owes its 
clients more than honesty and good faith alone. Rather, an adviser has 
an affirmative duty to act solely in the best interests of the client 
and to make full and fair disclosure of all material facts, 
particularly where the adviser's interests may conflict with the 
client's. Pursuant to this duty, ``an investment adviser must at all 
times act in its clients' best interests, and its conduct will be 
measured against a higher standard of conduct than that used for mere 
commercial transactions.'' \5\
---------------------------------------------------------------------------
    \4\ Id. at 194. See also, In re: Arleen W. Hughes, Exchange Act 
Release No. 4048 (February 18, 1948).
    \5\ Thomas P. Lemke & Gerald T. Lins, Regulation of Investment 
Advisers, at 2-34 (1999).
---------------------------------------------------------------------------
Effects of Banning Side-by-Side Management
    Banning individual portfolio managers from managing mutual funds 
and hedge funds would disadvantage mutual fund shareholders and fail to 
protect them fully.
Access to Investment Talent
    Allowing side-by-side management of mutual funds and other 
accounts, including hedge funds, affords mutual fund investors access 
to top investment firms and investment professionals. Based on our 
experience, there is a limited supply of exceptional investment 
advisory firms and investment professionals. It is important that all 
investors, including mutual fund investors and 401(k) plan participants 
(who largely invest through mutual funds), be afforded access to the 
same universe of investment expertise as may be otherwise available to 
large institutions or high- 
net-worth individuals.
    Many mutual funds with strong long-term performance records are 
managed by portfolio managers who also manage other accounts, including 
in some cases, hedge funds. These professionals have a range of options 
open to them regarding where they commit their time and talent. Hedge 
funds can be an attractive option because they allow for a broader 
range of investment techniques and provide an opportunity to earn 
higher fees based on performance. Banning the joint management of 
mutual funds and hedge funds would simply force these managers to 
choose between mutual funds and hedge funds. The unfortunate and 
undesirable result would be a reduction in the pool of managers 
available to mutual fund investors.
Management Continuity and Stability
    Such a ban would hurt fund investors in other ways as well. Mutual 
funds will experience higher portfolio manager turnover, whether the 
fund is managed by an individual manager or a team, as investment 
professionals move on to manage other accounts not subject to such a 
ban.
    Allowing management of different types of investment accounts also 
enhances the ability of investment management firms to retain their 
best portfolio managers. By managing a wide variety of accounts, 
investment firms and individual portfolio managers are able to 
diversify their client bases, as many businesses rationally seek to do. 
Moreover, the diversity of clients can give a top-quality investment 
firm greater balance and the ability to better attract and retain 
talented professionals. This stability benefits mutual fund investors 
because, in our experience, the continuity and quality of an investment 
organization is one of the key determinants of long-term investment 
success for the firm's clients, including mutual fund clients.
Consistent Investor Protection
    Importantly, a ban against the side-by-side management of mutual 
funds and hedge funds would not address potential conflicts that may 
arise with the management of accounts other than hedge funds. As 
explained above, such a ban would not prevent a portfolio manager from 
managing investments for pension funds and hedge funds, or separate 
accounts and mutual funds, or, for that matter, multiple mutual funds. 
In any of these instances, the fee structure could be higher for one 
account than another for a variety of reasons, just as the investment 
objectives, strategies, and risk characteristics will differ to meet 
client needs. The potential conflicts of interest that arise in these 
situations are the same and should be treated consistently to maximize 
investor protection. Multiple compliance regimes for similar 
circumstances would introduce complexity and confusion, and would 
likely weaken rather than strengthen industry-wide compliance around 
these issues. A better way to address concerns about conflicts of 
interest is to demonstrably strengthen compliance procedures, 
reporting, and oversight.
Oversight and Compliance Evaluation by Fund Independent Directors
    A better approach than banning side-by-side management of mutual 
funds and hedge funds is to require mutual fund directors to review and 
to approve stringent procedures to address conflicts of interest and to 
review the adviser's performance under those procedures. As mentioned 
earlier, at Vanguard the funds' independent directors monitor the 
independent advisory firms that manage money on behalf of the Vanguard 
funds. Our approach involves careful screening and selection, close 
supervision and evaluation of each firm's compliance policies and codes 
of ethics, and continuous review of its performance under those 
policies. We believe that advisers should be required to demonstrate to 
mutual fund boards that they have successfully followed all procedures 
and, when appropriate, to inform the Board how the firm's procedures 
can be improved.
    While mutual fund directors have long been charged with overseeing 
the performance and compliance of the fund's adviser, due to recent 
events, the Congress and the regulators have demanded more specific 
protections. As mentioned earlier, the SEC recently strengthened the 
position of fund directors in this regard by requiring that every 
mutual fund have a chief compliance officer reporting directly to the
directors.\6\ Each investment adviser must now have written policies 
and procedures, administered by its own chief compliance officer. These 
policies and procedures
must address a number of issues, including allocation of trades among 
multiple clients. The fund boards must approve the policies and 
procedures of their advisers, and funds must oversee the performance of 
their advisers under these procedures. This new regulation makes 
mandatory what ``best practice'' investment firms have long required.
---------------------------------------------------------------------------
    \6\ SEC Rel. No. IA-2204, ``Final Rule: Compliance Programs of 
Investment Companies and Investment Advisers'' (December 17, 2003).
---------------------------------------------------------------------------
    In addition, to the extent that fund directors require special 
experts to assist with their analysis of an adviser's performance, the 
SEC has recently proposed that mutual funds be required to explicitly 
authorize their independent directors to hire employees or other 
experts to help them fulfill their fiduciary duties.\7\ We support this 
authority for independent directors (the independent directors of 
Vanguard funds have long had this authority) and hope that this aspect 
of the proposal is adopted in the final rule.
---------------------------------------------------------------------------
    \7\ SEC Rel. No. IC-26323, ``Proposed Rule: Investment Company 
Governance'' (January 15, 2004).
---------------------------------------------------------------------------
    We believe that the combined effect of enhanced compliance 
obligations and additional support for independent directors will 
sufficiently protect investors from potential conflicts of interest 
present in the side-by-side management of mutual funds and hedge funds, 
as well as other investment accounts. In our view, this approach will 
benefit mutual fund investors and protect their interests at the same 
time. Accordingly, we believe that imposing an outright ban on the 
management of mutual funds and hedge funds is a drastic solution that 
does not appear to be necessary at this time, particularly in light of 
the SEC's recent adoption of more stringent compliance requirements for 
funds and advisers. To do so could well deprive mutual fund 
shareholders of the widest available universe of investment management 
talent--surely an unintended but severe consequence that should be 
avoided.
    Thank you. We appreciate the opportunity to testify before the 
Committee on issues of importance to mutual fund investors.

                                Appendix
   Management of Multiple Accounts Compliance Policies and Procedures

    In Vanguard's experience, investment advisory firms have developed 
very effective policies and procedures to address the conflict of 
interest potentially present to an advisory firm or its personnel 
managing simultaneously mutual fund and other accounts, including the 
accounts of hedge funds. Those policies and procedures are typically 
and appropriately tailored to reflect an advisory firm's business 
operations and other specific characteristics. Vanguard believes that 
acknowledging ``one-size-does-not-fit-all'' is crucial to the 
development of workable and effective compliance procedures in the area 
of joint management. In particular, policies may differ for equity and 
fixed-income securities. Nonetheless, in Vanguard's view, certain types 
of compliance procedures and policies having core elements can be 
effective in dealing with the conflicts present in joint management of 
hedge funds and mutual funds. The policies and the procedures adopted 
for this purpose by firms Vanguard has hired fall into three 
categories: Procedures, both general and specific, for the allocation 
of securities among different clients; specialized allocation 
procedures for securities offered through public offerings and other limited 
offerings; and oversight mechanisms. Examples of the three categories 
of policies and procedures follow bellow:

Allocation Policies and Procedures
 One way in which investment advisory firms seek to address the 
    potential that an individual portfolio manager responsible for 
    managing hedge fund and mutual fund accounts could favor the hedge 
    fund in allocating securities positions is by adopting specific 
    policies and procedures that require orders for the purchase or 
    sale of the same securities on behalf of multiple clients made on 
    the same day to be aggregated. The central elements of these 
    policies and procedures include:

  --assigning the same price per securities to all clients 
        participating in the aggregated trade, even if multiple trades 
        are needed to fulfill the entire aggregated order;

  --executing trades in accordance with a defined and objective 
        rotation system in which all clients participate on the same 
        basis;

  --distributing costs among clients participating in the aggregated 
        trade on a proportionate basis;

  --allocating trades at, or immediately after, execution, and entering 
        trades into client accounts promptly after execution and in 
        accordance with the allocation policy; and

  --in cases when the supply of securities is insufficient and the full 
        amount of an aggregated trade cannot be filled, allocating on a 
        proportionate basis to the original order or in some other 
        objective manner that is consistently applied.

 A second general way in which an investment advisory firm 
    seeks to deal with allocation of securities when managing mutual 
    funds and hedge funds is by only aggregating a purchase or sale 
    order if the aggregated order is in the best interests of each 
    individual client participating in the order and consistent with 
    the firm's best execution policies.

 A third general way of addressing joint management conflicts 
    by an investment advisory firm with a trading department is by 
    having the trading department aggregate orders in the same 
    securities, even when the orders are originated by different 
    portfolio managers, if aggregation provides clients with better, 
    cheaper, and more efficient execution.

 Other specific policies and procedures Vanguard has observed 
    that an investment advisory firm adopts in light of its business 
    operations and other factors, in seeking to ensure that mutual fund 
    clients are not disadvantaged by the firm's joint management 
    activities include some of the following:

  --executing at the same time all the transactions undertaken by a 
        portfolio manager employed by the firm in the same securities 
        during the day;

  --requiring consistent trading activity among all funds having 
        similar investment strategies, such as mandating that 
        transactions on behalf of 11 mutual funds be entered by a 
        portfolio manager when the portfolio manager has entered into a 
        transaction for a hedge fund that is deemed suitable for the 
        mutual fund;

  --prohibiting a portfolio manager from maintaining different 
        positions in the same securities on behalf of mutual funds and 
        hedge funds that generally follow the same principal investment 
        strategy;

  --allowing a portfolio manager to undertake a securities transaction 
        for one client while not contemporaneously entering into the 
        same transaction for other clients, only if the portfolio 
        manager determines and documents that the securities are or the 
        transaction is not appropriate for the other clients;

  --precluding a portfolio manager from purchasing securities for a 
        mutual fund that have been sold recently by a hedge fund 
        managed by the same manager, unless the manager obtains 
        approval for the transaction from the investment advisory 
        firm's chief investment officer or a compliance officer;

  --prohibiting a portfolio manager from assuming a long position in 
        equity securities on behalf of one client while simultaneously 
        selling short the same securities on behalf of another client;

  --establishing an order of trade execution priority for short and 
        long transactions, giving general preference to long 
        transactions;

  --separating hedge fund short sales from mutual fund sale orders when 
        they involve the same securities, and assigning trade execution 
        priority on the basis of the time each of these transaction 
        requests was received by the investment advisory firm's trading 
        desk;

  --prohibiting cross trades between the accounts of hedge funds and 
        any other 
        client;

  --limiting cross trades between or among client accounts to liquid 
        securities for which market quotations are readily available;

  --requiring that the price used for cross transactions be the same as 
        the last independent trade on a recognized market, and that the 
        transactions conform to the investment advisory firm's overall 
        trading policies and regulations; and

  --restricting cross trades among specific types of accounts, such as 
        trades involving accounts of employee benefit plans subject to 
        the requirements of the Employee Retirement Income Security Act 
        of 1974, as amended.
Allocation of Initial Public Offerings Securities and Other Limited 
        Issues
 Vanguard has observed many investment advisory firms that seek 
    to address the conflicts of interest presented by simultaneous 
    management of hedge funds and mutual assets by adopting specialized 
    rules covering securities purchased through initial public 
    offerings and other limited issues. Misallocation of IPO securities 
    has been at the center of a number of Securities and Exchange 
    Commission enforcement cases. In some of these cases, hedge funds, 
    but not other clients, were allocated IPO securities believed by an 
    investment advisory firm to have the potential for strong returns. 
    In seeking to preclude such inappropriate allocations, advisory 
    firms, in Vanguard's experience, have adopted some or all of the 
    following policies and procedures:

  --apportioning IPO securities and other securities available through 
        limited offerings according to equitable, predetermined rules, 
        such as for example, by apportioning securities to all clients 
        on a proportionate basis when the supply of a particular 
        securities position is insufficient to satisfy all clients;

  --predetermining clients that are eligible for securities offered 
        through specific types of IPOs;

  --dividing IPOs into categories according to size and to investment 
        strategies furthered by holding the securities offered through 
        the IPOs, and allocating IPO securities among all clients that 
        have similar investment strategies on the basis of market 
        capitalization of the issuers of the securities; and

  --prohibiting portfolio managers and other fund personnel from 
        participating in IPOs through hedge funds.

Oversight of Policies and Procedures
 Vanguard believes that crucial to effective compliance is a 
    strong oversight of policies and procedures adopted to protect the 
    interests of clients. Each investment advisory firm used by 
    Vanguard must demonstrate it has established review processes and 
    has retained the necessary oversight personnel to supervise trading 

    activities and to ensure compliance with Vanguard's and the 
    investment advisory firm's policies. An investment advisory firm 
    should, as a starting point, have a compliance officer to review 
    trading activity, monitor compliance with policies, and intervene 
    in situations in which conflicts of interest are apparent. Other 
    specific oversight mechanisms that Vanguard has observed investment 
    advisory firms adopt with respect to joint management allocation 
    policies and procedures include some or all of the following:

  --investment advisory firm personnel regularly on a periodic basis 
        reviewing client transactions to identify potential conflicts 
        of interest;

  --an investment advisory firm's portfolio managers, traders and/or 
        compliance employees bringing transactions to the attention of 
        a supervisor and/or an executive officer of the firm for closer 
        review;

  --investment advisory firm compliance personnel reviewing 
        representative samples of client transactions to assess overall 
        compliance with the firm's trade allocation policies and 
        procedures and to ensure fairness and equity in the operation 
        of the firm's trading systems;

  --an investment advisory firm's allowing for exceptions to the firm's 
        policies and procedures only if the exceptions are properly 
        documented and approved by a compliance officer employed by the 
        firm;

  --investment advisory firm personnel preparing and retaining separate 
        documentation for each client participating in an aggregated 
        order;

  --investment advisory firm compliance officers' periodically 
        reviewing past trade allocations to determine whether any 
        client was systematically disadvantaged as a result of 
        aggregated transactions;

  --investment advisory firm compliance officers' reviewing portfolio 
        manager determinations that trade aggregation provides all 
        clients with the opportunity to achieve more favorable 
        execution;

  --an investment advisory firm's identifying instances in which a 
        portfolio manager has deviated from the firm's allocation 
        policy, and if so, whether the portfolio manager has identified 
        a legitimate reason for the allocation;

  --an investment advisory firm's requiring portfolio managers to 
        document the 
        reasons for entering into different or opposite positions on 
        behalf of multiple clients, and requiring a compliance officer 
        of the firm to review portfolio manager explanations at least 
        every quarter;

  --investment advisory firm personnel automatically time-stamping, at 
        multiple stages of transactions, all records of transactions 
        undertaken on behalf of all 
        clients;

  --an investment advisory firm's allowing short selling of securities 
        by a hedge fund that are held long by a mutual fund advised by 
        the portfolio manager of the hedge fund only if the manager 
        receives approval for the short sale from the firm's compliance 
        department and if this policy is properly disclosed to all 
        clients involved, including the mutual fund;

  --an investment advisory firm's permitting cross trades subject to 
        the condition that they be monitored by compliance officials 
        charged with identifying trading patterns of cross trades 
        between or among mutual funds and hedge funds;

  --investment advisory firm compliance personnel simultaneously 
        reviewing hedge fund trading and mutual fund trading;

  --an investment advisory firm's compliance personnel reviewing daily 
        hedge fund transaction reports to identify transactions 
        executed on behalf of hedge funds by portfolio managers who 
        executed transactions on behalf of mutual funds within 7 days 
        before or after the hedge fund transactions;

  --an investment advisory firm's requiring portfolio managers to sign 
        quarterly trading reviews for each hedge fund and mutual fund 
        they manage, certifying that all trading was in compliance with 
        each fund's investment strategy and that all clients were 
        treated fairly and equally;

  --an investment advisory firm's requiring portfolio managers to 
        explain to oversight officials the investment rationale for 
        proposed transactions on behalf of hedge funds that appear to 
        be inconsistent with transactions undertaken on 
        behalf of mutual funds;

  --an investment advisory firm's establishing hedge fund review and 
        oversight groups to provide specific fiduciary oversight for 
        hedge fund transactions and to ensure that policies and 
        procedures relating to hedge fund management are followed;

  --an investment advisory firm's reviewing IPO allocation procedures 
        and allocations at least annually;

  --an investment advisory firm's having its compliance officer or an 
        investment committee review prospective allocation of IPO 
        securities prior to execution of the transaction in the 
        securities;

  --an investment advisory firm's requiring written explanations of the 
        investment rationale underlying hedge fund transactions;

  --an investment advisory firm's disclosing the potential conflicts of 
        interest presented by simultaneous management of client 
        accounts in the appropriate regulatory forms and offering 
        materials; and

  --an investment advisory firm's reviewing and updating compliance 
        policies and procedures and related disclosures to ensure 
        accurate representation to all 
        actual and prospective clients of potential conflicts of 
        interest.

                               ----------
                  PREPARED STATEMENT OF ANN E. BERGIN
      Managing Director, National Securities Clearing Corporation
                             March 2, 2004

    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, I appreciate the opportunity to discuss the SEC's proposal 
to amend Rule 22c-1 of the Investment Company Act of 1940. With your 
permission, I would like to have two documents previously provided to 
Committee staff included in the record: NSCC's February 6 comment 
letter to the SEC on the proposed amendment and a brochure that 
describes how our fund processing system, which is called Fund/
SERV', works.
    For those of you unfamiliar with our organization, NSCC and its 
affiliated clearing agencies play a significant role in supporting the 
U.S. financial markets. We provide post-trade clearance, settlement and 
information services for equities, corporate and municipal bonds, 
mutual funds, and other securities.
    Current regulation allows a mutual fund order to be priced 
according to the time it is received by an intermediary--a broker-
dealer or plan administrator, for example. Therefore, an order received 
by an intermediary by 4 p.m. is eligible for today's price, even if it 
is transmitted to the fund at a later time.
    I have been asked to speak about that aspect of the SEC's proposal 
providing that an order to purchase or redeem shares in a mutual fund 
would have to be received by a fund, its transfer agent or a registered 
clearing agency by 4 p.m. in order to receive the current day's price.
    The NSCC is a clearing agency, registered with the SEC under the 
Securities 
Exchange Act of 1934. As such, we are subject to comprehensive 
regulation and 
oversight by the SEC. We are currently the only registered clearing 
agency providing services to the mutual funds industry. In the past 
year we have been called upon to take an active part in several 
industry and regulatory initiatives involving mutual fund processing, 
including the NASD/Industry Task Force on Breakpoints and the NASD 
Omnibus Account Task Force.
    NSCC is owned by our users--broker-dealers, banks, mutual fund 
companies, and other financial service firms, and we are governed by a 
user-representative board of directors. The clearance, settlement, and 
information services NSCC provides are developed at the request of our 
users. Our revenues are generated by the fees that are paid by our 
users; and, to the extent those revenues exceed our costs, the excess 
revenues are refunded to them.
    NSCC's participation in the mutual fund industry began nearly 20 
years ago, in 1986, at the request of market participants.
    Our Fund/SERV system provides a standardized, automated process for 
distribution intermediaries to transmit purchase, redemption, and 
exchange orders through a single process and a single communications 
link. Like all of the NSCC's fund
services, participation in Fund/SERV is optional, but it has become the 
industry standard for processing fund and defined contribution 
transactions at the wholesale level. We estimate that today Fund/SERV 
processes the vast majority of these wholesale transactions. Last year, 
Fund/SERV handled 87 million fund transactions--roughly 350,000 a day--
with a value of $1.54 trillion. About 650 mutual fund companies and 
more than 430 intermediaries, offering 30,000 different funds, use 
Fund/SERV today.
    Fund/SERV has greatly reduced operational errors, lowered the cost 
of processing, established standards and introduced order into the 
marketplace. By acting as a central conduit, Fund/SERV allows 
intermediaries to offer investors a much broader range of funds than 
before at a much lower cost.
    Allow me to walk you through how a typical mutual fund trade is 
processed. In my example, once an individual investor advises his 
broker-dealer that he wishes to purchase a particular mutual fund, the 
broker-dealer enters the order into its system. That system transmits 
order files electronically to Fund/SERV periodically throughout the 
day. And through Fund/SERV the orders are directed to the appropriate 
fund company. The fund company either confirms or rejects the orders 
and then transmits that information back to the broker-dealer through 
Fund/SERV.
    As long as the broker-dealer is in receipt of the order by 4 p.m., 
under today's rules the order is given that day's price, regardless of 
what time the trade is processed through Fund/SERV. Fund/SERV receives 
order files over a 22-hour period each business day from 2 a.m. until 
midnight, and many of these files are received and then redirected to 
the fund companies between 5 and 8 p.m.
    Under the proposed regulation, even if the order is received by the 
broker-dealer before 4 p.m., unless the broker-dealer is able to 
retransmit the order to NSCC (as the registered clearing agency), the 
fund or its transfer agent by 4 p.m., the purchase will not be made at 
today's price.
    We anticipate that this would dramatically change the current trade 
flow, and 
result in a significant increase in the number of trades received at 
NSCC in the half-hour just prior to 4 p.m. We have done some 
preliminary analysis and believe that our current systems capacity is 
sufficient to handle the concentration of orders within that shortened 
time frame. However, we will need to make technological enhancements to 
some of our services. To date, we have identified three such major 
enhancements.
    One: We would need to create a uniform methodology to record the 
time of receipt of each order file at NSCC. Subsequently, each order 
within that file would be coded with that time of receipt before 
transmission to the fund.
    Two: Our system would need to recognize the elements of a very 
complete and valid order, so that the order is final and unalterable as 
of 4 p.m. Those elements would include the order type, that is, a 
purchase, redemption, or exchange; the name of the fund; and either the 
specific number of shares, or the dollar amount of the order.
    Three: We would need to build functionality to allow intermediaries 
to communicate additional information about a valid order after 4 p.m. 
This could include information not known prior to 4 p.m., as long as 
this information does not alter any of the essential elements of the 
order--for example, the breakpoint discount to which an investor is 
entitled or the purchase specifics of an exchange transaction.
    We believe we can complete these enhancements within the 1 year 
following the adoption of the amendment, as was proposed by the SEC, at 
an estimated cost of approximately $5 million. This estimate is limited 
to NSCC's costs, which, as I indicated earlier, would be funded by our 
users, and does not include costs that would be directly incurred by 
our users in making corresponding changes to their own systems, as many 
of them would have to do. Some in the industry also believe that 
additional time would be needed to ensure rigorous testing of these 
changes.
    NSCC does recognize that migrating the time-stamping function from 
the intermediary to NSCC will impose some limitations on the 
flexibility currently afforded to all mutual fund investors. We feel 
strongly, however, that applying a hard 4 p.m. close at NSCC is far 
better for investors than applying a hard 4 p.m. close only at the fund 
or its transfer agent.
    In our comment letter to the SEC, we advised that the flexibility 
of the current system could be retained through the implementation of 
the alternative solution that was proposed for comment by the SEC. That 
solution would leave the responsibility for time-stamping at the 
intermediary level--with the addition of new safeguards to prevent late 
trading abuses.
    Whatever the Commission's final determination is, NSCC is committed 
to working with the industry to facilitate compliance with the new 
regulations.
    I will be pleased to answer any questions.

    
    
    
    
                 PREPARED STATEMENT OF WILLIAM A. BRIDY
                President, Financial Data Services, Inc.
                            on behalf of the
                    Securities Industry Association
                             March 2, 2004

Introduction
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, I am William A. Bridy, President of Financial Data Services, 
Inc., a wholly-owned subsidiary of Merrill Lynch & Co., Inc. My 
business unit has overall responsibility for the prompt and accurate 
processing of all mutual fund orders placed through
our firm. I am pleased and honored to appear before the Committee on 
behalf of the Securities Industry Association (SIA) \1\ to discuss 
measures to eliminate late trading, as this Committee has contributed 
so much to the effort to protect the investing public.
---------------------------------------------------------------------------
    \1\ The Securities Industry Association, established in 1972 
through the merger of the Association of Stock Exchange Firms and the 
Investment Banker's Association, brings together the shared interests 
of nearly 600 securities firms to accomplish common goals. SIA member-
firms (including investment banks, broker-dealers, and mutual fund 
companies) are active in all United States and foreign markets and in 
all phases of corporate and public finance. According to the Bureau of 
Labor Statistics, the U.S. securities industry employs more than 
800,000 individuals. Industry personnel manage the accounts of nearly 
93 million investors directly and indirectly through corporate, thrift, 
and pension plans. In 2003, the industry generated an estimated $142 
billion in domestic revenue and $283 billion in global revenues. (More 
information about SIA is available on its home page: www.sia.com.)
---------------------------------------------------------------------------
    As a preliminary matter, we, and all members of SIA, agree that the 
practice of late trading is unequivocally illegal, and its very 
existence threatens to undermine the public's trust and confidence in 
mutual funds. For this reason, we applaud the strong enforcement 
actions the SEC and other regulators have taken to date to punish 
wrongdoers. We believe that these enforcement actions, and the broad 
attention they have received, have already had a significant deterrent 
effect on potential wrongdoers and have propelled broker-dealers, other 
intermediaries, and mutual funds to focus their compliance efforts more 
sharply on preventing late trading.
    We also applaud the expeditious manner in which legislators and 
regulators proposed rulemaking after evidence of late trading first 
surfaced in September 2003. In that regard, a manager's amendment 
relating to late trading was added to H.R. 2420, and the bill, 
inclusive of the manager's amendment passed the House of 
Representatives by a vote of 418 to 2 on November 3, 2003.\2\ 
Additionally, 3 of the 4 bills introduced in the Senate contain 
provisions that address late trading.\3\ Furthermore, the SEC has 
issued its own late trading proposal.\4\
---------------------------------------------------------------------------
    \2\ ``Mutual Funds Integrity and Fee Transparency Act of 2003,'' 
introduced by Congressman Richard Baker (R-LA).
    \3\ S. 1971 introduced by Senators Corzine and Dodd, S. 1958 
introduced by Senators Kerry and Kennedy and S. 2059 introduced by 
Senators Fitzgerald, Collins, and Levin. Senator Akaka 
has also introduced mutual fund legislation (S. 1822), but it does not 
contain a late trading 
provision.
    \4\ SEC Release No. IC-26288 (December 11, 2003).
---------------------------------------------------------------------------
    My testimony today will focus on a ``hard close'' solution at the 
intermediary level whereby mutual fund orders will be entitled to 
receive current day pricing, as long as the order is received by a 
broker-dealer or other intermediary by the time the subject mutual fund 
determines its net asset value (usually 4 p.m. Eastern), provided 
certain other conditions are met. The testimony is predicated on two 
core principles. First, that a critical factor is not where an order is 
physically located at the time a fund's net asset value (NAV) is 
determined, but rather whether its receipt by such time can be verified 
with a high degree of certainty. Second, and most importantly, the 
available hard close solutions must not be detrimental to, or in any 
way disadvantage, the tens of millions of honest mutual fund 
shareholders who are not trying to ``game'' the system.
Current Proposals
Legislative
    Section 205 of the Baker bill contains a provision specifically 
contemplating a hard close at the broker-dealer, plan administrator or 
other intermediary level, provided such intermediaries have procedures 
designed to prevent the acceptance of trades after the time at which 
NAV is determined, and such trades are also subject to an independent 
audit to verify adherence to those procedures. Sections 306 and 315 
respectively of the Corzine-Dodd and Fitzgerald-Collins-Levin bills 
contain substantially similar provisions, and neither the Akaka or 
Kerry-Kennedy bills would preclude an intermediary hard close solution.
Regulatory
    In December 2003, the SEC proposed amendments to Rule 22c-1 of the 
Investment Company Act which would preclude mutual fund orders from 
receiving current day pricing unless the order was received directly by 
a fund, its designated transfer agent, or a registered clearing agency 
by the time the fund establishes its NAV for the day. The SEC's 
proposal followed a recommendation by the Investment Company Institute 
(ICI) requiring that all orders be received by the fund company by the 
hard close in order to receive current day pricing.\5\ Although the SEC 
release accompanying the proposal invited comment on whether the SEC 
should consider an intermediary approach, contrary to the intent of the 
legislative proposals, the proposal excludes an intermediary solution. 
The SEC's proposal also appears to be inconsistent with the spirit of 
the legislative initiatives, since with respect to a hard close 
solution at the fund level it provides neither for procedures designed 
to detect and prevent late trades, nor for required audits to verify 
adherence to such procedures. This is no small shortcoming given that 
in testimony before a Senate subcommittee, the SEC has indicated that 
it found approximately a 10 percent shortfall in late trading 
compliance at the fund level.\6\ In a recent press release \7\ issued 
in conjunction with the filing of a comment letter on the SEC's 
proposal, the ICI moderated its position stating that:
---------------------------------------------------------------------------
    \5\ ICI Press Release ``Mutual Fund Leaders Call for Fundamental 
Reforms to Address Trading Abuses'' (October 30, 2003).
    \6\ Testimony of Stephen M. Cutler before the Senate Subcommittee 
on Financial Management, The Budget, and International Security 
(November 3, 2003).
    \7\ ICI Press Release ``ICI `Strongly Supports' SEC Proposal to 
Prevent Late Trading of Mutual Funds'' (February 5, 2004).

          ``. . . The Institute first urged that trade reporting 
        requirements be substantially tightened in early October in the 
        wake of investigations by Government officials that revealed 
        late trading abuses involving a number of mutual funds. In 
        renewing its support for tough new requirements today, 
        Institute General Counsel Craig Tyle also encouraged the 
        Commission to consider whether some intermediaries may already 
        be able to `document through unalterable means the precise date 
        and time' when orders were received. In such instances, the 
        letter suggests, the SEC should consider the benefits that 
        could accrue to fund shareholders by allowing the intermediary 
        to receive orders on the fund's behalf before the hard 4:00 
        p.m. deadline.''
Feasibility and Implications of Various Hard Close Alternatives
Hard Close at the Fund Level
    Essentially, the SEC's proposal allows for hard close solutions 
only at the fund or registered clearing agency level. In its proposing 
release, the SEC recognizes that requiring a hard close at the fund 
level would necessitate that intermediaries establish an earlier (pre-
close) cut-off time for investors to submit fund orders and obtain 
current day pricing, and that with respect to 401(k) plans, investors 
might not be able to receive same-day pricing at all.\8\
---------------------------------------------------------------------------
    \8\ See SEC proposing release at 4.
---------------------------------------------------------------------------
    This earlier cutoff would be necessary to allow broker-dealers to 
perform all essential order reviews prior to the 4 p.m. close. Among 
other things, that would include analysis to assure that any sales 
discounts (breakpoints) are properly applied. Even though many things 
can be done electronically to check for account linkages, much of this 
is still a manual process. Because of the numerous and varying rules 
that each fund group follows, many of these orders need to be held in 
the firm's system and reviewed manually before they are sent to the 
Fund/SERV system maintained by the National Securities Clearing 
Corporation (NSCC), and ultimately to the fund. If they are not 
properly reviewed, investors may not receive the discounts to which 
they are entitled. Other intermediaries, such as banks, must perform 
similar tasks prior to sending orders to fund companies.
    Orders processed through 401(k) plans \9\ involve even more 
complexities than those faced by broker-dealer recordkeeping systems. 
For example, 401(k) recordkeepers must place trades collectively, and 
perform a number of reconciliations at the participant and plan levels 
when executing transactions. In addition, recordkeepers perform other 
services that add time to the process, such as determining eligibility 
for loans, since Federal law regulates the amount of a loan based on a 
participant's account balance, and there are other complexities that I 
will leave to my co-panelists to address.
---------------------------------------------------------------------------
    \9\ Approximately one-third of all mutual fund shares are held in 
401(k) plans. See SEC proposing release, note 8.
---------------------------------------------------------------------------
    The net results of the earlier cut-off time is that the vast 
majority of fund shareholders who either prefer, or have no alternative 
but, to deal through intermediaries (as is the case with 401(k) 
accounts) would be denied the ability to effect fund purchases at 
current day prices for at least a portion of, and possibly an entire 
trading day. Correspondingly, with redemptions, shareholders would be 
exposed to an additional day of market risk. The SEC proposing release 
suggests that these earlier cutoff times would not impose a significant 
burden on most mutual fund investors who are making longer term 
investments, frequently through 401(k) plan payroll deductions, and who 
treat the time and date of investment as something of a random 
event.\10\ In essence, the SEC is speaking of those investors who are 
solely investing periodically in a static manner. This fails to 
consider a whole range of other activities in which 401(k) plan 
investors engage, which impose risks that cannot be managed through 
dollar-cost averaging.
---------------------------------------------------------------------------
    \10\ See proposing release, at 5.
---------------------------------------------------------------------------
    For example, various studies have shown that in 2002 between 14 and 
23.1 percent of 401(k) plan participants had outstanding loans, and 21 
percent of participants with account balances took a plan 
distribution.\11\ Additionally, a major plan administrator reported 
that in 1998, 24 percent of their plan participants made 
exchanges. Furthermore, exchanges increase with age, with a 
concentration in investors in their 50's and 60's, who have the largest 
amount of retirement funds. Such participants made an average of 3 
exchanges annually.\12\ Furthermore, a growing number of 401(k) 
participants are employing mutual fund portfolio rebalancing services 
that enable such participants to establish and maintain a targeted 
asset allocation in accordance with their investment objectives and 
risk tolerance. Rebalancing usually occurs several times a year. Our 
firm alone has 800,000 participants enrolled in such a program.
---------------------------------------------------------------------------
    \11\ See ``Beyond the Numbers, The 2003 Annual 401(k) Report,'' 
Principal Financial Group, p. 50. Also ``Profit-Sharing/401(k) 
Council's 46th Annual Survey of Profit Sharing and 401(k) Plans,'' p. 
43 (2003).
    \12\ See ``Building Futures: How American Companies Are Helping 
Their Employees Retire. A Report on Corporate defined Contribution 
Plans,'' Fidelity Investments p. 32-33. (1998).
---------------------------------------------------------------------------
    Therefore, the SEC's analysis fails to address what we believe to 
be the most substantial risks to 401(k) participants--the inability to 
promptly liquidate or exchange a large mutual fund portfolio in a 
rapidly declining market. In that regard, it should be noted that 
during the 5-year period ending December 2003, the Standard & Poor's 
500 Index declined by 1 percent or more on 257 days.\13\ Thus, a 401(k) 
participant approaching retirement seeking to liquidate a $500,000 
equity mutual fund portfolio,\14\ to purchase an annuity in a declining 
market, could easily lose thousands of dollars by being ``locked-in'' 
to his or her investment for an additional trading day. This type of 
result would potentially cause significantly greater harm to the 
participant.\15\
---------------------------------------------------------------------------
    \13\ Source: Standard & Poor's Index 1999-2003. Data provided by 
Reuters.
    \14\ Assumes $3,000 annual contributions over a 30-year period with 
an average annual rate of return of 10 percent. The actual annual 
average return of the S&P 500 for the 30-year period ending December 
2003 was 12.2 percent.
    \15\ The proposing release, note 42, cites a study by Professor 
Eric Zitzewitz which estimates that fund shareholders collectively lose 
as much as $400 million annually as the result of late trading. This 
figure would translate to approximately \1/2\ of a basis point (.00005) 
of fund assets, based on total fund assets of $7.4 trillion, or about 
$25 per annum for each $500,000 of fund assets owned.
---------------------------------------------------------------------------
    In addition to the disproportionate impact on market risk exposure 
the fund hard close remedy would have on fund investors, it also fails 
to provide for an effective, tamper-proof, electronic order capture 
time-stamping system. The proposed remedy merely carries over the same 
time-stamping requirement already included in Rule 22c-1, which recent 
history has shown to be prone to abuse both at the fund and broker-
dealer levels. We believe adopting the SIA's electronic order capture 
time-stamping approach for funds, brokers, and 401(k) intermediaries 
can cure this shortcoming. The problems associated with early order 
cut-offs cannot be readily resolved, and mutual fund investors should 
not be faced with the choice of having to either be denied market 
access during all or a portion of the trading day, or foregoing 
effecting their transactions through intermediaries--the preferred 
choice of more than 88 percent of fund investors. Nor should any 
solution be adopted which creates a competitive disadvantage between 
financial institutions. Therefore, the fund hard close proposal should 
not be adopted as an exclusive remedy.
Hard Close at a Registered Clearing Agency
    SIA members and representatives have attended exploratory meetings 
at NSCC, the only current registered clearing agency, regarding the 
possibility of developing a systems modification whereby intermediaries 
could submit mutual fund orders to the NSCC Fund/SERV system at or 
prior to 4 p.m. NSCC Fund/SERV, through its various linkages, would 
then transmit the orders to the applicable funds. Therefore, while SIA 
supports further efforts to determine the feasibility of an NSCC hard 
close solution, and looks forward to continuing to work cooperatively 
with the NSCC as the process moves forward, given its current status 
and the considerable amount of time it will take to develop, it should 
not serve as an exclusive solution. Under the proposal it would be 
necessary for intermediaries to transmit ``unenriched'' orders, which 
do not include all the data to execute, to NSCC by 4 p.m. in order to 
obtain current day pricing, and then forward enrichment data (such as 
information relating to sales breakpoints), after the close. This would 
essentially turn a one-step process into two steps, and to our 
understanding it has not yet been determined with certainty what impact 
that will have on operating efficiencies. Also the NSCC solution is 
likely to cause intermediaries to batch more fund orders near the close 
in an effort to reduce the number that will require subsequent 
transmission of enrichment data. The impact of such batching will need 
to be addressed. It is, of course, of utmost importance to assure that 
any systems or procedural changes implemented by NSCC to address late 
trading do not inadvertently compromise the efficiencies achieved by 
its mutual fund clearance and settlement process, which has served its 
participants and investors so well. It is also uncertain whether this 
would provide sufficient relief to 401(k) plan participants with 
respect to early cutoff times.
Hard Close at the Intermediary Level
    With regard to intermediaries, SIA recommends a three-pronged 
solution whereby the place of order acceptance to which the hard close 
would apply, would include:

 For Broker-Dealers. The broker-dealer's electronic order 
    capture and routing system which assigns a verifiable order entry 
    time aligned with the atomic clock currently used for equity order 
    time-stamping, provided the other conditions set forth in the 
    Baker, Corzine-Dodd, and Fitzgerald bills are met.

 For Other Regulated Entities. The electronic order capture 
    system of regulated 
    entities not currently under the SEC's jurisdiction, but regulated 
    by the OCC or other regulator, which would impose a companion rule 
    to require a hard close on order acceptance by 4 p.m.

 For Non-Regulated Entities. Such entities would have to employ 
    an electronic order capture time-stamping system which is 
    functionally equivalent to that utilized by broker-dealers and 
    other regulated entities. Such ``functional equivalency'' would 
    need to be certified to by an independent third-party and such 
    certification provided to the fund complexes for whom the fund 
    transactions are processed, and the system would be subject to the 
    same independent audit requirements set forth in the pending 
    legislation.

    The SIA recommendation contemplates that orders not accepted into 
    the intermediary's system by the hard close, even where the lack of 
    timely receipt was due to legitimate errors, would, without 
    exception, receive next day pricing. Thus, corrections would have 
    to be effected through their error account, and they, not fund 
    shareholders, would bear the economic risk of loss with respect to 
    any orders processed after the hard close. It is most important to 
    note that, unlike the current time-stamping procedure contained in 
    Rule 22c-1, and which would merely be perpetuated in the SEC's 
    proposal, the SIA proposal would impose stringent additional 
    requirements on the use of time-stamping methodology that would 
    make it extremely difficult to ``game'' the system. The SIA 
    recommendation as it relates to broker-dealers, reflects an 
    approach similar to the NASD's Order Audit Trail System (OATS), 
    which is an integrated audit trail of order, quote, and trade 
    information for Nasdaq securities. The applicable NASD rules \16\ 
    required member firms to develop a means for electronically 
    capturing and reporting specific data elements relating to the 
    handling or execution of orders, including recording all times of 
    these events in hours, minutes, and seconds, and to synchronize 
    their business clocks.
---------------------------------------------------------------------------
    \16\ NASD Rules 6950-6957, approved by the Commission on March 6, 
1998, and as amended on July 31, 1998.
---------------------------------------------------------------------------
    Broker-dealers already subject to OATS requirements should be able 
    to readily transfer the OATS technology to mutual fund order 
    processing without incurring significant additional costs. We 
    understand there are a number of service providers who may be able 
    to offer similar capabilities to other intermediaries, and that 
    certain other intermediaries may be able to develop this capability 
    internally.
    It is our understanding that OATS has significantly enhanced the 
    NASD's ability to track and audits Nasdaq equity orders and detects 
    violations of NASD's rules. Utilizing that same technology for 
    tracking mutual fund orders should bring similar benefits to the 
    SEC's examination staff. Additionally, internal compliance reviews 
    and outside audits of broker-dealers and/or other intermediaries 
    could include some or all of the following:

  --written policies and procedures and other controls designed to 
        detect late trading;
  --periodic review of such policies, procedures, and controls;
  --periodic audits including random testing of orders (conducted both 
        internally and by outside auditors) to validate the integrity 
        of the system; and
  --reviews of error accounts to detect patterns that might be 
        indicative of late trading.

    In summary, we believe that the SIA recommendation would eliminate 
    the inadequacies of the current time-stamping system and create a 
    readily auditable order trail, while avoiding the significant 
    adverse consequences of an earlier order cutoff time. Furthermore, 
    the SIA recommendation could be implemented expeditiously, whereas 
    the NSCC solution would require a lengthy developmental process, 
    and the funds themselves may not be equipped to handle the large 
    increase in direct transactions that could occur if the SEC's 
    proposal is adopted, without modification.
Conclusion
    In summary, SIA believes that electronic and auditable electronic 
time-stamping systems, which intermediaries and funds would be required 
to utilize, is a critical component of any effective hard close 
rulemaking solution. While imposing a hard close at the fund or 
registered securities clearing agency should be among the available 
alternatives, these measures should not be the exclusive solutions, 
given that they either have negative consequences for innocent 
investors, or remain untested. On the other hand, significant positive 
experience with electronic stamping system through OATS strongly 
supports a technological solution. Importantly, this type of approach 
would place the vast majority of investors holding their fund 
investments through intermediaries on a more level playing field with 
other investors.
    We commend the Committee for its efforts to swiftly and effectively 
address abusive practices such as late trading, and believe that such 
measures are essential to maintaining the integrity of our capital 
markets, and retaining the public trust of the 95 million Americans for 
whom mutual funds are a core investment vehicle.
    Thank you.

                               ----------
               PREPARED STATEMENT OF RAYMOND K. McCULLOCH
                  Executive Vice President, BB&T Trust
                            on behalf of the
                      American Bankers Association
                             March 2, 2004

    Mr. Chairman, I am Raymond McCulloch, Executive Vice President for 
BB&T Trust, based in Raleigh, North Carolina. I have over 26 years of 
banking experience, the last 12 of which have been focused on BB&T's 
institutional trust and employee benefit lines of business. I have 
previously served as Chairman of the American Bankers Association's 
National Senior Employee Benefit Services Committee and hold the 
professional designation of Certified Retirement Services Professional. 
BB&T Trust administers over 2,200 employee benefit plans, with an 
average of 250 participants and total assets of $5.2 billion. BB&T 
Trust's parent, BB&T Corporation, Winston-Salem, North Carolina, is the 
Nation's 13th largest bank with over $90 billion in assets.
    I am pleased to testify on behalf of the American Bankers 
Association (ABA). ABA brings together all elements of the banking 
community to best represent the interests of this rapidly changing 
industry. Its membership--which includes community, regional, and money 
center banks and holding companies, as well as savings institutions, 
trust companies, and savings banks--makes ABA the largest banking trade 
association in the country. The views in my testimony today are also 
endorsed by the ABA Securities Association (ABASA). ABASA is a 
separately chartered trade association and nonprofit affiliate of the 
ABA whose mission is to represent before the Congress, the Federal 
Government, and the courts the interests of banking organizations 
engaged in underwriting and dealing in securities, proprietary mutual 
funds, and derivatives.
    The ABA is pleased to testify on the issue of late trading for 
mutual funds. As investors in mutual funds, either for our own 
portfolio or for that of our fiduciary and brokerage clients, as well 
as transfer agents and investment advisers to mutual funds, our members 
are quite concerned about this issue.
    Let me be very clear: ABA members emphatically believe that late 
trading has no place in mutual funds. This practice is illegal under 
current law and we applaud the enforcement actions of the Securities 
and Exchange Commission (SEC) and other regulators to punish those at 
fault. More can be done to prevent late trading. We would submit, 
however, that any additional legislative or regulatory solutions to 
combat late trading should: (1) protect mutual fund investors; (2) 
restore investor confidence in mutual funds; (3) preserve choice of 
distribution channels; and (4) not limit investment options for mutual 
fund investors.
    The SEC has put forth a proposal, often referred to as a ``Hard 4 
p.m. Close.'' This rule, which amends Rule 22c-1 under the Investment 
Company Act, provides that an order to purchase or redeem fund shares 
would receive the current day's price only if the fund, its designated 
transfer agent, or a registered securities clearing agency, for 
example, the National Securities Clearing Corporation (NSCC), receives 
the order by the time that the fund establishes for calculating its net 
asset value (NAV). While at first blush this seems to be a simple 
solution to the problem, it would in fact result in different cutoff 
times in practice for mutual fund companies and intermediaries that 
sell shares of funds of those companies. This would create unnecessary 
confusion for investors and disruptions in the mutual fund market. The 
ABA and ABASA strongly oppose the mandatory Hard 4 p.m. Close as it 
would have detrimental effects on investors. Fortunately, technologies 
exist today that can 
accomplish the intended goals without risking investor confusion and 
market disruptions. Thus, in my statement today, I would like to 
emphasize two key points:

 A ``hard close'' discriminates against investors based solely 
    upon their choice of distribution channel and denies investors 
    choice by limiting their investment 
    options.

 Alternatives to a hard close exist that can accomplish the 
    goal of preventing late trading without disadvantaging mutual fund 
    shareholders.

    I will address each of these in turn.
A ``Hard Close'' Discriminates Against Investors Based Solely Upon
Their Distribution Channel and Limits Investment Options
    As mentioned above, the proposed amendment would provide that a 
mutual fund order receive the current day's price only if received 
before the deadline for determining the fund's NAV by the fund, its 
designated transfer agent, or a registered securities clearing agency. 
Typically, most funds calculate NAV when the major U.S. stock exchanges 
close at 4 p.m. Eastern Time. Importantly, fund intermediaries, 
including broker-dealers and retirement plan administrators, would not 
be able to receive orders up to that same time. They would be required 
to establish earlier trading cut-off times--as much as six or more 
hours earlier--in order to transmit mutual fund orders to the fund, 
transfer agent or clearinghouse in time for the 4 p.m. hard close. 
Thus, it creates in practice different cut-off times for mutual fund 
companies than for intermediaries that sell shares of funds of those 
companies.
    Thus, while the 4 p.m. hard cut-off would eliminate the potential 
for late trading through intermediaries that sell fund shares, the 
unintended consequences are severe. We see no reason to fix a problem 
caused by a few, yet discriminate against the vast majority of mutual 
fund investors who use intermediaries, including the millions currently 
saving for retirement through their company's 401(k) or individual 
retirement accounts. Over $2.11 trillion in assets were invested in 
defined contribution plans as of year-end 2001, the vast majority of 
which are in 401(k) plans, according to Employee Benefit Research 
Institute. As discussed below, there are better, less problematic 
methods to address late trading.
    To understand the problems created by the SEC's proposal, it is 
important to understand the operational complexities of these 
transactions. For example, processing 401(k) plan participant orders is 
an operationally complex and time-consuming task, no matter which type 
of financial intermediary is servicing the plan. There are multiple 
processes and systems involved for correlating and transferring data 
between receipt of the participant's order and delivery of that order 
to the fund company. Processing trade orders for a typical participant-
directed plan involves as many as five steps and four systems between 
the participant trade request and fund company receipt. Specifically, 
once the participant communicates a trade request (before the 4 p.m. 
Eastern Time market close), it is moved to the primary participant 
recordkeeping system, where it is given a value and reconciled with 
that participant's account. The participant's transaction is then 
combined and netted with others from that same plan, each one having 
been previously reconciled and valued. Next, the plan's trade orders 
are combined with other transactions from other plan accounts held by 
that recordkeeper, which are again valued, netted, and reconciled. The 
penultimate step requires the recordkeeper's net trade order to be 
turned over to the intermediary where it is valued and combined with 
trades of other recordkeepers for a single transmission on each fund. 
These processing steps are taken after the 4 p.m. close to give plan 
participants the same consideration for trade orders as a direct 
investor and to allow both sides (sale and purchase) of an investment 
option or rebalance of portfolio to occur as of the same trade date.
    At BB&T, this process generally takes about 3 hours. Other banks 
have estimated that this may take 6 hours or more, which means that 
trade orders would have to be placed before 10 a.m. Eastern Time in 
order to have any chance to get today's NAV. For plan participants 
located on the West Coast, the chance of receiving that day's NAV is 
even slimmer.
    The discriminatory impact of the proposed 4 p.m. hard close is most 
clearly illustrated when an individual investor invests in the same 
mutual fund through three different distribution channels: A retail 
brokerage account, a 401(k) plan trusteed by a bank, and an account 
held directly by the mutual fund. Today, if that investor makes an 
investment decision at 3 p.m. on day one that he or she wants to redeem 
the mutual fund shares held in all three accounts and communicates that 
decision simultaneously to all three financial service providers, the 
investor's trade orders for all three accounts will be effected at 
today's NAV. Under the proposed 4 p.m. hard close, the investor's trade 
order will be effected at two, and possibly three, different NAV prices 
despite the fact that the decision to redeem was communicated at the 
exact same time.
    Specifically, the account held at the mutual fund will definitely 
receive today's NAV. The account held at the brokerage account may or 
may not receive today's NAV depending on the amount of processing 
required. The degree of processing required for plan participant orders 
guarantees that the mutual fund shares held through the 401(k) plan 
will be priced at the next day's NAV, or possibly the NAV for 
additional days later. Different NAV prices for simultaneous orders 
will initially lead to investor confusion and, most likely, create a 
strong investor bias toward dealing directly with the mutual fund for 
all types of investment accounts.
    The transaction discussed above involves a simple redeem or 
purchase order. Even more complexity is involved when a participant's 
order involves a transfer from one fund to another, for example, a 
simultaneous redemption and purchase. Today, if a participant places an 
order to sell 1,000 shares of Fund X and uses the proceeds to purchase 
shares in Fund Y, a bank trustee can process both legs of the 
transaction, because, some time after the 4 p.m. market close, they 
have electronically been provided with NAV's for both funds. With a 4 
p.m. hard close to the mutual fund, the bank trustee would have to 
place the order to redeem 1,000 shares of Fund X before 4 p.m. Without 
a NAV for Fund X, the bank trustee could not place the purchase order 
for Fund Y before 4 p.m. Instead, the plan participant will purchase 
Fund Y shares at the next day's NAV. Here, again, a 4 p.m. hard close 
favors the mutual fund distribution channel over that provided by 
banks, broker-dealers, and others. Under the proposed 4 p.m. hard 
close, the participant's redemption and purchase orders will both be 
effectuated at today's NAV if both Fund X and Fund Y are members of the 
same fund family.
    The differing cutoff times would encourage investors to deal 
directly with mutual funds or their agents, rather than through 
intermediaries. Investors who invest directly with the mutual fund will 
get the benefit of today's NAV, while investors who invest through 
intermediaries will get the next-day's NAV, at best. The ABA is 
strongly opposed to a system that discriminates against investors based 
solely upon their choice of distribution channel.
    Creating incentives to deal directly with mutual funds rather than 
intermediaries would also mean that investors would gravitate to only 
one family of funds, regardless of whether those funds were ``best in 
class'' among all funds of a similar type and investment strategy. 
Thus, the ability of investors to choose the best combination of funds 
across all funds that are offered would be limited, denying investors 
both diversification and potential returns. For example, many employee 
benefit plans today offer participants fifteen or more investment 
options from a variety of mutual fund providers. For example, at BB&T, 
we offer over 200 funds from a wide variety of sponsors, including SEI, 
Managers, Vanguard, Oppenheimer, American, Dodge & Cox, T. Rowe Price, 
Fidelity, Goldman Sachs, Ariel, Royce, and AIM in addition to BB&T 
Funds. We trade over 100 funds each day. If a 4 p.m. hard close is in 
place, investors may be forced to choose only one mutual fund provider 
to be able to receive daily valuation and trading. If an investor is 
invested entirely in one fund family, there is far greater potential 
for loss if that fund family encounters difficulties. History has shown 
time and again that lack of diversification hurts 
investors.
    Simply put, a 4 p.m. hard close favors the mutual fund distribution 
channel over that provided by banks, broker-dealers, and other 
intermediaries because it allows the mutual fund complex to perform the 
processing tasks after 4 p.m. while all other providers must perform 
the requisite processing before 4 p.m. ABA strongly believes that the 
SEC should avoid adopting a solution to prevent illegal late trading 
that discriminates against investors based solely upon their choice of 
one distribution channel over another. The consumers should not be 
sacrificing choice to be able to receive daily valuation.
An Alternative to Hard Close Exists That Will Not
Disadvantage Investors
    Fortunately, alternatives to the 4 p.m. hard close do exist that 
would eliminate the potential of illegal late trading without 
disadvantaging mutual fund shareholders. The key to this solution is to 
require a tamper-proof order capture system where the entry time of an 
order can be verified with a high degree of certainty. An independent 
company would do the time-stamping. This would allow fund 
intermediaries to receive orders up to the time of the NAV calculation.
    We believe that the technology exists today to permit the creation 
of a tamper-proof system for ensuring that trades are, in fact, 
received at the time the trade is stamped and cannot be altered after 
the time-stamped without detection. The large volume of daily mutual 
fund trades requires an electronic network solution. Applications using 
cryptography, particularly one referred to as public key infrastructure 
(PKI), are increasingly being used in banks, corporations, and the 
Federal Government. Digital signatures are one example of how PKI 
technology identifies the signer and ensures the integrity of the 
signed data. Digital signatures on every transmission would 
authenticate the parties involved and also encrypt the content of every 
message, thereby permitting any alteration to a message content to be 
detected. Companies are already working to make the ``signing'' of 
documents electronically using digital certificates as simple as 
signing a piece of paper with a pen. Similarly, algorithms are already 
being used to create a unique identifier or a fingerprint of any file 
that would work for time-stamping. If the file's contents change at 
all--even if only an extra space is put in one line--then a different 
fingerprint is created, making it clear that an alteration has taken 
place.
    Most companies that use digital time-stamping use encryption 
hardware that is certified by the National Institute of Science and 
Technology. We believe that the time-stamping of the file should be 
done by an independent company storing the certified encryption 
hardware. The company that time-stamps the order would digitally sign 
the data using digital certificates, thus creating a verifiable and 
auditable method for assuring the time of the transaction and integrity 
of the original data. This solution can accommodate trade orders placed 
by intermediaries 
either individually or in batch form.
    There would, of course, be other associated requirements consistent 
with this approach that would have to be employed by the intermediary. 
For example, operating business standards and technical 
interoperability requirements that ensure consistency and legal 
reliability will likely be needed. Audit programs and compliance review 
programs could then examine and validate that the institution's 
policies and procedures contain the necessary controls to ensure 
integrity in the trading process.
    Thus, the elements of such a system could include:

 Electronic time-stamping of orders in a manner that orders 
    cannot be altered or discarded once entered into the trading 
    system.

 Annual certification that the intermediary has policies and 
    procedures in place designed to prevent late trades, and that no 
    late trades were submitted to the fund or its designated transfer 
    agent during the period.

 Submission of the intermediary to an annual audit of its 
    controls conducted by an independent public accountant who would 
    submit his report to the fund's chief compliance officer.

    The ABA recognizes that not all mutual fund companies, transfer 
agents, or intermediaries have the capability or desire to input a 
technology solution such as we have suggested. For example, we 
understand that some mutual fund companies only accept trade orders 
with original signatures and accompanying medallion stamps through the 
mail. Moreover, PKI technology can be expensive to implement, although 
programs that are just now coming to market will make PKI technology 
more accessible to smaller financial institutions and intermediaries. 
Thus, it is 
important that the approach be flexible, be sensitive to the attendant 
costs, and 
provide a considerable implementation period of at least 1 year.
    The point is this: Technology exists today--and is rapidly 
improving--that can be used to create a solution that meets the goal of 
assuring no late trading is occurring and does not create adverse 
consequences for investors.
Conclusion
    As investors in mutual funds, either for our own portfolio or for 
that of our fiduciary and brokerage clients, as well as transfer agents 
and investment advisers to mutual funds, ABA member banks applaud the 
SEC's goal of protecting mutual fund investors and restoring investor 
confidence in mutual funds by taking steps to eliminate the potential 
for illegal late trading. We are encouraged that the SEC is attacking 
the current market scandals by bringing swift enforcement actions when 
wrongdoing is uncovered and believe that those who violate the current 
prohibition on late trading should be brought to justice. We also 
believe that further regulation designed to prevent or to minimize the 
possibility of these abuses occurring in the future is warranted.
    The ABA appreciates efforts by Senators and Congressmen to assure 
that solutions to late trading do not disadvantage investors. We are 
hopeful that with your strong encouragement, the final SEC regulation 
will recognize this as well; should it not, addressing this through 
legislation will become necessary.
    Thank you for the opportunity to present the views of the American 
Bankers 
Association.

                               ----------
                  PREPARED STATEMENT OF DAVID L. WRAY
           President, Profit Sharing/401K Council of America
                            on behalf of the
     ASPA, Association for Financial Professionals, Automatic Data 
                              Processing,
  Inc., Committee on Investment of Employee Benefit Assets, The ERISA
    Industry Committee, Flint Ink Corporation, Florida Power & Light
     Company, Hewitt Associates, ICMA Retirement Corporation, Intel
     Corporation, Procter & Gamble, Profit Sharing/401k Council of
     America, Small Business Council of America, and Sungard Corbel
                             March 2, 2004

    Thank you for this opportunity to share the views of the employer-
provided retirement plan system with the Committee. My comments reflect 
the views of the companies and organizations listed on the transcript 
of my statement. As we all know, mutual funds play a key role in the 
employer-based system. According to the Investment Company Institute, 
36 million U.S. households invest one-third of all mutual fund assets 
through employer provided retirement plans. Like this Committee, we are 
concerned by the breaches of trust that have occurred recently and we 
applaud the efforts underway in Congress to restore confidence in our 
Nation's financial institutions.
    Late trading must be eliminated. At the same time, it is important 
that we preserve a level playing field for the ability to make 
investment decisions using same-day pricing. In most employer provided 
plans, investors can make trading decisions up to, or very close to, a 
fund's closing time, generally 4 p.m. Eastern Time. Some have 
questioned if plan participants value same-day pricing. I can assure 
you that they do as evidenced by the predominance of this feature in 
401(k) plans. Like all investors, plan participants adopt a long-term 
savings strategy and only infrequently make changes in their investment 
decisions. However, when plan participants do make investment change 
decisions they highly value same-day pricing. This is particularly true 
for distribution decisions upon retirement.
    Same day pricing in employer provided retirement plans is possible 
because intermediaries are permitted to process participant trades and 
forward the final aggregated trades to the funds or a clearing agency 
after 4 p.m. This late processing is necessary to ensure that all of 
the requirements surrounding the operation of a qualified retirement 
plan are met, including satisfying plan features and the highly complex 
rules issued by the Departments of Labor and Treasury. On a more basic 
level, fund trade processing is always delayed to reflect the fund's 
Net Asset Value for the current day--an event that does not occur until 
well after 4 p.m.
    Congress understands the need to preserve same-day pricing in 
employer provided plans when addressing late trading. The House 
overwhelmingly passed H.R. 2420 last November. It instructs the SEC to 
issue rules to address late trading that permit late processing by 
retirement plan and other intermediaries if procedures exist to prevent 
late trading and such procedures are subject to independent audit. 
Similar provisions are found in S. 1971, cosponsored by Senators 
Corzine, Dodd, and Lieberman; and S. 2059, cosponsored by Senators 
Fitzgerald, Levin, and Collins. I applaud these Members for their 
efforts and I urge this Committee to move forward on this important 
legislative provision if the final SEC rule on late trading fails to 
preserve equal opportunities for all investors.
    Under the SEC's proposed rule, to offer same-day pricing an order 
must be received by the fund, its designated transfer agent, or a 
registered securities clearing agency by the fund's closing time. This 
means that a retirement plan participant's ability to enjoy full same-
day pricing will be based on the employer's selection of a plan's 
intermediary and investment choices. Employers will be pressured to 
adopt service provider arrangements that favor same-day pricing over an 
open architecture design with offerings from several fund complexes. 
Participants could be influenced to invest in the proprietary funds of 
the intermediary when also offered funds from other fund complexes. 
Intermediaries will incur significant initial and recurring systems 
costs that will be borne by participants.
    I commend Ann Bergin and the NSSC staff for their valiant efforts 
to develop a viable process to meet the SEC's clearing agency proposal. 
Although the clearing agency approach will provide some relief to 
retirement plan participants that do not trade in a bundled provider 
arrangement, it will not create parity among investors. It will not 
accommodate all plan transactions. And it will result in additional 
costs for many plan participants.
    There is a preferable way to address late trading. The SEC has 
requested comments on an alternative approach that would allow fund 
intermediaries to submit properly received orders after closing time if 
verifiable procedures are implemented to prevent late trading. These 
procedures include tamper proof time-stamping, certification policies, 
and independent audits. This approach is very similar to that in the 
legislation I mentioned earlier in my comments. A large majority of SEC 
commenters, including leading consumer organizations, support inclusion 
of this approach in the final rule. Several technology companies have 
confirmed their ability to provide the technological safeguards sought 
by the SEC.
    I hope the SEC's final rule will include this alternative approach 
that preserves the opportunity for same-day pricing for all retirement 
plan participants. I repeat my request for this Committee to intercede 
legislatively if that does not occur.
    Thank you for your time. I look forward to answering your 
questions.


                        THE REGULATORY LANDSCAPE

                              ----------                              


                       WEDNESDAY, MARCH 10, 2004

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10 a.m. in room SD-538 of the Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order.
    This morning, the Banking Committee continues its 
examination of the mutual fund industry. As this Committee 
conducts its hearing process, the regulators have 
simultaneously worked to reform the fund industry. Both State 
and Federal regulators continue to bring enforcement actions 
against wrongdoers, assuring investors that fund executives and 
brokers who violate their duties will be punished.
    These enforcement actions have also helped to define the 
full scope of transgressions, conflicts, and structural 
problems that are at the root of the misconduct in the fund 
industry. In addition to enforcement actions, the regulators 
have also launched numerous rulemaking initiatives. The SEC is 
pursuing an aggressive rulemaking agenda aimed at improving the 
transparency of fund operations, strengthening fund governance, 
and halting abusive trading practices. The NASD has also 
proposed rules intended to improve disclosure by broker-dealers 
to investors at the point-of-sale, alerting investors to 
potential conflicts of interest affecting an investment 
decision. Understanding the scope, the application, and the 
consequences of these rulemakings are a critical component of 
the Banking Committee's hearing process.
    Although enforcement actions and rulemakings are vital 
elements of the regulatory landscape, we must also consider 
what regulators can do to prevent future abuses by funds and 
brokers. I believe that the regulators must demonstrate how 
they are revising compliance and examination programs to ensure 
that brokers and funds comply with the current law.
    This morning, I would first like to welcome Mr. David 
Walker, Comptroller General of the General Accounting Office, 
again to the Banking Committee. Comptroller Walker recently 
testified before this Committee regarding GSE reform, and we 
appreciate his willingness to return here so quickly. The GAO 
has examined the fund industry, and we look forward to its 
analysis and its insights.
    I would also like to welcome Lori Richards, Director of the 
Office of Compliance Inspections and Examinations at the 
Securities and Exchange Commission; Paul Roye, Director of the 
Investment Management Division at the SEC; and Mary Schapiro, 
Vice Chairman of NASD and President of NASD Regulatory Policy 
and Oversight, and no stranger to the Banking Committee 
because, while at the SEC, she used to appear here quite often.
    We welcome all of you to the Committee. Your written 
testimony will be made part of the record in its entirety.
    Comptroller Walker, we will start with you. Proceed as you 
wish.

                  STATEMENT OF DAVID M. WALKER

                      COMPTROLLER GENERAL

                 U.S. GENERAL ACCOUNTING OFFICE

    Comptroller Walker. Thank you, Mr. Chairman. It is a 
pleasure to be back before the Senate Banking Committee today 
for the purpose of discussing the GAO's work assessing the 
transparency of 
mutual fund fees and other fund practices and to discuss 
various proposed and anticipated regulatory reforms.
    As you know, Mr. Chairman, in the last 20 years mutual 
funds have grown from under $400 billion to just over $7.5 
trillion.
    Chairman Shelby. In how many years?
    Comptroller Walker. The last 20 years.
    Chairman Shelby. Twenty years.
    Comptroller Walker. As you know, mutual funds are not only 
important from the standpoint of institutional investors, but 
also for many individuals who invest in mutual funds as part of 
their retirement security, either through 401(k) plans or 
savings plans.
    I think it is important to note, because of various illegal 
and abusive practices that have come to light in the last 
several years, that the SEC is to be commended for placing 
additional time, attention, and resources in this area. They 
have taken a number of enforcement actions. They are proposing 
a number of regulatory actions. And as you know, Mr. Chairman, 
the NASD is also taking certain actions. I would like to 
highlight our comments on the SEC's proposals, and I appreciate 
your putting my entire written statement in the record.
    With regard to corporate governance and fund oversight, we 
believe the SEC is clearly moving in the right direction in 
order to assure that a supermajority of mutual fund boards are 
comprised of independent directors and that there be an 
independent chairman to head these boards. They also are 
proposing certain other recordkeeping requirements, that there 
be compliance officers and a code of ethics, et cetera. These 
are all clearly steps in the right direction.
    In addition, we believe that the Congress needs to consider 
providing the SEC with the legislative authority to better 
define director independence, because it is one thing to have a 
supermajority of independent directors, but it is also 
important to define what ``independent'' is in terms that will 
assure in substance as well as form that this requirement is 
met.
    With regard to late trading, the SEC is proposing in the 
short-term to impose a hard 4 p.m. close on all orders in order 
to ensure that everybody gets the same price. At the same point 
in time, we believe--and I believe the SEC has now 
acknowledged--that it would be prudent to also explore over a 
period of time other possible options that might achieve the 
same result, but without having potential adverse affects on 
certain investors, namely, employee benefit plan and savings 
plan investors.
    With regard to market timing and distribution practices, we 
believe that what the SEC is proposing here are also steps in 
the right direction: Additional disclosure, as well as in the 
case of market timing, a 2 percent redemption fee on shares 
that are held less than 5 days that would go into the fund. We 
think that is clearly a step in the right direction. At the 
same time, we believe that additional investor education will 
be necessary with regard to both of these proposed actions.
    On 12b -1 fees, the SEC is seeking comments on proposed 
revisions, which is an appropriate step. We think it is 
important to also consider as part of that whether or not there 
should be disclosure of the specific deductions from individual 
investor accounts with 
regard to these fees.
    On management fees, the SEC is proposing additional fee 
disclosures in shareholder reports. In our view, we think it is 
important to figure out how this type of information could be 
disclosed in the quarterly statements that participants 
receive. Mr. Chairman, you and I and probably many others have 
investments in mutual funds, and, quite frankly, the statement 
that I look at most closely is the quarterly statement. We get 
all kinds of prospectuses and other types of information, and, 
frankly, it does not stay in my hand very long. I don't know 
about yours.
    Soft-dollar practices, the SEC is not proposing any 
specific action at this time, but they are studying the issue. 
Mr. Chairman, when I was Assistant Secretary of Labor for 
Pensions and Health, this was an area of concern to us because 
of pension plan fiduciaries, and we were put in the position of 
basically having to allow certain types of soft-dollar 
practices, even though we had concerns from an ERISA fiduciary 
responsibility perspective because the SEC had already acted in 
this area.
    I think it is very important that the SEC consider 
narrowing or even repealing the legislative safe harbor and 
that more disclosure of soft-dollar usage with investor 
education is potentially called for. This is an area that has 
been in existence for a long time. In many ways you can call it 
frequent trading credits, similar to airline frequent flyer 
miles. And I think that it is something that needs further 
study.
    Thank you, Mr. Chairman. I would be happy to answer any 
questions after my colleagues have had a chance to testify.
    Chairman Shelby. Ms. Richards, if you will suspend a 
moment, Senator Schumer has joined us, and he has another 
hearing that he has to attend, and I want to give him a chance 
to make an opening statement here this morning.

            STATEMENT OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you, Mr. Chairman. And I thank you 
for and appreciate that opportunity. I want to thank every one 
of our witnesses for being here and I am sorry that I cannot 
stay. We have a whole bunch of things going on this morning, 
but I did want to be here and welcome all of you and just make 
a couple of brief comments.
    The bottom line here, of course, is not just that stock 
prices are down, but the more we hear of these problems, the 
average person's trust in the markets goes down. And that is 
the great worry. The mutual fund industry, of course, has 
always been a bastion of trust, and so it came as a shock to 
everybody that so many things were going on. You scratch your 
head and wonder at some of them, and you say, what has been 
going on when a multimillionaire breaks the law to make a small 
extra amount of money? It is a little like Martha Stewart. I 
care about this industry, as I care about our financial 
markets, and usually this happens after the fact, but I am sure 
there are going to be all kinds of things done to deal with all 
of the illegal and gray-area practices.
    I would just like to make one other point here on where I 
think we have to go--and I use my experience in the credit card 
industry. Credit card interest rates were at 19.8 percent, and 
everyone had them at 19.8 percent, and there was not much 
competition in terms of price until we required good 
disclosure. And then there was far better competition, and 
people were far more aware.
    And that is the direction I would like to see us all go in, 
Mr. Chairman. I think we need real simple disclosure. We need 
to show if you invest $1,000 how much the fund gets, and, of 
course, it is easier said than done because for some of the 
funds they will get a set fee and for others it will depend on 
how well they do. I think we can put in very simple and 
comparative terms how well each fund has done over the last 
year, 2 years, 5 years. And that to me will be a prophylactic.
    There are some who are proposing far more stringent 
regimens, but I believe that the free market works, and a 
really good disclosure system is where we have to go. I am 
working on that now and hope that I can avail all of you for 
your comments on it, and you, Mr. Chairman, because that is the 
direction I think we have to go in. And good disclosure ends up 
being a real prophylactic for future abuses, as well as 
creating greater competition. That is the point that I wanted 
to make here, Mr. Chairman. I do not think there is good enough 
disclosure now, but I think that is the answer before we try 
anything that goes further than that--in addition to wiping out 
all these abuses, some of which are already illegal.
    Thank you, Mr. Chairman.
    Chairman Shelby. Thank you, Senator. I think that 
Comptroller Walker alluded to that a few minutes ago, lack of 
disclosure when you get a prospectus. I wonder how many people 
are going to read that or halfway understand it.
    Ms. Richards, you may proceed. Thank you for your 
indulgence.

                 STATEMENT OF LORI A. RICHARDS

           DIRECTOR, OFFICE OF COMPLIANCE INSPECTIONS

                        AND EXAMINATIONS

            U.S. SECURITIES AND EXCHANGE COMMISSION

    Ms. Richards. Chairman Shelby and Senator Schumer, thank 
you for inviting me to testify here today on behalf of the SEC 
concerning our examinations of mutual funds.
    The Commission has undertaken aggressive steps to detect 
and prevent abusive market timing and late trading. As Chairman 
Donaldson said when he testified before this Committee in 
November, mutual fund investors have a right to an investment 
industry that is committed to the highest ethical standards and 
that places investors' interests first.
    The SEC oversees some 8,000 funds and over 8,000 investment 
advisers. Because the size of the mutual fund industry 
precludes a comprehensive audit of every area of a fund's 
operations, our routine examinations focus on those areas that pose the 
greatest risk to investors. Examinations identify compliance problems at 
the individual firms and also help us to identify area of 
emerging compliance risk. The examiners have identified a 
number of practices that may harm investors, including, for 
example, abusive soft- 
dollar arrangements, favoritism in the allocation of 
investments, misrepresentations in the sales of mutual fund 
shares to investors, the inaccurate pricing of mutual fund 
shares, the failure to obtain best execution, sales practice 
abuses, and most recently, the failure to give customers the 
discounts on large-volume purchases of mutual funds.
    SEC examiners, along with our enforcement staff, are 
conducting numerous examinations and investigations to ferret 
out abusive market timing and late trading arrangements. Prior 
to September 2003, however, examination staff did not detect 
the abusive market timing or late trading arrangements that 
fund executives had with select traders and that came to light 
as a result of the New York Attorney General's action.
    We have been reviewing our examinations to identify lessons 
learned from those cases and evaluating ways that our 
examination oversight can be improved, both to detect abusive 
market timing arrangements and, more broadly, to identify in a 
timely way other types of misconduct by fund firms.
    My testimony today focuses on the changes we are making to 
our examination oversight, specifically with respect to 
detecting market timing arrangements and, as I said, more 
broadly with respect to examination oversight generally. Today, 
examiners are increasing the frequency and the depth of 
examination reviews for high-risk firms, increasing the use of 
technology and data, developing new methods to identify new or 
emerging areas of compliance risk, conducting more targeted 
mini-sweep examinations to identify risk areas sooner and more 
timely, working more closely with other staff at the SEC to 
highlight the problems that examiners detect, and to identify 
possible solutions to those problems sooner.
    We have identified new examination steps that will help us 
better detect abusive market timing arrangements. In the past, 
prior to the discovery of market timing and late trading 
abuses, examiners reviewed trading by a mutual fund but did not 
review trading in the fund's own shares. The risk that 
examiners were concerned about was that funds were trying to 
inflate their performance returns or take on undisclosed risk 
that could harm investors.
    Our concern was that in attempting to produce strong 
investment returns that would attract new investors, fund 
portfolio managers had an incentive to engage in misconduct in 
the management of the fund. As a result, examiners focused on 
how the fund was managed, but because examiners' focus was on 
the fund itself and not in trading in the fund's shares, 
examiners did not detect the aberrant trading patterns that 
could be indicative of abusive market timing.
    In addition, although market timing is in itself not 
illegal, many mutual funds said that they discouraged the 
practice, and fund firms told us and showed us that they had 
appointed anti-market timing police who were responsible for 
detecting market timing trades and preventing market timers 
from continued trading in their funds. Not detected by 
examiners was the secret complicity of fund executives in 
allowing some select market timers to continue to time.
    Based on our recent examinations, we have identified ways 
to better detect market timing. We are obtaining now daily 
sales and redemption data that can better illustrate to our 
examiners patterns of trading in the mutual fund shares that 
could be indicative of market timing, as well as obtaining 
internal e-mails that may reflect the discussions and 
arrangements that the firm would not otherwise have shown to 
our examiners.
    Additional new examination steps include a review of 
personal trading records of fund executives that would show 
trading in the fund's shares, even in advance of new Commission 
rules that would require that those records be made available, 
and a review of procedures to ensure that orders are processed 
to receive the appropriate day's net asset value.
    In addition, we are also implementing other changes to SEC 
examinations to enhance our ability to detect problems more 
broadly, as well as to anticipate problems before they become 
widespread. Once emerging trends and problems are identified, 
we must share this information with other divisions and offices 
so that the Commission can bring all of its resources to bear 
to protect investors.
    Let me highlight those changes that I believe are the most 
important, and they are all described in my written testimony.
    First, as Chairman Donaldson announced on March 5th, he has 
formed an SEC task force that will be drafting the outlines of 
a new surveillance program for mutual funds. This task force 
will examine the existing information that is reported by 
mutual funds, looking at both the frequency of reporting, as 
well as the type of information that is reported. The goal of 
such a surveillance program would be to identify indications of 
problems and then allow examiners to better target their 
oversight to further reviewing and investigating the problem 
that has been identified.
    Second, examiners have been making increased use of 
computer technology to review large volumes of data.
    Third, examiners have been making increased use of 
interviews while on site which help examiners better understand 
the firm and obtain information that may not be available in 
the firm's books and records.
    Fourth, with the additional resources added to the 
examination program in 2003, we will be examining the largest 
and highest risk fund firms more frequently.
    Fifth, we are conducting more targeted mini-sweep 
examinations in order to quickly identify emerging compliance 
problems sooner. We have a number of these mini-sweeps ongoing 
now.
    Sixth, we have added new policies to enhance the speedy 
resolution of compliance problems that we do detect, including 
by holding exit interviews with senior fund personnel and by 
providing copies of our deficiency letters directly to the fund 
board.
    Seventh, we are increasingly requesting written reports 
from fund firms in order to allow us to review compliance by 
the fund in between examinations.
    Finally, as I said, it is critical that when examiners 
identify an emerging compliance problem in the industry that we 
act upon it promptly. To facilitate such actions, examination 
staff must share exam findings and trends with the Commission 
and with other Commission staff members.
    In sum, Mr. Chairman, we are moving aggressively to 
implement the lessons that we learned from recent market timing 
abuses and, more broadly, to enhance our ability to detect 
other compliance problems in the fund industry.
    I would be happy to answer any questions that you may have.
    Chairman Shelby. Thank you.
    Mr. Roye.

                   STATEMENT OF PAUL F. ROYE

          DIRECTOR, DIVISION OF INVESTMENT MANAGEMENT

            U.S. SECURITIES AND EXCHANGE COMMISSION

    Mr. Roye. Thank you, Chairman Shelby. On behalf of the 
Securities and Exchange Commission, I am pleased and honored to 
testify before you today regarding the Commission's recent 
regulatory actions to protect mutual fund investors. To address 
the various abuses that have come to light in recent months, 
and to help prevent abuses in the future, the Commission has 
embarked on a dramatic overhaul of the regulatory framework in 
which mutual funds operate. Equally important, the Commission's 
rulemaking initiatives are aimed at restoring the trust and 
confidence of investors that are crucial to the continued 
success of the mutual fund industry and preserving its key role 
in our economy.
    Under Chairman Donaldson's leadership, the Commission is 
pursuing an aggressive mutual fund regulatory agenda that is 
focused on four main goals: First, addressing late trading, 
market timing, and related abuses; second, improving the 
oversight of funds by enhancing fund governance, ethical 
standards, and compliance and internal controls; third, 
addressing or eliminating certain conflicts of interest in the 
industry that are potentially harmful to fund investors; and, 
finally, improving disclosure to fund investors, especially 
fee-related disclosures. I would like to briefly provide you an 
overview of these actions.
    First, late trading. The price that hundreds of thousands 
of mutual fund investors pay or receive on a daily basis turns 
on when the order is submitted and to whom. Typically, funds 
price their shares at 4 p.m. In what is known as ``forward 
pricing,'' investors submitting orders before 4 p.m. receive 
that day's price; and investors submitting orders after 4 p.m. 
get the next day's price. An 
investor that can place an order to buy or sell fund shares 
after 
4 p.m. and still receive the price set at 4 p.m. can profit 
from 
new information in the marketplace at the expense of other fund 
shareholders.
    The current rules permit a large number of intermediaries 
that accept or transmit trades in fund shares to determine 
whether the order will receive that day's 4 p.m. price. We know 
today that this system has failed. In order to help favorite 
customers, certain intermediaries have ``blended'' legitimate--
pre- 4 p.m. orders--with late trades, or post- 4 p.m. orders. 
In some cases, fund managers participated in the scheme; but in 
many cases they were the victims of dishonesty along with fund 
shareholders. The problem is that fund companies have no way of 
identifying a late trade when it is bundled with legitimate 
trades and submitted to the fund company in the evening hours. 
There are potentially enormous profits to be gained by late 
trading, and all of those profits come out of the pockets of 
mutual fund investors.
    To address this abuse, the Commission proposed the so-
called hard 4 p.m. rule. This proposal would require that a 
fund or a certified clearing agency, rather than the 
intermediaries, receive a purchase or redemption order prior to 
the time the fund prices its shares for an investor to receive 
that day's price. Now, we believe that this rule amendment will 
provide for a secure pricing system that would be highly immune 
to manipulation by late traders.
    We are currently analyzing the comment letters we received 
on this proposal, and we received over 800 comment letters so 
far. Now while we believe that the proposed rule amendment 
would virtually eliminate the potential for late trading 
through intermediaries that sell fund shares, it is clear from 
the comments that some believe that the hard 4 p.m. rule should 
not be the preferred approach. They argue that it will require 
the intermediaries to have cut-offs for trades well before 4 
p.m. and limit investor opportunities to place orders for fund 
transactions, particularly in the 401(k) context. So, 
consequently, we are studying other approaches to addressing 
this issue. We do not want to adversely impact fund investors 
if there are alternatives that effectively--truly effectively--
address late trading abuses.
    The Commission has taken a number of steps to address 
abusive market timing of mutual funds. Short-term trades in 
mutual fund shares impose costs on funds and their long-term 
investors. Some market timers attempt to purchase and redeem 
shares to take advantage of market actions they believe will 
occur in the future. Other types of market timers attempt to 
more directly take advantage of the fund's long-term 
shareholders by exploiting how funds calculate their net asset 
values. These ``arbitrage market timers'' buy and sell shares 
of funds if they believe that the fund's calculation of net 
asset value significantly lags behind the current value of a 
fund's portfolio securities, and this is typically in 
international funds or other funds that invest in thinly traded 
securities. Over time, the long-term shareholders in a fund 
will, in effect, pay the costs of the short-term shareholders' 
transactions and have the value of their fund shares diluted 
through this activity of arbitrage market timers.
    To help prevent this type of activity, the Commission has 
stressed that ``fair value pricing'' is a critical tool in 
effectively reducing or eliminating the profit that many market 
timers seek. The Investment Company Act requires funds to 
calculate their net asset values using the market value of 
portfolio securities when market quotations are readily 
available. If the market quotation for a portfolio security is 
not readily available or is unreliable, the fund must establish 
a ``fair value'' for that security, as determined in good faith 
by the fund's board of directors. The fair value pricing can 
minimize market timing and eliminate dilution of shareholders' 
interests. The Commission recently reiterated the obligation of 
funds to fair value their securities to reduce market timing 
arbitrage opportunities.
    Additionally, the Commission has proposed improved 
disclosure of a fund's policies and procedures regarding fair 
value pricing. Our staff is currently gathering information 
regarding funds' fair value pricing practices and evaluating 
whether to recommend additional measures to improve funds' fair 
value pricing. We have sought public comment on the need for 
additional guidance or rulemaking in this area.
    In a further effort to reduce the profitability of abusive 
market timing, the Commission late last month put forth a 
proposal that would require funds to impose a mandatory 2 
percent redemption fee when investors redeem their shares 
within 5 business days. Again, this fee would be payable to the 
fund, for the direct benefit of fund shareholders, rather than 
to the management company or any other service provider.
    Now this 2 percent fee is designed to strike a balance 
between two competing policy goals of the Commission--that is, 
preserving the redeemability of mutual fund shares and reducing 
or eliminating the ability of shareholders who frequently trade 
their shares to profit at the expense of their fellow 
shareholders. The Commission felt that the rule combined with 
fair value pricing would make market timing less profitable, 
and therefore reduce the incentive to engage in market timing. 
The Commission is considering whether this mandatory redemption 
fee is an appropriate approach to addressing short-term 
trading, including abusive market timing.
    The proposed rule would also require the intermediaries who 
sell fund shares to provide the fund at least weekly 
shareholder identification information that would allow the 
fund to identify market timers and impose their own market 
timing restrictions on these investors.
    The Commission has proposed enhanced disclosure 
requirements in order to combat abuses in the areas of market 
timing and the related issue of selective disclosure of 
portfolio holdings. These enhancements are intended to deter 
abusive practices and to enable investors to better understand 
a fund's policies in these areas.
    The Commission has proposed amendments intended to provide 
greater transparency of fund practices with respect to the 
disclosure of a fund's portfolio holdings. A fund would be 
required to describe its policies and procedures with respect 
to the disclosure of its portfolio securities, including any 
arrangements to make available information about the fund's 
portfolio securities, the identity of any person who receives 
such information, and any compensation or other consideration 
that would be received by the fund's adviser in connection with 
these arrangements. These amendments do not alter the 
requirement that a mutual fund or investment adviser may 
disclose its portfolio only if the disclosure of such 
information is consistent with the antifraud provisions of the 
Federal securities laws and the fiduciary duties owed to fund 
shareholders.
    As you mentioned, Mr. Chairman, recent events in the fund 
area have highlighted the need to improve oversight of the 
industry, and the Commission has undertaken several initiatives 
on this front. They are designed to strengthen the hand of the 
fund's board and to provide the directors, particularly the 
independent directors, additional tools with which to protect 
fund investors and reinforce ethical standards.
    In January, the Commission proposed a comprehensive 
rulemaking package to bolster the effectiveness of independent 
directors and enhance the role of the fund board as the primary 
advocate for fund shareholders. The proposals included a 
requirement for an independent board chairman; 75 percent of 
the board being independent directors; independent director 
authority to hire, evaluate, and fire staff; quarterly 
executive sessions of independent directors outside the 
presence of management; an annual board self-evaluation; and 
preservation of documents used by boards in the contract review 
process.
    This significant overhaul of the composition and workings 
of fund boards is intended to establish, without ambiguity, the 
dominant role of independent directors on a fund's board. With 
an independent board chairman and with independent directors 
representing at least 75 percent of a fund's board, independent 
directors will set the board agenda, as well as have the power 
to control the outcome of board votes.
    Boards would be required to perform a thorough self-
evaluation in order to identify structural changes and 
processes that might enable the board to be a more potent 
advocate for shareholder interests. Boards would be required to 
assess periodically whether they are organized to maximize 
their effectiveness. As part of this evaluation, boards would 
consider the number of fund boards on which each individual 
board member sits, as well as consider the nature and 
effectiveness of their board committee structures.
    The Commission recently proposed that all registered 
advisers adopt codes of ethics. Advisers are fiduciaries, and 
owe their clients a series of duties enforceable under the 
antifraud provisions of the Investment Advisers Act. This 
bedrock principle, which historically has been a core value of 
the money management business, appears to have been lost on a 
number of advisers and their personnel.
    The code of ethics would set forth standards of conduct for 
advisory personnel that reflect the adviser's fiduciary duties, 
as well as codify requirements to ensure that an adviser's 
supervised persons comply with the Federal securities laws, and 
require that these persons acknowledge receipt of a copy of the 
code of ethics.
    The code of ethics is designed to address conflicts that 
arise from the personal trading of advisers' employees. A 
principal focus of this code is a requirement that certain 
advisory personnel report their personal securities holdings 
and transactions, including transactions in any mutual fund 
managed by the adviser or an affiliate. This would close a 
loophole in the Investment Company Act under which investment 
company personnel have not been required to report trading in 
the shares of the funds that they manage.
    Now in an action that we expect to have a far-reaching 
positive impact on mutual fund operations and compliance 
programs, the Commission in December adopted rules that 
required that funds and their advisers have comprehensive 
compliance policies and procedure that are reasonably designed 
to ensure compliance with the Federal securities laws and that 
they designate a chief compliance officer. In the case of a 
fund, this chief compliance officer would be answerable to the 
fund's board and fired only with the board's consent. The fund 
directors would be required to review the adequacy of these 
procedures at least annually.
    We think an active and independent board of directors, 
supplied with reliable information as to the effectiveness of 
compliance programs and procedures, can serve as an important 
check against abuse and fraud on the part of fund management.
    The Commission is undertaking a series of initiatives aimed 
at certain conflicts of interest involving mutual funds and 
those who distribute fund shares.
    Last month the Commission voted to propose an amendment to 
Rule 12b -1 to prohibit the use of brokerage commissions to 
compensate broker-dealers for distribution of a fund's shares. 
In recent years, it has become clear that the practice of 
directing a fund's brokerage to a broker or dealer as 
compensation for distribution of a fund's shares presents 
opportunities for abuse. Advisers to funds are allocating 
brokerage commissions to pay for distribution when they could 
seek lower commission rates or rebates to the fund, or they 
could reduce custody or transfer agency or other costs of the 
fund. But the use of directed brokerage to pay for distribution 
benefits the adviser by increasing advisory fees and lowering 
the amounts that they would have to spend on distribution out 
of their own assets.
    Now the conflicts of interest that surround the use of 
brokerage commissions to finance distribution can harm funds 
and their shareholders and have led the Commission to propose a 
ban on these types of arrangements.
    Over time, Rule 12b -1 has come to be used in ways that 
exceed its original purpose. Consequently, the Commission in 
seeking comment on Rule 12b -1, asked for comment as to whether 
or not the rule should be repealed or modified. To address 
concerns that Rule 12b -1 has replaced sales loads in many 
cases, the Commission also requested comment on an alternative 
approach to Rule 12b -1 that would require distribution-related 
costs to be directly deducted from shareholder accounts.
    Chairman Donaldson has made the issue of soft dollars a 
priority and has directed the Commission to explore the problem 
and conflicts inherent in soft-dollar arrangements and the 
scope of the safe harbor in Section 28(e), and we are working 
with the Division of Market Regulation to conduct a review of 
this area. A primary focus is whether or not the current 
definition of qualifying ``research'' under the safe harbor is 
too broad and should be narrowed by rulemaking.
    Finally, the Commission is quickly progressing on its 
continued efforts to improve fund disclosures and highlight for 
investors fee-related information.
    The level of a fund's expenses, over time, can have a 
significant impact on a fund shareholder's investment 
experience. So last month, the Commission voted to 
significantly revise mutual fund shareholder report disclosures 
to assist investors in understanding these expenses. The 
shareholder reports will now be required to include dollar-
based expense information so that investors can better 
understand these expenses.
    This initiative also includes significantly improved 
disclosure to investors about a fund's investments. The recent 
amendments will make more information available and permit 
investors to tailor the amount of information they receive to 
meet their particular needs. This additional quarterly 
disclosure of fund portfolio holdings will enable investors, 
through more frequent access to portfolio information, to 
better monitor whether, and how, a fund is complying with its 
stated investment objectives.
    The Commission also proposed revisions to shareholder 
reports that will require fund directors to explain how they 
came to renew the advisory contract and make a determination 
that the fees that they pay the management company are 
reasonable.
    In a major proposal issued in January, the Commission 
proposed significant revisions to mutual fund confirmation 
forms and also proposed the first-ever point-of-sale disclosure 
document for brokers selling mutual fund shares. Together, 
these two proposals will greatly enhance the information that 
broker-dealers provide to their customers in connection with 
mutual fund transactions.
    We have seen wide-scale failures to provide appropriate 
breakpoint discounts on mutual fund sales charges to front-end 
load funds. We are proposing enhanced disclosure in this area 
so that investors understand the breakpoint opportunities for 
these types of funds. We have also issued a concept release to 
elicit views on how we could require better disclosure of 
quantification of transaction costs, which can be significant 
for investors.
    Finally, tomorrow, the Commission will consider new 
proposals to improve disclosure to fund shareholders about 
their portfolio managers' relationships with the fund. These 
proposals include disclosure regarding the structure of a 
portfolio manager's compensation, ownership of shares of the 
funds that a manager advises, and comprehensive disclosure of 
specific investment vehicles, including hedge funds and pension 
funds, that are also managed by the 
mutual fund's portfolio manager.
    As is hopefully evident, the Commission has been extremely 
busy in crafting rules that are designed to protect our 
Nation's mutual fund investors. Our focus has been directed not 
only on addressing the harms of late trading, abusive market 
timing, and related abuses, but also on strengthening the 
mutual fund oversight and regulatory framework to minimize the 
possibility that these and other potential abuses don't arise 
in the future. Also, we have been focused on the goal of 
providing meaningful and useful disclosure to facilitate 
informed decisionmaking on the part of mutual fund investors.
    Again, I thank you for the opportunity to be here, and I 
would be pleased to answer any questions you may have.
    Chairman Shelby. Thank you.
    Ms. Schapiro.

          STATEMENT OF MARY L. SCHAPIRO, VICE CHAIRMAN

           PRESIDENT, REGULATORY POLICY AND OVERSIGHT

           NATIONAL ASSOCIATION OF SECURITIES DEALERS

    Ms. Schapiro. Thank you very much, Mr. Chairman. It is an 
honor to be here and testify before the Committee. I really 
want to commend you and the Committee for your dedicated 
oversight in this area. It has been a real catalyst for 
aggressive and sustained action by the regulators.
    The NASD is the world's largest self-regulatory 
organization. We regulate every broker-dealer in the United 
States that conducts a securities business with the public. 
Last year, we brought more than 1,400 enforcement actions and 
barred or suspended more than 825 individuals from the 
securities industry, both of which are unfortunately record 
numbers.
    While the NASD does not regulate mutual funds, we do 
regulate broker-dealers who are a key distribution channel for 
mutual funds. Thus, we view broker-dealer participation in 
illegal or unethical practices in this area as a very direct 
concern.
    The disturbing revelations of abuses in the sale of mutual 
fund shares have brought a redoubling of our enforcement 
efforts as well as new rules requiring both better disclosure 
and higher standards for firm conduct. We have also increased 
our investor education focus dramatically.
    The NASD has brought more than 80 enforcement actions 
against securities firms dealing with mutual funds and variable 
annuities in 2003 and 2004, and well over 200 cases since the 
beginning of 2000. We have concentrated our enforcement efforts 
in four main areas.
    First, are compensation arrangements. Last year, NASD and 
the SEC fined Morgan Stanley $50 million for giving 
preferential sales treatment to some mutual funds in return for 
millions of dollars in brokerage commissions and other 
payments. NASD is currently conducting an examination sweep to 
look at more than 30 additional broker-dealers and fund 
distributors for similar violations.
    The NASD also prohibits the award of trips, entertainment, 
or other non-cash incentives to brokers for the sale of the 
firm's own mutual funds. Last fall, you may recall that we 
announced a $2 million fine against Morgan Stanley and a 
censure and a fine against the head of the firm's retail sales 
division for conducting sales contests featuring trips and 
Britney Spears and Rolling Stones concert tickets as prizes for 
the sale of Morgan Stanley's own proprietary funds.
    Our second area of focus is the suitability of mutual fund 
sales, in particular Class B shares. We are very concerned that 
brokers are making unsuitable recommendations to investors to 
buy more expensive Class B shares when they frequently are not 
the best investment choice for the customer. We have recently 
brought more than a dozen major B share cases involving 
millions of dollars of unsuitable sales, and we currently have 
more than 50 open and active investigations in this area.
    The third focus is on breakpoints and net asset value 
waivers. As we reported to you last year, NASD discovered that 
broker-dealers selling front-end-load mutual funds were not 
delivering breakpoint discounts to investors, resulting in an 
overcharge to investors that is conservatively estimated at $86 
million for 2001 and 2002 alone. We have directed all firms to 
make refunds with interest to investors and, in conjunction 
with the SEC, jointly sanctioned seven firms. NASD alone 
sanctioned eight additional firms with fines totaling over $21 
million.
    In February, NASD brought the first case of its kind in 
announcing the censure and fine of AXA Advisors and a senior 
employee for failing to obtain sales charge waivers through NAV 
transfer programs, thereby causing investors to overpay for 
certain mutual funds. We have also initiated a broad-based 
review of other firms to determine if they are meeting their 
obligations in this area.
    The fourth area is late trading and market timing. Last 
month, NASD announced the first of our market timing 
enforcement actions. We fined State Street Research Investment 
Services $1 million for failing to prevent market timing of 
their mutual funds as a result of inadequate supervisory 
systems. State Street was also ordered to pay $500,000 in 
restitution to the funds.
    As we continue our examinations and investigations into 
these areas, we have more than 200 mutual fund-related 
investigations under way. We will continue to impose fines, 
order restitution to customers, and suspend or expel bad actors 
from the industry, charging supervisors and even CEO's. In the 
appropriate case, we will limit a firm's ability to engage in 
entire lines of business.
    The NASD believes that investors deserve clear and easy to 
compare information about all the costs associated with the 
purchase and ownership of every mutual fund, as well as all of 
the financial incentives that may impact the recommendations of 
a broker. Therefore, we support the recent SEC proposals on 
point-of-sale and confirmation disclosure, and we have also 
proposed disclosure requirements on revenue sharing and 
differential cash compensation arrangements. By requiring 
broker-dealers to disclose and 
update these arrangements, NASD will help investors be alert to 

financial incentives that a firm may have in recommending a 
particular fund.
    The NASD also filed a new rule yesterday with the SEC 
requiring that every advertisement that promotes a mutual 
fund's performance also contains a prominent box with the 
fund's fees and expenses. This disclosure works a little bit 
like the Surgeon General's warning: To better inform investors 
about the cost of purchasing and owning a mutual fund, and it 
will also enable easy comparison across funds.
    From our perspective, success in this realm will require 
more than rules and enforcement cases. It will require a robust 
investor education program. NASD recently announced the 
establishment of a $10 million investor education foundation to 
further our already significant efforts in this area. Looking 
ahead, we are expanding our enforcement and rulemaking 
activities with respect to a product closely related to mutual 
funds, that is, variable annuity sales. While already active in 
this area, our focus will be expanded in the following four 
areas: The market timing in variable annuity sub-accounts; 
switching campaigns by firms and groups of migrating 
representatives; procedures surrounding sales of variable 
annuities into tax-deferred accounts; and anti-money-laundering 
procedures tailored specifically to the annuity business.
    In conclusion, NASD will continue to work tirelessly with 
other Federal and State authorities to solve the problems 
revealed in recent months in the mutual fund industry. We are 
committed to building and maintaining the integrity of our 
financial markets.
    Thank you, and I am happy to answer any questions.
    Chairman Shelby. Thank you.
    As this Committee examines the fund industry and the recent 
rulemakings, we are seeking to determine, among other things, 
if legislation is necessary. In your view, do the regulators 
currently have the necessary statutory authorities to punish 
wrongdoers and also to reform the industry? And if not, what 
additional authorities would you recommend that Congress grant?
    We will start with you, Comptroller Walker.
    Comptroller Walker. Chairman Shelby, the two areas that we 
mentioned in our statement at this point in time is to consider 
providing SEC with legislative authority to better define 
director independence and, second, to consider narrowing or 
repealing the legislative safe harbor dealing with soft 
dollars. Those are the two issues that we would put on the 
table at this time.
    Chairman Shelby. Ms. Richards.
    Ms. Richards. I would defer to my colleague. I guess I 
would say that the rules that the Commission has proposed or 
put in place will help examiners better detect problems.
    Chairman Shelby. It will help a lot, but it is a question 
of are they comprehensive enough under the statute.
    Mr. Roye.
    Mr. Roye. I think from the Commission's perspective, if you 
look at the various rulemakings that the Commission has pursued 
and the goals that the Chairman has laid out, we have been able 
to address each of the problem areas by addressing the specific 
abuses, trying to enhance the oversight of the industry, and 
putting in place the building blocks that will hopefully 
prevent the types of abuses that we have seen from occurring in 
the future. So, I think our existing authority is generally 
sufficient to deal with the problems and enhance the oversight 
of the industry.
    I think Mr. Walker does point out specific areas where we 
do not have the ability on our own to proceed.
    Chairman Shelby. Short of statutory authority.
    Mr. Roye. Yes, sir.
    Chairman Shelby. Ms. Schapiro, you came from the SEC at one 
time, so you have a great background.
    Ms. Schapiro. That is right. I spent 6 years at the SEC, 
and I think I would agree that there is sufficient authority 
currently. Certainly for us, our jurisdiction extends only to 
broker-dealers and not to mutual funds, and we have really 
quite complete authority in that regard. We will have to rely 
on the SEC's authority with respect to the issues that need to 
be resolved that revolve around the mutual funds themselves.
    I agree with Mr. Walker that 28(e) is something that 
Congress should examine carefully with a view toward whether 
the safe harbor is sufficiently circumscribed--is it too broad 
and is it allowing conduct to take place that really was never 
intended by the Congress in creating that statutory safe 
harbor? There ought to be a careful examination of whether 
28(e) should at least be narrowed.
    Chairman Shelby. Okay. Ms. Richards, there are those who 
say that much of the misconduct that has come to light in 
recent months was an open secret on Wall Street. Please 
elaborate on why these practices were apparently undetected by 
the SEC and how you are modifying examination practices to 
ensure compliance and better detect future misconduct in the 
fund industry. Also, do you have the resources you need to 
address these problems? I think you have to have both the will 
and the resources. Go ahead.
    Ms. Richards. Thank you. Certainly we have the will. I will 
say to you very clearly that we have since September 2003 spent 
a good deal of time reviewing our past examinations, our past 
examination protocols, and identifying what steps we can take 
going forward to make sure that we better detect not only 
market timing and late trading but also other abuses of this 
type.
    Certainly we were aware that market timing was a phenomenon 
in the securities industry. We were also aware that mutual 
funds were complaining about the existence of market timers and 
that they were adopting market timing police and other 
procedures to prevent market timing from occurring in their 
funds.
    As I said at the outset, our examination protocols at the 
time did not require that examiners receive daily sales and 
redemptions data which can indicate aberrant trading patterns 
indicative of market timing. We are now requesting that data as 
part of routine examinations and, more broadly, as part of the 
Chairman's initiation of a mutual fund surveillance program, we 
think that is the type of data that the Commission should 
receive routinely.
    It appears to us in conducting examinations and 
investigations that, in many of the market timing arrangements, 
secret and covert market timing arrangements were negotiated 
via e-mail communications. And in light of that, we believe 
that all of our examinations must now include a fairly thorough 
review of e-mails of 
selected fund executives, and examinations must now include a 
review of fund executives' trading in the shares of their own 
funds. And those are steps that we have implemented.
    More broadly, I described the changes that we are making to 
our examinations. We want to make sure that we are tackling and 
uncovering areas of emerging abuse in a more timely way, making 
sure that our colleagues on the Commission are aware of 
problems that we have identified, and that we are taking 
appropriate steps to bring enforcement actions where 
appropriate, and to undertake rulemaking, investor education, 
or other steps.
    As to your question about the resources, certainly if we 
had additional staff, we could conduct additional examinations. 
We are, however, undertaking a fairly radical change to our 
examinations. Each examination is likely to take longer than it 
had in the past because of the review of e-mail and because of 
the additional examination steps that we are implementing.
    The Chairman's initiative to create a mutual fund 
surveillance program may provide examiners with more 
efficiencies in the process. That is, if we are able to 
identify in a more streamlined and systematic way compliance 
problems in the industry and then use our limited examination 
staff to target those firms and those areas within firms for 
follow-up, we may be able to use our existing 
resources in a more efficient way.
    So what I would ask is if I could reserve responding to 
that question for just a short period of time until we can 
better assess the effect of the new changes and of the new 
surveillance program.
    Chairman Shelby. You will get back to us for the record on 
that?
    Ms. Richards. I would like to.
    Chairman Shelby. We want to make sure that you have the 
resources. You say you have the will, but the will without 
resources is not good enough. Resources without will is futile, 
too, is it not?
    Ms. Richards. Yes, it is. I would also like to thank this 
Committee for its support in giving us additional resources in 
2003 because that has been enormously helpful.
    Chairman Shelby. Senator Sarbanes.

              COMMENTS OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Mr. Chairman. I want 
to join with you in welcoming the panel.
    I actually want to go back to the Chairman's first question 
to the panel about in what areas is legislation necessary, as 
opposed to rulemaking and regulation by the SEC. I am not quite 
clear with what I am hearing.
    Mr. Roye, do you agree with Comptroller Walker in the two 
areas that he mentioned, where he thought legislative action 
was necessary?
    Mr. Roye. The two areas that he mentioned, first was the 
definition of independent director in the fund context, the 
statute sets forth a precise definition. It doesn't give the 
Commission the ability to expand that definition or to 
encompass situations where we think that the director really is 
compromised and shouldn't be deemed to be independent. We have 
limited ability to deal with that problem. The other area that 
he mentioned was soft dollars, and, of course, there is a 
statutory safe harbor that protects soft-dollar arrangements.
    The Chairman has created a task force to look at soft 
dollars. We do have the ability to look at what is research, 
the scope of that definition. We have the ability to do other 
things to make the soft-dollar arrangements more transparent 
and to address other issues. But we don't have the ability on 
our own to abolish the safe harbor.
    Senator Sarbanes. Ms. Schapiro, on the 28(e) safe harbor, 
you said restrict it. What about repealing it? We had testimony 
here by Marvin Mann before the Committee at the table, the lead 
independent trustee of the Fidelity Funds, advocating 
unbundling of portfolio brokerage costs, the elimination of 
soft dollars through the repeal of Section 28(e), and he said, 
and I am quoting now from his testimony, ``If an adviser wants 
to purchase research products or other services such as data 
terminals or other non-execution services or pay a dealer 
compensation for fund sales to the extent currently permitted 
by law, it would pay for those in hard dollars from its own 
resources, not from fund commissions. Investors would have a 
much better understanding of the expenses of investing in a 
mutual fund and would be able to make better informed 
investment decisions.''
    Ms. Schapiro. Senator, my view is that any practice that is 
as complicated, as lacking in transparency, and fundamentally 
conflicted as soft dollars is deserves intense scrutiny by the 
regulators and by the Congress. And whether that leads to a 
narrowing of the 28(e) safe harbor, greater transparency in the 
disclosure to investors about what portfolio transaction costs 
are going to execution versus to generate soft-dollar credits, 
or an abolition of the safe harbor entirely I think is a 
question for Congress. But I think it is one that is critical 
to address.
    From my perspective, transparency is the absolute minimum. 
This is an inquiry that could certainly take you to repealing 
of the safe harbor.
    Senator Sarbanes. Comptroller Walker.
    Comptroller Walker. Senator Sarbanes, sometimes disclosure 
is not enough. Disclosure is generally better in addressing 
competitive issues than it is equity issues. Disclosure can 
help to promote alternatives, but it by itself does not do 
enough to prevent abuse. I mentioned before, when I was 
Assistant Secretary of Labor for Pensions and Health and 
oversaw all the fiduciary responsibility provisions for the 
many pension employee benefit plans and trillions of dollars 
invested relating to those plans, we had serious concerns about 
soft-dollar arrangements, and we had serious questions about 
whether they should be allowed under ERISA's fiduciary 
responsibility provisions.
    At the same point in time, we were really constrained with 
being able to do too much because of Rule 28(e). So, I think 
that you need to consider the pros and cons of both narrowing 
and repealing the current safety harbor. I think the time has 
come to do that.
    Senator Sarbanes. Does anyone else want to add anything on 
this issue?
    [No response.]
    Ms. Richards, at the ``SEC Speaks'' seminar held just this 
past Saturday, your staff talked about the top five fund 
deficiencies in 2003. The staff said that the number one top 
deficiency was internal controls. We like to keep abreast of 
these SEC's seminars. Other deficiencies involved filings, 
board of directors conflicts of interests, and books and 
records.
    Could you just describe a bit about this top deficiency and 
what is and can be done to improve internal controls? Once 
again, do you need legislation in order to do it?
    Ms. Richards. Certainly. Broadly, the category of internal 
controls encompasses lack of policies and procedures in a given 
area, as well as lack of good quality policies and procedures 
and a failure to implement those policies and procedures. It is 
a most common finding that we make in our examinations of 
investment advisers and investment companies, and really 
incorporates our review of all aspects of a mutual fund or an 
investment adviser's business--that is, the internal controls 
weakness could relate to any one of a number of different 
areas.
    I think that what will help improve the quality of mutual 
funds and advisers' internal controls is the new compliance 
rule that the Commission adopted in December that will require 
funds and advisers for the first time to have written 
compliance policies and procedures in key areas of their 
operations, and will ensure that there is a compliance officer 
on staff at the mutual fund to make sure those compliance 
policies are being administered and enforced. We believe as 
examiners that the new rule will be extremely beneficial in 
creating an environment where the internal controls are strong 
and robust; that is, there are written compliance policies and 
procedures, and that there is someone inside the fund making 
sure that those policies and procedures are being enforced.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Thank you. We will keep going, swap 
rounds.
    This is to Ms. Richards and Mr. Roye. Some contend that the 

recent scandals continued without apparent detection by the SEC 

because the SEC's organizational structure did not facilitate 
information flow across divisions. Would you address that 
assertion and discuss any internal reforms that the SEC has 
initiated to enhance internal communication and coordination? 
Mr. Roye.
    Mr. Roye. The Commission is organized into divisions and 
offices. My division has responsibility for the rulemaking and 
the policy in the fund area. Lori's organization has 
responsibility for going out and doing examinations. We have an 
Enforcement Division that is out there enforcing the 
provisions. We try to work together and communicate.
    Chairman Shelby. It is essential that you communicate well, 
is it not?
    Mr. Roye. It is critical. I guess I would dispute the 
assertion that the organizational structure is what led to the 
SEC not picking up on the abuses. What we try to do is learn 
from our colleagues in doing examinations. When they go out, 
they spot problems and issues that implicate rulemaking and our 
policy judgments. We get input from them. When we do rulemaking 
we use our examination staff as our eyes and ears to understand 
what is going on in the industry. When we see issues and 
problems in our review of registration statements of mutual 
funds, we pick up the phone and call our colleagues in OCIE, or 
if it is more severe, our colleagues in the Division of 
Enforcement, to have them go and actually pursue an issue.
    But all that being said, the Chairman has set forth a 
number of initiatives designed to improve internal 
communication. One is a risk management analysis function. In 
each of our divisions we have individuals whose function is to 
think about risk and think about ways that investors can be 
disadvantaged in each of our respective areas. We serve 
collectively on a committee that surfaces up these risk 
management issues. The Chairman is looking for an individual to 
head up this risk management function. We think that is going 
to be extremely valuable. We meet periodically to go over the 
examination findings that OCIE has, not only the Investment 
Management group, but also the Enforcement group, to look at 
the types of deficiencies that are being surfaced.
    Ranking Member Sarbanes mentioned the five areas where we 
see deficiencies. From our perspective, does that mean our 
rules are deficient? Do we need to improve our rules? From an 
enforcement perspective, are these issues that merit further 
review and scrutiny on their part from an enforcement 
perspective? So, we are doing things to enhance our 
communication, our ability to understand what is going on in 
the industry.
    Chairman Shelby. Comptroller Walker.
    Comptroller Walker. Mr. Chairman, I would suggest three 
possible primary reasons why the SEC may not have discovered 
this earlier. First, one has to do with resources, staffing 
levels. Second, it is my understanding the SEC did not dedicate 
a tremendous amount of time and attention on trading activities 
dealing with the mutual fund's own shares, and a lot of the 
abuses have related thereto. Third, some of these practices 
have involved fraud and collusion, and the degree of difficulty 
in being able to ascertain that is much greater than the normal 
type of audit and evaluation type of activities. So, I think 
those are three of the primary contributing factors.
    Chairman Shelby. Ms. Schapiro, many of the recent 
revelations regarding the fund industry involve not only 
wrongdoing by the funds, but also by the brokers. Describe how 
the NASD has modified your examination practices to account for 
the large role that broker-dealers play in the distribution of 
funds.
    Ms. Schapiro. I would be happy to do that, and you make a 
very important point, that broker-dealers were complicit in 
some of the activity that we have been all dealing with over 
the last number of months.
    We have incorporated new examination protocols, much as the 
SEC has, into our examination program, and I would be happy to 
talk about those. We will have to always work closely, as I 
said before, with the SEC because we can only see a part of the 
activity that may be problematic. We can only see what has 
happened in, and is captured on the books and records of, 
broker-dealers.
    I would also agree that when we have a situation where an 
individual or a firm has either created false documents or 
destroyed documents, it will always be very difficult for us to 
detect violations. Nonetheless, we have rolled out to our 
examination staff across the country new exam protocols for 
identifying late trading and market timing red flags. Our 
traditional focus has always been very much in the sales 
practice area, revolving around suitability primarily. We will 
not ever take our focus off of those issues as well, because 
they impact individual investors in a very, very real way every 
day. Nonetheless, our examiners are now looking for red flags, 
large trades in and out in a short period of time in a 
particular account. They review order tickets and other books 
and records to look for manipulative practices that were 
intended to circumvent the prohibitions on late trading: For 
example, they identify whether the firm has access to any 
system that allows them directly to input an order to the 
mutual funds after the market close, and they look at all the 
supervisory procedures, policies and practices that are in 
place.
    With respect to market timing, again, they look at large 
transfers in and out. They look for whether the broker-dealer 
might have received a block letter from the mutual fund, and 
then circumvented that block letter by shutting down one 
account and opening another account for that customer, who is 
then unknown again to the mutual fund until the rapid trading 
begins again. And then we are also reviewing correspondence and 
e-mails, and working closely with the SEC to share the results 
of those exams, so we can learn from each other as we develop 
new techniques for examining for these practices.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Comptroller Walker, your GAO people, in a 
report, this was testimony over on the House side last June, 
say ``Mutual fund boards follow many sound corporate governance 
practices, but such practices are not mandatory for all 
funds.'' And in the course of the discussion under that 
heading, they pointed out that you have some reforms advocated 
by the ICI's best practices and others that have been 
recommended by blue ribbon groups that are not currently 
actually required for mutual funds. They were testifying about 
legislation in order that the legislature would make these and 
other practices mandatory for all funds, which would ensure 
consistent implementation of the practices across the industry. 
Could the SEC do that of its own authority?
    Comptroller Walker. Senator Sarbanes, my understanding is 
that is exactly what the SEC is proposing to do right now. They 
are proposing to require that a supermajority of directors of 
these funds be independent. I think specifically they are 
proposing 75 percent. They are also proposing that the chairmen 
of these boards of directors overseeing the funds should be 
independent. The one thing that we have suggested is you may 
want to think about providing them with legislative authority 
to define what is deemed to be independent beyond what the 
statute says right now. I think they have the authority, but I 
would ask the SEC to comment.
    Mr. Roye. Yes. If you look at our governance proposal, we 
do, in connection with a number of exemptive rules that are 
under the Investment Company Act that involve conflicts of 
interests, we expect boards of directors to manage and oversee 
those conflicts. We are proposing to attach to those rules 
about five different governance principles. And as Mr. Walker 
mentioned, requiring a 75 percent independent board, and an 
independent chairman, confirming the authority of the directors 
to retain staff, particularly the independent directors, to go 
out and hire experts to assist them in carrying out their 
responsibilities, requiring them to meet in executive session 
as a group of independent directors to confer on issues, as 
well as requiring the directors to go through a self-evaluation 
as to whether or not they are effective, and what they can do 
to improve that effectiveness.
    Senator Sarbanes. Has the SEC gone through the exercise of 
ascertaining what additional statutory authority they think 
they need or what current provision in the statutes ought to be 
changed with respect to the mutual funds? Have we had the 
benefit of your recommendations in that regard?
    Mr. Roye. We have not done that, per se. The Commission has 
taken a position, for example, on earlier versions of the Baker 
bill on the House side, where there were various provisions 
that were in that legislation, and testified in support of a 
number of those provisions, and then----
    Senator Sarbanes. Were you testifying in support of 
provisions that you are now seeking to put in place by rule or 
regulation?
    Mr. Roye. Much of what was in the Baker bill you see the 
Commission, through its rule proposals, actually proceeding on.
    Senator Sarbanes. I am beyond that. One of the questions we 
have to face is if you are doing it by rule and regulation and 
it can be accomplished, should we just leave it there or should 
we come along and also by statute require that. Of course, if 
you require it by statute and then subsequently you need to 
adjust it, you have to adjust it by statute. So, you have to be 
mindful of that.
    But I want to go beyond that. I want to get at difficulties 
or problems you see in which you think your authority under the 
statutes is not sufficient or adequate, and therefore, you 
would come to us and say: We can do A, B, C, D, and E, but we 
do not think we can do F, G, H, and I unless we get some change 
in the law. Have you done that exercise?
    Mr. Roye. I can tell you this: As we work with Chairman 
Donaldson on his action plan, everything that he has wanted to 
do we figured out a way to do it with our existing authority.
    Senator Sarbanes. But you just admitted at the table today, 
as I understood you, that in at least the two instances that 
Comptroller General Walker indicated, where he thought 
legislative 
action was necessary, you agree with that.
    Mr. Roye. That is correct, and the Commission is on record 
on the House side as supporting additional authority to be able 
to deal with the independent director definition. And as I 
indicated, Chairman Donaldson has formed a task force to look 
at the soft-dollar issue, and the Commission, as yet, has not 
formulated a position on that, but if you want to go so far as 
to repeal that, we do not have the authority to do it on our 
own.
    Senator Sarbanes. Is that task force at work?
    Mr. Roye. Yes.
    Senator Sarbanes. When does it intend to report?
    Mr. Roye. We have only about 15 things we have been trying 
to do all at the same time, but Chairman Donaldson has 
definitely made this a priority, and I cannot give you a firm 
time frame, but if you look at the speed with which we are 
moving in all these other areas, he is going to demand a report 
from us probably in short order, but I cannot give you a 
specific time frame.
    Senator Sarbanes. Did you want to add something, 
Comptroller Walker?
    Comptroller Walker. Senator Sarbanes, I would just say one 
of the things that I hope that the SEC is looking at, as well 
as part of its review is whether it believes it has adequate 
sanctions, whether it has an ability to impose high enough and 
targeted enough civil penalties, and whether or not in certain 
circumstances criminal sanctions might be appropriate for 
certain extreme abusive practices.
    I do not know what if anything they are doing on that, but 
I do know that in order for any system to work, you have to 
have incentives for people to do the right thing, adequate 
transparency to provide reasonable assurance they will because 
somebody is looking, and appropriate sanctions via 
accountability mechanisms if they do the wrong thing, if you do 
not have all three of those, the system will not work over 
time, and it does not make any difference whether it is a 
corporate governance system or the mutual fund industry or the 
health care system or the tax system, you have to have all 
those.
    Senator Sarbanes. Thank you.
    Chairman Shelby. As I understand it, the SEC is talking 
about 75 percent of the directors be independent, right?
    Mr. Roye. Yes, sir.
    Chairman Shelby. Why should the chairman be independent? 
Why should that not be left up to the directors to elect a 
chairman that would be deemed by them the leader and the most 
competent and so forth, as opposed to just mandating that the 
chairman be independent? This was brought out last week up 
here.
    Let me start with Ms. Schapiro.
    Ms. Schapiro. We have not taken an institutional view on 
this, as you can understand, because we do not regulate the 
funds themselves. I will say I think there is a tremendous 
amount of learning that has gone on over the last couple of 
years, given the corporate scandals that we have all witnessed, 
and I think that lead directors or independent chairmen and a 
number of the other things the SEC has already proposed, are 
very important for the fund industry to catch up in terms of 
the quality of governance that is taking place there, but I am 
going to defer to the SEC on the issue of whether this should 
be an independent chairman or a lead director.
    I do think a supermajority of independent directors is 
critically important.
    Senator Sarbanes. Seventy-five percent?
    Chairman Shelby. Of the directors?
    Ms. Schapiro. Yes.
    Chairman Shelby. Comptroller Walker, do you have a comment?
    Comptroller Walker. Mr. Chairman, I think it is important 
to have an independent chairman. Now whether that is a lead 
director or whatever, because to me boards have to do three 
things. They have to maximize value to shareholders. They have 
to manage risk to stakeholders and they have to hold management 
accountable for results. The lead director or the chairperson 
sets the agenda and has a tremendous amount of influence over 
the board's activities, and I think it is an important issue.
    Chairman Shelby. Comptroller Walker, would you elaborate on 
the GAO's assertion that investors should receive 
individualized cost disclosure? Has the GAO evaluated the cost 
and feasibility of computing such a figure?
    Comptroller Walker. I think it is important that we keep in 
mind that it is not just what is disclosed but how it is 
disclosed and where it is disclosed. Our experience has been, 
and frankly, my personal experience has been----
    Chairman Shelby. How it is disclosed to where the 
shareholder can understand it.
    Comptroller Walker. Correct. I know myself, having 
investments in a number of mutual fund shares, most of which, 
frankly, are through a 401(k) plan, the thing I look at on a 
recurring basis is my quarterly statement. There are annual 
reports that come out. There are prospectuses that come out, 
and they have a lot of information, but at least from a 
personal standpoint, I do not spend a whole lot of time on 
them.
    I think we need to figure out how we can get important 
information provided in a simple, straightforward manner in a 
statement that we believe that people will read.
    Chairman Shelby. People will understand.
    Comptroller Walker. And understand.
    Chairman Shelby. And understand too.
    Mr. Roye.
    Mr. Roye. I would agree with what Mr. Walker has indicated. 
The Commission has taken a number of steps to try to improve 
and simplify mutual fund disclosures. We made a major effort to 
try to improve the prospectus presentation. You alluded to the 
fact that the prospectus is something that many investors do 
not spend a lot of time focusing on. We want that document to 
be something that investors do focus on and can understand. Up 
front in that document is a fee table that lays out the fees 
and expenses. We recently went through an effort to improve the 
shareholder report presentation, and it does have the new 
dollars and cents disclosure Senator Schumer referred to in 
terms of $1,000, what does it cost me per $1,000 to be invested 
in the fund? Also formulations that allow you to compare one 
fund to another. Is my fund a high-cost fund or a low-cost 
fund?
    I will add that, as we worked through these disclosures 
recently with the Commission, a number of the Commissioners, 
and the Chairman have directed the staff to think about how we 
can go further in looking at issues like account statement fee 
information.
    Chairman Shelby. For example, why could investors not 
receive both an individualized number and a comparative number?
    Mr. Roye. That is certainly possible. I think that when you 
get to the account statement, one of the things that we have to 
work through is that there are a number of complications in 
doing that. Most fund shares today are sold through financial 
intermediaries, broker-dealers, banks, other intermediaries, 
and they are the ones who generate the account statement. So 
the funds are going to have to get the expense information, 
transmit it to a variety of--thousands of--intermediaries. Let 
us say you have 10 different funds that you are holding through 
that intermediary, they are going to have to bring all that 
information down to an account statement and get it out 5 days 
after the end of the quarter, which creates some processing 
issues that we would have to work through, but it is something 
that we are focusing on.
    Chairman Shelby. Mr. Roye, could you please just briefly 
elaborate on how the SEC intends to address the potential 
conflicts of interest inherent in the side-by-side management 
of hedge funds and mutual funds? Maybe Ms. Richards would have 
something to say there to.
    Mr. Roye. I think in the first instance we have the 
compliance policies and procedures requirement that the 
Commission recently adopted. Funds are going to have to have 
procedures and policies in place to deal with exactly these 
kinds of issues. If you look at the release you will see a 
discussion of just this kind of issue, side-by-side management, 
of a mutual fund, hedge fund, other accounts. How do you manage 
those conflicts? What are your procedures? The rules also 
require a compliance officer in every fund, and every adviser 
who is responsible for overseeing those procedures, to report 
to the board of directors as to whether or not those procedures 
are working.
    Tomorrow, we are recommending to the Commission enhanced 
disclosure about fund portfolio managers. How is your portfolio 
manager compensated? How is that compensation structured? Does 
the portfolio manager own shares of the fund? Maybe more 
significantly, what other accounts is your mutual fund manager 
running at the same time that he or she is running a mutual 
fund? Is the manager running a hedge fund, as well as a 
registered mutual fund? Again, disclosing to investors what the 
fund's policies and procedures are and how you manage that 
conflict?
    Chairman Shelby. Ms. Richards, do you have any comment?
    Ms. Richards. This is an area, I think, with significant 
conflicts of interest. Whenever a portfolio manager manages 
more than one account and may be paid in different ways for the 
success or failure of any one of those accounts, the manager 
may have an incentive to mismanage one account or to favor one 
account over another. As a result, this is an area where we try 
to look closely at the allocation decision the portfolio 
manager makes during examinations. It is also an area where the 
Commission has found abuse--where a portfolio manager has 
allocated a hot IPO, for example, to an account where he will 
receive more money for the favorable outcome.
    Just in the last year or so, the Commission brought a case 
against Zion Management, and a case against Nevis Capital, and 
in prior years against Dreyfus and Van Kampen, so it is clearly 
an area where there is conflict of interest and the potential 
for abuse.
    Chairman Shelby. Senator Dodd.

            COMMENTS OF SENATOR CHRISTOPHER J. DODD

    Senator Dodd. Thank you, Mr. Chairman. My apologies to you 
and Senator Sarbanes and the witnesses. We had a hearing in the 
Rules Committee of 527's. I know there is a great deal of 
interest in that subject matter, so I apologize for not being 
over to hear some of the earlier statements and the comments of 
my colleagues. If I am raising a question here, Mr. Chairman, 
that has already been covered, then interrupt me and we will 
wrap this up. I just want to raise one question.
    In a bill that Senator Corzine and I put together some 
months ago, we did not include a hard 4 o'clock close. I know 
this is not the first time you have been asked about this 
question, but the obvious concerns that have been raised about 
a hard 4 o'clock close are the two classes of investors, East 
Coast investors and West Coast investors, and making it 
difficult for them to get in and out of trades in the same day 
if you have a 1 p.m. cut-off. That is the argument that is 
being raised.
    I gather in--I should know which one--the opening 
statements, there was some reference to the SEC's examination 
of alternatives to the hard 4 o'clock close, and I wonder if 
you might comment on some of those alternatives and explain the 
benefits and problems of the clearinghouse for orders and 
electronic time-stamping of orders to ensure their veracity. 
Any of you want to jump at this?
    Mr. Roye. I would be glad to respond to that since it was 
our rule proposal. We did propose a hard 4 o'clock, and as I 
indicated in my statement, we are looking at a situation of 
widespread abuse in this area, abuse by intermediaries that the 
Commission regulates and the NASD oversees, but in some cases 
intermediaries that are not within the jurisdiction of the 
Commission. These include banks and third-party pension plan 
recordkeepers who are accepting orders, and who are blending 
late trades with legitimate trades so the funds cannot see 
those orders. So, we are faced with the questions of how do we 
attack that problem?
    If you think about the thousands of intermediaries taking 
orders, the solution the Commission proposed was to shrink that 
universe down to entities that we regulate and oversee. We 
regulate the funds, we regulate the clearing agencies that take 
the fund orders, but you are right, in doing that, you require 
the intermediaries to have earlier cut-offs in terms of 
accepting orders. But we are trying to deal with a situation 
where there are folks that we do not regulate, and to come up 
with a solution that we thought would solve the problems. We 
recognized in the release that the rule proposal was going to 
have the kinds of potential impacts that you mentioned in terms 
of 401(k) issues, with West Coast investors having to get their 
orders in.
    At the same time the Commission recognized and asked for 
comment on an alternative to a hard 4 o'clock. Is there a way, 
through procedures, time-stamping, electronic time-stamping, 
where orders cannot be altered through certification processes 
or third-party audits? Is there a solution that would give us 
reasonable confidence that we are not going to have a late-
trading problem in the future?
    We received about 800 comments on this particular 
rulemaking.
    Senator Dodd. Is that particularly high?
    Mr. Roye. That is very high for an SEC rule proposal. I 
think the only one that I can recall that exceeded that was the 
Commission's proxy voting proposals, requiring mutual funds to 
disclose how their proxies are voted.
    Senator Sarbanes. That was in the thousands, was it not?
    Mr. Roye. Oh, yes.
    [Laughter.]
    Consequently, when we started looking at this problem, we 
did not want to do anything that adversely impacts the ability 
of investors to get their orders in. We wanted them to have the 
widest window of opportunity to get the orders in. At the same 
time we do not want to be up here 2 years from now talking 
about late trading problems. Therefore, we are trying to 
understand alternatives, understand technological solutions to 
this. We have been working with Fund/SERV, the clearing agency. 
We want to hear from everybody in terms of solutions and 
alternatives. I can tell you that some of the alternatives we 
have seen and some of the intermediaries that have some of 
those procedures in place already, we found late trading.
    We are looking at it very carefully. We are going to be 
very careful in this area, and explore all the alternatives.
    Senator Dodd. Comptroller Walker or anybody else want to 
comment on this?
    Comptroller Walker. Senator Dodd, we at GAO have 
recommended that the 4 o'clock hard close might be the option 
that the SEC does right now, but they need to be looking for 
possible alternatives. The fact of the matter is, is that there 
is going to be a difference between people who live on the East 
Coast and the West Coast, no matter what the time is. That just 
exists. I think one of the issues that we have to think about 
is, is that what are we trying to accomplish?
    Part of this is there are differences here between short-
term traders and long-term investors, and in the case of 
pension funds and 401(k) plans, I hope that we are promoting 
people to be long-term investors, not short-term traders. I 
think if we look at the date with regard to pension and savings 
plans like 401(k) plans, you will find that a vast majority of 
participants do not trade on a frequent basis, and they are 
making asset allocation decisions and sticking with it over a 
longer term, and so this issue may or may not be as big a 
problem as some would lead you and others to believe.
    Senator Dodd. Anybody else?
    Ms. Schapiro. Senator Dodd, I would add I think you have 
highlighted important issues with respect to a dramatically 
shortened trading day for West Coast investors and difficulties 
for pension plan administrators who have a need to net 
positions before they transmit them to the fund, and I think 
the SEC has done the very logical thing to do in the first 
instance. But there are systems I think that can give you an 
unalterable electronic audit trail that are worth looking at.
    We administer an equity order audit trail for Nasdaq 
securities that captures 100 million reportable events 
electronically every day in the life of an order, so that there 
is an electronic time-stamp when an order is received at a 
branch office--this is for an equity security--when it is 
transmitted to a trading desk, if it is modified or canceled or 
altered in any way, and that data is then batch transmitted 
overnight to NASD for analysis through our surveillance system. 
That is a kind of system with tremendous capacity that may be a 
prototype or an analogy to look at for the mutual fund industry 
so that we can get the balance right. We do not want to 
disadvantage investors, particularly retail investors, by 
shortening the trading day, but we most certainly want to close 
the loop that permitted late trading to go on.
    Senator Dodd. Ms. Richards, you want to comment?
    Ms. Richards. I would just say that the current system is 
extremely vulnerable to late trading because of the way that 
orders are processed after 4 p.m. and batched, and also because 
of the fact there are so many intermediaries that process fund 
shares that are not regulated by securities regulators. So any 
alternative solution that would encapsulate these other 
nonregulated intermediaries would have to somehow incorporate 
an oversight mechanism, as well as some requirement that would 
bring them into the fold.
    Senator Dodd. But you would agree that there are some 
inherent disadvantages in a hard close rule at 4 p.m.?
    Ms. Richards. Yes, but as an examiner I am looking for the 
permanent fix to the problem. So, I come at this from a little 
bit different point of view.
    Senator Dodd. How do you feel about the PATRIOT Act? I will 
not ask that.
    [Laughter.]
    Thank you very much, Mr. Chairman.
    Chairman Shelby. Ms. Schapiro, it is important, I believe, 
that investors receive full disclosure concerning any 
incentives that may influence a settling broker. Would you 
discuss and compare your respective rules regarding point-of-
sale disclosure?
    Ms. Schapiro. I agree with you completely, Mr. Chairman. 
The ability for a broker-dealer in terms of the funds it 
includes on its preferred list, and the ability of a broker to 
recommend a particular fund to a particular investor can be 
influenced by payments that are made either to the brokerage 
firm or to the registered rep, and investors absolutely should 
know what those incentives are that may have skewed the 
recommendation they are receiving.
    We have proposed two rules, one with respect to revenue 
sharing and buying that shelf space at the broker-dealer by the 
fund----
    Chairman Shelby. Would this be in confirmation statements?
    Ms. Schapiro. This will be at account opening time, then 
updated and posted continuously on the website of the broker-
dealer, so that when you opened your account, you would be 
told, ``We offer the following 30 mutual funds. These are the 
ones that pay us for shelf space so that we will offer them to 
you and give them a preferred spot in our supermarket.'' You 
would be able to see all 
of that information on the website, and also be told it at 
account opening time.
    The other piece would be that an investor would get, again, 
account opening or point-of-sale disclosure with respect to the 
fact that the registered rep of that broker-dealer may get a 
higher payout from his firm for offering or recommending to you 
and having you purchase a particular mutual fund. I think this 
information is absolutely critical to an investor making an 
informed decision and understanding that brokers can sometimes 
be motivated by more than just what is in the best interest of 
the investor.
    Chairman Shelby. Mr. Roye, could you discuss the role of 
the 12b -1 fees and how these fees have evolved since their 
inception? Do they still serve their intended purpose?
    Mr. Roye. 12b -1 is a rule that the Commission adopted in 
1980. It is a rule that allows funds to use fund assets to 
facilitate the distribution of fund shares. It was put in place 
in 1980 in a time when the fund industry was in net 
redemptions, and funds were shrinking, and it was a method 
believed at that time to be sort of a temporary measure to 
bring in assets to the fund, and maybe lower overall expenses. 
Investors would benefit from the use of assets to bring in 
additional monies which would then bring down fees and 
expenses.
    It has evolved over time that 12b -1 fees are effectively 
an alternative to a sales load. As you have seen, mutual fund 
sales loads dropped over the years since 1980. I think the 
maximum was 8\1/2\ percent. Now the average fund and sales load 
is somewhere around 4\1/2\, 5\1/2\ percent. So, you have seen 
the sales loads drop. But then you see 12b -1 fees being 
introduced and used as a substitute for sales loads. Indeed, 
the NASD's maximum sales load rule now treats these asset-based 
fees as the equivalent of a sales load. You have funds that can 
charge 12b -1 fees up to 100 basis points in their expenses to 
pay for distribution-related expenses.
    The Commission, as I indicated, has proposed to amend 12b -
1 to prohibit directed brokerage arrangements, whereby 
commissions, which we view as fund assets, are being used to 
facilitate distribution, perhaps being used to circumvent the 
NASD's maximum sales load rule. The Commission has asked for 
comment as to whether or not we should move further and modify 
that rule. Should the rule continue to exist, be repealed? The 
Commission also asked for comment on a different approach to 
paying for distribution expenses. Should the investor who is 
generating the distribution costs, a new investor coming in, 
rather than paying the sales load up front, pay that 
distribution expense over time, as opposed to coming out of 
fund assets. There you have the investor actually paying their 
own freight, if you will.
    Chairman Shelby. Comptroller Walker.
    Comptroller Walker. A lot has changed since 12b -1 was put 
into place, and I do think it is appropriate that the SEC 
review and reconsider whether and to what extent these 
arrangements should continue to be allowed, and to the extent 
that they decided that they should be, then additional 
disclosures might be necessary to allow investors to understand 
exactly how much we are dealing with here.
    Chairman Shelby. Ms. Richards, to the extent that you are 
permitted, could you discuss any new examination sweeps or 
targeted inspections that OCIE is conducting? For example, 
recent press 
accounts report that you are investigating potential wrongdoing 
among pension consultants and are examining index funds that 
have high expense ratios are paying soft dollars.
    Ms. Richards. Yes, sir, both of those press statements are 
accurate. We are increasing the number of mini examination 
sweeps that we conduct, targeted to particular areas where we 
believe there is a risk of violations or problems. In our 
review of investment consultants, the concern is that these 
consultants are providing advice to pension plans and other 
investors about which money managers to retain. These 
consultants may also provide other services and have other 
products that they provide to money managers. We are interested 
in the intersection between those two things, that is, whether 
the consultant in any way influenced in recommending particular 
money managers to a pension plan by the receipt of monies that 
it is receiving from money managers. We are interested in the 
conflicts of interest that may exist in this area, and the 
extent to which these consultants are disclosing the conflicts 
of interest to their customers, the pension plans. So, we 
initiated a fact-finding review of this area in December.
    The other area that we are very interested in is the use of 
soft-dollar commissions by index funds. Are index funds using 
their customers' brokerage commissions, an asset that belongs 
to the fund, to purchase research? We question why an index 
fund would need to acquire research inasmuch as it is invested 
in the index. We are again conducting a fact-finding review.
    Other areas that we are exploring are payments by mutual 
funds for shelf space, as Ms. Schapiro mentioned, valuation and 
pricing of bond funds in light of the enforcement action the 
Commission brought against Heartland Investment Advisors for 
mispricing two of its bond funds; fair value pricing by foreign 
funds; U.S. funds that are invested in foreign securities 
appropriately fair valuing the stocks in their portfolios; and 
the use of affiliated service providers by a mutual fund that 
may retain an affiliate to provide key services and how are 
those negotiations for services negotiated, for example. Are 
they negotiated at arm's length? What price does the fund pay 
for affiliated service? Performance claims by investment 
advisers is an area where there has been significant abuse in 
the past with investment advisers misrepresenting or 
overstating their performance. We are also looking at small 
fund complexes that may not have enough assets or enough 
financial ability to adequately manage their compliance 
programs, as well as a number of other areas.
    Those are examples of areas where conducting targeted mini-
sweeps are likely to indicate problems, and lead to solutions 
in a rapid fashion.
    Chairman Shelby. Ms. Schapiro, would you comment, if you 
can, on any pending or anticipating examination sweeps by NASD 
concerning the fund industry?
    Ms. Schapiro. Sure. We are still engaged in sweeps with 
respect to late trading and market timing, about 58 different 
firms under scrutiny in that area.
    Chairman Shelby. Fifty-eight?
    Ms. Schapiro. Yes, 58 firms. We are doing an intense review 
of the B-share sales, where we are looking at eight very large 
broker-dealers to understand the extent to which they engaged 
in large transactions, either single transactions or 
transactions accumulated over a period of time, in B shares 
that would have been far cheaper for the individual investor, 
had they been done in A shares. As I said in my opening 
statement, we continue to have a great concern that the most 
expensive products are not necessarily the best products being 
offered to investors.
    We have 10 firms that we are currently looking at for these 
net asset value transfers, where investors should not have been 
charged a new front-end load, but were, and so were 
overcharged.
    Chairman Shelby. Does this involve a lot of money?
    Ms. Schapiro. Yes. It involves a significant amount of 
money. And we are looking at directed brokerage in about 50 
instances, and sales contests, much like the Morgan Stanley 
case, although perhaps not quite as flamboyant.
    Chairman Shelby. In directed brokerage, you are talking 
about a lot of money here too, are you not?
    Ms. Schapiro. Yes. And bad disclosure.
    Chairman Shelby. Billions of dollars maybe?
    Ms. Schapiro. We are looking at very, very large payments, 
yes.
    Chairman Shelby. Unusual payments?
    Ms. Schapiro. Large payments, yes. Then finally, with 
respect to breakpoints, an area where we have had really 
intimate involvement, 625 firms that failed to give breakpoint 
discounts to their investors will have to be reexamined since 
we have ordered them to give those discounts with interest to 
investors, and over the next period of time, and maybe it is a 
year, we will have to go back into each of those 625 firms and 
determine that they did, in fact, fulfill their obligations to 
refund that money to investors.
    Chairman Shelby. Comptroller Walker.
    Comptroller Walker. Mr. Chairman, the only thing I would 
say is I would hope that both the SEC and the NASD are 
coordinating their related activities with the Employee Benefit 
Security Administration at the Labor Department, who has 
responsibility for enforcing the fiduciary responsibility 
provision and has a significant amount of sanctions available 
to them, both civil and criminal in dealing with illegal and 
abusive practices.
    Chairman Shelby. Ms. Richards, do you want to comment on 
that? If not, why not?
    Ms. Richards. Yes, sir, we will do so. We will communicate 
with the Department of Labor.
    Ms. Schapiro. Absolutely.
    Chairman Shelby. I thank the panel for your informative 
statements today, and we will continue our examination of the 
mutual fund industry with more hearings to come. Thank you very 
much.
    The hearing is adjourned.
    [Whereupon, at 11:40 a.m., the hearing was adjourned.]
    [Prepared statements and response to written questions 
follow:]



                 PREPARED STATEMENT OF LORI A. RICHARDS
      Director, Office of Compliance Inspections and Examinations
                U.S. Securities and Exchange Commission
                             March 10, 2004

    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, thank you for inviting me to testify today on behalf of the 
Securities and Exchange Commission concerning our examinations of 
mutual funds. With more than 95 million Americans invested in mutual 
funds, representing tens of millions of households, and approximately 
$7 trillion in assets, mutual funds are a vital part of this Nation's 
economy. Millions of investors depend on mutual funds for their 
financial security. As Chairman Donaldson said when he testified before 
this Committee in November, mutual fund investors have a right to an 
investment industry that is committed to the highest ethical standards 
and that places investors' interests first. The Commission's regulatory 
and enforcement actions, as well as actions by State securities 
regulators, are intended to prevent and deter market timing and late 
trading abuses.
    The Commission is responsible for examining mutual funds and their 
investment advisers. There are now some 8,000 funds, managed in over 
900 fund complexes, and over 8,000 investment advisers. Until recently, 
the SEC had approximately 360 staff persons for these examinations. In 
2003, budget increases allowed us to increase our staff for fund 
examinations by a third, to approximately 500 staff. The size of the 
mutual fund industry precludes a comprehensive audit of each 
registrant's operations by examination staff. Our routine examinations, 
therefore, focus on those areas that, in our view, pose the greatest 
risk to investors.
    Examinations identify compliance problems at individual firms, and 
also help to identify areas of emerging compliance risk. In recent 
years, for example, examiners have identified and Commission staff have 
addressed a number of practices that may harm investors, including, for 
example, abusive soft-dollar arrangements, favoritism in the allocation 
of investments, misrepresentations and omissions in the sales of fund 
shares, inaccurate pricing of fund shares, the failure to obtain best 
execution in portfolio transactions, sales practice abuses in the 
distribution of different classes of mutual fund shares, and the 
failure to give customers the discounts generally available on the 
large purchases of fund shares--these discounts are known as 
``breakpoints.''
    The Commission examiners, along with enforcement staff, are 
actively conducting examinations and investigations of a large number 
of market participants to determine whether they engaged in abusive and 
undisclosed market timing and late trading in fund shares. The 
preliminary results from those examinations and investigations were 
reported by Stephen Cutler, Director of the SEC's Division of 
Enforcement, in his testimony before this Committee in November, and 
the Commission has brought numerous enforcement actions and engaged in 
an aggressive rulemaking agenda as a result of the misconduct.
    Prior to September 2004, however, examination staff did not detect 
the abusive market timing or late trading arrangements that fund 
executives had with select traders. We have been reviewing examination 
protocols to identify lessons learned from these cases and evaluating 
ways that our examination oversight can be improved, both to detect 
abusive market timing specifically, and more generally to timely detect 
other types of misconduct by fund firms.
    My testimony today focuses on the changes we are making to our 
examination oversight, specifically with respect to market timing, and 
more broadly with respect to overall examination oversight generally. 
Our goal is to improve examiners' ability to identify and scrutinize 
transactions and arrangements that place the interests of fund 
shareholders at risk. Today, examiners are increasing the frequency and 
depth of examination reviews for high-risk firms; increasing the use of 
technology and data; developing new methods to identify new or emerging 
areas of compliance risk; conducting more targeted ``mini-sweep'' 
examinations to identify risk areas sooner; and working more closely 
with other staff at the Commission to highlight problems detected, and 
identify possible solutions sooner. Attached to this testimony is a 
comprehensive report on the Commission's examinations of investment 
companies and investment advisers prepared in response to the request 
made by Chairman Shelby to Chairman Donaldson on November 18, 2003. 
This report describes the examination program and these initiatives in 
greater detail, as well as recent enforcement actions brought by the 
Commission involving mutual funds.
Examination Steps to Better Detect Market Timing
    Prior to the recent revelation of market timing and late trading 
abuses, examiners reviewed trading by a fund (for example, the fund's 
purchases and sales of securities on behalf of investors), but did not 
review trading in the fund's own shares. Examiners focused on whether 
funds were trying to inflate the returns of the fund, or take on 
undisclosed risk. The concern was that, in attempting to produce strong 
investment returns to attract and maintain shareholders, fund portfolio 
managers had an incentive to engage in misconduct in the management of 
the fund. As a result, examination protocols required that significant 
attention be focused on portfolio management, order execution, 
allocation of investment opportunities, pricing and calculation of net 
asset value, advertising returns, and safeguarding fund assets from 
theft. Examinations in these areas revealed problems and deficiencies. 
Because examiners' focus was on the fund itself, and not on trading in 
the fund's shares, however, examiners did not detect aberrant trading 
patterns that could be indicative of abusive market timing.
    Although market timing in itself is not illegal, many mutual funds 
said that they discouraged the practice, and fund firms told examiners 
that the firms had appointed antimarket timing ``police'' who were 
responsible for detecting market timing trades and preventing timers 
from continued trading in their funds. The shocking development, not 
detected by examiners, was the secret complicity of some fund personnel 
in allowing select timers to continue to time.
    Based on our recent examinations, we have identified ways to better 
detect market timing. These examinations have shown that daily sales 
and redemptions data can reveal patterns of trading in a fund's shares 
that may indicate market timing, and we now have made a review of this 
data a part of every routine examination. Additionally, our review of 
funds' books and records did not reveal the covert arrangements that 
fund executives had with select shareholders, allowing them to trade 
frequently in fund shares. These arrangements appear to have been 
evidenced often only in e-mail communications and not in written 
agreements, contracts, or other documents. In the past, routine 
examinations did not include a random review of employees' internal e-
mail communications (unless there was cause to believe that particular 
communications were relevant to the examination). Now to aid in 
detecting any misconduct that might not otherwise be reflected in the 
books and records kept by the firm and shown to examiners, routine 
examinations include a review of a sample of fund executives' internal 
e-mail communications. We are now deploying software that will enable 
us to review large volumes of e-mail traffic, and we have made this a 
key element of our regular oversight.
    Additional new examination steps include a review of personal 
trading records showing trading in the fund shares by select fund 
executives (even in advance of new Commission rules that would require 
that this information be made available), and a review of procedures to 
ensure that orders are processed to receive the appropriate day's net 
asset value, including firms' procedures governing order receipt time 
and order time-stamping.
    Recent Commission rule proposals that would require better and more 
specific disclosure of funds' antimarket timing policies and a possible 
``Hard 4 p.m. Close'' for receiving fund orders would aid examiners in 
detecting abuses of this type in the future. More broadly, the 
Commission has recently adopted rules to improve compliance by funds 
and advisers by requiring that they strengthen their own internal 
compliance programs. The new rules require that advisers and funds 
implement and maintain compliance policies and procedures designed to 
prevent, detect, and correct compliance problems in key areas of their 
operations. The new rules also require that funds and advisers 
designate a chief compliance officer to implement those compliance 
policies and procedures, and, in order to assist the fund board in 
exercising compliance oversight, to report on compliance matters to the 
fund's board of directors.
    In sum, we are taking aggressive steps to address abusive timing, 
and to improve our ability to detect this type of misconduct.
Other Changes to Fund Examinations
    We are implementing other changes to SEC examinations to enhance 
our ability to detect problems, as well as to anticipate problems 
before they become widespread. This is the central goal of the 
Commission's risk assessment initiative.
    The challenge for any examination oversight program is to determine 
how best to use limited resources to oversee a large and diverse 
industry. More specifically, the challenge is to identify the areas of 
highest risk to investors, and to probe these areas effectively, while 
still providing examinations of each industry participant with 
appropriate frequency. In addition, once emerging trends and problems 
are identified, we must share our knowledge with other Divisions and 
Offices so that the Commission can bring all of its resources to bear 
on efforts to protect investors. We have implemented or are 
implementing changes that we believe will better allow us to meet these 
challenges. These changes are summarized below.
New Fund Surveillance Program
    As Chairman Donaldson announced on March 5, he has formed an SEC 
staff task force that will be drafting the outlines of a new 
surveillance program for mutual funds. This task force will examine the 
mutual fund reporting regime--looking at both the frequency of 
reporting to the Commission and the categories of information to be 
reported, as well as how new technologies can be used to enhance our 
oversight responsibilities. The goal of such a surveillance program 
would be to identify indications of problems, and then target the 
particular fund or adviser for follow up inquiry by telephone, letter, 
or on-site visit. Staff will also be able to examine the relevant 
data--industry-wide--to determine if a systemic problem is emerging.
Increased Use of Data Analysis
    Examiners have been making increased use of computer technology to 
facilitate review of large volumes of data. This has significantly 
enhanced the level of oversight possible in critical areas such as 
portfolio trading and best execution.
Interviews
    Examiners have been making increased use of interviews. More 
recently, these interviews have played a critical role when assessing a 
firm's control or risk environment.
More Frequent Examinations
    With the additional resources added to the examination program in 
2003, we are able to increase examination frequency of the largest fund 
firms, and those fund firms posing the greatest compliance risk (from 
once every 5 years, to once every 2 years). Prior to 1998, examination 
cycles had been as infrequent as once every 
12 - 24 years.
More Targeted ``Mini-Sweeps''
    To quickly identify and investigate a particular industry practice, 
and to help the Commission and staff expeditiously solve or mitigate 
the compliance risk, we have been conducting more examination sweeps 
focused on particular issues. Examples of some of the ongoing or recent 
sweeps or mini-sweeps include: Payments by mutual funds for ``shelf-
space;'' use of soft dollars by index funds, valuation and pricing of 
bond funds; fair value pricing; and practices of investment 
consultants.
Facilitating Immediate Corrective Action
    Recently, we have adopted new policies to enhance the speedy 
resolution of any problems found, including holding exit interviews 
with senior management of firms and providing deficiency letters 
directly to fund boards of directors.
Requests for Reports
    Examiners have increased their requests for written reporting by 
funds and advisers. This allows the staff to monitor compliance in 
between on-site examinations, obtain information on an expedited basis, 
and gather information on particular issues across a large number of 
firms. It also enables examiners to better manage and prioritize a 
large number of sweep examinations and focus examinations before the 
on-site portion of the review.
Collaboration with Other Commission Staff
    As noted above, we must act promptly on emerging areas of 
compliance risk. To facilitate such action, examination staff must 
share exam findings and trends with other Commission staff. Now a 
committee composed of examination, enforcement, and regulatory staff 
reviews all examinations indicating serious problems to ensure that 
appropriate findings are investigated promptly. In addition, so that 
any emerging trends are identified and made known promptly, examination 
findings and trends are shared with other Commission staff on a routine 
basis. Examiners also seek input from other Commission staff on 
possible areas of examination scrutiny.
``Benchmarking'' Examinations
    We are adopting a program to test the assumptions we use in our 
routine, risk-based examinations. Each year, we will conduct 
comprehensive ``wall-to-wall'' examinations of a select number of firms 
to test the assumptions used in our risk-based exams and to benchmark 
our procedures. These comprehensive reviews should identify weaknesses 
in our risk-based models and allow us to expand, as needed, our review 
of risky activities.
Other Areas of Examination Scrutiny
    As noted above, in addition to market timing, SEC's examiners are 
conducting sweep examinations and mini-sweep examinations designed to 
identify areas of emerging compliance risk. In routine examinations, 
examiners are also focusing on compliance risk areas. Examples of 
recent and current areas of scrutiny include: Allocations of securities 
among accounts; valuations of portfolio securities; use of soft dollars 
to pay for fund distribution; whether customers are provided with 
breakpoint and other discounts on purchases of funds; use of affiliated 
service providers; performance claims by advisers; antimoney laundering 
protections; Regulation S-P; and best execution, among other areas.
Conclusion
    As outlined in this statement, and described in greater detail in 
the attached report, we are moving aggressively to implement the 
lessons learned from recent market timing abuses, and more broadly, to 
enhance our ability to detect abuses in the fund industry.
    I would be happy to answer any questions you may have.
    Thank you.

    
    
                   PREPARED STATEMENT OF PAUL F. ROYE
              Director, Division of Investment Management
                U.S. Securities and Exchange Commission
                             March 10, 2004

Introduction
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, it is both a pleasure and an honor to testify before you 
today. On behalf of the Securities and Exchange Commission (the 
``Commission''), I am pleased to discuss the Commission's recent 
regulatory actions to protect mutual fund investors. To address the 
various abuses that have come to light in recent months, the Commission 
has embarked on a dramatic overhaul of the regulatory framework in 
which mutual funds operate. The Commission's regulatory actions, taken 
together with its recent enforcement proceedings and actions by State 
securities regulators, are intended to prevent and deter the types of 
market timing, late trading and sales practice abuses that have 
dominated the headlines in recent months. Equally important, the 
Commission's rulemaking initiatives are aimed at restoring the trust 
and confidence of investors that are crucial to the continued success 
of the mutual fund industry and preserving their key role in our 
country's economy.
    Approximately 95 million investors have entrusted over $7 trillion 
dollars to mutual funds. As mutual fund investments increasingly fund 
the most important personal goals in Americans' lives, from retirement 
and education savings to charitable giving, our Nation's investors 
rightfully look to fund managers and fund directors to act in their 
interests. Sadly, these investors have been let down, as some of those 
charged with protecting investors have willfully disregarded their 
responsibilities to act for the benefit of their investors.
    The Commission has committed its unceasing effort to holding 
accountable those who violate the Federal securities laws to abuse fund 
investors. The Commission is equally devoted to enhancing the mutual 
fund regulatory framework so that it best serves fund investors.
Commission's Regulatory Agenda
    Under Chairman Donaldson's leadership, the Commission is pursuing 
an aggressive mutual fund regulatory agenda that is focused on four 
main goals: (1) addressing late trading, market timing and related 
abuses; (2) improving the oversight of funds by enhancing fund 
governance, ethical standards, and compliance and internal controls; 
(3) addressing or eliminating certain conflicts of interest in the 
industry that are potentially harmful to fund investors; and (4) 
improving disclosure to fund investors, especially fee-related 
disclosure. Outlined below is an overview of the Commission's recent 
regulatory actions in each of these areas.
Initiatives to Address Late Trading, Abusive Market Timing,
and Related Abuses
Late Trading
    Every day hundreds of thousands of investors purchase or redeem 
shares of mutual funds. The price they pay (or receive) turns on when 
the order is submitted and to whom. Typically, funds price their shares 
at 4 p.m. Investors submitting orders before 4 p.m. receive that day's 
price; investors submitting orders after 4 p.m. get the next day's 
price. This is a simple, but very important concept known as ``forward 
pricing.'' If you can place an order to buy or sell fund shares after 4 
p.m., and still receive the price set at 4 p.m., you can profit from 
new information in the marketplace at the expense of other fund 
shareholders. The Commission's recent review of the largest brokers 
that sell fund shares identified numerous instances of late trading of 
fund shares. It is just plain cheating, and something that clearly 
violates existing Commission rules.
    The current rules permit a large number of intermediaries that 
accept or transmit trades in fund shares to determine whether the order 
will receive that day's 4 p.m. price. Typically, investor trades are 
accepted throughout the business day by fund transfer agents, as well 
as brokers, banks, and retirement plan administrators--so-called fund 
intermediaries. These intermediaries pass on orders to fund companies 
in batches at the end of the day after 4 p.m. They are only supposed to 
pass on orders they receive before 4 p.m. This system, which was first 
created 35 years ago, relies heavily on the honesty of fund 
intermediaries to segregate orders based on the time they are received 
and then playing by the rules.
    We know today that this system failed. In order to help favored 
customers, certain intermediaries have ``blended'' legitimate (pre-4 
p.m. orders) with late trades (post-4 p.m. orders). In some cases, fund 
managers participated in the scheme; but in many cases they were the 
victims of dishonesty along with fund investors. The problem is that 
fund companies have no way of identifying a late trade when it is 
bundled with legitimate trades and submitted to the fund company in the 
evening hours. There are potentially enormous profits to be gained by 
late trading, and all of those profits come out of the pockets of 
mutual fund investors.
    To address this abuse, the Commission proposed the so-called ``Hard 
4 p.m. Close'' rule. This proposal would require that a fund or a 
certified clearing agency, such as NSCC--rather than an intermediary 
such as a broker-dealer or other unregulated party--receive a purchase 
or redemption order prior to the time the fund prices its shares 
(which, as previously stated, is typically 4 p.m.) for an investor to 
receive that day's price. We believe that this rule amendment will 
provide for a secure pricing system that would be highly immune to 
manipulation by late traders.
    We are currently analyzing the comment letters we received during 
the comment period on this proposal, which closed on February 6th. 
While we believe the proposed rule amendment would virtually eliminate 
the potential for late trading through intermediaries that sell fund 
shares, it is clear from the comments that some believe that the hard 4 
p.m. rule is not the preferred approach. They argue that it will 
require the intermediaries to have cut-offs for orders well before 4 
p.m. and limit investor opportunities to place orders for fund 
transactions, particularly in the 401(k) context. Consequently, we are 
studying other approaches to addressing this issue. We do not want to 
adversely impact fund investors if there are alternatives that 
effectively--truly effectively--address late trading abuses.
Market Timing
    The Commission has taken a number of steps to address abusive 
market timing of mutual funds. Short-term trades in mutual fund shares 
impose costs on funds and their long-term investors. Some market timers 
attempt to purchase and redeem fund shares to take advantage of market 
actions they believe will occur in the 
future. Other types of market timers attempt to more directly take 
advantage of the fund's long-term shareholders by exploiting how funds 
calculate their net asset value. These ``arbitrage market timers'' buy 
and sell shares of funds if they believe that the fund's calculation of 
net asset value significantly lags behind the current value of a fund's 
portfolio securities, typically in international funds or other funds 
that invest in thinly traded securities. Over time, the long-term 
shareholders in a fund will, in effect, pay the costs of the short-term 
shareholders' transactions and have the value of their fund shares 
diluted through the activity of arbitrage market timers.
Fair Value Pricing
    To help prevent ``arbitrage market timing,'' the Commission has 
stressed that ``fair value pricing'' is a critical tool in effectively 
reducing or eliminating the profit that many market timers seek. The 
Investment Company Act requires funds to calculate their net asset 
values using the market value of portfolio securities when market 
quotations are readily available. If a market quotation for a portfolio 
security is not readily available (or is unreliable), the fund must 
establish a ``fair value'' for that security, as determined in good 
faith by the fund's board of directors. Fair value pricing can minimize 
market timing, and eliminate dilution of shareholders' interests. In a 
recent release adopting the new compliance procedures rule, the 
Commission reiterated the obligation of funds to fair value their 
securities to reduce market timing arbitrage opportunities. 
Additionally, the Commission has proposed improved disclosure of a 
fund's policies and procedures regarding fair value pricing. SEC staff 
are currently gathering information regarding funds' fair value pricing 
practices and evaluating whether to recommend additional measures to 
improve funds' fair value pricing. The Commission has also sought 
public comment on the need for additional guidance or rulemaking in 
this area.
Mandatory Redemption Fee
    In a further effort to reduce the profitability of abusive market 
timing, the Commission just late last month put forth a proposal that 
would require funds to impose a mandatory 2 percent redemption fee when 
investors redeem their shares within 5 business days. This fee would be 
payable to the fund, for the direct benefit of fund shareholders, 
rather than to the management company or any other service provider.
    The 2 percent fee is designed to strike a balance between two 
competing policy goals of the Commission--preserving the redeemability 
of mutual fund shares and reducing or eliminating the ability of 
shareholders who frequently trade their shares to profit at the expense 
of their fellow shareholders. Combined with fair value pricing, the 
Commission felt that the rule would make market timing less profitable, 
and therefore reduce the incentive to engage in market timing. The 
Commission is considering whether a 2 percent redemption fee is an 
appropriate approach to addressing short-term trading, including 
abusive market timing.
Enhanced Disclosure Related to Abusive Activities
    The Commission also has proposed enhanced disclosure requirements 
in order to combat abuses in the areas of market timing and the related 
issue of selective disclosure of portfolio holdings. These enhancements 
are intended to deter abusive practices and to enable investors to 
better understand a fund's policies in these areas. The Commission 
proposed amendments to require more open and unambiguous disclosure 
with respect to the methods that mutual funds use to combat market 
timing activity. Among other changes, the Commission's proposed reforms 
would:

 Require a mutual fund to describe in its prospectus the risks 
    that frequent purchases and redemptions of fund shares may present 
    for other fund shareholders.

 Require that a mutual fund state in its prospectus whether the 
    fund's board of directors has adopted policies and procedures with 
    respect to frequent purchases and redemptions of fund shares. If 
    the board has not adopted any such policies and procedures, the 
    fund's prospectus would be required to state the specific basis for 
    the view of the board that it is appropriate for the fund not to 
    have such policies and procedures.

 Mandate that a fund describe with specificity any policies and 
    procedures for deterring frequent purchases and redemptions of fund 
    shares, and any arrangements that exist to permit frequent 
    purchases and redemptions of fund shares. This description must 
    include any restrictions on the volume or number of purchases, 
    redemptions, or exchanges that a shareholder may make, any exchange 
    fee or redemption fee, and any minimum holding period that is 
    imposed before an investor may make exchanges into another fund. 
    Moreover, a fund would be required to indicate whether each 
    restriction applies uniformly in all cases, or whether the 
    restriction will not be imposed under certain circumstances, and to 
    describe any such circumstances with specificity.
Selective Disclosure of Portfolio Holdings
    The Commission also proposed amendments intended to provide greater 
transparency of fund practices with respect to the disclosure of a 
fund's portfolio holdings. Specifically, a fund would be required to 
describe its policies and procedures with respect to the disclosure of 
its portfolio securities, including any arrangements to make available 
information about the fund's portfolio securities, the identity of any 
persons who receive such information, and any compensation or other 
consideration received by a fund or its investment adviser in 
connection with such arrangements. These amendments do not alter the 
requirement that a mutual fund or investment adviser may disclose a 
fund's portfolio of investment securities only if the disclosure of 
such information is consistent with the antifraud provisions of the 
Federal securities laws and the fiduciary duties owed to fund 
shareholders.
    This new disclosure requirement should have the effect of requiring 
fund management to carefully assess the propriety and circumstances 
under which portfolio holding information is divulged, as well as 
inform fund investors of the fund's policies in this area.
Initiatives to Enhance Fund Oversight
    The recent mutual fund scandals have highlighted the need to 
improve oversight of the industry, and the Commission has undertaken 
several initiatives on this front. These initiatives are designed to 
strengthen the hand of the fund's board and to provide the directors, 
particularly the independent directors, additional tools with which to 
protect fund investors, as well as reinforce ethical standards.
Fund Governance
    In January, the Commission proposed a comprehensive rulemaking 
package to bolster the effectiveness of independent directors and to 
enhance the role of the fund board as the primary advocate for fund 
shareholders. The proposals included a requirement for: (i) an 
independent board chairman; (ii) 75 percent independent directors; 
(iii) independent director authority to hire, evaluate, and fire staff; 
(iv) quarterly executive sessions of independent directors outside the 
presence of management; (v) an annual board self-evaluation; and (vi) 
preservation of documents used by boards in the contract review 
process.
    This significant overhaul of the composition and the workings of 
fund boards is intended to establish, without ambiguity, the dominant 
role of independent directors on a fund's board. With an independent 
board chairman and with independent directors representing at least 75 
percent of a fund's board, the independent directors will set the board 
agenda, as well as have the power to control the outcome of board 
votes.
    The very nature of external management that characterizes the U.S. 
fund industry creates conflicts of interest, particularly when 
personnel of fund advisers may be tempted by opportunities to benefit 
the adviser over fund shareholders. While not a guarantee that all 
conflicts of interest will be resolved in the best interests of 
shareholders, a board composed of an independent chairman and a super-
majority of independent directors is more likely to be an effective 
check on management, particularly when so much of the board's 
responsibility involves policing the management company's conflicts of 
interest.\1\ As Chairman Donaldson recently commented, ``a fund board 
can be more effective when negotiating with the fund adviser over 
matters such as the management fee, if it were not at the same time led 
by an executive of the adviser with whom the board is negotiating.''
---------------------------------------------------------------------------
    \1\ At the open meeting at which the Commission proposed the rule, 
Commissioners Glassman and Atkins questioned whether an independent 
chairman would in fact provide a more effective check on management and 
thus be more effective in promoting shareholder interests.
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    By empowering independent fund directors to retain staff, in 
conjunction with the role envisioned for the newly-required chief 
compliance officer, the Commission's proposals emphasize the importance 
of boards relying on experts other than advisory personnel to provide 
information in appropriate circumstances. In addition, reinforcing the 
ability of the board to hire staff recognizes that directors often must 
make decisions on issues about which they may need to seek out 
expertise, such as the fair value pricing of portfolio securities.
    Boards would also be required to perform a thorough self-evaluation 
in order to identify structural changes and processes that might enable 
the board to be a more potent advocate for shareholder interests. 
Boards would be required to assess periodically whether they are 
organized to maximize their effectiveness. As part of this evaluation, 
boards would consider the number of fund boards on which individual 
board members sit, as well as consider the nature and effectiveness of 
their board committee structures.
    As part of its effort to enhance fund governance, the Commission 
has proposed to mandate that funds keep copies of the materials 
directors considered when reviewing the fund's advisory contract each 
year. This amendment is designed to give the Commission's examinations 
staff access to the information on which directors rely when performing 
this crucial function. This requirement also could have the effect of 
focusing directors on this key information, since they would be aware 
that it will be subject to Commission scrutiny.
Adviser Codes of Ethics and Fund Transactions Reporting
    The Commission recently proposed that all registered investment 
advisers adopt codes of ethics. Investment advisers are fiduciaries, 
and owe their clients a series of duties enforceable under the 
Investment Advisers Act's antifraud provisions. This bedrock principle, 
which historically has been a core value of the money management 
business, appears to have been lost on a number of advisers and 
advisory 
personnel.
    The Commission believes that prevention of unethical conduct by 
advisory personnel is part of the answer to avoiding the problems we 
have encountered recently. Consequently, the code of ethics would set 
forth standards of conduct for advisory personnel that reflect the 
adviser's fiduciary duties, as well as codify requirements to ensure 
that an adviser's supervised persons comply with the Federal securities 
laws, and require that supervised persons receive and acknowledge 
receipt of a copy of the code of ethics. In addition, the code of 
ethics must include provisions that address the safeguarding of 
material nonpublic information about client transactions, reporting 
promptly any violations of the code of ethics, and mandating 
preclearance of personal investments in initial public offerings and 
private offerings.
    Finally, the ethics code is designed to address conflicts that 
arise from the personal trading of advisers' employees. A principal 
feature of the code of ethics rule is a requirement that certain 
advisory personnel, referred to as access persons, must report their 
personal securities holdings and transactions, including transactions 
in any mutual fund managed by the adviser or an affiliate. The rule 
would close a loophole in the Investment Company Act under which 
investment company personnel have not been required to report trading 
in shares of funds they manage. This loophole became apparent when, 
unfortunately, fund personnel were discovered market timing their own 
funds.
Compliance Policies and Compliance Officer
    In an action we expect to have a far-reaching positive impact on 
mutual fund operations and compliance programs, the Commission in 
December adopted rules that require funds and their investment advisers 
to have comprehensive compliance policies and procedures in place, and 
to designate a chief compliance officer. In the case of a fund, the 
chief compliance officer would be answerable to the fund's board and 
fired only with the board's consent.
    The compliance officer has dual roles: First, as the primary 
architect and enforcer of compliance policies and procedures for the 
fund; second, and perhaps more importantly, as the eyes and ears of the 
board on all compliance matters. The chief compliance officer, at the 
behest of the board, is expected to strengthen the board's hand of 
compliance oversight into the details of the operations of funds and 
advisers, where compliance lapses and abuses often germinate and remain 
hidden from even the most watchful board. In order to support the 
``watchdog'' role of the compliance officer, the rules require the 
chief compliance officer to meet in executive session with the 
independent directors at least once each year, outside the presence of 
fund management and the interested directors. This executive session 
will create an opportunity for open dialogue between the chief 
compliance officer and the independent directors and encourage the 
compliance officer to speak freely about any sensitive compliance 
issues, such as any reservations about the cooperativeness or 
compliance practices of fund management. To insulate a chief compliance 
officer from the pressures, real or perceived, brought to bear by fund 
management, a fund's board, including a majority of the independent 
directors, must approve the chief compliance officer's compensation, as 
well as any changes in compensation.
    To further encourage a culture of compliance among fund officers 
and personnel of fund advisers, the compliance rule calls for funds and 
advisers to adopt policies and procedures designed to lessen the 
likelihood of securities law violations. The adequacy of these policies 
and procedures must be reviewed at least annually in order to ensure 
that fund directors assess whether internal controls and procedures are 
working well and whether certain areas can be improved.
    An active and independent board of directors, supplied with 
reliable information as to the effectiveness of compliance programs and 
procedures, can serve as an 
important check against abuse and fraud on the part of fund management.
Initiatives Aimed at Conflicts of Interest
    In addition to the matters outlined above, the Commission is 
undertaking a series of initiatives aimed at certain conflicts of 
interest involving mutual funds and those who distribute fund shares.
Directed Brokerage
    Last month, the Commission voted to propose an amendment to Rule 
12b -1 to prohibit the use of brokerage commissions to compensate 
broker-dealers for distribution of a fund's shares. Effectively, this 
proposal would ban so-called directed brokerage practices by mutual 
funds. When Rule 12b -1 was adopted by the Commission in 1980, the 
Commission thought that it would be relatively benign to permit funds 
to consider distribution when making brokerage allocation decisions. 
However, in recent years, it has become clear that the practice of 
directing a fund's brokerage to a broker or dealer as compensation for 
distribution of a fund's shares presents opportunities for abuse. 
Advisers to funds are allocating brokerage commissions to pay for 
distribution when they could seek lower commission rates, rebates to 
the fund, or reduce custody, transfer agency or other fund costs. The 
use of directed brokerage to pay for distribution benefits fund 
advisers by increasing their advisory fees, which generally are based 
on the size of fund assets, and lowering the amount they have to spend 
on distribution out of their own assets. The conflicts of interest that 
surround the use of brokerage commissions (which, of course, are fund 
assets) to finance distribution can harm funds and their shareholders. 
Directed brokerage practices potentially could compromise best 
execution of portfolio trades, increase portfolio turnover, conceal 
actual distribution costs, and corrupt broker-dealers' recommendations 
to their customers. Therefore, the Commission has proposed to ban these 
types of arrangements.
Rule 12b -1
    At the same time, the Commission voted to request comment on the 
need for additional changes to Rule 12b -1. Over time, Rule 12b -1 has 
come to be used in ways that exceed its original purpose. Consequently, 
the Commission is seeking comment on whether Rule 12b -1 continues to 
serve the purpose for which it was intended and whether it should be 
repealed. To address concerns that Rule 12b -1 fees have replaced sales 
loads in many cases, the Commission also requested comment on an 
alternative approach to Rule 12b -1 that would require distribution-
related costs to be deducted directly from shareholder accounts rather 
than from fund assets. Under this approach, a shareholder would pay the 
same sales load regardless of when the load is paid. An investor could 
pay the load at the time of purchase or over the period of the 
investment, with any remaining load paid upon redemption. This approach 
may have a number of advantages: First, actual sales charges would be 
clear to investors; second, existing shareholders would not pay for 
sales to new investors; and third, long-term shareholders would not pay 
12b -1 fees that may exceed their fair share of distribution costs.
Soft Dollars
    Chairman Donaldson has made the issue of soft dollars a priority 
and has directed the staff to explore the problems and conflicts 
inherent in soft-dollar arrangements and the scope of the safe harbor 
contained in Section 28(e) of the Securities Exchange Act. The 
Divisions of Market Regulation and Investment Management are working 
together to conduct this review. A primary area of focus is whether the 
current definition of qualifying ``research'' under the safe harbor is 
too broad and should be narrowed by rulemaking. The Commission has also 
sought public comment on whether it would be possible to require mutual 
fund managers to identify the portion of Commission costs that purchase 
research services from brokers so as to enhance the transparency of 
these arrangements.
Initiatives to Improve Fund Disclosure, Including Fee-Related 
        Information
    The Commission is quickly progressing on its continued effort to 
improve fund disclosures and highlight for investors fee-related 
information. This effort began long before mutual fund scandals hit the 
headlines, and Chairman Donaldson has identified improved disclosure as 
a priority for the Commission's mutual fund program.
Shareholder Reports Disclosure
    The level of a fund's expenses, over time, has a significant impact 
on a fund shareholders' investment experience. The Commission has 
wrestled for years with the problem of how to convey expense 
information to investors in a cost-effective way that permits investors 
to compare funds and to understand and appreciate the effect that 
expenses have on their investment. Last month, the Commission voted to 
significantly revise mutual fund shareholder report disclosures to 
assist investors in understanding these expenses. Shareholder reports 
will now be required to include dollar-based expense information for a 
hypothetical $1,000 investment. Using that information, investors can 
then estimate the dollar amount of expenses paid on their investment in 
a fund. Shareholder reports also will contain the dollar amount of 
expenses an investor would have paid on a $1,000 investment in the 
fund, using an assumed rate of return of 5 percent. Using this second 
dollar-based number, investors can compare the level of expenses across 
various potential fund investments. Increased transparency of fees 
should enhance fee-based competition in the fund industry.
    This initiative also includes significantly improved disclosure to 
investors about a fund's investments. The recent amendments will 
replace a one-size-fits-all approach to portfolio holdings disclosure, 
where all funds deliver their full portfolio schedules to all their 
shareholders twice a year, with a layered approach that will make more 
information available, while permitting investors to tailor the amount 
of information they receive to meet their particular needs. The 
additional quarterly disclosure of fund portfolio holdings will enable 
interested investors, through more frequent access to portfolio 
information, to better monitor whether, and how, a fund is complying 
with its stated investment objective. The amendments also require 
shareholder reports to include tables, graphs, or charts that 
concisely, and in a user-friendly format, effectively convey key 
information about a fund's portfolio. Finally, management's discussion 
of fund performance is now required to appear in annual shareholders 
reports, and should assist investors in assessing the fund's 
performance over the prior year. This package of initiatives will 
provide better information to investors regarding fund costs, 
investments, and fund performance.
    At the same time as it adopted these revisions, the Commission 
proposed to require disclosure in fund shareholder reports about how 
fund boards evaluate investment advisory contracts. A fund's board of 
directors plays a key role in negotiating and approving the terms of 
the advisory contract between the fund and the investment adviser who 
is charged with its management. The Commission is proposing to make 
this process more transparent to fund shareholders. The disclosure 
would include discussion of the material factors considered by the 
board and the conclusions with respect to those factors that formed the 
basis for the board's approval or renewal of the advisory contract. In 
making this proposal, the Commission is seeking to promote insightful 
disclosure of the board review process, rather than meaningless 
boilerplate that is not helpful to investors. Transparency of fees, 
informed investors and independent, vigorous boards of directors will 
allow the market to determine appropriate fee levels. This proposal 
should encourage fund boards to consider investment advisory contracts 
more carefully and encourage investors to consider more closely the 
costs and value of the services rendered by the fund's investment 
advisers.
Fund Advertising
    In September, the Commission adopted amendments to raise the 
standards for mutual fund performance advertising. The amended rules 
require that fund advertisements state that investors should consider 
fees, as well as investment objective and risks, before investing and 
that advertisements direct investors to a fund's prospectus to obtain 
additional information about fees, investment objectives and risks. The 
rules also require more balanced information when mutual funds 
advertise performance, as well as provide ready access to more timely 
performance information.
Mutual Fund Confirmation Form and Point-of-Sale Document
    In a major proposal issued in January, the Commission proposed 
significant revisions to mutual fund confirmation forms and also 
proposed the first-ever point-of-sale disclosure document for brokers 
selling mutual fund shares. Together, these two proposals would greatly 
enhance the information that broker-dealers provide to their customers 
in connection with mutual fund transactions.
    The proposals call for disclosure of targeted information, at the 
point-of-sale and in transaction confirmations, regarding the costs and 
the conflicts of interest that arise from the distribution of mutual 
fund shares. The point-of-sale document would provide information to 
investors prior to transactions in mutual fund shares regarding the 
distribution-related costs that the customers would be expected to 
incur in connection with the transaction, including information 
regarding the sales loads, asset-based sales charges and services fees 
paid out of fund assets, whether the broker-dealer receives revenue 
sharing payments or portfolio brokerage commissions from the fund 
complex, as well as whether it pays differential compensation in 
connection with different classes of shares or proprietary products. 
The new mutual fund confirmation form incorporates and quantifies these 
same disclosures. In an effort to ensure that these disclosure 
documents will be as meaningful as possible to investors, the 
Commission has directed the staff to gather information from 
investors--through educational summits, focus groups and other means--
so that the Commission has meaningful input from the actual investors 
who will benefit from these disclosures.
Breakpoints Disclosure
    In light of the wide-scale failure to provide appropriate 
breakpoint discounts on front-end load mutual fund purchases, the 
Commission in December proposed improved prospectus disclosure about 
fund breakpoints. This disclosure is designed to highlight for 
investors the availability of breakpoint discounts and implements 
recommendations made by a Joint NASD/Industry Taskforce that convened 
to study and make recommendations to improve the identification and 
processing of breakpoint opportunities for fund investors.
Transaction Costs Concept Release
    Also in December, the Commission issued a concept release 
requesting comment on methods to calculate and improve the disclosure 
of funds' portfolio transaction costs. Transaction costs can represent 
a significant portion of the overall expenses incurred by a mutual 
fund. Although transaction costs are taken into account in computing a 
fund's total return, there is a concern that investors do not fully 
understand the impact of transaction costs on their fund investments 
because those transaction costs are not separately disclosed in a 
fund's expense table. However, there is no agreed-upon, uniform method 
for the calculation of fund transaction costs. Thus, the Commission 
issued its concept release to elicit helpful commentary to guide us as 
we pursue this issue.
Portfolio Managers
    Finally, on March 11, the Commission is considering new proposals 
to improve disclosure to fund shareholders about their portfolio 
manager's relationship with the fund. These proposals include 
disclosure regarding the structure of portfolio manager compensation, 
ownership of shares of the funds that a manager advises, and 
comprehensive disclosure of specific investment vehicles, including 
hedge funds and pension funds, that are also managed by the mutual 
fund's portfolio manager. This proposal will also require clear 
disclosure as to who is managing a fund, addressing the current 
requirement that allows advisers to use a portfolio management team to 
avoid identifying the principal managers of the fund.
Conclusion
    As should be evident, the Commission has been extremely busy in 
proposing and adopting rules that are designed to protect our Nation's 
mutual fund investors. Our focus has been directed not only on 
addressing the harms of late trading, abusive market-timing and related 
abuses, but also on strengthening the mutual fund oversight and 
regulatory framework to minimize the possibility that these and other 
potential abuses arise in the future and on taking steps to provide 
meaningful and useful disclosure to facilitate informed decisionmaking 
on the part of mutual fund investors. Again, I would like to thank you 
for the opportunity to be here today to discuss the Commission's recent 
regulatory actions to protect mutual fund investors. I would be pleased 
to answer any questions you may have.

                               ----------
                 PREPARED STATEMENT OF MARY L. SCHAPIRO
      Vice Chairman and President, Regulatory Policy and Oversight
           National Association of Securities Dealers (NASD)
                             March 10, 2004

    Mr. Chairman and Members of the Committee, NASD would like to thank 
the Committee for the invitation to submit this written statement for 
the record.
NASD
    NASD is the world's preeminent private sector securities regulator, 
established in 1939 under authority granted by the 1938 Maloney Act 
Amendments to the Securities Exchange Act of 1934. We regulate every 
broker-dealer in the United States that conducts a securities business 
with the public--nearly 5,200 securities firms that operate more than 
92,000 branch offices and employ more than 663,000 registered 
representatives.
    Our rules comprehensively regulate every aspect of the brokerage 
business, and NASD examines broker-dealers for compliance with NASD 
rules, MSRB rules, and the Federal securities laws--and we discipline 
those who fail to comply. Last year, 2003, NASD filed a record number 
of new enforcement actions (1,410) and barred or suspended more 
individuals (827) from the securities industry than ever before. Our 
market integrity and investor protection responsibilities include 
examination, rule writing, professional training, licensing and 
registration, dispute resolution, and investor education. NASD monitors 
all trading on the Nasdaq Stock Market--more than 70 million orders, 
quotes, and trades per day. NASD has a Nationwide staff of more than 
2,000 and is governed by a Board of Governors, more than half of whom 
are unaffiliated with the securities industry.
NASD Oversight of Mutual Fund Sales
    Millions of Americans invest in mutual funds each year. The NASD is 
deeply 
disturbed by recent revelations of a wide range of abuses that 
undermine the confidence of mutual fund investors and the integrity of 
the industry. Portfolio managers have traded ahead of mutual fund 
investors, released portfolio information differentially and 
selectively, and made deals with preferred customers to permit market 
timing and late trading. NASD does not have jurisdiction or authority 
over mutual funds or their advisers. Nevertheless, we do regulate 
broker-dealers who sell mutual funds, including mutual fund 
underwriters. Broker-dealer participation in illegal or unethical sales 
practices in the sale of mutual fund shares is a matter of immediate 
concern to NASD.
    NASD reviews mutual fund advertisements, whether they appear in a 
magazine or newspaper, radio or television commercial. We vigorously 
enforce our suitability rule and our prohibition against compensation 
arrangements that create unacceptable conflicts of interest in the sale 
of mutual fund shares.
    During 2003 and 2004, NASD brought more than 80 enforcement actions 
for violations concerning the sale of mutual funds and pooled 
investment products. The violations in these cases included suitability 
of the mutual fund share classes that brokers recommended, sales 
practices, improper disclosures, and compensation arrangements between 
the funds and brokers. These actions bring to more than 200 the number 
of cases NASD has taken in the investment company area since 2000. In 
addition, and most recently, NASD has brought enforcement actions 
dealing with market timing and the improper failure of a broker-dealer 
to waive certain sales charges, and 15 cases involving the failure to 
deliver breakpoint discounts on shares with front-end load sales 
charges.

NASD Oversight of Mutual Fund Advertising
    The NASD requires that all advertisements and other sales material 
issued by broker-dealers be fair, balanced, and not misleading. Every 
mutual fund advertisement distributed through the media and every 
mutual fund sales brochure issued by a broker-dealer must be filed with 
NASD. We review these advertisements and sales pieces to ensure that 
they comply with the highest standards of fair and balanced disclosure. 
This undertaking is significant: In 2003, NASD reviewed over 80,000 
investment company sales pieces.
    When a broker-dealer's mutual fund sales material fails to meet 
applicable standards, NASD staff directs the firm either to revise the 
material to meet applicable standards or to stop using the material 
entirely. NASD also brings enforcement actions against broker-dealers 
that violate our advertising rules.
    One of the most important issues that NASD has addressed in our 
administration of the advertising rules concerns the manner in which 
mutual funds advertise their past performance. Too often, mutual fund 
advertisements stress their impressive past performance by the 
advertised fund, without providing balanced disclosure concerning the 
fees and the expenses that investors incur when they purchase and own 
shares of the fund. Yet these fees and expenses can have a significant 
impact on the long-term future performance of a mutual fund investment 
an investor makes today.
    In December, NASD proposed to amend our advertising rules to 
require that every advertisement that promotes a mutual fund's 
performance also presents the fund's fees and expenses in a prominent 
text box, not in a footnote. This would include the fund's maximum 
front-end and back-end sales load, if any, and the fund's ongoing 
expense ratio, including any 12b -1 fees. The proposal also would 
require that the text box contain the standardized 1-, 5-, and 10-year 
total return performance required by the SEC.
    This proposal, which NASD filed with the SEC earlier this week, 
would help investors compare mutual funds and would make the costs of 
purchasing and owning mutual funds more apparent. NASD looks forward to 
working with the SEC staff on this proposal and to its prompt adoption 
and implementation.

Compensation Arrangements between Brokers and Funds
    NASD recognizes that compensation arrangements between mutual funds 
and brokers can inappropriately influence the investment 
recommendations that brokers make to their retail customers. 
Accordingly, NASD has taken a number of steps, both in terms of 
rulemaking and enforcement of existing rules, to help ensure that 
investors are protected from misleading practices.

Noncash Compensation
    NASD prohibits most forms of noncash compensation, such as luxury 
cruises, trips and lavish entertainment, for the sale of mutual fund 
shares. These compensation arrangements present a conflict of interest 
for sales personnel and interfere with the ability of regulated firms 
to supervise their sales forces. In September 2003, NASD sanctioned 
Morgan Stanley DW, Inc. and fined the firm $2 million for sponsoring 
sales contests that awarded meals, trips, concert tickets, and other 
prizes to sales representatives that met certain sales targets and 
favored Morgan Stanley proprietary funds. NASD also charged Morgan 
Stanley and the head of its retail sales division with supervisory 
violations, because Morgan Stanley failed to have any supervisory 
systems or procedures in place to detect and prevent this widespread 
misconduct.

Directed Brokerage Compensation
    NASD rules have long addressed the possibility that a mutual fund 
may direct its portfolio brokerage to a broker-dealer in exchange for 
the broker-dealer's commitment to feature or promote the sale of the 
fund's shares. Such an arrangement presents a potential conflict of 
interest for the investment adviser to the mutual fund, who must 
execute the fund's portfolio transactions; it also presents a conflict 
for the broker-dealer, who may recommend fund shares to its customers 
in order to reap brokerage commissions from the fund. NASD prohibits 
any broker-dealer from accepting brokerage commissions from a mutual 
fund as a condition to favoring the sale of the fund's shares. 
Exchanging prominent placement of a fund or family of funds on a firm's 
website or in the firm's marketing material or placing a fund on a 
``featured'' or ``preferred'' list of funds in exchange for brokerage 
commissions from the fund may be misleading to investors and is a 
violation of NASD rules.
    In November 2003, NASD and the SEC sanctioned and fined Morgan 
Stanley $50 million for violations of this rule due to its use of 
directed brokerage arrangements to promote sales of its proprietary 
funds. In return for brokerage commissions and other payments, Morgan 
Stanley gave 16 of 115 mutual fund families it sold preferential 
treatment, including placement on a ``preferred list'' of funds that 
financial advisers were to look to first in making recommendations of 
fund products; higher visibility on Morgan Stanley's sales systems and 
workstations; eligibility to participate in the firm's 401(k) programs 
and to offer offshore fund products to Morgan Stanley customers; better 
access to its sales force and branch managers; and payment of special 
sales incentives to Morgan Stanley financial advisers.
    NASD recently proposed to expand these directed brokerage 
prohibitions. Under our proposal, a broker-dealer would be prohibited 
from selling shares of any mutual fund that even considers its fund 
sales as a factor in selecting a broker-dealer to execute its trades. 
The SEC has proposed a similar amendment to its Rule 12b -1.

Revenue Sharing and Differential Compensation
    In September 2003, NASD proposed new rules to address ``revenue 
sharing'' and ``differential compensation'' arrangements. Frequently, 
mutual funds seek to improve the sales of their shares by paying for 
``shelf space'' at a broker-dealer. This practice, commonly known as 
``revenue sharing,'' can take a variety of forms, including sharing of 
advisory fees, direct cash payments, and reimbursing brokers for their 
sales and training-related expenses. Our rule proposal would require 
every broker-dealer to disclose to its customers whether the firm 
accepts revenue sharing payments from funds. The broker-dealer would 
have to list the funds in order based on the amount of revenue sharing 
received. Broker-dealers also would have to periodically update the 
list of funds that pay revenue sharing to the firm and make the list 
available through a website, toll-free telephone number, or customer 
mailings.
    In addition, some broker-dealers may pay ``differential 
compensation'' to their sales force. Under these arrangements, a 
broker-dealer may pay its sales representatives higher compensation for 
the sale of certain funds, such as a firm's proprietary fund family or 
funds that pay revenue sharing to be included on a preferred list. Our 
proposal would require broker-dealers to disclose these differential 
compensation arrangements to their customers and to name the funds that 
benefit from these arrangements.
    The SEC recently issued its own proposal that would require brokers 
to make similar disclosures regarding revenue sharing and differential 
cash compensation at the point-of-sale and as part of a customer's 
sales confirmation statement. We are reviewing this proposal and we 
will work with the SEC both on its proposal and on how best to proceed 
with our own rule proposal.

Suitability of the Fund Sales
    Many mutual funds offer different classes of the same investment 
portfolio. Each class provides broker-dealers and their customers with 
a choice of distribution fee structure. For example, Class A shares 
charge a ``front-end'' sales load when the customer purchases shares 
and they may impose an ongoing distribution fee, called a Rule 12b -1 
fee. Class B shares do not impose a ``front-end'' sales load, but they 
do impose higher annual Rule 12b -1 fees which are assessed over the 
first 6 to 8 years of their investment or until they convert into Class 
A shares. Class B shares normally impose a ``contingent deferred sales 
charge'' (CDSC) which a customer pays if the customer sells the shares 
within first six or eight years. This CDSC declines over time during 
that 6- or 8-year period. Class C shares usually do not impose a front-
end sales load, but often impose a load if a customer sells shares 
within a short time of purchase, usually 1 year. Class C shares 
typically impose higher Rule 12b -1 fees than Class A shares, and, 
unlike Class B shares, do not convert into a lower expense class 
following a specified holding period.
    While Class A shares impose a front-end sales load, most mutual 
funds offer a reduced load, or ``breakpoint,'' for large purchases. 
NASD has found that some broker-dealers have recommended Class B shares 
in such large amounts that the customer would have qualified for 
significant breakpoint discounts had the broker-dealer recommended 
Class A shares instead. Some broker-dealers also have recommended 
transactions in Class B shares that are so frequent as to cause the 
customer to incur CDSC charges. In both cases, the broker may receive 
higher compensation for the Class B recommendations. NASD has 
vigorously prosecuted these violations of our rules, and we are 
continuing our comprehensive monitoring of Class B share sales 
practices. Over the last 2 years, NASD has brought more than a dozen 
enforcement actions against firms and individual brokers for these 
types of violations. Currently, NASD has more than 50 active 
investigations in this area.

Discounts for Customers
    One area that has been a focus for NASD in recent months is 
reviewing whether brokers are giving their customers all the discounts 
and waiver of sales charge benefits to which they are entitled when 
buying certain funds.

NAV Transfer Programs
    Some mutual fund families offer programs that essentially permit a 
customer to exchange shares from another fund family at the new fund's 
net asset value (NAV), without paying the front-end sales load. These 
programs permit customers to purchase Class A shares without paying a 
front-end sales load, if in purchasing those shares the customer used 
proceeds from a recent redemption of shares of another load fund. 
Investors who qualify for NAV transfer programs have no reasonable 
basis to purchase any class of shares other than Class A shares.
    Last month, the NASD brought the first enforcement action involving 
a broker-dealer's failure to obtain sales load waivers for mutual fund 
customers through these NAV transfer programs. NASD fined AXA Advisors, 
LLC $250,000 for these failures. We also jointly fined a senior vice 
president of the firm $50,000.
    NASD found that the firm failed to have an adequate supervisory 
system in place to identify and provide customers with sales charge 
waivers to which they were entitled. We determined that, from February 
2000 through July 2003, AXA earned more than $700,000 in revenue on 
more than $18 million invested by the customers of the firm in these 
two mutual fund families offering NAV transfer programs. As part of the 
settlement, the firm was ordered to provide full restitution to all 
customers who paid sales charges on purchases that were subject to 
these programs over a 4-year time period.
    NASD is initiating a broad-based review to determine whether other 
firms are meeting their obligations to provide sales charge waivers to 
their customers under similar types of programs. Examinations and 
investigations are underway and NASD will bring additional enforcement 
actions when they are warranted.

Breakpoints
    As previously discussed, most mutual funds offer discounts on their 
front-end sales charge at certain predetermined levels of investment. 
These discounts are called ``breakpoints.'' Front-end loads and 
breakpoints vary across fund complexes and also may vary among funds 
within a single fund complex. An investor usually is entitled to 
discounts on sales charges at investment levels of $50,000, $100,000, 
$250,000, and $500,000, and, typically, sales charges are eliminated at 
the $1,000,000 level.
    Significantly, an investor usually may aggregate purchases in one 
or more of his own accounts and the accounts of related parties to 
reach a breakpoint threshold. These rights of accumulation vary from 
fund family to fund family. In addition, fund families typically permit 
investors to sign a letter of intent, which allows them to aggregate 
future sales over a set time period (usually 13 months) to meet 
breakpoint thresholds.
    During routine examinations of broker-dealers by our Philadelphia 
District Office, NASD discovered that several broker-dealers were 
selling front-end load mutual funds without properly delivering 
breakpoint discounts to investors. We expanded our inquiry by 
conducting a sweep of a large number of broker-dealers of varying sizes 
and business models and found the same problem. Following this NASD 
effort, in late 2002 the SEC and New York Stock Exchange joined us for 
an examination sweep of 43 firms selling front-end load mutual funds. 
We found that most of those firms did not give investors all the 
breakpoint discounts they should. Failures to give the discounts did 
not appear to be intentional but stemmed from a variety of operational 
problems, including a failure to link share classes and holdings in 
other funds in the same fund family and a failure to link accounts of 
family members. As was the case in the earlier NASD-only sweep, the 
problem was not confined to firms of a particular type; therefore, the 
problem required industry-wide analysis.

Assessing and Correcting Past Performance
    NASD required all broker-dealers that conducted more than a minimal 
amount of automated front-end load, Class A share business in 2001 or 
2002 to complete an assessment of their breakpoint compliance. The 
assessment used a statistical sampling technique, developed in 
conjunction with an outside expert, to enable us to assess the universe 
of transactions in that time period. Approximately 625 firms completed 
the assessment. The assessments showed that most firms did not 
uniformly deliver appropriate breakpoint discounts to customers. 
Overall, discounts were not delivered in about one of five eligible 
transactions. The average amount overcharged per transaction was $243, 
and ranged up to $10,000. We estimated that at least $86 million was 
owed to investors for 2001 and 2002 alone.
    In August 2003, NASD notified broker-dealers that they were 
required to make appropriate refunds, plus interest, owed to their 
customers. In November, NASD directed almost 450 broker-dealers to 
notify customers who purchased Class A mutual fund shares since January 
1, 1999, that they may be due refunds as a result of the firms' failure 
to provide breakpoint discounts. NASD directed firms to contact 
investors, through an NASD-drafted letter and claim form, to assure 
uniform treatment of investors. In addition, we supplemented that 
system of notification with an unprecedented NASD national advertising 
campaign to assure that investors were informed of their rights. We 
also directed about 175 of the securities firms with poor records of 
providing breakpoint discounts to complete a comprehensive review of 
transactions since the beginning of 2001 for possible missed discount 
opportunities.
    In February 2004, the SEC and NASD announced enforcement actions 
against a number of firms for failure to deliver mutual fund breakpoint 
discounts during 2001 and 2002. The SEC and NASD each brought cases 
against a group of seven firms, and NASD separately brought actions 
against an additional eight firms. The 15 firms agreed to compensate 
customers for the overcharges, pay fines in an amount equal to their 
projected overcharges that total over $21.5 million, and undertake 
other corrective measures.

Correcting the Problem
    At the request of the SEC, NASD, working with the Securities 
Industry Association and the Investment Company Institute, also led a 
task force on breakpoints, which included representatives from the 
broker-dealer and mutual fund industries, as well as academia and 
regulators. The Joint NASD/Industry Task Force on breakpoints was 
charged with recommending industry-wide changes to address errors and 
missed opportunities to provide discounts in the calculation of sales 
loads charged on the purchase of mutual fund shares that carry a front-
end sales load.
    The Task Force issued its report in July 2003, making 
recommendations that affect virtually every level of the mutual fund 
distribution chain, including broker-dealers that sell mutual funds, 
the mutual funds, and the transfer agents that administer mutual fund 
accounts. The Task Force made a series of recommendations for 
modification of the systems used by broker-dealers and mutual funds to 
process mutual fund transactions; additional steps by mutual funds to 
ensure that investors are aware of breakpoint discounts; enhancement of 
broker-dealer procedures to gather the necessary information from 
investors; and enhanced industry and investor education. The industry 
immediately began to implement the report's recommendations. Many of 
the recommendations are fully implemented and others are nearing 
completion. In addition, NASD, the NYSE, and the SEC will rigorously 
examine firms to ensure that they are meeting their responsibility to 
deliver breakpoint discounts.

Late Trading and Market Timing
    NASD is extremely concerned about the recent revelations of illegal 
late trading and market timing arrangements. On September 5, 2003, we 
reminded the broker-dealers that they would violate NASD rules if they 
knowingly or recklessly effect mutual fund transactions that constitute 
impermissible ``late trading'' or facilitate market-timing or other 
transactions in collusion with a mutual fund that is contrary to a 
representation in the fund's prospectus.

Investigations
    In September 2003, NASD sought information regarding these 
practices from 160 broker-dealers. Our review indicates that a number 
of those examined clearly received and entered mutual fund orders after 
U.S. markets had closed for the day. Other broker-dealers were not 
always able to tell with clarity whether or not they had entered late 
trades. This imprecision indicates poor internal controls and record 
keeping--issues that NASD is also pursuing.
    NASD has identified a number of broker-dealers that were involved 
in market timing. These cases have been referred to our Enforcement 
Department for full investigation. A number of firms have been told 
that the staff believes that their market timing activities were 
impermissible under NASD rules or applicable Federal statutes. These 
firms appear to have facilitated customers' market timing strategies in 
mutual funds or variable annuities, employed staff who agreed with a 
mutual fund or variable annuity to market time the issuer's shares, or 
had an affiliate involved in some form of market timing of mutual funds 
or variable annuities. We expect to conclude these cases in the coming 
months and bring enforcement actions where warranted.
    In February 2004, NASD announced the first of its market timing 
enforcement actions. NASD fined State Street Research Investment 
Services, Inc. (SSR) $1 million for failing to prevent market timing of 
State Street Research mutual funds as a result of its inadequate 
supervisory systems. SSR also agreed to pay more than $500,000 in 
restitution to the individual State Street Research mutual funds to 
compensate for the losses attributed to market timing activity.
    NASD found that, from 2001 thorough August 2003, SSR's inadequate 
supervisory system improperly permitted the customers of at least one 
other securities firm to buy and sell shares of SSR funds 
alternatively, beyond the annual limits set forth in the prospectuses. 
SSR's supervisory procedures and systems were not adequate to prevent 
and detect customers circumventing restrictions designed to limit the 
number of exchanges made in excess of the prospectus limits.
    The SSR action highlights the need for firms to follow up on red 
flags. While the SSR did make some efforts to prevent market timing, it 
did not follow through to 
ensure proper compliance with the measures it had put in place. Firms 
must respond quickly and effectively to market timing issues once they 
are placed on notice that such activities are occurring.

Omnibus Task Force
    In November 2003, SEC Chairman Donaldson requested that NASD 
convene a task force to determine how omnibus processing would affect 
SEC efforts to curb abusive market timing trading activity in mutual 
funds, and in particular imposition of mandatory redemption fees for 
short-term trading. The mechanics of regulating market timing, and 
imposing redemption fees, are complicated by the fact that various 
broker-dealers, banks, and pension plan administrators and insurance 
companies use omnibus processing of mutual fund transactions, which 
generally does not disclose the identity of the mutual fund shareholder 
to the mutual fund.
    Although the NASD's jurisdiction extends only to the broker-dealers 
involved in mutual fund sales, the SEC requested our assistance in 
analyzing the issue and offering suggestions as to how to achieve the 
SEC's objectives in an omnibus environment before it moved forward with 
rulemaking. The Task Force consisted of 16 professionals, who represent 
a broad range of participants in the omnibus trading process--broker-
dealers, mutual fund sponsors, third-part administrators, banks, 
transfer agents, and clearing corporations. We also had discussions 
with a number of other interested parties who, although not members of 
the Task Force, were identified as having expertise, including members 
of the insurance and actuarial communities.
    In January 2004, NASD presented the SEC with a report from the 
Omnibus Task Force. The Omnibus Task Force report does not reach 
definitive conclusions regarding omnibus processing and market timing 
practices; rather, it provides the Commission with an analysis of the 
advantages and disadvantages of various avenues for removing the 
economic incentives for mutual fund market timing and policies when 
such timing occurs. The options considered and discussed range from the 
disclosure of information about the underlying shareholders or their 
accounts to delegating compliance obligations in this area on the 
omnibus processor. Since the issuance of the report, the SEC has 
proposed a mandatory redemption fee rule, which reflects the 
operational pragmatics and other views offered by the Task Force.

Investor Education
    Mutual funds have also been an ongoing focus of NASD's investor 
education efforts. In 2003 and 2004, NASD issued the following Investor 
Alerts on share classes, principal-protected funds, and breakpoint 
discounts: Net Asset Value Transfers: Look Before You Leap Into Another 
Mutual Fund (2/26/2004). Mutual Fund Breakpoints: Are You Owed a 
Refund? (11/03/2003). Class B Mutual Fund Shares: Do They Make the 
Grade? (06/25/2003). Principal-Protected Funds--Security Has a Price 
(03/27/2003). Mutual Fund Breakpoints: A Break Worth Taking (01/14/
2003). Understanding Mutual Fund Classes (updated; 01/14/2003).
    Each of these Investor Alerts educates investors about the wide 
variety of mutual fund fee structures that exist and urges investors to 
scrutinize mutual fund sales charges, fees, and expenses.
    The NASD's research has shown that many investors are unaware of 
how much they pay to own mutual funds and that even small differences 
in fees can result in thousands of dollars of costs over time that 
could have been avoided. For example, nearly 80 percent of those 
responding to NASD's investor survey did not understand fully the 
meaning of ``no load'' funds.
    To help investors make better decisions when purchasing mutual 
funds, we have unveiled an innovative mutual fund and exchange-traded 
fund expense analyzer on our website. Unlike other such tools, the 
expense analyzer allows investors to compare the expenses of two funds 
or classes of funds at one time, tells the investor how the fees of a 
particular fund compare to industry averages, and highlights when 
investors should look for breakpoint discounts. To make this tool more 
widely available to investors, we developed a version of the expense 
analyzer for broker-dealer intranet and websites.
    NASD also recently announced the creation of an Investor Education 
Foundation to focus our efforts on the critical area of investor 
education. The Foundation has been initially funded with $10 million.

Conclusion
    NASD will continue its vigorous examination and enforcement focus 
on mutual fund advertising, the suitability of the mutual fund share 
classes that the broker-dealers are selling, the compensation practices 
between the funds and the broker-dealers, and the question of whether 
brokers are delivering to their customers the sales charge and pricing 
discounts to which they are entitled. And as we continue our 
examinations and investigations into late trading and market timing 
issues, we will enforce NASD rules with a full range of disciplinary 
options--which include stiff fines, restitution to customers, and the 
potential for suspension or expulsion from the industry. NASD will 
continue to work with other regulators to protect investors and restore 
investor confidence in this very important area of the securities 
markets.

 RESPONSE TO WRITTEN QUESTION OF SENATOR JOHNSON FROM MARY L. 
                            SCHAPIRO

Q.1. In your oral statement, you referenced an ongoing NASD 
investigation of the variable annuity marketplace, and outlined 
several suspected abuses. Would you please describe in greater 
detail what abuse you suspect may be taking place, estimate the 
degree to which this is a problem and tell the Committee 
whether you believe the NASD has the authority to address the 
problem?

A.1. In 2003, the NASD convened a Variable Annuities Task Force 
(Task Force) to identify potential abusive practices and other 
areas of concern in the marketing and sales of variable 
annuities. The Task Force is chaired by the NASD Enforcement 
Department and includes representatives of the NASD Advertising 
Regulation and Investment Companies Regulation teams, the NASD 
Office of the General Counsel, and the Member Regulation 
Department.
    The Task Force is charged with identifying areas of concern 
and approaches to addressing these concerns. Our approaches may 
include a wide range of initiatives, such as recommended 
enforcement action, investor and industry education 
initiatives, expanded examination content, notifications to 
NASD member firms and rulemaking. Set forth below is a summary 
of the areas of concern:

    1. Market timing in sub-accounts. As in the case of mutual 
fund market timing, NASD has found instances where broker-
dealers are facilitating timing in variable annuity sub-
accounts (similar to mutual funds) in contravention of the 
funds' prospectuses or the terms of the annuity contract. 
Timing in sub-accounts raises the same issues as timing in 
mutual funds. NASD has ongoing investigations in this area. Our 
examiners also look for red flags that may be indicative of 
market timing during the course of routine examinations.

    2. Third-party or affiliated advisers used for sub-account 
allocation. This involves firms selling variable products with 
high fees, then recommending that either third-party or 
affiliated investment advisers make sub-account allocations, 
and charging an additional layer of fees for such advice. While 
legal if properly disclosed, it 
appears that the aggregate fees could be so high as to make 
such recommendations unsuitable.

    3. Sale of ``C share'' variables. As is sometimes the case 
with the sales of mutual fund ``C shares,'' investors in these 
products pay substantial on-going expenses that may not be 
accurately disclosed.

    4. Replacement campaigns. Registered representatives (RR's) 
frequently recommend that their clients switch from one 
variable product to another when the RR's switch firms. We 
believe that in many instances, these recommendations are based 
solely on the RR's desire to generate income with the new firm. 
Moreover, it appears that the firms employing these RR's may be 
looking the other way in the face of such activity, failing to 
supervise with a view to preventing unsuitable recommendations.

    5. Tax advice. NASD is concerned that some broker-dealers 
are giving poor tax advice in connection with the sale of 
complex products. In particular, firms continue to recommend 
placing variable products into tax-advantaged accounts (IRA's, 
401(k)'s) where the tax benefit is redundant.

    6. Marketing. Some firms use illustrations in their 
marketing materials designed to highlight the advantages of the 
tax deferral feature of variable annuities. We are concerned 
that firms are using incorrect or otherwise unreasonable or 
unrealistic tax rate and tax bracket assumptions that distort 
the true difference between a tax deferred and taxable 
investment account. We will soon release a Member Alert to NASD 
member firms reminding them of the importance of using accurate 
tax rates in these illustrations that reasonably reflect the 
tax brackets of the intended recipients.

    In addition to the areas of concern noted above, we are 
looking at other variable annuity-related issues. The first is 
in the anti- 
money laundering context. Annuity distributors face unique 
issues in establishing adequate antimoney laundering (AML) 
procedures tailored to a variable products business. For 
example, firms that sell variable annuities should have 
procedures designed to offer ``free looks'' and other quick 
surrenders of variable products (some already do, do not 
they?). The ``free look'' period is designed to give customers 
a very short window (often a week to 10 days) in which to 
change their minds before getting locked into a long-term 
annuity product. There is a danger that a customer could buy an 
annuity, surrender the product and get their money returned to 
them--in effect laundering money by exploiting the free look 
period. While this is being addressed specifically in the Task 
Force sweep for the firms being reviewed, it is also routinely 
reviewed by the NASD's examiners during all examinations of 
firms over which NASD has AML exam responsibility. In cases 
where a firm is a dual NASD and NYSE member, the NYSE may 
review for compliance with AML requirements.
    Another issue is whether firms are complying with a rule 
that applies to sales in New York, called New York State 
Insurance Department Regulation 60. This regulation requires 
two meetings with customers prior to a switch. The purpose of 
having two meetings is to give the client a chance to rethink 
the transaction. NASD's New York District Offices have been 
investigating variable annuity replacements that violated Reg. 
60. In one instance involving Prudential Securities' successor, 
the firm reported the problem to us and our investigation 
uncovered backdated and altered documents. We believe 
transactions in violation of Reg. 60 may be occurring at other 
broker-dealers as well and, as a result, NASD is investigating 
about a dozen firms. At this time, NASD cannot state for 
certain the degree to which each of the issues enumerated above 
is a problem. Rather, we are continuing to look at each of the 
issues surrounding the sales of variable annuities through the 
Task Force and during examinations and investigations into the 
targeted areas.
    The issues presented by these problematic practices are 
serious and worthy of regulatory scrutiny. Variable products 
are complex securities and require a high degree of product 
knowledge by the firms and the RR's selling them, the 
supervisors at the firm who review the suitability of 
recommendations, and investors who consider purchasing variable 
products.
    In April of this year, in an effort to address continuing 
concerns surrounding sales and exchanges of deferred variable 
annuities, NASD's Board of Governors proposed a rule that would 
impose a wide range of requirements tailored specifically to 
transactions in deferred variable annuities--from new sales 
practice standards and supervisory requirements to increased 
disclosure and sales force training. In general, the rule would 
codify and make mandatory best-practice guidelines that NASD 
has previously issued. NASD intends to request public comment 
on the proposed rule.
    Among the key requirements of the proposed rule is that 
RR's who recommend a deferred variable annuity transaction 
ensure that the customer has been informed of the annuity's 
unique features; the customer has a long-term investment 
objective; and the deferred variable annuity as a whole, and 
also its underlying sub-accounts, are suitable for the 
customer, particularly with regard to risk and liquidity. The 
RR would be required to document these determinations.
    The firm or its representative would be required to provide 
the customer with a current prospectus and a separate, brief, 
``plain English'' risk disclosure document highlighting the 
main features of the particular variable annuity transaction. 
Those features would include: Liquidity issues, such as 
potential surrender charges and IRS' penalties; sales charges; 
fees (including mortality and administrative fees, investment 
advisory fees and charges for riders or special features); 
Federal tax treatment for variable annuities; any applicable 
State and local government premium taxes, and market risk. The 
risk disclosure document also would be required to inform the 
customer whether the variable annuity contract offers a ``free 
look'' period, during which the customer could terminate the 
contract without paying any surrender charges and receive a 
refund of his or her purchase payments.
    Before an RR could effect any transaction in a deferred 
variable annuity, a registered principal would be required to 
review and approve the transaction. The registered principal 
would be required to consider specific factors, such as whether 
the customer's age or liquidity needs made a long-term 
investment inappropriate. Before an RR could complete a 
recommended transaction, the registered principal would be 
required to review and approve, in writing, the suitability 
analysis document and a separate exchange or replacement 
document, if the transaction involved an exchange or 
replacement of an existing variable annuity.
    The proposed rule would require registered firms to 
establish and to maintain specific, written supervisory 
procedures reasonably designed to achieve compliance with the 
rule's standards.
    Registered firms would be required to develop and document 
specific training policies or programs designed to ensure that 
RR's and registered principals comply with the rule's 
requirements and that they understand the unique features of 
deferred variable annuities.
    Through a combination of investor education, education of 
sales persons recommending variable products, guidance to 
regulated firms about suitability of recommendations, 
supervision, and other areas, effective and fair rules, and 
thorough examination and enforcement programs, we believe that 
NASD, working in concert with the SEC and other regulators, 
have the tools necessary to address those issues and the 
authority to take appropriate action.


                     FUND OPERATIONS AND GOVERNANCE

                              ----------                              


                        TUESDAY, MARCH 23, 2004

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10 a.m. in room SD-538 of the Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order.
    This morning, the Banking Committee holds its seventh 
hearing on reforming the mutual fund industry. As we continue 
our wide-ranging examination of the fund industry, this morning 
we will hear from various experts on fund operations and 
disclosure practices. We have assembled a diverse panel, and I 
look forward to hearing their recommendations and insights.
    Professor Mercer Bullard is an Assistant Professor of Law 
at the University of Mississippi School of Law, and the 
President and Founder of Fund Democracy, a nonprofit membership 
organization that serves as an advocate and information source 
for mutual fund shareholders and their advisers.
    Professor William Lutz is a Professor of English at Rutgers 
University. Professor Lutz is an expert in information design, 
and served as a consultant to the SEC during the compilation of 
the SEC's ``Plain English Handbook: How to Create Clear SEC 
Disclosure Documents.'' Given Professor Lutz' expertise, I look 
forward to hearing his recommendations for improving investors' 
comprehension of disclosure documents through clear and concise 
disclosure.
    Mr. Robert Pozen is the Non-Executive Chairman of the 
Massachusetts Financial Services Company and is a Visiting 
Professor at Harvard Law School. Mr. Pozen is also the former 
Vice Chairman of Fidelity Investments and President of Fidelity 
Management and Research Company.
    Finally, the Committee will hear from Ms. Barbara Roper, 
who is the Director of Investor Protection for the Consumer 
Federation of America. Ms. Roper has served on the board of 
Fund Democracy and the SEC's Consumer Affairs Advisory 
Committee.
    I thank each of you for appearing this morning and I look 
forward to your testimony as we proceed down this road.
    All of your written testimony will be made part of the 
hearing record in its entirety. Professor Bullard, we will 
start with you. Proceed as you wish this morning.

                 STATEMENT OF MERCER E. BULLARD

          PRESIDENT AND FOUNDER, FUND DEMOCRACY, INC.

                   ASSISTANT PROFESSOR OF LAW

            UNIVERSITY OF MISSISSIPPI SCHOOL OF LAW

    Mr. Bullard. Thank you, Chairman Shelby and Members of the 
Committee for the invitation to appear here today. It is a 
privilege and an honor to be before the Committee, and I 
particularly compliment the Committee on its very careful and 
thorough analysis of the issues with a number of hearings in 
the past and perhaps a number of more to come.
    The reason we are here today, of course, is that mutual 
funds command $7 trillion of America's retirement assets, and 
therefore mutual funds are at the center of retirement security 
for Americans. I would like to start with what my philosophy is 
on mutual fund regulation just so you know where I am coming 
from, and that is generally that whereas some investors are 
going to do better than others in the market as a necessary by-
product of our capitalist system, as a whole what we would like 
investors to do is to get as much of the performance of the 
market as possible. That is, as a group, ideally they would 
achieve the entire gains of the market, but once you take away 
the transaction cost, the cost of investing, the cost of 
servicing their accounts, they are going to be left with a 
little bit less. What we hope to do is to leave as much of the 
return of the market in their pockets as possible.
    The problem is that what seems to be happening is quite the 
opposite. A recent study by DALBAR, and I would like to make 
this part of the record if I may?
    Chairman Shelby. Sure, go ahead. You want that to be made 
part of the record?
    Mr. Bullard. Part of the record, please.
    Chairman Shelby. Yes, it will be included in the record 
without objection.
    Mr. Bullard. Thank you, Chairman.
    In that study, DALBAR, which is an independent quantitative 
analysis firm, looked at the question of how much of this 
market have investors really achieved by investing in equity 
funds? From 1984 to 2003, they analyzed the S&P 500 and 
calculated the return on an annual basis. It was 12.22 percent. 
They found that the return of equity fund investors was 2.57 
percent. That is 12.2----
    Chairman Shelby. Say that again. I want you to go over 
that. That is very important.
    Mr. Bullard. Let me make sure I have the numbers exactly 
right here. From 1984 to 2002 the return on the S&P 500 Index 
was 12.22 percent annually. The return of the average equity 
fund investor was 2.57 percent. That is a difference of almost 
10 percentage points.
    My general view is that most of that is the responsibility 
of those shareholders. They make bad decisions. They time the 
market. They invest in funds at their peak, they sell the funds 
at their bottom, and that is not only a problem of investor 
education that we also need to deal with, but it is also a 
problem of the way that the industry is structured and 
regulated. Investors are leaving too much of the market's 
return on the table that for the future of our retirement 
security we need to be in their pockets when they are retiring. 
In a number of respects--and this will be the focus of my 
statement--this requires action by Congress. There are a number 
of areas, in fact the most important areas where reform is 
needed, where the SEC either does not have the authority to 
accomplish the reform or is unwilling to do so.
    The first category is fund governance. In my testimony I 
described a mutual fund oversight board. I think we need such a 
board in order to do two things. One is to establish clear 
guidance for fund directors, that they have as a group 
generally complained they are lacking for decades, and also to 
follow up on that guidance with enforcement. It is an area 
where the SEC has been weakened from the standard-setting point 
of view. The SEC simply is not in a good position to set those 
kinds of detailed standards and keep them current. We need a 
focused, expert body that would work very closely with the 
industry to establish minimum standards. In addition, the SEC 
has not done a good job in bringing enforcement action against 
independent directors when they engage in misconduct. 
Throughout this scandal where we have had dozens of actions 
brought, not one has been brought against the independent 
directors with the possible exception of Bank of America, 
although it is unclear to me how the SEC could have entered 
into a settlement as it claims it has regarding the Bank of 
America directors when the settlement did not involve the fund 
or the directors, and involved only the fund manager, my 
understanding being that fund directors are supposed to be 
independent of the fund manager and that the fund manager does 
not have the authority to reach that settlement.
    Another area where reform is needed to establish a 
fiduciary duty for directors that goes not just to the fees 
received by the manager, which is where it resides now, but 
with respect to the fund as a whole as a reasonable investment 
vehicle for investors. The problem with the current standard 
is, while it addresses the most important conflict of 
interest--that is between the fund manager and the fund--it 
does not go to the issue of whether this fund is conceivably a 
reasonable investment. When you have a number of funds out 
there with expense ratios that exceed 5 percent--there are even 
some that exceed 10 percent of assets--there is a crying need 
for some fiduciary standard to which directors will be held so 
that they have to ensure not necessarily that the fees received 
by the custodian service provider are reasonable, but the fund 
itself could be a reasonable investment option.
    Another area is generally the independence of the board, 
where we need to ensure that independent directors, for 
example, are not former directors, officers, or employees of 
the adviser. It would seem obvious that those persons should be 
excluded from being independent directors.
    That is not currently what the law states, and the SEC does 
not have the authority to change that view. The SEC has stated, 
and even proposed, that the fund chairman be independent and 
that the board be 75 percent independent, but that is an 
exaggeration of the SEC's authority for this reason. The SEC is 
going to, if it adopts these rules--against which there is 
significant opposition in the Commission itself, so it is not 
clear that it will even happen--the SEC is doing this by a form 
of bootstrapping. What it does is it adds an independent 
chairman requirement and a 75 percent independent board 
requirement to about a dozen different exemptive rules. These 
are rules that the SEC has developed over the last 65 years of 
regulation under the Investment Company Act, and which most 
funds rely on and rely on importantly, in that they need to 
rely on those rules in order to function.
    The SEC figures that since they need these rules to 
function, they will always have to rely on the rules, and 
therefore always have to have an independent chairman and 75 
percent independent board. In fact, when those provisions are 
most needed, and that is when there is a confrontation, a 
difference of opinion between the fund's directors and the 
investment manager, the investment manager can decide at that 
moment to stop relying on those rules. So for example, if you 
have a 12b -1 plan, you are relying on Rule 12b -1. The SEC 
proposes to require that if you rely on that Rule, you have a 
12b -1 plan, you have to have an independent chairman, 75 
percent independent board, but the moment the fund manager 
wants to get rid of that independent chairman or has a problem 
with that board, it will stop relying on Rule 12b -1, cancel 
the
12b -1 plan, and get rid of the board. If you have any doubt as 
to whether that might happen, that is precisely what happened 
when there was a conflict between Don Yacktman, the Fund 
Manager, of the Yacktman Funds. He was in a conflict with the 
board. He engineered a proxy vote in which the board was 
replaced. He replaced the board with hand-picked successors, 
and because it no longer qualified under Rule 12b -1's 
independent governance provisions, he had to cancel the 12b -1 
plan.
    What we have now is an SEC proposal that will work in most 
cases but will never work where it is needed most, where there 
is actually a confrontation between the fund manager and the 
board, because the board will know that if the fund manager 
simply is willing to give up reliance on those rules, the 
requirements disappear, and in that case we do not even have a 
majority requirement to fall back on. All we have is that the 
board has to be 40 percent independent, and that is the only 
requirement that would apply. It can be hand-picked by the fund 
manager and 60 percent of the board can be fund manager 
executives.
    The second category where legislation is needed is in the 
area of fee disclosure, again, where the SEC usually has the 
authority but has either not supported or expressly opposed----
    Chairman Shelby. Let me stop you a minute. You say fee 
disclosure, but you are not saying you want us to set fees, are 
you?
    Mr. Bullard. No. I am with the SEC on our Government really 
having no role to play in regulating fees.
    Chairman Shelby. It should not set fees.
    Mr. Bullard. Absolutely not.
    Chairman Shelby. But we are talking about disclosure.
    Mr. Bullard. Absolutely. And in my mind, the essence of 
disclosure is that, like the SEC has stated, the marketplace 
should regulate fees. Investors should make decisions. That 
marketplace is working fairly well. We have a fair amount of 
competition in the industry. But what we have is, and that the 
SEC has failed to recognize, is fee disclosure that simply is 
not telling the market how much it really costs to own funds. 
The most glaring example of that is portfolio transaction 
costs. A recent study that was sponsored by the Zero Alpha 
Group, by a number of academics--and if I might add this as 
part of the record as well?
    Chairman Shelby. It will be made part of the record.
    Mr. Bullard. Thank you, Chairman.
    In this study a couple of academics looked at the question 
of how much are these portfolio transaction costs. Let us just 
start by looking at the commissions, the dollar amount paid, 
and to see whether it really has an impact, and then we will do 
a reasonable estimate of spread cost. Spread cost is the 
difference between if there is a buy price and a sell price, it 
is the difference that you would pay. I find the best way to 
imagine it is to imagine that you were buying and selling the 
same amount of stock at the same time. You would think that you 
would break even, but you will not. The difference is that you 
are going to buy at the high price and you are going to sell at 
the low price in that spread. Just including those two 
components of portfolio transaction costs, they found that the 
average equity funds portfolio transaction costs equaled 43 
percent of their expense ratio, which I call the partial 
expense ratio because any time you have an expense ratio that 
leaves out 43 percent of the cost, that is not something that 
is representative of what it costs to own the funds. Rather, I 
consider that to be a misleading number.
    If you look at the last page of my written testimony, I 
included a chart from their study in which they show--and this 
is only for funds that have more than $100 million in assets. 
These are not outliers. A couple of funds, for example, the 
PBHG Large Cap Fund expense ratio--and this is what the SEC is 
telling us this fund costs--is 1.16 percent. What the study 
shows us is there are an additional 4.27 percent of assets 
spent on commissions, another 3.16 percent spent on spread, so 
that the total actual expenses, just including those two 
components of portfolio transaction costs, is more than seven 
times what the SEC is telling us this fund costs. This is 
misleading because it does not punish fund managers for 
behavior that the market may consider important.
    I am not saying anything about whether they should be 
allowed to do the frequent trading that causes these costs. The 
market should make that decision. But what the SEC has done is 
said, we are going to make the decision for the market. We are 
going to give the market a partial expense ratio. That is the 
only standardized figure we are going to give the market, and 
we are not going to let the market have another standardized 
figure so it can choose. I say let the market choose which is 
the number that they think is the best reflection of costs, and 
leave it at that. Thus far the SEC has been flatly opposed to 
that approach.
    The second area that the SEC has opposed disclosure is the 
actual disclosure of individual shareholder costs in their 
statements. This was a proposal they specifically rejected in a 
recent rulemaking. Ironically, just last week, MFS--and I am 
sure Chairman Pozen can talk about that--has proposed to 
provide precisely the disclosure the SEC rejected in quarterly 
statements to its shareholders. This is a shocking development.
    Chairman Shelby. Explain how that would work if the SEC had 
adopted it.
    Mr. Bullard. What I would have had the SEC do is two 
things. One is you have to tell the shareholder either exactly 
what they paid or a pretty good estimate of what they paid so 
it is an individualized number, and the second thing is it has 
to be on their statement. That is exactly what MFS is doing.
    Chairman Shelby. And should be in plain English. We will 
get into that in a few minutes.
    Mr. Bullard. Absolutely. And of course, what Professor Lutz 
has worked up is an excellent analysis of the issue of what 
your broker got paid, and it is the confirm disclosure. This 
would be on the statement, and the reason that it is important 
that it be on the statement is that what we are trying to do is 
reach investors who are currently not price sensitive. We are 
trying to affect a part of the market by putting a number in 
front of them--and again, let the market decide--but put it in 
a place where they are actually going to read it. The average 
investor, including probably most of the people in this room, 
take their shareholder report, and it goes right from the 
mailbox into the trash. What everybody in this room does, 
however, is you open your statements, look at them, see the 
value of your account, and you feel great if it went up that 
quarter and you feel bad it went down that quarter. But what 
you would also be informed by would be the dollar amount what 
it cost you to pay that manager to be in that fund, right on 
that statement. You cannot overload it with a lot of things. I 
do not think you should do much more if anything than tell the 
person what the value of their account is and what it costs to 
be in that account.
    What the SEC has decided instead is to give you a 
hypothetical number, which is not the number that you paid, and 
to put it in the shareholder's statement.
    Chairman Shelby. Why would they want to do that?
    Mr. Bullard. For two reasons. One is the cost which the 
industry said was prohibitive. I imagine Mr. Pozen would have 
some comments about how MFS is going to be able to afford this 
prohibitive cost since they have now decided to do precisely 
the same thing. The other reason was they thought it might be 
misleading. Apparently Mr. Pozen also believes that it is not 
misleading. Now that those two arguments seem to have been 
washed away by----
    Chairman Shelby. If it is misleading, although it might 
cost more, truth should trump that, should it not?
    Mr. Bullard. I take a very economic view of this business. 
Truth should trump that, and the net cost should be exceeded by 
the benefits. If you could show me that this disclosure in the 
statements would not mean that investors will save more money 
because of
increased competition, I would be opposed to that disclosure. 
The
test has to be that the benefit has to exceed the cost because 
ultimately the mutual fund industry is about creating wealth 
for Americans across the board and keeping as much of the 
market return as possible.
    The other areas where the SEC has opposed disclosure would 
be putting those fees in context, having disclosure like they 
have for performance in the prospectus, that shows you that 
your expense ratio for this fund is 1.2 percent and the average 
of your peers is, let us say, 1.4 percent, and what you would 
pay to be an index fund, that is, what you are paying to choose 
to have your money managed rather than have it simply by the 
market is let us say 0.2 percent. So, people can really see the 
decision they are making, and again, you let the market decide 
by forcing standardization, which is really where the 
Government can intrude and can promote efficiency and 
competition without having any decisionmaking authority as to 
what people should pay.
    An area regarding fee disclosure is the distribution 
expenses. Currently, the SEC requires that the fee table have a 
line item that says ``Distribution.'' That is the 12b -1 fee. 
In fact, there are distribution costs that are being paid out 
of the management fee. So what you have is a group of 
shareholders who use 12b -1 fees as a cut-off, as a screen, 
thinking that if I do not want to buy a fund that is spending 
money on distribution, I will simply ignore the ones that 
charge a 12b -1 fee. And, nothing could be further from the 
truth. In fact, you could have two funds, one charges a 12b -1 
fee and one does not, and the amount that that shareholder is 
effectively spending on distribution is the same in both cases.
    The area where the SEC does not have authority in this case 
is soft dollars, and I have reached the point where I would 
support a ban on soft dollars. The problems with soft dollars 
have been well-studied. They are essentially twofold. One is 
that you have fund managers spending other people's money on 
something that they would otherwise pay for out of their own 
pockets, and that was well-illustrated in a couple of Wall 
Street Journal articles last week in which both MFS's plans and 
Fidelity's requests of the SEC include a discussion of how much 
of their commissions they estimate are actually being spent on 
things they would otherwise pay for out of their own pockets. 
MFS has proposed to ban soft dollars. Vanguard has always 
shunned soft dollars. American Century has always severely 
restricted soft dollars. Putnam is now severely restricting 
soft dollars and is considering banning soft dollars.
    The problem with each of these positions is that Mr. 
Pozen's shareholders are going to be asking him, why is it you 
are still paying 5 cents a share and the price has not gone 
down, yet you are spending more of the fund manager's money on 
these reports because you are not willing to buy them with that 
5 cents a share? I believe--Mr. Pozen may disagree for business 
reasons--but I believe he is going to be under some pressure 
competitively because it is going to put him at a disadvantage 
because other fund managers are going to be spending the fund's 
money on those reports that are coming out of MFS's pocket. I 
am saying you have to have a level playing field for this to 
work, and we begin with a ban.
    But if we do not have a ban, the least we could do is 
either
severely restrict soft dollars so that they pay only for 
reports that represent an opinion about an issuer's value, or 
we restrict them in the sense that Fidelity has proposed, in 
that we should completely unbundle the transaction and require 
that there be an objective value assigned to all the 
nonexecution components, or at an absolute minimum, let the 
market know what soft dollars is costing us. The reason the 
market does not know goes back to the portfolio transaction 
cost problem. It is not in the expense ratio. So at a minimum, 
let the market decide if it wants to allow this practice to 
continue, then let people know what the cost of it is and let 
them decide for themselves, and I would say that would be at 
the top of my list as to how to deal with soft dollars, but 
there are a lot of different approaches, none of which the SEC 
seems to support.
    Another area where Congress needs to act is in the reform 
of distribution costs. Congress, in 1940, wisely enacted 
Section 12b of the Investment Company Act. The effect of that 
provision was essentially to prevent funds from underwriting 
their own securities, that is, being in the business of 
distributing their own shares. The reason for that was that 
Congress was concerned that fund managers would simply spend 
the fund's money to sell more shares in order to increase the 
fund manager's advisory fee.
    The SEC opposed for years any exception to that standard. 
They finally relented, as we all know, with Rule 12b -1 in 
1980. Initially that was intended to allow simply marketing 
expenditures, and it was designed to deal with periods of net 
redemptions when the
industry was actually losing assets and it needed a competitive
temporary boost. The SEC never anticipated what has happened 
today, which is now those costs represent, based on ICI 
statistics, only 5 percent of what 12b -1 fees go to. Sixty-
three percent of 12b -1 fees go for a purpose that was never 
intended by the SEC and is flatly contrary to Section 12b, and 
that is to compensation for brokers. The problem with that 
structure is essentially you have brokers being paid by the 
product to sell the product, so that instead of selling the 
best product and being compensated on the basis of a successful 
relationship with their clients, the broker is getting 
compensated based on which fund complex he can pressure the 
most payments out of, and you have a system where the brokers' 
interests are not aligned with shareholders' interests because 
the broker is pushing the fund manager which pays the highest 
fees to the broker. So what 12b -1 has done is essentially it 
has tied the compensation of the fund manager with the 
compensation of the broker, whereas the broker's compensation 
should be tied to the relationship to the customer.
    What Congress needs to do is to set things back the way 
they were in Section 12b in 1940 and prohibit fund managers and 
prohibit funds from paying brokers in connection with selling 
fund shares. That is an important distinction. I do not think 
there is a problem with funds or fund managers paying to market 
the funds. A classic example would be running ads in Money 
Magazine. That is generally where you have a reasonable 
alignment of interest between the fund manager and the fund. It 
is something that the directors could oversee and they should 
be expressly required to do so. But the fund should not be 
paying for the relationship between the customer and the 
broker, and neither should the fund manager. That requires 
outlawing revenue sharing, also known as shelf-space payments, 
and that would require repealing 12b -1, since for 24 years the 
SEC has been unwilling to take any action on this, even though 
it has repeatedly promised to reform 12b -1 fees.
    I note that it recently proposed some changes to 12b -1 to 
ban
directed brokerage, and once again it has missed the 
opportunity to accomplish real reform and return 12b -1 to what 
everyone on the Commission and on the staff admits is a purpose 
for which it was originally intended.
    Finally, the last area where we really need Congressional 
action is in fund names, and I think this is an issue that will 
strike home for this Committee especially, in that the SEC has 
stated that funds can use the term ``U.S. Government'' in their 
names, that they can invest fully 100 percent of their assets 
in Government Sponsored Enterprises. That means that a fund can 
say, I am a U.S. Government fund, and I am going to address 100 
percent of my assets in Fannie Maes. My view is that your 
average American expects a U.S. Government fund to invest in 
creditworthy instruments, and what we are learning every day, 
more and more, is that Fannie Maes are not as creditworthy as 
we thought. They are not guaranteed by the Government. It is 
inherently misleading that any U.S. Government funds invest 
more than the legal limit normally required by your name, and 
the SEC has expressly refused to take that position.
    I applaud the SEC for the steps that it has taken. The 
Division of Investment Management has accomplished more good 
rulemaking in the last 6 months than it has probably in its 
history, but again, even though they are dealing with important 
aspects of the ongoing scandal, they do not go to the most 
significant problem facing the industry, and that is with the 
market over 19 years returning 12.22 percent and investors 
receiving only 2.57 percent, there is something wrong with the 
system, and the primary problem with the system is that fees 
are not being disclosed in a way where people are making 
rationale decisions. To a large extent, that is their own 
fault. We need to educate people to make better informed 
decisions, but we also have a responsibility for putting out an 
expense ratio that we say is the total cost of the funds but is 
not actually representing those costs.
    My number one priority would be each of the fee disclosure 
issues that I have laid out for the Committee before any other, 
because my view is we should look to the market and look to the 
market first, and we have to give the market the tools to make 
efficient decisions.
    Thank you again for the opportunity to appear here today. I 
will be happy to take any questions.
    Chairman Shelby. Thank you.
    Professor Lutz.

           STATEMENT OF WILLIAM D. LUTZ, PH.D., J.D.

            PROFESSOR OF ENGLISH, RUTGERS UNIVERSITY

    Mr. Lutz. Thank you for the invitation, Chairman Shelby.
    I have rewritten about 58 mutual fund prospectuses into 
plain language, at least as far as I was allowed to write them 
into plain language. I can remember the first time I ran into 
the turnover rate, which was always buried in the back of the 
prospectus, and asking what that was.
    Chairman Shelby. When you were rewriting them--excuse me--
were you getting all the ambiguity out of them, much as you 
could?
    Mr. Lutz. As far as I was allowed to. There was a strict 
adherence to the SEC regulations, no more, no less. What I 
wanted to do more to explain more, for example, the churn rate 
or the turnover rate, or in that wonderful phrase ``portfolio 
transactions cost,'' which I have absolutely no idea what that 
means to any normal human being who does not have a CPA.
    Chairman Shelby. Say that again?
    Mr. Lutz. Portfolio transaction cost. It makes one's eyes 
tend to glaze over.
    Chairman Shelby. Portfolio transaction cost. What does that 
really mean in plain English?
    Mr. Lutz. In plain English, it means when you are buying 
and selling the assets in the fund you have to pay for that, 
and that is what you are paying for, all the costs that are 
associated with that. But you have collapsed a lot of costs 
into that phrase and you have made a wonderful abstraction, the 
kind of abstraction that people do not question because they do 
not want to appear to be stupid or uninformed.
    Chairman Shelby. Do they bundle these costs together for 
the reasons not to disclose in a sense?
    Mr. Lutz. Oh, of course. George Orwell said, ``the great 
enemy of clear language is insincerity.''
    Chairman Shelby. Funneling, is it not, funneling too? You 
put them all together and you do not know what is what.
    Mr. Lutz. One big ball of wax and one big ball of twine 
that you have to try and unwind.
    I was always impressed by the mutual fund industry--and 
there are a lot of people who can do this--but I was 
particularly impressed by the number of synonyms they found for 
the word ``fee.''
    [Laughter.]
    Chairman Shelby. Take your time. Go ahead.
    Mr. Lutz. My apologies to Gertrude Stein, but a fee is a 
fee is a fee. It is money out of my pocket. When I bought my 
house and I went through all those lists of settlement fees, 
and all I knew was there was a bottom line and I had to write 
that check.
    Chairman Shelby. But they were broken down.
    Mr. Lutz. But they were broken down. I knew exactly how 
much I was paying for the residual fuel oil in that heating 
tank of the house I was buying and the sewage bill and the 
water. It was all broken out so that I could question things if 
I had any questions.
    There is no comparable effort in a mutual fund prospectus. 
There could be, no trouble at all, easily done if you want to 
do it. I think there is an important word here and it goes with 
an important phrase. The first word is transparency. The 
strength of the American financial markets is transparency 
because nobody gives money to somebody if they do not know what 
is going on. And second, disclosure is not disclosure if it 
does not communicate. To simply give data is not to 
communicate. To say the portfolio transactions costs are $150 
tells me nothing, absolutely nothing. There is no information 
there, and it is the job of the people putting this prospectus 
together to give information, to explain things, to create a 
context. What does this cost? Why is it going to affect my 
investment?
    I agree with Professor Bullard. The idea of doing this 
hypothetical $10,000 investment, and we would draw the charts, 
means absolutely nothing to anybody. It certainly did not mean 
anything to us. In fact, I do not think anybody knew, at least 
any investor knew where those numbers came from or what they 
meant. The question always is, what does that mean to me and my 
investment?
    In an age of computers--and I am not a computer expert, but 
I have seen enough that can be done with them--to say we cannot 
do individualized reports I find mystifying at best. My 
investment through the University is with TIAA-CREF, and each 
quarter I get a detailed breakdown of all my investments.
    Chairman Shelby. Banks give you a monthly statement.
    Mr. Lutz. My checking account, my savings account, and in 
fact, if anything, we are flooded with data. Computers can 
grind out more data than any human being could ever assimilate, 
but we are not talking about information. To simply give 
numbers to investors does not say anything. We have to tell 
them what the numbers mean and how the numbers affect them.
    In the appendix to my statement that I submitted in the 
redesigned form of the confirmation of sale, we tried to take 
that data and make sense out of it to the person who is buying 
these shares. We wanted to say, okay, what is this going to 
cost me, bottom line? How much is it going to cost me while I 
hold these mutual fund shares? Is it going to cost me anything 
when I sell them? Just give me these numbers. So if I am 
investing $1,000, but I find out that over $300 of this $1,000 
is going to various sales fees, I might want to think about 
that. I might want to look for another fund that says, hey, we 
only charge $150. I am a terrific believer in competition, but 
you cannot have competition when all the guys are hiding the 
information from you. Then it does not work.
    Chairman Shelby. But it would enable the consumer, the fund 
holder, the people that buy $7 trillion, have invested 
everything, to make an informed decision, is that correct, for 
the market?
    Mr. Lutz. Exactly. I drive down the street and I can choose 
which gasoline station I am going to because they post their 
prices. There is nothing hidden there, and I know what those 
numbers mean. But when I go to look for a mutual fund in which 
I might want to invest, I am swamped with meaningless data, and 
if anybody in this room suffers from insomnia, let me suggest 
simply picking up a statement of additional information, and by 
page 8, I guarantee you will cure your insomnia, even though 
that statement may run over 100 pages long of 8-point type, 
single-spaced, no indentations. It is designed to put you to 
sleep.
    I am mystified--I guess I am not, I am not that innocent. 
This is done deliberately. Because one of the things we 
discovered on the Plain Language Project at the SEC is that the 
sales materials for mutual funds, the pamphlets, the brochures 
that they put out, were magnificent in design, communication, 
clarity, graphics information, and you would turn around and 
look at the other information in the prospectus and it was 
exactly the opposite. There was not anything there to explain 
things to you, and in all of the investor information given to 
you once you were a shareholder.
    Chairman Shelby. You might be going to get into this. Maybe 
I am getting ahead of you. What is the average financial 
literacy? In other words, rate of the average American, the 
average investor. It seems to me that a lot of stuff that we 
get in the mail you would either have to be an investment 
banker, an analyst, a securities lawyer, or somebody that was 
dealing with this to understand what was coming to you.
    Mr. Lutz. You have two issues. The first is readability, 
that is the reading level. You should be at a seventh grade 
reading level to have a reasonable chance of having a 
significant amount of the population to understand your 
materials, and in fact, if you want to guarantee wide 
readability you would have to aim for the fifth grade level. On 
the SEC proposed forms on one readability study I did, the 
lowest grade level I got was 12.5. The highest I got was 15, 
which means that all you needed was a high school diploma and 3 
years of college and you would have a 50-percent chance of 
understanding this document.
    The second is financial literacy, and numerous studies have 
been done to show that that is extremely low. The Department of 
Education also does a literacy study, which it updates 
regularly, and it is a detailed and magnificence study. They 
found that less than 10 percent of the people in that study--
and this is a representative sample--could not read and 
interpret a bar chart. Only about 30 percent--I think it was 
around 28 percent--could read and interpret a simply age and 
weight chart for determining the amount of medication to give 
to a child. You had to find the age on one side and on the top 
the weight, draw the two lines together. When it comes to 
literacy, financial literacy, it is much, much lower being able 
to interpret this kind of technical data. It is really 
incumbent on us who provide information to do our best to use 
information designed plain language to communicate as clearly 
and as simply as possible. It can be done. It has been done, 
and it is done regularly if you want to do it.
    One of the main points in my statement is that the 
Securities and Exchange Commission has to incorporate this into 
all of their procedures. Document design, information design, 
should just be automatic and standard. It is in a number of 
Federal agencies already. The Social Security Administration 
has done extensive work. The Veterans Benefits Administration 
has found that they saved a huge amount of money by redesigning 
their forms to make them understandable to the recipients. So, 
we are not talking about anything new. We are talking about not 
just money. We are talking about retirement, your future life, 
your children's college education. You are talking about the 
quality of how people will live. Will they be able to retire? 
This is more than money. It goes to the very heart of the 
quality of our lives.
    Transparency is important because it leaves to confidence 
that we have the information we need, and when we have 
confidence we trust, and if we trust, we invest. If we do not 
trust, we draw back, as we have seen recently. My theory is 
that there will be a great distrust of mutual funds, and once 
trust is lost it is very difficult to get back, no matter how 
hard you try.
    Chairman Shelby. Thank you.
    Mr. Pozen.

                  STATEMENT OF ROBERT C. POZEN

              CHAIRMAN, MFS INVESTMENT MANAGEMENT

             VISITING PROFESSOR, HARVARD LAW SCHOOL

    Mr. Pozen. Thank you, Chairman Shelby and Ranking Member 
Sarbanes.
    I know that you have been holding these important hearings 
on the broad subject of mutual fund reform, but today I would 
like to concentrate on three areas, one having to do with 
brokerage commissions, which the professors already started to 
address; another individualized reporting which has also been 
discussed; and finally, fund governance. Then I would like to 
add just a few comments on 12b -1 fees.
    Beginning with brokerage commissions, we at MFS want to 
reduce the brokerage commissions that are paid by the fund 
shareholders, but it is now very difficult to negotiate for a 
lower price on commissions because the system is not 
transparent. If a mutual fund has a large trade, for example, a 
500,000 share order in a stock like Genzyme, you will need to 
go to a full service broker to get a good execution. A trade 
this big would not be easily executable through electronic 
networks because they do not handle that sort of volume. You 
might need capital on the desk, you need a much higher level of 
skill. Such a trade cannot easily be done through a passive 
facility. If you go to any full service broker on the street, 
it will charge you 5 cents a share and it is very hard to get a 
lower price. But full-service firms are very willing to give 
all types of what I call in-kind discounts. If you want to, 
they will forward some of the commission to pay for third-party 
research. If you want to, they will forward some of the 
commission to Bloom-
berg and provide you with a Bloomberg terminal. If you want to, 
they may even pay your rent. So there clearly is a system by 
which there are noncash items that are being paid for by soft 
dollars, and these items are not very easy to separate from the 
overall price of the commission.
    MFS announced last week that we will be paying cash out of 
our own pocket for third-party research and certain types of 
market data, and we hope to get a lower price on the 
commission, but we need help. MFS alone is not going to change 
the pricing structure on Wall Street.
    As mentioned before, there are some firms like 20th Century 
that are moving in this direction or already have moved, but we 
need many mutual fund companies to move in this direction. We 
also need the help of the SEC.
    In 1975, Congress passed a safe harbor for soft dollars in 
Section 28(e) of the 1934 Act. Early on the SEC had a rather 
strict and narrow interpretation of that safe harbor, saying 
you could only use soft dollars when the good or service was 
not readily available for cash. But then in 1986, the 
Commission vastly expanded the safe harbor by saying 
essentially that you could use soft dollars for any 
``legitimate use,'' and this has led to a widespread 
proliferation of soft dollars.
    What I am proposing is fairly simple. I think we should go 
back to the stricter definition that the SEC originally had, 
and that will constrain soft dollars.
    Chairman Shelby. What was that? What was the stricter----
    Mr. Pozen. The stricter definition was you can only use 
soft dollars if the good or service is not readily available 
for cash. In that case you could not have somebody paying for 
your Bloombergs, you could not have somebody paying your rent, 
you could not have a lot of things that go on.
    Chairman Shelby. Senator Sarbanes has a question.
    Senator Sarbanes. What is the rationale for having it at 
all?
    Mr. Pozen. I would say we do not know how the system would 
work without any safe harbor, and I would like to see from an 
evolutionary point of view how it would work out with a narrow 
safe harbor, so the rationale is both a preference for an 
experiential approach, and second of all, that in all 
industries there is some bundling, there are things that are 
put together, and I think the key is to understand what the 
bundles are composed of. We are very much supportive of the 
value of research. I was misquoted in The New York Times about 
a week ago on that. But the question is, what research is 
exactly being provided as part of that commission? The SEC has 
proposed an itemization or a better accounting of the 
components of the commission. I have no problem if I am buying 
a 3-cent execution and I am paying one penny more for access to 
a very well-trained and very good set of researchers. I just 
want to know what I am paying for. If research and execution 
are bundled together, you could argue this is no different than 
the fact that when you buy a computer, you also get software.
    Chairman Shelby. Sir, how can you know what you are paying 
for if it is all intertwined?
    Mr. Pozen. Now, it is intertwined. That is why I support 
the SEC's concept release where they would itemize the elements 
and so we would know what they are. But that is very different 
than saying if you know what the elements are, then you cannot 
buy a bundle. In order to allow the industry to continue buying 
bundles of products, you probably do need the safe harbor in 
Section 28(e).
    I am just explaining that there are two very different 
questions. One is, should there be an itemized breakdown of the 
commissions? And I strongly agree. I also feel that the SEC 
should have a much stricter definition of 28(e). But I would 
not answer yes to the second question--should we push for the 
repeal of 28(e)? If we knew the prices of all the items 
included in the commission and the SEC adopted a stricter 
interpretation of 28(e), I believe we could have a transparent 
negotiation, and some of the services might be bundled with 
others, as long as we know what we are getting, which we do not 
now.
    Chairman Shelby. But any market works more efficiently when 
people know what the cost of this is and where it is out there, 
as Professor Lutz says, ``in plain English.'' Otherwise you are 
guessing. It is ambiguous.
    Mr. Pozen. Here we are talking about the disclosure by the 
Wall Street firms as to what are the components of the full-
service commission. As I said, I strongly support the proposal 
to have an accounting of those items so that we can see what 
the items are. But I am just trying to say that is a very 
different question than if you understand all the items, can 
you buy two services together?
    Chairman Shelby. But you will never understand them if they 
are not itemized, will you?
    Mr. Pozen. I agree with that.
    Chairman Shelby. You will never know, just like Professor 
Bullard referenced. Go ahead.
    Mr. Pozen. I would also advocate in the semi-annual and 
annual reports that there be an average commission per share 
that is disclosed, but I would be against putting brokerage 
commissions into the expense ratio for two reasons. One is, 
brokerage commissions are treated for both accounting and tax 
purposes as a capitalized expense, and all the other expenses 
in the ratio are ordinary expenses. By capitalized expense, I 
mean that it goes to the basis, the tax basis of the security. 
So if you buy a security for $10 and you pay 5 cents a share, 
then its basis is $10.05, and when you go to sell it, you 
subtract the $10.05. So, you are really mixing apples and 
oranges.
    Chairman Shelby. But it is still an expense.
    Mr. Pozen. I believe it should be disclosed as a separate 
average commission per share. But I am saying if we put 
brokerage commissions in the expense table, we create the sense 
that it is the same expense as management fees and transfer 
agency fees; it is not the same expense.
    Chairman Shelby. It might be apples as opposed to oranges, 
but it is still fruit, is it not?
    Mr. Pozen. It is fruit, and we definitely need to have 
disclosures about brokerage commissions. All I am saying is 
that it should probably be right below the expense table, but 
should not be in the expense table.
    The other thing is that commission prices are only one 
element of brokerage costs. You also have spreads, and spreads 
are extremely difficult to compute. I do not know how anyone 
would be able to say the exact amount of spread that had been 
paid. So, I am all for the disclosure of the average commission 
per share that the fund pays, but I think that we should be 
careful to understand that it is a very different expense than 
the other expenses in the expense table and should be broken 
out separately.
    On the question of expense reporting, I think we should 
understand that there has been an effort over the past decade 
to have expense reporting in the prospectus. There is a fee 
table with the advisory fee, the transfer agency fee, the 12b -
1 fee, and other fees. I think the problem is that these are 
expressed in basis points which most people have a hard time 
understanding.
    Chairman Shelby. Excuse me. But they could change that. You 
could have a little formula there, saying 10 basis points 
equals so-and-so, or 5 basis points, rather than just basis 
points.
    Mr. Pozen. I agree, and the hypothetical, the $10,000 
hypothetical is there to try to give you an actual dollar 
amount, but still, it is a hypothetical. What we are doing at 
MFS is to provide for every shareholder in the quarterly report 
the estimated dollar expense of their expenses in each of their 
funds.
    There has been a large debate about whether or not this is 
too expensive for the industry, and if you really tried to get 
the actual expenses of every single shareholder and every 
single fund, it would be in fact a very large computer 
programming project and would cost a lot of money. But what we 
have done is made two simplifying assumptions which are quite 
reasonable and give you a very good estimate. The first 
assumption is that at the end of the quarter we look and see 
what funds you hold, and then we assume that you have held them 
for the full quarter. We do not assume that, for instance, you 
came in on January 21 and came out on March 21. That assumption 
makes it a lot easier. In fact, by making that assumption, we 
might be overstating a little your fund
expenses because if you came in on January 21, we are actually
giving you what you would have paid during the full quarter.
    We are also making a second simplifying assumption that you 
are reinvesting your dividends, which most shareholders do. So 
with those two simplifying assumptions, which are applicable to 
over 90 percent of our shareholder base, we are able to provide 
later this year an estimated dollar amount of the expenses for 
each shareholder for each of the funds that he or she holds at 
the end of the quarter. I think this is a case in which the 
best is the enemy of the good. We can give a good estimate. It 
is not perfect. We can do it at a reasonable cost. If we try to 
have the perfect number, the exact number per shareholder, then 
we are imposing these large computer programming costs, which I 
think are unnecessary because I think we can get a very good 
estimate that is applicable to most shareholders through such 
assumptions.
    I also wanted to talk about fund governance, and here again 
MFS is leading the way. We already have over 75 percent 
independent directors and we have independent co-chairmen of 
the funds drawn from the independent directors. But I have to 
say in this debate about whether you should have an independent 
chairman or an independent lead director, I think it has become 
a little symbolic. The question from my point of view is, do 
you have a senior independent director who is playing the 
functional roles that you need? Among these functional roles, 
the most important are first to have an executive session of 
the independent directors in which management is not there, 
where they can have a discussion about issues. And you need a 
senior independent director to lead that. Second, you need a 
senior independent director to work with management to help set 
the agenda for the board meetings. If you have such a senior 
independent director playing those two functions, in my view it 
is not so important whether that person is called a chairman or 
a senior lead director. The key is to have the functions 
played, and if those functions are played, it seems to me it is 
okay to have them called in some complexes ``chairman'' and in 
other complexes ``senior lead directors.'' The key point is to 
have the functions played.
    Another aspect of fund governance is to have outside advice 
for the independent directors that is really their own advice. 
Most complexes, as MFS, have outside counsel to the independent 
directors, and that outside counsel is an independent firm. At 
MFS, we have gone one step further and we will have an outside 
compliance monitor who works for the independent directors and 
who will monitor the compliance activity of management.
    Of course, we on the management side have our own 
compliance director, but this will serve as an additional check 
and balance.
    On the management side of MFS we have my position, which is 
a new position, the Non-Executive Chairman of the management 
company who reports directly to the fund directors. We also 
have a second new position, an Executive VP for Regulatory 
Affairs, which shows how important we think those issues are, 
and that person is now a member of the management committee, 
the executive committee of the management company.
    However, I have heard various proposals on governance that 
I would respectfully disagree with. Some of these proposals 
involve establishing an SRO for mutual funds. Some of them 
involve having a special board to provide guidelines to 
directors. I personally am in favor of a flat organizational 
structure. I think it is best when people are getting the word 
from the real authority. I believe that the key is to have an 
effective Investment Management Division at the SEC, to 
strengthen it, and to give it more personnel if necessary. SEC 
officials are the ones who should be dealing directly with the 
regulation of the industry, and they are the ones who should 
also be giving guidelines to directors if guidelines are 
appropriate. So, I would urge the Committee to take the 
approach of giving the SEC more resources, which I know has 
been done, rather than to create these intermediate boards or 
bodies which I believe would not be particularly helpful.
    The last question, on which I had not intended to testify, 
but since it was brought up, I will mention it involves 12b -1 
fees. Here I would strongly agree with the people who say we 
need better disclosure at the point of sale. When the broker or 
representative is presenting these issues to the customer, the 
customer needs to understand if there are 12b -1 fees and how 
much they are paying in addition to the other fees. The SEC has 
a proposal now for better point-of-sale disclosure. I think it 
is a step in the right direction. And it is quite a good 
proposal. Obviously there are aspects of it that people will 
debate.
    But I am strongly against the elimination of 12b -1 fees, 
because 12b -1 fees are essentially an installment payment plan 
for a sales load. It used to be the case that we had sales 
loads of 8 percent up front. Then 12b -1 fees were allowed by 
the SEC. The historical origins of 12b -1 are quite complex, 
and people can debate historically what its original intent 
was. But now it serves as an installment sale plan, so instead 
of paying 8 percent up front or 6 percent up front, you pay a 
certain amount each year for a certain number of years. In my 
view, people should have the choice. They should have the 
choice between an up front payment and an installment sale over 
a number of years. But the key point is that they understand 
the difference and they understand what they are signing up 
for. If they know that they are signing up in one instance for 
a front-end load and in another instance for an installment 
plan with a certain amount of payments each year, then that is 
a reasonable choice. If we do not have good point-of-sale 
disclosure, then we are not building a good system.
    I think it would be a big mistake to eliminate 12b -1 fees 
and eliminate the choice of an installment sale plan for many 
people who want that plan.
    I think I am going to end there and leave the floor for Ms. 
Roper.
    Chairman Shelby. Thank you.
    Ms. Roper.

                   STATEMENT OF BARBARA ROPER

                 DIRECTOR, INVESTOR PROTECTION

                 CONSUMER FEDERATION OF AMERICA

    Ms. Roper. Thank you very much. Thank you, Chairman Shelby 
and Senator Sarbanes for holding this hearing today and for 
inviting me to testify.
    When I prepared for my testimony today, I thought it was a 
good opportunity to look back at what has been done at the SEC 
since the mutual fund scandals first hit. I would like to say 
at the outset that we at CFA think that the SEC has done a very 
good job in recent months of developing a strong and credible 
mutual fund reform program. Although the Agency may have been 
caught off guard initially by the mutual fund scandals, it 
seems now to be acting aggressively in all three areas of its 
responsibility--enforcement, oversight, and regulatory policy.
    It is on that issue of regulatory policy that CFA has 
primarily focused its attention. Last November we, along with 
Fund Democracy and several other national consumer groups, 
released a blueprint for mutual fund reform, outlining the 
steps we believed were necessary to restore badly shaken 
investor confidence and the integrity of the mutual fund 
industry. When I prepared my testimony today, I went back to 
that blueprint to see what we had recommended, what the SEC has 
since done, and what we believe 
remains to be done by Congress or by the SEC to achieve that 
agenda. My written statement goes point by point through the 
blueprint and analyzes those issues.
    Chairman Shelby. Could you touch on those just a minute?
    Ms. Roper. There are probably 30 recommendations in the 
blueprint, but, yes, I will look at that. When you look at what 
the SEC has done, it is a preliminary assessment at this point. 
Most of what they have proposed is either in the rule proposal 
or concept release stage on the key issues, and we do not know 
for sure what the final rules will look like. In some cases, 
particularly like the point of sale and confirmation 
disclosure, we are very supportive of the thrust of what the 
SEC is trying to do, but believe significant amendments are 
needed to realize the potential of those reforms. We believe 
Professor Lutz has some very helpful suggestions. We do not 
know whether those changes will be adopted, so we do not know 
what this program will look like 6 months from now. What is 
really rather remarkable, when you go back and perform this 
exercise, is how much of the policy that we suggested in the 
blueprint in November has since been taken up by the SEC. So in 
areas that have to do with how you specifically address the 
trading scandals or how you deal with broker-dealer sales 
abuses or how you deal with oversight of mutual funds, most of 
what we have suggested has since been either proposed or 
adopted by the SEC.
    Despite that important progress, we see some areas where we 
think there is still a need for legislation. Some of those are 
the result of the SEC's lack of authority to act, or lack of 
authority to adopt reforms that we believe are needed. Some of 
them are areas where the SEC would appear to have the authority 
but simply has not taken the actions that we think are 
necessary to adopt important investor protections. So while we 
do not necessarily see the need for sweeping legislation, the 
mutual fund equivalent of the Sarbanes-Oxley Act, we do still 
believe that there is a need for a narrower bill targeted at 
some specific issues.
    At the top of our list of those issues is one that we have 
discussed a lot this morning, and that is mutual fund cost 
disclosure. It has for us been the one big disappointment in 
the SEC's response that they have not proposed the innovative 
presale cost disclosure for mutual funds that we believe is 
necessary to provide real effective market discipline of mutual 
fund costs. I am going to leave aside the point on portfolio 
transaction costs. I agree with the statements that Mercer has 
made, that if we are going to provide cost disclosure 
information, it needs to be complete cost disclosure. We need 
to be covering the costs in a way that does not create a 
misleading impression about the affordability of that fund.
    That said, I think that the current system works reasonably 
well for a portion of the investing public--those people who 
either have the sophistication themselves to find the relevant 
information and use it to make cost conscious decisions and buy 
high-quality, low-cost funds, and those people who have 
objective advisers who are helping to steer them into those 
high-quality, low-cost funds. But we also know that there are a 
lot of low-quality, high-cost funds that are able to survive 
and even thrive in this marketplace. And the question is why? I 
think ineffective boards is part of the answer. I think reverse 
competition in the broker sold market is part of the answer. 
But I think a major part of the answer is that we are not 
giving unsophisticated average investors the type of cost 
information they need to make good purchase decisions.
    The way we assess disclosure is, does it provide the 
information you need at a time when it is useful to you in 
making your purchase decision and in a form you can understand 
and that encourages you to act on that information? I would say 
that the current cost disclosure on mutual funds fails all 
three of those tests.
    The SEC's recently adopted rule on cost disclosures, 
putting this information in the shareholder report, in my view, 
simply fine tunes the system for the people for whom it is 
already working reasonably well. It does not do much to help 
ensure that the investors who are not well-served by the 
current system are now going to get the information they need 
in a form they can understand at a time when it is useful to 
them.
    So, we would certainly like to see this Committee take up 
the issue of improved mutual fund cost disclosure. Because you 
can bring down costs a fairly modest amount, and add billions 
of dollars to the retirement and other savings of working 
Americans.
    The goal should be to look at how we are going to make the 
system work for the people for whom it does not work now--for 
the people who are buying high-cost, low-quality funds, and the 
average unsophisticated investors who are most in need of 
controlling their costs and least likely to do so now.
    To do that, in very general terms, we would like to see you 
adopt legislation that requires presale disclosure of 
comparative cost information for mutual funds in plain English, 
in a document that is accessible to average investors, that is 
tested in advance for its readability and usability by average 
investors. And we would also like to see mandatory disclosure 
along the lines that MFS is now providing on account statements 
of estimated actual costs for shareholders.
    We know investors look at their account statements. It is a 
document that we believe is an effective place to provide cost 
information. It is not as good as presale disclosure, because 
it comes after the purchase has been made. But at least it 
provides an opportunity to make investors much more aware of 
the impact of costs and to maybe encourage them to make more 
informed decisions in the future.
    We believe that approach combined with the fund governance 
reforms proposed by the SEC--and we would like to see those 
enhanced in certain ways, creating a broader fiduciary duty 
along the lines that Professor Bullard has recommended--we 
believe that those steps could go a long way toward wringing 
out excess costs from the mutual fund industry, enhancing the 
retirement savings of average Americans, and doing that without 
any need to set costs or impose costs. Let the market 
discipline costs. But for the market to discipline costs, we 
have to have an effective system of disclosure, which we do not 
have now.
    And then quickly looking beyond the cost issue, there are 
several areas where we believe the SEC needs enhanced authority 
to act--where we believe they may have the will to adopt 
reforms, but not the ability. One of those that we think is 
very important is in the issue of the independent governance 
requirements. We believe that the SEC needs to be able to apply 
those reforms directly, not rely on the exemptive rule process. 
We believe they need the ability to strengthen the definition 
of what constitutes an independent director so that your uncle 
or someone who retired 2 years ago from the fund manager cannot 
serve as an independent director. And, as I said, we would like 
to see the fiduciary duty of directors expanded to cover the 
entire range of costs of the mutual fund.
    We also believe that Congress either needs to ban soft 
dollars directly or the SEC needs to be given the authority to 
do that. You cannot allow funds to shift the costs for certain 
operating expenses on to shareholders in a form that they 
cannot see or understand--to take costs that are operating 
costs that they should have to be paying for directly, and that 
should be reflected in the expense ratio, and allow them to 
shift it into the portfolio transaction costs, where they are 
paid by shareholders and hidden from view. When you have a 
system that discloses costs in one area and hides them in 
another, the incentive to move expenses into the hidden arena 
is too strong. We think a ban on soft dollars is the cleanest 
approach to solving that problem.
    I was here when you held a hearing recently with the 
officials from the SEC, and one of the issues that they raised 
is the hard 4 p.m. close to deal with late trading. That has 
been a controversial proposal because of certain inequities it 
creates for those of who do not live on the East Coast or who 
invest through retirement plans. They suggested that the reason 
they had been forced to take that approach is that they do not 
have regulatory oversight authority over a number of the 
intermediaries who handle mutual fund transactions. So, they 
could not be confident that, if they relied on a system that 
was based on end-to-end tracking of mutual fund transactions, 
they would have the authority to ensure that that system was 
functioning properly.
    Chairman Shelby. They would have to have statutory 
authority.
    Ms. Roper. Presumably. They seem to think that they need 
statutory authority to do that. I am not certain whether there 
is not an alternative without that. But if that is the case, I 
think that they need at least some limited oversight authority 
of those intermediaries so we can get to an alternative to the 
hard 4 p.m. close that does not have its same drawbacks.
    These are the issues that we see on a short-term agenda. 
There is a longer-term issue that I think has been raised in 
the mutual fund scandals, and that has to do with the abusive 
sales practices by brokers. The SEC has put forward a number of 
helpful proposals, fairly bold proposals in some cases, to deal 
with those problems targeted at mutual funds. But I think the 
issue of abusive broker-dealer sales practices is a broader, 
more complex issue that needs a lot more study. The goal should 
be to narrow or eliminate this gaping divide between the 
professional advisory image that brokers portray of themselves 
to the public, the way they market themselves to the public, 
and the conflict-laden, sales-driven reality of their conduct.
    Thank you.
    Chairman Shelby. Thank you.
    Professor Pozen, could you elaborate on the conflicts 
surrounding soft dollars and how a ban would benefit investors, 
if it would. In other words, how would a ban on soft dollars 
impact both smaller and full-service broker-dealers and 
independent research providers?
    Mr. Pozen. I think that that is a complex question because 
we have never had a ban. But I believe there is an issue 
involving research and then there is an issue involving market 
data, and then there is an issue involving other services, and 
I think it is important to distinguish among them.
    There are certain products which are now paid for with soft 
dollars, which are clearly readily available for cash. Those 
include things like terminals. They include items like computer 
software, these types of things. In that case, the broker-
dealer to whom you are paying the 5 cents a share is only 
acting as a paying agent. They are acting as a conduit. So, I 
do not think there would be much disruption if those types of 
soft-dollar payments were cut out.
    But research is a much more complex matter. We have 
independent research firms, and some of them are excellent and, 
not surprisingly, we have some independent research firms that 
are not so good. We have some good research departments on Wall 
Street or some particular analysts that are good and some that 
are not so good. We want to encourage securities research. We 
want to encourage good research.
    Any management company like MFS that is really excellent 
has a large stable of its own analysts, but we need to be able 
to get research from other places, so I think we need to be 
very careful about what we do with soft dollars with regard to 
research, as opposed to other goods and services.
    Chairman Shelby. I think you have answered this, but a 
number of broker-dealers and independent research providers 
have 
advocated that a ban on soft dollars would drive fund advisers 
to integrated firms that provide in-house execution and 
research at the expense of independent broker-dealers and 
third-party researchers.
    Mr. Pozen. I think this is an issue and that there are two 
ways to solve it. One is going back to the old test of readily 
available for cash, since that eliminates a lot of goods and 
services other than research, and maybe it should be limited to 
nonresearch services; and, second of all, as you point out, 
requiring more of a specific accounting for the elements of the 
full-service commission because then people would know whether 
they are paying for research and what type of research they are 
paying for.
    Chairman Shelby. Professor Bullard, some contend that 
instead of prohibiting soft-dollar arrangements, the SEC should 
require broker-dealers and the funds to unbundle commissions 
and disclose the values assigned to execution and research. In 
addition, others contend that the SEC should tighten the 
definition of research, narrowing the scope of products and 
services that qualify.
    How would unbundling commissions and redefining research 
help to reform soft-dollar practices? In other words, would 
unbundling create greater transparency for soft dollars and 
allow competitive market forces to work? If commissions are 
unbundled, should the underlying cost of the research be 
disclosed in the expense ratio?
    Mr. Bullard. It is a good question. As Mr. Pozen has 
already suggested, under the current environment, it is very 
difficult, even for a huge money manager such as Fidelity and 
MFS, to negotiate down that 5-cents-a-share commission. 
Unbundling permits competition between the fund manager and the 
broker by giving the fund manager a much stronger leverage in 
order to negotiate a lower price because now the amount of that 
5 cents that is paying for research has been separated out.
    This proposal was actually made by the SEC a number of 
years ago when I was at the Commission. It was shot down mainly 
by the independent researchers on the view that at that time 
what would get quantified was what they provided and what the 
Goldman Sachs and the Merrills of the world provided would not 
because they would argue, that is just overhead. It does not 
really cost us anything, and they would hurt the independent 
researchers.
    What I am hearing from the independent researchers is they 
think it can be done. If it can be done, that would be a very 
good step to promoting competition in that context. It does not 
do anything, however, to promote price competition between 
funds and
let shareholders see the real impact of different approaches, 
and that is why putting it in the expense ratio or at least 
allowing the SEC to provide a number that adds up all of those 
figures, and let Morningstar and Don Phillips decide whether 
that is a number that really reflects expenses as your exchange 
with Mr. Pozen
suggested.
    Chairman Shelby. Ms. Roper and Mr. Pozen, could you comment 
on the effectiveness of unbundling commissions and tightening 
the definition of research as means to reform soft-dollar 
practice.
    Ms. Roper, we will start with you.
    Ms. Roper. First of all, when we talk about banning soft 
dollars, we think it is essential that you require the full 
service firms to unbundle, that you cannot discriminate against 
independent research and let Wall Street continue to include 
the cost of its research in the portfolio transaction costs. 
So, for us, unbundling is part of a ban, as well as a 
possibility for another approach that stops short of a ban and 
yet provides significant benefits.
    With unbundling, if there is at least disclosure, clear 
disclosure of what you are paying for when you are paying those 
commission--it helps to provide transparency. But it still 
allows those costs that are operating costs to be shifted onto 
shareholders. If they are legitimate operating costs, they need 
to be reflected in the operating expense ratio.
    Chairman Shelby. And disclosed?
    Ms. Roper. And disclosed. I think it is Jack Bogel, who 
said, ``It is amazing what you are willing to pay when you are 
paying with other people's money.'' You need to exert some 
market discipline on research costs. We need to make sure that 
when funds are buying research, they are buying research that 
adds real value to shareholder and does not simply satisfy 
certain trading agreements that they have made with brokers.
    I think there is progress that can be made short of a ban, 
in terms of making those costs transparent, making it easier 
for fund managers to negotiate down their transaction costs. I 
think the best solution is to make, I mean, you can, if you get 
portfolio transaction costs into the expense ratio, then you 
have solved the problem of the cost shifting onto shareholders.
    There are different ways to approach this, but the goal of 
that should be one, that operating costs are reflected in the 
expense ratio and, two, that costs that should be borne by the 
fund manager are not shifted onto shareholders.
    Chairman Shelby. Mr. Pozen.
    Mr. Pozen. Again, I think that we have to distinguish 
research from all of the other goods and services. I think that 
most of the other goods and services are readily available for 
cash, and management companies should pay cash for them, so 
then we can eliminate all these issues. The SEC has the 
authority to do it now. All they have to change is their 
interpretation of 28(e).
    As to research, I think it is much more complicated. We do 
not want to put independent research at a disadvantage to the 
full-service firms. And the only way I know to do that is to 
require an accounting of the items that compose the full-
service commission. But then I think you should disclose the 
average commission per share in the semi-annual reports, and 
then that would reflect, to the extent there was any bundling, 
a higher or lower cost so that the shareholders could see. If 
somebody was reporting an average commission share of 5 cents a 
share, then they obviously were paying in part for research 
versus someone who was reporting an average of 3 cents a share. 
I think from the shareholders' point of view, they should 
understand what is being paid for commission per share.
    Again, what is the real expense of a brokerage transaction? 
You have to combine the commission with the spread. And if you 
start to try to compute the spread, I really do not know how 
you would compute it, and therefore I am very reluctant to say 
that this is the total brokerage expense for a fund. I think it 
is more accurate to say this is the average commission per 
share, recognizing that there are other elements to brokerage 
cost--the market making spread, a whole series of other 
things--and that would be a more accurate approach.
    Chairman Shelby. Thank you.
    Senator Sarbanes, thanks for your indulgence.

              COMMENTS OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you, Mr. Chairman.
    First of all, I want to thank the members of the panel not 
only for their statements here today, but also the careful work 
that has gone into the written statements which are very 
helpful to the Committee.
    I want to try to get a little more focus. I want to ask 
each of you what you think are the one or two or, if you feel 
compelled, the three priorities the Congress should address and 
whether the SEC has the authority now to do these items. There 
are different categories. There are some priorities that you 
could say this should be done, and the SEC cannot do it because 
they need authorities that they are now lacking statutorily. 
Therefore, we call on the Congress to give them those 
authorities. Or, indeed, you can go a step further and say that 
is not enough, either with respect to those authorities or 
authorities they already have; they do not seem to be moving to 
apply a standard that we think is appropriate, and therefore we 
ask the Congress to apply or impose that standard.
    Could we very quickly just get what your top priorities 
would be in response to that framework of analysis?
    Mr. Bullard. Sure. My top priorities would be all fee 
disclosure proposals.
    First, portfolio transaction costs. And I think it is 
important to emphasize this is not about the SEC forcing the 
market to take the commission, plus the spread, which is 
routinely measured by fund boards at virtually every major 
complex and forcing that on the market. This is offering the 
market, this is offering Morningstar a decision about whether 
it thinks the best number to use for its clients is a number 
that includes portfolio transaction costs.
    I do not see why either MFS or the SEC should make that 
decision for the market by refusing to let that portfolio 
transaction cost number be added to the expense ratio that the 
SEC apparently believes is more truthful, notwithstanding that 
the most recent study showed it is 43 percent of cost.
    In addition to that, dollar disclosure, which Mr. Pozen has 
just explained, is not too costly, as argued by the Investment 
Company Institute for the last 9 months, and the consumer 
groups have consistently supported the best possible, most 
practical approach that you just described. The SEC, to answer 
the question of where they are on that issue, has flatly 
rejected that approach.
    Finally, with respect to 12b -1 fees, I think that that is 
an area where we can have real cost savings if we start making 
investors see more precisely what they are paying.
    I totally agree with Mr. Pozen that I would not repeal 
12b -1 unless you still allowed installment loads to be one way 
that investors paid, but there is nothing inconsistent about 
the two. The SEC can allow installment loads to be used, as 
well as front-end loads and back-end loads and any combination 
thereof, and that is a good thing for investors. It is just 
that in each case it should come out of the investor's pocket. 
It should be clearly paid as a result of the investor's 
relationship with the broker so that you do not have this 
harmful incentive to buy shares that have an installment load 
that the fund is paying, so you do not see the cost, as opposed 
to a front-end load that comes right out of your pocket.
    So it would be fee disclosure, fee disclosure, fee 
disclosure.
    Chairman Shelby. Professor Lutz.
    Mr. Lutz. I would agree that number one, would be to reveal 
all fees, but to explain them clearly and understandably and in 
a format that makes them comparable from fund to fund to fund.
    Number two, I would design all disclosure documents, forms, 
et cetera, from a user's point of view. The current proposed 
forms are designed from a broker's point of view, that is, to 
ensure that the broker is complying with the regulations. It 
seems to me that that is backward. We should design all of the 
documents from the user's point of view.
    Number three, I would require all the principals of 
information design, and any such forms or documents delivered 
to people before and after the sale. That would include 
usability testing, document design, plain language, et cetera, 
so that these are fully understandable as stand-alone 
documents. You do not need a lawyer and an accountant to 
explain these things to you.
    I think that, for that third one, perhaps the SEC might 
need some small additional funding for that, but once in place, 
it would not be a significant expense, but the benefits would 
be tremendous from the investors' point of view.
    Chairman Shelby. Mr. Pozen.
    Mr. Pozen. It will not be surprising to know that the first 
item I think we should rework is 28(e) for nonresearch items; 
we need a better accounting and itemization disclosure system 
for research payments done through soft dollars.
    The second item, as we are doing at MFS, I would advocate 
individualized expense reporting based on these two simplifying 
assumptions--that the person holds all his or her funds through 
the whole quarter and that they reinvest their dividends.
    The third item, which I think Barbara raised, is an 
interesting point about the hard close. My concern is that this 
is not an authority issue so much as a practicality issue. I 
have been involved with the development of a lot of computer 
systems, and let us put it this way, it is very rare that you 
see a big system brought in on time and on budget, and that 
these macro systems are very expensive and take a long time.
    I would actually be in favor of a much simpler system in 
which any pension fund or any brokerage firm that sends bundled 
orders to a mutual fund be required to certify that all of the 
orders were submitted to them before 4 o'clock, and we should 
have some random audit that should be done by their auditors to 
make sure that that is really true.
    All of the cases of late trading that I know of involve 
instances of collusion, where people were actively colluding 
with firms. What we need is both a certification and an outside 
person, an external auditor and perhaps an occasional SEC 
random check, to make sure that when these firms put a time 
stamp on an order and when they certify that it was submitted 
before 4 o'clock, it actually was.
    MFS was never involved with any of these collusive 
activities, so I am not an expert on them. But it seems logical 
to me that before developing a hugely expensive computer 
system, we should again look at what is a good system rather 
than the best, go to time-stamping, with an external audit and 
an occasional random check. This might be the most practical 
way to deal with this very difficult set of issues for pension 
funds and brokers that send bunched groups of orders rather 
than individual orders.
    Senator Sarbanes. Ms. Roper.
    Ms. Roper. Our top priority, as I said before, is that we 
develop a system of mutual fund disclosure that is designed 
with average, unsophisticated investors in mind to give them 
presale comparative cost disclosure and other key information--
about the fund, such as risks or investment style, strategy, 
who it is appropriate for--at the point that that fund is 
recommended so that we enable investors--average, 
unsophisticated investors--to make better mutual fund purchase 
decisions.
    The SEC in our view has the authority to do that, but has 
not taken that approach. And what is interesting is they have 
now created the opportunity with their proposed disclosure, at 
point of sale, which we would like to see as a point of 
recommendation. But with their proposed disclosure on broker-
dealer costs and conflicts, they have introduced a point in the 
transaction where you can provide that disclosure, but have not 
taken the next step of saying that we are going to disclose not 
just these distribution-related issues, but this mutual fund 
information as well.
    Beyond the specific issues, I already outlined where we 
believe the SEC needs added authority, there is another longer-
term issue that I think is extraordinarily important, and that 
has to do with brokers; sales practices. Anyone who has looked 
at a broker's ad sees that they portray themselves to the 
public as if their investment advice were the primary service 
they had to offer, as if they were objective professional 
advisers. Yet the law says that they are salespeople and that 
they are exempt from the Investment Advisers Act to the degree 
that they give advice that is solely incidental, or merely 
secondary, to product sales.
    I think this disconnect between how brokers market 
themselves to the public and how they then behave in reality 
has a lot to do with the lack of effective cost competition in 
the mutual fund industry. They have an impression that they 
create with the investor that they are operating in their best 
interests, but no legal obligation to do so. They have an 
obligation to make generally suitable recommendations, which, 
as enforced, falls far short of any obligation to act in their 
clients' best interests, or to put their clients' interests 
ahead of their own.
    Even where we have for advisers an obligation to put their 
clients' interests ahead of their own, we have never seen that 
enforced in a way that makes them take costs and quality of the 
product into account in their recommendations.
    And so I think there is a longer-term agenda of looking at 
the way that we sell products to the investing public that 
looks at this disconnect between the image that is planted in 
the public's mind about what to expect and the reality of 
practices. That would go a long way toward helping average 
investors. Because we can do great disclosure. I mean, we could 
design a system that provided great disclosure. But you have to 
take into account the reality that the average person who goes 
in and consults a broker does not expect to second-guess their 
recommendations. So what are we going to do to make sure that 
they get the services that they expect when they enter that 
relationship?
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Professor Lutz, you are a lawyer and an 
English professor. You have a Ph.D. and a J.D. You state that 
mutual fund disclosure is confusing because investors are 
presented with a lot of data that is located in several 
documents. It seems that fund disclosure documents are written 
by lawyers for lawyers.
    I appreciate that there can often be a balance between 
insuring sufficient disclosure to protect against legal 
liability and presenting information in an easy-to-understand 
manner. For example, some would contend that technical language 
is necessary in order to protect the funds against subsequent 
allegations that they did not provide full disclosure. How do 
you balance these interests and give investors the information 
that they need to make informed investment decisions, as well 
as comply with the necessary language to protect the----
    Mr. Lutz. There is no conflict.
    Chairman Shelby. No conflict. I am glad to hear that.
    Mr. Lutz. Well, stop and think for a second. We are talking 
about using plain language to explain things. How can we be 
distorting or hiding?
    Chairman Shelby. The people that contend otherwise, it is 
not a good argument, in other words.
    Mr. Lutz. But I have done it. The State of New Jersey has a 
plain language law which it passed over 20 years ago. I was in 
law school at the time that the New Jersey legislature passed 
it. I remember the instructor in one of my courses saying, he 
called it the Employers' Full Employment Act because we would 
be litigating all of these plain language documents. Since that 
time there has not been one lawsuit in the State of New Jersey 
over the plain language documents that are used.
    The Michigan State Bar Association a few years ago 
conducted a search as far as they could find any lawsuits, 
whether Federal or State level, brought because of plain 
language, and they found none. Since I have translated 
technical language into plain language, stop and think for a 
second. What you are saying is that only these words can 
communicate this reality. It is linguistically impossible. This 
is why we have synonyms.
    Chairman Shelby. Ms. Roper, you know the SEC has recently 
proposed rules requiring brokers to make certain disclosures to 
investors at the point of sale. Would you discuss how investors 
might benefit from point of sale disclosure regarding the cost, 
the expenses, and performance of the fund that they are 
purchasing.
    Ms. Roper. Right. First of all, I want to move the timing 
back. I want it at point of recommendation, not at point of 
sale. I think if you get a document when you are ready to write 
the check or transfer the money, you have made your decision. 
You are not going to then carefully review that information. So 
the information needs to come at the time when you are still 
considering your purchase so that you can factor it into your 
purchase.
    It seems to me to be simple common sense, that if we want 
people to make cost-conscious purchase decisions, that we 
should give them information about costs before they make their 
purchase.
    Right now, if you buy through a broker, you do not have to 
get that prospectus until 3 days after the sale. The likelihood 
that you will then take that information and act on it and try 
to rescind that transaction or bear the costs of changing into 
a lower-cost fund is just remote, at best. If you want people 
to have information they are going to act on, common sense 
dictates it has to be presale.
    I think if you then present the information in a way that 
is compelling--not just data, as Professor Lutz said, but 
information in a way that is compelling. You could, for 
example, say, when we talk about comparative information--and I 
do not have all of the answers about the best way to do this--
but say you said this is how the costs of your fund compare to 
the category average costs, this is how it compares to an index 
fund that invests in the same type of securities, and this is 
the dollar cost implications of that difference over 1-, 5-, 
and 10-year periods. Assuming the same rate of return, this is 
what you are going to pay more or this is what you are going to 
save, by virtue of the costs of your fund, how it compares. If 
you give that information to people in advance of the sale and 
say, look, you are going to pay $900 extra over the next 10 
years because you chose this fund rather than one that has just 
average costs or you are going to pay more than that extra 
because you chose this actively managed fund rather than a 
comparable index, you might get people to factor costs into 
their decisions.
    What that means is that 30 years down the line when they 
are retired, it is tens of thousands of dollars that they have 
in their retirement savings account that they would not have 
had, had they invested in a high-cost fund. That, to me, is why 
we have to care about this issue. We know that people are not 
making adequate preparations for retirement. We have a way that 
we can help address that situation by giving them information 
that they can use. I think we should be doing it. We should 
reflect, in our approach to disclosure, the fact that the 
markets have changed.
    Chairman Shelby. Information they can use before they make 
their decisions.
    Ms. Roper. Before they make their decision, and information 
that is designed with the idea in mind that the nature of 
investors has changed in the last 20 years, that we have a lot 
of people in the markets today who are not financially 
sophisticated. We need to design a system with them in mind.
    Chairman Shelby. Professor Bullard, do you have any 
comments?
    Mr. Bullard. Sure. I would like just to add to your 
question about liability versus plain English. I think there 
are situations when they can be in conflict. To give you an 
example, there was a District Court decision recently in which 
a plaintiff alleged that there was a fund that had A, B, and C 
shares and that there was no rational investor for whom B 
shares could possibly be the best investment. The question was 
do you have to tell them that in your prospectus? Do you have 
to say in your prospectus, look, we are offering you A, B and 
C, none of you could conceivably be better off with B?
    The Court said, okay, I will assume that that is the case, 
and I will find there is absolutely no obligation to disclose 
that no one would be better off buying B shares. This was the 
holding of the Court.
    The SEC has specifically decided not to require that you 
explain to people the pros and cons of different classes and 
that you do not have to tell people when one of those classes 
would never be the best investment.
    Now imagine that you are counsel for that fund, and they 
come to you and they say, well, clear language would require 
that we tell them do not buy B shares, even though we are 
offering them, and the lawyer has to tell them you would be out 
of your mind to say anything about those B shares because, 
first of all, you will not sell any and second, you will get 
sued, and the District Court has just told you, you are 
completely insulated if you keep your mouth shut.
    There are other instances like that when they are in 
conflict. That is why we need the type of disclosure that we 
have been talking about today.
    Chairman Shelby. Mr. Pozen, do you have any comments?
    Mr. Pozen. We had an effort maybe 5 or 6 years ago, and I 
actually designed what was called a short-form prospectus, and 
at that point people were trying to come to grips with the fact 
that most investors will not read a long prospectus. And with 
all respect to Professor Lutz, if it is a 20-page prospectus, 
even with his great English, I am not sure they are going to 
read it.
    Chairman Shelby. But they have a better chance to read it.
    Mr. Pozen. They would have a better chance, but----
    Chairman Shelby. And a better chance to comprehend.
    Mr. Pozen. I agree, but they would have a much better 
chance if we could have a 3- or 4-page prospectus in Q&A form, 
and that is what was developed, plus a backup longer form.
    I guess I am just wondering out loud whether or not, 
regardless of how well you write the prospectus, if it is 20 or 
25 pages long. I have a feeling that a lot of people I know who 
are not investment experts would still go to sleep on the 
prospectus. I urge the Committee to look at these short-form 
prospectuses that were done. They were done especially for 
401(k) plans. They were all done in similar question and answer 
order. They gave you the gist of the prospectus so you could 
get most of what you want quickly.
    The real dilemma here is the investor will read something 
that is short and gets at the major points, but there are a lot 
of other points that the investor probably should take into 
account. Once you start putting all of those in, even though 
you do a good job, like Professor Lutz says, it gets to be a 
20- or 25-page document. So, I am still trying to figure out 
how you resolve that tension.
    But I know one thing, when we did a number of focus groups, 
more people will read a 3-page prospectus than will read a 20-
page prospectus, no matter how well that 20-page prospectus is 
written.
    Chairman Shelby. But the bottom line is what is in that 
information and how well-disclosed it is.
    Mr. Pozen. I agree with that. But still, if you are going 
to do a 3-page prospectus with a backup, you inevitably have to 
focus those 3 pages on the main points, and there are other 
points which can be important in individual circumstances which 
you are not going to be able to get into those 3 pages.
    Chairman Shelby. But what we are trying to do, at least 
this would be my perspective, is to have a well-informed mutual 
fund purchaser.
    Mr. Pozen. Sure.
    Chairman Shelby. You know, a purchaser of mutual funds 
would know what the costs were. Nothing hidden, no hidden 
agenda----
    Mr. Pozen. I agree with that.
    Chairman Shelby. --nothing hidden by words or deeds and so 
forth. In other words, we have all been taught, I think, that 
an informed purchaser is the best purchaser because then they 
can trade or not trade in the marketplace.
    Mr. Pozen. My experience has been that if we really want to 
accomplish that goal in practice, we need what I call 
``tiered'' disclosure. We need a short-form prospectus in 3 or 
4 pages that you can look at quickly, and then we need that to 
be backed up with a 20- or 25-page prospectus that Professor 
Lutz would write in plain English.
    Chairman Shelby. All of this reflecting the truth, though.
    Mr. Pozen. Of course. All I am trying to say is that there 
is a tradeoff--the more information you give people, the longer 
the prospectus is, the less likely people are going to read it. 
What I mean by a tiered disclosure system, what I would like to 
see, is a good Q&A, short-form prospectus which would be 
attached to the long-form prospectus, so that people would have 
the benefit of getting the main points in those 3 or 4 pages. 
Then if they wanted more, we would encourage them to read the 
full prospectus.
    As a practical matter, from my experience with focus 
groups, many investors are not prepared to read the full 20 to 
25 pages no matter how good the English is, no matter how good 
the disclosure is. So that is why I am in favor of two 
documents--a short-form prospectus and then a full prospectus 
written in plain English, as Professor Lutz suggests.
    Chairman Shelby. Professor Lutz, throughout this reform 
process, we have tried to remain mindful as to the increased 
costs that might accompany the proposed regulatory reforms 
because ultimately the shareholder is going to pay the cost. 
Could you estimate how much it would cost mutual funds and 
broker-dealers to revise their disclosure practices to 
incorporate the information design and usability reforms that 
you have suggested. If you want to do that for the record or 
you can do it now.
    Mr. Lutz. I could not give you a dollar amount. Based on my 
experience, I can tell you that it is capital intensive, but it 
is something that, once done, lives for the life of the 
investment.
    Chairman Shelby. What is done is there, is it not?
    Mr. Lutz. So the costs are spread out over the life of the 
form. But the forms that we are looking at would come from the 
SEC and would be model forms.
    They could be easily customizable through desktop 
publishing, so it really does not become that much of an 
expense once it is installed, as a continuing expense.
    Let me say one thing about the short form, if I may.
    Chairman Shelby. Okay.
    Mr. Lutz. I helped design short forms at the SEC. When we 
did the plain language project, we did a number of them. I 
think there is a misperception here about a 20-page document 
and people not wanting to read it. It is not a matter of plain 
language. It is a matter of document design, making the 
information attractive, enticing, making you want to read it.
    Chairman Shelby. Understandable.
    Mr. Lutz. Drawing you into it. What do we do with 
magazines? The magazines make you want to read them. That is 
the whole purpose of their design. We should do the same thing. 
There is no reason why we cannot.
    Chairman Shelby. You could usher in a new era in the 
average American's financial literacy, could you not?
    Mr. Lutz. Absolutely, and there is something else that 
nobody has mentioned here. We are all talking about writing 
these documents of what we want them to know. One of the things 
that I have learned as a teacher is that I never know what they 
do not know, and I am always amazed to find out what they do 
not know.
    Chairman Shelby. Should it not be what they should know?
    Mr. Lutz. Well, you start with what they want to know 
first. Let me give you one simple example. I have done work 
with some of the health disclosure issues currently in the 
medical profession, and the hospital had designed a very good 
document on a procedure to get the permission of the patients, 
but none of the patients were paying any attention to it. And 
when they sat down and talked to them about it, the first 
question that the patients had was, how much does this cost? 
Because if I cannot afford it, I am not going to read this 
pamphlet. And the hospital never thought to even mention cost 
in the document. It was not in their minds.
    We do not know what is in the minds of investors. That is 
why we do usability testing, to sit down and find out what it 
is they want to know, and that becomes our starting point for 
disclosure, and I agree, you are absolutely correct. We have to 
also educate them at the same time, but if we are going to get 
them to read those 20 pages, we are going to lure them in by 
giving them what they want to know.
    Chairman Shelby. After all, it is their money, is it not?
    Mr. Lutz. All of it is their money.
    Chairman Shelby. It is their investors' money, the $7 
trillion, the 100 million people, more or less, that invest, 
and they should have the knowledge of what is happening to 
their money.
    Mr. Lutz. They should have some say in it someplace along 
the line. Every penny of every expense and every salary is 
their money.
    Chairman Shelby. Mr. Pozen, in addition to the governance 
reforms proposed by the SEC, some people contend that 
additional reforms are necessary.
    First, some contend that Congress should amend the 
Investment Company Act to give fund boards authority to hire 
and fire the investment adviser without having to get a 
shareholder vote. Many believe that this authority would shift 
the balance of power from the adviser to the board.
    Second, others contend that Congress should redefine the 
fiduciary standards for fund boards and advisers.
    What is your perspective on these two proposals, the 
issues?
    Mr. Pozen. On the first one, in terms of the management 
contract, I think that there is a lot of power now in the 
independent directors to terminate management contracts and to 
change management contracts. Also to the extent that the 
shareholders have bought into a fund because they have been 
attracted by the management company, I think they have a right 
to have some say in whether or not the management company that 
they chose, would continue to be there.
    Chairman Shelby. But does the board not run companies?
    Mr. Pozen. The independent directors of the management 
company----
    Chairman Shelby. The shareholders elect members of the 
board. That is true of anything. So if the board runs things, 
should they not have the ability to hire and fire?
    Mr. Pozen. They have the ability to fire a management 
company now.
    Chairman Shelby. The board now has the ability, in 
corporate America, to fire a chairman or to fire a president.
    Mr. Pozen. So I have heard.
    [Laughter.]
    Chairman Shelby. Is this not right, though?
    Mr. Pozen. I believe that the independent directors of a 
mutual fund board now have the power to terminate the advisory 
contract of a director, and they have the power also to change 
the terms, to negotiate new terms of the contract.
    Chairman Shelby. But without getting a shareholder vote.
    Mr. Pozen. Yes, without getting a shareholder vote. I think 
they have the power now. They have the ability to terminate an 
advisory contract now.
    May I ask Professor Bullard for a little help on this one? 
Do the independent directors have this legal authority?
    Mr. Bullard. The directors at any time can terminate the 
adviser, as long as they are willing to be sued for the next 5 
years by the fund manager. If you are going to do something, 
you might provide them that protection, something that 
certainly would be appreciated by the Navellier directors, who 
I think 7 years after the battle they had with the fund manager 
are still in litigation.
    Mr. Pozen. I have terminated subadvisers without a lawsuit.
    Chairman Shelby. But you cannot be intimidated by the 
adviser. What if he is a sorry adviser, and you say, ``Gosh, 
what you are giving me is wrecking the fund. You have to----''
    Mr. Pozen. There are two different issues--a legal issue 
and a factual issue. Legally, I believe that the independent 
directors now have the authority to terminate the adviser if 
they do not think the adviser is doing a good job and that that 
power is there and is already in the statute in Section 15 of 
the Investment Company Act.
    As to the second question of fiduciary duties, I think that 
there already are fiduciary duties under State law, the duty of 
care and duty of loyalty that are incorporated through Section 
36(a) of the Investment Company Act. And Section 36(b), which 
is on fees, has been heavily litigated, and I think the case 
law is pretty good.
    The last thing I would like to do is to change the 
fiduciary standard so that we then have another 10 years of 
litigation to try to figure out what exactly that standard 
means.
    So, I believe that on these two issues, the statute and the 
case law are already in a reasonable position.
    Mr. Bullard. Mr. Chairman, if I could add something to 
that. The record under the fiduciary standard in the case law 
is pretty good because no fund manager has ever lost a decided 
case under Section 36(b) in a private action.
    Mr. Pozen. But there have been a lot of settled cases.
    Mr. Bullard. There have been a lot of settled cases.
    Mr. Pozen. That is true of most class action lawsuits. Very 
few of them go to actual judgment.
    Mr. Bullard. Right, that is true. And frankly, I am not 
that big a fan of private class actions as a way of inducing 
competition, but even more noteworthy is the fact that in 34 
years, this provision the SEC specifically asked for has never 
exercised its authority under 36(b) to bring a true excessive 
fees case against a board that signed off on an excessive 
management fee.
    There have been two 36(b) cases, and neither is really an 
excessive fee case. They are essentially churning cases where 
fees being charged that should not have been charged in the 
first place, not that the advisory agreement fee was too high.
    Mr. Pozen. I think you would agree, Professor Bullard, it 
is not for lack of legal authority that the SEC has not brought 
a case.
    Mr. Bullard. That is correct. The SEC has made a conscious 
decision not to bring those cases, and it is a real gap in 
their enforcement program, and there are cases out there they 
can bring.
    Chairman Shelby. Why, though? What is behind the conscious 
decision?
    Mr. Bullard. The investment management directors have said 
that they tried to find cases and have not been able to find 
them. I think that they need to be more aggressive. I think 
that this is not the Fidelitys that they should be suing, as 
are typically the defendants in the civil cases. These are the 
outliers, where the expense ratio is 5 or 10 percent of assets, 
and the performance has, for 5 or 10 straight years, lagged the 
S&P 500, where there is no rational basis for the fund 
directors to approve those contracts.
    I think Mr. Pozen would agree, if you can give me those set 
of facts, that is a case where the SEC should sue that fund 
board under 36(b).
    Chairman Shelby. Mr. Bullard, you state that 12b -1 fees 
have evolved beyond their intended purpose and are now used as 
substitutes for sales loads. In a sense, fund advertising cost 
and distribution costs are blended.
    Comment, if you would, on the SEC's concept release 
regarding changes to Rule 12b -1 and how advertising and 
distribution fees might be separated, also how would such a 
separation impact mutual funds and broker-dealers.
    Mr. Bullard. Well, the first step the SEC has taken and has 
said that you simply cannot use a fund asset in the form of the 
fund's brokerage to pay brokers for sales. I think the SEC will 
finalize that position and that issue will be taken care of.
    As to the separation of the two, I do not believe the SEC 
can really do what is necessary because of the current lack of 
statutory authority to expressly allow, if 12b -1 fees are not 
used, some other source of fund assets to pay for, let us say, 
Money magazine advertisements, what I would call classic 
distribution services. You need Congressional action, you need 
an amendment to Section 12b to expressly allow the management 
fee to be used for that purpose, and thereby give the fund 
manager incentive to keep those costs low, albeit allowed to 
spend that money.
    As far as the sales charges go, I agree, as I said before, 
I agree with Mr. Pozen. You should not repeal 12b -1, if you 
are then going to be depriving shareholders of the ability to, 
instead of paying a front-end load or a back-end load, spread 
that load out over time. But that is already possible under SEC 
rulemaking authority. They can allow, under whatever set of 
standardized arrangements they choose, brokers to collect a 
front-end load on an installment basis, be it 25 basis points a 
quarter, 100 basis points at the end of each year, either paid 
by through a check written by the investor or paid by automatic 
redemptions from fund shares.
    So there are a lot of different ways to do it. The key is 
not to change any of the payments that are currently made, and 
not in any way to force any reduction or increase. It is simply 
to rationalize the way in which they are paid. When you pay 
your broker, it is coming out of your pocket, whether it is an 
installment load or not, and you can see what that cost or that 
relationship is and understand that this is not a fund cost. 
This is a cost that you are incurring because you need the 
services of that broker, and that is what will make you think 
twice about whether you are paying too much and whether you 
need to get smarter about making more investment decisions 
perhaps with a little less help.
    Chairman Shelby. Do you agree with Professor Bullard?
    Ms. Roper. I do. When you look at the evolution of 12b -1 
fees, I think you need to keep in mind that there is a reason 
we have gone to compensating brokers this way. And it is 
because when we first created no-load funds and investors were 
presented with a clear choice between paying a load and not 
paying a load, they said, ``Well, I do not want to pay a load. 
Why would I want to pay this sales charge?'' And so there was 
an effort made to shift the way that we pay brokers so that it 
is less evident to investors.
    Chairman Shelby. But should the investors not know?
    Ms. Roper. Yes. As you look at how you reform 12b -1 fees, 
the goal should be that investors understand what they are 
paying for the services from their brokers and what they are 
paying for the operations of the funds and how those two things 
are separate.
    Right now the disclosures I do not think effectively do 
that. I do not think there is a single one approach that solves 
the 12b -1 problem, but I agree you should have an ability to 
pay an installment load. You should recognize that that is what 
you are paying for the services of the broker and, frankly, I 
think it should be something that is negotiated between the 
investor and the broker and not set by the mutual fund.
    When I buy a share of stock, the company that issues that 
stock does not tell me how much I have to pay my broker to buy 
that stock, but the mutual fund does. And so what you do is you 
take that element of broker compensation out of the competitive 
marketplace. It is not negotiated between the investor and the 
broker in the same way, and you create a system in which mutual 
funds compete to be sold instead of competing to be bought, and 
they compete to be sold by offering financial incentives to the 
broker.
    And so you have a system of reverse competition that drives 
costs to investors up, not down, and makes it possible for 
mediocre funds to continue to survive by virtue of offering 
generous compensation to the broker. I think the SEC concept on 
12b -1 fees is a very helpful start, but there is a broader 
look that needs to be taken on how we design this system so 
that it better aligns investor interests with the funds. It 
better protects investor interests, better ensures that there 
is an incentive on the part of the broker to sell them a good 
fund instead of one that pays the broker well.
    Chairman Shelby. Mr. Pozen, how, if at all, should 12b -1 
practices be reformed, from your perspective?
    Mr. Pozen. I, again, think that the key is for investors to 
know what they are getting. I think it is perfectly reasonable 
for some people to want to pay up front, for other people to 
want to pay on an installment basis. The question is: Do they 
know exactly what they are paying on an installment basis?
    You do have in the prospectuses now a separate line for 
12b -1 fees, but it is expressed in basis points. Maybe we 
should express this in dollars so people would have a better 
sense of what it actually is. As long as they know, at the 
point of sale, what the various fees are, including the 12b -1 
fees, then we should give them whatever choice they want.
    Mr. Bullard. Chairman Shelby, if I could just clarify one 
point Ms. Roper made.
    Chairman Shelby. Go ahead.
    Mr. Bullard. When she said that an ultimate goal would be 
to try to ``unfix'' these payments, just so we understand, that 
under the Investment Company Act, prices for mutual funds are 
fixed, not just with respect to the shares themselves, but what 
you pay to the broker. And ultimately it would truly be a 
courageous step for the Committee to look at the question of 
whether we need to repeal fixed pricing, which the Division has 
supported repealing for almost 15 years, the Division of 
Investment Management.
    Mr. Pozen. I am sorry. I do not understand what you mean by 
``fixed pricing.''
    Mr. Bullard. Well, under the Investment Company Act, 
Section 22(d), a broker is only allowed to sell shares at the 
price in the prospectus, and that price in the prospectus 
includes not only the NAV or the way the NAV is calculated, but 
also the percentage that the broker gets paid.
    A broker cannot give you a discount on the front-end load, 
for example, it cannot give you a rebate of the 12b -1 fee, for 
example, if you happen to be an investor who requires a lot 
less services than some other investor, and that is because, 
under 22(d), those prices are required to be fixed.
    In a SEC Division of Investment Management study in 1992, 
the Division came out in opposition to 22(d) and in favor of 
its repeal, and I think that that ultimately should be the 
direction that we are going to be going in, whether it is now 
or later. Just as commissions were unfixed in the 1970's for a 
retail brokerage, it is inevitable that they will become 
unfixed in the fund industry. It is just going to be very hard 
to do that as long as we force the tying of the product price 
and the distribution price. You have to separate the 
distribution costs from the product costs in order then to 
allow the freeing up of the distribution costs and competition 
between brokers, as far as their charges go.
    Mr. Pozen. Chairman Shelby, with all due respect, I believe 

Professor Bullard is technically right, but as a practical 
matter, the results are quite different.
    You are allowed, under Section 22(d), to create any waiver 
you want, and the SEC is extremely flexible in allowing you to 
create many types of pricing waivers. Therefore, you will see 
differential sales loads based on how much you invest, based on 
whether you are a trust, based on whether you are a retirement 
plan. There is a broad range of flexibility in pricing.
    However, if you decide that you are going to treat, say, 
all charitable trusts one way, and you put it in your 
prospectus, then you have to follow the language. But you can 
even say for a charitable trust, if the charitable trust 
invests more than $25,000, we will charge them 2 percent load, 
rather than 4 percent load.
    So, in practice, Section 22(d) is a weak constraint; I am 
impressed by how much flexibility that Section provides load 
waivers. And I think, in the scheme of things, increasing that 
flexibility is a minor point, rather than a major point.
    Mr. Bullard. Just to clarify, all of those variations are 
done by the fund, not by the brokers. Once Fidelity or MFS sets 
all of those variations, the brokers have no leeway to change 
them based on their actual relationships with their clients, 
based on the services their clients provide to them and how 
much those clients value those services.
    Mr. Pozen. I can assure you, if the brokerage community 
says we need a certain set of waivers, then those waivers will 
definitely be provided.
    Mr. Bullard. Yes, but brokers like fixed commissions. 
Consistently, if you have regulators come in and fix prices, it 
is more profitable for the industry.
    Chairman Shelby. Let us give Ms. Roper the last word.
    Ms. Roper. I would just say the last thing the brokers want 
is for customers to be able to negotiate those costs and to 
have them subject to actual price competition. It is not in 
their interests.
    Chairman Shelby. What we really want is the market to work, 
do we not?
    Ms. Roper. Right. What I think Professor Bullard and I are 
saying is this is an area where the market does not work. It is 
not allowed to work. It is not allowed to discipline those 
costs.
    Chairman Shelby. I want to thank all of you for appearing 
today. We are continuing to learn a lot as we look into these 
abuses in the mutual fund industry. I want to thank all of you.
    Mr. Bullard. Thank you, Chairman.
    Ms. Roper. Thank you.
    Chairman Shelby. The hearing is adjourned.
    [Whereupon, at 12:02 p.m., the hearing was adjourned.]
    [Prepared statements and additional material supplied for 
the record follow:]

                PREPARED STATEMENT OF MERCER E. BULLARD
              President and Founder, Fund Democracy, Inc.
  Assistant Professor of Law, University of Mississippi School of Law
                             March 23, 2004

    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, thank you for the opportunity to appear before you to 
discuss enforcement and regulatory developments in the mutual fund 
industry. It is an honor and a privilege to be before the Committee 
today.\1\

Introduction
    The Committee's topic today is current investigations and 
regulatory actions regarding mutual funds, and this is precisely where 
the Committee's focus should be. With more than $7 trillion in assets, 
mutual funds are this country's most important investment vehicle. The 
ongoing scandal in the mutual fund industry has demonstrated the need 
for significant reform in mutual fund regulation. I applaud this 
Committee's deliberate, thorough, and careful review of the full range 
of issues facing fund regulators and the fund industry today.
    I commend the efforts of the Commission, Attorney General of the 
State of New York, Secretary of the Commonwealth of Massachusetts, 
National Association of Securities Dealers (NASD), other regulators, 
and the Justice Department for their forceful and diligent 
investigation and prosecution of persons and firms who have violated 
the law and investors' trust.
    I applaud the efforts of the Commission and NASD to identify gaps 
in regulation and propose practical, effective solutions. As a former 
member of the staff of the Division of Investment Management, I am 
especially impressed with the Division's extraordinary accomplishments 
of the last 4 months. During this time, the Division has made more 
progress in reforming mutual fund regulation than in any period in its 
history.
    As the Commission has itself noted, however, there are many 
important gaps in regulation that it does not have the authority to 
address. There are also instances in which the Commission has the 
authority to effectuate important reforms, but it has chosen not to do 
so.
    Where the Commission cannot or will not implement reform, 
legislation provides the only hope for promoting competition and 
adequately protecting investors. Part I of this testimony discusses the 
following areas where Congressional action is necessary: mutual fund 
governance, disclosure of fund fees, soft-dollar and distribution 
arrangements, and misleading fund names.
    Part II briefly describes other areas where reform is needed and 
the Commission has taken reasonable steps in the right direction. This 
Committee should note, however, that the Commission is divided on a 
number of these matters. The Committee should continue to be vigilant 
that a minority of the Commission does not succeed in derailing these 
efforts.

I. Areas Where Legislation is Necessary
Mutual Fund Governance
    The problems with mutual fund boards fall into two categories: (1) 
oversight and accountability, and (2) independence and authority. Fund 
directors will not actively negotiate fees to keep fund costs low or 
assiduously fund managers' conflicts of interest without guidance as to 
the minimum standards to which they will be held and accountability for 
living up those standards. No amount of board oversight and 
accountability will help shareholders if directors do not have the 
independence and authority to effectively carry out their mandate.

Mutual Fund Oversight Board
    As I discussed in prior testimony,\2\ the mutual fund scandal 
reflects pervasive, systemic compliance failures that require 
structural changes in the way that fund boards are regulated. These 
failures can be partly traced to a lack of guidance regarding the 
minimum standards to which boards will be held in the fulfillment of 
their duties. To address this problem, Congress should create a Mutual 
Fund Oversight Board that would provide such guidance.
    This Board would promulgate informal, minimum standards for fund 
boards regarding a range of issues, including fee negotiations, fair 
value pricing, market timing policies, redemption policies, and 
distribution practices. The Board's focused mandate would give it the 
flexibility to respond quickly to changing circumstances and to develop 
an unparalleled depth of expertise regarding the role of fund 
directors. The model for the Board, the Public Company Accounting 
Oversight Board, is widely considered one of the most effective 
creations of the Sarbanes-Oxley Act of 2002.\3\
    The Commission does not have the authority to create a Mutual Fund 
Oversight Board or the capacity to provide effective guidance itself. 
For example, the Commission issued guidelines for the approval of 12b -
1 plans in 1980 that have never been updated,\4\ despite repeated 
promises do so.\5\ The requirements of the formal rulemaking process, 
among other things, make it difficult for the Commission to maintain 
current guidelines for fund directors. The breadth of the Commission's 
mandate also makes it difficult to stay continually focused on the 
evolving responsibilities of fund boards. The Oversight Board would 
effectively supplement the Commission by providing the kind of current, 
continuous guidance necessary for boards to function effectively.\6\
    The Board also would have examination and enforcement authority 
over mutual fund boards. It would be charged with identifying potential 
problems in the fund industry and ensuring that fund boards are 
actively addressing these problems 
before they spread. For example, the Board would promulgate guidance 
regarding current regulatory issues and best practices regarding how to 
deal with them, and examine boards to ensure that they are taking 
necessary steps to protect shareholders.
    One reason that an oversight board is needed is that the Commission 
has not held fund boards accountable for misconduct. The Commission's 
enforcement actions in the wake of the mutual fund scandal have 
suffered from a major flaw. To date, not one case has been brought 
against an independent fund director, despite settlements involving 
dozens of different complexes and individuals.\7\ A settlement was 
recently announced regarding fund directors who exempted a market timer 
from a fund's redemption fee, yet the only punishment for such 
misconduct was that the directors would have to retire by the end of 
2005.\8\
    In 2003, the Commission agreed to settle charges with the directors 
of the Heartland funds with the sole penalty being a cease and desist 
order.\9\ These directors were responsible for overseeing the worst 
mispricing incident in the history of the fund industry, in which 
shareholders in two Heartland funds lost 70 percent and 44 percent of 
the savings in a single day in 2000. Nonetheless, they were permitted 
to retain their directors' fees--even those earned during the 3 years 
that the case was pending. In dissent, Commissioner Campos stated:

        The investigation in this case presents significant evidence, 
        if proven at trial, of directors, having unambiguous 
        information that funds' NAV is significantly overstated and 
        that the funds were illiquid, failing to act in any meaningful 
        way to protect shareholder interests.\10\

    In view of the extraordinary level of misconduct involved in the 
Heartland matter, and the impotence of the penalty imposed, it is 
difficult to imagine the Commission justifying any sanction on any fund 
director in connection with current mutual fund scandal.
    For 34 years, the Commission has abdicated its statutory duty to 
prosecute funds and directors for excessive fees. Section 36(b) of the 
Investment Company Act, which was passed in 1970, provides that a fund 
director and fund manager shall have a fiduciary duty with respect to 
the fees charged by the fund, and tasks the Commission with bringing 
actions against directors and fund managers who violate this duty. The 
Commission has never brought a case for excessive fees.\11\
    The Mutual Fund Oversight Board would remedy the Commission's 
failure to hold independent directors accountable by promulgating and 
enforcing minimum standards of conduct for fund boards.
    The Board would be financed from assessments on mutual fund assets 
to provide an adequate and reliable source of funding. Board members 
would be persons with specific expertise in the fund industry and would 
be appointed for 5-year terms by the Commission to ensure their 
independence. This model, which ideally combines the strengths of 
independent, expert oversight with the advantages of a reliable and 
adequate funding source, would do more to restore confidence in the 
fund industry and protect fund shareholders than any changes in the 
makeup, qualifications, or authority of fund boards.

Board's Fiduciary Duty
    Creating a Mutual Fund Oversight Board alone will not be sufficient 
to ensure that fund directors are held accountable for failing to 
protect the interests of shareholders. Under current Federal law, the 
only express fiduciary duty that applies to directors is limited to 
fees paid to the fund manager.\12\ When a fund's high fees are 
attributable not to fees paid to the fund manager, but to fees paid on 
account of the administrative expense of operating a small fund, this 
fiduciary duty is not triggered. Thus, a fund director's decision to 
offer a fund with an 8 percent or 10 percent expense may be reviewable 
only under a toothless State law standard.\13\ Congress should enact 
legislation that creates a fiduciary duty for fund directors that would 
require, for example, that directors affirmatively find that the fund 
could be a reasonable investment in light of its investment objective, 
performance history, and expenses. The Commission does not have the 
authority to establish such a fiduciary duty.

Directors' Independence and Authority
    As discussed above, recent frauds demonstrate systemic weaknesses 
in mutual fund compliance. These systemic weaknesses necessitate the 
creation of a regulatory structure, such as a Mutual Fund Oversight 
Board, that is designed to ensure that fund boards of directors fulfill 
their responsibility to protect shareholders. A fund board cannot 
protect shareholders unless its independent members have the 
independence and authority necessary to counter the influence of the 
fund manager.
    In order for independent directors to provide oversight that is 
truly free of the fund manager's control, the board's chairman must be 
independent, the board must be at least 75 percent independent, and the 
definition of independent director must be amended to exclude former 
directors, officers, and employees of the fund manager. In addition, 
independent directors should have to stand for election at least every 
5 years. Independent fund directors often are appointed by the fund 
manager or nominated as the result of a relationship with the fund 
manager and never stand for election because funds--unlike publicly 
traded companies--are not required to elect directors periodically. 
Finally, as suggested by the Commission, Congress should require that 
independent fund directors perform a self-evaluation at least annually 
and meet at least quarterly in a separate session, and expressly 
authorize independent directors to hire their own staff.
    The necessity of these reforms has been well-documented over the 
last year--in a wide range of contexts including statements by Members 
of Congress, Commission releases, and Congressional testimony--that 
does not need repeating here.\14\ What needs to be emphasized here is 
that, contrary to popular perception, the Commission does not have the 
authority to enact these reforms. The Commission does not have the 
authority to require a fund to have an independent chairman or a 75 
percent independent board, to hold separate meetings of independent 
directors, or to require annual self-evaluations. These reforms can 
only be accomplished through legislation.
    Although the Commission has proposed certain fund governance 
rules,\15\ these will not be remotely as effective as legislation for 
two reasons. First, the Commission has excluded critical reforms from 
its proposal. The Commission's proposal includes no provisions that 
would prevent a former director, officer, or employee of the adviser 
from being considered to be an independent director. Nor does the 
Commission's proposal include any provision regarding the election of 
independent directors, thereby effectively leaving their election in 
the hands of fund management. Only if Congress passes legislation will 
independent directors have to be truly independent and at least 
periodically meet with the approval of fund shareholders.
    Second, the Commission's proposal does not effectively require fund 
boards to be 75 percent independent and have an independent chairman. 
In fact, as the Commission concedes, the proposed rules ``would apply 
only to funds that rely on one or more of the Exemptive Rules.'' \16\ 
The Exemptive Rules to which the Commission refers are rules that many 
funds may, but are not required to, rely on in the operation of their 
funds. For example, a fund can charge a 12b -1 fee only in compliance 
with Rule 12b -1. The Commission proposes to amend Rule 12b -1, among 
other Exemptive Rules, to require that funds relying on Rule 12b -1 
comply with certain fund governance provisions.\17\ If a fund cancels 
its 12b -1 plan, however, it will be able to replace its independent 
chairman with an officer of the fund manager and reduce the percentage 
of independent directors from 75 percent to 40 percent (the statutory 
minimum), thereby returning control of the board and fund in the hands 
of the fund manager.
    The Commission claims that, ``[b]ecause almost all funds either 
rely or anticipate someday relying on at least one of the Exemptive 
Rules, we expect [the governance conditions] would apply to most 
funds.'' \18\ This is no doubt true, but it is not ``most funds'' at 
which these provisions are targeted. These governance measures are 
targeted at funds where the likelihood of fund manager overreaching is 
greatest. The Commission's proposal has a fatal Achilles' heel. When 
the independence of the board is most critical, that is, when there is 
a conflict between the board and the fund manager, the board will know 
that the manager need only cease relying on the Exemptive Rules to 
dismiss the independent chairman and eviscerate the independent 
majority. The question is not whether, at any given time, ``most 
funds'' have truly independent boards, but whether fund directors have 
the requisite independence and authority when they most need it--when 
they are challenged by the fund manager.
    This is precisely the scenario that unfolded when the independent 
directors of the Yacktman Funds confronted Don Yacktman, the fund 
manager. At the time, the Funds charged a 12b -1 fee under Rule 12b -1, 
which required that the board be ``selected and nominated'' by the 
independent directors. Mr. Yacktman engineered a proxy battle that led 
to the ouster of the independent directors and the installation of an 
``independent'' slate of directors that he selected and nominated. No 
longer able to rely on Rule 12b -1, Mr. Yacktman cancelled the fund's 
12b -1 plan. The ``selected and nominated'' provision that was intended 
to ensure the independence of the board was swept aside at the very 
moment when it was most needed. The lesson from the Yacktman experience 
is that the Commission's proposal will only guarantee an independent 
chairman and a 75 percent board as long as the fund manager does not 
object. The independent chairman and independent director majority will 
know that they serve at the whim of the fund manager. Only legislation 
can guarantee that a board must be 75 percent independent and that its 
chairman is not under the control of the fund manager.

Fee Disclosure
    As the Commission has recognized, fund fees ``can have a dramatic 
effect on an investor's return. A 1 percent annual fee, for example, 
will reduce an ending account balance by 18 percent on an investment 
held for 20 years.'' \19\ Notwithstanding the importance of fees, ``the 
degree to which investors understand mutual fund fees and expenses 
remains a significant source of concern.'' \20\
    In many respects, investors' lack of understanding is directly 
attributable to the way in which fees are disclosed. The current 
expense ratio is misleading because it excludes what can be a fund's 
single largest expense: Portfolio transaction costs. The 12b -1 fees 
are misleading because they create the impression that funds that do 
not charge 12b -1 fees therefore do not incur distribution expenses. 
Fund fees are disclosed in dollars based on hypothetical amounts, 
rather than a shareholder's actual costs, and the location of this 
disclosure makes it unlikely that investors will pay attention to this 
information. Nowhere are funds required to put their fees in context by 
comparing them to fees charged by index funds and comparable managed 
funds. The Commission has failed to support or actively opposed reforms 
designed to address each of these problems.

Portfolio Transaction Costs
    The current expense ratio, which to be accurate should be referred 
to as the ``partial expense ratio,'' excludes portfolio transaction 
costs. Portfolio transaction costs are the costs incurred by a fund 
when it trades its portfolio securities. Some portfolio transaction 
costs are easy to measure. For example, commissions paid by funds are 
disclosed as a dollar amount in the Statement of Additional 
Information, which is provided to shareholders only upon request. Other 
portfolio transaction costs must be measured indirectly, such as spread 
costs, but their existence and their substantial impact on fund 
expenses is no less certain.
    The Commission concedes that portfolio transaction costs constitute 
a significant expense for fund shareholders. ``[F]or many funds, the 
amount of transaction costs incurred during a typical year is 
substantial. One study estimates that commissions and spreads alone 
cost the average equity fund as much as 75 basis points.'' \21\ A 
recent study commissioned by the Zero Alpha Group, a nationwide network 
of fee-only investment advisory firms, found that commissions and 
spread costs for large equity funds, the expenses and turnover of which 
are well below average, exceeded 43 percent of the funds' expense 
ratios.\22\ A recent survey by Lipper identified at least 86 equity 
funds for which the total amount paid in commissions alone exceeded the 
fund's total expense ratio, in some cases by more than 500 percent.\23\
    Notwithstanding the significance of portfolio transaction costs, 
the Commission has opposed including these costs in the mutual fund 
expense ratio. In a June 9, 2003, memorandum, the Commission 
demonstrated that it had already prejudged the issue of the disclosure 
of portfolio transaction costs.\24\ It concluded that ``it would be 
inappropriate to account for commissions as a fund expense'' and 
unequivocally answered the question of ``whether it is currently 
feasible to quantify and record spreads, market impacts, and 
opportunity costs as a fund expense. We believe the answer is `no.' '' 
\25\ Only after reaching this decision has the Commission proceeded 
with the formality of issuing a concept release asking for comment on 
disclosure of portfolio transaction costs, apparently for the purpose 
of considering any alternative other than full inclusion in the expense 
ratio.\26\ Thus, without Congressional action, there is little doubt 
that the Commission will continue to require funds to use the current, 
partial expense ratio. Congress should require that funds include 
portfolio transaction costs in a total expense ratio.
    The Commission's position is inconsistent with its responsibility 
to provide the information that the marketplace needs to promote price 
competition. By requiring funds to use the partial expense ratio, the 
Commission is effectively forcing the public to choose funds based on 
the Commission's view of the proper measure of fund costs. The 
Commission's decision to second-guess the market by deciding for 
investors which kinds of information they are capable of understanding, 
contradicts basic market principles and is inconsistent with our 
capitalist system of free enterprise.
    Investors logically look to the Commission to provide standardized 
reporting of expenses, and it is appropriate for the Commission to 
provide this service. But once the Commission has provided the 
important service of providing standardized information, it should 
remove itself from the market-driven determination of which information 
provides the best measure of a fund's true costs.
    The Commission has argued that including portfolio transaction 
costs might distort fund managers' behavior.\27\ As noted above, this 
is not for the Commission to judge. The marketplace should decide which 
expense ratio--the partial expense ratio or a total expense that 
includes portfolio transaction costs--is the best measure of a fund's 
costs.
    Furthermore, it is the partial expense ratio that distorts fund 
managers' and investors' behavior alike. The partial expense ratio 
distorts fund managers' behavior by not holding them accountable for 
their decisions to spend a substantial amount of fund assets on trading 
securities.
    As illustrated in Exhibit A, for example, the Commission believes 
that investors should only be told that the expense ratio for the PBHG 
Large Cap Fund is 1.16 percent, and that they should not be told that 
when commissions and spread costs are included, the Fund's expense 
ratio is 8.59 percent.\28\ The true cost of that Fund is more than 
seven times the amount shown in the Commission's expense ratio! How can 
it be in the best interests of investors or consistent with free market 

economics to require, much less permit, the Fund to show its total 
costs of 1.16 percent? The partial expense ratio is misleading because 
it impliedly represents, in conjunction with other shareholder expenses 
listed in the fee table, the total cost of fund ownership.
    The data in Exhibit A does not reflect outliers, but randomly 
selected examples from funds with more than $100 million in assets. If 
smaller funds with high turnover were considered, the differentials 
would be so large as to render the Commission's partial expense ratio 
fraudulent. For example, Lipper reports that the Rydex Telecom Fund's 
commissions for the fiscal year ending March 31, 2003, equaled 8.04 
percent of assets. By applying the Zero Alpha Group study's methodology 
of estimating spread costs, we can estimate that total spread costs 
during that period equaled 8.75 percent of assets. Thus, whereas the 
Commission tells us that the Rydex Telecom Funds are only 1.37 percent, 
its true costs are 18.16 percent, or 13 times higher.\29\ The 
Commission's partial expense ratio distorts investors' behavior because 
investors obviously would make different investment decisions if they 
knew the true costs of owning certain funds.
    The Commission's partial expense ratio also distorts managers' 
behavior because it creates an incentive for them to pay for 
nonexecution expenses with fund commissions. Under current law, fund 
managers can pay higher commissions--that is, more than it would cost 
merely to execute the fund's trades--in return for nonexecution 
services. By paying for these nonexecution services with commissions, 
or what are known as soft dollars, fund managers effectively move these 
costs out of the expense ratio where they belong. This enables the fund 
that uses soft dollars to show a lower partial expense ratio than a 
fund that does not--even if the fund managers use identical services 
and have identical operating expenses. The Commission itself has 
conceded that ``[t]he limited transparency of soft-dollar commissions 
may provide incentives for managers to misuse soft-dollar services.'' 
\30\
    Furthermore, the nondisclosure of portfolio transaction costs 
exacerbates the conflict of interest that is inherent in the payment of 
soft dollars. As the Commission has recognized,

          [s]oft dollar arrangements create incentives for fund 
        advisers to (i) direct fund brokerage based on the research 
        provided to the adviser rather than the quality of execution 
        provided to the fund, (ii) forego opportunities to recapture 
        brokerage costs for the benefit of the fund, and (iii) cause 
        the fund to overtrade its portfolio to fulfill the adviser's 
        soft-dollar commitments to brokers.\31\

    The continued concealment of portfolio transaction costs permits 
the soft-dollar conflict to operate virtually unchecked by market 
forces, whereas including portfolio transaction costs in a total 
expense ratio would, at least, permit the marketplace to judge the 
efficacy of soft-dollar arrangements. If Congress does not take steps 
to eradicate soft dollars, at least it can require that these costs be 
disclosed so that the market can reach its own judgments regarding 
their efficacy.

Dollar Disclosure of Fees
    Under current disclosure rules, funds are not required to disclose 
to investors how much they pay in fees. Many other financial services 
documents show investors exactly how much they are paying the service 
provider, including bank statements, insurance bills, credit card 
statements, mortgage loans, and a host of other documents. But mutual 
funds provide only an expense ratio (and a partial one, at that, see 
supra) and the dollar amount of a hypothetical account.
    Congress should require that funds provide individualized dollar 
disclosure of fund expenses in shareholder statements, as proposed by 
the Government Accounting Office.\32\ This requirement is necessary for 
two reasons. First, although the expense ratio is appropriate for 
providing comparability across different funds, it does not pack the 
same import as a dollar amount. Providing investors with the amount in 
dollars that they actually spent will give concrete form to an 
indefinite concept and make investors consider more fully the costs of 
different investment options.
    Second, placing the dollar amount of expenses in the shareholder 
statement will direct shareholders' attention to the actual costs of 
fund ownership. No document is more likely to be read than a 
shareholder statement that shows the value of the shareholder's account 
and transaction activity during the period. Whereas the prospectus and 
shareholder report typically go directly from the mailbox to the trash 
can, even the most uninformed investors normally open their statements 
to check on the status of their accounts. There is no better way to 
draw shareholders' attention to the costs of investing than to require 
that the dollar amount of fees for the period be disclosed next to the 
value of the investor's account.
    Some members of the fund industry have opposed informing investors 
about the actual costs of their fund investments on the grounds that 
doing so would be too costly and might mislead investors.\33\ It 
appears that MFS Investment Management, the 12th largest mutual fund 
manager in America, disagrees. Earlier this month, MFS announced that 
it would begin providing fund shareholders with a quarterly statement 
of their actual fees.\34\
    The Commission opposes disclosure of shareholders' actual costs and 
opposes including dollar disclosure in shareholder statements. The 
Commission recently concluded its consideration of a proposal to 
require funds to disclose individualized costs in shareholder 
statements by expressly rejecting both concepts. Instead, the 
Commission decided to require disclosure of the hypothetical fees paid 
on a $1,000 account in the shareholder report, despite the facts that 
the hypothetical fees paid on a $10,000 account are already disclosed 
in the prospectus, and shareholders who most need to have their 
attention directed to the fees that they pay are least likely to read 
the shareholder report. In view of the Commission's, express opposition 
to effective disclosure of actual fees paid by shareholders, 
shareholders will receive disclosure of their actual fees in 
shareholder statements only if Congress requires funds to provide that 
information.

Fee Comparisons
    Congress should take additional steps to promote price competition 
in the mutual fund industry by requiring that funds disclose fees 
charged by comparable funds and, for managed funds, the fees charged by 
index funds. Without any context, current fee disclosure provides no 
information about whether a fund's fees are higher or lower than its 
peers. Current disclosure rules also do not show the premium paid to 
invest in a managed funds as opposed to an index fund. Requiring 
comparative information in the fee table would enable investors to 
consider a fund's fees in context and evaluate how they compare to fees 
across the industry.

Distribution Fees
    The Commission currently requires that 12b -1 fees be disclosed on 
a separate line that describes those fees as ``distribution fees.'' It 
does not require that the fee table show the amount spent on 
distribution by the fund manager out of its management fee. This is 
inherently misleading, as investors often use the presence of 12b -1 
fees as a negative screen that they use to avoid paying any 
distribution fees. In fact, investors in non-12b -1 fee funds may 
actually pay as much or more in distribution expenses than some 
investors in 12b -1 fee funds.\35\
    Congress should overrule the Commission's position and require 
that, if distribution fees are stated separately in the fee table, they 
must reflect all distribution expenses paid by a fund, directly or 
indirectly. Alternatively, Congress should require that fund expenses 
be displayed in a pie chart that shows how much of a fund's fees were 
spent on each type of service. The Commission's current fee table is 
misleading and understates the amount of fund assets spent on 
distribution.

Soft Dollars
    Congress should ban soft dollars. The term ``soft dollars'' 
generally refers to brokerage commissions that pay for both execution 
and research services. The use of soft dollars is widespread among 
investment advisers. For example, total third-party research purchased 
with soft dollars alone is estimated to have exceeded $1 billion in 
1998.\36\ An executive with American Century Investment Management has 
testified that the research component of soft-dollar commissions costs 
six times the value of the execution component.\37\
    Soft-dollar arrangements raise multiple policy concerns. The 
payment of soft dollars by mutual funds creates a significant conflict 
of interest for fund advisers. Soft dollars pay for research that fund 
advisers would otherwise have to pay for themselves. Advisers therefore 
have an incentive to cause their fund to engage in trades solely to 
increase soft-dollar benefits.\38\
    Soft-dollar arrangements normally would be prohibited by the 
Investment Company Act because they involve a prohibited transaction 
between the fund and its 
adviser.\39\ Section 28(e) of the Securities Exchange Act, however, 
provides a safe harbor from the Investment Company Act for soft-dollar 
arrangements as long as the brokerage and research services received 
are reasonable in relation to the amount of the commissions paid.
    The conflicts of interest inherent in soft-dollar arrangements are 
exacerbated by current disclosure rules. The amount of fund assets 
spent on soft dollars is not publicly disclosed to shareholders, so 
they are unable to evaluate the extent, and potential cost, of the 
adviser's conflict.
    Current disclosure rules reward advisers for using soft dollars 
because this practice creates the appearance that a fund is less 
expensive. The expense ratio does not include commissions, which gives 
advisers an incentive to pay for services with soft dollars, thereby 
enabling them to lower their management fees and the fund's expense 
ratio. Advisers can effectively reduce their expense ratios by spending 
more on soft dollars, while the fund's actual net expenses remain 
unchanged.
    Finally, current disclosure rules may encourage excessive spending 
on soft dollars. Advisers would tend to spend less on soft dollars if 
they knew that they would be held publicly accountable for their 
expenditures.
    The Commission has frequently recognized but declined to address 
the problem of soft dollars. As discussed above, the Commission is 
opposed to including portfolio transaction costs in funds' expense 
ratios, which would have the benefit of enabling the market to 
determine for itself the efficacy of soft-dollar arrangements. The 
Commission previously proposed a rule that would require that soft-
dollars costs be quantified, but decided against adopting it.\40\ When 
the Commission staff last evaluated soft-dollar arrangements in 1998, 
it concluded that additional guidance was needed in a number of 
areas.\41\ For example, the staff found that many advisers were 
treating basic computer hardware--and even the electrical power needed 
to run it--as research services qualifying under the Section 28(e) safe 
harbor.\42\ The staff recommended that the Commission issue 
interpretive guidance on these and other questionable uses of soft 
dollars, but it has failed to do so.
    In fact, the only formal action that the Commission has taken in 
recent years is to expand the use of soft dollars. In December 2001, 
the Commission took the position that the safe harbor should apply to 
markups and markdowns in principal transactions, although Section 28(e) 
expressly applies only to ``commissions.'' \43\ This position directly 
contradicts not only the plain text of the statute, but also the 
position taken by the Commission in 1995 that Section 28(e) ``does not 
encompass soft-dollar arrangements under which research services are 
acquired as a result of principal transactions.'' \44\ Although the 
Commission has, once again, suggested that it intends to narrow the 
scope of soft dollars, its recent history suggests that Congressional 
action is necessary. In any case, the Commission lacks the authority to 
ban soft dollars.
    There is no better evidence that the time has come to ban soft 
dollars than the recent recognition of the insidious nature of this 
practice by members of the fund industry. Earlier this month, MFS 
Investment Management announced that it has ceased the payment of soft 
dollars.\45\ The chairman of the board of the Putnam Funds, America's 
6th largest fund complex, recently announced that the Funds intended to 
severely restrict the use of soft dollars and to consider a complete 
ban.\46\ Vanguard, the Nation's second largest fund complex, has 
traditionally shunned soft dollars.\47\ American Century, the Nation's 
third largest fund complex, uses soft dollars only for research, and 
not for other nonexecution services.\48\
    The explanations provided by fund directors and executives reflect 
the insidious nature of soft dollars. In addressing the fact that soft 
dollars enable fund managers to use the fund's money to pay for 
research used by the manager, the independent chairman of the Putnam 
Funds stated that ``[t]he best decisions get made when you buy services 
with your own money.'' \49\ Similarly, MFS' Chairman, Robert Pozen,

          Sees the soft-dollar funnel as a lucrative one for brokers, 
        but one that hides the true cost of such services to 
        shareholders. ``It is all camouflaged,'' said Mr. Pozen, a 
        former Associate General Counsel of the SEC. Now, he added, 
        ``If we want something, if we think it is valuable, we will pay 
        cash.'' \50\

    A Fidelity executive acknowledged the procompetitive advantage of a 
ban on soft dollars, stating: ``[w]e do not rule out a competitive 
environment through which all research is acquired through cash rather 
than commissions.'' \51\
    The difficulty for fund firms, however, is that without a statutory 
ban on soft dollars they may suffer a competitive disadvantage MFS 
estimates that paying for its own research will reduce its advisory 
fees.\52\ Fidelity estimates that of the $1.1 billion in commission it 
paid in 2003, $275 million paid for soft-dollar research.\53\ It is 
unrealistic to expect these fund managers to maintain the high road at 
the expense of reduced advisory fees, while other fund managers 
continue to pay their own research expenses through soft dollars rather 
than out of their own pockets.

Distribution
12b -1 Fees and Revenue Sharing
    When Congress enacted the Investment Company Act of 1940, it 
expressly prohibited fund managers from using fund assets to finance 
the distribution of the fund's shares. Section 12(b) of the Act 
recognized the inherent conflict of interest between the manager's 
desire to increase fund assets in order to increase its fees on the one 
hand, and the fund's desire to hold down costs on the other hand. 
Unfortunately, the policy underlying Section 12(b) has long been 
abandoned, as fund assets are used for a wide range of distribution 
expenses that benefit fund managers at the expense of fund 
shareholders.
    The policy of separating the product from its distribution was 
first abandoned by the Commission when, after a prolonged review, it 
adopted Rule 12b -1 in 1980.\54\ In the 1970's, mutual funds 
experienced periods of net redemptions that prompted fund managers to 
lobby the Commission to permit the use of fund assets to finance the 
distribution of the funds' shares.\55\ Fund managers argued that net 
redemptions resulted in increased costs and that the financing of 
distribution by the fund would help reduce or eliminate net 
redemptions.\56\
    The Commission initially rejected these arguments,\57\ but 
ultimately relented, provided that certain conditions were observed. 
For example, the Commission required that the fund's independent 
directors approve the 12b -1 plan.\58\ Among the factors the Commission 
said a fund's directors should consider when evaluating whether to 
adopt or renew a 12b -1 plan was the plan's effectiveness in remedying 
the problem that it was designed to address, for example, increased 
costs resulting from net redemptions.\59\
    The Commission's most significant concern regarding 12b -1 fees was 
the conflict of interest that they created between the fund and its 
adviser.\60\ The Commission feared that 12b -1 fees would result in 
higher advisory fees and the fund's adviser would not share the 
benefits of asset growth.\61\ Some would argue that this is precisely 
what has happened, with any growth-based economies of scale realized 
from 12b -1 fees being pocketed by fund managers and not shared with 
fund shareholders.\62\
    Of course, this analysis goes primarily to the use of 12b -1 fees 
for marketing the fund, which is what Rule 12b -1 was intended to 
permit. It does not address the ways in which 12b -1 are actually used 
today and that were wholly unanticipated by the Commission when Rule 
12b -1 was adopted. According to the Investment Company Institute, only 
5 percent of 12b -1 fees are spent on advertising and sales promotion, 
whereas 63 percent of 12b -1 fees are spent on broker compensation.\63\
    The use of fund assets to compensate brokers is precisely what 
Section 12(b) was intended to prohibit. This practice puts the fund 
squarely in the position of underwriting its own securities. The fund's 
assets are used to incentivize brokers to recommend the fund over 
competing funds. The lesser the quality of the fund, the greater the 
pressure on the fund and its manager to pay brokers more to sell the 
fund.
    This irreconcilable conflict is mirrored on the distribution side 
of the business. When brokers are paid by the funds, rather than their 
customers, they have an incentive to recommend the fund that offers the 
biggest payout, rather than the fund that will provide the best 
investment for their customers.\64\ There is another incentive for 
brokers to favor arrangements whereby they are compensated by funds, 
and that is the fact that the compensation from the fund is not 
transparent. Whereas the payment of a front-end load is relatively 
evident to the investor, the payment of a 12b -1 fee is not. It is even 
less clear that the already opaque 12b -1 fee is ending up in the 
broker's pocket. For this reason, brokers and investors have begun to 
favor classes of fund shares where the broker is compensated by the 
fund, regardless of whether that class is in the best interests of 
shareholders.\65\
    Thus, the Commission has created a distribution compensation 
structure that is directly at odds with the interests of investors and 
the Investment Company Act. Rather than tying brokers' compensation to 
their relationships with their customers, where the Investment Company 
Act requires that it be placed, the Commission has tied brokers' 
compensation to their relationships with the funds, where the 
Investment Company Act expressly forbade its placement.
    Congress should reaffirm the supremacy of Section 12(b) and 
prohibit funds from compensating brokers for selling fund shares. 
Although this will necessarily entail the repeal of Rule 12b -1, it 
will in no way limit the ways in which investors can choose to pay 
their brokers. It will simply require that however brokers are 
compensated--through a front-end load, back-end load, level-load, or 
any combination thereof--they are compensated by their customers, not 
by the funds. Thus, if a customer chooses to pay his broker on an 
installment basis, at 0.50 percent each year, for example, that amount 
would be paid by the customer directly or deducted from his fund 
account.
    In addition, Congress should prohibit fund managers from 
compensating brokers in connection with the purchase or sale of fund 
shares. For decades, the Commission has permitted fund managers to 
circumvent the prohibition against fund assets being used for 
distribution by endorsing the fantasy that managers' payments to 
brokers are made out of the managers' ``profits,'' and not out of the 
fees they receive from the funds.\66\
    One might argue that, to maintain perfect legislative coherence, 
Congress should also prohibit fund managers from paying for 
distribution that is not connected to sales and purchases, that is, 
distribution that does not compensate the broker for distribution 
services provided to its customer. I disagree. The conflict is 
substantially reduced in this situation because the fund manager's and 
the fund's interests are generally aligned. General marketing payments 
do not create a direct incentive for brokers to favor one fund group 
over another. General marketing does what advertising for decades has 
been shown to do: Promote competition. Indeed, by locating these 
payments in the management fee, the manager will be spending its own 
money and accordingly will have an incentive to minimize costs. With an 
express requirement that independent fund directors evaluate the 
efficacy of fund manager expenditures on marketing and determine that 
resulting economies have been shared with fund shareholders, expressly 
permitting fund managers to use the management fee to pay for marketing 
would be appropriate.

Misleading Fund Share Classes
    Mutual funds often offer several classes of shares that reflect 
different ways of paying for distribution services. Typically, Class A 
shares carry a front-end load, Class B shares a back-end load, and 
Class C shares carry a level load. An investor is usually better off 
buying Class A shares if he intends to hold his shares for the long-
term, and Class C shares if he may sell in the short-term. When Class B 
shares are best option, it is for the shareholder who holds for the 
mid-term. In some cases there is virtually no shareholder for whom 
Class B shares are the best option.\67\
    The Commission does not prohibit funds from offering Class B 
shares, even when there is no shareholder for whom Class B shares could 
be the best investment option. The Commission even rejected a rule 
amendment that would have required that funds illustrate in the 
prospectus the relative costs of each class of shares. Following the 
Commission's lead, a court held in January 2004 that, even assuming 
that there was no rational investor for whom Class B shares would be 
the best investment, the fund had no duty to disclose this fact in the 
prospectus.\68\
    It is unconscionable that under current Commission positions a fund 
can offer a class of shares that would not be the best investment for 
any rational investor. Congress should require that multiclass funds 
illustrate, in a graphic format, the costs of investing in different 
classes over a 15-year period. In addition, Congress should require 
that the fund's independent directors find, subject to a fiduciary duty 
as described above, that each class of shares offered could be a 
reasonable investment alternative.

Fund Advertising
    Throughout the late 1990's, the Commission frequently berated the 
fund industry for misleading investors by advertising short-term 
performance.\69\ Funds with short life-spans routinely advertised 1 
year, sometimes even 2- and 3-year annualized investment returns in 
excess of 100 percent. With the crash of the stock bubble in 2000, the 
Commission's concerns were validated, as many of these funds 
experienced huge losses, in some cases in excess of 70 percent of their 
value.
    The Commission's actions have not reflected its words, however. In 
September 2003, the Commission adopted advertising rules that utterly 
failed to address the very problems that it had identified in the late 
1990's.\70\ The rules require funds to provide a telephone number or 
web address where current performance information is available, as if 
the problem with short-term performance was that it wasn't current 
enough. The Commission also required that the text in fund ads include 
the statement that ``current performance may be higher or lower than 
the performance data quoted.''
    Recent fund advertisements have demonstrated the inadequacy of the 
Commission's new rules. After 3 years of negative returns, stock funds 
had a banner year in 2003. Many of those funds are now advertising 
their stellar 1-year performance without any disclosure of their poor 
returns in 2000, 2001, and 2002. Because they are required only to show 
their 1-, 5- and 10-year returns, the negative returns of 2000 to 2002 
are hidden from view. The ads create a misleading impression by showing 
the outsized returns of 2003 without any mitigating disclosure of the 
down years that preceded them and the performance volatility that those 
years' returns illustrate.
    For example, one ad shows SEC-mandated performance for four funds, 
each of which experienced superior returns in 2003, but experienced 
losses or substantially lower performance in each year from 2000 to 
2002. As illustrated in the table below, the disclosure of each fund's 
annual performance in the years preceding 2003 would have presented a 
very different, far more accurate picture. The Commission's rulemaking 
has done nothing to prevent such misleading ads, which have appeared 
routinely in business and personal finance magazines in the first few 
months of this year.

----------------------------------------------------------------------------------------------------------------
                                          Disclosed*                         Not Disclosed**
                Funds                ---------------------------------------------------------------------------
                                             2003               2002               2001               2000
----------------------------------------------------------------------------------------------------------------
Fund No. 1..........................     51.68 percent    (21.27 percent)    ( 7.56 percent)    (18.10 percent)
Fund No. 2..........................     42.38 percent    ( 9.37 percent)    (12.99 percent)    ( 8.96 percent)
Fund No. 3..........................     23.36 percent    (20.44 percent)    ( 3.74 percent)     12.25 percent
Fund No. 4..........................     29.96 percent    (17.16 percent)    ( 5.02 percent)     8.54 percent
----------------------------------------------------------------------------------------------------------------
 *Source: Business 2.0 (March 2004).
**Source: Fund Prospectuses.


    The Commission's rulemaking also did nothing to address the problem 
of the disconnect between the advertised performance of funds and the 
actual returns experienced by shareholders. As confirmed by a recent 
DALBAR study, ``[i]nvestment 
return is far more dependent on investment behavior than on fund 
performance.'' \71\ DALBAR found that the average equity fund investor 
earned 2.57 percent annually over the last 19 years, in comparison with 
the S&P 500's 12.22 percent annual return during the same period. This 
translates into a cumulative return for the S&P 500 of 793.34 percent 
from 1984 to 2002, compared with equity fund investors' actual 
cumulative return of 62.11 percent during the same period.
    These stunning and disheartening data illustrate, in part, a 
failure of investor education and individual choice. Investors have 
consistently chased the best performing funds just before they crashed, 
and dumped the worst performing funds just before they recovered. This 
sell-high, buy-low mentality is only encouraged by the Commission's 
current approach to fund performance advertising, which permits funds 
to present outsized returns with no meaningful caveats regarding their 
volatility and the likelihood that performance will soon revert to the 
mean.\72\
    Not only do current rules fail to require meaningful disclosure 
about the volatility of fund returns, but they also fail to place 
outsized, 1-year returns in the context of the market as a whole. To 
illustrate, the performance of the S&P 500 for 2003 was 28.68 percent, 
which puts the 51.68 percent return of the fund cited above in a light 
very different (albeit still positive) from one in which the 
performance data stands alone. The fund's advertised 10-year return of 
10.58 percent would tell a different story if it were required to be 
juxtaposed against the S&P 500's 11.07 percent 10-year return.
    The Commission also has recognized the need for investment returns 
to be considered in the context of fees, yet its rules do virtually 
nothing to benefit investors in this respect. In its proposing release, 
the Commission promised that its new rule would ``ensure that fund 
advertisements remind fund shareholders about the availability of 
information about fund charges and expenses.'' \73\ Yet the final rule 
required only that fund advertisements refer investors to the 
prospectus for consideration of fund expenses, among other things.\74\ 
In contrast, the NASD has proposed that fund advertisements include a 
box that shows both the fund's maximum sales charge and its expense 
ratio.\75\
    Congress should require that fund advertisements include all 
information necessary to make the information presented not misleading. 
This must include, at a minimum, investment returns for each individual 
year where such returns differ materially from fund's 1-year 
performance, disclosure of the fund's total expense ratio (for example, 
including the fund's portfolio transaction costs) and sales charges, 
and the performance and expenses of a comparable index fund.

Misleading Fund Names
    Funds are prohibited from using misleading names, yet the 
Commission has taken the position that a fund with ``U.S. Government'' 
in its name can invest 100 percent of its assets in Fannie Mae or 
Freddie Mac securities.\76\ These securities are not guaranteed by the 
U.S. Government, which is the guarantee investors reasonably believe 
they are getting when they invest in Government securities. Congress 
should prohibit funds from using names that imply that they invest in 
U.S. Government securities unless at least 80 percent of the funds' 
assets are actually invested in securities that are backed by the full 
faith and credit of the U.S. Government.

Commission Initiatives
    As discussed above, there many areas where Congressional action is 
needed either because the Commission lacks the necessary authority or 
opposes mutual fund reforms. In other areas, however, the Commission 
has taken strong steps to address problems in the mutual fund industry, 
in some cases over the objections of certain Commissioners. None of 
these initiatives has taken the form of final rules, and the Committee 
accordingly should continue to encourage the Commission to proceed with 
these rulemaking proposals to ensure they do, in fact, become law. Fund 
Democracy strongly supports the Commission's efforts in each of these 
areas.

Directed Brokerage
    Many fund managers compensate brokers for selling fund shares with 
fund brokerage. Under these arrangements, the fund manager pays the 
broker through commissions received in connection with a fund's 
portfolio transactions.\77\ This practice increases funds' portfolio 
transaction costs while reducing the amount the fund manager might 
otherwise spend on distribution, thus creating a significant conflict 
of interest. The Commission has proposed to prohibit fund managers from 
considering sales of fund shares when selecting brokers to effect fund 
transactions.\78\ Fund Democracy expects to file detail comments 
generally supporting this proposal.

Disclosure of Brokers' Compensation
    For virtually all securities transactions other than purchases of 
mutual fund shares, investors receive a transaction confirmation that 
shows how much the broker was paid in connection with the transaction. 
Permitting brokers to hide their compensation on the sale of mutual 
funds has spawned a Byzantine and harmful array of selling 
arrangements, including revenue sharing (also known as payments for 
shelf space), directed brokerage, and noncash compensation.
    Mutual fund shareholders should be entitled to receive the same 
information as other investors in securities in the form of full 
disclosure of their brokers' compensation on fund transaction 
confirmations. Such disclosure also should show how breakpoints applied 
to the transaction, as well as any special compensation received by 
brokers for selling particular funds.
    Brokers also should be required to provide, at or before the time 
the investor places the order, an estimate of compensation to be 
received by the broker in connection with the transaction and the total 
costs of investing in the fund. When buying a house, purchasers are 
provided with an estimate of their total closing costs before making a 
final decision. As discussed immediately above, however, fund 
shareholders do not even receive a final statement of their actual 
costs, much less an up-front estimate of such costs.
    The Commission has proposed to require brokers to provide, both at 
the point-of-sale and in the transaction confirmation, disclosure of 
the costs and conflicts of interest that arise from the distribution of 
mutual fund shares.\79\ Fund Democracy expects to file comments with 
the Commission generally supporting its proposal.

Mandatory Redemption Fee
    The most substantial losses resulting from the current mutual fund 
scandal were caused by funds' selling their shares at inaccurate or 
stale prices and allowing certain investors to trade rapidly in and out 
of the fund to take advantage of those pricing discrepancies. Some 
academics who have studied the issue have estimated that this practice 
costs long-term fund shareholders billions of dollars each year. Funds 
are already required to price their shares accurately, and this 
requirement should be more strictly enforced. To the extent that 
pricing is not a perfect science, however, some funds still may use 
slightly inaccurate prices that sophisticated traders can identify and 
exploit.
    These opportunities would be eliminated by the imposition of a 
small redemption fee on all sales of fund shares occurring within a 
short time period after the purchase. The Commission has proposed to 
require ``funds (with certain limited exceptions) to impose a 2 percent 
redemption fee on the redemption of shares purchased within the 
previous 5 days.'' \80\ In all cases, the redemption fee would be 
payable to the fund, so that shareholders would receive the benefits. 
Fund Democracy expects to file comments with the Commission generally 
supporting its proposal.

Hard 4 p.m. Close
    In connection with the current mutual fund scandal, some mutual 
fund companies apparently conspired to allow late trading in their 
funds. Others were the victims of brokerage firms and other trade 
processing intermediaries who assisted their clients in evading those 
restrictions. Steps must be taken to better prevent evasion of the late 
trading restrictions, including tough sanctions against those who 
knowingly violate or aid their clients to violate those restrictions. 
In addition, the quality of compliance systems at both the funds and 
the trade processing intermediaries must be upgraded to ensure 
detection of these and other abuses and to allow an effective 
regulatory inspection of those procedures.
    The Commission has proposed to require that orders to purchase fund 
shares be received by the fund, its designated transfer agent, or a 
registered securities clearing agency no later than the time at which 
the fund is priced.\81\ This is known as a ``Hard 4 p.m. Close'' 
because most funds price their shares at 4 p.m. Eastern Time. Fund 
Democracy and the Consumer Federation of America have submitted joint 
comments to the Commission generally in support of its efforts to 
prevent late trading of mutual fund shares.

Portfolio Manager Compensation
    In some cases, a portfolio manager's compensation or fund 
investments may not align his or her interests with the interests of 
fund shareholders. For example, a fund portfolio manager who also 
manages a hedge fund or other private accounts may have an incentive to 
favor those accounts over the mutual funds.\82\ The highest-paid 
executives of operating companies are required to disclose their 
compensation and their trades in company stock, yet there is no 
comparable requirement for mutual funds.
    Recent revelations have included investments by portfolio managers 
that are harmful to shareholders' interests. The Commission has 
proposed that fund managers be required to disclose the structure of 
their compensation and their investments in the funds they manage.\83\ 
Fund Democracy expects to file comments with the Commission generally 
supporting this proposal.



                                ENDNOTES

    \1\ I wish to thank the assistance of Thomas Walker and Milo 
Mitchel in the preparation of this testimony.
    \2\ Testimony before the Subcommittee on Capital Markets, 
Insurance, and Government Sponsored Enterprises, Committee on Financial 
Services, U.S. House of Representatives (November 6, 2003) and 
Testimony before the Subcommittee on Financial Management, the Budget, 
and International Security, Committee on Governmental Affairs, U.S. 
Senate (November 3, 2003).
    \3\ T3See Marcy Gordon, Accounting Oversight Official pledges 
``tough love'' Kansas City Star (November 21, 2003) (William McDonough, 
Chairman of the Public Company Accounting Oversight Board, suggesting 
that a similar agency may be needed for the mutual fund industry).
    \4\ See Bearing of Distribution Expenses by Mutual Funds, 
Investment Company Act Rel. No. 11414 (October 28, 1980) (adopting Rule 
12b -1).
    \5\ See, e.g., Report on Mutual Fund Fees and Expenses, Division of 
Investment Management, Securities and Exchange Commission, Part IV.B.2 
(December 2000) (recommending that the Commission issue new guidance to 
fund directors regarding the review and approval of 12b -1 plans).
    \6\ The Board would supplement, and not in any way supplant, the 
SEC's authority over mutual funds. In the event of any disagreement 
between the SEC and the Board, the SEC would have final decision making 
authority.
    \7\ See, e.g., SEC v. Columbia Management Advisors, Inc. and 
Columbia Funds Distributor, Inc., Civil Action No. 04 CV 10367-GAO (D. 
Mass., February 24, 2004); SEC v. Mutuals.Com, Inc., Connely Dowd 
Management, Inc., Mtt Fundcorp, Inc., Richard Sapio, Eric McDonald, and 
Michele Leftwich, Civil Action No. 303 CV 2912D (N.D. Tex., December 4, 
2003); SEC v. Invesco Funds Group, Inc., and Raymond R. Cunningham, 
Civil Action No. 03-N-2421 (PAC) (D. Col., December 2, 2003); SEC v. 
Millennium Capital Hedge Fund, L.P., Millennium Capital Group, LLC, and 
Andreas F. Zybell, Civil Action No. CV-03-1862-PHX-FJM (D. Ariz., 
December 2, 2003); SEC v. Security Trust Company, N.A., Grant D. 
Seeger, William A. Kenyon and Nicole McDermott, Civil Action No. CV 03-
2323 PHX JWS (D. Ariz., November 25, 2003); SEC v. Gary L. Pilgrim, 
Harold Baxter and Pilgrim Baxter & Associates, Ltd., Civil Action No. 
03-CV-6341 (E.D. Penn., November 20, 2003); SEC v. Justin M. Scott and 
Omid Kamshad, Civil Action No. 03-12082-EFH (D. Mass., October 28, 
2003); In the Matter of Massachusetts Financial Services Co., John W. 
Ballen and Kevin R. Parke, Investment Company Act Rel. No. 26347 
(February 5, 2004); In the Matter of Paul A. Flynn, Investment Company 
Act Rel. No. 26345 (February 3, 2004); In the Matter of Alliance 
Capital Management, L.P., Investment Company Act Rel. No. 26312 
(December 18, 2003); In the Matter of James Patrick Connelly, Jr., 
Investment Company Act Rel. No. 26209 (October 16, 2003); In the Matter 
of Theodore Charles Sihpol, III, Administrative Proceeding File No. 3-
11621 (September 16, 2003). None of the individuals named in these 
complaints was an independent fund director.
    \8\ The Commission and Attorney General for the State of New York 
reported that they had reached a settlement with Bank of America in 
which ``Bank of America has also agreed to implement certain election 
and retirement procedures for the Nations Funds trustees that will 
result in the replacement of the Nations Funds trustees within 1 
year.'' SEC Press Release 2004-33 (March 15, 2004); see Press Release, 
New York Attorney General (March 15, 2004) (``Under a specific 
provision of the agreement, eight members of the Board of Directors of 
Nations Funds, BOA's mutual fund complex, will resign or otherwise 
leave the board in the course of the next year''); see also Beth Healy, 
Pressure to Quit Riles Trustees, Boston Globe (March 17, 2004) (``Under 
the deal, Bank of America promised the regulators it would `use its 
best efforts' to persuade 8 of the 10 Nations Funds directors to leave 
the board by May 1, 2005, . . .''). Bank of America does not have the 
legal authority to set procedures for the board of the Nations Funds, 
however, and suggesting that Bank of America has such authority 
effectively undermines the principle that a fund's board is independent 
of the fund manager. See Yuka Hayashi, Directors' Treatment In Bk Of 
Amer Settlement Causes Stir, Wall Street Journal (March 19, 2004) 
(quoting Allan Mostoff, President of the Mutual Fund Directors Forum: 
``I think a lot of people are confused.'') The Nations Funds trustees 
reportedly have denied that they plan to give up their positions, 
thereby suggesting that not even this de minimis ``penalty'' will 
stand. See Healy, supra (directors may fight agreement to by Bank of 
America); Christopher Oster & Tom Lauricella, Bank of America Likely 
Will Face Trustees' Review, Wall Street Journal (March 19, 2004) 
(same); see generally Mark Boslet, Spitzer Reiterates Vow To Watch 
Mutual Fund Board Members, Wall Street Journal (March 19, 2004).
    \9\ In the Matter of Jon D. Hammes, Albert Gary Shilling, Allan H. 
Stefl, and Linda F. Stephenson, Investment Company Act Rel. No. 26290 
(December 11, 2003).
    \10\ Id. (dissent of Commissioner Roel C. Campos).
    \11\ I am aware of two cases that the Commission has brought under 
Section 36(b), neither of which involved an excessive fees claim. See 
In the Matter of American Birthright Trust Management Company, Inc., 
Litigation Rel. No. 9266, 1980 SEC LEXIS 26 (December 30, 1980); SEC v. 
Fundpack, Inc., No. 79-859, 1979 WL 1238 (D.D.C., August 10, 1979).
    \12\ Investment Company Act Section 36.
    \13\ For example, my research assistant was able to identify 18 
funds in Morningstar's database with expense ratios in excess of 5 
percent, yet the average management fee for these funds was only 1.06 
percent, and only one fund's expense ratio exceeded 1.29 percent.
    \14\ See, e.g., Letter from Senator Daniel Akaka, Representative 
Richard Baker, Senator Peter Fitzgerald, Senator Carl Levin, and 
Representative Michael Oxley to William Donaldson, Chairman, Securities 
and Exchange Commission (March 11, 2004); Letter from Representative 
Richard Baker and Representative Michael Oxley to William Donaldson, 
Chairman, Securities and Exchange Commission (July 30, 2003); 
Investment Company Governance, Investment Company Act Release No. 26323 
(January 15, 2004); Testimony, supra note 2; Letter from Mercer Bullard 
to Richard Baker, Chairman, and Paul Kanjorski, Ranking Member, 
Subcommittee on Capital Markets, Insurance, and Government Sponsored 
Enterprises, Financial Services Committee (July 9, 2003).
    \15\ See Investment Company Governance, id.
    \16\ Id.
    \17\ If the Commission could really impose ``requirements'' in this 
way, then it could effectively rewrite the entire Investment Company 
Act simply by amending the Exemptive Rules and enact every reform 
discussed in this testimony, but the Commission has expressly conceded 
that its authority is not so broad. See, e.g., Ian McDonald, SEC's Roye 
Wades Through New Rules for Mutual Funds, Wall Street Journal Online 
(March 19, 2004) (interview with Paul Roye, Director, SEC Division of 
Investment Management, in which he acknowledges that the Commission 
does not have the authority to ban soft dollars).
    \18\ Investment Company Governance, supra note 14.
    \19\ Shareholder Reports and Quarterly Portfolio Disclosure of 
Registered Management Investment Companies, Investment Company Act 
Release No. 25870, Part I.B (December 18, 2002).
    \20\ Id. (citing a joint report of the Commission and the Office of 
the Comptroller of the Currency that ``found that fewer than one in 
five fund investors could give any estimate of expenses for their 
largest mutual fund and fewer than one in six fund investors understood 
that higher expenses can lead to lower returns'').
    \21\ Concept Release at Part I (citing John M.R. Chalmers, Roger M. 
Edelen, Gregory B. Kadlec, Fund Returns and Trading Expenses: Evidence 
on the Value of Active Fund Management, at 10 (August 30, 2001) 
(available at http://finance.wharton .upenn.edu/edelen/PDFs/
MF_tradexpenses.pdf ). ``These estimates omit the effect of market 
impact and opportunity costs, the magnitude of which may exceed 
commissions and spreads.'' Id. [Emphasis added].
    \22\ See Jason Karceski, Miles Livingston & Edward O'Neal, Mutual 
Fund Brokerage Commissions at 9 (January 2004) (available at http://
www.zeroalpha group.com/headlines/
ZAG_mutual_fund_true_cost_study.pdf ). Exhibit A to this testimony 
shows the expense ratios, brokerage commissions, and spread costs for 
total costs for eight of the funds studied.
    \23\ See Sara Hansard, Lipper Data Miffs Some Firms, Investment 
News at 3 (February 23, 2004) (173 funds paid commissions in excess of 
0.99 percent of net assets, which is the dollar-weighted average 
expense ratio for equity funds).
    \24\ Memorandum from Paul F. Roye, Director, Division of Investment 
Management, Securities and Exchange Commission to William H. Donaldson, 
Chairman, Securities and Exchange Commission, (June 3, 2003) (available 
at http://financial services.house.gov/media/pdf/02-14-70%20memo.pdf ) 
(Donaldson Memorandum).
    \25\ Id. at 28 & 30.
    \26\ See Request for Comments on Measures to Improve Disclosure of 
Mutual Fund Transaction Costs, Investment Company Act Rel. No. 26313 
(December 19, 2003) (Concept Release).
    \27\ See, e.g., Donaldson Memorandum at 30-31, supra note 24.
    \28\ Exhibit A also shows that, when commissions and spread are 
included, the expenses of the Strong Discovery Fund rise from 1.50 
percent to 4.50 percent, the CGM Focus Fund from 1.20 percent to 4.48 
percent, and the RS Mid Cap Opportunities Fund from 1.47 percent to 
7.52 percent.

    \29\ The Lipper data show that at least 31 funds' expense ratios 
would exceed 10 percent if they include commissions and spread costs.

    \30\ Concept Release at Part III.A, supra note 26.

    \31\ Donaldson Memorandum at 36, supra note 24. Regarding directed 
brokerage, the Commission recently stated: ``We believe that the way 
brokerage has been used to pay for distribution involves unmanageable 
conflicts of interest that may harm funds and fund shareholders.'' 
Prohibition on the Use of Brokerage Commissions to Finance 
Distribution, Investment Company Act Rel. No. 26356 at Part II 
(February 24, 2004).

    \32\ Government Accounting Office, Mutual Funds: Information On 
Trends In Fees And Their Related Disclosure (March 12, 2003).

    \33\ See, e.g., Testimony of Paul G. Haaga, Jr., Executive Vice 
President, Capital Research and Management Co. and Chairman, Investment 
Company Institute, before the Subcommittee on Capital Markets, 
Insurance, and Government Sponsored Enterprises, Committee on Financial 
Services, U.S. House of Representatives, at 16-17 (June 18, 2003).

    \34\ MFS to Make Sweeping Reforms to Tell Investors About Fees, 
Wall Street Journal Online (March 16, 2004) (`` `We want people to know 
that although we have had a difficult time lately, we will do 
whatever's necessary to put shareholders first,' [MFS Chairman Robert] 
Pozen said.'').

    \35\ In 1999, Paul Haaga, Chairman of the Investment Company 
Institute and Executive Vice President of the Capital Research and 
Management Company, stated at an SEC roundtable: ``The idea that 
investors should prefer the funds that do not tell what they are 
spending on distribution over the ones that do is nonsense. You know, 
if you are spending money on distribution, say it. If you are not 
spending money on distribution do not say it; but do not pretend that 
there are no expenses there for a fund that doesn't have a 12b -1 
plan.'' Conference on the Role of Investment Company Directors, 
Washington, DC. (February 23 & 24, 1999) (Haaga was not ICI Chairman at 
this time).

    \36\ Inspection Report on the Soft-Dollar Practices of Broker-
Dealers, Investment Advisers and Mutual Funds, Securities and Exchange 
Commission, at text accompanying note 1 (September 22, 1998).

    \37\ Testimony of Harold Bradley, Senior Vice President, American 
Century Investment Management, before the Subcommittee on Capital 
Markets, Insurance, and Government Sponsored Enterprises, Committee on 
Financial Services, U.S. House of Representatives, at 5 (March 12, 
2003).

    \38\ Id. at 2 (the statutory safe harbor permitting soft-dollars 
arrangements ``encourages investment managers to use commissions paid 
by investors as a source of unreported income to pay unreported 
expenses of the manager'').

    \39\ See Investment Company Act Section 17(e); Inspection Report at 
38, supra note 36.

    \40\ Donaldson Memorandum at 13-17, supra note 24. Fidelity 
recently recommended that the Commission reconsider its decision not to 
require the quantification of soft-dollar costs. Ann Davis, Fidelity 
Wants Trading Costs to Be Broken Down, Wall Street Journal (March 15, 
2004).

    \41\ Inspection Report on the Soft-Dollar Practices of Broker-
Dealers, Investment Advisers and Mutual Funds, Securities and Exchange 
Commission, at text accompanying note 1 (September 22, 1998) (``Section 
28(e) Report'').

    \42\ Id. at Section V.C.4.

    \43\ Commission Guidance on the Scope of Section 28(e) of the 
Exchange Act, Exchange Act Rel. No. 45194 (December 27, 2001).

    \44\ Investment Advisers Act Release No. 1469 (February 14, 1995).

    \45\ John Hechinger, MFS Ends Soft Dollar System on Concerns over 
Ethics, Wall Street Journal (March 16, 2004).

    \46\ Id.

    \47\ Id.

    \48\ Id.

    \49\ Id. (quoting John Hill).

    \50\ Id.

    \51\ Landon Thomas, Jr., Mutual Fund Tells Wall Street It Wants a 
la Carte Commissions, New York Times (March 16, 2004).

    \52\ MFS Ends ``Soft Dollar'' System, supra note 35.

    \53\ Fidelity Wants Trading Costs to Be Broken Down, supra note 40.

    \54\ Bearing of Distribution Expenses by Mutual Funds, Investment 
Company Act Rel. No. 11414 (October 28, 1980) (adopting Rule 12b -1); 
Bearing of Distribution Expenses by Mutual Funds, Investment Company 
Act Rel. No. 10862 (September 7, 1979) (proposing Rule 12b -1) (``12b -
1 Release 10862''); Bearing of Distribution Expenses by Mutual Funds, 
Investment Company Act Rel. No. 10252 (May 23, 1978) (advance notice of 
rulemaking) (``12b -1 Release 10252''); Bearing of Distribution 
Expenses by Mutual Funds, Investment Company Act Rel. No. 9915 (August 
31, 1977) (rejecting requests to permit funds to finance their 
distribution expenses) (``12b -1 Release 9915''). The Commission held 
public hearings on the bearing of 
distribution expenses by mutual funds on November 17, 18, 22 & 23, 
1976. See Investment Company Act Rel. No. 9470 (October 4, 1976) 
(announcing hearings on appropriateness of funds' bearing their 
distribution expenses); see also Vanguard Group, Inc., et al., 
Investment Company Act Rel. No. 9927 (September 13, 1977) (order of 
temporary exemption and notice and hearing on application for exemption 
to permit funds to bear their distribution expenses).

    \55\ 12b -1 Release 10252, supra n.3.

    \56\ 12b -1 Release 10252, supra at 1.

    \57\ See 12b -1 Release 9915.

    \58\ See Rule 12b -1(b)(2).

    \59\ See 12b -1 Release 10862, supra at 11-13 (when renewing a 
12b -1 plan, the directors should consider ``whether or not the plan 
was working as anticipated'').

    \60\ See 12b -1 Release 10252, supra at 3; 12b -1 Release 10862, 
supra at 9. Indeed, the Dreyfus Corporation, a major fund complex, 
argued against Rule 12b -1 on the ground that that no amount of 
protections ``could ameliorate the adviser's conflict of interest.'' 
12b -1 Release 10862, supra at 6.

    \61\ See 12b -1 Release 10252, supra at 3 (proposing that the 
advisory fee be a fixed amount to prevent the adviser from confiscating 
benefits derived from 12b -1 fees); Donaldson Memorandum, supra at 70-
71 (``When a fund bears its own distribution expenses, the fund's 
investment adviser is spared the cost of bearing those expenses itself, 
and the adviser benefits further if the fund's distribution 
expenditures result in an increase in the fund's assets and a 
concomitant increase in the advisory fees received by the adviser.'').

    \62\ Report on Mutual Fund Fees and Expenses, at Part F, supra note 
5 (noting funds whose assets exceed their highest breakpoint).

    \63\ Use of Rule 12b -1 Fees by Mutual Funds in 1999, Investment 
Company Institute, 9 Fundamentals 2 (April 2000). Funds spend the other 
32 percent of 12b -1 fees on administrative services. Id.

    \64\ See Laura Johannes and John Hechinger, Conflicting Interests: 
Why a Brokerage Giant Pushes Some Mediocre Mutual Funds, Wall Street 
Journal (January 9, 2004); see also In the Matter of Morgan Stanley DW 
Inc., Exchange Act Rel. No. 48789 (November 17, 2003).

    \65\ See Complaint, Benzon v. Morgan Stanley, No. 03-03-0159 (M.D. 
Tenn.).

    \66\ This has created the ludicrous situation, embodied in 
Commission positions, in which fund directors technically are prevented 
from reviewing the manager's payments to brokers. Under Section 36(b) 
of the Act, fund directors are supposed to consider the manager's 
profitability, which means that they must ignore distribution payments 
or risk being accused of reducing the manager's profitability to make 
the management fee seem more palatable. See Remarks of Robert Pozen, 
President and Chief Executive Officer, Fidelity Management & Research, 
at the Roundtable on the Role of Independent Investment Company 
Directors, Washington, DC (February 23, 1999) (``The second deficiency 
is one that the SEC has chosen to take a position on that I have always 
believed doesn't make any sense. The SEC's position is that independent 
directors are not allowed to see sales and promotional expenses. They 
are not allowed to consider them, unless there is a 12b -1 plan in 
place.'') [Emphasis added].

    \67\ See Complaint, Benzon v. Morgan Stanley, No. 03-03-0159 (M.D. 
Tenn.).

    \68\ See Benzon v. Morgan Stanley, Morgan Stanley, 2004 WL 62747 
(M.D. Tenn.).

    \69\ See, e.g., Statement by Arthur Levitt at the Investment 
Company Institute (May 15, 1998) (``I want you to look beyond your 
prospectuses when you think about how you communicate with investors. I 
do, and I worry that the fund industry is building unrealistic 
expectations through performance hype. I read the ads. I see nothing 
but performance, performance, performance. Why not outline clearly the 
impact of expenses or the nature of risks?'').

    \70\ Amendments to Investment Company Advertising Rules, Investment 
Company Rel. No. 26195 (September 29, 2003).

    \71\ DALBAR, Quantitative Analysis of Investor Behavior at 2 
(2003).

    \72\ Notably, the Commission requires that the prospectus include a 
bar chart that shows a fund's return for each of the preceding 10 
years. If such a disclosure is necessary to make the prospectus not 
misleading, it is unclear why the same reasoning is not applicable in 
the context of a fund advertisement.

    \73\ Proposed Amendments to Investment Company Advertising Rules, 
Investment Company Rel. No. 25575, Part II.C (May 17, 2002).

    \74\ Amendments to Investment Company Advertising Rules, supra note 
60.

    \75\ See Disclosure of Mutual Fund Expense Ratios in Performance 
Advertising, National Association of Securities Dealers (January 23, 
2004).

    \76\ Letter from Paul F. Roye, Director, SEC Division of Investment 
Management, to Craig Tyle, General Counsel, Investment Company 
Institute (October 17, 2003).

    \77\ See supra note 64.

    \78\ Prohibition on the Use of Brokerage Commissions, supra note 
31.

    \79\ Confirmation Requirements and Point of Sale Disclosure 
Requirements for Transactions in Certain Mutual Funds and Other 
Securities, and Other Confirmation Requirement Amendments, and 
Amendments to the Registration Form for Mutual Funds, Investment 
Company Act Rel. No. 26341 (January 29, 2004).

    \80\ Mandatory Redemption Fees for Redeemable Fund Securities, 
Investment Company Act Rel. No. 26375A (March 5, 2004).

    \81\ Amendments to Rules Governing Pricing of Mutual Fund Shares, 
Investment Company Act Rel. No. 26288 (December 11, 2003).

    \82\ See Ian McDonald, A Look at What Drives Money Managers' Pay, 
Wall Street Journal Online (March 16, 2004) (describing survey that 
found that ``most portfolio managers say their firms' sales and profits 
are often greater drivers of their bonuses than the investment returns 
they earn for clients'').

    \83\ Disclosure Regarding Portfolio Managers of Registered 
Management Investment Companies, Investment Company Act Rel. No. 26383 
(March 11, 2004).

                               ----------
           PREPARED STATEMENT OF WILLIAM D. LUTZ, Ph.D., J.D.
                Professor of English, Rutgers University
                             March 23, 2004

    I would like to thank Chairman Richard Shelby for this opportunity 
to comment on the Security and Exchange Commission's proposed 
requirement that investors be provided with both cost and conflict of 
interest information before they invest in mutual fund shares and 
certain other investments.
    I have served as a consultant in plain language to the Securities 
and Exchange Commission, and I have worked with a number of 
corporations and mutual fund companies to revise their documents into 
plain language. I have also written extensively on plain language and 
clear communication.
    I believe the SEC's proposal is an important step in the right 
direction. As the SEC notes in its proposed rules, providing this 
information will help investors determine the full cost of an 
investment. Both point of sale and confirmation of sale disclosure will 
certainly go far in revealing to investors just what they are paying in 
fees for a particular investment. However, I think the proposal, as 
good as it is, does not go far enough, and what it does propose doesn't 
help investors as much as it could or should.
    Right now investors face many problems in trying to figure out how 
much it will cost them to buy, hold, and sell shares in a mutual fund. 
First, they are overwhelmed with data, all kinds of data. Please note 
that I say ``data'' and not ``information.'' ``Data'' consists of all 
the numbers, facts, and statements that fill the 
prospectus and the statement of additional information (SAI). Not only 
is there a flood of data, but it is located in two places. So assuming 
intrepid investors have carefully read the prospectus, and have even 
managed the Herculean task of reading the statement of additional 
information, just what have the investors learned? Who knows, because 
both documents offer ``data'' not ``information.''
    Data is not information. Information is that which leads to 
understanding. In other words, data must be transformed into 
information. And who has the responsibility of performing that 
transformation? I would argue that the responsibility lies not with 
investors but with those who would sell investments such as mutual fund 
shares to investors. It is the responsibility of the seller to provide 
investors with information, not data.
    Transforming data into information is the function of information 
design. Professionals in information design deal with designing 
everything from websites to the instrument panels in civilian and 
military airplanes. They also design documents that communicate 
information. Indeed, in 1984, one entire issue of Information Design 
Journal, the international publication of professional information 
designers, was devoted to ``The Design of Forms and Official 
Information.'' The editors of the journal said that this issue focused 
on the one question that concerned all citizens: How can complex 
organizations communicate with the public. Information designers have 
been working for over 20 years on the problems of designing documents 
that communicate complex information clearly. It would seem prudent, 
therefore, to use the skills of information designers when confronted 
with the challenge the SEC faces in designing their proposed set of 
disclosure forms.
    Document design uses a variety of tools--from plain language to the 
best type face--to create a document that gives readers the information 
they need, and gives it to them simply, quickly, clearly, efficiently. 
Information design transforms data into information that readers can 
use. With information design, sellers can design disclosure documents 
that give investors not data but information.
    To ensure that the forms they create do indeed communicate clearly 
and effectively, document designers evaluate their designs not 
theoretically but practically. They see how well the forms work when 
people use them. The procedure they use is called usability testing, 
and it is a well-established methodology that produces documents that 
meet the needs of those who use them. When joined with information 
design, usability testing produces documents that communicate, in every 
sense of that word. Data not only becomes information, but it also 
becomes information that people can use quickly, easily, and with a 
minimum of errors or misunderstanding.
    Through usability testing, document designers discover what people 
want to know, and what they need to know in order to accomplish a 
specified task. Usability testing can help the SEC learn what 
information, if any, to leave out of the document because investors 
find it unnecessary, as well as learning what information investors 
want included. And I would like to stress that usability testing is a 
professional field, with proper procedures, standards, and protocols. 
(See, for example, Carol M. Barnum, Usability Testing and Research, 
Longman, 2002; Joseph Dumas and Janice Redish, A Practical Guide to 
Usability Testing, Ablex, 1993; Jeffrey Rubin, Handbook of Usability 
Testing, Wiley, 1994.) Investors should not have to root about the 
endless pages of dense, jargon filled prose of the statement of 
additional information. Nor should they have to piece together the 
information they need from the data scattered throughout the 
prospectus.
    I am sure that usability testing would quickly reveal a fundamental 
problem with the SEC's proposed disclosure forms: All the forms present 
disclosure from the point of view of the seller, not the buyer. The 
proposed forms are designed to ensure that the broker conforms to the 
new rules about disclosure. They are not designed to communicate the 
information investors want and need to make informed decisions. Indeed, 
at this point no one, neither the SEC, I, nor anyone else, knows what 
investors want to know because as far as I know no one has asked them 
in a systematic, controlled way designed to elicit accurate, reliable 
information.
    Right now investors have to assemble data from the prospectus and 
the statement of additional information. While the new forms proposed 
by the SEC will ideally present the most important cost data gathered 
from these two documents, we must remember that we are adding another 
document to the hierarchy of data for investors. These new forms should 
not replace the prospectus or the statement of additional information 
but should be designed to function as part of this hierarchy. The new 
forms should present in summary format the essential information about 
costs based on the statement of additional information and the 
prospectus, both of which should continue to be available to those 
investors who want to consult them. But the addition of these summary 
forms does not address the question of what information should be 
communicated to investors that is not now available.
    To be sure, the SEC's call for comments on its proposed rules has 
elicited many comments, but these are from those people who just 
happened to learn about the proposed rules. These comments will 
certainly be helpful, but this procedure does not systematically engage 
investors in seeking to discover what they want to know. Document 
design and usability testing is a more effective, accurate, and 
reliable way to find out if these rules and the proposed disclosure 
forms will provide the information that investors need, what 
information investors want, what kind of forms will best communicate 
that information, and the best way to present the information so 
investors can use it.
    Generally speaking, I think investors want to know what I, as an 
investor, want to know: What will it cost me to make this investment; 
What will it cost me while I own it; What will it cost me to sell it; 
and are there alternatives that are better and cheaper for me?
    These are the money issues, and it should not be difficult to 
provide this information to investors. However, as The Wall Street 
Journal recently (March 17, 2004) pointed out, mutual fund investors 
may be paying significant transaction costs while they hold their 
shares, and they probably do not know they are paying them. These costs 
are difficult to locate because, in the words of the Journal, they are 
``buried.'' The SEC has discussed these hidden costs in its concept 
release number 33-4389 (December 19, 2003) ``Request for Comments on 
Measures to Improve Disclosure of Mutual fund Transaction Costs.'' In 
this release, the SEC identifies the transaction costs of commissions, 
spread, market impact, and opportunity. While estimates of the 
magnitude of these costs vary, it is very clear from the studies cited 
by the SEC that these transaction costs can add up to a significant 
expense, an expense which occurs yearly. These costs can substantially 
affect the rate of return for long term investors, as the Journal 
article dramatically illustrates in its hypothetical examples. Yet most 
of these costs are not revealed in any currently available documents 
for investors.
    And this leads to another problem with the SEC's proposed 
disclosure forms. As presented, these forms imply that investors are 
being told of all the costs they are paying. Since the present proposal 
makes no provision for revealing these hidden costs in any disclosure 
form, investors are not informed of all the costs they are paying over 
the term of the investment. If these transaction costs are not included 
in the disclosure form, investors should be told that the expenses as 
listed on the form do not include transactions costs over the life of 
the investment, and these costs may significantly affect the return on 
their investment.
    I am submitting with my statement a sample revision of the SEC's 
proposed disclosure form for a confirmation of a hypothetical purchase 
of a class A share (Attachment 1 to SEC Release No. 33-8358, January 
29, 2004). This redesigned form is the result of a term effort that 
included me, Nancy Smith (who previously served as Director of the SEC 
Office of Investor Education and Assistance) and Dan Koh, of The 
Corporate Agenda, a design firm in New York. I must stress that this is 
not a final copy because we did not have time to conduct usability 
testing to refine the form. We addressed what we saw as the design 
deficiencies in the proposed SEC form, and we have tried to produce a 
document where investors can see in one place all the information that 
is currently available. And we have tried to design a form that 
communicates quickly, clearly, efficiently using both plain language 
and good document design.
    In our form we tried to include all the data we thought important 
for investors, and we tried to turn it into information that the 
investor can use. Since we did not have the opportunity to conduct 
usability testing on the form, we do not know what information is not 
included in our form that investors would want included, nor do we know 
if investors would find unnecessary any of the information we have 
included. We did try to make the information clear, simple, and 
accessible. Among other techniques, we use serif typeface, a readable 
type size, lots of white space, plain language and no jargon, and we 
defined in context any terms we thought needed to be defined. We simply 
eliminated the full page of definitions included with the proposed form 
because it is been our experience that no one will read these 
definitions, let alone understand any of them. If a technical term is 
necessary in the disclosure form then it should be defined in the 
context in which it is used, but we found we could avoid technical 
language and still be clear and accurate. In short, we followed many of 
the principles of information design and plain language, principles 
that are listed and explained in the SEC's own publication, A Plain 
English Handbook: How to Create Clear SEC Disclosure Documents, which 
the SEC published in 1998 under the aegis of Nancy Smith and which I 
helped write. (You can download a copy of the handbook at www.sec.gov/
pdf/handbook.pdf.)
    Let me repeat that I think the SEC's proposed disclosure rules are 
extremely important in improving disclosure to investors. But let me 
also repeat and emphasize that as proposed the disclosure forms simply 
aren't up to what should be the SEC's standards for clear and effective 
financial disclosure documents. I have suggested here what can and 
should be done to make these forms really disclose information in a way 
that investors can use. I have also included a sample to suggest ways 
in which the SEC can improve its proposed forms.
    Finally, I would like to urge that given the importance of clear, 
effective communication in financial disclosure documents the SEC 
should incorporate document 
design and usability testing into its regular procedures for producing 
all such documents. Many Federal agencies have already made extensive 
use of usability testing and document design to produce forms and 
documents, among them the Food and Drug Administration, Federal Trade 
Commission, National Institutes of Health, Internal Revenue Service, 
Veterans Benefits Administration, Federal Aviation Administration, and 
the Department of Housing and Urban Development.
    The SEC must do more than just give investors new and better 
information. It must give investors this information in a form and 
format that really communicates and doesn't simply present numbers. 
Document design is just as important as any other consideration when 
creating a financial disclosure document. I believe the SEC has done 
and continues to do an excellent job in providing American investors 
with access to more financial data than investors in just about any 
country in the world. Now, the SEC needs to take the next step to 
ensure that this data is transformed into information that investors 
can use. We must always remember that disclosure is not disclosure if 
it doesn't communicate.



                 PREPARED STATEMENT OF ROBERT C. POZEN
                  Chairman, MFS Investment Management
                 Visiting Professor, Harvard Law School
                             March 23, 2004

    Thank you, Chairman Shelby, Ranking Member Sarbanes, and other 
Members of the Committee for this opportunity to present my views on 
appropriate reforms for the mutual fund industry.
    My name is Robert C. Pozen and I am from Boston, Massachusetts. I 
am currently Chairman of MFS Investment Management, which manages 
approximately $140 billion for approximately 370 accounts including 
over 100 mutual funds serving approximately six million investors. I am 
also a Visiting Professor at Harvard Law School and author of the 
textbook The Mutual Fund Business (2 ed. Houghton Mifflin 2001).
    I commend the Committee for engaging in a deliberative and broad-
ranging review of the operations and regulation of the mutual fund 
industry. While I welcome questions about any aspect of the fund 
industry, I will limit my testimony today to three areas where I 
believe that MFS is helping to set important new standards for the fund 
industry: (1) maximized shareholder value through fund brokerage; (2) 
individualized reporting of shareholder expenses; and (3) structural 
enhancements for fund governance. We are making changes in these three 
areas to benefit MFS shareholders and, if followed by the rest of the 
industry, to benefit all fund shareholders.
Reducing Reliance on Soft Dollars
    The current system of paying for goods and services with ``soft 
dollars,'' taken out of brokerage commissions, is detrimental to mutual 
fund shareholders. The use of ``soft-dollar'' payments makes it 
virtually impossible for a fund manager to ascertain the true costs of 
executing trades because execution costs are bundled together with the 
costs of other goods and services such as research reports and 
Bloomberg terminals. If these costs were unbundled, then fund managers 
could pay cash out of their own pockets for independent research or 
market data, and could negotiate for lower execution prices for fund 
shareholders.
    Currently, if a trader from a mutual fund executes fund trades 
through a full-service broker on Wall Street, the trader pays 5 cents a 
share for execution plus a broad range of goods or services from the 
executing broker or third parties: For example, securities research, 
market data, and brokerage allocations to promote fund sales. These 
goods and services are paid in ``soft dollars'': That is, they are 
bundled into the 5-cents-per-share charge in a nontransparent manner. 
If MFS does not accept these ancillary goods or services through ``soft 
dollars,'' it will still be required to pay 5 cents per share by the 
full-service broker.
    In other words, it is almost impossible to obtain a price discount 
from a full-service Wall Street firm for executing a large fund trade. 
However, that firm is willing to provide an in-kind discount in the 
form of soft dollars that can be used to purchase various goods or 
services. This is more than a technical pricing oddity. The key point 
is this: A price discount on the trade (for example, from 5 cents to 3 
cents per share) would go directly to the mutual fund and its 
shareholders. In-kind services like market data services go directly to 
the fund management company and only indirectly to the mutual fund and 
its shareholders.
    MFS has already eliminated the use of ``soft dollars'' to promote 
sales of mutual fund shares. Since January 1, 2004, MFS has been paying 
cash out of its own pocket to broker-dealers to promote fund sales. 
While the SEC has proposed a rule to this effect, MFS has switched from 
soft dollars to cash to promote fund sales regardless of whether and 
when the SEC adopts its rule.
    More dramatically, earlier this month MFS decided to stop using 
soft dollars to pay for third-party research \1\ and market data. Again 
MFS will pay cash out of its own pocket for these items. MFS estimates 
that this decision will cost the management company $10 to $15 million 
per year. Yet MFS has agreed not to raise its advisory fees for its 
funds over the next 5 years.
---------------------------------------------------------------------------
    \1\ We are not stopping the use of ``soft dollars'' for proprietary 
research and other services. Only recently has the SEC issued a concept 
release on accounting for all the elements of a bundled commission. SEC 
Release IC-26313 (December 19, 2003).
---------------------------------------------------------------------------
    Why is MFS willing to take the lead on getting off the addiction to 
soft dollars and moving to the healthy environment of price discounts? 
The simple answer is: MFS puts the fund shareholder first. We recognize 
the need to employ a full-service broker to execute a large block trade 
(for example, 500,000 shares in Genzyme); we need their skills and 
capital to actively work the trade and take up a portion of the trade 
themselves if necessary. But we want to pay a price in the range of 3 
cents per share for an agency-only trade, though we are willing to pay 
more for a trade requiring capital to be put at risk by the broker-
dealer.
    The broader answer is that MFS wants to lead the industry to lower 
and more transparent execution costs. To accomplish this objective, MFS 
will need support from other asset managers as well as the SEC. Section 
28(e) of the Securities 
Exchange Act provides a safe harbor for asset managers using ``soft 
dollars'' for research and brokerage services. Initially, the SEC 
interpreted this safe harbor narrowly--allowing payment in ``soft 
dollars'' only if a good or service or product were not readily 
available for cash. Several years later, however, the SEC broadened the 
safe harbor to include any ``legitimate'' purpose for soft dollars (SEC 
Exchange Act Release 23170, April 23, 1986). The SEC should move back 
to its initial narrow interpretation of 28(e) to reduce the reliance on 
the use of ``soft dollars.''
Individualized Expense Reporting
    MFS will issue an individualized quarterly statement, rather than a 
general listing of fund expenses in basis points, which will show each 
fund shareholder a reasonable estimate of his or her actual fund 
expenses in dollar terms. The MFS design for this individualized 
quarterly statement is cost effective as a result of one key 
assumption: That shareholders hold their funds for the whole prior 
quarter. This assumption is reasonable because over 90 percent of MFS 
shareholders fall into this category.
    At present, the prospectus of every mutual fund contains an expense 
table listing the various categories of fund expenses in basis points. 
The table might say, for
instance:

------------------------------------------------------------------------
                    Fund Expenses                         Basis Points
------------------------------------------------------------------------
Advisory Fee.........................................                53
Transfer Agency Fee..................................                10
Other Fees...........................................                 2
12b-1 Fee............................................                25

------------------------------------------------------------------------
    Total Expenses...................................                90
------------------------------------------------------------------------


    In addition, the prospectus of every fund includes a hypothetical 
example of a $10,000 investment in the fund to show the dollar amount 
of actual fund expenses paid by such a fund shareholder during the 
relevant period. The hypothetical example for the mutual fund with the 
expenses described above, for instance, would show $90 in total fund 
expenses over the last year.
    Nevertheless, some critics have argued that mutual fund investors 
need customized expense statements. By that, these critics mean the 
actual expenses paid by a shareholder in several funds based on his or 
her precise holding period as well as the fund dividends during that 
period. For example, we would have to compute the exact expenses of a 
shareholder who held Fund A from January 15 until March 31 without 
reinvesting fund dividends; another shareholder who held Fund B for the 
whole year and reinvested all fund dividends; and yet another 
shareholder who held Fund C from February 1 until June 15, as well as 
from August 22 until December 11 (during both periods, assuming no 
record date for fund dividends occurred).
    This type of customized expense statement would, in my opinion, 
involve enormous computer programming costs. The program would have to 
track the holdings of every fund shareholder on a daily basis, take 
into account whether a fund dividend was reinvested or paid out to the 
shareholder, and apply monthly basis point charges to fund balances 
reflecting monthly appreciation or depreciation of fund assets. Of 
course, these large computer costs would ultimately be passed on to 
fund shareholders.
    At MFS, we will provide every fund shareholder with an estimate of 
his or her actual expenses on their quarterly statements.\2\ We can do 
this at an affordable cost by making one reasonable assumption--that 
the fund holdings of the shareholder at the end of the quarter were the 
same throughout the quarter. Although this is a simplifying assumption, 
it produces a good estimate of actual fund expenses since most 
shareholders do not switch funds during a quarter. Indeed, this 
assumption will often lead to a slightly higher estimate of 
individualized expenses than the actual amount because some 
shareholders will buy the fund during the quarter and other 
shareholders will reinvest fund dividends during the quarter.
---------------------------------------------------------------------------
    \2\ These individualized expenses will not include brokerage costs 
because they are capitalized in the cost of the portfolio security.
---------------------------------------------------------------------------
    In addition, MFS will send its shareholders in every fund's semi-
annual report the total amount of brokerage commissions paid by the 
fund during the relevant period as well as the fund's average 
commission rate per share (for example, 4.83 cents per share on 
average). But this information on brokerage commissions should be 
separated from the fund expense table because all the other items in 
the table are ordinary expenses expressed in basis points. By contrast, 
brokerage commissions are a capital expense added to the tax basis of 
the securities held by the fund, and brokerage commissions are 
expressed in cents per share.
Enhanced Governance Structure
    The mutual fund industry has a unique governance structure: The 
fund is a separate entity from its external manager. The independent 
directors of the fund must annually approve the terms and conditions of 
the fund's contract with its external manager. Of course, the 
independent directors usually reappoint the management company. In an 
industrial company, how often do the directors throw out the whole 
management team? But the independent directors of most mutual funds, in 
my experience, do represent fund shareholders by negotiating for 
contract terms and monitoring potential conflicts of interest.
    At MFS, we believe we have the most advanced form of corporate 
governance in the industry. To begin with, over 75 percent of the board 
is comprised of independent directors, who elect their own independent 
chairman. The chairman leads the executive sessions of independent 
directors, which occur before or after every board meeting. The 
independent chairman also helps set the board's agenda for each 
meeting. A lead independent director could definitely take charge of 
the executive sessions and a lead director could also help set the 
board's agenda. Thus, it does not matter which title is employed; the 
key is to ensure that a senior independent director plays these two 
functions.
    In many boards, the independent directors have their own 
independent counsel, as the MFS boards do. But the independent 
directors of the MFS funds are going one step further by appointing 
their own compliance officer. This officer will monitor all compliance 
activities by MFS as well as supervise the fund's own activities, and 
will report regularly to the Compliance Committee of the Board (which 
itself is composed solely of independent directors).
    On the management company side, MFS is the only company I know of 
that has a nonexecutive chairman reporting to the independent directors 
of the MFS funds. This is a new position designed to assure that the 
management company is fully accountable to the funds' independent 
directors.
    Finally, MFS as a management company has established the new 
position of 
Executive Vice President for Regulatory Affairs, and filled the 
position with a distinguished industry veteran. In addition, MFS has 
hired a distinguished law firm partner as its new general counsel. Both 
will serve on the executive committee of MFS. The new Executive Vice 
President will be in charge of several regulatory functions--
compliance, internal audit, and fund treasury. This high profile 
position within MFS is more than symbolic; it represents the great 
significance given by MFS to these regulatory functions. While these 
functions are performed in most fund management companies, it is rare 
to see the person in charge of these functions having the title of 
executive vice president and serving on the executive committee of the 
firm.
Conclusions
    In summary, MFS is trying to establish standards of best practices 
in three 
important areas to fund shareholders: (1) reduced reliance on ``soft 
dollars,'' (2) individualized expense reporting, and (3) enhanced 
governance structure. Other management firms are trying to take the 
lead in setting industry standards in other areas. At the same time, 
the SEC is in the process of proposing and adopting a myriad of rules 
on disclosure requirements and substantive prohibitions for the fund 
industry--which overlap to a degree with the efforts of the fund 
management firms.
    Because the SEC and the management firms are making such serious 
efforts to develop higher behavioral norms for the mutual fund 
industry, it might be useful for Congress to monitor these efforts 
before finalizing a bill on mutual fund reforms. These are complex 
issues that may be better suited to an evolutionary process, led by an 
expert public agency with the flexibility to address the changing legal 
and factual environment.
    Thank you again for this opportunity to testify on mutual fund 
reform. I would be pleased to answer any questions the Chairman or 
Committee Members might have.

                  PREPARED STATEMENT OF BARBARA ROPER
     Director, Investor Protection, Consumer Federation of America
                             March 23, 2004

    Good morning. I am Barbara Roper, Director of Investor Protection 
for the Consumer Federation of America. CFA is a nonprofit association 
of 300 consumer groups, which in turn represent more than 50 million 
Americans. It was established in 1968 to advance the consumer interest 
through research, education, and advocacy. Ensuring adequate 
protections for the growing number of Americans who rely on financial 
markets to save for retirement and other life goals is among our top 
legislative and regulatory priorities.
Introduction
    I want to congratulate Chairman Shelby, Ranking Member Sarbanes, 
and the Members of this Committee for the thorough and careful 
attention you have given to a wide range of issues arising out of the 
recent mutual fund trading and sales abuse scandals. In the best 
tradition of the Congressional oversight process, your hearings have 
helped to inform the debate, guide the SEC regulatory response, and lay 
the groundwork for additional reforms.
    Let me make clear at the outset, CFA believes the SEC has done a 
very good job since the trading scandals first broke of developing a 
strong and credible mutual fund reform agenda. While the SEC may have 
initially been caught unaware, it has since responded aggressively on 
all three fronts of Agency responsibility enforcement, oversight, and 
regulation. The settlements of enforcement actions announced by the SEC 
in recent months have included an appropriate combination of 
shareholder restitution, stiff penalties, and governance reforms. The 
Agency is reportedly at work on a number of positive steps designed to 
promote quicker identification of potential problems within the 
industry and to improve the quality of its oversight program. On the 
regulatory front, the Commission has proposed a host of new rules to 
end trading abuses, strengthen fund governance, and address a range of 
abuses in the sale of mutual funds.
    It is in this area of the regulatory response that CFA has 
primarily focused its attention. Last November, CFA and Fund Democracy 
developed a ``blueprint'' for mutual fund reform, which we released 
together with Consumer Action, Consumers Union, and the U.S. Public 
Interest Research Group.\1\ The document provided a brief review of the 
broad range of reforms we believed were needed to restore badly shaken 
investor confidence in the mutual fund industry. Our proposals fell 
into five basic categories: Reforms specifically designed to address 
trading abuses; reforms to improve regulatory oversight of mutual 
funds; reforms to enhance the independence and effectiveness of mutual 
fund boards of directors; reforms to improve mutual fund sales 
practices; and reforms to improve mutual fund fee disclosures. (A copy 
of the blueprint is included as an appendix to my testimony.)
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    \1\ A Pro-Investor Blueprint for Mutual Fund Reform, prepared by 
Mercer Bullard, Founder and President of Fund Democracy and Barbara 
Roper, Director of Investor Protection for the Consumer Federation of 
America, November 25, 2003.
---------------------------------------------------------------------------
    The purpose of the blueprint was to provide a benchmark against 
which our organizations would measure legislative and regulatory 
proposals put forward in the wake of the trading and sales abuse 
scandals. In preparing for my testimony today, I have used that 
document as a starting point for assessing the adequacy of the SEC's 
regulatory response to date. My conclusions are necessarily 
preliminary, as the SEC is still in either the rule proposal or concept 
release stage on a number of key issues. We won't know for some time 
what the Commission's final actions will be. In some instances, we 
support the general thrust of an SEC proposal but have suggestions for 
significant amendments that may or may not be adopted. Despite those 
caveats, what is really quite remarkable is how many of the suggestions 
laid out in our blueprint have since been taken up by the SEC.
    Despite that fact, we believe legislation is absolutely essential 
this year to fill certain significant gaps in the SEC's regulatory 
response. Several of these gaps result from the SEC's lack of authority 
to act. For example, legislation is needed to enhance the SEC's 
independent governance reforms by giving the Agency authority to impose 
its requirements directly, to strengthen the definition of independent 
directors, and to expand the fiduciary duty of fund directors. We also 
believe investors would benefit from a repeal of the soft-dollar safe 
harbor, which cannot be accomplished without legislation. In addition, 
we believe legislation is needed to give the SEC limited oversight 
authority over intermediaries that handle mutual fund transactions. 
This would allow the Agency to develop an effective alternative to the 
hard 4 p.m. close that provides a strong degree of certainty that late 
trading will be prevented without the inequities associated with the 
hard 4 p.m. close.
    When we look beyond the areas where the Agency is prevented from 
acting, the one area where we see major shortcomings is in the SEC's 
completely inadequate efforts to promote vigorous cost competition 
among mutual funds. This is a serious deficiency, since evidence 
strongly suggests market discipline is not currently serving as a 
reliable and effective check on excessive fees. Because bringing down 
costs even a modest amount would add billions each year to the 
retirement and other savings of mutual fund shareholders, we believe it 
is essential that Congress step in and adopt major improvements to 
mutual fund cost disclosure. The goal should be to enable and encourage 
investors to make better mutual fund purchase decisions and to enhance 
the ability of market forces to discipline costs.
    These are the proposals we believe should be included in 
legislation this year. In addition, although the SEC has put forward a 
number of very useful proposals to reform mutual fund sales, we believe 
that the issue of abusive broker-dealer sales practices deserves much 
further scrutiny and a more comprehensive legislative and regulatory 
response. We recognize, however, that this as a task that cannot be 
accomplished in the time remaining in this legislative session. We, 
therefore, urge the Committee to make this a top priority for 
comprehensive review in the next 
Congress.
    My testimony will briefly review the reforms we have advocated in 
each of the categories mentioned above, what actions the SEC has taken, 
where the SEC lacks authority to complete its reform agenda, and what 
additional actions Congress should take for the benefit of mutual fund 
investors. I will then lay out in greater detail what steps we believe 
are needed to promote effective cost competition in the mutual fund 
industry and to further reform broker-dealer sales practices.

Reforms to Address Trading Abuses
    Our blueprint outlined several steps to ensure that abusive trading 
practices are ended, that perpetrators are punished, and that investors 
receive full and fair restitution for their losses.

Fair Value Pricing
    Our Recommendation: As a starting point, our organizations 
advocated stricter enforcement of the existing requirement that funds 
price their shares accurately. Such an approach is key to reducing the 
opportunity for investors to trade rapidly in and out of a fund to take 
advantage of pricing discrepancies.
    Commission Action: In December, the Commission issued a release 
clarifying its position that funds are required to calculate their net 
asset value based on the ``fair value'' of a portfolio security if the 
market quotes are either unavailable or unreliable. In addition, the 
Commission staff is reportedly currently gathering additional 
information about funds' fair value pricing practices to determine 
whether additional steps are needed. CFA strongly supports this 
approach. However, because fair value pricing introduces an element of 
subjectivity into the pricing of fund shares, it also creates an 
opportunity for abuse. We, therefore, believe it is essential that the 
SEC continue to carefully monitor funds' use of fair value pricing to 
ensure that a reform adopted to address one set of abuses doesn't 
itself become an avenue of abuse.
    Congressional Oversight Needed: We urge this Committee to provide 
on-going oversight to ensure that mutual funds are not abusing fair 
value pricing or that this approach to pricing does not create 
unanticipated flaws in the pricing of mutual fund shares. Should it 
find problems with the use of fair value pricing, we urge the Committee 
to work with the SEC to identify steps that could be taken to eliminate 
those problems.

Mandatory Redemption Fees
    Our Recommendation: Because pricing is not a perfect science, we 
also recommended requiring at least those funds that claim to restrict 
short-term trading to impose a small redemption fee on sales occurring 
within a short-time period after the purchase. We specified that the 
fee should be payable to the fund, so that shareholders and not 
management would receive the benefit. And we indicated that redemptions 
should be permitted without triggering a redemption fee in financial 
emergencies.
    Commission Action: The Commission issued a proposed rule in March 
that would require all funds except those that disclose that they allow 
rapid trading to impose a mandatory, uniform 2 percent redemption fee 
on trades within 5 days of purchase.\2\ Although we have not yet had an 
opportunity to review this proposal in detail, it appears to meet the 
basic criteria that we laid out for helping to take the profits out of 
rapid trading. It contains provisions to allow partial, small, and 
emergency redemptions without triggering the fee, which should limit 
any potentially harmful effects on average retail investors. It also 
requires that fees be paid to the fund, not the fund managers. The rule 
also includes a requirement that intermediaries send funds, on at least 
a weekly basis, taxpayer identification numbers, and specific trading 
information for those shareholders who trade through omnibus accounts. 
This is an essential and welcome step to allow funds to identify those 
shareholders who engage in rapid trades and ensure that they pay 
appropriate redemption fees.
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    \2\ File No. S7-11-04.
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Prevent Late Trading
    Our Recommendation: In addition to advocating tough sanctions for 
those who knowingly help their clients to evade late trading 
restrictions, we recommended that the Commission adopt an approach to 
ending late trading that relies on compliance systems to provide 
reliable tracking of fund trades. With that in mind, we suggested that 
the quality of compliance systems at funds and trade processing 
intermediaries needs to be upgraded to ensure detection of these and 
other abuses. We also noted that the system must allow an effective 
regulatory inspection of those procedures. Under our suggested 
approach, intermediaries who could not provide adequate assurances of 
the integrity of their order processing systems, including fool-proof 
time-stamping of trades, would be prohibited from submitting orders to 
the fund after 4 p.m.
    Commission Action: The Commission has finalized a rule requiring 
that funds have policies and procedures in place that are designed to 
prevent late trading and requiring that these policies and procedures 
be administered by a chief compliance officer who reports to the fund 
board.\3\ In addition, the Commission has proposed a rule requiring 
that all orders for the purchase or sale of mutual fund shares be 
received by the fund, its designated transfer agent, or a registered 
clearing agency before the time the fund is priced in order to receive 
that day's price.\4\ Because of concerns expressed over inequities in 
this approach, the Commission is reportedly currently considering 
whether alternative approaches exist that would prove equally effective 
without posing the same drawbacks of a hard 4 p.m. close.
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    \3\ File No. S7-03-03.
    \4\ File No. S7-27-03.
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    Congressional Oversight Needed: While we do not oppose the hard 4 
p.m. close as a short-term solution to late trading abuses, we believe 
an alternative long-term solution must be found. With that in mind, we 
urge this Committee to monitor developments to ensure that the final, 
long-term approach adopted by the Commission meets basic standards of 
fairness to all investors.
    Legislation Needed: In addition, the Commission has suggested that 
one reason it adopted the hard 4 p.m. close approach is that it lacks 
oversight authority over certain intermediaries who handle mutual fund 
transactions and therefore cannot assure their compliance with 
appropriate standards under an alternative system that relies on 
creating an end-to-end audit trail for mutual fund transactions. To the 
degree the Commission needs additional oversight authority to provide 
end-to-end tracking of mutual fund transactions, Congress should 
provide the Commission with that authority. The goal would be to 
provide the Commission with narrowly targeted oversight authority, for 
example to inspect systems to determine whether they are adequate to 
prevent late trading and other trading abuses. This would enable the 
SEC to identify those intermediaries that lack adequate systems to 
prevent trading abuses and deny them the privilege of forwarding 
transactions after the 4 p.m. close.

Reforms to Improve Regulatory Oversight of Mutual Funds
    Because we believe the mutual fund scandals provided evidence of a 
structural breakdown of mutual fund oversight, our blueprint identified 
several steps necessary to strengthen regulatory oversight of the fund 
industry.

SEC Efforts to Enhance its Regulatory Operations
    Our Recommendation: Acknowledging that the SEC had begun to take 
steps to improve its regulatory oversight, we urged Congress to support 
and expand on those efforts to ensure that the Agency gets at the root 
cause of its oversight failure in this and other areas.
    Commission Action: Responding to criticism that it should have 
detected trading abuses earlier, the Commission announced late last 
year that it was creating a new risk assessment office whose purpose is 
to identify emerging problems and better coordinate the Agency's 
response. In addition, in recent testimony before this Committee, Lori 
Richards, Director of the Office of Compliance Inspections and 
Examinations, outlined a number of steps being taken to improve the 
SEC's oversight of the mutual fund industry. These include creating a 
new surveillance program for mutual funds, improving examination 
procedures, by including more interviews and reviewing more e-mail for 
example, conducting more targeted mini-sweep examinations, and 
reviewing the largest and highest risk funds more frequently.
    Congressional Action Needed: We believe these efforts both deserve 
Congressional support, in the form of adequate agency funding, and 
merit Congressional scrutiny, to ensure that they deliver the desired 
results, a more aggressive and effective oversight program for the 
mutual fund industry, and for the securities industry as a whole.

Independent Regulatory Board to Oversee Mutual Funds
    Our Recommendation: We recommended that Congress consider creating 
an independent board, modeled after the Public Company Accounting 
Oversight Board, with examination and enforcement authority to 
supplement SEC oversight and enforcement efforts.
    Commission Actions: SEC Chairman, William Donaldson, said in his 
November testimony before the House Financial Services Committee that 
the Commission was considering whether there were ways in which funds 
could ``assume greater responsibilities for compliance with the Federal 
securities laws, including whether funds and advisers should 
periodically undergo an independent third-party compliance audit. These 
compliance audits could be a useful supplement to our own examination 
program and could ensure more frequent examination of funds and 
advisers.'' Ms. Richards indicated in her March testimony before this 
Committee that the size of mutual funds precluded a comprehensive audit 
of every area of fund operations. Given the poor record of private 
audits in uncovering wrongdoing, if the SEC needs a supplement to its 
own examination program, we believe a far better approach would be to 
create an independent board, subject to SEC oversight, to conduct such 
audits.
    Legislation and Oversight Needed: As a first step, we believe 
Congress needs to assess the adequacy of SEC resources for oversight of 
mutual funds. If it is not possible to provide the Agency with adequate 
funding directly, Congress should determine whether an independent 
board would provide the best supplement to agency efforts. With this in 
mind, we support the requirement in legislation introduced by Senators 
Dodd and Corzine (S. 1971) to require a General Accounting Office study 
of the issue. We also urge this Committee, which has taken the lead in 
the past in improving SEC funding, to provide on-going oversight on 
this issue.

Settlements Without an Admission of Wrongdoing
    Our Recommendation: Although the SEC settlements of trading abuse 
cases have included a number of proinvestor provisions, the Agency 
continues to rely almost 
exclusively in this and other areas on settlements without any 
admission of wrongdoing by the perpetrators. While we believe this is 
in most cases an appropriate approach for the agency to take, we also 
believe there are some instances when the Commission should not allow 
those guilty of egregious violations to get off without an admission of 
culpability. We therefore recommended that Congress look into this 
practice, not just with regard to the mutual fund scandals, but also 
with regard to the SEC's enforcement program more generally.
    Congressional Action Needed: Either through its own oversight 
process or by commissioning a GAO report, we urge this Committee to 
examine the SEC policy of 
settling even cases involving egregious ethical and legal violations 
without an admission of wrongdoing.

Reforms to Enhance the Independence and
Effectiveness of Mutual Fund Boards
    The mutual fund scandals helped to shine new light on the failure 
of all too many mutual fund boards to provide effective oversight of 
fund managers on behalf of fund shareholders. To address this systemic 
breakdown in fund governance, we advocated a number of steps to improve 
the independence and effectiveness of fund boards.

Independence of Fund Boards
    Our Recommendation: To clarify that fund boards are responsible for 
representing shareholders, not management, our organizations 
recommended that three-quarters of fund boards be required to be 
independent and that funds be required to have an independent chairman. 
Such an approach should help to ensure that fund boards are firmly 
under the control of those individuals whose sole obligation is to 
shareholders. Given the primary role of the board in policing conflicts 
of interest and negotiating the management contract, we believe it is 
essential that funds be chaired and dominated by individuals whose 
loyalty is exclusively to shareholders.
    Commission Action: The Commission proposed a rule that would 
require all funds that rely on one of the Commission's exemptive rules 
to have an independent chairman and three-quarters of board members who 
are independent.\5\ The rule, portions of which face strong industry 
opposition, has not been finalized, so it is not clear whether this 
strong proposal will actually be adopted. The Commission also requested 
comment on a much weaker alternative approach that would require funds 
to have a lead independent director. This approach would continue to 
allow executives of the fund management firm to chair the board, 
putting them in the position, among other things, of negotiating with 
themselves when it comes time to negotiate the advisory contract.
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    \5\ File No. S7-03-04.
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    Legislation Needed: Because the SEC lacks authority to strengthen 
the definition of independent director, individuals with close family 
and business ties to the fund manager could still serve in this 
capacity, undermining the intent of this reform. Congress should adopt 
legislation that, at a minimum, gives the SEC authority to strengthen 
the definition of independent director. The definition included in the 
bill introduced by Senators Fitzgerald, Collins, and Levin (S. 2059) 
provides both a good statutory definition and authorization for the SEC 
to further refine the definition as needed. The Dodd-Corzine bill (S. 
1971) gives the SEC authority to add new categories of individuals who 
would be precluded from serving as independent directors because family 
or business ties to the fund manager. Either approach would provide 
much needed enhancements to the SEC's proposed independent governance 
reforms.
    In addition, because the SEC lacks authority to impose its 
governance reforms directly, it is forced to rely on the indirect means 
of imposing them as a condition of relying on the Commission's 
exemptive rules. Past experience suggests that this approach may be 
most likely to fail just when it is needed most--when there is a bona 
fide confrontation between the independent directors and the fund 
manager. The risk is that, in the event of such a confrontation, the 
fund manager will simply cease relying in the exemptive rules, in which 
case the independence requirements will no longer apply. We therefore 
strongly urge Congress to amend the Investment Company Act to give the 
SEC authority to impose its fund governance requirements directly.
    Congressional Oversight Needed: We also urge this Committee to 
monitor agency action on this issue to ensure that the final rule does 
not back away from the Commission's initial very strong reform 
proposal.

Election of Independent Directors
    Our Recommendation: Fund directors rarely stand for election by 
shareholders, leaving shareholders with little ability to hold 
directors accountable for protecting their interests. We therefore 
recommended that independent directors be required to stand for 
election every 5 years.
    Legislation Needed: The Committee should seriously consider 
adopting provisions from the Dodd-Corzine bill (S. 1971) which would 
require that all directors be approved by shareholders every 5 years 
and would establish a nominating committee composed entirely of 
independent members to nominate new board members.

Fiduciary Duty of Board Members
    Our Recommendations: Current law imposes a fiduciary duty on a 
fund's manager and directors only with respect to fees received by the 
manager. We recommended that the fiduciary duty of fund directors be 
expanded to cover the totality of a fund's fees in relation to the 
services offered.
    Commission Actions: As part of its rule on independent governance, 
the SEC would require fund boards to maintain records of documents used 
in the review of the fund manager's contract. It has proposed a 
separate rule that would require funds to disclose more detailed 
information regarding its approval of the advisory contract, including 
such factors as the actual cost of services provided and the degree to 
which economies of scale are being realized by shareholders.\6\ We 
believe the Commission requirements are a good step toward making fund 
directors more aware of their responsibilities to keep fund costs 
reasonable and more accountable for how they arrive at those decisions. 
However, we believe more can and should be done to increase board 
accountability on this central area of board responsibility.
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    \6\ File No. S7-08-04.
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    Legislation Needed: The Fitzgerald-Collins-Levin bill (S. 2059) 
contains excellent provisions spelling out an expanded fiduciary duty 
for fund directors. We strongly support its adoption.

Reforms to Improve Mutual Fund Sales Practices
    The mutual fund scandals helped to shine a light on a number of 
unsavory sales practices that stand in sharp contrast to the image 
brokers promote of themselves as objective, professional financial 
advisers. We recommended a number of steps to improve the quality of 
mutual fund sales practices and to give investors information they need 
to better protect themselves.

Presale Delivery of Mutual Fund Profile
    Our Recommendation: When investors purchase mutual funds from 
brokers, they are not required to receive the fund prospectus until 3 
days after the sale. The idea is that the broker's obligation to make 
suitable recommendations substitutes for full presale disclosure. 
Because this clearly provides inadequate protections to investors, we 
recommended that investors who purchase funds through a broker or other 
sales person be provided with at least a copy of the fund profile at 
the point when the broker makes his or her recommendation.
    Commission Actions: The Commission has proposed a rule that would 
require point-of-sale disclosure of broker-dealer costs and conflicts, 
but it would not require comparable disclosure about the operating 
costs of the mutual fund or about other important fund characteristics, 
such as investment strategy and risk.\7\
---------------------------------------------------------------------------
    \7\ File No. S7-06-04.
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    Legislation Needed: We urge the Committee to adopt legislation that 
would require mutual fund investors to be provided with a copy of 
either the fund profile or the full prospectus at the time when a 
mutual fund purchase is recommended.

Disclosure of Broker Compensation
    Our Recommendation: We recommended that mutual fund investors get 
the same disclosure on the transaction confirmation that is provided 
for virtually all other securities transactions showing how much the 
broker was paid in connection with the transaction. We also recommended 
that mutual fund investors get an up-front estimate of both broker 
compensation and the total cost of investing in the fund.
    Commission Actions: The Commission has proposed a rule that would 
require point-of-sale disclosure of the dollar amount of any front-end 
or deferred sales load, if applicable, including the amount of the 
sales fee that is to be paid to the broker.\8\ It would also require 
disclosure of the estimated first-year asset-based distribution fees or 
service fees to be received by the broker from the fund (12b -1 fees). 
In addition, the point-of-sale document would disclose whether the 
broker engages in certain practices that create potential conflicts of 
interest, including directed brokerage arrangements, revenue sharing 
payments, increased compensation for sale of proprietary products, and 
increased compensation for sale of back-end sales load products. The 
same rule would require disclosure on the confirmation statement of the 
actual amount paid in the sales load and how it compares with industry 
norms and the amounts paid to the broker by the fund and its 
affiliates.
---------------------------------------------------------------------------
    \8\ File No. S7-06-04.
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    The rule proposal offers significant progress in getting investors 
important information about costs and conflicts in advance of the sale. 
While we have not yet completed our review of the rule proposal, our 
initial review has led us to conclude that it needs significant 
amendments to improve the timing, format, and content of the proposed 
disclosures. Among other things, we believe it is essential that the 
proposed disclosures also include mutual fund operating costs, in 
addition to sales costs. Creating a document that purports to offer 
apparently comprehensive information on mutual fund costs but leaves 
out this key cost may make investors even less likely to consider 
operating costs when selecting a mutual fund than they already are. To 
the degree possible, information provided should be specific to the 
fund being recommended.
    For example, instead of using boilerplate language referring 
investors to the prospectus for more information on breakpoints, it 
could identify the next available breakpoint opportunity. We also 
believe the disclosures should be reworded and reformatted to improve 
their readability for average, unsophisticated investors and should be 
tested for effectiveness on investors. Finally, we believe the 
information must be provided at the point of recommendation, rather 
than at the point of sale, so that the investor has an opportunity to 
consider the information in making their purchase decision. Leaving 
these disclosures to the last minute when the investor is preparing to 
write a check or transfer funds for the purchase greatly diminishes the 
likelihood that they will be carefully read and incorporated into the 
purchase decision.
    Congressional Oversight Needed: We urge this Committee to monitor 
development of this proposal to ensure that it fulfills its potential. 
We also believe investors would greatly benefit from a long-term 
comprehensive review of securities industry disclosure practices 
generally. The goal of such a review should be to determine, 
comprehensively, whether these disclosures are effective in giving 
investors the information they need about the professionals they hire 
and the products that they purchase, at a time when it is useful to 
them, and in a form they can understand. Ultimately, we believe 
investors would benefit from major reforms in the disclosure system. 
Obviously, that is not a goal that can be accomplished in the time 
remaining in this Congress. We therefore urge the Committee to make 
this a top legislative priority in the next Congress.

Directed Brokerage
    Our Recommendation: Many fund managers compensate brokers for 
selling fund shares by directing their portfolio transactions to that 
broker, often paying commissions on those transactions that are higher 
than those available elsewhere. Because this drives up portfolio 
transaction costs and creates significant conflicts of interest for 
both fund managers and brokers, we recommended that this practice be 
banned.
    Commission Actions: The Commission has proposed a rule that would 
prohibit funds from compensating brokers for distribution by allocating 
portfolio transactions to that broker.\9\ It would require that funds 
have procedures in place to prevent allocation of portfolio 
transactions based on distribution considerations. We strongly support 
this rule.
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    \9\ File No. S7-09-04.
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12b -1 Fees
    Our Recommendation: At the time we developed our blueprint, our 
organizations recommended only that disclosure of 12b -1 fees be 
reformed to eliminate the currently misleading impression that these 
are the only distribution payments being made by fund managers out of 
shareholder assets. Our thinking on this issue has since evolved, and 
we have subsequently recommended that all payments for distribution 
using shareholder assets be banned. We do not object to a system that 
allows periodic (annual, quarterly, or monthly) payments for 
distribution as an alternative to paying a front-end or deferred load, 
but we believe the current system creates unacceptable conflicts of 
interest. Furthermore, we believe the growing use of 12b -1 fees to 
compensate brokers is a direct result of funds' and brokers' desire to 
hide the distribution costs from investors who might otherwise prefer a 
genuine no-load fund.
    Commission Actions: As part of its rule proposal to ban directed 
brokerage the Commission has solicited suggestions on how to reform 
12b -1 fees.\10\ Although it is too soon to say what approach the 
Commission will ultimately recommend, it appears to be leaning toward 
an approach that would require funds to deduct 12b -1 fees directly 
from shareholder accounts, rather than from fund assets. Under such an 
approach, the account-based fee would be subject to NASD caps on sales 
charges. This approach would make the charges more transparent, 
particularly if they are accompanied by good disclosures making clear 
that these are charges for the services provided by the broker rather 
than charges associated with operations of the fund. As an important 
added benefit, long-term shareholders wouldn't be forced to go on 
paying the fees after their own distribution costs had been paid, and 
existing shareholders would not be forced to bear the cost of 
distribution to other shareholders. While we have not yet had an 
opportunity to study the proposal in detail, we strongly approve of the 
Commission decision to study the issue and believe the approach they 
have outlined offers a number of significant benefits over the current 
system.
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    \10\ File No. S7-09-04.
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    Congressional Oversight Needed: We encourage this Committee to 
conduct a comprehensive review of distribution practices in the 
securities industry to determine whether they create unacceptable 
conflicts of interest. Although the Commission has made a good start in 
examining mutual fund sales practices, we believe a more thorough, 
long-term review of this issue is warranted, as we will discuss in more 
detail below.

Reforms to Improve Mutual Fund Fee Disclosures
    Regulators, financial advisers, and investor advocates all agree 
that minimizing costs is one of the most effective steps investors can 
take to improve the long-term performance of their investments. 
Unfortunately, most also agree that investors do not currently give 
adequate consideration to costs in selecting mutual funds and other 
investment products. This is a particularly troubling situation with 
regard to mutual funds, given the central role they play in the long-
term savings of average, middle-class Americans. Our blueprint 
contained several recommendations to improve mutual fund fee 
disclosures to make them much more complete and to make it more likely 
that investors will incorporate that information into their investment 
decisions.

Portfolio Transaction Costs
    Our Recommendation: Investors in mutual funds receive information 
on fund expenses that purports to provide an accurate assessment of the 
costs of operating that fund. In reality, however, the fund expense 
ratio omits what for many actively managed stock funds is the largest 
expense--the trading costs for portfolio transactions. Because this 
failure to include portfolio transactions costs results in fee 
disclosures that may dramatically understate actual costs, eliminates 
market discipline to keep these costs as low as possible, and creates a 
strong incentive for funds to pay for other operating costs through 
portfolio commissions, our organizations recommended that portfolio 
transaction costs be incorporated in the fund operating expense ratio.
    Commission Actions: The Commission issued a concept release at the 
end of last year seeking suggestions on whether and how disclosure of 
portfolio transaction costs could be improved.\11\ The industry opposes 
incorporating transaction costs in the expense ratio, and the 
Commission has long resisted this approach. It is therefore not at all 
clear that this concept release will result in meaningful improvements 
to portfolio transaction cost disclosure.
---------------------------------------------------------------------------
    \11\ File No. S7-12-03.
---------------------------------------------------------------------------
    Legislation Needed: Congress should require that all portfolio 
transaction costs be included in the expense ratio that can feasibly be 
included. The Fitzgerald-Collins-Levin bill (S. 2059) takes a 
reasonable approach to this issue, requiring that at least the 
commission and spread costs be incorporated in the expense ratio and 
requiring that the information be provided both as part of a total 
expense ratio and separately. Such an approach allows the market to 
decide which number is most useful to investors. We urge this Committee 
to include this provision in any legislation it adopts on mutual fund 
issues.

Soft Dollars
    Our Recommendation: Failure to incorporate portfolio transaction 
costs in the expense ratio creates a strong incentive for funds to find 
a way to pay for other items, beyond trading services, through their 
portfolio transaction payments. This allows fund managers both to 
create the impression that the funds are cheaper than they actually are 
and to shift costs the manager would otherwise have to absorb onto the 
fund shareholders. For these reasons, we have advocated a ban on use of 
soft dollars for all purposes. Such a ban should include a requirement 
that Wall Street firms unbundle their commissions and charge funds 
separately for research and other services currently being paid for 
through trading commissions.
    Commission Actions: The Commission is reportedly studying soft-
dollar practices, but it lacks authority to ban soft dollars. It could, 
however, take steps to improve the current situation, by limiting use 
of soft dollars to genuine research and requiring full disclosure of 
soft-dollar payments, including total unbundling of commissions by 
full-service brokerage firms who conduct portfolio transactions for 
mutual funds. Absent Congressional action, this is the approach we 
believe the Commission should take.
    Legislation Needed: Because we believe a soft-dollar ban is the 
cleanest solution that offers the greatest benefits to investors, 
however, we urge this Committee to repeal Section 28(e) of the 
Investment Company Act.

Comparative Fee Disclosures
    Our Recommendation: If the goal is to get investors to make more 
cost-conscious mutual fund purchase decisions, they need to receive 
cost information presale and in a format that is likely to help them 
understand the differences in mutual fund costs. To accomplish that 
goal, we recommended requiring that fee tables show both the average 
fees charged by a peer group of funds and the average fees for index 
funds that invest in the same types of securities. Ideally, the table 
should show the dollar amount impact of those costs over 1-, 5-, and 
10-year periods, assuming a uniform rate of return. Such an approach 
would help investors to better understand the significant differences 
in fund costs and the major impact that paying higher costs can have on 
long-term returns.
    Commission Actions: The Commission adopted a rule requiring mutual 
funds to disclose their costs in dollar amounts in annual and semi-
annual shareholder reports.\12\ While requiring the information to be 
reported in dollar amounts, and in a form that allows comparison among 
funds, is a step forward, putting the information in the shareholder 
reports greatly minimizes its benefits. Because few investors read 
these reports in advance of a fund purchase, the new disclosures will 
do little if anything to change investor behavior or introduce 
meaningful cost competition to the mutual fund industry.
---------------------------------------------------------------------------
    \12\ File No. S7-51-02.
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    Legislation Needed: In order to promote cost-conscious purchase 
decisions by mutual fund investors, the Committee should adopt 
legislation that requires presale disclosure of fund costs and presents 
those costs in comparative terms, as described above. These changes 
could be incorporated into the fund profile document, as well as the 
prospectus, in keeping with our earlier recommendation that investors 
be provided with one or the other of these documents at the time a fund 
purchase is recommended.

Actual Dollar Cost Disclosure
    Our Recommendation: As another way to get investors to focus more 
on costs, we recommended requiring funds to present individualized 
information on actual dollar amount costs on the shareholder account 
statement. Putting this information on the account statement would 
greatly increase the likelihood that it would get read. In addition, 
putting the information in close proximity to information on fund 
returns would help investors to understand how high costs can eat into 
fund returns. While not as desirable as presale disclosure, since it 
would come too late to influence the purchase decision, this approach 
could at least make investors more cost-conscious when it comes to 
future mutual fund purchases.
    Commission Action: The Commission has opposed requiring 
individualized cost disclosure on account statements and adopted its 
far weaker shareholder report disclosure requirement instead.
    Legislation Needed: The Committee should adopt legislation 
requiring mutual funds to provide dollar amount cost information on 
account statements in close proximity to information on fund returns.

Why High Mutual Fund Costs Persist
    Three forces are supposed to work together to discipline mutual 
fund costs. Mutual fund boards of directors are supposed to ensure that 
fees are reasonable, and the SEC has authority to take action against 
fund boards and managers that charge excessive fees. But the main check 
on excess costs is supposed to be supplied by market discipline. Many 
within the industry argue that these forces, and market discipline in 
particular, are working effectively to keep costs reasonable. There is 
compelling evidence, however, that this is not the case.
    To approach this issue from the simplest, most straightforward 
angle, CFA examined costs at S&P 500 index funds, using a list of such 
funds complied for us and Fund Democracy in July of last year by 
Morningstar. We chose this type of fund because no one can credibly 
argue that higher costs bring added benefits to shareholders in these 
passive investments, which seek only to match the returns of the 
underlying index. Yet, when we examined the data last fall, we turned 
up 16 fund families that offer S&P 500 index funds with annual expenses 
of more than 1 percent. This compares with expenses of 0.18 percent and 
0.19 percent respectively for the Vanguard and Fidelity funds.
    Most of the funds on the list were B and C shares, for which a 
significant portion of the annual expenses came in the form of 12b -1 
fees set at or near the maximum permissible level. The most expensive 
of these was the AAL Large Company Index II B fund, with an annual 
expense ratio at that time of 2.18 percent. However, two of the funds 
on the list, the AAL Large Company Index A and Mainstay Equity Index A, 
charged front loads of 5.75 percent and 3 percent respectively for 
their very high-cost funds.
    While distribution costs were a significant factor contributing to 
the high costs of most of the funds, virtually all of the funds on the 
list had underlying management and administrative costs (with 12b -1 
fees subtracted) that were two, three, and even four times as high as 
those of the Vanguard and Fidelity funds. While we recognize that not 
every fund company can match the rock-bottom prices charged by 
Vanguard, when such large discrepancies exist for a passive investment 
like an S&P 500 index fund, we believe it is reasonable to conclude 
that the costs at the higher end of that scale are excessive. If funds 
that charge clearly excessive costs exist among S&P 500 index funds, 
there is every reason to believe they exist among all other types of 
funds as well. A separate search for very high cost funds confirmed 
this view, when it turned up a handful of funds with annual expenses at 
or around 10 percent.\13\
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    \13\ The search was conducted by Fund Democracy President Mercer 
Bullard in response to a request from Senator Fitzgerald. The highest 
cost fund turned up in that search was the Frontier Equity Fund, which 
according to its registration statement, has annual expenses of 43.24 
percent and a front load of 8 percent. Because the adviser waives 
certain fund expenses, however, the annual fee charged to investors is 
reduced to 42.26 percent.
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    The question is why, given the several protections that exist, high 
fund costs persist. One reason is that the SEC has never used its 
authority to attack excessive fees. Some progress is apparently being 
made on that front, with the enforcement division reportedly looking 
into high costs for index funds. Another reason is that mutual fund 
boards have too often taken the approach of approving fees as 
reasonable, without regard to the underlying cost of services provided, 
as long as they are not too far out of line with industry norms. The 
recently proposed rules on independent governance and disclosure 
regarding approval of the advisory contract offer the prospect of 
progress on this front as well. Supplemented by legislation as outlined 
above, this approach could provide real progress toward getting boards 
to take seriously their obligation to keep costs reasonable.
    Despite this progress, market discipline will continue to be the 
primary factor keeping costs reasonable. In a market in which investors 
are free to choose from among hundreds of fund companies offering 
thousands of funds using several 
different distribution and pricing models, one would expect to find 
vigorous price competition. In reality, however, only a relatively 
small portion of the mutual fund marketplace could currently be said to 
be truly cost competitive. That is the roughly 13 percent of mutual 
fund transactions that occur directly between the fund company and the 
retail investor and outside of any employer-sponsored retirement 
plan.\14\ While performance-based advertising may distort this market 
somewhat, the prevalence of relatively low-cost funds in the direct-
marketed segment of the industry strongly suggests that minimizing 
costs is viewed as critical to success for funds that rely on their 
ability to sell themselves to investors directly.
---------------------------------------------------------------------------
    \14\ Investment Company Institute, 2003 Mutual Fund Fact Book, 43rd 
Edition.
---------------------------------------------------------------------------
    As we all know, a growing percentage of mutual fund transactions 
today occur through employer-sponsored retirement plans.\15\ In these 
plans, investors generally have very limited options and therefore very 
little ability to consider costs in choosing among funds. These 
investors must instead rely on their employers to consider cost when 
selecting the plan. But plans often compete for employers' business by 
keeping administrative costs low, which they are able to do by shifting 
those costs onto employees in the form of higher 12b -1 fees. While the 
recent trading scandals may have made employers somewhat more sensitive 
to their fiduciary duties in selecting a plan, it is by no means 
certain that this is that case or, if it is, that this new sensitivity 
will extend to issues of cost.
---------------------------------------------------------------------------
    \15\ Ibid.
---------------------------------------------------------------------------
    That leaves the approximately 50 percent of mutual fund 
transactions that occur through broker-dealers and other salespeople 
outside a company-sponsored retirement plan.\16\ Funds that rely on 
this market compete to be sold, not bought. While funds that compete to 
be bought can be expected to do so by offering a high-quality product 
and good service at a reasonable price, funds that compete to be sold 
do so by offering generous financial incentives to the selling firm and 
to the individual salesperson. They do this through a variety of means 
sales loads, 12b-1 fees, payments for shelf space, and directed 
brokerage that drive costs to investors up, not down. This sales-driven 
model offers mediocre, high-cost funds a means to compete for sales 
despite the fact that better alternatives for investors are widely 
available. As such, it allows funds to survive, and even thrive, that 
simply could not do so in a truly competitive market.
---------------------------------------------------------------------------
    \16\ ``Misdirected Brokerage,'' by Rich Blake, Institutional 
Investor Magazine, June 17, 2003.
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How to Encourage Vigorous Cost Competition in the Mutual Fund
Marketplace
    To turn this situation around, it will require both truly 
innovative and effective cost disclosure and a new approach to sales 
practices.

Improved Cost Disclosure
    We have described above some of the changes needed to improve cost 
disclosure. The goal is to ensure that these disclosures provide the 
information that investors need to accurately assess costs, at a time 
when it is useful to them in making their purchase decision, and in a 
format that catches their attention and conveys the information clearly 
and compellingly.
    Content: At its most basic, the cost information provided must be 
accurate. That means it must incorporate as many of the operating costs 
of the fund as possible. Ideally, this means including all portfolio 
transaction costs in the annual expense ratio. As we explained in more 
detail in our joint CFA-Fund Democracy comment letter on the SEC's 
concept release, we believe this is an achievable goal. Many funds 
already get an analysis of their total transaction costs for their 
internal use. Setting standards for computing these costs and then 
requiring that they be included in a total expense ratio, while 
complex, should therefore not pose insurmountable challenges.
    Should Congress and SEC decide for some reason against 
incorporating portfolio transaction costs in the expense ratio, it 
becomes even more important to ban soft dollars, something the SEC 
cannot do on its own. Soft-dollar payments are used to shift operating 
costs out of the sunlight of disclosed costs and into the undisclosed 
arena of portfolio transaction costs. If portfolio transaction costs 
remain undisclosed, then it is imperative that they be used only to 
cover trading costs and not to cover other products and services. 
Failure to adopt these reforms makes a mockery of the expense ratio as 
an accurate reflection of mutual fund operating costs.
    In addition, if cost disclosure is to promote cost-conscious 
purchase decisions, the information must be presented in a context that 
helps investors to understand the long-term implication of paying 
higher costs. We believe the best way to accomplish this is by 
requiring comparative information to be included when costs are 
disclosed. One such approach would be to require the fee table to 
include an average cost figure for funds in the category and an average 
cost for index funds that invest in similar securities. To make the 
information even more compelling, the 1-, 5-, and 10-year dollar amount 
added costs or savings, relative to the category average and the index 
fund cost should be presented. Showing an investor that, performance 
being equal, they will pay an additional $900 over 5 years in fees 
because of a fund's above-average costs might cause them to carefully 
consider what they are getting in return for those high costs. Showing 
that they could save thousands over 10 years by investing in a low-cost 
index fund could provide an even greater incentive to take costs into 
account when purchasing a fund.
    Timing: It is simple common sense to suggest that cost competition 
will only thrive if investors receive cost information in advance of 
the sale. Yet the current disclosure system does not require that this 
information be disclosed until several days after the sale has been 
completed. The SEC has taken an enormous step forward by suggesting 
that distribution-related costs should be provided presale, but it has 
not suggested providing similar presale disclosure of operating costs. 
This makes no sense from an agency that has emphasized the importance 
of allowing market competition to discipline costs. Once you have taken 
the step of requiring presale disclosure, there is every reason to use 
that opportunity to ensure that investors receive all the appropriate 
information that should inform their purchase decision. We believe the 
best approach would be to amend the fee table along the lines that we 
have suggested above and require that investors receive a copy of 
either the fund prospectus or fund profile including that fee table in 
advance of the sale.
    It is not enough to provide the information at the actual point of 
sale, when the check is being written or the funds are being 
transferred. At that point, the purchase decision has already been 
made. Far better is to provide the information at the point of 
recommendation, so that the investor has a reasonable opportunity to 
include cost considerations (and other factors, such as investment 
strategies and risks) as they decide whether to accept the 
recommendation or seek out a better
alternative.
    Format: Almost as important as getting investors the right 
information at the right time is getting it to them in a format that 
catches their attention. The best disclosure in the world can be 
fatally undermined if it is presented in a way that encourages 
investors to ignore it. If the Commission can be convinced, or 
compelled by Congress, to develop more effective cost disclosures, they 
should consult experts such as my fellow panelist Professor Lutz on the 
best way to convey the appropriate information. They should also be 
required to test prototype disclosures with investors to determine 
whether they are effective.

A New Approach to Product Sales
    While improved disclosure can help to alert investors to conflicts 
of interest and to make them more aware of the importance of costs, 
disclosure alone is unlikely to promote vigorous cost competition in 
the broker-sold market. A broader solution to this problem must take 
into account the fundamental reality of how investors relate to brokers 
and other financial professionals and, specifically, the degree to 
which they rely on them for advice.
    Brokers are legally salespeople, without an adviser's obligation to 
place client interests ahead of their own. In fact, their exemption 
from the Investment Advisers Act is conditioned on their limiting 
themselves to giving advice that is ``solely incidental'' or ``merely 
secondary'' to product sales. However, this is not how they present 
themselves to clients. Instead, they adopt titles, such as financial 
adviser or investment consultant, that are designed to convey to their 
customers that advice is the primary service they have to offer. They 
spend millions on advertising campaigns that relentlessly send the same 
message.
    Even sophisticated personal finance writers often fail to make this 
distinction between brokers, whose role is to effect transactions in 
securities, and investment advisers, whose role is to offer advice. If 
those who make their living covering personal finance issues make this 
mistake, it should not come as a big surprise that unsophisticated 
investors tend to approach their relationship with their broker with an 
attitude of trust. Lacking confidence in their own financial acumen, 
they seek out the advice of a financial professional, and they expect 
to rely without question on that professional's recommendations.
    Improved disclosure of conflicts of interest, as the SEC has 
proposed, should help encourage investors to see their financial 
professionals in a more realistic light. We doubt, however, that even 
the best disclosures will be able to overcome multimillion-dollar 
advertising campaigns that send exactly the opposite message. Instead, 
we believe it is long past time to require brokers either to live up to 
the advisory image they project--and accept the attendant 
responsibility to make recommendations that are in their customers' 
best interests--or to cease misrepresenting themselves to customers and 
prospective customers as advisers. To the degree that the Commission 
has taken a position on this issue, however, it has been to propose to 
expand the loophole that allows brokers to portray themselves as 
advisers, earn fees they identify as fees for advice, and still rely on 
the ``solely incidental'' exclusion from the Advisers Act.\17\
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    \17\ SEC Proposed Rule, ``Certain Broker-Dealers Deemed Not To Be 
Investment Advisers,'' File No. S7-25-99. The rule was proposed in 
1999, at which time the Commission adopted a ``no action'' position 
that assured brokers that they would not be subject to enforcement 
actions based on a violation of the rule pending adoption of a final 
rule. No final rule has been adopted, and the no action position is 
apparently still in place.
---------------------------------------------------------------------------
    Even where advisers have an obligation to put their clients' 
interests ahead of their own, the SEC has not, to our knowledge, ever 
enforced this obligation with respect to price or challenged advisers 
based on their recommendation of high-cost, inferior products. We 
believe it is high time for the Agency to start. However, given its 
history on this issue, we doubt the Commission will take this position 
without prodding from Congress. As a first step, Congress should 
conduct a thorough investigation of the role and operations of brokers 
and advisers as the basis for legislation to ensure that their conduct 
matches their representations about the services they offer.
    The focus on mutual fund sales practices has raised some issues 
that should be included in such a review. One question it has raised 
for us is why distribution costs should be set by and paid through the 
mutual fund. When an investor buys shares in Microsoft, Microsoft does 
not determine what the broker is paid for that transaction. As a 
result, we have vigorous cost competition among brokers when it comes 
to trading costs for stocks. Yet, when an investor purchases shares in 
a mutual fund, the mutual fund's underwriter sets the level of the 
broker's compensation, either through loads or asset-based distribution 
fees. This results in the kind of competition to be sold that we 
described above, a competition that drives costs up and allows 
mediocre, high-cost funds to survive that could not do so absent their 
ability to buy distribution. 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 broker-sold funds might have to compete by offering a quality 
product and good service at a reasonable price, just as direct-marketed 
funds must do.
    Obviously, this is not an approach that can be adopted without more 
thorough study of all of its implications. We believe, however, that 
similarly dramatic changes in the sales practices of brokers and other 
financial professionals will be necessary to truly change the dynamics 
of this marketplace in ways that benefit investors. We urge this 
Committee to include these issues on its agenda, if not this Congress, 
which is quickly drawing to a close, then in the next Congress.

Conclusion
    Mutual funds have long offered the best way for investors who have 
only modest amounts of money to invest to obtain broad diversification 
and professional management. The trading scandals have sullied the fund 
industry's reputation, but they have also opened up an opportunity to 
reexamine some industry practices that have too long gone unchallenged. 
The SEC has so far done an excellent job of addressing many of these 
issues, particularly fund governance, sales abuses, and improved 
regulatory oversight.
    There are, nonetheless, significant gaps in its efforts. Some 
result from the SEC's lack of authority to act. Others result from the 
SEC's apparent lack of a vision for how the market could be 
transformed. The most serious gap in this regard is the Agency's total 
failure to adopt reforms that would introduce vigorous cost competition 
in the mutual fund marketplace. It is a failure that is responsible for 
allowing billions of dollars to be transferred each year from the 
retirement savings of working Americans into the pockets of highly 
profitable mutual fund companies and financial services firms.
    Because of the SEC's aggressive response to the mutual fund 
scandals, there is not a pressing need for sweeping legislation to 
address the abuses that have been uncovered. Legislation is clearly 
needed, however, to fill specific gaps in the SEC's regulatory agenda. 
Such a bill should do the following things:

 Strengthen the definition of independent director, authorize 
    the SEC to impose its governance requirements directly (rather than 
    as a condition of relying on exemptive rules), and clarify and 
    expand the fiduciary duty of fund directors.

 Give the SEC the oversight authority it needs over 
    intermediaries who handle mutual fund transactions in order to 
    enable the Agency to adopt an alternative late trading solution 
    that does not rely on a hard 4 p.m. close.

 Ban soft dollars.

 Direct the SEC to adopt rules to require that portfolio 
    transaction costs be included in the operating expense ratio, to 
    amend the fee disclosure table to provide comparative operating 
    cost information; to require that mutual fund investors receive a 
    copy of either the prospectus or the fund profile at the time when 
    a fund purchase is recommended; to require dollar amount cost 
    disclosure on shareholder account statements; and to pretest those 
    disclosures for effectiveness in conveying the key information to 
    investors.

    It is also imperative that Congress continue to ensure that the 
Agency has adequate funding to fulfill its responsibilities, as this 
Committee has taken the lead in doing in the past. As part of that 
effort, we would encourage you to include in legislation a provision 
requiring a GAO study of whether investors would also benefit from 
creation of an independent oversight board for mutual funds. Another 
area that deserves further study, in our view, is the SEC's reliance on 
settlements without an admission of wrongdoing.
    Beyond the issues that can and should be addressed in legislation 
this year, we believe there is a compelling longer-term need to 
reexamine broker sales practices. The goal should be to eliminate the 
gaping divide that separates the professional, advisory image brokers 
promote to the public and the reality of their conflict-laden, sales-
driven conduct. Forcing brokers to live up to the advisory standards 
they promote, and raising the bar for advisors as well, would go a long 
way toward improving the long-term financial well-being of American 
investors.
    We congratulate you, Chairman Shelby, and Members of the Committee 
for the thorough and careful consideration you have given to a wide 
range of mutual fund issues. That attention has already helped to 
support and promote proinvestor reforms at the SEC. It has also helped 
to identify additional areas where legislation is needed. We look 
forward to working with you to create a more equitable and honest 
mutual fund marketplace.




         PREPARED STATEMENT OF GEOFFREY I. EDELSTEIN, CFA, CIC
                  Managing Director, Westcap Investors
                            on behalf of the
               Investement Council Association of America
                             March 31, 2004

    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, I greatly appreciate the opportunity to appear before you 
today to address issues related to soft dollars. On behalf of the 
Investment Counsel Association of America (ICAA), I wish to commend the 
Committee for convening this and other hearings on issues related to 
current investigations and regulatory actions regarding the mutual fund 
industry.
    I am a Managing Director and Co-Founder of Westcap Investors, LLC, 
an investment advisory firm located in Los Angeles, California. Westcap 
was founded in 1992 and is registered as an investment advisory firm 
with the Securities and Exchange Commission.\1\ Our firm provides 
investment advisory services to both individuals and institutions. Our 
clients include a wide variety of individual investors as well as 
pension and profit sharing plans, charitable organizations, 
corporations, State and municipal government entities, and pooled 
investment vehicles, such as limited liability companies and mutual 
funds (as a subadviser). Today, our firm employs 43 people and is 
majority-owned by its employees. Westcap's current assets under 
management total about $2.8 billion.\2\
---------------------------------------------------------------------------
    \1\ Section 202(11) of the Investment Advisers Act of 1940 defines 
an investment adviser as ``any person, who, for compensation, engages 
in the business of advising others . . . as to the value of securities 
or as to the advisability of investing in, purchasing, or selling 
securities. . .'' This section also sets forth several exceptions to 
the definition.
    \2\ As with all other SEC-registered investment advisers, Westcap's 
Form ADV Part 1 is publicly available on the Investment Adviser Public 
Disclosure website: www.adviserinfo.gov. This required registration and 
disclosure form provides information about an investment advisory firm, 
its principals, its clientele, any disciplinary history, and various 
activities.
---------------------------------------------------------------------------
    The Investment Counsel Association of America \3\ is a nonprofit 
organization based in Washington, DC that represents the interests of 
SEC-registered investment advisory firms. Westcap has been a member of 
this organization for many years and I am pleased to offer my testimony 
today on behalf of the ICAA. A statement on soft dollars that was 
released by the ICAA earlier this month is included as part of my 
statement.
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    \3\ The ICAA's membership consists of more than 300 SEC-registered 
investment advisory firms that collectively manage in excess of $4 
trillion for a wide variety of individual and institutional clients. 
For more information, please visit: www.icaa.org.
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Summary of Positions
 Investment advisers are fiduciaries and, as such, have an 
    obligation to seek best execution in connection with client 
    transactions and to disclose potential conflicts of interests to 
    both existing and prospective clients. Client brokerage is an asset 
    of the client--not of the adviser, and thus there is a potential 
    conflict where an adviser uses client brokerage for research. 
    Accordingly, the ICAA supports full and appropriate disclosure of 
    soft-dollar practices by all investment advisers. Consistent with 
    the basic approach of U.S. securities laws and market principles, 
    we strongly believe that the SEC should ensure that there is 
    adequate disclosure about soft-dollar practices, combined with 
    appropriate inspection and enforcement of regulations governing 
    these practices.
 The ICAA fully supports the SEC's current initiative to 
    examine soft-dollar practices. Specifically, the ICAA believes the 
    SEC should conduct a rulemaking aimed at ensuring that required 
    disclosures related to soft-dollar arrangements are adequate and 
    appropriate and to clarify the current definition of ``research.'' 
    The consequences of abolishing soft dollars--an outcome that would 
    require Congressional action--likely will adversely affect smaller 
    investment advisory firms, create entry barriers for new investment 
    advisory firms, and diminish the quality and availability of 
    proprietary and third-party research. Consequently, the ICAA 
    strongly believes that a rulemaking is the best option for 
    considering and implementing changes in this important area.
 The ICAA supports appropriate recordkeeping requirements for 
    investment advisers regarding soft-dollar transactions. Investment 
    advisers should maintain appropriate documentation of soft-dollar 
    transactions, the services received, their uses, and allocation 
    methodologies for mixed-use items (a service or product that 
    provides both research and other uses). In addition, the ICAA 
    believes that investment advisers should develop and implement 
    appropriate internal controls and procedures that are designed to 
    ensure that soft-dollar arrangements are supervised, controlled, 
    and monitored.
 As set forth in the ICAA's March 3 statement, however, we 
    oppose the suggestion that the SEC should eliminate the use of soft 
    dollars for third-party research. We believe this approach would 
    harm investors and diminish the availability of quality research. 
    It would result in an unjustifiable, unlevel playing field for many 
    market participants. It would provide a regulatory-driven advantage 
    for full-service brokerage firms and disadvantage third-party 
    research providers. Ironically, eliminating soft dollars for third-
    party research also would result in less transparency to investors, 
    regulators, and market participants.
Profile of the Investment Advisory Profession
    The profile of the investment advisory profession is often 
mischaracterized and misunderstood. Investment companies (mutual funds) 
and the investment management companies that provide investment advice 
to mutual funds constitute a significant and important part of the 
investment advisory profession. However, mutual fund companies and 
their advisers comprise only a portion of the entire investment 
advisory profession. In fact, statistics indicate that the vast 
majority of SEC-registered investment advisory firms are small 
companies and that most of them do not manage mutual funds.
    Beginning in 2001, investment advisers have been required to use an 
electronic filing system--the Investment Adviser Registration 
Depository (IARD)--when submitting Form ADV, Part 1, the basic 
registration and disclosure document required by the SEC.\4\ Since 
then, the ICAA and National Regulatory Services have issued annual 
reports profiling the investment advisory profession based on these 
required filings. In 2003, we reported that there were a total of 7,852 
entities registered with the SEC as investment advisers. Of this total, 
5,299 (67.5 percent) reported having 10 or fewer employees. On the 
other end of the spectrum, only 260 (3.3 percent) of all SEC-registered 
investment advisory firms reported that they employ more than 250 
persons. And only 1,478 (less than 20 percent) of all SEC-registered 
investment advisers reported that they provide portfolio management for 
mutual funds (investment companies).\5\
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    \4\ In general, any investment adviser that manages in excess of 
$25 million must file Form ADV, Part 1 via the IARD system.
    \5\ Evolution/Revolution: A Profile of the U.S. Investment Advisory 
Profession, Investment Counsel Association of America and National 
Regulatory Services (May 2003). The report is posted on the ICAA's web 
site: www.icaa.org.
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    While a relatively few large firms dominate the investment advisory 
profession in terms of their collective assets under management, the 
fact remains that most investment advisory firms are small businesses 
that are extremely diverse, both in terms of the investment services 
they provide and the extremely wide range of investors they serve. We 
submit that this fact should be considered carefully in making any 
significant regulatory or policy decisions that affect investment 
advisers.
Definition of Soft Dollars/Proprietary vs. Third-Party Research
    The subject of today's hearing is often misunderstood and 
controversial, in part due to the unfortunate term, ``soft dollars.'' 
Soft dollars simply refers to the provision by broker-dealers of 
research in addition to execution of securities transactions in 
exchange for commission dollars. The SEC staff has described soft-
dollar arrangements as follows:

        Research is the foundation of the money management industry. 
        Providing research is one important, long-standing service of 
        the brokerage business. Soft-dollar arrangements have developed 
        as a link between the brokerage industry's supply of research 
        and the money management industry's demand for research. 
        Broker-dealers typically provide a bundle of services including 
        research and execution of transactions. The research provided 
        can be either proprietary (created and provided by the broker-
        dealer, including tangible research products as well as access 
        to analysts and traders) or third-party (created by a third 
        party but provided by the broker-dealer). Because commission 
        dollars pay for the entire bundle of services, the practice of 
        allocating certain of these dollars to pay for the research 
        component has come to be called ``softing'' or ``soft 
        dollars.'' \6\
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    \6\ Inspection Report on the Soft-Dollar Practices of Broker-
Dealers, Investment Advisers and Mutual Funds, The Office of Compliance 
Inspections and Examinations, U.S. Securities and Exchange Commission 
(September 22, 1998).

    As noted in the SEC's report, soft-dollar arrangements generally 
can be categorized as either ``proprietary'' or ``third party.'' When 
the broker-dealer that 
executes a trade also provides internally generated research in 
exchange for one bundled commission price, that arrangement is referred 
to as ``proprietary.'' This is often also referred to as ``Wall Street 
research.'' Wall Street, or full-service brokerage firms, will not 
break out the costs to purchase these proprietary services ``a la 
carte'' to the vast majority of its clients. Instead of proprietary 
research, however, the executing broker can provide independent 
research generated by third parties in exchange for commission dollars. 
In these instances, the executing broker must be obligated to pay for 
the third-party research provided to the investment adviser in order 
for the arrangement to fall within the 28(e) safe harbor. These 
``third-party'' arrangements are an important mechanism for the 
distribution of independent research and analytic services.
    Several issues are raised by soft-dollar arrangements. First, the 
commissions used for execution and research services are paid by the 
investment advisers' clients. As such, an investment adviser has the 
obligation to use these commissions in the best interests of its 
clients and consistent with its fiduciary duties. Second, because 
proprietary research is bundled with execution services, the costs of 
research, execution, and other services are not as transparent as they 
would be if charged separately. Third, the definition of what is 
allowable research has been blurred as new products and services are 
created, particularly those using various technological innovations. 
Ultimately, we believe these issues are best addressed by ensuring that 
investors receive full and accurate disclosure of soft-dollar 
arrangements; by clearly delineating the types of research services 
that are eligible in such arrangements; and by giving the SEC 
appropriate tools and resources for inspection and enforcement 
activities.
Fiduciary Duty
    Investment advisers are subject to a fundamental fiduciary duty. 
This duty has been upheld by the U.S. Supreme Court \7\ and reiterated 
by the SEC in various pronouncements over the years.\8\ As described in 
the following excerpt, an investment adviser's fiduciary duty is one of 
the primary distinctions between investment advisers and others in the 
financial services industry:

    \7\ SEC v. Capital Gains Research Bureau, 375 U.S. 180, 186 (1963).
    \8\ See, for example, In re: Arleen W. Hughes, Exchange Act Release 
No. 4048 (February 18, 1948). ``The record discloses that registrant's 
clients have implicit trust and confidence in her. They rely on her for 
investment advice and consistently follow her recommendations as to the 
purchase and sale of securities. Registrant herself testified that her 
clients follow her advice `in almost every instance.' This reliance and 
repose of trust and confidence, of course, stem from the relationship 
created by registrant's position as an investment adviser. The very 
function of furnishing investment counsel on a fee basis--learning the 
personal and intimate details of the financial affairs of clients and 
making recommendations as to purchases and sales of securities--
cultivates a confidential and intimate relationship and imposes a duty 
upon the registrant to act in the best interests of her clients and to 
make only recommendations as will best serve such interests. In brief, 
it is her duty to act in behalf of her clients. Under these 
circumstances, as registrant concedes, she is a fiduciary; she has 
asked for and received the highest degree of trust and confidence on 
the representation that she will act in the best interests of her 
clients.''

        As a fiduciary, an adviser owes its clients more than honesty 
        and good faith alone. Rather, an adviser has an affirmative 
        duty of utmost good faith to act solely in the best interests 
        of the client and to make full and fair disclosure of all 
        material facts, particularly where the adviser's interests may 
        conflict with the client's. Pursuant to this duty, an 
        investment adviser must at all times act in its clients' best 
        interests, and its conduct will be measured against a higher 
        standard of conduct than that used for mere commercial 
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        transactions.\9\

    \9\ Lemke & Lins, Regulation of Investment Advisers, at p. 174 
(2003).
---------------------------------------------------------------------------
    Among obligations that flow from an adviser's fiduciary duty are: 
(1) The duty to have a reasonable, independent basis for its investment 
advice; (2) the duty to seek best execution for clients' securities 
transactions where the adviser is in a position to direct brokerage 
transactions; (3) the duty to ensure that its investment advice is 
suitable to the client's objectives, needs, and circumstances; (4) the 
duty to refrain from effecting personal securities transactions 
inconsistent with client interests; and (5) the duty to be loyal to 
clients.\10\
---------------------------------------------------------------------------
    \10\ Id., at p. 175.
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    Since it was founded in 1937, the ICAA has emphasized an adviser's 
fiduciary duty as a cornerstone of an investment adviser's 
obligations.\11\ In the soft-dollar context, we believe that fiduciary 
principles require an investment adviser to make 
appropriate disclosure to their clients about soft-dollar practices. 
Appropriate disclosure will allow investors to make informed judgments 
about such practices based on all relevant facts. In addition, 
fiduciary principles require investment advisers to make trade 
execution decisions in the best interests of their clients in light of 
relevant facts and circumstances.\12\
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    \11\ ``An investment adviser is a fiduciary and has the 
responsibility to render professional, continuous, and unbiased 
investment advice oriented to the investment goal of each client.'' 
ICAA Standards of Practice.
    \12\ Interpretive Release Concerning the Scope of Section 28(e) of 
the Securities Exchange Act of 1934 and Related Matters, Exchange Act 
Release No. 23170 (April 23, 1986).
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Disclosure and Transparency
    Disclosure is a bedrock principle of the U.S. securities laws. As a 
general matter, in fulfilling its fiduciary obligations to clients, an 
investment adviser is required to make full and fair disclosure of all 
material facts necessary for informed decisionmaking by clients, 
particularly where a potential conflict of interest is involved.
    One of the primary disclosure tools required of investment advisers 
is Form ADV, Part II, or the so-called ``brochure.'' The brochure is 
the key disclosure document that all investment advisers must deliver 
to existing and prospective clients (and offer to clients each year).
    In the soft-dollar context, Form ADV, Part II requires investment 
advisers to disclose information related to brokerage and commissions. 
Specifically, Item 12 requires disclosure regarding whether: (a) The 
adviser or a related party has authority to determine, without specific 
client consent, the broker-dealer to be used in any securities 
transaction or the commission rate to be paid, and (b) the adviser or a 
related party suggests broker-dealers to clients. If the adviser 
engages in either of these practices, it is required to describe the 
factors considered in selecting broker-dealers and in determining the 
reasonableness of commissions charged. If the value of research 
products or services given to the adviser or a related party is a 
factor in these decisions, the adviser must describe the following:

 The research products and services;
 Whether clients may pay commissions higher than those 
    obtainable from other broker-dealers in return for these products 
    and services;
 Whether research is used to service all of the adviser's 
    clients or just those accounts whose commission dollars are used to 
    acquire research products or services; and
 Any procedures the adviser has used during the past fiscal 
    year to direct client transactions to a particular broker-dealer in 
    return for research products or services.

    The SEC has proposed enhancements to these soft-dollar disclosures 
by investment advisers. While the proposal has not yet been finalized, 
the ICAA anticipates final action later this year. Following is an 
excerpt from the SEC's regulatory proposal that describes these 
enhancements (all footnotes omitted): \13\
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    \13\ Electronic Filing by Investment Advisers; Proposed Amendments 
to Form ADV, Advisers Act Release No. 1862 (April 5, 2000).

        Soft-Dollar Practices. Advisers often receive ``soft-dollar'' 
        benefits from using particular brokers for client trades. 
        Client brokerage, however, is an asset of the client--not of 
        the adviser. When, in connection with client brokerage, an 
        adviser receives products or services that it would otherwise 
        have to produce itself (or pay for), the adviser's interest may 
        conflict with those of its clients. For example, soft-dollar 
        arrangements may cause an adviser to violate its best execution 
        obligation by directing client transactions to brokers who are 
        not able to adequately execute the transactions, or may give 
        the adviser incentive to trade client securities more often 
        than it would absent the benefits the adviser receives. Because 
        of these conflicts, we have required advisers to disclose their 
        policies and practices on use of client brokerage to obtain 
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        soft-dollar benefits.

        During 1997-1998, our staff conducted a wide-ranging 
        examination of advisers' soft-dollar practices and disclosure. 
        Our Office of Compliance Inspections and Examinations found 
        widespread use of soft dollars by investment advisers that 
        manage client portfolios. The Office concluded that advisers' 
        disclosure often failed to provide sufficient information for 
        clients or potential clients to understand the adviser's soft-
        dollar practices and the conflicts those practices present. In 
        its report, the Office noted that most advisers' descriptions 
        were simply boilerplate, and urged that we consider amending 
        Form ADV to require better disclosure. Today we are acting on 
        those recommendations.

        Item 11 would require an adviser that receives research or 
        other products or services in connection with client securities 
        transactions (soft-dollar benefits) to disclose the adviser's 
        practices and discuss conflicts of interest that result. The 
        brochure's description of soft-dollar practices must be 
        specific enough for clients to understand the types of products 
        or services the adviser is acquiring and permit them to 
        evaluate conflicts. Disclosure must be more detailed for 
        products or services not used in the adviser's investment 
        decisionmaking process.

        Item 11 would describe the types of conflicts the adviser must 
        disclose when it accepts soft-dollar benefits, and require the 
        adviser to disclose its procedures for directing client 
        transactions to brokers in return for soft-dollar benefits. The 
        item would require the adviser to explain whether it uses soft 
        dollars to benefit all clients or just those accounts whose 
        brokerage ``pays'' for the benefits, and whether the adviser 
        seeks to allocate the benefits to client accounts 
        proportionately to the brokerage credits those accounts 
        generate. The item would also require the adviser to explain 
        whether it ``pays up'' for soft-dollar benefits.

    These enhanced disclosures will put more detailed information in 
the hands of clients, permitting clients to decide whether they approve 
of their advisers' use of their commissions.
    In addition to disclosure and other regulatory requirements, there 
are a number of market factors that play a significant role in soft-
dollar arrangements. For example, many investment advisory clients (or 
their consultants) request and receive extensive information relating 
to soft-dollar practices. These requests often extend to information 
that go beyond disclosures required by regulations, including specific 
client information. The fact of the matter is that investment advisers 
often supply a great deal of information regarding soft-dollar 
practices in response to requests from clients or their consultants.
    Similarly, it should be recognized that excessive trading or paying 
excessive commissions to ``earn'' soft-dollar credits for research 
takes an adverse toll on an investment adviser's investment performance 
(by creating additional trading costs that must be deducted from any 
appreciation in value of a client's account). This fact alone serves as 
an important ``market'' deterrent from abusing soft-dollar 
arrangements. Investment performance is clearly the single most 
significant factor that 
investors (and their consultants) use to hire or fire an investment 
adviser. Accordingly, investment advisers whose clients are able to 
monitor their portfolios and investment performance will be sensitive 
to potential negative effects that may follow from trading activities 
associated with soft-dollar arrangements. In addition, clients 
(including mutual fund directors) receive independent custodial reports 
and can judge for themselves the appropriateness of commissions paid 
and the turnover of securities in their portfolios.
    The ICAA supports full and appropriate disclosure of soft-dollar 
practices by all investment advisers. Consistent with the basic 
approach of U.S. securities laws and market principles, we believe that 
the SEC should ensure that there is adequate disclosure about soft-
dollar practices, combined with appropriate inspection and enforcement 
of such regulations.
Definition of ``Research''
    Section 28(e) of the Securities Exchange Act of 1934 was enacted by 
the Congress in 1975 following the abolition of fixed commission rates. 
The section provides that: ``no person . . . in the exercise of 
investment discretion with respect to an account shall be deemed to 
have acted unlawfully or to have breached a fiduciary duty under State 
or Federal law . . . solely by reason of his having caused the account 
to pay a member of an exchange, broker, or dealer an amount of 
commission for effecting a securities transaction in excess of the 
amount of the commission another member of an exchange, broker, or 
dealer would have charged for effecting that transaction, if such 
person determined in good faith that such amount of commission was 
reasonable in relation to the value of the brokerage and research 
services provided by such member, broker, or dealer, viewed in terms of 
either that particular transaction or his overall responsibilities with 
respect to the accounts as to which he exercise investment 
discretion.''
    In order to rely on the safe harbor under Section 28(e), an 
investment adviser must satisfy the following conditions:

 The adviser must be supplied with ``brokerage and research'' 
    services;
 The services must be ``provided'' by a broker-dealer;
 A ``broker-dealer'' must be the provider of the service;
 The investment adviser must have ``investment discretion'' in 
    placing the brokerage;
 The commissions paid must be ``reasonable'' in relation to the 
    services provided;
 ``Commissions'' must be used to purchase the services; and
 The brokerage commissions paid must relate to ``securities 
    transactions.''

    One of the most important aspects of the safe harbor is the 
definition of ``research'' services. The leading pronouncement on this 
issue is the SEC's 1986 interpretive release. According to the 1986 
release, the test for determining ``whether something is research is 
whether it provides lawful and appropriate assistance to the money 
manager in the performance of his decisionmaking responsibilities.'' 
\14\ The SEC noted that what constitutes lawful and appropriate 
assistance ``in any particular case will depend on the nature of the 
relationships between the various parties involved and is not 
susceptible to hard and fast rules.'' In later decisions, the SEC has 
noted that ``research'' does not cover a wide variety of expenses, 
including overhead (such as office rent, utilities, and salaries), 
administrative expenses, exam review courses, association membership 
dues, electronic proxy voting services, consulting services designed to 
assist an investment adviser in client marketing, legal expenses, 
accounting and tax software, as well as items such as travel, meals, 
hotel, and entertainment expenses associated with attending a research 
seminar or conference.\15\
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    \14\ Supra, fn.10.
    \15\ In re Kingsley, Jennison, McNulty & Morse, Inc., Advisers Act 
Release No. 1396 (December 23, 1993); In re Goodrich Securities Inc., 
Exchange Act Release No. 28141 (June 25, 1990); In re Patterson Corp., 
Advisers Act Release No. 1235 (June 25, 1990).
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    The 1986 interpretive release specifically identified so-called 
``mixed-use'' products and services that may have both research and 
nonresearch purposes. Among such mixed-use products are: Computer 
equipment used for research undertaken on behalf of clients and for 
nonresearch functions, such as bookkeeping or administrative 
operations; quotation systems that provide information pertinent to the 
valuation of securities while facilitating the adviser's reports to 
clients; and information management systems that integrate trading, 
execution, accounting, recordkeeping, and other administrative 
functions. The SEC requires investment advisers that receive a mixed-
use product or service to make a reasonable allocation of the cost of 
the product or service according to its use.
    Since the enactment of Section 28(e) in 1975, investment advisers 
have begun to use investment styles that require quantitative analytic 
tools that are in some ways quite different from the traditional 
research tools used by investment advisers. In addition, the way that 
research is delivered has significantly changed since 1986, when the 
SEC last defined ``research.'' The predominant form of research in 
1975--paper documents covering one issuer--have now developed into a 
myriad of research services, including electronic delivery and software 
that provides consolidations of research covering entire sectors, 
industries, and other categories into searchable, analytical databases. 
These changes have presented many challenges for advisers attempting to 
interpret the SEC's guidance from 1986.
    The ICAA supports the SEC's efforts to ensure that soft dollars are 
used only for legitimate research purposes. We also recognize the 
difficult challenges associated with this task. Particularly given 
advances in technology, including communications and electronics, the 
line between research and nonresearch products and services is more 
difficult to discern and to delineate. We support a rulemaking by the 
SEC to clarify the definition of research to preclude the use of soft 
dollars for nonresearch products and services while retaining enough 
flexibility so as not to preclude the development of innovative and 
valuable research services.
1998 SEC Report on Soft-Dollar Practices
    The best starting point for evaluating actual practices related to 
soft dollars is the report issued by the SEC's Office of Compliance 
Inspections and Examinations (OCIE) in 1998.\16\ From November 1996 
through April 1997, OCIE conducted an extensive inspection sweep to 
gather information about the current uses of soft dollars, based on on-
site examinations of 75 broker-dealers and 280 investment advisers and 
investment companies. In September 1998, OCIE issued a written report 
detailing the results of their sweep and setting forth recommendations 
for consideration by the SEC. Among the key findings set forth in the 
report are the following:
---------------------------------------------------------------------------
    \16\ Supra, fn.4.

 ``Almost all'' investment advisers obtain products and 
    services (both proprietary and third-party) other than pure 
    execution from broker-dealers and use client commissions to pay for 
    those products and services.
 Most products and services obtained by investment advisers 
    with soft dollars fall within the definition of research, that is, 
    they provide lawful and appropriate assistance to the adviser in 
    the performance of its investment decisionmaking responsibilities.
 While most of the products acquired with soft dollars are 
    research, OCIE found that a significant number of broker-dealers 
    (35 percent) and investment advisers (28 percent) provided and 
    received nonresearch products and services in soft-dollar 
    arrangements. In such cases, OCIE found that investment advisers 
    failed to provide meaningful disclosure to their clients.
 OCIE also reported shortcomings by investment advisers with 
    respect to ``mixed use'' items, for example, products that have 
    both research and nonresearch uses.\17\
---------------------------------------------------------------------------
    \17\ Id., at p. 3.

    The staff report set forth the following recommendations for the 
---------------------------------------------------------------------------
SEC to consider:

    ``1. We noted many examples of advisers claiming the protection of 
the safe harbor without meeting its requirements. We also found that 
industry participants were not uniformly following prior Commission 
guidance with respect to soft dollars. As a result, we recommend that 
the Commission publish this report to reiterate guidance with respect 
to the scope of the safe harbor and to emphasize the obligations of 
broker-dealers, investment advisers and investment companies that 
participate in soft-dollar arrangements. We also recommend that the 
Commission reiterate and provide further guidance with respect to the 
scope of the safe harbor, particularly concerning (a) the uses of 
electronically provided research and the various items used to send, 
receive, and process research electronically, and (b) the uses of items 
that may facilitate trade execution.
    ``2. Many broker-dealers and advisers did not keep adequate records 
documenting their soft-dollar activities. We believe the lack of 
adequate recordkeeping contributed to incomplete disclosure, using soft 
dollars for nonresearch purposes without disclosure, and inadequate 
mixed-use analysis. We recommend that the Commission adopt 
recordkeeping requirements that would provide greater accountability 
for soft-dollar transactions and allocations. Better recordkeeping 
would enable advisers to more easily assure compliance and Commission 
examiners to more readily ascertain the existence and nature of soft-
dollar arrangements when conducting inspections.
    ``3. We noted many instances where advisers' soft-dollar 
disclosures were inadequate or wholly lacking--especially with respect 
to nonresearch items. We 
recommend that the Commission modify Form ADV to require more 
meaningful disclosure by advisers and more detailed disclosure about 
the products received that are not used in the investment 
decisionmaking process. In addition, the Commission should require 
advisers to provide more detailed information to clients upon request.
    ``4. In light of the weak controls and compliance failures that we 
found, we recommend that the Commission publish this report in order to 
encourage advisers and broker-dealers to strengthen their internal 
control procedures regarding soft-dollar activities. We suggest that 
advisers and broker-dealers review and consider the controls described 
in this report, many of which were observed as effective during 
examinations.'' \18\
---------------------------------------------------------------------------
    \18\ Id., at pp. 4-5.

    At the time it was issued, the OCIE report clearly represented the 
best available information on soft-dollar practices. In light of the 
fact that the report was published more than 5 years ago, one of the 
key questions today is whether any of the practices described in the 
report have changed. Some of the key issues that may warrant 
reexamination include whether documentation, disclosure, and control 
procedures relating to soft-dollar arrangements have improved.
Current SEC Initiatives
    Following the recommendations set forth in the 1998 OCIE Report, 
the SEC issued an extensive proposal in April 2000 to revise the so-
called ``brochure'' (Form ADV, Part 2), the disclosure document that 
all investment advisers must offer to provide to clients and 
prospective clients each year.\19\ As discussed above, the proposed 
rule would amend the brochure requirements to mandate more specific 
disclosure regarding soft-dollar practices and any resulting conflicts. 
The ICAA expects the SEC to finalize this important rule later this 
year.
---------------------------------------------------------------------------
    \19\ Supra, fn.11.
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    In addition, the SEC recently finalized a major new rule that 
requires all investment advisers to adopt written compliance policies 
and procedures that are reasonably designed to prevent violations of 
the Investment Advisers Act of 1940, to 
review such policies and procedures at least annually, and to designate 
a chief compliance officer who is responsible for administering the 
policies and procedures.\20\ The written release accompanying the SEC's 
new regulation lists a number of areas that investment advisers should 
consider in developing written policies and procedures, including best 
execution and soft-dollar practices. Clearly, the new rule will 
encourage investment advisers to enhance--and review on a continuing 
basis--their written policies and procedures relating to soft-dollar 
practices and will provide the SEC with an additional tool in 
identifying potential problems in this area.
---------------------------------------------------------------------------
    \20\ Compliance Programs of Investment Companies and Investment 
Advisers, Advisers Act Release No. 2204 (December 17, 2003).
---------------------------------------------------------------------------
    Early this year, Chairman Donaldson announced that he has directed 
SEC staff to explore various issues relating to soft dollars. SEC staff 
have been meeting with a number of interested parties to discuss issues 
related to soft-dollar practices, including contracts for soft-dollar 
arrangements, recordkeeping practices, and disclosure practices. At the 
March 10 hearing before this Committee, the Director of the SEC's 
Division of Investment Management noted in his prepared testimony that:

        Chairman Donaldson has made the issue of soft dollars a 
        priority and has directed the staff to explore the problems and 
        conflicts inherent in soft-dollar arrangements and the scope of 
        the safe harbor contained in Section 28(e) of the Securities 
        Exchange Act. The Divisions of Market Regulation and Investment 
        Management, along with the Office of Compliance Inspections and 
        Examinations, are working together to conduct this review. A 
        primary area of focus is whether the current definition of 
        qualifying ``research'' under the safe harbor is too broad and 
        should be narrowed by rulemaking. The Commission has also 
        sought public comment on whether it would be possible to 
        require mutual fund managers to identify the portion of 
        commission costs that purchase research services from brokers 
        so as to enhance the transparency of these arrangements.\21\
---------------------------------------------------------------------------
    \21\ Testimony Concerning the Securities and Exchange Commission's 
Recent Regulatory Actions to Protect Mutual Fund Investors, Paul F. 
Roye, Director, SEC's Division of Investment Management, before the 
U.S. Senate Committee on Banking, Housing, and Urban Affairs (March 10, 
2004).

    We understand that as part of this review, the SEC is considering 
certain public comments that have been filed with the SEC that set 
forth a number of suggestions for improving disclosure of soft-dollar 
arrangements and for narrowing the scope of allowable research.\22\ 
Among these comments is a suggestion that proprietary research costs be 
``unbundled'' from execution costs.\23\ Although we have not had an 
opportunity to fully consider this proposal, we strongly believe that 
any such reform should place full responsibility to calculate the cost 
or price of nonexecution services on the broker-dealer providing the 
services, rather than requiring investment advisers to make a 
subjective estimate regarding such services.
---------------------------------------------------------------------------
    \22\ See March 2, 2004 Comment Letter from Fidelity Management and 
Research Company to SEC re: Concept Release on Measures to Improve 
Disclosure of Mutual Fund Transaction Costs, Release No. 33-8349; 34-
48952: IC-26313; File No. S7-29-03.
    \23\ Id.
---------------------------------------------------------------------------
    The ICAA fully supports the SEC's current initiative to examine 
soft-dollar practices and issues. Specifically, the ICAA would support 
an SEC rulemaking aimed at improving disclosure of soft-dollar 
practices and arrangements to investors and to clarify the current 
definition of ``research.''
Conclusions and Summary
    In summary, the ICAA supports a rulemaking by the SEC that would:

 Enhance soft-dollar disclosure requirements, as envisioned by 
    the SEC's proposal to revise Form ADV;
 Strengthen books and records requirements related to soft 
    dollars; and
 Clarify the scope of allowable ``research'' within the Section 
    28(e) safe harbor.

    We believe that these rule changes, combined with appropriate 
inspection and enforcement of these regulations will strengthen the 
transparency of soft-dollar arrangements and deter abuses in this area.
    However, we believe that the SEC should reject suggestions to 
eliminate the use of soft dollars for third-party research.\24\ As 
described in the ICAA's March 3, 2004 statement, we believe such a 
suggestion is fundamentally flawed:
---------------------------------------------------------------------------
    \24\ See December 2, 2003 Comment Letter from the Investment 
Company Institute to the SEC re: soft dollars.

        It would result in a diminution of quality research and thus is 
        contrary to our strong support for independent research that 
        benefits investors. If adopted, the proposal would unfairly 
        advantage full-service brokerage firms and disadvantage third-
        party research providers, as well as clients of investment 
---------------------------------------------------------------------------
        advisers who benefit from third-party research.

    Finally, the ICAA believes that an SEC rulemaking is a better 
approach than repealing Section 28(e). While the consequences of 
eliminating soft dollars cannot be predicted with certainty, we believe 
the SEC is in the best position to consider the complex issues related 
to this important question. Abolishing soft dollars may well diminish 
the amount of quality research that is made available to investment 
advisers and thus may hurt investors. In addition, repealing section 
28(e) may disproportionately disadvantage thousands of smaller 
investment advisory firms and their 
clients while favoring the relatively few larger firms that have 
greater resources to produce and acquire research.
    In closing, the ICAA wishes to commend the Committee for conducting 
this hearing on these important issues. We would be pleased to provide 
any additional information that may be helpful to you in your 
continuing deliberations.
                               * * * * *
FOR IMMEDIATE RELEASE
March 3, 2004

CONTACT: DAVID TITTSWORTH
202.293.4222

ICAA STATEMENT RE: SOFT DOLLARS

(Washington, DC) The Investment Counsel Association of America today 
issued the following statement regarding soft dollars:

    The ICAA fully supports SEC Chairman Donaldson's announced 
initiative to analyze issues related to soft dollars and we stand ready 
to assist the Commission in this important effort. Specifically, we 
encourage the SEC to require enhanced disclosure of soft-dollar 
practices to clients and to focus on whether the SEC's interpretation 
of allowable research requires clarification. However, the ICAA 
believes the SEC should reject the Investment Company Institute's 
proposal to eliminate all third-party research from soft-dollar 
practices. We believe this aspect of ICI's proposal is fundamentally 
flawed. It would result in a diminution of quality research and thus is 
contrary to our strong support for independent research that benefits 
investors. If adopted, the proposal would unfairly advantage full-
service brokerage firms and disadvantage third-party research 
providers, as well as clients of investment advisers who benefit from 
third-party research.
    The ICAA has been a consistent advocate for high ethical standards 
and strong and effective compliance practices. The ICAA Standards of 
Practice, first adopted in 1937, continue to emphasize that an 
investment adviser is a fiduciary that has the responsibility to render 
professional, continuous, and unbiased investment advice to its 
clients. As such, basic fiduciary principles prohibit an investment 
adviser from taking an interest that is potentially adverse to its 
clients without the client's informed consent and from using client 
assets for its own benefit. Client brokerage is an asset that should be 
used in the best interests of the client. Accordingly, 
investment advisers that choose to enter into soft-dollar arrangements 
must be mindful of their fiduciary obligations, including their duty to 
make full and complete disclosure to investors about such practices.
    In 1975, the Securities and Exchange Commission acted to make the 
U.S. securities markets more competitive by abolishing fixed commission 
rates. Shortly thereafter, Congress enacted Section 28(e) of the 
Securities Exchange Act of 1934, the safe harbor that allows investment 
advisers to ``pay up'' for research. Section 28(e) provides that a 
person who exercises investment discretion with respect to an account 
will not be deemed to have breached a fiduciary duty solely by reason 
of having caused the account to pay more than the lowest available 
commission, if such person determines in good faith that the amount of 
the commission is reasonable in relation to the value of the brokerage 
and research services provided. Soft-dollar practices, as defined by 
the SEC, consist of arrangements in which products or services other 
than execution of securities transactions are obtained by an investment 
adviser by or through a broker-dealer as a result of the adviser's 
using the broker-dealer for execution of client securities 
transactions. The SEC's current definition of soft dollars makes no 
distinction between proprietary and third-party research and services.
    The Investment Company Institute, a trade association that 
represents the mutual fund industry, wrote to SEC Chairman Donaldson in 
December proposing, among other things, that the SEC issue rules to 
exclude certain research products and services from the scope of 
Section 28(e), including computer hardware and software, publications 
that are available to the general public, and all third-party research 
services. In January, Chairman Donaldson stated that he had directed 
the SEC staff to explore a number of complex issues, including ``the 
use of soft-dollar arrangements by investment managers and the scope of 
the safe harbor contained in Section 28(e) of the Exchange Act.''
    The ICAA fully supports Chairman Donaldson's initiative and stands 
ready to assist the Commission in analyzing current practices and 
identifying appropriate ways to improve soft-dollar disclosure and to 
clarify current law. However, we believe the SEC should not eliminate 
all third-party research from the scope of the safe harbor.
    As an initial matter, it is worth noting that the vast majority of 
investment advisory firms are small businesses that do not manage 
mutual funds. There are approximately 8,000 entities registered as 
investment advisers with the SEC. Of this total, more than 5,000 have 
10 or fewer employees. More than 6,000 investment advisers report that 
they have no mutual fund clients. In fact, investment advisory firms 
have a wide variety of business models and investment styles and an 
extremely varied clientele, from individuals, families, and trusts, to 
a diverse range of institutional clients, including public and private 
pension plans, endowments, foundations, and pooled investment vehicles 
such as mutual funds and hedge funds. The ICAA's membership represents 
a cross-section of the broader universe of registered investment 
advisory firms.
    Given the enormous diversity among the investment advisory 
profession and our membership, it should come as no surprise that there 
is not unanimous agreement on issues related to soft dollars. Some 
firms have expressed support for the concept of severely restricting--
or even eliminating--soft-dollar usage. In fact, some firms have 
voluntarily taken the position that they will not engage in soft-dollar 
transactions, other than receiving research from full-service brokers. 
On the other hand, many firms have expressed a variety of serious 
concerns about the ICI's proposal. They particularly object to the 
proposal to eliminate the use of soft dollars for all third-party 
research, on the grounds that this will hurt clients and all investors 
because it will result in less innovative and independent research. 
Even among the minority of firms that view soft dollars as 
objectionable, most agree that the proposal to eliminate soft dollars 
for third-party research may have significant and unpredictable 
consequences.
    We are persuaded that any proposal to eliminate soft dollars for 
third-party research, if adopted, would have unfortunate and untenable 
results. If adopted, it would have a number of profoundly negative 
consequences. It would result in an unjustifiable, unlevel playing 
field for many market participants. It would provide a regulatory-
driven advantage for full-service brokerage firms and disadvantage 
third-party research providers. As such, it would increase costs for 
existing investment advisers and third-party research firms and would 
create an additional barrier to entry for new advisory and research 
firms. Most important, it would have adverse consequences for clients 
of investment advisory firms that benefit from third-party research. 
Instead of helping investors by giving investment advisers access to 
superior, independent research, the proposal in fact would reduce the 
overall research available, to the detriment of investors. Such a 
result would be particularly ironic in view of the problems that have 
been uncovered during the past few years relating to conflicted 
research provided by various brokerage firms. Indeed, many advisers 
believe that third-party research provided by independent firms is of 
higher quality than propriety research provided by large Wall Street 
brokerage firms. Further, using soft-dollar credits for third-party 
research is undeniably more transparent than ``paying up'' for 
proprietary research from full-service brokers bundled with execution 
services. Third-party research is separately identified, invoiced, and 
quantifiable. Proprietary research is not. In this respect, the mutual 
fund industry's proposal would result in less transparency to market 
participants, regulators, clients, and investors.
    In addition, we believe that eliminating third-party research will 
drive up costs for many investment advisory firms and may have 
undesirable economic consequences, particularly for smaller firms. 
Accordingly, the ICAA strongly urges the SEC to evaluate carefully the 
impact of such a proposal on investment advisers, including the 
thousands of smaller investment advisory firms. We also urge the SEC to 
study the potential impact of such a proposal on the quality and 
availability of research, a review that has never, to our knowledge, 
been undertaken. Due to the widespread use of soft dollars, we believe 
that any major change in their usage may have significant and 
unpredictable consequences--for investors, investment advisers, third-
party research providers, and full-service brokerage firms. Given these 

potentially far-reaching implications, the SEC should take time to 
investigate the likely effects of any major changes in soft-dollar 
regulations.
    Several years ago, the SEC's Office of Compliance Inspections and 
Examinations conducted an intensive fact-finding effort regarding 
current practices. OCIE's targeted examinations involved a large number 
of brokerage firms and investment advisers. In September 1998, OCIE 
issued an extensive written report detailing its findings. Among the 
most prominent findings were the following: (1) Nearly all investment 
advisers obtain products and services (both proprietary and third-
party) other than pure execution from broker-dealers and use client 
commissions to pay for those products and services; (2) by far, most of 
the products and services obtained by investment advisers with soft 
dollars fall within the definition of research, for example, they 
provide lawful and appropriate assistance to the adviser in the 
performance of its investment decisionmaking responsibilities; and (3) 
in cases where investment advisers received nonresearch products and 
services using soft-dollar arrangements, virtually all investment 
advisers failed to provide meaningful disclosure of such practices to 
their clients (a practice that already violates current laws and 
regulations). A sound starting point for further SEC action would be to 
assess whether the conclusions from the prior report are still valid.
    The ICAA believes that policy makers should ensure that there is 
adequate disclosure about soft-dollar practices and then allow market 
forces to work in determining how and when such practices make sense. 
Investors deserve to have accurate and complete disclosure about soft-
dollar practices of brokerage firms and investment advisers so they can 
make a competent decision as to whether such practices are consistent 
with their interests. Ensuring appropriate disclosure in a competitive 
market will allow investors--rather than regulators--to make choices 
about soft-dollar practices that work for them. As noted above, some 
investment advisory firms already have made the voluntary decision not 
to engage in soft-dollar transactions involving third-party research 
providers. We believe that allowing market-driven decisions by 
investors, combined with full and complete disclosure, is certainly a 
better solution than abolishing soft-dollar arrangements for third-
party research services.
    The ICAA also supports efforts by the SEC to clarify the types of 
products and services that constitute permissible research under 
current law. We recognize that research products and services are 
evolving, with innovative developments continuing on an ongoing basis. 
However, the SEC's clear guidance in this area, to the extent feasible, 
will have a salutary effect on both investment advisers' compliance 
programs, and the SEC staff's inspection of such programs.
    The ICAA supports full and complete disclosure of potential 
conflicts of interest that confront investment advisers, including 
soft-dollar arrangements. We look forward to working with the Congress, 
the SEC, and other policymakers to ensure that investors have full and 
complete disclosure of soft-dollar practices and that uniform and 
consistent laws and regulations are in place governing these and 
related issues.

                               * * * * *

    The ICAA is a not-for-profit association that represents the 
interests of investment adviser firms. Founded in 1937, the ICAA's 
membership today is comprised of more than 300 firms that are 
registered as investment advisers with the SEC that collectively manage 
in excess of $4 trillion for a wide variety of individual and 
institutional investors. For more information, please visit 
www.icaa.org.

                              ------------
           PREPARED STATEMENT OF HOWARD M. SCHILIT, PHD, CPA
                            Chairman and CEO
            Center for Financial Research & Analysis (CFRA)
                             March 31, 2004

    Thank you for the opportunity to share my views on the role of 
independent research, soft-dollar commissions, and their 
interdependence.
    My name is Howard Schilit. I am author of the book Financial 
Shenanigans and founder and CEO of the Center for Financial Research & 
Analysis (widely known as CFRA), a forensic accounting organization 
serving the investment management community. Our center serves as a 
``watchdog'' organization for investors, warning about unusual 
accounting practices. For example, over the last decade, we warned 
investors about problems at Worldcom, Enron, Parmalat, Cendant, and 
Sunbeam.
    Independent research organizations perform a vital watchdog role 
that greatly benefits investors. As we all know, our founding fathers 
had the wisdom to devise a system of checks and balances to not allow a 
single branch of Government to exert undue power. In much the same way, 
the independent research industry provides checks over potentially 
biased and misleading information distributed by public companies and 
their sponsors at investment banking brokerage firms.
    Independent research organizations typically are paid by third-
party brokers that use soft-dollar commissions. A ban on soft-dollar 
commissions would have a devastating impact on independent research 
firms and, indirectly, hurt investors. I urge this Committee to search 
for other solutions and leave soft-dollar payments intact.
Historical Perspective
    Historically, when investment managers trade stock they have had to 
purchase a bundled package of services from one source--full-service 
brokerage firms. All research, trading, and other brokerage services 
came from this one source.
    Within the last generation, competition has emerged as smaller 
boutique brokerage firms entered the market, driving down commission 
rates. In order to truly compete with the full-service brokerage firms, 
the boutiques needed to bundle some value-added services. Since 
customers wanted research, the boutiques outsourced these products by 
partnering with value-added independent research organizations.
    Investment managers loved having new trading partners and new 
research sources. In contrast, traditional proprietary full-service 
brokerage firms were not at all pleased with competition emerging on 
two fronts--brokerage and research. In the ``old days,'' proprietary 
brokerage firms were the only game in town; they had a monopoly on 
trading and research. And investors paid exorbitant commissions for 
research of questionable value.
    Fortunately for investors, the proprietary brokerage monopoly has 
been threatened. Today, competition is fierce for trading commissions, 
driving trading costs lower for investors. And fierce competition 
exists on the research front, as well, with over 300 entrepreneurial 
independent research firms pushed to produce the most value-added 
research at the best price. Investors never had it so good, with 
commission costs dropping and high quality independent research widely 
available.
    Unfortunately for investors, however, the proprietary brokerage 
firms are fighting hard to regain their monopoly in trading and 
research. They are pushing for a ban on soft-dollar trading--the 
commissions typically paid to smaller brokerage firms and later 
directed to independent research firms. The single act of banning soft 
dollars would irreparably hurt the competition from boutique brokers 
and independent research providers. And proprietary brokers would again 
emerge with the monopoly they enjoyed for many years.
    I urge this Committee and your colleagues in Congress to create 
laws and policies to nurture competition. Then investors win. Banning 
soft-dollar payments would have unintended and undesirable effects of 
eliminating competition for proprietary brokerage firms on both the 
research and trading fronts.
    Recommendation No. 1: Soft dollars should be retained to provide a 
flexible payment option for purchasing independent research.
    Make no mistake, there are serious issues that need to be addressed 
to ensure that brokerage commissions charged are fair and reported in a 
transparent fashion and investment managers always act in the best 
interest of the investing public.
    Before offering certain much-needed reforms, please consider the 
following fundamental questions:

    What is the appropriate currency (brokerage commissions or cash) to 
be used to pay for investment research? Is it inherently wrong for 
investment managers to use commissions as the currency to pay for 
research or consulting services? I would think not, since for over 200 
years most investors have used trading commissions as the sole currency 
for such services.
    If, however, you disagree and believe that a new currency should be 
used--that is, cash only for research--that would be agreeable to me, 
provided all research purchased by investment managers is paid for with 
cash. Thus, if commissions were banned as the currency to pay for 
third-party independent research, then I urge you to establish a total 
ban on using commissions for any research from any source. 
Specifically, if an investment manager purchased research from my 
independent research organization and must pay cash then, in all 
fairness, research acquired from Merrill Lynch, Goldman Sachs, or 
Morgan Stanley should require a cash payment, as well. I would have 
absolutely no objection to creating a meritocracy that allows all 
research providers to compete on the same playing field. Indeed, I 
would advocate such an approach.
    Recommendation No. 2: Assuming little interest exists in a ``cash-
only'' approach, commissions should be the currency to pay for any 
investment research. No distinction should be made between proprietary 
and third-party research.
    Assuming the commission-for-research model is retained, several 
important problems must be addressed:

 Bundling execution costs and nonexecution trading costs;
 Failure of mutual fund companies to include the nonexecution 
    portion of the commission in their reported expense ratio;
 Inflated brokerage commissions; and
 Inadequate disclosure of portion of brokerage commissions 
    directed to third-parties.
    Recommendation No. 3: All brokerage organizations must unbundle 
execution and nonexecution costs and disclose this information to 
investment companies. Since nonexecution brokerage commissions are 
identical at all firms, regulations should treat them as such.
    Requiring the unbundling of brokerage costs and showing the trade 
execution costs and the other service costs separately can easily solve 
many problems that this Committee is addressing. Full-service brokerage 
firms typically charge 5 cents per share to trade (down in recent years 
from 8 cents). Included is approximately 2 cents for execution and the 
remaining 3 cents for nonexecution costs, such as research. Brokerage 
firms have not been required to disclose to investors and other 
stakeholders how the 3 cents per share is spent, and consequently, fail 
to report this information. In many cases, the 3 cents supports in-
house research and operations at a proprietary brokerage firm. In 
contrast, at a ``soft-dollar'' brokerage firm, the 3 cents is paid to 
third-party research firms. The money generally is spent for research--
indeed the reason for the trade--and it clearly benefits the investor. 
And, if the investment manager believes the most value-added researcher 
works at an independent research firm, proceeds from trades should be 
directed to the research enterprise. That is the essence of a ``soft-
dollar'' arrangement.
    With an unbundled menu, investment managers can now shop ``a la 
carte.'' That is, they can trade with a broker with best execution and 
the lowest pricing. And they could purchase research and other 
investment tools from an organization (Wall Street proprietary or 
independent) based on the value-added quotient of those services. The 
logical result would be that:

 Commission costs would be lowered with more disclosure and 
    competition;
 Trading volume would be reduced with less pressure to trade; 
    and
 Research quality would improve, since only the strongest 
    research products would be purchased.

    Recommendation No. 4: Non-execution costs should be included in the 
expense ratio the mutual fund companies disclose.
    If all brokers must disclose the nonexecution costs that pertain to 
research, then mutual fund companies would have the necessary data to 
include such costs in their expense ratio. And, I would recommend that 
mutual funds should be required to include such nonexecution costs in 
the expense ratio reported to investors.
    Recommendation No. 5: Regulators and accountants should audit the 
records of both brokerage organizations and investment managers to 
ascertain proper accounting and disclosure of nonexecution costs and 
expense ratios.
    Recommendation No. 6: Severe penalties should be meted out to 
organizations that fail to properly account for nonexecution costs or 
expense ratios.
    Recommendation No. 7: Whatever changes are made, there must be one 
consistent set of rules concerning brokerage commissions and research 
services.
    No distinction should be made between proprietary and third-party 
research. Full disclosure of an investment manager's research expenses 
should be required regardless of the source. Excluding costs by 
proprietary brokers would discriminate against third-party independent 
research enterprises.
Concluding Thoughts
    A ban on allowing soft-dollar payments for third-party research 
would be a big mistake. It would not directly solve the real problems 
and instead, would have the undesirable effect of eliminating an 
important resource for investors--value-added independent research.
    I believe that my recommendations would have a number of desirable 
results that:

 Allow the emerging industry of independent research to 
    solidify and provide the checks and balances that Wall Street 
    needs;
 Give investment managers choices in trading and research that 
    would result from unbundling and disclosure of brokers commission;
 Drive trading costs down and quality of research up with 
    healthy competition; and
 Drive out unethical commission kick-back arrangements with new 
    mandated disclosures.

    

               PREPARED STATEMENT OF GRADY G. THOMAS, JR.
                    President, The Interstate Group
               Division of Morgan Keegan & Company, Inc.
                             March 31, 2004

Introduction and Background
    Thank you for the opportunity to appear before this distinguished 
Committee to discuss research-commission arrangements under Section 
28(e) of the Securities Exchange Act of 1934. My name is Grady Thomas. 
I have been in the securities business for 40 years, and in 1986 became 
the President of the Interstate Group, today a Division of Morgan 
Keegan & Co., Inc., a subsidiary of Regions Financial Corporation. I 
have been active in the securities industry throughout my career. I was 
on the Board of Directors of the Boston Stock Exchange for 8 years; 
served as Chairman and President of the National Organization of 
Investment Professionals; was a District Chairman of the NASD; two-term 
Governor of STA; Founding President and Chairman Emeritus of the North 
Carolina Security Traders Association; and am currently Chairman of the 
SIA Institutional Brokerage Committee.
    I have been involved in providing independent research to 
investment managers, including mutual fund portfolio managers, for 30 
years, and in that period of time I have seen innovative research 
flourish and commission rates fall, to the benefit of all investors. I 
have also seen the transparency of independent research arrangements 
improve to the point where investment mangers involved in independent 
research arrangements receive monthly statements detailing the type of 
research provided, its cash value, and the aggregate commissions used 
to pay for that research. The driving force behind these beneficial 
developments has been the Section 28(e) safe harbor adopted by Congress 
in 1975. My experience has been that Section 28(e), and various 
interpretations of the safe harbor by the Securities and Exchange 
Commission, have done an excellent job of assuring that research and 
execution services provided by broker-dealers to investment managers 
provide value to the investment managers' accounts.
    You will notice that throughout my testimony I use the terms 
``research-commission'' or ``independent research'' arrangement rather 
than ``soft dollars.'' This is 
intentional. In the first place, the term soft dollars has come to have 
negative connotations that do not reflect the reality of independent 
research arrangements. Second, the term soft dollars is not defined in 
the securities laws, and is often used as shorthand to describe many 
uses of commissions by investment managers, including uses that do not 
involve the provision of investment research or execution services. In 
contrast, Section 28(e) provides protection only to arrangements where 
broker-dealers provide brokerage and research services that benefit an 
investment manager's managed accounts.

History of Research-Commission Arrangements and Section 28(e)
    Because broker-dealers are deeply involved in the investment 
decisionmaking process through their execution and trading activities, 
it follows that they would also provide research and other advisory 
services to investors. Indeed, the practice of providing both trade 
execution and investment research in exchange for commissions may go 
back to the opening of the New York Stock Exchange in 1792. Some large 
full-service broker-dealers budget hundreds of millions of dollars to 
providing in-house research to their brokerage clients. Other firms, 
such as The Interstate Group, service their institutional clients by 
providing research services and analytical tools developed or authored 
by independent organizations. Arrangements for the provision of 
independent research are estimated to involve approximately $1 billion 
of institutional commissions on an annual basis. Commissions committed 
to proprietary research and execution-only trades are estimated at 
about $9 billion annually.

Definition of a Research-Commission Arrangement
    A research-commission arrangement under Section 28(e) of the 
Securities Exchange Act of 1934 is one in which a broker-dealer 
provides research services to a fiduciary, such as an investment 
adviser or bank, who manages other people's money. In such an 
arrangement, the fiduciary must use the research to assist in the 
investment decisionmaking process on behalf of account beneficiaries. 
The beneficiaries pay for the research indirectly with commissions on 
portfolio transactions that the broker-dealer effects for their 
accounts.
    Under a lawful Section 28(e) arrangement, a fiduciary may use 
commissions only to acquire services that are useful in the investment 
decisionmaking process. A fiduciary may not, for example, use 
commissions for administrative expenses such as carpeting, telephones, 
or other items which benefit the fiduciary but not the account. If a 
research service has the potential to provide administrative or 
nonresearch assistance to the money manager, Section 28(e) guidelines 
require the money manager to allocate the cost of the service according 
to its use. Where a research service has a ``mixed-use,'' only that 
percentage of the service attributable to the investment decisionmaking 
process may be paid for with commission dollars. The fiduciary must use 
its own resources to pay for that portion of the service that provides 
nonresearch assistance to the fiduciary.

History of Section 28(e)
    Commission rates on exchanges have been competitive only since 
1975. Before that time, commission rates on portfolio transactions 
generally were fixed by law and had been throughout the history of the 
New York Stock Exchange. Under the old fixed rate system, money 
managers were able to obtain research through expenditure of their 
accounts' commissions without incurring additional costs to the 
accounts, since commission rates were the same regardless of whether 
the broker-dealer provided research. Because commission rates were 
fixed by law, the practice of providing research services to fiduciary 
accounts eventually was prevalent, as much as brokers recognized the 
need to compete for orders on the basis of services rendered. In this 
way, brokers came to provide necessary support for the professional 
fiduciaries' internally developed advisory functions. These business 
relationships and expectations that evolved between fiduciaries and 
their accounts continue today in the era of competitive commission 
rates.
    When commission rates on exchanges were made competitive in 1975, 
the investment community was concerned that the flow of research would 
be restricted. Money managers feared that fiduciary principles would or 
could require fiduciaries to operate under the principle that 
``cheapest is best'' and that only the lowest cost execution would 
avert a lawsuit for failure to obtain best execution. In response to 
these concerns, Congress passed Section 28(e) of the Securities 
Exchange Act of 1934, a safe harbor for fiduciaries who receive 
research services in consideration of portfolio commissions, to ensure 
the continued availability and quality of research in the competitive 
commission rate environment. The Congressional hearings on this 
provision reflect the notion that without Section 28(e) protection, the 
flow of research previously furnished to institutions under a fixed 
commission rate structure could be cut off, and investors would be 
harmed.\1\
---------------------------------------------------------------------------
    \1\ Securities Act Amendments of 1975, Report of Committee On 
Banking, Housing, and Urban Affairs, S. Rep. No. 75, 94th Cong., 1st 
Session 71 (1975).
---------------------------------------------------------------------------
    Both Congress and the SEC have taken steps to ensure that the legal 
standards that apply to Section 28(e) arrangements protect the 
interests of investors. Section 28(e) itself limits the definition of 
research that can be obtained for commissions, and requires the 
fiduciary to determine that the commissions paid are reasonable in 
relation to the research and brokerage services provided. Based on the 
legislative history of Section 28(e), the SEC has interpreted that 
research services received by investment managers under these 
arrangements must assist the manager in the investment decisionmaking 
process.

Benefits to Investors of Research Commission Arrangements
    Investors reap a number of benefits from the research-commission 
arrangements described above:

 Flow of Research Services to Money Managers

    One of Congress' principal objectives in adopting Section 28(e) was 
to ensure ``the future availability and quality of research and other 
services'' to the investment community.\2\ It was adopted to address 
the concern that investors would suffer if the flow of research 
services to money managers were impeded. Events over the past 29 years 
demonstrate that Section 28(e) has indeed facilitated the flow of 
research to investment managers.
---------------------------------------------------------------------------
    \2\ Report of the Committee On Banking, Housing, and Urban Affairs, 
S. Rep. 94-75 (1975).
---------------------------------------------------------------------------
    Broker-dealers now provide literally hundreds of independent 
research services to money managers to assist in the investment 
decisionmaking process. The vast majority of these research services 
have only become available to money managers since Congress adopted 
Section 28(e) in 1975. These services include not only investment 
information but fundamental databases, portfolio modeling, and strategy 
software. Equally significant, the technology for the delivery, 
formatting, and use of 
information has made research more accessible to the investor and has 
added greatly to market efficiencies. Technology decisions relating to 
the investment process have become extremely important as money 
managers today face growing market complexities and information needs.
    The Section 28(e) safe harbor has been particularly useful in 
assisting in the development of the independent research community. 
Independent research providers are often small operations using 
innovative and unique methodologies and targeting research at a 
specific segment of the market which is not given sufficient coverage 
by full service firms. It is extremely difficult for a small 
independent research provider with a limited marketing budget to gain a 
foothold in the market for investment research. Section 28(e) 
arrangements allow independent research providers to rely upon and 
obtain assistance from broker-dealers to gain market acceptance. In 
turn these broker-dealers provide independent research and execution 
services to many investors.

 Competition Among Broker-Dealers Providing Research Has 
    Reduced Execution Costs

    By becoming major competitors for institutional order flow, 
research brokers such as The Interstate Group have exerted downward 
pressure on commission rates. Since commission rates became unfixed in 
1975, execution costs have declined significantly. Prior to 1975, 
commission rates on institutional trades were on a sliding scale based 
on volume with a high of $0.82 per share. In 1998, a SEC report found 
commission rates of about $0.06 per share for those institutional 
accounts examined by the SEC Staff. My experience is that commission 
rates today average $0.05 -$0.06 per share for institutional trades.

 Smaller Asset Managers Have Benefited from the Favorable 
    Regulatory Environment for Providing Research in Conjunction with 
    Execution

    In its deliberations on Section 28(e), Congress recognized that 
without highly developed internal research resources, smaller money 
management firms might be required to rely entirely on Wall Street 
research. Congress feared that without access to research that broker-
dealers provide, small investment managers would be pressured to charge 
higher fees than large money managers would charge.\3\
---------------------------------------------------------------------------
    \3\ Report of the Committee On Banking, Housing, and Urban Affairs, 
S. Rep. 94-75 (1975).
---------------------------------------------------------------------------
    What was true in 1975 is true today. Many startup investment 
advisers cannot establish their businesses and compete against larger 
money managers (who command large fee bases from which they can sustain 
in-house research) without access to the research services that broker-
dealers provide. Section 28(e) has thus facilitated small firms' entry 
into the investment advisory business.
Common Misconceptions Regarding Section 28(e) Arrangements
    Over the years, I have noted that many people within and without 
the financial industry harbor misconceptions regarding Section 28(e) 
arrangements. Following are a few I encounter most frequently.

 Misconception 1: Section 28(e) arrangements are used by 
    investment managers to pay for administrative expenses such as 
    carpeting and rent.

    As discussed above, the definition of ``research'' under Section 
28(e) extends only to items that provide assistance to fiduciaries in 
the investment decisionmaking process. Administrative expenses such as 
rent are not, and have never been, covered by the Section 28(e) safe 
harbor. Furthermore, in the last industry-wide examination sweep 
conducted by the SEC staff in 1997, the staff found no instances `` . . . 
in which [mutual] fund commissions were used to purchase nonresearch 
items, which did not benefit the funds themselves.'' While it is true 
that some privately managed investment vehicles, such as hedge funds, 
engage in directed brokerage activity to pay for nonresearch services, 
this type of activity is not covered under the Section 28(e) safe 
harbor. Accordingly, changes to the Section 28(e) safe harbor would not 
effect these types of arrangements.

 Misconception 2: Section 28(e) arrangements lack transparency 
    and are not disclosed to investors.

    Independent or ``third-party'' research arrangements are among the 
most transparent arrangements in use in the investment industry today. 
Investment managers involved in such arrangements receive monthly 
statements detailing the dollar value of research provided, the 
aggregate commissions used to pay for the research and an 
identification of the research provided. While it is true that some 
proprietary research arrangements lack this level of transparency, all 
Section 28(e) arrangements, both proprietary and independent, must be 
disclosed by investment advisers in their Form ADV, and by mutual funds 
in their Form N-1A.\4\
---------------------------------------------------------------------------
    \4\ See Part II of Form ADV, Item 12(b); Form N-1A Item 16.

 Misconception 3: Investment managers who execute trades with 
    Wall Street firms, and receive proprietary research services, do 
---------------------------------------------------------------------------
    not engage in ``soft dollars.''

    Every so often I will encounter an investment manager who will 
declare that his firm does not use ``soft dollars.'' When I probe the 
issue, I usually discover that the manager does indeed execute 
portfolio trades with large Wall Street firms, and receives services 
such as research reports, access to research analysts, etc., from these 
firms. Proprietary research arrangements require the protection of the 
Section 28(e) safe harbor to the same extent as do independent research 
arrangements. However, because investment managers involved in 
proprietary research arrangements do not typically receive statements 
detailing the value and type of research they receive, they do not 
understand that they are indeed involved in a ``soft-dollar'' 
arrangement.

 Misconception 4: Requiring investment managers to pay cash for 
    research would benefit investors.

    Denying investment managers the use of portfolio commissions to 
purchase research would have a devastating effect on the securities 
markets and investors. Smaller investment managers would lack the 
resources to compete with larger peers, driving them out of business. 
Independent research firms, which have flourished in recent years, 
would lose the invaluable marketing mechanism provided by broker-
dealers seeking to provide research to their institutional customers. 
Small independent research firms would fail, and the now vibrant market 
of new types of research would dry up.
    If required to finance research expenses from their own resources, 
investment managers would be forced to raise management fees, or to 
reduce their use of investment research. Neither of these outcomes 
would be helpful to investors or the markets. If investor managers 
merely passed research costs along to investors through higher 
management fees, investors would end up paying more for research and 
commissions than they do now, as studies have shown that combining 
research and execution services leads to economic efficiencies that 
would be lost if they were provided separately. Furthermore, research 
costs would be less, not more, transparent than under the current 
structure, as they would be lumped in with all of the managers' other 
overhead costs.
    If managers were to reduce their use of research, investors would 
also suffer. Studies have shown the use of research has a positive 
correlation with investment return. A reduction in research used by 
managers would result in inferior performance for investor's accounts. 
Many managed funds would resort to a form of indexing, trying to mimic, 
rather than beat, the overall market. While index-type investing 
certainly has a place in the investment management field, investors and 
the markets as a whole have greatly benefited from growth, value, and 
other more research-centric investment strategies in the past. The 
diminution of the amount of research available to managers would 
disproportionately affect managers who rely on these types of 
strategies, to the detriment of investors and the price discovery 
mechanism of our securities markets.
    Finally, I believe this argument ignores the fact that there is 
nothing stopping investment management firms from determining on their 
own to pay for research with cash, and for competing for clients on 
that basis. In fact, some firms do so today. As discussed above, 
investment advisers and mutual funds must disclose to investors whether 
or not they receive research in exchange for portfolio commissions. If 
investors truly believe that they would benefit from using an 
investment manager who pays only cash for research, they can easily 
find such a manager. On the other hand, if managers were required to 
pay only cash for research, investors would lose the opportunity to 
select a manager or investment vehicle that benefits from the practice 
of combining research and execution services.
Conclusion
        Research is the foundation of the money management industry. 
        Providing research is one important, long-standing service of 
        the brokerage business. Soft-dollar arrangements have developed 
        as a link between the brokerage industry's supply of research 
        and the money management industry's demand for research.\5\
---------------------------------------------------------------------------
    \5\ Statement made by the SEC Office of Compliance Inspections and 
Examinations in the ``Inspection Report on The Soft-Dollar Practices of 
Broker-Dealers, Investment Advisers and Mutual Funds,'' (September 22, 
1998, Section I.)

    Congress' adoption of Section 28(e) in 1975 has fostered the 
development of innovative and useful research products by both 
independent and proprietary research providers. Section 28(e), and SEC 
interpretations thereof, have done an excellent job of assuring that 
research services are readily available to investment managers and 
provide value to investors by supporting managers in the investment 
decisionmaking process.
    The last major study of Section 28(e) arrangements conducted by the 
SEC staff did not observe any instances in which mutual fund 
commissions were used to purchase nonresearch items, which did not 
directly benefit the funds themselves. The SEC staff did, in Section 
VIII of its 1998 Inspection Report, make a number of 
recommendations pertaining to the provision of investment research for 
portfolio commissions. I encourage the SEC to give further 
consideration to these recommendations, and note that many of them have 
already been adopted by The Interstate Group and other broker-dealers 
involved in the provision of independent research.
    Thank you for the opportunity to appear before you and express my 
views on behalf of The Interstate Group.

                               ----------
                 PREPARED STATEMENT OF JOSEPH M. VELLI
         Senior Executive Vice President, The Bank of New York
                             March 31, 2004

Introduction
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, I am Joseph Velli, Senior Executive Vice President of The 
Bank of New York. Thank you for inviting me to testify about research 
commissions, commonly called ``soft dollars,'' an issue important to 
investors, investment managers, independent research firms and broker-
dealers. We appreciate the Committee's efforts to examine issues 
concerning mutual fund fees, expenses, and governance. We also applaud 
the efforts of the Securities and Exchange Commission (SEC) in 
proposing rules changes designed to curb abusive behavior, address 
conflicts of interest and ensure that investors are given a fair shake. 
We think The Bank of New York can add to the dialog in a meaningful 
way.

The Bank of New York and BNY Securities Group
    The Bank of New York is the oldest bank in the United States. It 
was founded in 1784 by Alexander Hamilton and was the first corporate 
stock to be traded on the New York Stock Exchange in 1792. Together 
with its parent company, The Bank of New York Company, Inc., The Bank 
of New York has a distinguished history of serving clients around the 
world through its five primary businesses: Securities Servicing and 
Global Payment Services, Private Client Services and Asset Management, 
Corporate Banking, Global Market Services, and Retail Banking. The Bank 
of New York Company, Inc. is a global leader in securities management 
services operating in more than 100 markets and servicing issuers, 
institutional investors, and broker-dealers. The Company plays an 
integral role in the infrastructure of the capital markets safekeeping 
over $8 trillion in investors assets. Through its nearly 23,000 
employees, the Company provides quality solutions for global 
corporations, financial institutions, asset managers, governments, 
nonprofit organizations, and individuals.
    I am a Senior Executive Vice President of The Bank of New York and 
head of BNY Securities Group. Over the past several years, The Bank of 
New York has greatly enhanced its brokerage and clearing capabilities 
through both targeted 
acquisitions and internal growth. This focused strategy is part of The 
Bank's continued efforts to provide clients with the resources and 
highly personalized service 
required to succeed in the investment marketplace. BNY Securities 
Group's core business lines include institutional agency brokerage, 
clearing and financial services outsourcing businesses.

Agency Brokerage
    BNY Securities Group's execution businesses focus on agency 
brokerage.\1\ We act as our clients' agent in the marketplace, 
representing their interests in seeking best execution of their orders. 
An agency broker receives orders from its clients--in our case, 
investment managers, pension plans, and corporations--and executes the 
transactions with the ``Street,'' other broker-dealers in the 
marketplace who may be acting on their own behalf (that is, principal) 
or their customers (that is, agent). We earn a commission for this 
service, which is fully disclosed to our clients.
---------------------------------------------------------------------------
    \1\ BNY Securities Group does not engage in investment banking 
business or principal underwriting business. One of the Group's 
members, Pershing Trading Company, L.P., acts as a market maker and 
specialist to facilitate the Group's broker-dealer clearing business. 
The Group's other broker-dealers, however, act solely as agent or 
``riskless'' principal (that is, the economic equivalent of agent).
---------------------------------------------------------------------------
    In contrast to an agency broker's role, a broker-dealer acting as 
principal buys from its customer (in the case of a sell order) or sells 
to its customer (in the case of a buy order) using the firm's capital. 
The broker-dealer makes money in such transactions by charging a mark-
up or markdown, that is, adding to or subtracting from the price to the 
customer. In most cases, the broker-dealer's charge and the customer's 
cost are not disclosed to the customer.
    Agency brokerage provides investors two primary benefits they do 
not receive when transacting with a principal: (1) transparency of the 
explicit cost of execution; \2\ and (2) absence of a conflict between 
the interests of the broker and those of the client. In an agency 
transaction, the client receives a confirmation setting forth, among 
other things, the amount of commission charged by the broker.
---------------------------------------------------------------------------
    \2\ Implicit transaction costs, such as market impact and 
opportunity cost are borne by a broker-dealer's customer regardless of 
the mode of execution. Although such implicit costs indeed are costs to 
the customer, the customer's broker-dealer is not the beneficiary; such 
costs flow to market participants other than the executing broker-
dealer.
---------------------------------------------------------------------------
    This information enables the client to take a methodical approach 
in assessing execution quality: First, to review the execution quality 
against appropriate benchmarks (for example, volume weighted average 
price, market opening price, market closing price, or some other 
relevant measure), and second, to review whether the explicit cost of 
execution--the commission--was reasonable in relation to the value of 
the services provided.
    Agency brokerage also gives clients the comfort of knowing their 
broker is working on their behalf. An agency broker has no incentive 
other than to obtain the best execution reasonably available on behalf 
of the client. Moreover, agency brokerage significantly reduces the 
risk of economic incentives that adversely affecting the client. The 
institutional investment community recognizes the value of agency 
brokerage--we believe the agency brokerage business as a percent of the 
total institutional brokerage business has increased significantly in 
the past few years.

Research Commissions and Section 28(e)
    The provision of securities-related research is an integral part of 
the brokerage business. This is perfectly natural, for a broker's 
business is to assist clients in the purchase and sale of securities. 
Brokers are expected to know the ``market,'' to understand and provide 
valuable information about securities trading activity and the factors 
affecting the prices of the market generally as well as individual 
securities. Indeed, customers demand it. As a result, brokers long have 
distinguished their services from competitors' by highlighting the 
quality of their research.
    What has been true for decades is true today: Investors want their 
brokers to provide them with high-quality research. One need only turn 
on the television to see major retail financial services firms 
publicizing the quality of the research they provide customers to 
enable them to make well-informed investment decisions. Research 
Commissions\3\ (soft dollars) are no different. Institutional brokers 
distinguish their services, among other ways, by providing their 
clients--asset managers--with research that helps the asset managers 
make better investment decisions on behalf of their clients (for 
example, mutual fund investors).
---------------------------------------------------------------------------
    \3\ A Research Commission is one in which an investment adviser 
receives securities brokerage and research services from a broker-
dealer in exchange for the investment adviser directing some portion of 
its clients' brokerage transactions to the broker-dealer.
---------------------------------------------------------------------------
Background of Section 28(e)
    It would be helpful to provide some background on the history and 
scope of Section 28(e) of the Securities Exchange Act of 1934. In 1975, 
when Congress abolished fixed commission rates, investment managers 
were concerned that they would be deemed to have violated their 
fiduciary duty to act in the best interests of their 
clients if they caused their clients to pay a commission higher than 
the lowest commission available. The concern was driven by the existing 
practice of an adviser obtaining from its brokers research as well as 
brokerage services. In some cases, the research would be directly 
related to transaction and the account generating the commission, while 
in other cases the adviser would use the research to benefit its 
advised accounts generally. Congress responded by enacting Section 
28(e), a ``safe harbor'' that shields an investment adviser from breach 
of fiduciary duty claims for causing its clients to pay a higher 
commission to a broker-dealer that provides ``brokerage and research 
services'' within the meaning of the statute.
    To rely on the safe harbor, an adviser must determine in good faith 
that the commissions paid are reasonable in relation to the value of 
the brokerage and research services provided. Section 28(e) permits an 
adviser to obtain services, particularly research services, with client 
commission dollars so long as the adviser determines that the services 
provide ``lawful and appropriate assistance'' to the asset manager in 
the investment decisionmaking process.\4\ Section 28(e) is a tacit 
recognition that securities brokers legitimately have always been in 
the business of providing research to their clients--the person who is 
making the investment decisions. In retail brokerage, the investment 
decisionmaker usually is the individual owner of the account. In 
institutional brokerage, the investment decisionmaker often is an 
investment adviser acting on behalf of its clients. In both cases, 
brokers are assisting the decisionmaker--the client--by providing 
research that the client deems valuable.
---------------------------------------------------------------------------
    \4\ See S. Rep. No. 75, 94th Cong. 1st Sess. 248 (1975); Securities 
Exchange Act Release No. 23170 (April 23, 1986).
---------------------------------------------------------------------------
Scope of Section 28(e)
    Many misunderstand the scope of ``soft dollars'' and Section 28(e). 
The safe harbor applies to any transaction pursuant to which an adviser 
causes a client to pay a higher commission than the lowest available in 
exchange for brokerage and research services. Specifically, it applies 
to commissions where the adviser receives proprietary research 
(proprietary research transactions) as well as commissions for third-
party research services (independent research commissions). Advisers 
executing transactions with integrated investment banks at full service 
rates are engaging in soft-dollar transactions primarily with respect 
to the provision of proprietary research and, to a far lesser extent, 
with respect to the provision of third-party research. Integrated 
investment banks dominate the institutional commission market. In fact, 
independent research transactions account for only about 12 percent of 
the institutional commission market, $1 billion out of a total of $8.4 
billion in 2003, with the vast majority of the remaining 88 percent 
going to investment banks.\5\
---------------------------------------------------------------------------
    \5\ U.S. Equity Investors: Soft-Dollar Market Trends, Greenwich 
Associates, 2003.
---------------------------------------------------------------------------
    Despite the very clear application of Section 28(e) to both 
proprietary research commissions and independent research commissions, 
critics of these commissions sometimes focus on the latter. We believe 
the criticisms of independent research commissions are unfounded. In 
particular, we believe the vast majority of market participants--
investment advisers, broker-dealers, and independent research 
providers--conduct their business in compliance with the SEC's guidance 
pursuant to Section 28(e).

The SEC's 1998 Sweep Report
    In 1996 and 1997, the SEC's Office of Compliance Inspections and 
Examinations (OCIE) conducted a sweep examination of the soft-dollar 
industry. OCIE issued a report in 1998 detailing its findings (the 
Sweep Report). OCIE found that approximately 2 percent of commissions 
paid in purported reliance on Section 28(e) was in fact for 
``nonresearch products and services.'' OCIE's finding merits comment.

 First, OCIE's finding of only 2 percent of commissions being 
    used for services outside the safe harbor is remarkably low, 
    particularly considering that, prior to issuance of the Sweep 
    Report, the legislative history, and other guidance on the 
    definition of research for purposes of Section 28(e) was sparse. 
    Indeed, the Sweep Report is the most extensive guidance on the 
    topic to date.
 Second, among the items to which OCIE objected as being 
    outside the safe harbor are proxy services, membership and 
    licensing fees related to investment management certification 
    programs, and services related to regulatory compliance. In most 
    cases, the industry was acting in the good faith belief that many 
    of these products and services were within the safe harbor.
 Third, a corollary to the first two points is that the 
    industry's practices have improved a great deal since the Sweep 
    Report was issued. Once guidance was issued and standards were set, 
    even informally, the industry responded. Independent agency brokers 
    generally, and BNY Securities Group's brokers in particular, have 
    adopted policies and procedures designed to ensure that their 
    practices are consistent with the requirements of Section 28(e) for 
    those clients required or desiring to stay within the safe harbor.

    The Sweep Report made a series of recommendations to the SEC 
regarding potential soft-dollar reforms. The primary recommendations 
were: (1) publication of the Sweep Report to provide guidance to 
investment advisers and broker-dealers; (2) enhanced recordkeeping by 
investment advisers and broker-dealers with respect to soft-dollar 
arrangements; (3) enhanced disclosure by investment advisers of 
research products and services; and (4) enhanced internal controls.
    Advisers and agency brokers responded to the Sweep Report's 
guidance by adopting procedures and controls designed to ensure 
compliance with the requirements of the safe harbor. Agency brokers, 
such as those within BNY Securities Group, provide detailed information 
to investment adviser clients regarding their brokerage commissions and 
the services they receive; we also retain detailed records of the 
products and services provided and information about the research 
providers. Exhibit A is a sample monthly report, which shows in great 
detail the commissions generated by the client and each research 
service, with the associated cost, provided to the client.
    The Securities Industry Association has issued a Best Practices 
guide on soft dollars that many brokers have adopted wholesale. The 
Association of Investment Management and Research also issued soft-
dollar standards shortly after the issuance of the Sweep Report, which 
have been adopted by some in the investment adviser community. In 
addition, the SEC recently adopted rules requiring investment advisers 
to adopt formal compliance programs.\6\ Investment advisers are 
required to comply by October 5, 2004. Accordingly, we believe the 
current system works as intended. We believe, however, that enhanced 
disclosure about transaction costs would benefit investors (see below).
---------------------------------------------------------------------------
    \6\ See Investment Advisers Act Release No. 2204 (December 17, 
2003).
---------------------------------------------------------------------------
Independent Research Commissions Should be Encouraged
    At BNY Securities Group, we believe Independent Research 
Commissions benefit investors and play a valuable role in the 
marketplace. Such commissions combine best execution and choice of 
independent research in an unbundled, transparent fashion. Accordingly, 
Congress and the SEC should encourage their use.

Best Execution
    Research commissions can only exist in an environment where 
investment advisers are required to obtain, and broker-dealers are 
required to provide, best execution of the underlying securities 
transactions. In the case of independent research arrangements, agency 
brokers must compete on the basis of best execution. Advisers can 
obtain third-party research services from any number of sources, 
including other broker-dealers. Therefore, execution quality has a 
central role in differentiating market participants.
    Agency brokers involved in independent research commissions--
sometimes called ``soft-dollar'' brokers--provide best execution by 
using people and technology to find liquidity in a fragmented 
marketplace. BNY Securities Group's broker-dealers operate business 
models designed to provide choice to investment advisers. BNY 
Securities Group allows advisers to execute through a fully integrated 
agency broker with direct access to the NYSE floor, through a network 
of over 30 third-party executing brokers pursuant to correspondent 
clearing arrangements, or through an electronic communications network. 
Investment advisers are able to choose the model best designed to 
obtain the best prices reasonably available for their clients, 
depending on such factors as the size of the transaction, the liquidity 
of trading in the security, and the speed at which the adviser must 
execute.

Independent Research Commissions Provide Transparency
    Most independent research commissions are negotiated by the 
investment adviser and broker-dealer based on a ratio of commission 
dollars to value of research services provided (for example, 1.5:1). 
The ratio, which represents the value of execution and research 
services provided, is explicit. Moreover, investment advisers engaged 
in such commissions receive extensive information from the providing 
brokers regarding the commissions they generate, the products and 
services they receive, and the cost of those services. This information 
typically is provided in detailed monthly account statements. 
Proprietary research commissions with integrated investment banks, by 
contrast, are opaque. Integrated investment banks generally do not 
charge a separate fee for research. Rather, trade execution and 
research are ``bundled.'' The investment adviser is left to its own 
devices to determine what it is being charged for each service and 
whether the amount charged is reasonable. Accordingly, independent 
research commission arrangements facilitate the adviser's 
determination, required by Section 28(e), that the cost of the 
brokerage and research services is reasonable in relation to the value 
of such services.

The Global Research Analyst Settlement
    In settling the case of tainted research with 10 major investment 
banks earlier this year, the SEC, the New York Attorney General, and 
other regulators insisted that the settling firms spend $432.5 million 
for their client on independent research over the next 5 years. The 
Global Research Analyst Settlement evinces the value of independent 
research product versus the value of in-house research product of 
investment banks. I discuss below the value inherent in independent 
investment research. It is important that Congress not place an 
additional unfair burden on independent research that could discourage 
the growth of the market for independent research, a result for example 
at odds with the fundamental principles of the Global Research Analyst 
Settlement. I believe that independent, conflict-free research is an 
essential element in restoring investor confidence in the markets. We 
should encourage, not discourage, its use.

Access to Independent Research
    Independent agency brokers offer access to hundreds of sources of 
independent research, including fundamental and technical research on 
individual issuers, industry and sector analyses and broad-based 
economic research. We believe that access to such a wide variety of 
ideas encourages better decisionmaking on the part of the adviser. Many 
of the sources of independent research are small businesses with little 
or no research distribution capability. Such boutiques might not 
survive but for the business provided by independent agency brokers. 
Independent agency brokers can assist advisers in sourcing independent 
research and, where available, achieve volume discounts. Independent 
research commissions provide critical access to research and remain the 
most viable distribution vehicle for the independent research 
providers.

Small Investment Advisers Benefit the Most
    Small investment advisers typically have small research 
departments. Many do not have the resources to create an elaborate in-
house research infrastructure. Small advisers benefit the most from 
having continued access to a wide variety of independent research. 
Independent research commissions allow small advisers to compete with 
the bigger players.

Powerful Combination for Investors
    BNY Securities Group combines best execution brokerage with an 
opportunity for institutional customers to select from the highest 
performing sources of independent research in an environment where all 
costs are completely transparent. If the expression ``soft dollars'' 
was created on Wall Street as jargon for those services whose costs or 
values are undefined, then it does not exist at the Bank of New York. 
Indeed, we prefer to use the term ``research commissions,'' because it 
more accurately describes the practice of providing clients with 
research that complements our execution services, and disclosing the 
costs of each.
    BNY Securities Group, other leading agency brokers and full service 
firms that offer independent research have made a business out of 
disclosure and commission management. Our clients expect us to account 
for every penny of their client's commissions, and we do. Like many 
other brokerage firms, we give our clients detailed monthly 
statements--reporting all of their trading activity, the independent 
research providing the cost of each. A sample client statement is 
attached hereto as Exhibit A.

The Intrinsic Values of Independent Research
    BNY Securities Group has grown to be one of the largest aggregators 
of independent research in the world. We see four intrinsic values in 
this kind of research:

    First, it is free of conflicts. While we believe the global 
settlement and recently adopted SEC and SRO rules \7\ provide a 
framework for reform of research on Wall Street, the possibility of 
conflicts arising again is as enduring as human nature.
---------------------------------------------------------------------------
    \7\ Amendments to NYSE Rule 472 and NASD Rule 2711, and SEC 
Regulation AC.
---------------------------------------------------------------------------
    Second, independent research must stand on its own merits--it 
performs well or is no longer selected. Our clients are not required to 
purchase one product or service as a condition to receiving another. 
One of the products we offer our clients is access to a proprietary 
rating system, which allows the client to sort and analyze research on 
approximately 6,000 issuers covered by over 150 research providers 
according to factors they select. Utilizing this rating system, our 
clients can measure performance of independent research and choose only 
those who are providing real value.
    Third, independent research is serious, innovative, and often 
completely different from Wall Street research. Due to its 
independence--and because of the system of commission payments--market 
data providers were able to grow from ideas into a revolutionary and 
highly successful research services business.
    Fourth, independent research serves the public interest. 
Independent research firms pioneered the concept of ``forensic 
research,'' hunting through complex financial documents searching for 
mismanagement or worse. Long before the public or regulators reacted, 
various independent research firms uncovered the frauds of Enron, 
Worldcom, Tyco, HealthSouth, and many more. We do not need less 
independent research we need more.

Research Should Be Paid for with Commissions
    We believe permitting fiduciaries to use client commissions to 
obtain independent research provides proper incentives to the asset 
management and brokerage communities to promote the development and 
distribution of products and services that benefit investors.
    The first reason research should be paid for with commission 
dollars is that the value of research is included in the cost of the 
commission. Research has just as much ``right'' to be paid out of the 
proceeds of the trade, as does the cost of executing the trade. In 
fact, with recent increases in trading efficiencies and declines in 
overall commission rates, research is often the primary value received 
for the commission. Disclosure will better allow the investor to judge 
the value of the research and will make the asset manager and broker 
more accountable. Some assert that mutual fund managers engage in this 
practice for their own benefit or without knowledge of the investor or 
the mutual fund's board. The correct answer to these concerns is 
disclosure plus stricter fund governance.
    There will be considerable negative consequences to banning the use 
of commissions to pay for research. Among the losers will be: 
Investors, independent research, smaller mutual funds, agency brokers, 
and funds reliant on sophisticated market analytics.
    We believe such a radical change will severely impair a growing and 
important independent research industry. We have heard from prominent 
independent researchers who believe that the damage will be even 
greater, possibly even fatal. Agency brokers and independent 
researchers are used to competing on an uneven playing field. The 
integrated investment banks dominate the market for many reasons but 
partially because they offer a number of highly valuable services which 
we do not. Allowing advisors to use commissions to pay for the research 
from integrated firms, but not for independent research, would simply 
be unfair and create a complete disadvantage.
    It is not in the interests of investors in a mutual fund to require 
a mutual fund manager to add to the expenses of the fund when 
commission dollars can be, and always have been, used to defray the 
costs of research. Some propose a requirement that any and all research 
be paid for in cash and that it be included in the expense line of the 
fund. They assert that such requirements will push down commission 
rates. We believe it is far more likely that the net return to the 
investor will go down. We believe this will strike a hard blow to 
independent research just as it is coming into full bloom and will lead 
to the full service firms further reducing the amount of research they 
produce. This cannot be good for investors.
    Most mutual funds often have limited internal research staffs. They 
rely almost exclusively on independent research. Some of the larger 
mutual fund complexes 
employ hundreds of their own researchers. Yet some of the highest 
returns in the industry are generated by the smaller funds. Reducing 
choice and hurting smaller mutual funds are not good ideas.
    According to a 1998 SEC report, the smallest advisory firms use 
over half of their commissions for independent research, while the 
largest advisory firms use on average, just 8.3 percent. In other 
words, independent research provides essential 
support to smaller asset management firms; abolishing independent 
research commissions would extend the dominance of the largest mutual 
fund complexes, reducing choice, and hurting smaller mutual funds are 
not good ideas.
    Finally, but certainly not least important, is that since the costs 
of independent research are disclosed, they can be, and are, audited.

Comment on Unbundling
    The Bank of New York believes that commissions used to pay for 
research should be accounted for. We do not support full unbundling of 
commissions by integrated investment banks. Even though we, as agency-
brokers, might benefit, we believe that full unbundling would be highly 
disruptive to the capital markets, difficult to accomplish, and would 
likely lead to a drastic reduction in research.

Conclusion
    Soft-dollar practices should continue to be regulated, but let us 
establish the problem first. The problem is that commission dollars 
used to acquire research are only disclosed in 10 percent of the 
cases--when independent or third-party research is involved.
    The Bank of New York agrees with the Securities Industries 
Association, which supports the current safe harbor for research 
created by Section 8(e) and proposes that the SEC mandate reasonable 
additional disclosure. We are confident that the SEC can manage this 
responsibility well and we look forward to working with the Commission 
on this.
    If we are to ban anything, let us ban the term ``soft dollars.'' 
Let's call them what they are--independent research commissions--and 
let us encourage their greater use.
    Mr. Chairman, Senator Sarbanes, Members of the Committee, thank 
you. I would be delighted to answer any of your questions.



                               EXHIBIT C

Independent Research Commissions
    We appreciate the opportunity to express our views concerning the 
recent Congressional and regulatory scrutiny focused on mutual fund 
fees and expenses. In this paper, we address issues regarding soft-
dollar arrangements, particularly those soft-dollar arrangements 
whereby broker-dealers provide third-party services, which we call 
independent research arrangements.\1\ As discussed in detail below, we 
believe the current system works well, although we support enhanced 
disclosure of quantitative information regarding investment advisers' 
use of client commissions and advisers' brokerage allocation practices. 
We also emphasize that any changes contemplated must be applied fairly.
---------------------------------------------------------------------------
    \1\ Throughout this paper, we refer to brokerage arrangements that 
include provision of third-party research services as ``independent 
research arrangements,'' and brokerage arrangements that include 
provision of proprietary research services as ``soft-dollar'' 
arrangements. We also use the term ``soft dollars'' to identify 
generally the practice whereby an investment adviser causes its clients 
to pay a commission higher than the lowest commission available in 
consideration for the value of brokerage and research services 
provided.
---------------------------------------------------------------------------
    The Bank of New York, through a number of entities in the BNY 
Securities Group sector, is committed to providing institutional 
clients, such as investment advisers, institutional investors, and 
broker-dealers, with a broad range of agency brokerage, clearing and 
financial outsourcing services. Critical components of the Group's 
offerings include trade execution, commission management, and 
independent research. Investment advisers can maximize the value of 
their clients' commission dollars by choosing a broker capable of 
providing best execution and a host of independent third-party research 
services unencumbered by investment banking conflicts. We believe we 
are uniquely qualified to comment on the current legislative and 
regulatory focus on soft-dollar arrangements.
Regulatory Status of Soft-Dollar Arrangements
    ``Soft dollars'' are arrangements under which an investment adviser 
receives securities brokerage and research services from a broker-
dealer in exchange for the investment adviser directing some portion of 
its clients' brokerage transactions to the broker-dealer. It has been 
estimated that 90 percent of investment advisers engage in soft-dollar 
arrangements.\2\
---------------------------------------------------------------------------
    \2\ Greenwich Associates Survey, 2001.
---------------------------------------------------------------------------
    An investment adviser has a fiduciary duty to act in the best 
interests of the client. In 1975, when Congress abolished fixed 
commission rates, there was a concern that advisers would be deemed to 
have violated their fiduciary duty if they caused their clients to pay 
a commission higher than the lowest commission available. The concern 
was driven by the existing practice of an adviser obtaining research 
services that might not directly benefit the account generating the 
commissions. Congress responded by enacting Section 28(e) of the 
Securities Exchange Act of 1934, a ``safe harbor'' that shields an 
investment adviser from breach of fiduciary duty claims for causing its 
clients to pay a higher commission to a broker-dealer that provides 
``brokerage and research services'' within the meaning of the statute. 
To rely on the safe harbor, an adviser must determine in good faith 
that the commissions paid are reasonable in relation to the value of 
the brokerage and research services provided. Thus, Section 28(e) 
permits an adviser to obtain services, particularly research services, 
with client commission dollars even though the services do not directly 
benefit any particular client.
    Many misunderstand the scope of ``soft dollars'' and Section 28(e). 
The safe harbor applies to any transaction or arrangement pursuant to 
which an adviser causes a client to pay a higher commission than the 
lowest available in exchange for brokerage and research services. 
Specifically, it applies to arrangements where the adviser receives 
proprietary research, as well as arrangements for third-party research 
services. Advisers doing business with integrated investment banks (for 
example, Morgan Stanley or Goldman Sachs) at full service rates are 
engaging in soft-dollar transactions primarily with respect to the 
provision of proprietary research and, to a far lesser extent, with 
respect to the provision of third-party research. Integrated investment 
banks dominate the institutional commission market. In fact, 
independent research arrangements account for only about 10 percent of 
the institutional commission market, less than $800 million out of a 
total of $8.6 billion in 2001, with the vast majority of the remaining 
90 percent going to investment banks.\3\ In other words, investment 
banking firms dominate the soft-dollar market.
---------------------------------------------------------------------------
    \3\ Greenwich Associates Survey, 2001.
---------------------------------------------------------------------------
    We believe that permitting an adviser to obtain execution services 
and independent research that the adviser determines provides lawful 
and appropriate assistance in its investment decisionmaking process 
serves the best interests of the adviser's clients. Independent agency 
brokers and independent research arrangements provide the combination 
of best execution and independent research.
Independent Agency Brokers Provide Best Execution
    Independent agency brokers--sometimes called ``soft-dollar'' 
brokers--provide best execution by using people and technology to find 
liquidity in a fragmented marketplace. BNY Securities Group's broker-
dealers operate business models designed to provide choice to 
investment advisers. BNY Securities Group allows advisers to execute 
through a fully integrated agency broker with direct access to the NYSE 
floor, through a network of over 30 third-party executing brokers 
pursuant to corres-pondent clearing arrangements, or through an 
electronic communications network. Indeed, independent agency brokers 
must compete on the basis of best execution. Advisers can obtain third-
party research services from any number of sources, including other 
broker-dealers. Therefore, execution quality has a central role in 
differentiating market participants. Integrated investment banks 
offering proprietary research, by contrast, do not necessarily have to 
compete on the same basis. For example, an adviser may be forced to 
trade through Investment Bank XYZ to gain 
access to XYZ's ``star'' analyst or to receive higher-end proprietary 
quantitative research or modeling products. Such arrangements create 
conflicts, which could compromise an adviser's duty to obtain best 
execution.
Independent Research Arrangements Provide Greater Transparency
    Most independent research arrangements are negotiated by the 
investment adviser and broker-dealer based on a ratio of commission 
dollars to value of research services provided (for example, 1.5:1). 
The ratio, which represents the value of execution and research 
services provided, is explicit. Moreover, investment advisers 
engaged in such arrangements receive extensive information from the 
providing brokers regarding the commissions they generate, the products 
and services they receive, and the cost of those services. This 
information typically is provided in detailed monthly account 
statements. Proprietary research soft-dollar arrangements with 
integrated investment banks, by contrast, are opaque. Integrated 
investment banks generally do not charge a separate fee for research. 
Rather, trade execution and research are ``bundled.'' The investment 
adviser is left to its own devices to determine what it is being 
charged for each service and whether the amount charged is reasonable. 
Accordingly, independent research arrangements facilitate the adviser's 
determination, required by Section 28(e), that the cost of the 
brokerage and research services is reasonable in relation to the value 
of such services.
The Market for Independent Research Must Remain Vibrant
    It has been evident for many years, but most pointedly as a result 
of the bursting of the late-1990's market bubble, that research created 
by integrated investment banks is tainted by conflicts created by 
association with the corporate finance business. In settling the case 
of tainted research with 10 major investment banks earlier this year, 
the Commission and other regulators insisted that the settling firms 
spend $432.5 million on independent research over the next 5 years. The 
Global Research Analyst Settlement evinces the value of independent 
research product versus the value of in-house research product of 
investment banks. Placing unfair burdens on independent research could 
discourage the growth of the market for independent research, a result 
that is at odds with the fundamental principles of the Global Research 
Analyst Settlement. We agree that independent, conflict-free research 
is an essential element in restoring investor confidence in the 
markets.
Access to Independent Research
    Independent agency brokers offer access to hundreds of sources of 
independent research, including fundamental and technical research on 
individual issuers, industry and sector analyses and broad-based 
economic research. We believe that access to such a wide variety of 
ideas encourages better decisionmaking on the part of the adviser. Many 
of the sources of independent research are small businesses with 
little or no distribution capability. Such boutiques might not survive 
but for the business provided by independent agency brokers. 
Independent agency brokers can assist advisers in sourcing independent 
research and, where available, achieve volume discounts. Independent 
Research Arrangements provide critical access to research and remain 
the most viable distribution vehicle for the independent research 
providers.
Small Investment Advisers Benefit the Most
    Small investment advisers typically have small research 
departments. Many do not have the resources to create an elaborate in-
house research infrastructure. Small advisers benefit the most from 
having continued access to a wide variety of independent research. 
Independent research arrangements allow small advisers to compete with 
the bigger players.
The Current System Works Well
Abuses Are Rare
    In 1996 and 1997, the Commission's Office of Compliance Inspections 
and Examinations (OCIE) conducted a sweep examination of the soft-
dollar industry. OCIE issued a report in 1998 detailing its findings 
(the Sweep Report). OCIE found that approximately 2 percent of 
commissions paid in purported reliance on Section 28(e) was in fact for 
``nonresearch products and services.'' OCIE's finding merits comment.

 First, OCIE's finding of only 2 percent of commissions being 
    used for services outside the safe harbor is remarkably low, 
    particularly considering that, prior to issuance of the Sweep 
    Report, the legislative history, and other guidance on the 
    definition of research for purposes of Section 28(e) was sparse. 
    Indeed, the Sweep Report is the most extensive guidance on the 
    topic to date.
 Second, among the items to which OCIE objected as being 
    outside the safe harbor are proxy services, membership and 
    licensing fees related to investment management certification 
    programs, and services related to regulatory compliance. In most 
    cases, the industry was acting in the good faith belief that many 
    of these products and services were within the safe harbor.
 Third, a corollary to the first two points is that the 
    industry's practices have improved a great deal since the Sweep 
    Report was issued. Once guidance was issued and standards were set, 
    even informally, the industry responded. Independent agency brokers 
    generally, and BNY Securities Group's brokers in particular, have 
    adopted policies and procedures designed to ensure that their 
    practices are consistent with the requirements of Section 28(e) for 
    those clients required or desiring to stay within the safe harbor.

The Sweep Report's Recommendations Largely Have Been Adopted by the
Independent Agency Brokerage Industry
    The Sweep Report made a series of recommendations to the Commission 
regarding potential soft-dollar reforms. The primary recommendations 
were: (1) publication of the Sweep Report to provide guidance to 
investment advisers and broker-dealers; (2) enhanced recordkeeping by 
investment advisers and broker-dealers with respect to soft-dollar 
arrangements; (3) enhanced disclosure by investment advisers of 
research products and services; and (4) enhanced internal controls.
    As noted above, advisers and agency brokers responded to the Sweep 
Report's guidance by adopting procedures and controls designed to 
ensure compliance with the requirements of the safe harbor. Independent 
agency brokers, such as those within BNY Securities Group, provide 
detailed information to investment adviser clients regarding their 
brokerage commissions and the services they receive; we also retain 
detailed records of the products and services provided and information 
about the research providers. The Securities Industry Association has 
issued a Best Practices guide on soft dollars that many brokers have 
adopted wholesale. The Association of Investment Management and 
Research also issued soft-dollar standards shortly after the issuance 
of the Sweep Report, which have been adopted widely by the investment 
adviser community. In addition, the Commission recently proposed rules 
that would require investment advisers to adopt formal compliance 
programs.\4\ Accordingly, we believe the current system works as 
intended. We believe, however, that enhanced disclosure about 
transaction costs would benefit investors (see below).
---------------------------------------------------------------------------
    \4\ See Investment Advisers Act Release No. 2107 (February 5, 
2003).
---------------------------------------------------------------------------
The Scope of the Section 28(e) Safe Harbor Is Appropriate
    As stated by the Commission, ``the controlling principle to be used 
to determine whether something is research is whether it provides 
lawful and appropriate assistance to the money manager in the 
performance of his investment decisionmaking responsibilities.'' \5\ 
What constitutes lawful and appropriate assistance depends on the facts 
and circumstances and is ``not susceptible to hard and fast rules'' \6\ 
or ``laundry lists'' of specified items. This is because the definition 
of ``research'' necessarily will evolve along with changes in market 
practices, investment strategies, and technology. It's up to the 
investment adviser to determine in good faith whether a particular 
product or service is ``research'' based on the beneficial effect it 
has on the adviser's investment decisionmaking process.
---------------------------------------------------------------------------
    \5\ Securities Exchange Act Release No. 23170 (April 23, 1986).
    \6\ Id.
---------------------------------------------------------------------------
    Market data and the services that typically accompany market data 
are properly within the scope of Section 28(e).\7\ Providers such as 
Reuters, Baseline, Thomson, and Bloomberg offer highly sophisticated 
products that include data feeds, quotes, news, analyses, analytics, 
and customizable functions. These products permit investment advisers 
to conduct in-depth research of issuers, industries, economic and 
market factors and trends. Many advisers use these tools to support 
momentum and quantitative investment and trading strategies. In other 
words, these products provide just the ``research'' that should be 
available to investment advisers under the safe harbor, because they 
provide lawful and appropriate assistance to advisers' investment 
decisionmaking process. We believe that singling out such products, as 
is currently being discussed in the United Kingdom, reflects a bias in 
favor of ``fundamental'' over ``technical'' or other research that is 
inconsistent with Section 28(e) and marketplace practices. We recommend 
that the Commission does not narrow the Section 28(e) safe harbor to 
preclude an adviser from paying for such products.
---------------------------------------------------------------------------
    \7\ Section 28(e) defines ``research services'' to include, among 
other things, advice, either direct or through publications or 
writings, ``as to the value of securities, the advisability of 
investing in, purchasing, or selling securities, and the availability 
of securities or purchasers or sellers of securities,'' and ``analyses 
and reports concerning issuers, industries, securities, economic 
factors and trends, portfolio strategy, and the performance of 
accounts.''
---------------------------------------------------------------------------
Hedge Funds and Other Investment Advisers Can and Do Operate Outside
the Safe Harbor
    Investment advisers to clients other than mutual funds or ERISA 
plans may use client commissions to obtain services outside the safe 
harbor, provided the adviser receives client consent. The adviser to a 
hedge fund is a common example of the type of adviser that receives 
such services. We believe the perception that soft dollars are abused 
may relate to the fact that advisers to hedge funds commonly receive 
services outside the safe harbor (for example, office rent). In most 
cases, such advisers have received client consent to do so. As such, 
this is neither an abuse of the Section 28(e) safe harbor nor a matter 
that requires regulatory intervention.
Enhanced Disclosure
    As stated above, we believe the current system works well. 
Nevertheless, we feel that investors could benefit from enhanced 
disclosure by investment advisers regarding their soft-dollar 
practices. As noted in the staff memorandum, the Commission ``twice has 
proposed requiring increased disclosure of quantitative information 
about the use of client brokerage and the research and services 
advisers obtain from brokers. Both times the rules were not adopted 
because of intractable problems in valuing the research and services 
that advisers receive for soft dollars, tracing the allocation of those 
benefits to clients' accounts, and quantifying the effect of the 
benefits on the accounts' performance.'' \8\
---------------------------------------------------------------------------
    \8\ Staff memorandum at 40.
---------------------------------------------------------------------------
    The Commission last proposed such rules in 1995.\9\ The rules would 
have required disclosure on an annual basis of the twenty brokers other 
than ``execution-only'' brokers (research brokers) to which the adviser 
directed the most commissions, and the three execution-only brokers to 
which the adviser directed the most commissions. For each broker, the 
adviser would have disclosed the aggregate amount of commissions 
directed by the adviser to the broker, the percentage of the adviser's 
discretionary brokerage commission that this represents, the average 
commission rate paid to the broker, and a description of soft-dollar 
services provided by the broker.
---------------------------------------------------------------------------
    \9\ See Investment Advisers Act Release No. 1469 (February 14, 
1995).
---------------------------------------------------------------------------
    Goldman Sachs and Morgan Stanley offered an alternative proposal. 
The Goldman/Morgan proposal would have required explicit disclosure of 
independent research arrangements, but would have exempted soft dollars 
used to pay integrated firms, such as themselves. One of the arguments 
put forth in support of the Goldman/Morgan proposal was that it was too 
difficult to separate the costs of execution, research, and other 
services provided as a bundle. The Commission correctly refused to move 
forward with its rule proposal unless it applied equally to integrated 
investment banks. Last December, the Investment Company Institute (ICI) 
issued a letter to the Commission essentially parroting the failed 
Goldman/Morgan proposal. We find it ironic that during a time when it 
is more apparent than ever that more disclosure encourages better 
practices and decisionmaking, the ICI would propose a framework, 
rejected almost 10 years ago, that would increase the opacity of 
brokerage commissions.
    We offer a different approach. We support enhanced disclosure by 
broker-dealers to their investment adviser clients regarding the costs 
of execution, clearance, and settlement (brokerage), research and other 
services provided by the broker-dealer, so long as any requirements are 
applied equitably to all market participants.
    We recognize that average investors would have difficulty 
understanding detailed transaction cost disclosures. We agree with the 
Commission that fund independent directors are in the best position to 
monitor brokerage allocation practices and to protect fund investors' 
interests. Nevertheless, we believe that investors can benefit from 
enhanced disclosure of summary information that would provide them with 
a clearer picture of their advisers' brokerage allocation practices. We 
favor requiring disclosure of commissions and mark-ups/mark-downs (to 
the extent they are required to be disclosed in a Rule 10b-10 
confirmation) in the aggregate, and broken out into three categories: 
Execution-only, proprietary research commissions, and independent 
research commissions. We believe this information will be easily 
understood by investors and will help them assess their advisers' use 
of their commission dollars.
Changes Must be Applied Equitably
    Any changes to soft-dollar practices, whether in limiting the scope 
of ``research'' under Section 28(e) or enhanced disclosure about soft-
dollar arrangements, must be made in a way that does not discriminate 
against market participants. As demonstrated above, the direction of 
commissions to an integrated investment bank in exchange for access to 
its analyst is every bit as much a soft-dollar transaction as the 
direction of commissions in exchange for a Reuters terminal. Moreover, 
the amount of commissions directed to the integrated investment banks 
dwarfs the amount directed to independent agency brokers. No reform 
effort could be meaningful unless it addresses the practice of 
providing proprietary research.
Conclusion
    Independent research arrangements provide a combination of best 
execution and independent research. Independent research is vital to 
our financial markets, because it provides advisers access to a wide 
variety of thoughts and investment ideas, and the absence of conflicts 
will help restore investor confidence in our markets.
    Compliance practices with respect to independent research 
arrangements are state of the art. Indeed, investment advisers and 
broker-dealers largely have adopted the Sweep Report's recommendations. 
Firms have enhanced policies and procedures, training, and 
recordkeeping in response to the Sweep Report's guidance. Independent 
research arrangements are transparent and actively managed by 
investment advisers. Accordingly, we believe the Commission should not 
enact broad change that could have unintended adverse repercussions.
    Although we believe the system currently works well, we believe 
investors can benefit from enhanced disclosure about how their 
investment advisers direct brokerage. We support requiring disclosure 
by investment advisers of the amounts and percentages of commission 
dollars directed to execution-only firms, independent agency brokerage 
firms and proprietary research firms (for example, integrated 
investment banking firms). Most importantly, any contemplated changes 
must be applied fairly.

         RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI
                   FROM GRADY G. THOMAS, JR.

Q.1. Last week, a Federal judge approved monies from the $1.4 
billion that would go toward financial literacy. How should 
this money be used to educate investors?

A.1. Interstate Group Division of Morgan Keegan & Company, Inc. 
was not a party to the referenced civil action, and I am not 
privy to the terms of the settlement. I do believe that 
improving the financial literacy of retail investors is a 
worthwhile cause. One suggestion I have is for investors to be 
educated as to the importance of consulting several sources of 
information before making an investment decision, and the 
differences between various investment research tools, such as 
independent versus proprietary research.

Q.2. Can we truly improve market transparency or enhance 
investment governance in the best interest of shareholders, or 
implement enduring reform, without a widespread expansion of 
investor comprehension?

A.2. I believe that over the past two decades, the SEC and the 
securities industry have greatly improved market transparency 
by way of rapid and broad dissemination of market data (last 
sale information, quotations, etc.) and improved disclosure of 
investment practices through the evolution of confirmations, 
prospectuses, and investment adviser registration documents. In 
that regard, I support the goal of continuing to improve the 
dissemination of financial information to investors. I also 
support actions such as the SEC's ``plain English'' initiative 
to provide information to retail investors in a clear, easy to 
understand format. I do, however, believe that we must take 
care not to overload investors with information. The danger 
here is twofold. First, information overload tends to obscure 
the truly important disclosure from the eyes of investors. 
Second, the costs of producing and distributing such 
information are ultimately passed down to investors, lowering 
investment returns.

Q.3. As a representative from an independent research company, 
you strongly oppose a ban on soft-dollar commissions for third-
party market research. How does your company, and other 
companies like yours, improve the mutual fund industry from an 
investor's perspective?

A.3. The Interstate Group Division of Morgan Keegan & Company, 
Inc. is a registered broker-dealer who provides independent 
research to our institutional clients, some of whom are 
advisers to mutual funds. Mutual fund investors reap a number 
of benefits from arrangements through which broker-dealers like 
The Interstate Group provide research to mutual fund portfolio 
managers.
Independent Research Arrangements Improve The Flow Of
Investment Research To Investment Managers
    When Congress adopted Section 28(e) it was concerned that 
investors would suffer if the flow of research services to 
their money managers were impeded. Investment research is the 
lifeblood of the investment management industry and allows 
portfolio managers to maximize the performance of their managed 
accounts. At least one study has suggested that the use of 
research commission arrangements by money managers is 
positively correlated with investment returns. Under the rubric 
of Section 28(e), broker-dealers such as the Interstate Group 
now provide literally hundreds of independent research services 
to money managers to assist in the investment decisionmaking 
process. These services include not only investment information 
but also fundamental databases, portfolio modeling, and 
strategy software. The Interstate Group and other broker-
dealers have been particularly successful in assisting the 
development of the independent research community as a viable 
alternative to proprietary research produced by Wall Street 
firms. Independent research firms are often small operations 
who use innovative and unique methodologies and/or who target 
research at a specific segment of the market not given 
sufficient coverage by Wall Street. It is difficult for small 
independent research providers with limited marketing budgets 
to gain a foothold in the market for investment research. Firms 
like The Interstate Group provide assistance to independent 
research firms in gaining market acceptance through the use of 
research commission arrangements.
Competition Between Broker-Dealers Providing Independent
Research Has Reduced Execution Costs To Investors
    By becoming major competitors for institutional order flow, 
brokers such as The Interstate Group have exerted downward 
pressure on commission rates, thus lowering costs to investors. 
Since commission rates were unfixed in 1975, execution costs 
have declined significantly. Prior to 1975, commission rates on 
institutional trades were on a sliding scale based on volume 
with a high of $0.82 per share. In 1998, an SEC report found 
commission rates of about $0.06 per share for those 
institutional accounts examined by the SEC staff. My experience 
is that commission rates have further been reduced and today 
average $0.05-$0.06 per share for institutional trades.
Independent Research Arrangements Allow For Enhanced
Competition Between Investment Managers
    In its deliberations on Section 28(e), Congress expressed 
the fear that without access to the research that broker-
dealers provide, small investment managers would be pressured 
to charge higher fees than those charged by large money 
managers. What was true in 1975 is true today. Many start-up 
investment advisers cannot establish their businesses and 
compete with larger money managers without access to research 
provided by broker-dealers such as The Interstate Group under 
Section 28(e) arrangements. Enhanced competition between money 
managers provides more choice to investors while keeping 
management costs down.

Q.4. Do you think that other proposals, including enhanced 
disclosure of soft dollars and stiffer penalties for 
violations, will be strong enough to prevent future abuses of 
soft-dollar commissions?

A.4. I believe that abuses of soft-dollar arrangements are rare 
and can be easily dealt with by the SEC using its existing 
enforcement tools. Indeed, in the last industry-wide 
examination sweep conducted by the SEC staff in 1997, the staff 
found no instances ``. . . in which [mutual fund] commissions 
were used to purchase nonresearch items, which did not benefit 
the funds themselves.'' This being said, I note that the SEC 
staff did, in Section VIII of the 1998 inspection report that 
discussed its 1997 examination sweep, make a number of 
recommendations pertaining to the provision of research for 
portfolio commissions. I encourage the SEC to give further 
consideration to these recommendations, and note that many of 
them have already been adopted by The Interstate Group and 
other broker-dealers.

         RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI
                      FROM JOSEPH M. VELLI

Q.1. Last week, a Federal judge approved monies from the $1.4 
billion that would go toward financial literacy. How should 
this money be used to educate investors?

A.1. There are a number of private foundations, such as the 
Foundation for Investor Education founded by the Securities 
Industry Association, that are dedicated to raising the level 
of investor literacy in the United States. These foundations 
have a variety of programs and web-based tutorials that are 
available to investors. The track records and reach of these 
programs should be reviewed so that the settlement monies can 
go to objective education programs that will have the greatest 
impact. In addition, the SEC, NASD, and the NYSE all have 
substantial websites that include investor information sections 
that could be further supported and enhanced.

Q.2. Can we truly improve market transparency or enhance 
investment governance in the best interest of shareholders, or 
implement enduring reform, without a widespread expansion of 
investor comprehension?

A.2. I agree with you that improved transparency, enhanced 
investment governance and other reforms, while positive 
developments for and beneficial to investors, may not be fully 
understood by them. A better-educated investor would better 
comprehend these reforms and utilize the improved information 
and protections 
afforded to make more informed investment decisions. Investor 
education is critical to such reforms. However, such reforms, 
nevertheless, benefit investors.

Q.3. How would the proposed changes to the regulation of soft 
dollars, especially enhancing disclosure and ``unbundling'' 
commission payments, affect your firm?

A.3. Fund boards and individual investors should have more 
information about how their commissions are being used. The 
Bank of New York supports enhanced disclosure requirements 
regarding the use of commissions to acquire research. We 
believe a policy of greater disclosure will serve investors 
well, restore their confidence, increase merit-based 
competition among sources of research, increase competition 
between execution-only brokers and full-service brokers and, 
ultimately, benefit the securities industry.
    As an agency broker, we already disclose to our asset 
manager customers the amount of commissions used to pay for 
research products and services selected by the asset managers--
including an itemized list of the research we provided and the 
cost of each product or service. We believe that all broker-
dealers can, and should, disclose these costs, to the extent 
they are quantifiable, and make narrative disclosure about what 
is not quantifiable. We have shared with the staff of the 
Securities and Exchange Commission a suggested approach to 
disclosure, a copy of which was included in our submitted 
materials.
    We draw a distinction between the disclosure of research 
commissions and complete unbundling. The Bank of New York 
believes that commissions used to pay for research should be 
accounted for and disclosed. We do not support the full 
unbundling of commissions by integrated investment banks 
because such investment banks provide other services, such as 
capital commitment, as part of their commission. However, to 
the extent that disclosure drives the market, resulting in a 
component-priced research product for proprietary research, 
much like the way third-party independent research currently is 
priced, we continue to believe that it is appropriate to use 
commissions to pay for research because the research benefits 
the investor.

Q.4. If commission unbundling was mandated, how would it affect 
your relationships with independent and third-party research 
companies?

A.4. Presently, independent third-party research commissions 
are effectively unbundled, because each research product 
component is individually priced. Investment managers know 
exactly what is paid for execution and each research product 
component. Accordingly, mandated disclosure of the bundled 
services would have no impact on third-party independent 
research companies, assuming that commissions could continue to 
pay for research.
    However, if such unbundling also prohibited the use of 
commissions to pay for research, this would have a significant 
adverse 
impact on independent third-party research companies because 
smaller investment managers would not be able to afford their 
products and large money managers would rely more heavily on 
internal 
research because of cost. This further would result in smaller 
investment managers becoming less competitive in terms of their 
expenses and would negatively impact the quality of their 
investment advice and judgment.
                       AFTERNOON SESSION

    The Committee met at 2:35 p.m., in room SD-538, Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order.
    We have already had a hearing most of the day on mutual 
funds. We are continuing that, so we may have worn out some of 
the Members.
    This afternoon, the Committee continues its examination of 
the mutual fund industry. Since the mutual fund scandals broke 
last November, a number of my Senate colleagues have offered 
remedial legislation. This afternoon, we are fortunate to have 
with us several of our colleagues who have advocated such 
reform. I would like to welcome Chairman Susan Collins, from 
the Governmental Affairs Committee, and Senators Fitzgerald, 
Levin, and Akaka. I look forward to hearing their comments on 
their proposed reform package and the fund industry generally.
    On the second panel this afternoon, we will hear from 
representatives of several mutual funds and broker-dealers. At 
the beginning of this hearing process, I challenged these two 
industries to recommit themselves to the ideal of investor 
protection and demonstrate an ability to abide by it. I believe 
that an industry so dependent on integrity and investor trust 
must identify and address potential conflicts of interest and 
nontransparent practices. Although a few months time is 
certainly insufficient for final judgment of the industry's 
response, I do believe that we have a preliminary record to 
begin to evaluate its commitment to reform. As we near the 
conclusion of our scheduled hearings, it is important to 
understand the industry's response to the SEC's slate of 
proposed rules and to examine whether additional reforms are 
necessary.
    During the course of our hearings, we have learned how the 
growing role of broker-dealers in fund sales and distribution 
has significantly changed fund operations. Funds rely on 
broker-dealers not only to provide brokerage and research 
services, but also to widely market and distribute their 
investment products. As the role of the intermediaries has 
evolved, so too, have the payment and cost structures. Funds 
employ a number of payment methods such as 12b-1 fees, revenue 
sharing, and directed brokerage arrangements to enhance the 
distribution of their products. This hearing will be an 
opportunity to better understand these practices and their 
impact on investors.
    On the second panel this afternoon, we will hear from Mr. 
Paul Haaga, Executive Vice President and Director of Capital 
Research and Management Company and the Chairman of the 
Investment Company Institute; Mr. Chet Helck, President and 
Chief Operating Office, Raymond James Financial; Mr. Thomas 
Putnam, Founder and CEO of Fenimore Asset Management; Mr. 
Edward Siedle, Founder and President of The Benchmark 
Companies; and Mr. Mark Treanor, General Counsel and Head of 
the Legal Division of Wachovia Corporation.
    I thank each of you for appearing this afternoon. Your 
written testimony will be made part of the record in its 
entirety. Chairman Collins, I will start with you. Welcome to 
the Committee.
    Senator Collins. Thank you, Mr. Chairman. I think Senator 
Fitzgerald would like to proceed first.
    Chairman Shelby. If you will yield to him. You are the 
Chairman.
    Senator Collins. I will. Thank you.
    Chairman Shelby. I will recognize Senator Fitzgerald.

                STATEMENT OF PETER G. FITZGERALD

           A U.S. SENATOR FROM THE STATE OF ILLINOIS

    Senator Fitzgerald. Thank you, Mr. Chairman, and I want to 
at the outset compliment you on the very comprehensive series 
of hearings you have held in the Banking Committee, and I 
compliment your reform-mindedness and your independence. You 
are taking on a lot of important issues, like GSE reform, stock 
options accounting, and the like. Thank you very much for 
allowing us the opportunity to appear here.
    I want to thank my cosponsors, Senator Collins and Senator 
Levin, who are also appearing on the panel, and I want to 
compliment my good friend, Senator Akaka, who is here to talk 
about a serious reform bill that he has introduced. We also 
have a very serious bill that has been introduced by Senators 
Dodd and Corzine, too, who have also come up with some very 
good ideas.
    In our Governmental Affairs Committee, we did two hearings 
on this issue, and actually a third hearing on the Government 
Thrift Savings Plan. We spent about 6 months analyzing the 
issues, and mainly what we concluded is that consumers could be 
much better protected if there were enhanced disclosure of the 
types of fees that mutual fund shareholders are charged.
    The first thing I want to point out, Mr. Chairman, is that 
most Americans now are investing in mutual funds. This is a 
graph that shows by State and percentage of the population. In 
your State, you have 1.1 million mutual fund shareholders; 24 
percent of your State is invested in mutual funds. Overall in 
the country, 95 million Americans are invested in mutual funds.
    Chairman Shelby. What is the average percentage State by 
State of the population investing?
    Senator Fitzgerald. It is 39 percent, almost 40 percent. In 
my State, there are 5 million mutual fund investors.
    Chairman Shelby. That is high.
    Senator Fitzgerald. And it is not clear to me--in 
households, if you say 95 million Americans are invested in the 
markets, then that is a majority of the households, certainly, 
in America.
    Chairman Shelby. I agree.
    Senator Fitzgerald. If you could flip the----
    Chairman Shelby. Involving $7 trillion I believe, is it 
not?
    Senator Fitzgerald. Exactly. Exactly.
    Now, if you go back to 1980, the mutual fund industry was 
very small. There was only $115 billion in assets total in the 
industry. The growth has been explosive in the last 20 years. 
It has grown from $135 billion in 1980 to $7.5 trillion that 
are invested in mutual funds.
    When you hear the average fees on mutual funds, they are 
expressed as a percentage. In fact, the average mutual fund 
percentage expense ratio is 1.56, 1.5 percent. Now, that sounds 
diminutive, it sounds trifling, 1.5 percent fees. But if you 
add that up in dollars, 1.5 percent of $7.5 trillion, you are 
talking tens of billions of dollars. In fact, probably in total 
there are close to $200 billion a year being earned on 
America's savings in mutual funds.
    Our main concern that our bill addresses is that a lot of 
the fees are not disclosed. You would think that as mutual 
funds' assets have grown, you would think the fees would have 
shrunk as a percentage of the assets because there are enormous 
economies of scales in money management. But, in fact, mutual 
funds' assets have risen. That is the red axis. It has risen. 
As it has climbed to $7 trillion, it has risen 60 times over in 
the last 20 years. But fees have risen more. They have risen 90 
times over. So what happened to the economy of scale?
    What has happened is that, for some reason, there are a lot 
of mutual funds out there. In fact, there are 8,800 mutual 
funds. There are only 6,600 publicly traded corporations, but 
there are 8,800 mutual funds. It tells you it is a pretty good 
business to start a mutual fund. Most Americans do not 
understand--are trapped in high-cost funds because I do not 
think they understand the significance of fees, and it turns 
out 88 percent of mutual funds underperform the market over 
time.
    Chairman Shelby. By ``the market,'' is that the S&P, for 
example?
    Senator Fitzgerald. Just the overall market, yes. The 
overall market funds underperform the overall market.
    Chairman Shelby. Okay.
    Senator Fitzgerald. And there is a big difference whether 
you are in a low-cost fund--if you are in a low-cost fund, 
imagine a fund with only a 0.15-percent fee. That is 15 cents 
for every $100 invested. If you invested $10,000 in the low-
cost fund and kept it there for 40 years, you would wind up 
with $205,000 at the end of the 40 years. If you go in a high-
cost fund, however, with a percentage point more in fees, you 
will have substantially less. You will wind up with only 
$141,000 at the end of 40 years.
    It turns out a 1-percentage-point increase in the fees you 
are paying will cut your retirement nest egg by something close 
to 45 percent over a lifetime of investing.
    Mr. Chairman, what we have sought to do is very clear. The 
evidence is clear that the lowest-cost quartile of funds 
dramatically outperform the highest-cost quartile. This is over 
10-years returns on equity funds, much higher returns for the 
lower-cost funds.
    Nonetheless, many investors are going into high-cost funds, 
and I think it is because the fees are ill-disclosed and people 
do not understand the importance of fees. About half the fees 
aren't disclosed at all. Those are the transaction costs.
    We seek in our bill a very free market solution to this 
dilemma and, that is, enhanced disclosure. We do not want to 
regulate fees. We totally believe in a free market, but we want 
to liberate those free market forces so that you can go look 
and compare one fund with the other on a cost basis, on an 
apples-to-apples basis.
    I am going to turn this over to Senator Collins and Senator 
Levin. The other thing I want to mention that our bill does, 
though, is we do bolster the fiduciary duty that fund directors 
would owe to fund shareholders. My legal staff has surveyed all 
the cases and found that it is very rare for a court to find a 
breach of fiduciary duty on behalf of a fund director or on 
behalf of a fund adviser. And it turns out that the fiduciary 
duty that is now in the Federal law is very weak and without 
content. In fact, no case in the country has ever found a 
breach of fiduciary duty by an investment adviser, no matter 
how high their fees were, because the fiduciary duty in our 
Investment Company Act is very weak. We seek to boost that.
    We also go in the same direction as the SEC does in terms 
of mandating an independent chairman of the board. In my 
closing, I would just like to rebut a point that was made by 
Mr. Ned Johnson, the Chairman of Fidelity Advisers, in his op-
ed piece in The Wall Street Journal on February 17. He argued 
that it is a bad idea to have an independent chairman of a 
mutual fund who is different than the chairman of the fund's 
adviser. And he said it would be akin to having two captains to 
a ship.
    The point I would make is that Mr. Johnson's analogy is 
wrong because there are two separate ships here: one ship is 
the mutual fund, in which the consumers are investing; the 
other ship is the adviser firm, the asset manager firm that Mr. 
Johnson's family owns. He can be chairman of his asset manager 
firm, and he owes a fiduciary duty to that. But, in my 
judgment, I agree with Justice Harlan Fiske Stone, who said 
that one man cannot serve two masters. How can he both fulfill 
his fiduciary duties to his adviser, his asset management firm, 
and the mutual fund?
    That is why we do go in the same direction as the SEC, and 
I would like to point out that I do think Fidelity is a very 
good fund. They have one of the lowest-cost funds, and 
obviously they have been successful, in part for that. But I 
did want to rebut that point of Mr. Johnson's.
    Thank you.
    Chairman Shelby. Senator Collins.

                 STATEMENT OF SUSAN M. COLLINS

             A U.S. SENATOR FROM THE STATE OF MAINE

    Senator Collins. Thank you very much, Mr. Chairman. I want 
to thank you for inviting me and other Members of the 
Governmental Affairs Committee. Under the leadership of Senator 
Fitzgerald, the Committee has spent a great deal of time 
investigating mutual fund issues, and we hope to be able to 
share our findings with you today. I want to commend you for 
your leadership on this issue. I know your Committee has held 
several hearings, and this issue really matters. As you pointed 
out, it affects some 95 million American investors who hold 
assets exceeding $7 trillion that are invested in mutual 
funds--funds that are often touted as a safe haven for the 
small investor.
    As the Governmental Affairs Committee pursued its 
investigation, I thought about a fundamental question: Why is 
it that in a society built on competition, market forces do not 
drive down mutual fund fees? Why is it that the legendary 
American consumer, who will search far and wide for the 
cheapest gas, clip newspaper coupons, and take advantage of 
early bird specials, appears to be oblivious to fees that can, 
over time, affect his or her net worth by thousands of dollars, 
as Senator Fitzgerald's charts amply demonstrate? Why is it 
that mutual fund fees seem more impervious to competitive 
forces than almost any other cost in our society? In fact, the 
only thing I can think of that is more impervious is college 
tuition, which seems to not be affected at all by competition 
among schools.
    I start with the basic notion that competition can only 
work when market participants have adequate information. If 
mutual fund investors do not fully understand either the level 
of their fees or the fees' impact on fund performance, then 
competition lacks one of its essential ingredients. 
Furthermore, if this is true for many mutual fund investors, 
then we cannot expect the informed choices and decisions of a 
majority to protect the uninformed decisions of the minority as 
occurs in markets that are efficient. This theory would suggest 
that the Government should act to improve either the amount of 
fee information provided to investors or the clarity with which 
it is provided, or both. And I believe that this is the most 
important reform included in our bill.
    What we need to do is to help investors focus attention on 
the costs of owning mutual funds. For most investors, high 
mutual fund expenses will cost them far more than such abusive 
practices as late trading or market timing, which have grabbed 
the headlines. As Senator Fitzgerald indicated, even a 1-
percent difference in fees over a lifetime of investment can 
result in a 35- to 40-percent difference in the ultimate 
retirement savings for a worker.
    We cannot enjoy the benefits of competition among these 
8,000 funds unless we have an efficient marketplace. And an 
efficient marketplace requires that prices be both transparent 
and easily accessible to investors. Currently, however, mutual 
fund expenses and fees are often opaque and obscure. In 
contrast, historical performance of funds, the rate of return, 
is well known because successful funds tout their past 
performance data through large advertising campaigns.
    I recognize the impediments to calculating and providing to 
consumers the true costs of mutual funds. For example, as 
Senator Fitzgerald noted, mutual fund trading costs, which 
funds pay to brokers when the funds buy or sell securities for 
their portfolios, are not included in the expense ratio.
    Compounding this problem, there are many expenses that are 
bundled in with these transactions, which means that even more 
mutual fund expenses never make it into the expense ratio. They 
include, for example, research and related costs that are 
purchased with so-called soft dollars. Another example is the 
practice of directed brokerage, by which trades are executed 
with certain brokers that sell the fund's shares and are 
understood by both parties to be a form of compensation. This 
practice, in essence, combines distribution costs with 
brokerage costs and becomes a hidden 12b-1 fee.
    Now, the SEC has made a good start in improving cost 
disclosure with its recent proposal that mutual funds disclose 
in shareholder reports, their costs per $1,000 invested. 
However, I believe that Congress should go further. In our 
legislation, S. 2059, we would require that such data be 
published on a shareholder's account statement at least 
annually. In addition, such data should be personalized for 
each investor to the extent practical.
    It is not enough to tell an investor how much his costs 
would have been had he owned x amount of shares that he does 
not actually own. Like a bank checking account statement that 
tells a bank customer how much he or she was charged for 
individual banking services, a mutual fund statement should 
tell an investor how much his or her actual share of the fund's 
fees were.
    I recognize, Mr. Chairman, that there would be costs to 
generating and reporting this personalized data. But, still, 
having reviewed the analysis done by the General Accounting 
Office, I have concluded that this disclosure is warranted, it 
is needed, and would be welcomed by consumers. It is not that 
expensive.
    GAO estimates it would cost about 65 cents each year for 
the individual accountholder. And GAO has recommended that the 
SEC seriously consider requiring that types of disclosure. As I 
have said, the SEC has not gone that far. I hope this Committee 
will.
    In view of the number of witnesses you have today, I would 
ask that the balance of my statement be put in the record. And, 
again, I commend you for your leadership in this area.
    Chairman Shelby. Without objection, your statement will be 
made part of the record.
    Chairman Shelby. Senator Levin.

                    STATEMENT OF CARL LEVIN

           A U.S. SENATOR FROM THE STATE OF MICHIGAN

    Senator Levin. Mr. Chairman, thank you for holding this 
important hearing, for listening to those of us who are just 
part of the numbers of Senators who are deeply concerned about 
these mutual fund problems that were disclosed about 7 or 8 
months ago. In particular, I also want to thank this Committee 
for the very prompt response to the corporate scandals of 2002, 
the Enrons, the WorldComs and the Tycos. This Committee led the 
way with a bipartisan effort. We adopted in Sarbanes-Oxley, a 
real reform that has made a difference, and we hope this 
Committee will also act promptly relative to the need for 
mutual fund reforms indicated by recent events in that area as 
well.
    Late trading, market timing, hedge fund favoritism, hidden 
fees, and other abuses have undermined public confidence in 
this industry. Senator Fitzgerald has been a tremendous leader 
in this bill. I am proud to join with him. Our Chairman, 
Senator Collins, as always, has been very supportive and 
helpful in the efforts of her Committee and in the oversight 
role of that Committee, in this case relative to mutual funds, 
and I am proud to join them and other supporters of this 
legislation.
    The Mutual Fund Reform Act was introduced in February. It 
addresses a number of the issues which you have already heard 
about in the last few minutes, but I want to just focus on the 
conflicts-of-interest component of this bill.
    It troubles me greatly that people who are selling me 
mutual fund shares or advising me on investments are, on the 
one hand, being paid a fee by me at the same time they are 
receiving financial rewards from the mutual funds that they are 
promoting. And the issue is: What do we do about that?
    There is an inherent conflict of interest when someone who 
is saying to me ``buy this mutual fund'' is receiving from that 
mutual fund a benefit.
    I think most people say that is wrong. There is a conflict 
in there. ``You can only serve one master,'' as Senator 
Fitzgerald quoted properly. We have to really make a decision 
here as to whether, it is going to be tolerated in the future 
that we can have a situation where a broker or a financial 
adviser is receiving the fee from the investor to advice on a 
mutual fund at the same time that adviser is receiving an 
incentive to promote that mutual fund from the mutual fund 
itself.
    And there are two alternatives here. One is to ban it 
because it is an inherent conflict of interest. The other one 
is to disclose it. And these alternatives are really what, it 
seems to me, the tug of war is about. It is clear we have to do 
something. To me, banning it is right because it is an inherent 
conflict of interest. Disclosing this conflict of interest does 
not address the conflict. All it does is say to an investor, if 
he or she can understand it--because these are complicated 
issues--there is a conflict of interest. But that frequently 
gets buried in verbiage. We have seen these disclosures, for 
instance, on other things, on telephone bills and on long 
distance, on pharmaceutical purchases, and a whole lot of 
areas. These disclosures do not do the job, number one. But, 
number two, they do not address the fundamental problem here, 
which is that you have a conflict of interest. Disclosure does 
not correct and cleanse the conflict.
    Chairman Shelby. You are saying basically that if you 
disclose a wrongdoing, that does not cure the wrongdoing.
    Senator Levin. It does not, and there are two forms that I 
want to just to spend 30 seconds or a minute on: the so-called 
revenue sharing and the directed brokerage. And what it amounts 
to is this. If a mutual fund has an agreement with a broker or 
financial adviser that they will purchase from that broker 
stock for their own inventory, for their own portfolio, if that 
broker will promote its mutual fund to those investors, those 
95 million investors out there, you have got an inherent 
conflict.
    The other form, which is called revenue sharing, is when a 
mutual fund tells the broker, if you will promote my fund to 
those 95 million people out there, I will give you a share of 
the profits of my fund. There is an inherent conflict because 
the broker or the financial adviser there is not only being 
paid, on the one hand, by the person who is benefiting from the 
sale on the sale end, but also getting a fee from the person 
who is purchasing that share in the mutual fund.
    Those are two, it seems to me, inherently conflicting 
situations.
    Chairman Shelby. Could the SEC ban that?
    Senator Levin. We hope they can. We hope they have got the 
legislative authority, but you can strengthen their hand. In 
the one case, they are proposing to ban it. In the other case, 
they are proposing to disclose it. In the case of the revenue 
sharing, the SEC is proposing disclosure. In the case of 
directed brokerage, they are proposing a ban. But it is 
important that the Congress strengthen their hand, give them 
the clear authority, hopefully, to ban both since there is an 
inherent conflict and disclosure does not solve the conflict 
but, in any event, to support their efforts. The SEC has taken 
important steps, and legislatively we can give them a greater 
legal hand, it seems to me, if we give them the clear statutory 
authority.
    There are other conflicts which we address in this bill, 
but I just wanted to focus on two of them because they really 
need the attention of the Congress, and we hope that this 
Committee will again lead the way in the Senate toward bringing 
a strong bill to the floor so that we can get on with restoring 
the credibility which this industry needs and deserves, for the 
reasons given. The Chairman has already indicated it is a $7 
trillion industry. This is a big chunk of our economy. There 
are 95 million people relying on this industry for their 
retirement, buying a house, or educating their kids. So this is 
a big chunk of the economy, and we look forward to this 
Committee's continuing leadership in this reform effort.
    Thank you, Mr. Chairman.
    Chairman Shelby. Thank you.
    Senator Akaka.

                  STATEMENT OF DANIEL K. AKAKA

            A U.S. SENATOR FROM THE STATE OF HAWAII

    Senator Akaka. Mr. Chairman, I thank you very much for 
holding this hearing and for giving me the opportunity of 
participating in it. And I want to thank you for what you have 
done in addressing this problem.
    The mutual fund industry, Mr. Chairman, and its reform is 
important to our country because 95 million people have placed 
their trust and significant portions of their future financial 
security into mutual funds. And I must tell you that Hawaii has 
approximately 371,000 investors in mutual funds. Mutual funds 
provide middle-income Americans with an investment vehicle that 
offers diversification and professional money management. 
Mutual funds are what average investors rely on for retirement, 
savings for children's college educations, or other financial 
goals, and even for their dreams.
    Last fall, I was appalled by the flagrant abuses of trust 
among mutual fund companies. So, I introduced S. 1822, the 
Mutual Fund Transparency Act of 2003, to bring about structural 
reform in the mutual fund industry, increase disclosures in 
order to provide useful and relevant information to mutual fund 
investors, and restore trust among investors.
    I want to commend the SEC for its proposals to improve the 
corporate governance of mutual funds and to increase the 
transparency of mutual fund fees that investors pay. The 
proposed requirement for an independent chairman for mutual 
fund boards, increased percentage of independent directors to 
75 percent, and development of a confirmation notice so that 
investors will be able to know how their broker gets paid in 
mutual fund transactions are a solid and measured response to 
the litany of transgressions which have undermined public 
confidence in the mutual fund industry. These provisions mirror 
those in my legislation. In addition, I have been impressed 
with the SEC's attempts to address point-of-sale disclosure.
    However, I continue to believe that legislation is 
necessary to codify some of the proposed regulations so that 
the reforms will not be rolled back in the future. It is also 
important to legislatively address areas where the SEC needs 
additional statutory authority to address problems and abuses 
in the mutual fund industry. Legislation is necessary to ensure 
corporate governance improvements apply these rules universally 
among mutual funds. Finally, additional legislation may be 
necessary if disclosures of revenue sharing agreements and 
portfolio transaction costs are not adequately addressed by the 
Commission.
    S. 1822 includes a number of provisions that are important 
for Congress to enact. Boards must be strengthened and more 
independent to be more effective. Investment company boards 
should be required to have an independent chairman, and 
independent directors must have a dominant presence on the 
board. My bill strengthens the definition of who is considered 
to be an independent director. It also requires that mutual 
fund company boards have 75 percent of their members considered 
to be independent. To be considered independent, shareholders 
would have to approve them. In addition, a committee of 
independent members would be responsible for nominating members 
and adopting qualification standards for board membership. 
These steps are necessary to add much needed protections to 
strengthen the ability of mutual fund boards to detect and 
prevent abuses of the trust of shareholders.
    To increase the transparency of the actual costs of the 
fund, brokerage commissions must be counted on as an expense in 
filings with the SEC and included in the calculation of the 
expense ratio, so that investors will have a more realistic 
view of the expenses of their fund. Consumers often compare the 
expense ratios of funds when making investment decisions. 
However, the expense ratios fail to take into account the cost 
of commissions in the purchase or the sale of the securities. 
Therefore, investors are not provided with an accurate idea of 
the expenses involved. Currently, brokerage commissions have to 
be disclosed to the SEC, but not to individual investors. 
Brokerage commissions are only disclosed to the investor upon 
request. My bill puts teeth into brokerage commission 
disclosure provisions and ensures that commissions will be 
included in a document that investors actually have access to 
and utilize.
    I know soft-dollar practices, Mr. Chairman, were discussed 
during hearing this morning. The inclusion of brokerage 
commissions in the expense ratio creates a powerful incentive 
to reduce the use of soft dollars. Soft dollars can be used to 
lower expenses since most purchases using soft dollars do not 
count as expenses and are not calculated into the expense 
ratio.
    There have been calls for the prohibition of soft dollars. 
However, my bill provides an immediate alternative, which is an 
incentive for funds to limit their use of soft dollars by 
calculating them as expenses. If commissions are disclosed in 
this manner, the use of soft dollars would be reflected in the 
higher commission fees and overall expenses. This makes it 
easier for investors to see the true costs of the fund and 
compare the expense ratio of funds.
    Some may argue that this gives an incomplete picture and 
fails to account for spreads, market impact, and opportunity 
costs. My bill merely uses what is already reported and 
presents this information in a manner meaningful to investors.
    One of the provisions in my bill requires the SEC to 
conduct a study to assess financial literacy among fund 
investors. This study is necessary because any additional 
disclosure requirements for mutual funds will not truly work 
unless investors are given the tools they need to make smart 
investment decisions, and we must first know what education 
exists.
    Mr. Chairman, I look forward to working with you, my 
colleagues, and the SEC to address problems identified in the 
mutual fund industry. Thank you very much, Mr. Chairman.
    Chairman Shelby. I want to thank all of you. I have a few 
questions. It is not every day we have a bipartisan effort 
here, two Republicans, two Democrats, on a very important 
issue.
    Senator Levin, on the conflict, I think you touched on 
something just a few minutes ago. If you just disclose a 
conflict and do nothing about it, there is still a conflict, 
isn't there?
    Senator Levin. I am afraid so.
    Chairman Shelby. And a lot of the people might not even 
recognize it as a conflict. Isn't that one of your concerns?
    Senator Levin. The fear is that if it is just simple 
disclosure, the verbiage which surrounds it may not be easily 
understood by that average investor who does not have a lot of 
time to pore over that verbiage and words. So particularly 
where the inherent conflict is not resolved, it is still there, 
as you just pointed out. There are some things where disclosure 
is fine. If you are disclosing side effects of a drug, well, if 
you read about that, you still may want to take the drug even 
though it may give you headaches or stomachaches. But here the 
question is whether or not that conflict is something which 
should be corrected or whether we should tolerate and accept 
that conflict.
    I do not think we should accept these fundamental conflicts 
as to who is the beneficiary of a sale of a share in a mutual 
fund. Do we want the person who is selling that mutual fund to 
be paid by the mutual fund at the same time they are getting a 
fee from the person they are selling to?
    Now, it is worse when that person does not know about it. 
The question is if somehow or another this conflict is 
surrounded by verbiage, will that be enough knowledge for that 
investor to say, well, I understand there is a conflict here, 
but I will take a chance that you are really giving me advice 
in my interest rather than lining your own pocket with that 
money that you are getting from the mutual fund. I do not think 
we can assume that most investors are going to take the time to 
understand the language which surrounds that disclosure.
    Chairman Shelby. Does the SEC in your judgment have the 
power to ban this conflict if it had the will to do it?
    Senator Levin. I am not sure it does. I hope it does. In 
one case, it bans it; in the other case, the conflict I 
mentioned, there is simple disclosure. But I do not know for 
sure that it does.
    Chairman Shelby. It would be an inconsistent message, would 
it not?
    Senator Levin. Very inconsistent. But even if it has the 
legal power to do it----
    Chairman Shelby. It has to have the will, too.
    Senator Levin. Exactly, it has to have the will. But as 
Senator Akaka points out, too, when you put something in 
legislation, it is stronger because it cannot readily be 
changed, as a regulation can. But I would say that there is 
always the possibility of a legal challenge. I do not know of 
any power that a regulatory body has that cannot be subject to 
some legal challenge or another. Very few of them have that 
clarity, and I think we should reinforce their case in case it 
is challenged.
    Senator Fitzgerald. May I interject on this point? The one 
thing the SEC definitely cannot ban is soft-dollar transactions 
because that is----
    Chairman Shelby. It is statutory, is it not?
    Senator Fitzgerald. --in Section 28(e), I guess it is, of 
the Securities Exchange Act. It is a safe harbor. And so we 
have to act, and that is something even, as I understand it, 
the ICI has come out for banning those soft-dollar 
arrangements.
    Chairman Shelby. Should they be banned or disclosed?
    Senator Fitzgerald. Well, the reason we say they should be 
banned is because if you get into trying to disclose all these 
shadow transactions, you will create a document dump on the 
consumer that will only succeed in confusing him. And we 
believe you have to keep the disclosure as simple as possible.
    On soft dollar, for example, funds will still be able to go 
out and buy some research or buy Bloomberg terminals for every 
desk. But what they cannot do is permit a brokerage firm to 
charge the fund shareholders an exorbitant brokerage fee in 
return for having the brokerage firm provide those Bloomberg 
terminals on everybody's desk. They are running up costs for 
shareholders in an underhanded way that troubles me greatly. 
And your statement that you do not cure wrongdoing by 
disclosing it hits the nail on the head.
    Chairman Shelby. That was Senator Levin's statement, and I 
just picked up on it.
    Senator Fitzgerald. It is great. But I think some of these 
other things the SEC probably can ban. SEC cannot redefine 
``independence'' of the directors.
    Chairman Shelby. The reason we are asking these questions, 
we are going to have the SEC up here. It will be our last 
hearing. We want to be prepared for what the SEC can do, has 
the will to do, and so forth, what they cannot do or what is 
murky, because I think those are relevant to our hearings.
    Senator Fitzgerald. We have a list of things they cannot 
do, and we will share that with your staff.
    Chairman Shelby. We will share that with our Committee.
    Senator Collins, what about the 4 p.m. closing? Have you 
spent some time on that?
    Senator Collins. I support the SEC's proposal for a hard 4 
p.m. closing. I think that makes a lot of sense and would deal 
with the late trading problem.
    Chairman Shelby. What do you say to people in Hawaii, 
Senator Akaka's people, or California, if you have a 4 p.m. 
Eastern time closing? We have got all these time zones. This 
question has been asked right here at the table, we will ask 
the Chairman of the SEC on it, too, because you have the time 
zone issue, as Senator Akaka knows very well.
    Senator Collins. You do.
    Chairman Shelby. You have to weigh it.
    Senator Collins. Exactly.
    Chairman Shelby. Senator Akaka, do you have any concerns 
since your constituents are from Hawaii and they would have a 4 
p.m. closing?
    Senator Akaka. Mr. Chairman, you have put your finger on 
one of the concerns. I am glad to hear from the industry that 
they are aware of this problem and they are working to address 
it.
    Chairman Shelby. Okay. Senator Fitzgerald, let us start 
with you. What about the proposed independent chairman? If you 
are going to mandate that you have 75 percent of the directors 
be independent--I am just posing the question--why should you 
say that the chairman has to be independent, too, when the 
other directors elect the chairman? In other words, you have 
got three-fourths of the boards members that will be 
independent. They could elect a chairman or not elect one. Why 
should we do that? This question has been asked.
    Senator Fitzgerald. The mutual fund industry just has a 
bizarre setup because if you and I are shareholders in a mutual 
fund, let us say ABC mutual fund, we are the owners of the 
fund. But the way it is set up in America is an outside firm, 
which is the principal supplier or adviser to the fund, winds 
up dominating the fund.
    So the ABC adviser firm, which is owned by somebody else, 
the officers of which owe a duty of loyalty and fidelity to ABC 
adviser firm, they wind up controlling ABC mutual fund that is 
really owned by you and me. And they also owe a duty of loyalty 
and fidelity to us. But sometimes the interests of--when they 
are trying to serve two masters, the interests diverge with the 
scandals----
    Chairman Shelby. Do all mutual funds do it the same way?
    Senator Fitzgerald. All except Vanguard. Vanguard is the 
only one that is set up where the fund shareholders actually 
own the----
    Chairman Shelby. They do it all inside.
    Senator Fitzgerald. --Vanguard Group, and they did 
explicitly to eliminate the conflicts and, interestingly, they 
are by far the lowest-cost mutual fund in America because they 
competitively bid out the management services and they get much 
lower costs.
    With the scandals you saw breaking, you saw directors 
engaging in behavior that harmed the fund shareholders but 
benefited the management companies that they also work for. I 
believe we have to recognize that the mutual fund and the 
outside adviser are two separate ships, and you need somebody 
looking out on the fund shareholder side.
    You know, in politics, when somebody tells us they are 
neutral and we have a hard time deciding whose side they are 
on? Pretty good bet if you do not know whose side they are on, 
they are not on your side. I think when I look at the mutual 
funds, I see a lot of instances in which the boards have been 
engaging in behavior that suggests they are not fully on the 
fund shareholder side.
    Chairman Shelby. Senator Collins, how would you define the 
fiduciary relationship that the management of the mutual fund 
owes to the shareholders?
    Senator Collins. Well, I think that is one of the problems. 
I think we need an explicit statement in the law that the 
management of the mutual fund owes the fiduciary duty to the 
shareholders of the fund. And that is not clear right now.
    But there was another point that I just wanted to touch on 
if you will allow me, and that is, in addition to the issue of 
how many independent directors and whether the chairman should 
or should not be required to be independent, we have found that 
directors tend to serve on many, many different fund boards 
within a family of funds.
    Chairman Shelby. I have heard 80. Somebody served on 80.
    I do not know how much time they spend on that board.
    Senator Collins. That is my issue. What we have found were 
several cases where the director was serving on over 100 
boards. And I wonder if the real question here is not whether 
or not the person is an independent director, but whether you 
can serve on 113 mutual fund boards and really devote the 
attention and oversight that you need.
    I realize that a lot of these funds are very similar and 
they may be in the same family. But, nevertheless, I do not 
know how anyone could be an aggressive board member fulfilling 
that oversight responsibility if you are stretched that thin.
    Chairman Shelby. I do not know about you Senators, but I am 
on enough committees and subcommittees, and if you do due 
diligence to any of them, you are still strained, aren't you?
    Senator Collins. Absolutely.
    Chairman Shelby. Senator Levin, what about the fiduciary 
duty? Shouldn't it be of the highest order?
    Senator Levin. I think so, and it should be defined and 
clear so there is no ambiguity about it to whom you owe your 
loyalty. And I think the clearer, frankly, the better. When you 
come to fiduciary duty, there should not be ambiguity as to 
where you owe your allegiance.
    Chairman Shelby. Senator Akaka, do you agree with that?
    Senator Akaka. Yes. Mr. Chairman, I ask to be excused at 
this point in time.
    Chairman Shelby. Certainly, and thank you.
    Senator Fitzgerald. You know, that is one of the areas the 
SEC cannot do. Only Congress can amend that. Right now the Act 
recites a fiduciary duty, but there is no content to it and no 
case has ever found a breach of fiduciary duty.
    Chairman Shelby. I think one of the purposes of all these 
hearings is, one, to get to the bottom of the scandals, what 
caused it, how you can avoid it in the future; what is the role 
of the SEC, their proper role, according to statute what they 
can do and what they cannot do; what do we need to do, if 
anything. And we start with these hearings.
    I appreciate your appearance and your leadership on these 
issues. We look forward to your participating in some kind of 
solution to this. Thank you very much.
    Senator Fitzgerald. Thank you, Mr. Chairman.
    Senator Collins. Thank you, Mr. Chairman.
    Senator Fitzgerald. And may I have leave to introduce my 
full statement as well as----
    Chairman Shelby. Without objection, all of your statements 
will be made part of the record.
    Senator Fitzgerald. --a letter from John Bogle endorsing 
our bill.
    Chairman Shelby. Absolutely.
    Chairman Shelby. Our second panel, if you will come up 
while the other one is making an exit.
    We welcome all of you on the second panel to the Committee. 
Your written testimony will be made part of the hearing record 
in its entirety. We hope you will sum up your remarks because 
we do have a few questions.

                STATEMENT OF PAUL G. HAAGA, JR.

                    EXECUTIVE VICE PRESIDENT

            CAPITAL RESEARCH AND MANAGEMENT COMPANY

             CHAIRMAN, INVESTMENT COMPANY INSTITUTE

    Mr. Haaga. Thank you very much. Good afternoon, Chairman 
Shelby, Members of the Committee staff. My name is Paul Haaga, 
Executive Vice President and Chairman of the Executive 
Committee of Capital Research and Management Company. Capital 
Research is the investment adviser to The American Funds Group, 
the third largest U.S. mutual fund group, with more than $500 
billion in assets under management. I also serve as Chairman of 
the Board of Governors of the Investment Company Institute, and 
I appear here today on behalf of the Institute and its members.
    Chairman Shelby. That is the trade association of mutual 
funds.
    Mr. Haaga. It is the association of mutual funds, yes. This 
afternoon, I will discuss how the industry and regulators have 
been responding over the past several months to the unfortunate 
and very disappointing revelations of abusive trading practices 
in the mutual fund industry. But I want to begin by recognizing 
the key role that this Committee and Chairman Shelby, in 
particular, have played in responding to the problems that have 
occurred.
    It is very important for the Committee to engage, as it has 
been doing, in a thorough and deliberate process of gathering 
information from all interested parties to help determine what 
actions may be needed to ensure that the interests of fund 
shareholders are served. I thank you, most sincerely, for your 
efforts and especially for giving me an opportunity to 
participate in today's hearing.
    Having worked with mutual funds for over 30 years, 
beginning as an attorney on the SEC staff, I am outraged and 
personally offended that some mutual fund officials and others 
appear to have temporarily ignored the guiding principle by 
which we all must live: Our fund shareholders always come 
first. I look forward to a time in the future when the wounds 
have healed and we can look back on these events from a broader 
perspective and once again speak proudly of mutual funds' 
record of integrity. I have several thoughts on what we need to 
do to reach that point.
    First, Government officials must continue investigating and 
taking forceful actions against wrongdoers.
    Second, regulatory reform is necessary to address late 
trading, abusive short-term trading, and selective disclosure 
of portfolio holdings.
    Third, as painful as this process has been, it has also 
presented all of us with a golden opportunity to make 
improvements that go beyond the specific problems that have 
been revealed, but that will further reinforce protection and 
enhance the confidence of fund investors. The institute, the 
SEC, and the Congress have seized upon this opportunity, and I 
look forward in the questions to elaborating on some of those 
efforts.
    Finally, as we take advantage of the opportunity to improve 
what is already a strong regulatory system, we must reject 
changes that, while well-informed and well-intentioned, would 
have harmful consequences. It would be most unfortunate if the 
late trading and market timing problems were used as a 
predicate for making changes that are not cost-effective and 
fostering the interests of fund shareholders. These problems 
are serious, and they must be readdressed. But we should not 
lose sight of the fact that mutual funds still offer the best 
and least expensive way for millions of Americans to invest in 
the securities markets and reach important financial goals.
    To serve investors' best interests, reforms should preserve 
the industry's defining characteristics rather than making 
changes that would render the industry less entrepreneurial, 
less competitive, less creative, and less responsive to 
investors' changing needs.
    On behalf of the Investment Company Institute and the 
entire mutual fund industry, I pledge our continued commitment 
to take necessary steps to make sure that fund shareholders are 
fully protected.
    I thank you again for the opportunity to testify and I 
would be happy to respond to any questions.
    Let me ask the Chairman, if I can take one more minute.
    Chairman Shelby. Go ahead.
    Mr. Haaga. I would like to respond to something in the 
charts. You hear a lot of numbers thrown out about expenses and 
fees in the funds and have they gone up and have they gone 
down. And I want to give one word of advice to everybody, is 
just be careful of simple unweighted averages. They can be 
misleading.
    Let me use a simple example. Let us say that our funds are 
the only ones in the industry, American funds are the entire 
industry. Among our largest funds, our average fees are 65 
basis points, so that is also the industry average. Now, if my 
friend, Tom Putnam, starts up the FAM Group of--Fenimore Group 
of that mutual funds, his average fees on his large funds are 
1.25 percent. If you are looking at average fees in the 
industry, they have now jumped to 0.95 percent, nearly a 50 
percent increase. That is a lot of what has been happening in 
the 1990's. Average fees have gone up because small new fund 
groups have started and they tend to be of the more expensive 
types of funds to manage, international funds, growth funds, et 
cetera. Nobody raised their fees. Our fees stayed at 65. His 
fees are 1\1/4\, and yet the industry average just jumped 50 
percent. Be careful if you read that.
    I might also point out that the 1.5-percent number is a 
simple unweighted average. If you look at the weighted average, 
which is actually what is happening to shareholders, that is 
about 1 percent. Total costs, that is all in, the costs of 
buying shares and owning them, have declined by about 40 
percent since 1980. You need to look at the total cost, not 
just the fund expenses.
    Finally, I would point out that 77 percent of shareholders 
own funds with lower than average cost. That tells us that 
shareholders are not paying the average costs. I think it also 
tells us that they understand very well what the costs are and 
they are voting with their feet for the less expensive funds.
    Thank you very much for letting me add that.
    Chairman Shelby. Thank you very much, Mr. Haaga.
    Mr. Helck.

                    STATEMENT OF CHET HELCK

            PRESIDENT, RAYMOND JAMES FINANCIAL, INC.

    Mr. Helck. Thank you, Chairman Shelby.
    I am Chet Helck, President and Chief Operating Officer of 
Raymond James Financial and a member of the board of directors 
of the Securities Industry Association. I am honored to be here 
today and present our views on this important subject.
    I have three points I would like to make to you today, and 
these points are set out in greater length in my written 
submission, but I think I can summarize them as follows.
    First, mutual funds have been and should continue to be the 
basic investment vehicle for most Americans and partly small 
investors. Second, many investors need financial advice from 
trained professionals to make mutual funds an effective part of 
their financial plans. The present mutual fund compensation 
structure makes that possible. Third, the mutual fund 
distribution system works for the benefit of investors. We 
support improved disclosure, but we do not believe that the 
current distribution system is fundamentally flawed. Let me 
make each of these points in turn.
    First, mutual funds allow investors, and particularly small 
investors, to obtain professional management of their 
investment dollars. Investors can diversify a relatively small 
investment which is essential for both growth and safety. Half 
the households in America trust mutual funds with their hard-
earned dollars and for good reason. Mutual funds have helped 
turn Americans from a country of savers to a country of 
investors. Mutual funds help investors pay to support their 
standard of living, educate their children, and provide for 
their retirement.
    Second, more than ever, investors need sound investment 
advice. I represent some 5,000 financial advisers at Raymond 
James, and thousands of others around the country whose firms 
are members of the Securities Industry Association. We are 
proud of the work we do and the services we provide to our 
customers. Most Americans know that they must save during their 
working days and invest wisely for their retirement years. Many 
investors want assistance when making their financial choices. 
To be sure, there are those investors who believe they can do 
it themselves, select the proper mix of fixed income and equity 
investments, adjust those portfolios on a regular basis and 
select from the enormous panoply of financial products to meet 
their needs. But for most of us that is a daunting task and not 
one that can be safely done in our spare time. This Committee 
is addressing issues that go directly to the compensations 
structure that supports the financial advisers who help their 
clients.
    Broker/dealers receive compensation from the funds for 
evaluating thousands of mutual fund choices, for educating its 
financial advisers, providing costs associated with 
comprehensive investor reporting, and for advisory services 
provided to clients such as financial planning, portfolio 
review, and performance reporting for the investors. The 
compensation streams from fund complexes to broker/dealers 
support these services that investors want and need.
    At Raymond James, we sell over 11,000 mutual fund share 
classes. That includes load and no-load funds. To support those 
sales efforts and provide investor reports to clients, provide 
them with comprehensive tax information, and combined critical 
information on one consolidated statement, it costs us roughly 
$30 million a year. In addition we spend well over $7 million a 
year to educate our financial advisers. We do that to help our 
advisers make sound recommendation to their customers.
    My third and final point is that we agree that we must 
improve the investing public's awareness of the compensation 
systems and how they affect the costs of mutual fund ownership. 
The current system for distributing mutual funds benefits 
investors, there is certainly room for improvement, but that 
improvement should be undertaken from a perspective that 
recognizes that mutual funds have been a significant component 
in making financial security for generations of Americans 
possible.
    We have all read about abuses in the mutual fund and 
securities fund industries. We agree that abusers should be 
rooted out and punished. We condemn abuses of fiduciary duties 
and urge where appropriate, swift, and sure penalties for the 
wrongdoers. We should make improvements to restore public 
confidence in this critical vehicle, but if this Committee or 
the regulatory community leaves American investors with the 
impression that they cannot trust mutual funds and should 
regard the product and all those who distribute it with 
hostility, that will ill serve the very investors you are 
dedicated to protecting.
    At Raymond James, we have always believed in good 
disclosure, and that is a fundamental part of our client 
service philosophy. There needs to be improvement overall in 
disclosure of these different ways of compensating broker/
dealers. The SEC has proposed a disclosure format for 
confirmations of point of sale disclosure that addresses many 
of these issues. We and others in the industry will be 
commenting on these proposals in an effort to make them useful 
and meaningful to investors. While we agree that disclosure 
should be improved, we believe it should be disclosure that is 
meaningful, concise, and understandable, and above all, 
relevant to investor needs.
    We think the SEC does have the authority it needs to 
provide for that disclosure, and we in the industry propose to 
help them do it. We want to join in making the system better, 
and we do not want to make the mistake of thinking we have to 
create a new one in its place.
    Thank you for inviting me to testify.
    Chairman Shelby. Thank you.
    Mr. Putnam.

                 STATEMENT OF THOMAS O. PUTNAM

                      FOUNDER AND CHAIRMAN

           FENIMORE ASSET MANAGEMENT, INC. /FAM FUNDS

    Mr. Putnam. Chairman Shelby, Members of the Committee, it 
is an honor to appear before you today. My name is Tom Putnam, 
and I am Founder and Chairman of Fenimore Asset Management, a 
small investment advisory firm with 30 employees in rural 
upstate New York.
    We manage investment portfolios for about 400 individuals 
and institutions and we offer two mutual funds. I serve as co-
portfolio manager for each of the FAM Funds, which have 
combined assets of about $700 million and approximately 25,000 
shareholders. In addition to my varied duties at the firm, I 
also serve as Chair of the Small Funds Committee of the 
Investment Company Institute.
    First let me express my deep disappointment about the 
events that have brought us here today. Investors' trust in the 
entire mutual fund industry has been shaken, and rightfully so, 
by the current revelations of wrongdoing. In an industry based 
on fiduciary principles, there is simply no place for this kind 
of behavior.
    I am pleased that the SEC and State officials have moved 
very quickly to investigate and punish those responsible. I 
also applaud the SEC's swift action in developing regulatory 
reforms aimed not only at remedying immediate problems such as 
late trading, but also addressing potential conflicts of 
interest, strengthening fund governance, and enhancing 
standardized fund disclosures. These are sweeping reforms that 
will benefit investors for years to come.
    This Committee also has played a critical role by 
thoroughly examining the recent scandals and thoughtfully 
considering what steps are necessary in response. I hope that 
my perspective, as a founder of a small mutual fund group, will 
assist you in this important effort.
    Specifically, I would like to share with you my thoughts 
about the impact of regulatory changes on small fund groups. My 
written statement explores this issue more fully and also 
provides my views on some of the specific reform proposals that 
have been advanced. I hope my testimony today clearly conveys 
my strong support for the tough reforms undertaken by the SEC 
to date.
    Let me also say this: If other proposals are shown to 
clearly benefit long-term mutual fund investors, I am very 
likely to support them, and my firm would find a way to bear 
the associated costs. At the same time, however, I have serious 
concerns about the enormous number of changes proposed for our 
industry.
    Former Senator William Armstrong testified before this 
Committee and said he counted 106 pending reforms. My fear is 
that some of the proposals might be approved in the name of 
reform without any real basis of whether they are likely to 
achieve benefits for shareholders that begin to justify their 
costs. For small fund groups, with our smaller asset bases and 
thinner profit margins, the cost could be prohibitive.
    Small mutual funds can be easy to overlook, in part, 
because we do not have the immediate name recognition that many 
of our larger fund groups enjoy. In fact, if you look at the 
number of fund groups in the industry, small groups constitute 
a substantial majority. Of the approximately 500 fund groups in 
the United States, more than 370 of them have assets under $5 
billion or less. By comparison, a large fund group may have 
hundreds of billions of dollars under management.
    Small fund groups like FAM Funds provide a greater choice 
for investors and help foster competition. Small mutual funds 
typically find a niche and stick with it, achieving success by 
staying within their circle of competency, rather than trying 
to be all things to all investors. In addition, a small mutual 
fund group typically can provide its shareholders a level of 
individual service and attention, such as providing access to 
fund portfolio managers that simply is beyond the reach of a 
large fund group with millions of shareholders.
    Finally, it is important to note that many of the most 
innovative fund products and services, such as money market 
funds, were introduced by entrepreneurs new to the industry. As 
this Committee considers whether additional steps are necessary 
to respond to the recent scandals, I respectfully request that 
you bear in mind the law of unintended consequences.
    No proponent of mutual fund reforms wants to damage the 
long-term competitiveness and creativity of this industry which 
is so vitally important to millions of lower and middle-income 
investors. Yet, if the scales are tipped so that the regulatory 
restrictions and costs of managing mutual funds outweigh the 
possible rewards, there could be a brain drain. At the very 
least, the brightest portfolio managers might be drawn away 
from the mutual fund industry to more creative and lucrative 
forms of money management.
    New firms simply might not enter our industry at all, 
choosing instead to limit their investment offerings to less-
regulated products. The creativity to provide new investment 
funds that would be advantageous to lower- and middle-income 
investors might be stifled, if not lost. If one proposal 
creates a barrier to entry for a mutual fund entrepreneur, that 
would be tragic.
    I hope these observations about the potential threat of 
overregulation are taken by the Committee in the spirit in 
which I offer them--as constructive commentary based on my 30 
years of serving individual investors and my strong belief that 
a vibrant, competitive mutual fund industry serves our Nation's 
interests.
    Please allow me to share with you one final observation. It 
is clear to me that the problems that have been found in the 
mutual fund industry cannot be fixed solely by changing rules 
and regulations. Rather, the industry itself, fund group-by-
fund group, must renew its commitment to act in accordance with 
the highest standards of ethics, morality, and integrity. This 
has always been an integral part of our philosophy at Fenimore, 
and I firmly believe that these values have served our 
shareholders well.
    I thank you for the opportunity to participate today.
    Chairman Shelby. Thank you for your statement.
    Mr. Siedle.

                STATEMENT OF EDWARD A.H. SIEDLE

         PRESIDENT, BENCHMARK FINANCIAL SERVICES, INC.

    Mr. Siedle. Chairman Shelby, Ranking Member Sarbanes, 
Members of the Committee, thank you for the opportunity to 
appear before you today to discuss the crisis of confidence in 
the mutual fund industry.
    I am the Founder and President of Benchmark Financial 
Services, Inc., a firm that investigates money management 
abuses primarily on behalf of public pension funds. The matters 
we examine typically involve esoteric breaches of fiduciary 
duty by brokers, money managers--many of whom manage mutual 
funds--and pension consultants.
    I have worked in financial services for over 20 years. I 
originally started as an attorney with the Division of 
Investment Management of the SEC in 1983. Subsequently, I 
served as Associate Counsel and Director of Compliance of the 
Putnam Companies.
    From 1990 through 1997, I owned a soft-dollar brokerage 
firm, so I have a great deal of familiarity with the soft-
dollar industry.
    Years ago, unfortunately, I was referred to in an article 
as the ``Sam Spade of money management,'' and I am sorry to say 
the name has stuck with me. I have also been called ``the 
Nation's most vocal critic of money management abuses.'' Over 
the past 10 years, I have written about, and spoken about, 
illegal and unethical activity in the mutual fund industry. In 
the course of the investigations my firm has undertaken, I have 
collaborated with the FBI, law enforcement, and the SEC to 
actively pursue those involved in wrongdoing involving the 
mutual fund industry and the money management industry, in 
general. It is a real pleasure, after so many years in the 
industry, to witness the dawn of an era of heightened public 
scrutiny of mutual fund practices.
    The harm to investors related to the mutual fund industry's 
betray of the public trust is tremendous. How big is the price 
tag? It is clear to me that over the years a significant 
portion of mutual fund investment advisory fees that investors 
have paid is excessive.
    Our firm, in 2003, conducted a survey of 100 pension funds 
and the investment advisory fees they actually pay. The 
findings from our survey indicated that the pricing of 
institutional investment advisory services is somewhat 
irrational; that is, even institutions sometimes pay excessive 
money management fees. We found that some pensions are actually 
paying as much as four times the fees as others for the exact 
same services. Our conclusion was that pensions need to be more 
informed regarding fees, negotiate more vigorously and 
carefully draft ``Most Favored Nation's'' provisions for 
inclusion in their contracts with managers. These clauses are 
designed to assure that the funds receive the lowest fees that 
the money managers have to offer.
    As bad as the news is about the pension investment advisory 
fees, it is my perception that for mutual fund investors, it is 
far worse. We have actually seen mutual funds that pay up to 10 
times the advisory fees that pensions pay for the same services 
from the same managers. There are no good reasons for mutual 
funds to pay these excessive fees.
    I have concluded that mutual funds pay excessive management 
fees simply because the fund's boards of directors fail to 
fulfill their fiduciary duties and do not vigorously negotiate 
fees with managers. And it is the Nation's mutual fund 
investors who are paying the price.
    I recommend that the fiduciary duty of mutual fund trustees 
be strengthened. And in discharging their duties, I believe 
that fund trustees should negotiate ``Most Favored Nation's'' 
clauses in their contracts with every fund manager.
    Chairman Shelby. What do you mean by ``Most Favored 
Nation'' clauses?
    Mr. Siedle. Most Favored Nation clause is where you, the 
money manager, represent to the client you are giving him your 
best rate for an account that size. It is your best price. 
Eliot Spitzer has also endorsed this proposal and called for it 
recently in a Forbes article.
    Members of the fund's boards of directors who are 
affiliated with fund managers face conflicts of interest that 
may make them resist vigorous negotiations with fund managers. 
These conflicts would be eliminated by requiring a 
supermajority of independent directors on fund boards and an 
independent fund chairman.
    The mutual fund managers will resist such negotiations to 
reduce fees. Excessive investment advisory fees enable fund 
managers to comfortably enter into revenue-sharing arrangements 
with brokers. Revenue sharing results in tremendous amounts of 
money being paid to brokers that agree to push the funds.
    Mutual fund brokerage commission rates related to portfolio 
trading are also in excess of what they should be and are 
intentionally kept high by managers who want to use the excess 
to compensate brokers for selling fund shares.
    Another practice that I wanted to discuss was that of using 
soft dollars to purchase goods and services. I believe that 
Congress should repeal the safe harbor for soft dollars. 
However, if soft dollars continue to be allowed, the amount of 
soft dollars should be disclosed and included in computing 
management fees, since soft-dollar amounts are, in reality, 
another form of manager compensation. Many pensions actually do 
this. They will add into a money manager's fee the cost of soft 
dollars.
    As a result of using client commissions for marketing and 
research, fund investors are essentially giving huge amounts of 
money in commissions for the business expenses and interests of 
the mutual fund money managers.
    Fund directors should ensure that the client funds are used 
to benefit the investors. I believe it is inappropriate to use 
fund assets to pay the ICI, the industry lobby group, because I 
have not seen that it has historically advocated in the best 
interest of mutual fund investors and, thus, investors do not 
benefit from the ICI receiving their money. I bring to your 
attention an article from Forbes, dated September 15, 2003, 
entitled, ``Your Money at Work Against You,'' in which Neil 
Weinberg and Emily Lambert have stated similar views. In short, 
the ICI ``uses the money to oppose virtually every proinvestor 
initiative to come out of the SEC or Congress.''
    Mutual fund investors are treated as second-class citizens 
by many money managers. Mutual fund investors are typically far 
less fee- and performance-sensitive than institutional 
accounts, and are less profitable to money managers than hedge 
funds.
    In the mutual fund industry, ``assets under management'' 
has unfortunately come to mean ``assets used by management.'' 
So, in the face of the ethical shortcomings that have surfaced, 
there is a stronger need for Congress to protect mutual fund 
investors.
    The serious problems that I have mentioned have been 
longstanding. While some believe that the transgressions 
surfacing at this time were desperate measures adopted by the 
mutual fund industry as assets under management plummeted 
around 2000, I can assure you, from personal experience, that 
improper and unethical activity has been pervasive for over 20 
years.
    The effect that the problems with mutual funds have had on 
the Nation's retirement savers is tragic. The entire investment 
return attributable to an individual's retirement account over 
a lifetime may be eaten away by excessive fees and other 
malfeasance.
    I believe that skimming by the mutual fund industry is a 
significant factor in explaining why the Nation's retirement 
savers will enter into retirement with lesser assets than they 
envisioned.
    While we cannot eliminate the potential for poor investment 
decisionmaking, we must seek to ensure that investors have 
clear disclosure of the information necessary to make good 
investment decisions and, most importantly, are treated fairly. 
When the industry fails to do this itself, we must have 
statutes and regulations that promote this.
    We want mutual fund investors to succeed. And we want as 
many of these investors to succeed as possible. Every success 
strengthens our society, and every time an investor is robbed 
of his hard-earned savings, our society suffers. It is time to 
put an end to self-dealing by the mutual fund industry and 
provide mutual fund investors with the protections they always 
thought they had.
    Thank you very much.
    Chairman Shelby. Thank you, sir.
    Mr. Treanor.

                   STATEMENT OF MARK TREANOR

             GENERAL COUNSEL, WACHOVIA CORPORATION

         ON BEHALF OF THE FINANCIAL SERVICES ROUNDTABLE

    Mr. Treanor. Thank you, Mr. Chairman.
    Mr. Chairman, I am Mark Treanor of Wachovia Corporation. I 
am the general counsel there. Wachovia is one of the largest 
providers of financial services to retail, brokerage, and 
corporate customers in the country. We serve 12 million 
households and businesses primarily in the 11 East Coast States 
and here in Washington. Our full-service brokerage, Wachovia 
Securities, serves 
clients in 49 States, and Evergreen Investments is our asset 
management business, serving more than 4 million investors with 
a broad range of financial products.
    I am a member of The Financial Services Roundtable, and I 
am very pleased to be here to testify on the Roundtable's 
behalf today.
    The Roundtable would like to start off by commending you, 
Chairman Shelby, and this Committee for the thorough and 
deliberate examination of mutual fund issues which has been 
conducted to date. The Securities and Exchange Commission is 
also conducting a comprehensive review of mutual fund 
regulation. Not only is the SEC moving aggressively to consider 
proposals to prevent recurrences of such things as abusive 
late-trading and market timing, but the Agency has also 
proposed or already adopted rules across virtually the entire 
spectrum of mutual fund operations. The Roundtable believes the 
regulatory process should be allowed to work to a conclusion 
before legislative changes are enacted.
    The comment periods for many of the proposals are still 
open, and the Roundtable expects to file comments with the SEC 
and has not yet taken final positions on many of these SEC 
proposals, and the Roundtable would be very pleased, of course, 
to provide the Chairman and the Committee with copies of those 
comment letters when they are filed.
    I would like to take a few minutes on behalf of the 
Roundtable. I have submitted a more detailed statement, but to 
comment on some of the issues and the SEC positions on some of 
these as well.
    I will start off by pointing out, as has been noted a 
little bit earlier, that some investors, have the time, 
sophistication, and inclination to investigate and evaluate 
mutual fund options on their own. Other investors prefer to 
have an intermediary help them identify their investment goals 
and the funds that may be appropriate to help them meet those 
goals. In fact, 88 percent of mutual fund shares are purchased 
through intermediaries.
    In addition to distributing mutual funds, intermediaries 
may have an important role to play in servicing customers' 
accounts on an ongoing basis. Many investors prefer the 
convenience of receiving a single statement that presents all 
of their investments, including their investments in various 
mutual fund families, rather than receiving multiple statements 
from different financial institutions. Intermediaries may also 
help investors understand those statements and the performance 
returns of all of their mutual fund investments.
    It is proper to compensate intermediaries for those 
services. They are done for the benefit of the investors who 
choose to avail themselves of them. Historically, that 
compensation has taken the form of an up-front charge paid by 
the investor, known as a front-end sales load. Today, 
compensation can take various forms, including 12b-1 fees, 
which are deducted from fund assets to pay for distribution. 
The SEC has the authority to regulate a fund's distribution of 
securities, including how the 12b-1 fees are used. Rule 12b-1 
permits funds to adopt written plans for using fund assets to 
pay for distribution and it, in essence, allows investors to 
pay for distribution and related costs over time, rather than 
all at once up front.
    Some fund advisers may also make payments to intermediaries 
for distribution, sometimes known as revenue-sharing payments. 
It is important to note that these payments are made from the 
assets of the adviser, as opposed to the assets of the fund. 
Futhermore, a broker-dealer's registered representatives always 
remains subject to rules that require that the funds they 
recommend to investors be suitable for those investors.
    Payments by fund advisers to their affiliates may also 
compensate broker-dealers for performing routine shareholder 
servicing. These functions can include processing transactions, 
maintaining accounts, mailing prospectuses and the like. 
Payment of those administrative services have helped investors 
have the convenience of accessing multiple fund families in a 
single place and receiving a single statement covering their 
mutual fund investments.
    The term ``directed brokerage'' refers to the use of fund 
brokerage commissions to facilitate the distribution of fund 
shares. The NASD regulates this. The rule allows a fund to 
consider sales of shares and the selection of brokers to 
execute portfolio transactions for the fund subject to best 
execution and provided the policy is disclosed.
    The SEC expects that fund boards will consider the 
potential conflict of interest inherent in using fund assets to 
pay for distribution. The SEC has proposed alternative 
amendments to the rule to prohibit mutual funds from directing 
brokerage transactions to compensate a broker-dealer for 
promoting fund shares or, alternatively, seeking comment on 
requiring greater disclosure.
    There are a number of other items like that that the SEC is 
looking at. For example, requiring brokers to provide customers 
with information about distribution-related costs at the time 
of the purchase of shares. Brokers would have to estimate and 
disclose total annual dollar amounts of asset-based sales 
charges, including 12b-1 fees. Additionally, the SEC is seeking 
comment on whether to prohibit funds from deducting certain 
distribution-related costs, including some 12b-1 fees from fund 
assets and, instead, deducting them directly from shareholder 
accounts.
    All of this causes the Roundtable, on each of these issues, 
to believe that disclosure is a very crucial tool to ensure 
that funds serve their shareholders and that shareholders can 
evaluate fund performance effectively. The Roundtable supports 
improvements to make certain that fund disclosures are 
periodic, timely, robust, efficient, uniform, and easy to 
administer.
    As I said, the Roundtable is studying the SEC's proposals 
carefully and will comment on them. In general, the Roundtable 
feels that improvement to disclosure is a better response to 
these issues than is a prohibition of specific business 
practices. We believe the SEC is moving aggressively in its 
rulemaking and commend them for doing so, and we commend this 
Committee for its thorough examination of these issues and look 
forward to working with the Agency and the Committee so that 
investors can continue to have confidence in mutual funds as an 
important investment vehicle.
    Thank you, Mr. Chairman.
    Chairman Shelby. Would you all agree with a premise that 
financial integrity in the mutual fund or any financial 
integrity should not put a burden on anyone? In other words, if 
you had integrity in your system, it should not put a burden on 
you if you have the basic integrity in the fund.
    Do you want to comment on that, sir?
    Mr. Siedle. Yes, I would absolutely agree with that; the 
people who should be entrusted with the Nation's savings to 
manage should be people who have integrity in their blood.
    Chairman Shelby. Especially mutual funds.
    Mr. Siedle. Yes, this is the common man's savings vehicle 
really.
    Chairman Shelby. Trust. Trust.
    Mr. Siedle. Trust is critical.
    Chairman Shelby. Do any of you have problems with that?
    Mr. Haaga. Not at all. We have spent the last several 
months trying to restore trust.
    Chairman Shelby. But it should not have a price. Without 
financial integrity, you are going to destroy the industry, are 
you not?
    Mr. Helck. Absolutely.
    Chairman Shelby. Is that right, Mr. Treanor?
    Mr. Treanor. Yes, sir, I agree. I was going to say I do not 
believe that one can either regulate or legislate integrity.
    Chairman Shelby. You cannot legislate morality. You cannot 
do that, absolutely right. But you can regulate and put rules 
and laws out there that if you do violate it, you pay a price, 
could you not?
    Mr. Treanor. That is correct, Mr. Chairman.
    Chairman Shelby. And that does not keep people from doing 
it. That is like having a statute against murder, but people 
are going to murder some people. We hate that, but there are. 
And we also have a statute against robbery, but people are 
going to break the statutes--that does not keep us from doing 
it, I mean, to legislate in the field, does it?
    Let me ask you all a question because I do not know. I will 
start with you, Mr. Treanor. Let us say I had several accounts 
at Wachovia, mutual funds--whatever you sell. What would I get 
at the end of the month or quarterly or whatever you send out? 
Would I get a statement showing, let us say I invested 
$100,000--that is a lot of money. I do not know where I would 
get it--but $100,000. Would I get a statement back showing what 
that $100,000 has done a year later? In other words, the value 
of the portfolio now as opposed to what and the costs 
associated with this? Do you see what I am getting at?
    Mr. Treanor. You get a monthly and an annual statement.
    Chairman Shelby. Would I be able to understand it?
    Mr. Treanor. I think that you will.
    Chairman Shelby. I do not know.
    Mr. Treanor. I think if you go back to actually purchasing 
the funds, also, Mr. Chairman, that you will find that the 
broker or the intermediary from whom you purchased those funds 
explains at the front end what is going to go into----
    Chairman Shelby. Is this explained--we had a hearing the 
other day on unambiguous language that the average person is 
not used to--the 100 million Americans or 95 million Americans, 
could they understand, if they spent 10, 15 minutes on it, what 
their $100,000 did or did not do and the costs associated with 
it? We are talking about disclosure. Everybody is advocating 
disclosure, and I like disclosure too. Would they be able to 
understand what you are disclosing, I guess is the question.
    Mr. Treanor. That is certainly the goal of adequate 
disclosure all along in the process and starting at the front 
end of that.
    Mr. Haaga. Mr. Chairman, the $100,000, actually, they do 
not have to wait a whole year. They can get it every day.
    Chairman Shelby. See, I did not know.
    Mr. Haaga. Just go up on the website, and it is there every 
day, and it is what the $100,000 worth now because all of our 
results are given net of all fees.
    Chairman Shelby. Let us say it went up because the market 
went up and so forth, and let us say it went up from $100,000 
to $122,000--22 percent. Now, in addition to that, would it 
show what it cost when that person sent $100,000 to you; in 
other words, what are the costs to maintain it, to invest it 
and all of this?
    Mr. Haaga. Any up-front charges----
    Chairman Shelby. Do you understand what I am getting at?
    Mr. Haaga. Yes, sir.
    Chairman Shelby. See, I do not.
    Mr. Haaga. Any up-front charges are deducted from the 
amount they send us, so they would get a confirmation saying it 
is $98,000 or whatever the number was.
    They would also get a prospectus, and on the front cover 
page, in clear language, in a single percentage number, they 
would see the annual effect of all fees, so they would know 
what was deducted from the outcome.
    And, of course, any statement they get is going to be net 
of the fees, so they know what the fees are, but what they see 
is their actual account value throughout the life of the 
investment.
    Chairman Shelby. Mr. Helck.
    Mr. Helck. In addition to showing what you put in and any 
deductions that came out for front-end sales charges, so 
therefore the net amount your account was worth, the statement 
may also tell you what it was worth last month, at the end of 
last year, and give you a rate of return on how you are doing 
in your investment. And maybe, depending on the account 
services that you enlist in your account, how that might 
compare to other comparable indexes.
    Chairman Shelby. Explain this to me about brokerage fees. 
If I were a broker, I would expect to be paid for my services, 
otherwise I would not do them. The market does work, let us be 
honest with you. Why would I sell mutual funds if I were not 
going to get paid for it? I would not. No one would.
    Mr. Helck. Absolutely not.
    Chairman Shelby. Are those fees disclosed? And if they are 
not disclosed, why are they not disclosed?
    Mr. Helck. The fees are disclosed.
    Chairman Shelby. I know, but we have been hearing for 
sometime that they need more disclosure on brokerage fees.
    Mr. Helck. The fees that are disclosed are the sales 
charges that paid the person who is selling you the funds, and 
they have several different models that they can offer you, and 
they are obligated, by regulation, to explain those choices to 
you, to include also a fee-based account which may not have any 
commissions at all, but have an advisory fee.
    Chairman Shelby. Well, I certainly do not believe we should 
legislate or regulate what fees are, that the market should set 
fees, but it seems to me that it would behoove the mutual fund 
industry that you had an informed purchaser or shareholder, 
that it would be in your long-term interest, especially if you 
were a well-managed fund. If you were not, you might not want 
to disclose anything. You might want to get out of town.
    Mr. Helck. And to a good point. If you do not disclose it, 
your competition clearly will disclose to your client what you 
paid or should have paid or could have paid, and if they feel 
like you have abused their trust, then they are very quick to 
move to another source of their services.
    Chairman Shelby. This morning--a lot of you heard or aware 
of the hearing this morning--we held a hearing that examined 
soft-dollar practices. The witnesses, among other things, 
discussed the merits of various reform alternatives. We will 
start with you, Mr. Haaga. Would you comment specifically on 
should Congress repeal Section 28(e)? And if not, why not? And 
should the SEC require firms to unbundle commissions? And what 
should be done to revise the definition of ``research'' as a 
broad term?
    Mr. Haaga. We strongly recommended the SEC tighten the 
definition of ``research'' so it includes only intellectual 
content and does not include the Bloomberg machines that 
Senator Fitzgerald described. So we are clearly in line with 
his recommendation on that.
    We have also suggested that third-party research, where 
there was actually a portion of the commission that is paid to 
someone else, and therefore it is identifiable, and it is clear 
that these products are commercially obtainable for a cash 
price, that those be eliminated from the 28(e).
    Chairman Shelby. Personally, if I was investing in a mutual 
fund, and if you were well managing and you made my fund grow, 
I would not mind paying a little research or whatever it was. 
That is just common sense.
    Mr. Haaga. I think the question is not whether they should 
pay it, it is how they should pay it, and we think the advisory 
fees----
    Chairman Shelby. And how it should be disclosed----
    Mr. Haaga. Exactly, sir.
    Chairman Shelby. --with a definition.
    Mr. Haaga. We think the advisory pays for that.
    As far as repealing 28(e), you would have to take an 
initial step, and it is one that the United Kingdom regulator 
is struggling with now, and that is, in order to repeal the 
safe harbor for proprietary research--that is the research that 
is given to you by----
    Chairman Shelby. Can the Commission deal with it without 
statutory----
    Mr. Haaga. The SEC can do the things we have recommended 
without statutory approval.
    Chairman Shelby. If they have the will.
    Mr. Haaga. Correct.
    Chairman Shelby. For many years, you have worked at this. 
So you know.
    Mr. Haaga. Yes. The SEC can do everything that we have 
recommended that they do, tightening the definition and 
eliminating third party on their own.
    Chairman Shelby. We are going to find out what they are 
going to do.
    Mr. Putnam. Mr. Chairman, could I add, also----
    Chairman Shelby. Yes, sir.
    Mr. Putnam. --from a small fund's perspective, the total 
elimination of 28(e) would be very harmful I think to many 
small funds who do not have access to----
    Chairman Shelby. Yes, that was made this morning.
    Mr. Putnam. --to research, to intellectual property, and 
they depend on soft dollars to access intellectual property, 
and I think that is appropriate because that is in the best 
interests of long-term shareholders.
    Chairman Shelby. Would it bring about unfair competition, 
in a sense?
    Mr. Putnam. Pardon me?
    Chairman Shelby. Would it bring unfair competition for the 
big versus the small in the mutual funds?
    Mr. Putnam. Well, that is one of the ways actually to bring 
more competition and enable smaller funds to participate in 
that arena.
    Mr. Helck. No matter how large the organization, nobody has 
the resources to cover every company as thoroughly as they need 
to be covered. So having outside research resources is in all 
of our interests, and the more competition there is, the better 
it serves our industry.
    Chairman Shelby. Yes, sir. Go ahead.
    Mr. Siedle. The remarkable thing about money managers is 
when you ask them do they do their own research or do they rely 
on the information of others, uniformly, money managers say 
they do their own research.
    The Nelson's Guide to money managers asked managers to 
indicate how much they rely on Street research and how much do 
they use their own research. We asked Nelson's to do an 
analysis to indicate how much managers claim to do their own 
research.
    Managers claim to do 80 percent of their own research. A 
good money manager does his own research and does not rely 
heavily on research done by others, and that is one of the 
selling points of their services.
    Mr. Haaga. Can I respond to that?
    Chairman Shelby. Yes, sir. Go ahead.
    Mr. Haaga. We do our own research at Capital. We are famous 
for it. We have several hundred research analysts all over the 
globe, but we also read the Street research to see what other 
people are saying. So he is positing it as an either/or. It is 
not an either/or. We look at every resource possible.
    Mr. Putnam. Mr. Chairman, could I also add to that?
    Chairman Shelby. Yes, sir, go ahead, and then I am going to 
call on Mr. Treanor.
    Mr. Putnam. We are an internal research house. And while I 
talked to the issue of soft dollars, we do not use any soft 
dollars.
    There are several small-fund groups that are very good 
groups who do their own internal research. One of the small-
fund groups was before this Committee February 26--Mellody 
Hobson, from Ariel Group, and they do a great job too. We know 
several of those groups that do internal research. But I do 
think soft dollars provide some flexibility for smaller fund 
groups who do not have access to the full range of research 
that we perhaps look at.
    Chairman Shelby. Mr. Treanor, go ahead.
    Mr. Treanor. Mr. Chairman, what I was going to say is just 
three brief points.
    First, I think this discussion points out that, in many 
respects, one size does not fit all. There is a great deal of 
variety in the industry.
    Second, there has been an SEC study that looked at the use 
of soft dollars over the last several years, and it concluded 
that there were very few instances of abuse of soft dollars, 
that they were actually well-used to help investors themselves.
    Third, I think that the Chairman hit the nail on the head 
with the idea that this is again a disclosure issue, when you 
do not have something that is uniform across the industry, and 
it will be something that will differentiate funds.
    Chairman Shelby. Mr. Haaga, many people contend that your 
proposal to eliminate soft-dollar payments for third-party 
research provides a regulatory advantage for full-service 
brokerage firms. Why did you not also propose to ban the use of 
soft dollars for proprietary research that is produced by full-
service broker-dealers?
    Mr. Haaga. Let me say, if there were proprietary research 
that had a cash price on it, then it would follow logically 
that it should be banned as well because that should be paid 
for by the adviser.
    The challenge here is that there really is, if you look at 
28(e), it defines the term ``brokerage and research services.'' 
It does not separate out the two. And in the United Kingdom, 
they have been working for the past several years trying to 
unscramble that egg and say when brokerage ends and research 
begins, and they are having a terrible time of it.
    I think if you wanted to do that, if you wanted to 
eliminate proprietary research, you would have to first define 
where the brokerage ends and the research begins, and then make 
them unbundle it and pay for it, and that is the challenge. 
That may be a later step, but we certainly did not want to hold 
up the very good step and the very straightforward and easy 
step of eliminating the third-party research payments. Of 
course, the important part of that is also the directed 
brokerage for sales.
    Chairman Shelby. I am going to direct this question to Mr. 
Treanor and Mr. Helck.
    How would a requirement that broker-dealers must unbundle 
commissions and assign specific values for research and 
execution impact commission cost? Would commissions decrease? 
Would it impact the availability of independent research?
    Do you want to try that, anybody? Do you want me to ask 
that again?
    Mr. Helck. I think that I understand the thrust of your 
question.
    Chairman Shelby. You understand the question.
    Mr. Helck. I believe that it would result in less research 
being available.
    Chairman Shelby. Why?
    Mr. Helck. Because it would seek to allocate artificially 
the costs or the value of research and execution.
    Chairman Shelby. Why do you use the term ``artificially'' 
here?
    Mr. Helck. As I thought Mr. Haaga said so artfully, it is 
unscrambling an egg, and nobody knows how to do it. And so you 
have to make an arbitrary decision and make some assignments. 
The problem with that is that execution is so nonuniform. 
Different trades, different liquidity, different days of the 
week, and different requirements of the portfolio put different 
values on the trade. And so if we artificially say x percent 
goes to this and that, it is not real. Therefore, in some cases 
it will be over, in some cases undervalued, and I am not sure 
that improves anything unless we figure out a way to do it that 
is just and appropriate.
    Chairman Shelby. It is not exactly in the math, is it, not 
totally?
    Mr. Helck. If it results in firms saying, I cannot be in 
this business because I cannot execute appropriately, and 
therefore they withdraw coverage on companies, therefore there 
is less coverage and less research available, that would be bad 
for investors.
    Chairman Shelby. Mr. Treanor.
    Mr. Treanor. I think the only thing that I would add to 
that is, again, this is one of the issues I think that the 
Roundtable is taking a look at across the industry because it 
would have a different impact on different firms and the way 
that they would be able to handle that going forward.
    Chairman Shelby. You all are very familiar with what has 
been going on in the Banking Committee, and you are probably 
familiar with Bob Posen's testimony here. He proposed a method 
for providing investors individualized cost disclosure in their 
quarterly statements. Mr. Posen indicated that an individualize 
estimate could be done without great cost or administrative 
burdens to the funds.
    Would each of you address his comment on the utility of 
providing investors an individual cost figure. Also, should 
investors receive both an individual cost figure and an expense 
number that they can use to compare funds? In other words, they 
are in the marketplace.
    Mr. Haaga, do you want to start.
    Mr. Haaga. Yes, I think the important word in Mr. Posen's 
phrase was ``estimate.'' It is an estimated phrase, and of 
course since they can do their own estimate when we give them 
the percentage, when we give them the amount per thousand 
dollars, they just multiply by the thousand they have, so they 
can come up with that estimate.
    I think that the most relevant aspect of expenses is how 
they look comparatively. There is no relevance to them unless 
you can compare them to what you would use for another fund.
    Chairman Shelby. But if they have something to compare 
with, they could compare, could they not?
    Mr. Haaga. That is why we support the SEC's proposal versus 
the GAO proposal, which would give a standardized fee 
disclosure. And I think one disclosure is enough. Adding 
something else that says, and here is what the math would be if 
you applied it to your own fund, I do not think is necessary. I 
think it is better to stick with the one number--this is the 
per thousand--because that is the one they can compare.
    Chairman Shelby. Mr. Helck.
    Mr. Helck. Keeping in mind that your condition on that 
question was that it was cost-effective, we, as I said earlier, 
have over 11,000 CUSIP's, that means different mutual fund 
classes, that we propose. It is hard enough, we need only 
consult the break-point issue to see how complex it is for 
broker-dealers to be informed by the funds of all of the 
various discount criteria for administering that program, which 
is overwhelming, and those are relatively stable. Once stated 
in the prospectus, they tend to stay the same for a long period 
of time, but these expense numbers change daily, quarterly, 
annually.
    And so it is a process of having to have good sources of 
information on a flowing, dynamic basis that can recalculate 
against every fund, and every shareholder, and every account 
value and get recalculated, and how you can do that in a cost-
effective way eludes any of us who have given it consideration, 
which is why we say let us come up with something that is cost-
effective, that will not unduly burden the cost of the funds 
and the shareholders and does represent to them what their 
experience would be on a reflective basis.
    Chairman Shelby. Mr. Putnam.
    Mr. Putnam. I might anecdotally add we have our own 
shareholder services firm and also transfer agency, and I 
talked to the person that heads that up and said, ``Could we be 
able to do this?''
    And he looked at me and he said, ``Well, you know, I do not 
know how we are going to be able to do it at this point. I do 
not know of any software that is available to do that, 
especially for small funds.'' And the 60-cent-per-statement 
cost I heard earlier was shocking to me.
    But, at any rate, I think fee disclosure is important when 
it is in the best long-term interests of shareholders. And the 
only way that I think that is possible is to make it in a form 
that they could compare it to other funds. And I think the 
expense ratio does this pretty adequately. I mean, if you think 
about gasoline, when you compare gasoline, you do not compare 
the total costs that you are putting in your tank. You compare 
the price per gallon. And I think expense ratios do that.
    But I also would like to add that I think the emphasis on 
looking at fees only as being part of the solution to how 
investors think about buying a fund is one that only looks at a 
very small minority piece of that decision.
    If I may, for just a minute, I would like to just read this 
from my--this happens to be our shareholder letter that is 
going out with our statements at the end of March.
    Chairman Shelby. Yes, sir. Take your time.
    Mr. Putnam. This is a paragraph from that shareholder 
letter that I wrote:

    We agree with several new proposals designed to ensure that 
shareholders fully understand the expenses of mutual fund 
ownership. In fact, we are taking an extra step to prepare an 
owner's manual, which we hope will help our shareholders 
understand all fees and expenses associated with an investment 
in FAM Funds.
    However, we believe that a shareholder's decision to invest 
in a mutual fund should not be based solely on numbers, whether 
they are related to expenses or performance, but also on a 
system of shared beliefs about investing. The alignment of fund 
managers and shareholders should be forged in terms of shared 
interests, similar beliefs in terms of investment objectives, 
risk tolerance, and service levels.
    While performance and expenses can be quantified, the 
inclusion of these other components combine both the art and 
science of investing and create an understanding that goes 
beyond mere numbers.

    So I think there is more to the discussion as to what is in 
the best interests of long-term shareholders than just looking 
at fees as being part of the equation.
    Chairman Shelby. Putting in information that they can 
understand as to cost, long-term and short-term interest to 
them.
    Mr. Putnam. That is correct.
    Chairman Shelby. Mr. Siedle.
    Mr. Siedle. I do not think most investors have a system of 
shared beliefs about investing. I do not know if you do. I do 
not know that I do. Most investors, their belief about 
investing is that they are going to put their money away 
somewhere and hope that it grows, and that is about it. And the 
fact is that one of the most objective criteria an investor can 
look at is cost and fees. And as we heard earlier, the lowest 
cost funds, in fact, generally outperform the higher cost 
funds.
    So fee information is terribly important, and the only 
other information investors typically rely on is past 
performance, and we all know how fallible that is. So, I think 
enhancing fee information is critical and giving information 
about the cost of index funds versus actively managed funds is 
also critical.
    One last point I want to make is I have owned brokerage 
firms for 14 years, and I can tell you to a penny what it costs 
to execute a trade. I do not know what this difficulty in 
calculating it is. In fact, firms like mine that clear through 
Merrill Lynch, we are given a statement on every trade of what 
the cost of execution is. It is 15 percent of the commission. 
The rest is fluff. It is commission. It goes in my pocket.
    Chairman Shelby. Mr. Treanor.
    Mr. Treanor. I think the key on that issue is that 
disclosure of the fees to investors is extremely important and 
that it needs to be done in a fashion which will allow them to 
compare fund-to-fund so that they can make the appropriate 
investment decisions, and that is probably done in the best 
fashion by using the SEC proposal on that instead of the 
individualized account that otherwise would be proposed.
    Chairman Shelby. Should funds be required to deliver to 
investors a summary prospectus with material cost and expense 
information at or before the time of their purchase?
    Mr. Haaga. Well, summary prospectus. We supported very much 
the Arthur Levitt effort back in the late 1980's, early 1990's, 
to develop the summary prospectus.
    We also support the proposal to have point-of-sale 
disclosure of fees. The actual proposal now is not a full 
summary prospectus, but it is a statement of fees, and we think 
that both those proposals are a good idea.
    Chairman Shelby. Do you have any comments, Mr. Helck?
    Mr. Helck. We are all in favor of full disclosure. It is 
the method of how we do it that we want to talk about it.
    Chairman Shelby. But the method is important, is it not, 
the method of disclosure?
    Mr. Siedle. I think a summary prospectus would be a fine 
idea.
    Chairman Shelby. The SEC is considering, as you all know, a 
rule change that would clarify the use of 12b-1 fees by stating 
that the fees can only be used for advertising and distribution 
payments and must be deducted directly from the shareholder's 
account rather than fund assets.
    What is your view on the use of 12b-1 fees and the merits 
of the SEC's potential proposal?
    We will start over here on the left.
    Mr. Haaga. I think it would be a mistake to repeal 12b-1, 
which is I think the proposal as you summarized it, and to 
require that all ongoing payments be made by the shareholder.
    I would go back to 1988, when we adopted our 12b-1 plans, 
and we decided that 25 basis points--we, American Funds--was 
the right amount of ongoing service fees to pay brokers, and 
set that, and that has been the rate, and it has never changed 
since.
    And I have a hard time believing that if we quit dictating 
it--we, the provider of the fund or manager of the funds--quit 
dictating what that 12b-1 fee is going to be and turn it over 
to the brokers, I cannot imagine it is going to go down. I 
would suggest that it may even go up.
    In addition, we have an incentive to keep the fees low and 
that is that all of our investment results are reported net of 
that fee. If the fee is shifted over to the shareholder, we 
will report investment results that are not net of that fee, 
and we will have less of an incentive to keep it low. So, I 
think we should keep the fee in the fund in the form of the 
12b-1.
    Chairman Shelby. Should funds be permitted to charge 12b-1 
fees after a fund has already closed?
    Mr. Haaga. Well, I deal with a lot of people who are 
retired. We have a lot of friends who are retired, and they are 
never going to buy another fund share in their life. Their goal 
now is not to outlive their savings. And every time the market 
moves, and every quarter, whether it does not, they go visit 
their broker, and they talk to them about how much money they 
can take out, get them to do the recalculations, talk about, 
assure them that they are not going to outlive their money.
    If one of their funds that they are invested in stops 
selling fund shares, they do not stop owning them. They still 
go visit their broker, and somebody needs to pay that broker. 
So the idea that for some reason the service fees should be 
stopped on all of those retirees that are going and seeing 
their brokers just perplexes me. It is the wrong view of what a 
12b-1 fee is for.
    Chairman Shelby. Does anybody have any different--yes, sir, 
Mr. Siedle.
    Mr. Siedle. But there are a lot of other fees that mutual 
fund companies pay brokers to keep clients in their funds--
their commissions, directed commissions, which are substantial, 
their revenue-sharing arrangements. And so 12b-1 fees are not 
the sole source of compensation to brokers.
    Chairman Shelby. How about after the fund is closed?
    Mr. Siedle. After the funds close, it still trades. 
Commissions are being directed to brokers out there.
    Mr. Haaga. We propose to eliminate directed brokerage 
commissions.
    Mr. Siedle. I think that would be an excellent idea.
    Mr. Helck. The assumption of that proposal is that the 
basic value provided by the financial adviser is the 
transaction when they buy it. And what we are trying to point 
out is it is the ongoing service, advice, due diligence, and 
counsel that is provided that is being compensated for, and it 
is appropriate that it should be.
    Chairman Shelby. Getting into a little different area now. 
I appreciate your patience. These are important questions for 
the record here we think.
    The Committee is considering reforms that would help ensure 
that funds are subject to competitive market forces. We all 
agree with that. People make choices in the market.
    In light of this objective--and I hope it is yours--would 
each of you discuss Section 22(d) of the Investment Company Act 
in this regard, which essentially requires funds to fix sales 
load in the prospectus. In other words, why should sales loads 
be fixed in the prospectus rather than allowing funds and 
broker-dealers to compete with one another on price?
    Mr. Siedle. Section 22(d) I think is, in order to establish 
fairness----
    Chairman Shelby. That is right.
    Mr. Siedle. --that brokers are not cutting deals with 
everybody under the sun, and therefore you will never know that 
you are paying the same price as someone else. I think the 
statutory provision makes sense, and I think it should stay.
    Mr. Helck. Actually, that has served well, if you look back 
over the history of funds. But there is an emerging alternative 
to that, that the marketplace has created in fee-based 
accounts, where essentially there is no sales charge added to 
the fund share price, but a fee is paid directly by the client 
for advisory services, and that choice exists as well. So the 
marketplace can choose how it wants to be served.
    Chairman Shelby. And what is generally that advisory fee?
    Mr. Helck. That is negotiated based on the level of service 
that is expected from the client.
    Chairman Shelby. It depends on the quality of the advice, I 
would hope.
    Mr. Helck. Exactly right, and the amount of service that 
the client expects.
    Chairman Shelby. In a recent press report in The Washington 
Post, it was said that some fund managers ``have engaged in the 
practice of window dressing, a practice through which funds 
seek to improve their portfolios by selling more speculative 
investments and buying more conservative ones right before they 
disclose their holdings to investors twice a year.''
    Is window dressing another widespread industry practice 
that investors do not know about? What other practices are out 
there that we should know about as we near the conclusion here?
    Mr. Haaga. I am certainly not aware of any window dressing 
practices, widespread or otherwise. It would be pretty easy for 
the SEC to finally go in and do an inspection and say, ``Give 
me all of your trades for the last 3 days of the period.''
    I also would point out that the investment results do not 
stop at the end of every quarter. We have to disclose those 
over 1-, 5-, and 10-year periods, and you cannot----
    Chairman Shelby. Most people in mutual funds are in it for 
the long haul.
    Mr. Haaga. Right. You can dress up your portfolio, but you 
cannot dress up your results. I wonder what the incentives are, 
but----
    Chairman Shelby. If you are playing games with your fund, 
you are playing games on yourself, too, are you not?
    Mr. Helck. And the cost of doing those transactions comes 
out of your results, so it is counterproductive unless it does 
you some good.
    Chairman Shelby. Mr. Putnam, do you have any comment on 
window dressing?
    Mr. Putnam. No, I agree with everything that was just said.
    Chairman Shelby. Mr. Siedle.
    Mr. Siedle. I think there are a lot of abuses that have 
still not surfaced that will surface in time. Front-running by 
portfolio managers----
    Chairman Shelby. Tell us what you mean by ``front-
running.''
    Mr. Siedle. Front-running is, if I am running a portfolio, 
and I know I am going to buy a million shares of Dell stock 
today or tomorrow, I will buy it for myself today, knowing that 
when I buy it tomorrow, it will go up in price, and I will have 
made an immediate profit.
    Front-running is something I have investigated, and it does 
happen at mutual fund companies.
    Chairman Shelby. Does it happen everywhere there is a lot 
of money being traded?
    Mr. Siedle. As long as there are human beings involved, 
yes. As long as there is temptation, there is always going to 
be somebody who succumbs to it. There are other practices like 
parking. Funds that have affiliated investment banking arms 
will park client stock in the mutual fund portfolios. Another 
thing is what is called pump-priming, which is where you start 
a fund out with like $100,000 and trade a bunch of stock and 
show a great performance record, and then you advertise it, and 
then of course it goes down immediately as money starts rolling 
in.
    Mr. Haaga. Each of the things that Mr. Siedle just 
described is illegal. So do not worry that we need any more 
rules.
    Mr. Siedle. No, we need enforcement.
    Chairman Shelby. Enforcement. If it is illegal, we do need 
enforcement.
    Mr. Treanor, you have a comment?
    Mr. Treanor. That is exactly the point I was going to make 
is that I do not know that any of those are major problems in 
the industry, and they are all covered by laws and regulations 
today.
    Chairman Shelby. But you are not suggesting there is not 
trouble in the industry or has not been.
    Mr. Treanor. No, I am not suggesting that at all. There 
certainly has been. I do believe firmly, though, Senator, that 
the overwhelming majority of people in the industry get up 
every morning and try to do the right thing.
    Chairman Shelby. I do not doubt that.
    I appreciate the panel being here today. It is going to be 
interesting when we have the SEC at our final hearing. I know 
you will be watching that. We will probably have a big 
attendance that day.
    Thank you very much.
    The hearing is adjourned.
    [Whereupon, at 4:32 p.m., the hearing was adjourned.]
    [Prepared statements and additional material supplied for 
the record follow:]

               PREPARED STATEMENT OF PETER G. FITZGERALD
               A U.S. Senator from the State of Illinois
                             March 31, 2004

    Good afternoon, Chairman Shelby, Ranking Member Sarbanes, and 
Members of this distinguished Committee. Thank you for including me as 
a witness today during your hearing on mutual fund fees. I would like 
to commend you and the Banking Committee for the series of in-depth 
hearings you are holding on the mutual fund industry.
    Today, I would like to discuss S. 2059, the Mutual Fund Reform Act 
of 2004, that I introduced on February 10, 2004. I was pleased to be 
joined in introducing this legislation by my distinguished colleagues 
on the Committee on Governmental Affairs, Senator Carl Levin and 
Senator Susan Collins, the Committee's Chairman, from whom you also 
will hear today. I am grateful for the extensive and important input 
both Senators provided in the drafting of this bill, and appreciate the 
invaluable perspective Senator Collins provided based on her first-hand 
experience as Maine's Commissioner of Professional and Financial 
Regulation.
    Since we introduced MFRA, we have been joined by a solidly, 
bipartisan group of Senators who are cosponsors. We welcome the support 
of Senators Lugar, Voinovoich, Hollings, Lautenberg, Durbin, and 
Kennedy.
    The Mutual Fund Reform Act, referred to as MFRA, would make fund 
governance truly accountable, require genuinely transparent total fund 
costs, enhance comprehension and comparison of fund fees, confront 
trading abuses, create a culture of compliance, eliminate hidden 
transactions that mislead investors and drive up costs, and save 
billions of dollars for the 91 million Americans who invest in mutual 
funds. Above all, MFRA strives to preserve the attraction of mutual 
funds as a flexible and investor-friendly vehicle for long-term, 
diversified investment.
    I would like to take this opportunity to recognize the work of a 
number of our colleagues in this area. Last year, I was pleased to 
cosponsor S. 1822, introduced by Senator Daniel Akaka, the Ranking 
Member of the Senate Governmental Affairs Subcommittee on Financial 
Management, the Budget, and International Security, which I chair, to 
address mutual fund trading abuses. Senators Corzine, Dodd, and Kerry 
also have sponsored mutual fund bills from which I drew, as well as 
legislation introduced by Congressman Richard Baker last summer and 
overwhelmingly passed by the House of Representatives at the end of the 
last session.
    Mr. Chairman, MFRA reflects extensive testimony that was presented 
during oversight hearings of the Financial Management Subcommittee that 
I chaired on November 3, 2003 and January 27, 2004. 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 posed a much more serious threat to American investors. Witnesses 
at our hearing in January testified regarding the propriety and the 
adequacy of the disclosure of mutual fund fees, specifically hidden 
costs such as revenue sharing, directed brokerage, soft-money 
arrangements, and hidden loads such as 12b-1 fees. The Subcommittee 
also heard from two whistleblowers who were responsible for the initial 
revelations regarding Putnam Investments and Canary Capital Partners, 
LLC.
    MFRA also reflects the constructive input from a number of key 
organizations and leaders of mutual fund reform. I especially 
appreciate the extensive contributions of John Bogle, the Founder and 
former CEO of the Vanguard Group, who has been a champion of reforms in 
the mutual fund industry for many years. In his letter of endorsement 
of February 6, 2004, Mr. Bogle indicated that he viewed MFRA ``as the 
gold standard in putting mutual fund shareholders back in the driver's 
seat.''
    In addition to Mr. Bogle, the following individuals and 
organizations have endorsed MFRA: Massachusetts Secretary of State 
William Galvin, the Coalition of Mutual Fund Investors, Fund Democracy, 
Consumer Federation of America, U.S. Public Interest Group, Consumer 
Action, Consumers Union, and the Government Accountability Project.
    I ask consent from the Committee that letters of endorsement from 
these leading individuals and organizations be made a part of the 
record following my statement.
    As Members of this Committee know well, in 1980 only a small 
percentage of Americans invested in mutual funds and the assets of the 
industry were only $115 billion. Today, roughly 91 million Americans 
own shares in mutual funds and the assets of all the funds combined are 
now more than $7 trillion. Mutual funds have grown in popularity in 
part because Congress has sanctioned or expanded a variety of tax-
sheltered savings vehicles such as 401(k)'s, Keoghs, traditional IRA's, 
Roth IRA's, Rollover IRA's, and college savings plans. Given that 
mutual funds are now the repository of such a large share of so many 
Americans' savings, few issues we confront are as important as 
protecting the money invested in mutual funds.
Overview of the Mutual Fund Reform Act of 2004
     The Mutual Fund Reform Act of 2004 puts the interests of investors 
first by:

 Ensuring independent and empowered boards of directors;
 Clarifying and making specific fund directors' foremost 
    fiduciary duty to shareholders;
 Strengthening the fund advisers' fiduciary duty regarding 
    negotiating fees and providing fund information; and
 Instituting Sarbanes-Oxley-style provisions for independent 
    accounting and auditing, codes of ethics, chief compliance 
    officers, compliance certifications, and whistleblower protections.

     The Mutual Fund Reform Act of 2004 empowers both investors and 
free markets with clear, comprehensible fund transaction information 
by:

 Standardizing the computation and disclosure of (i) fund 
    expenses and (ii) transaction costs, which yield a total investment 
    cost ratio, and tell investors actual dollar costs;
 Providing disclosure and definitions of all types of costs and 
    requiring that the SEC approve imposition of any new types of 
    costs;
 Disclosing portfolio managers' compensation and stake in the 
    fund;
 Disclosing broker compensation at the point of sale;
 Disclosing and explaining portfolio turnover ratios to 
    investors; and
 Disclosing proxy voting policies and records.

     The Mutual Fund Reform Act of 2004 vastly simplifies the 
disclosure regime by:

 Eliminating asset-based distribution fees (Rule 12b-1 fees), 
    the original purpose of which has been lost and the current use of 
    which is confusing and misleading--and amending the Investment 
    Company Act of 1940 to permit the use of the 
    adviser's fee for distribution expenses, which locates the 
    incentive to keep distribution expenses reasonable exactly where it 
    belongs--with the fund adviser;
 Prohibiting shadow transactions--such as revenue sharing, 
    directed brokerage, and soft-dollar arrangements--that are riddled 
    with conflicts of interest, serve no reasonable business purpose, 
    and drive up costs;
 ``Unbundling'' commissions, such that research and other 
    services, heretofore covered by hidden soft-dollar arrangements, 
    will be the subject of separate negotiation and a freer and fairer 
    market;
 Requiring enforceable market timing policies and mandatory 
    redemption fees--as well as provision by omnibus account 
    intermediaries of basic customer information to funds to enable the 
    funds to enforce their market timing, redemption fee, and 
    breakpoint discount policies; and
 Requiring fair value pricing and strengthening late trading 
    rules.

    The Mutual Fund Reform Act also would perpetuate the dialogue and 
preserve the wisdom gathered from hard experience. MFRA directs the SEC 
and the General Accounting Office to conduct several studies, including 
a study of ways to minimize conflicts of interest and incentivize 
internal management of mutual funds; a study on coordination of 
enforcement efforts between SEC headquarters, SEC regional offices, and 
State regulatory and law enforcement entities; and a study to enhance 
the role of the Internet in educating investors and providing timely 
information about laws, regulations, enforcement proceedings, and 
individual funds, possibly by mandating disclosures on websites.
The Essential Role for Congress in Putting America's Investors First
    Mr. Chairman, some people now inquire whether this institution has 
any role to play in cleaning up an industry that controls so much of 
America's savings. I believe it would be a serious mistake if we fail 
to enact meaningful reform legislation. This is an historic opportunity 
to do right by 91 million Americans who trusted too well.
    I certainly commend the many recent regulatory initiatives from the 
Securities and Exchange Commission. They are collectively a step in the 
right direction and a demonstration of our seriousness in Washington 
about putting the interests of America's mutual investors first. But 
the SEC does not have the statutory authority to take all of the needed 
steps to restore integrity and health to the mutual fund industry. The 
current scandals demand that Congress take a comprehensive look at an 
industry still governed by a 64-year-old law.
    For example, the SEC cannot tighten the definition of what 
constitutes an ``independent director.'' The definition of 
``interested''--in contrast to ``independent''--appears in the 1940 
Act, and the SEC is normally not empowered to make law around acts of 
Congress. (I say ``normally'' because the SEC has in fact done 
precisely that in several areas, through its so-called ``exemptive 
rules,'' which I will discuss in a moment.)
    As we aim to empower a truly independent board of directors to act 
as the ``watchdogs'' for investor interests that they were intended to 
be, it is critical we tighten the statutory definition of what 
constitutes ``independence.'' The SEC itself has made this point 
persuasively in testimony before the House Financial Services 
Subcommittee on Capital Markets, Insurance, and Government Sponsored 
Enterprises. Mr. Paul Roye, Director of Investment Management at the 
SEC, testified before that Subcommittee on June 18, 2003 about H.R. 
2420, the bill that ultimately overwhelmingly passed the House, as 
follows:

        Finally, Section 4 of the bill would amend Section 2(a)(19) of 
        the Investment Company Act to give the Commission rulemaking 
        authority to deem certain persons to be interested persons as a 
        result of certain material business or close familial 
        relationships. We strongly support this amendment, which would 
        permit us to close ``gaps'' in the Investment Company Act that 
        have permitted persons to serve as independent directors who do 
        not appear to be sufficiently independent of fund management. 
        For example, currently a fund manager's uncle is permitted to 
        serve on the fund's board as an independent director. In other 
        cases, former executives of fund management companies have 
        served as independent directors. Best practices guidelines of 
        the Advisory Group provided that former fund management 
        executives should not serve as independent directors because 
        their prior service may affect their independence, both in fact 
        and in appearance.

    I could not have said it better than the SEC itself has testified 
about the need for Congress to step up to the plate--even if the SEC 
remains absolutely committed to doing what it can to clean up the 
industry.
    Mr. Chairman, I will give you a few more examples of what the SEC 
cannot do. Of the various nefarious transactions that have become 
commonplace in the industry, few match soft-dollar arrangements for 
sheer anticompetitive and anti-investor brazenness. With soft-dollar 
arrangements, investment advisers essentially get to finance their 
office overhead with investors' money--and that is on top of the 
substantial adviser's fee they collect, also from investors' money. 
Investment advisers cause investors to pay an artificially inflated 
commission on every transaction in the fund's portfolio--and investment 
advisers thereby obtain ``soft-dollar credits,'' which they can use for 
research, computer terminals, and other office overhead. In Section 
28(e) of the Securities Exchange Act, Congress permits soft-dollar 
arrangements. MFRA prohibits soft-dollar arrangements--and only 
Congress can do that. Through rulemaking, the SEC can interpret the 
``safe harbor'' in Section 28(e) narrowly or broadly--and it has done 
both--but it cannot eliminate the safe harbor. It is time for Congress 
to correct the error of that safe harbor.
    As for the SEC view, I am pleased to quote again from Mr. Roye's 
testimony on June 18, 2003:

        Our current regulatory regime primarily relies on disclosure by 
        advisers of their soft-dollar policies and practices. The staff 
        responses submitted last week suggested that disclosure alone 
        might not be adequate and suggested the need for Congressional 
        reconsideration of Section 28(e).

    Congress should act to eliminate this indefensible and 
anticompetitive confiscation of shareholder money.
    Further, Congress must act to strengthen and clarify what it truly 
means to be a fiduciary in the mutual fund industry. A ``fiduciary 
duty'' is supposed to entail much more than mere honesty and good 
faith, but it has too often meant much less. The Investment Company Act 
of 1940 refers to the fiduciary duty of both fund directors and fund 
advisers--but in both cases, the duty has been relatively empty and 
virtually unenforced. Indeed, the investment adviser's fiduciary duty 
with respect to fees is so weak--as interpreted by Federal courts--that 
I am advised that not a 
single plaintiff has ever prevailed in an excessive fees case. MFRA 
amends the Investment Company Act to strengthen these twin fiduciary 
duties of directors and advisers to make abundantly clear that the 
interests of investors are always paramount. In the case of advisers, 
MFRA makes clear that their fiduciary duty extends not only to fair 
fees, but to providing all material information to directors in the 
directors' exercise of their fiduciary duties--a statutory and 
regulatory lapse that has made it very difficult for good-faith 
directors to wrangle essential information out of advisers.
    A level playing field is critical to the proper resolution of 
market forces. Arm's-length negotiations over fees are supposed to be 
the key market dynamic that keeps State and Federal regulators out of 
the board rooms. But both directors and advisers need a clearer and 
more specific statement of their fiduciary duties, and MFRA provides 
it.
    For a final example, MFRA shifts the fund distribution dynamic from 
its current anti-investor and anticompetitive posture to a fairer and 
more rational market-based dynamic--a change that only Congress can 
make. MFRA directs the SEC to repeal its Rule 12b-1--but simultaneously 
makes it clear that distribution expenses may be incurred by fund 
advisers, and thereby (1) gets funds out of the distribution business; 
and (2) imposes the incentive to keep distribution expenses reasonable 
exactly where it belongs--with the investment adviser.
     The SEC cannot amend the 1940 Act to prohibit asset-based fees for 
distribution of fund shares. The SEC cannot amend the 1940 Act to make 
it clear that distribution expenses may be incurred out of the 
management fee paid to investment advisers. These fundamental changes 
embodied in MFRA would rationalize a system that has become a mockery 
of the 1940 Act's preamble declaration that the interests of investors 
are always paramount. Consider carefully what happens as a consequence 
of the SEC's Rule 12b-1. While funds themselves have some incentive to 
``grow'' (primarily, for example, to ensure sufficient liquidity to 
meet redemptions), the overwhelmingly more powerful incentive to swell 
net assets is with the fund adviser, whose fee is a percentage of those 
assets. The current incentive and fee structure is accordingly 
troublesome: Individual investors typically gain nothing from growth, 
except in the very unusual circumstance of sustained net redemptions, 
in which portfolio holdings must be sold disadvantageously to meet 
redemptions. Yet, the industry forces these very investors to pay for 
promotion and growth. And it gets worse. Investors pay for promotion 
and growth that do not directly benefit them (and may often actually 
hurt them if the fund grows so large as to make strategic portfolio 
transactions unwieldy or impossible)--and they pay a fixed percentage 
for the ``privilege'' of doing so, regardless of fund size (that is, 
Rule 12b-1--in conspicuous contrast to its founding theoretical 
framework--has been almost entirely impervious to economies of scale).
    Free market principles would typically discipline excessive 
distribution costs as a direct bite out of profits--but fund advisers 
are (1) collecting their substantial fees as a percentage of fund 
assets; and (b) financing the sustained swelling of those same assets 
with investors' money. Put another way, the King compels the cook to 
buy the food that fattens the King. Does the King worry about his food 
budget? Unlikely. MFRA rearranges this incentive structure--without 
dictating any specific diet. Fund advisers will now bear distribution 
expenses--and if, as appears virtually self-evident, some of these 
expenses are excessive, we can be certain that fund advisers, spending 
their own money, will discover the cost discipline that has been 
elusive to date.
     Only Congress can rationalize the fund distribution system that 
its own Act of 64 years ago created--and that the SEC complicated with 
its well-intended but injuriously perpetuated Rule 12b-1.
    Finally, Mr. Chairman, I would like to say a word about the SEC's 
so-called ``exemptive rules.'' I am struck, given our system of 
separation of powers, that the SEC has managed, for example, to require 
a majority of independent directors on mutual fund boards, when 
Congress said quite clearly in the 1940 Act that only 40 percent of the 
directors need be independent. You won't learn about that kind of power 
in any basic civics textbook, because it seems to run directly counter 
to what the framers established. I happen to believe the SEC is right 
on the merits about independent directors--but I am concerned that 
Congress appears to have abdicated its essential legislative power to 
an unelected agency of the executive branch.
    The SEC accomplishes this legislative function through ``exemptive 
rules''--rules that essentially create carrots for funds, and then 
oblige the funds to abide by certain additional rules of they wish to 
take advantage of the carrots. Perhaps the best known example of an 
exemptive rule is Rule 12b-1--which allows funds to pay for 
distribution expenses if they comply with certain fund governance 
rules. \1\ Apart from the separation of powers concerns triggered by 
reliance on such exemptive rules, I believe the system has spiraled 
into unacceptable complexity. Congress should make the essential policy 
determinations that have driven the SEC's exemptive rules. And Congress 
should make those policy directives independently binding--not 
dependent upon use of an agency-conferred benefit. It is one obvious 
weakness of reliance on exemptive rules that funds may--though it is 
rare for obvious reasons--opt out of the agency-conferred benefit, and 
thus decline to be bound by the requirements in the exemptive rules.
---------------------------------------------------------------------------
    \1\ Other examples include Rule 10f-3 (permitting the purchase of 
securities in a primary offering where a fund affiliate is a member of 
the underwriting syndicate); Rule 15a-4 (permitting the approval of 
interim advisory contracts without shareholder approval); Rule 17a-7 
(permitting securities transactions between a fund and certain 
affiliated persons of the fund); Rule 17a-8 (permitting mergers of 
certain affiliated funds); Rule 17d-1(d)(7) (permitting funds to 
purchase joint liability insurance policies with affiliates); Rule 17e-
1 (addressing when funds may pay commissions to affiliated brokers); 
Rule 17g-1(j) (permitting joint insured bonds); Rule 18f-3 (permitting 
funds to issue multiple classes of shares); and Rule 23c-3 (permitting 
closed-end funds to repurchase shares periodically from investors and 
thereby operate as interval funds).
---------------------------------------------------------------------------
    These are a few of my concerns with abdication of our Congressional 
role to the SEC. There are more. I believe, however, the foregoing 
examples well illustrate the essential role of Congress in giving the 
mutual fund industry back to its owners--the 91 million American 
investors who will rely on mutual fund investment for their college and 
retirement security. They would be big winners under this legislation--
and the big losers would be high-cost funds that cannot compete in a 
fair market.
    Thank you again, Mr. Chairman, for the opportunity to testify 
today. I look forward to continuing to work with this Committee as it 
considers reporting the Mutual Fund Reform Act to the full Senate for 
consideration.

                               ----------
                 PREPARED STATEMENT OF SUSAN M. COLLINS
                 A U.S. Senator from the State of Maine
                             March 31, 2004

     Chairman Shelby, Senator Sarbanes, and Members of the Committee, 
thank you for inviting me to testify on legislation that I have 
introduced with Senators Fitzgerald and Levin, who have spent an 
enormous amount of time examining the complex issues involving mutual 
funds. Our bill, The Mutual Fund Reform Act, is a comprehensive 
approach that contains many different proposals for strengthening our 
system of mutual fund regulation. I commend the Committee for your work 
on these issues that affect approximately 95 million investors who have 
invested more than $7 trillion into mutual funds.
     As the Committee on Governmental Affairs pursued its investigation 
of mutual funds, I thought about a fundamental question. Why is it that 
in a society built on competition, market forces do not drive down 
mutual fund fees? Why is it that the legendary American consumer, who 
will search for the cheapest gas, clip newspaper coupons, and take 
advantage of early bird specials, is oblivious to fees that can, over 
time, affect his or her net worth by thousands of dollars? Why is it 
that mutual fund fees seem more impervious to competitive forces than 
almost any other cost in our society, surpassed, in this regard, 
perhaps only by college tuition?
     I start with the basic notion that competition can only work when 
market participants have adequate information. If mutual fund investors 
do not fully understand either the level of their fees or their impact 
on fund performance, competition lacks one of its essential 
ingredients. Furthermore, if this is true of many mutual fund 
investors, then we cannot expect the informed decisions of the majority 
to protect the uninformed choices of the minority, as occurs in markets 
that are efficient. This theory would suggest that the Government 
should act to improve either the amount of fee information provided to 
investors or the clarity with which it is presented, or both.
     The most important reform that can be made, in my view, is to 
focus investors' attention on the costs of owning mutual funds. For 
most investors, high mutual fund expenses will cost them more than such 
abusive practices as ``market timing'' or ``late trading.'' For 
example, assume a worker chooses a mutual fund at the beginning of her 
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 with only a 0.5 percent expense ratio? 
Unfortunately, there is a very good chance that she will choose the 
former when choosing the latter would, by the end of her career, have 
returned 35 to 40 percent more money in this particular case.
     We cannot enjoy the benefits of competition unless we have an 
efficient marketplace. And, an efficient marketplace requires that 
prices be both transparent and easily accessible to investors. 
Currently, however, mutual fund expenses and fees are often opaque and 
obscure. In contrast, historical performance is well known as 
successful funds tout the past performance data that puts them in the 
best light through large advertising campaigns.
     The American Enterprise Institute's Shadow Financial Regulatory 
Committee, which is comprised of some of the top economists and 
financial experts in the country, recently stated:

        Mutual fund expenses are an important determinant of investors' 
        actual returns. Though market fluctuations may swamp the impact 
        of fund expenses on short-run returns, such expenses become 
        much more significant in determining differential returns among 
        funds over a number of years. Therefore, expense ratios are 
        particularly important to long-term investors.

     I recognize the impediments to calculating the true costs of 
mutual funds. Most important, mutual fund trading costs, which funds 
pay to brokers when the fund buys or sells securities for its 
portfolio, are not included in the expense ratio, which is the most 
commonly used mutual fund cost metric.
     Compounding this problem, there are many expenses that are bundled 
in with these transactions, which means that even more mutual fund 
expenses never make it into the expense ratio. They include research 
and related costs, which are purchased with so-called ``soft dollars.'' 
Another example is the practice of ``directed brokerage,'' by which 
trades are executed with certain brokers that sell the fund's shares, 
and are understood by both parties to be a form of compensation for 
such sales. This practice, in essence, combines distribution costs with 
brokerage costs and becomes a hidden 12b-1 fee.
     The SEC made a good start in improving cost disclosure with its 
recent proposal that mutual funds disclose their costs per thousand 
dollars invested in the funds' shareholder reports. I believe, however, 
that Congress should go further. S. 2059, for example, would require 
that personalized data be published on a shareholder's account 
statement at least annually.
     It is not enough to tell an investor how much his costs would have 
been had he owned an amount of shares he does not actually own. Like a 
bank checking statement that tells a bank customer how much he or she 
was charged for individual banking services, a mutual fund statement 
should tell an investor how much his or her actual share of the fund's 
fees were.
     I realize, Mr. Chairman, that there would be costs to generating 
and reporting personalized cost data to each mutual fund investor. 
Still, having reviewed work done by the General Accounting Office 
(GAO), I have concluded that this disclosure is warranted, just as it 
is in other types of financial records, such as checking account 
statements.
     Specifically, using industry data, GAO calculated that, spread out 
over the vast number of accounts, such disclosure would cost each fund 
account holder about 65 cents every year after a one dollar initial 
cost.
     Also, I would urge the Committee to report mutual fund reform 
legislation as soon as possible, so that it can be enacted prior to 
adjournment.
    The Investment Company Act, which is the principal statute 
governing mutual funds, was originally passed in 1940. As originally 
enacted, the Investment Company Act of 1940 was considered to be a weak 
law. It has not been significantly amended since 1970. At 64 years of 
age, the law governing mutual funds is therefore approaching what we 
typically consider to be retirement age. Although I do not think we 
need to retire the 1940 Act, leaving matters to the SEC alone would be, 
in my view, an insufficient response to the recent revelations about 
wrongdoing in the mutual fund industry.
     This is not to slight the SEC's recent activities. The SEC has 
taken many steps to improve the oversight and regulation of the mutual 
fund industry. They include new proposals regarding fund governance, 
broker compensation disclosure, and many other facets of mutual fund 
regulation. The end result of all of this activity will be a better-
regulated and safer environment for Americans to invest in mutual 
funds. Still, I want to urge the Committee to report mutual fund reform 
legislation so that we can ensure that reforms endure regardless of who 
becomes future members of the SEC.
     Since their earliest conception as 19th century English investment 
trusts, mutual funds have been touted as allowing small investors 
access to the same advantages enjoyed by larger and wealthier 
investors. What we have learned from practices such as ``late trading'' 
and ``market timing,'' however, is that there has all too often been 
two sets of rules--one for favored investors, and another for everyone 
else. Although American families continue to invest in mutual funds, 
their continuing trust in them and our capital markets in general is 
not something that we can take for granted. We must not only address 
abusive practices but also, arguably even more important, excessive 
fees, and we must do so in a manner that maximizes investor faith in 
the mutual fund industry.
     Striking the right balance, Mr. Chairman, is the job of you and 
your colleagues on this Committee. I wish you well in your efforts, as 
I believe that protecting our Nation's mutual fund investors is one of 
the most important tasks that your Committee could undertake this 
Congress.

                    PREPARED STATEMENT OF CARL LEVIN
               A U.S. Senator from the State of Michigan
                             March 31, 2004

    Chairman Shelby, Ranking Member Sarbanes, other Members of the 
Banking Committee, thank you for inviting us here today to testify 
about what needs to be done to tackle the abuses associated with the 
recent mutual fund scandals. Your series of hearings shows the same 
thoughtfulness and thoroughness that this Committee displayed in 
response to the corporate scandals of 2002, and, I hope, will also 
result in sensible and meaningful reforms this year.
    When Enron, WorldCom, Global Crossing, and other scandals exploded 
onto the scene in late 2001 and early 2002, this Committee acted with 
deliberation, but it also did not let these scandals fester. Within a 
year, you produced a bipartisan bill, and moved it through the Senate. 
Enactment of the Sarbanes-Oxley Act of 2002 was a proud moment for this 
Committee, for the Senate, and for the country.
    With respect to mutual funds, 7 months have now passed since 
abusive practices and allegations of wrongdoing came to light. Late 
trading, market timing, hedge fund favoritism, hidden fees, and other 
abuses have sullied an industry. These mutual fund abuses should not be 
allowed to infect investor confidence. With your leadership, Congress 
will again act decisively to restore investor confidence in what has 
been a powerful source of investment capital for the markets and a 
critical source of savings for millions of average American families.
    I want to recognize and acknowledge the important enforcement and 
regulatory actions already taken by the SEC. These actions have sent a 
message to wrongdoers seeking to take advantage of mutual fund 
investors. But as much as the SEC has done, it doesn't have the 
authority to undertake certain key mutual fund reforms. Congress should 
strengthen the hand of the SEC by taking a stand on these issues and 
placing mutual fund reforms in statutory law.
    Over 95 million Americans now invest more than $7 trillion in 
mutual funds. These investors deserve complete and accurate information 
about mutual fund costs so they can make informed decisions and 
comparison shop to find well-run, efficient mutual fund products. They 
need to have confidence that the fees they pay are legitimate. They 
also deserve to know that the persons advising them relative to their 
investments are exercising independent and objective judgments.
    Unfortunately, significant conflicts of interests in the industry 
today have undermined confidence in some of the investment advice being 
offered on the market. It is essential that we act to eliminate these 
conflicts. The Mutual Fund Reform Act, which was introduced in February 
by Senators Fitzgerald, Collins and me, zeroes in on, among other 
things, the conflicts of interest problem. And it takes the approach of 
banning rather than simply disclosing unacceptable conflicts of 
interest that undermine public confidence in the mutual fund market.
    Disclosure is not enough to address the conflicts problems in the 
mutual fund field. Complicated disclosures of such practices as revenue 
sharing and directed brokerage would, I am afraid, confuse and 
overwhelm average investors. Just look at what disclosure has done to 
our telephone bills -- there are pages of information, but the sheer 
length and amount of unfamiliar data make it virtually impossible to 
decipher.
    Mutual fund data is even more complex than long distance and local 
call data, and it unlikely that meaningful disclosures can be designed 
to educate investors and stamp out conflict of interest abuses.
    The conclusion our bill reaches is that a disclosure-only regime is 
not enough. Mere disclosure also blurs a key point: The conflicts are 
not acceptable--period. Instead, we prohibit those practices that 
embody conflicts of interest and undermine confidence in the market. I 
would like to briefly touch on a few of the conflicts of interest that 
our bill has determined need to be ended, not continued under a cloak 
of disclosure, if we are to act forcefully to restore confidence in the 
mutual fund industry.
Revenue Sharing
    A key conflict of interest targeted by our bill is a practice known 
as revenue sharing. Revenue sharing occurs when a mutual fund manager 
pays a broker to promote the mutual fund to the broker's clients. This 
payment creates a clear conflict of interest by throwing in a new 
factor for an investment advisor to consider--his or her company's own 
financial profit--when deciding which mutual funds to recommend to an 
investor. The SEC recently conducted a review of the 15 largest Wall 
Street brokerage firms to determine the extent of revenue sharing 
between those firms and various mutual funds. It found that 14 of the 
15 brokerage firms received payments from mutual funds in exchange for 
steering their clients toward those funds.
    The SEC and the National Association of Securities Dealers (NASD) 
have proposed addressing this issue by requiring brokers to disclose 
revenue sharing payments to their clients at the time of purchase. But 
disclosure is not enough. Even if an investor is clearly told that his 
or her broker is getting paid to promote a mutual fund, the investor is 
left wondering whether the broker's recommendation is based on the 
mutual fund's merits or the broker's financial benefit. Disclosure does 
not resolve the conflict; it allows revenue sharing payments to 
continue to undermine objective investment advice. The better course of 
action is to ban revenue sharing from the mutual fund marketplace.
Directed Brokerage
    A second conflict of interest targeted by our bill is directed 
brokerage. In directed brokerage, a mutual fund typically promises to 
buy a certain amount of brokerage services from a broker-dealer who 
agrees to promote that mutual fund to investors. Like revenue sharing, 
this practice undermines objective investment advice, to the detriment 
of average investors. To its credit, the SEC has already proposed 
prohibiting, rather than just disclosing, directed brokerage. Our bill 
would provide the SEC's proposed ban with a statutory basis, helping 
the SEC to remove another cloud over the objectivity of investment 
advice.
Independent Directors
    A third conflict of interest I want to mention today involves 
mutual fund directors. Recent scandals have disclosed a number of 
problems with mutual fund boards of directors. In some cases, the same 
person is the chairman of the board of both the mutual fund and the 
fund manager, meaning that when fees are negotiated, the same person is 
on both sides of the table. In other cases, close relations between a 
mutual fund's board members and its management company leads to lax 
oversight and a misplaced reliance on the managers to protect 
shareholder interests. Shareholders are best represented when board 
members engage in active oversight and arms-length negotiations with 
management over expenses and investment decisions. The SEC has already 
proposed requiring that 75 percent of each mutual fund board members be 
independent from the fund's management, for example the people who set 
up the fund, and that an independent chairman sit at the helm. Our bill 
would, again, strengthen the SEC's position.
Mutual Fund Expense Disclosures
    I want to mention one other topic, the importance of enacting 
legislation establishing a standard for calculating and disclosing 
mutual fund expenses that includes all material costs. The current 
``expense ratio'' calculation allows funds to leave out key 
transactional expenses like brokerage commissions, which means that 
investors cannot accurately comparison shop to find well-run, low-cost 
mutual fund products. Just like grocery shelf price tags give a ``price 
per ounce'' so shoppers can assess the price savings between different 
brands and sizes, investors should have access to a cost ratio that 
includes all expenses and allows easy and accurate comparisons between 
mutual funds. Expense disclosures that are comprehensive, easy to 
understand, and easy to compare are critical to creating a vibrant and 
fair mutual fund market and guaranteeing investors access to the 
information they need to make informed choices.
    Mutual funds are a $7 trillion engine of growth for our economy and 
investment of choice for many average Americans. I urge this Committee 
to act decisively and to act this year so the Senate can consider 
meaningful investor protections and help restore the confidence needed 
to keep this mutual fund engine humming.

                               ----------
                 PREPARED STATEMENT OF DANIEL K. AKAKA
                A U.S. Senator from the State of Hawaii
                             March 31, 2004

    Thank you, Chairman Shelby and Ranking Member Sarbanes, for the 
opportunity to participate in today's hearing.
     Mutual fund reform is important because 95 million people have 
placed a significant portion of their future financial security into 
mutual funds. Mutual funds provide middle-income Americans with an 
investment vehicle that offers diversification and professional money 
management. Mutual funds are what average investors rely on for 
retirement, savings for children's college education, or other 
financial goals and dreams.
     On November 5, I introduced S. 1822, the Mutual Fund Transparency 
Act of 2003. I believed that legislation was necessary to bring about 
structural reform in the 
mutual fund industry, increase disclosures in order to provide useful 
and relevant information to mutual fund investors, and restore trust 
among investors. I was appalled by the flagrant abuses of trust among 
mutual fund companies.
     I commend the SEC for its proposals to improve the corporate 
governance of mutual funds and to increase the transparency of mutual 
fund fees that investors pay. The proposed requirements for an 
independent chairman for mutual fund boards, increased percentage of 
independent directors to 75 percent, and development of a confirmation 
notice so that investors will be able to know how their broker gets 
paid in mutual fund transactions are a solid and measured response to 
the litany of transgressions which have undermined public confidence in 
the mutual fund industry. These provisions mirror those in my 
legislation. In addition, I have been impressed with the SEC's attempts 
to address point-of-sale disclosure.
     However, I continue to believe that legislation is necessary to 
codify some of the proposed regulations so that the reforms will not be 
rolled back in the future. It is also important to legislatively 
address areas where the SEC needs additional statutory authority to 
address problems and abuse in the mutual fund industry. Mr. Mercer 
Bullard, in his testimony before this Committee, indicated that the 
``Commission's proposal does not effectively require fund boards to be 
75 percent and have an independent chairman'' because the rules would 
only apply to funds that rely on one or more of the exemptive rules. 
This means that these rules would not apply to all funds. Legislation 
is necessary to ensure corporate governance improvements apply these 
rules universally among mutual funds. Finally, additional legislation 
may be necessary if disclosures of revenue sharing agreements and 
portfolio transaction costs are not adequately addressed by the 
Commission.
     S. 1822 includes a number of provisions that are important for 
Congress to enact. Boards must be strengthened and more independent to 
be more effective. Investment company boards should be required to have 
an independent chairman, and independent directors must have a dominant 
presence on the board. My bill strengthens the definition of who is 
considered to be an independent director. It also requires that mutual 
fund company boards have 75 percent of their members considered to be 
independent. To be considered independent, shareholders would have to 
approve them. In addition, a committee of independent members would be 
responsible for nominating members and adopting qualification standards 
for board membership. These steps are necessary to add much needed 
protections to strengthen the ability of mutual fund boards to detect 
and prevent abuses of the trust of shareholders.
     My bill will also increase the transparency of often complex 
financial relationships between brokers and mutual funds in ways that 
are meaningful and easy to understand for investors. Shelf-space 
payments and revenue-sharing agreements between mutual fund companies 
and brokers present conflicts of interest that must be addressed. 
Shelf-space and revenue sharing agreements present risks to investors. 
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 
for solid returns or low volatility, when the broker's recommendation 
may be influenced by hidden payments. S. 1822 will require brokers to 
disclose in writing, to those who purchase mutual fund company shares, 
the amount of compensation the broker will receive due to the 
transaction, instead of simply providing a prospectus. The prospectus 
fails to include the detailed relevant information that investors need 
to make informed decisions. Prior to their recent rulemaking, the SEC 
exempted mutual funds from Rule 10b-10, which requires that 
confirmation notices of securities transactions be sent to customers to 
indicate how the broker was compensated in the trade. My legislation 
would prevent the exemption of mutual funds from confirmation notice 
requirements.
     To increase the transparency of the actual costs of the fund, 
brokerage commissions must be counted as an expense in filings with the 
SEC and included in the calculation of the expense ratio, so that 
investors will have a more realistic view of the expenses of their 
fund. Consumers often compare the expense ratios of funds when making 
investment decisions. However, the expense ratios fail to take into 
account the costs of commissions in the purchase and sale of 
securities. Therefore, investors are not provided with an accurate idea 
of the expenses involved. Currently, brokerage commissions have to be 
disclosed to the SEC, but not to individual investors. Brokerage 
commissions are only disclosed to the investor upon request. My bill 
puts teeth into brokerage commission disclosure provisions and ensures 
commissions will be included in a document investors actually have 
access to and utilize.
     The inclusion of brokerage commissions in the expense ratio 
creates a powerful incentive to reduce the use of soft dollars. Soft 
dollars can be used to lower expenses since most purchases using soft 
dollars do not count as expenses and are not calculated into the 
expense ratio.
     There have been calls for the prohibition of soft dollars. This is 
a recommendation that needs to be examined. However, my bill provides 
an immediate alternative, which is an incentive for funds to limit 
their use of soft dollars by calculating them as expenses. If 
commissions are disclosed in this manner, the use of soft dollars will 
be reflected in the higher commission fees and overall expenses. This 
makes it easier for investors to see the true cost of the fund and 
compare the expense ratios of funds.
     Some may argue that this gives an incomplete picture and fails to 
account for spreads, market impact, and opportunity costs. However, the 
SEC has the authority to address the issue further if it can determine 
an effective way to quantify these additional factors. My bill does not 
impose an additional reporting requirement that would be burdensome to 
brokers. It merely uses what is already reported and presents this 
information in a manner meaningful to investors.
     One of the provisions in my bill requires the SEC to conduct a 
study to assess financial literacy among mutual fund investors. This 
study would identify the most useful and relevant information that 
investors need prior to purchasing shares, methods to increase 
transparency of expenses and potential conflicts of interest in mutual 
fund transactions, existing efforts to educate investors, and a 
strategy to increase the financial literacy of investors that results 
in positive change in investor behavior. This study is necessary 
because any additional disclosure requirements for mutual funds will 
not truly work unless investors are given the tools they need to make 
smart investment decisions, and we must first know what education 
exists.
     I look forward to working with my colleagues and the SEC to 
address problems identified in the mutual fund industry.



                    PREPARED STATEMENT OF CHET HELCK
                President, Raymond James Financial, Inc.
                             March 31, 2004

Introduction
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee. I am honored to address the Senate Banking Committee 
concerning a subject that I believe is crucial to the welfare of 
American investors and our Nation's securities markets, as well as the 
industry and regulators who support these markets.
    I am Chet Helck, the President and Chief Operating Officer of 
Raymond James Financial. Raymond James provides financial services to 
individuals, corporations, and municipalities through its 5,000 
financial advisors throughout the United States and internationally. I 
am also privileged to represent my firm on the Board of Directors of 
the Securities Industry Association (SIA) and to testify today on 
behalf of Raymond James and on behalf of SIA.\1\
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    \1\ The Securities Industry Association, established in 1972 
through the merger of the Association of Stock Exchange Firms and the 
Investment Bankers Association, brings together the shared interests of 
nearly 600 securities firms to accomplish common goals. SIA member-
firms (including investment banks, broker-dealers, and mutual fund 
companies) are active in all U.S. and foreign markets and in all phases 
of corporate and public finance. According to the Bureau of Labor 
Statistics, the U.S. securities industry employs more than 800,000 
individuals. Industry personnel manage the accounts of nearly 93 
million investors directly and indirectly through corporate, thrift, 
and pension plans. In 2002, the industry generated $222 billion in 
domestic revenue and $304 billion in global revenues.
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    While I represent a securities firm that serves hundreds of 
thousands of investors, I am also speaking to you as an experienced 
financial advisor who has spent more than 20 years providing counsel 
and services to help individuals take care of their families and 
realize their financial objectives. Through these experiences, I have 
witnessed the dramatic impact that knowledgeable advisors who are 
supported by effective resources can make on their clients' lives. My 
experience has taught me full-well that investors' trust and confidence 
is a hard-earned, precious, and essential asset, on which our business 
is built. Abuses that undermine investor trust and confidence must be 
met with tough and firm regulatory action. At the same time, my 
perspective makes me concerned that proposed mutual fund reforms not 
have unintended consequences that could ultimately degrade the 
infrastructure that makes it possible for these relationships to 
thrive--to the detriment of the investing public, and particularly the 
small investor.
Importance of Professional Advice to the Investing Public
    Most Americans realize that they can no longer depend on one 
lifelong job or an employer's pension to provide them with a secure 
retirement. They know that they must develop meaningful savings during 
their working days and then establish an investment plan to create a 
revenue stream to sustain them over retirement. Planning for education 
and health care costs represents similarly daunting financial 
challenges. For most of us, even if there were no other mitigating 
factors complicating these planning processes, creating these types of 
investment plans would be overwhelming.
    It is against this backdrop that I suggest that most Americans need 
financial advice more than ever before. Indeed, many investors have 
learned to truly value professional financial advice during these 
difficult times. Even some securities firms that traditionally served 
only self-directed investors have recently recognized this need and 
established lines of business to provide advice.
    I believe that our current system, which provides investors with 
the ability to engage professional advisors for financial guidance, 
works well for millions of Americans and I also believe that mutual 
funds play a critical role in the financial plans of millions. For that 
reason, we should all be concerned about instances of illegal conduct 
occurring in some funds. For the same reason, it is important that 
proposals for fundamental changes to this system avoid unintended 
consequences that could harm individual investors and also weaken the 
financial markets that help make our free enterprise economy so strong.
    In my capacity as a member of SIA's Board of Directors, I 
appreciate that many SIA member firms follow a different business 
model, encouraging investors to make investment choices on their own. I 
respect that alternative and certainly believe in competition--that is 
the American way. But my own career and my firm are dedicated to the 
idea that financial consultants can add great value by helping 
investors make intelligent choices when confronted with so many 
investment alternatives.
Mutual Funds and the American Investing Public
    The focus of your deliberations is the compensation structure for 
the services associated with selling mutual funds, and the advisory and 
administration services required to support investors in the purchase 
of mutual funds. We believe that mutual funds are, and will continue to 
be, a basic investment vehicle for most Americans. In spite of the 
barrage of recent bad press concerning these investments, mutual funds 
are the vehicle by which an overwhelming majority of investors 
participate in our markets. Mutual funds offer investors an inexpensive 
way to share in the benefits of owning stocks and bonds and a method 
for diversifying a relatively small investment, thereby managing their 
risk exposures. And they allow investors to 
benefit from professional management of their invested dollars. For 
these reasons, mutual funds are extremely popular products for small 
investors, as well as for retirement plans such as 401(k) plans.
    Overall, 49.6 percent of all households in the United States own 
mutual funds directly or through a retirement account.\2\ As of January 
2002, 89 percent of U.S. equity investors owned stock mutual funds, and 
51.5 percent of equity investors held stock only mutual funds.\3\ 
Twenty-six percent of all household liquid financial assets were in 
mutual funds as of the end of 2003.\4\
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    \2\ http://www.sia.com/research/pdf/equity_owners02.pdf.
    \3\ Id.
    \4\ http://www.federalreserve.gov/releases/Z1/Current.
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    The health of our capital markets depends to a great extent on the 
public's continued robust participation in mutual funds. As of January 
2004, equity mutual funds had a market capitalization of $3.8 trillion 
dollars, roughly 25 percent of the total capitalization of our equity 
markets.\5\
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    \5\ For equity market capitalization (combined New York Stock 
Exchange and Nasdaq) see http://www.nyse.com/pdfs/mmv1204.pdf; http://
www.marketdata.nasdaq.com/daily/daily 2004.xls; For mutual fund data 
see http://www.ici.org/stats/latest/trends_01_04.html#TopOf Page.
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    Retail investors put their trust in the integrity of mutual fund 
managers and advisers, as well as in the financial advisors who assist 
in their investment decisions and the broker-dealers that implement 
their trade orders. It is certainly troubling that recent events have 
severely damaged the reputation of mutual funds and their management 
companies, as well as those who participate in their distribution. I 
know that all of us in the industry firmly believe that abuses such as 
insider trading should be rooted out and punished wherever it occurs--
whether at high profile public companies, at broker-dealers, or at 
mutual funds. Abuse of fiduciary responsibilities should be condemned 
and, where appropriate, punished. And we also recognize that, as I 
shall discuss in a few moments, better disclosure of mutual fund 
compensation practices can be helpful to investors and should be 
required.
    In order to restore public trust and confidence in mutual funds and 
their distributors, the interests of investors must come first. 
Investors must be assured that fraud, self-dealing, and dishonesty will 
not be tolerated. Investors should be treated fairly, and should be 
given clear and useful information about the funds they buy. Fund fee 
structures, financial support offered to intermediaries, fund 
investment, and redemption policies--all should be as transparent and 
meaningful as possible. When an investor seeks investment advice, the 
financial advisor should recommend mutual funds that are suitable in 
light of an investor's objectives. And all investors should be assured 
of prompt execution and fair pricing of their mutual fund transactions.
    But public trust is a fragile thing. This Committee, and the 
regulatory community, can either work to restore it--or can diminish 
that public confidence even further by actions that ultimately detract 
from that trust. We are confident that this Committee, along with other 
policymakers, will choose wisely and strengthen the viability of these 
products and the vital distribution systems that bring them to 
investors' doorsteps. The recent scandals have presented a serious 
challenge to all of us who believe that funds serve investors well. We 
must face these challenges forthrightly and seek thoughtful and 
workable solutions that will protect investors' interests. This 
Committee and the regulatory community must help restore public 
confidence by rooting out instances of wrongdoing, without diminishing 
the basic value of mutual funds or of the advisory structure that has 
grown up around it. Because mutual funds are good investment planning 
solutions for most Americans--particularly those who are of modest 
means--anything that unfairly undermines their confidence in funds or 
makes it more difficult to provide meaningful advice concerning them 
would be a disservice to the investing public.
Compensation for Mutual Fund Sales
    As with any product, there are costs associated with distributing 
and servicing mutual funds. As mutual funds types have proliferated--a 
result of vigorous competition and innovation--selling arrangements for 
funds have expanded as well. 
Because selling arrangements have raised particular concerns, we 
address several aspects of these arrangements.
Forms of Compensation
    Broker-dealers receive payments in connection with sales of mutual 
funds, unit investment trusts, municipal fund securities, variable 
annuity contracts, and variable life insurance policies (collectively, 
funds) from a variety of sources. Some payments are made by the funds 
themselves or by investors when they buy or sell fund shares. Other 
payments may be made by investment advisers, fund distributors, or 
other fund affiliates; and some broker-dealers charge investors 
directly for their services through the medium of fee-based accounts.
    In addition to these various sources, broker-dealers may receive 
payments in several different ways. Some payments may represent hard-
dollar payments from funds and investors (encompassing sales loads and 
12b-1 fees). Other payments may represent hard-dollar payments from 
fund affiliates (commonly known as revenue sharing). Still other 
payments may be made in the form of commission payments on fund 
portfolio brokerage transactions (often referred to as directed 
brokerage).
    Some observers believe that fund payments, directed brokerage, and 
revenue sharing are simply ``taxes'' that broker-dealers impose upon 
funds and their affiliates, and that all such payments go straight to 
the broker-dealers' bottom lines. However, these arrangements are 
necessary to enable broker-dealers to support the administrative costs 
associated with fund sales and investor reporting, and provide more 
comprehensive investor services such as financial planning, total 
portfolio review, and performance reporting that investors have come to 
expect.
    In recent years, broker-dealers have been handling functions that 
mutual fund organizations previously might have performed exclusively. 
This shift in function has provided many operating efficiencies and 
benefits to investors, including consolidation of investments within a 
single financial services organization, and easier access to investment 
services. Revenue-sharing payments often help reimburse broker-dealers 
for some of the following expenses associated with processing fund 
transactions and maintaining customer accounts:

 Customer sub-accounting.
 Mailing trade confirmations, prospectuses, and other 
    disclosure documents.
 Comprehensive tax reporting.
 Maintaining information websites.
 Implementing changes initiated by funds, including revising 
    systems and procedures and communicating changes to financial 
    advisors and customers.
 Overseeing and coordinating fund wholesaler activities at the 
    firm.

    To the extent that the services are performed by the broker-dealer, 
instead of the fund, investors are not paying more. For example, there 
is a cost to maintaining an accurate shareholder record--whether the 
fund's transfer agent performs that function or the fund delegates that 
responsibility to the broker-dealer.
    In addition, broker-dealers use revenue-sharing payments to fund 
other activities, such as educational seminars for their financial 
advisors and their clients about the different funds they consider. 
These activities make the financial advisors more knowledgeable about 
the funds and can help them tailor their recommendations more 
effectively. SIA members offer a broad spectrum of fund choices--
ranging from offering perhaps a few families of funds to thousands of 
different share classes. But regardless of how many mutual funds a 
broker-dealer sells, it is in investors' best interest if the broker-
dealer's financial advisors are well acquainted with those funds and 
can help their customers choose wisely. Revenue sharing contributes 
significantly to that goal.
12b-1 Fees
    The SEC adopted Rule 12b-1, which permitted mutual funds to use 
their assets to pay for distribution, as long as the fees were 
disclosed and regulated.\6\ Since Rule 12b-1 was adopted, more than 
half of all mutual funds have enacted Rule 12b-1 plans, using these 
charges, alone or with sales loads, as the primary means of financing 
distribution.\7\ Other mutual funds have added a relatively modest Rule 
12b-1 fee to pay for some sales commissions, printing prospectuses and 
sales literature, advertising, and similar expenses.\8\ It is important 
to note that while Rule 12b-1 was intended to assist no-load mutual 
funds to finance their distribution expenses, the vast majority of load 
mutual funds have adopted Rule 12b-1 plans as a complement to, or a 
substitute for, a front-end sales load.
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    \6\ SEC Division of Investment Management, Protecting Investors: A 
Half Century of Investment Company Regulation, at 322 (1992) 
(Protecting Investors Study), citing SEC Division of Investment 
Management, Regulation, Mutual Fund Distribution, and Section 22(D) of 
the Investment Company Act of 1940, at 19, 20-22 (1974) (1974 
Distribution Report).
    \7\ Protecting Investors Study, at 320.
    \8\ Id.
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    The impact of these fees has been positive. They have allowed funds 
to reduce front-end sales charges. They have contributed to development 
of longer holding periods and a more stable investment profile for 
clients. And, because they are paid over an extended period of time, 
they promote a continuing relationship, encouraging the financial 
advisors to offer continued service over a period of time.
Mutual Fund Share Classes
    Sometimes lost in the discussion of mutual fund fees is the fact 
that the fund industry also created a number of share classes. The wide 
variety of share classes available today affords investors a variety of 
options for compensating advisors for their services. Advisors and 
clients can select fund classes to establish a compensation arrangement 
that is consistent with clients' objectives, time horizons, and 
personal preferences. Each class of a multiple class fund must have a 
different arrangement for shareholder services or distribution or both, 
and must pay all of the expenses of that arrangement. Some multiple 
class funds enter into arrangements whereby particular classes of fund 
shares are sold to specific institutional investors, such as banks 
acting in a fiduciary, advisory, agency, custodial, or similar capacity 
on behalf of customer accounts, insurance companies, investment 
counselors, brokers, or other financial institutions.\9\
---------------------------------------------------------------------------
    \9\ See Id., at 330.
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    Multiple class funds also permit investors to select the method of 
financing distribution best suited to their investment horizon and the 
size of their investment.\10\ Some investors may wish to pay a front-
end sales load, whereas others may wish to avoid paying a front-end 
sales load, and are willing to pay a Rule 12b-1 fee and contingent 
deferred sales charge (CDSC) instead.\11\
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    \10\ Id., at 331.
    \11\ A CDSC is a sales load paid by investors upon redemption that 
declines over the period of a shareholder's investment. So-called B 
shares typically feature a combination of Rule 12b-1 fees ranging from 
0.50 percent to 1.00 percent of the average daily net assets of a 
mutual fund attributable to the B shares (annualized), and CDSC's in 
lieu of front-end sales loads, while so-called A shares typically 
feature front-end sales loads and Rule 12b-1 fees of no more than 0.25 
percent of the average daily net assets of the mutual fund attributable 
to the A shares (annualized). However, the NASD has taken enforcement 
actions against broker-dealers who have sold B shares to individuals in 
instances in which A shares would have been an economically superior 
investment. See, for example, McLaughlin, Piven, Vogel Securities, Inc. 
(MPV) (press release available at http://www.nasdr.com/news/pr2003/
release_03_027.html).
---------------------------------------------------------------------------
    As the type and level of mutual fund charges began to change, the 
NASD revised its rules governing the level of mutual fund sales loads 
and distribution fees to provide consistency of approach and fairness 
to investors (NASD Conduct Rule 2830(d)).
Brokerage and ``Soft-Dollar Payments''
    When Congress enacted Section 28(e) of the Securities Exchange Act 
of 1934, it recognized the need for money managers to obtain research 
from a wide range of sources. Section 28(e) permits money managers to 
pay for research and related services through commission (soft) dollars 
rather than paying for them in cash. Such research helps money 
managers, including fund managers, do a better job of serving their 
customers.
    Eliminating this source of research dollars would be contrary to 
investors' interests. Research improves the quality of markets by 
helping money managers channel capital to the most promising companies. 
Research analysts challenge companies to explain their business models 
and their record of results. Reducing research dollars would mean the 
elimination of research on certain types of companies. Reducing 
research dollars could therefore adversely affect the ability of 
smaller, newer companies to obtain financing for their activities. We 
all know that new businesses create the most jobs in America; raising 
their cost of capital hurts everyone.
    Some have urged that research is not a legitimate expense for 
investors to bear through ``soft-dollar'' payments made in the form of 
trades placed by broker-dealers on behalf of the fund company. Over the 
years, the SEC has monitored the use of soft dollars by the industry. 
We believe that few abuses have been found and, in general, soft 
dollars have proved to be proinvestor and procompetitive, because they 
increase competition among money managers, encourage independent 
research, and give investors more choices.
    We believe that research, whether from the broker-dealer, or a 
third party, contributes to the effort to identify better investments. 
Third-party research is a valuable resource to money managers because 
it provides managers with ideas and 
insights that otherwise might be overlooked; and any ban on soft 
dollars is likely to diminish independent research.\12\ Consequently, 
we believe that any movement to abolish soft dollars or to prohibit the 
use of soft dollars to obtain independent research would adversely 
affect the quality of the research available to money managers, which 
would ultimately harm investors.\13\
---------------------------------------------------------------------------
    \12\ We note that one objective of last year's global research 
settlement was to require investment banks to fund independent 
research.
    \13\ Market forces also may affect how investment advisers buy 
execution and research services from broker-dealers and third-party 
providers.
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Raymond James and its Mutual Fund Expenses
    Let me give you some examples of what costs are supported at 
Raymond James. At Raymond James, we sell over 11,000 mutual fund share 
classes, offered by over 200 fund companies. During fiscal year 2003, 
the total cost to our firm for providing the administrative support for 
mutual fund sales was approximately $30 million. These payments also 
help fund our Mutual Fund Research Department, which analyzes the 
universe of mutual fund offerings to generate a recommended list of 
mutual funds that we consider to have superior prospects. And that list 
has nothing to do with our receipt of ``revenue sharing'' payments; 
there are mutual funds on that list from whom we receive no payments, 
and there are funds from which we receive payments that are not on that 
list.
    In addition to administrative support and research, we are required 
to provide educational programs for our financial advisors to help them 
deal with the complexities and regulatory requirements involved in 
making effective use of mutual funds in client financial planning. 
During the past 12 months, on major regional and national educational 
conferences we spent well over $7 million. Many of the sessions in 
these conferences qualified for continuing education credit by 
regulators, CFP and CPA societies and others. These are serious 
substantive courses that improve the effectiveness of our financial 
advisors and better equip them to help clients face the issues that 
they must face.
    All of these costs and programs are supported by the payments that 
we receive from mutual fund companies and their managers in all the 
forms that we have discussed: Sales loads, revenue sharing, and 
directed brokerage. In our view, it is entirely reasonable that the 
fund complexes sponsoring these mutual fund families should help defray 
the expense of educating our financial advisors about their particular 
products. The net result of this effort is that our financial advisors 
have a much deeper understanding about the products that they sell and 
can be of much greater help to their clients in making investment 
choices. Why would anyone want to dismantle a system that provides such 
advantages to investors?
Full Disclosure--But Meaningful and Cost-Effective Disclosure
    The Securities and Exchange Commission has proposed new 
confirmation rules that would require brokers, dealers, and municipal 
securities dealers to provide customers with information about 
distribution-related costs that investors incur when they purchase 
those types of securities, as well as disclosure of other distribution-
related arrangements. Furthermore, it has proposed new point-of-sale 
disclosure rules that would require brokers, dealers and municipal 
securities dealers to provide point-of-sale disclosure to customers 
about costs and conflicts of interest.\14\ (The SEC has also proposed 
rule amendments that would prohibit funds from using portfolio 
brokerage commissions to pay for the cost of distributing their 
shares.\15\)
---------------------------------------------------------------------------
    \14\ Confirmation Requirements and Point-of-Sale Disclosure 
Requirements for Transactions in Certain Mutual Funds and Other 
Securities, and Other Confirmation Requirement Amendments, and 
Amendments to the Registration Form for Mutual Funds, Release Nos. 33-
8358; 34-49148; IC-26341; http://www.sec.gov/rules/proposed/33-
8358.htm.
    \15\ Prohibition on the Use of Brokerage Commissions to Finance 
Distribution, Release No. IC-26356; http://www.sec.gov/rules/proposed/
ic-26356.htm.
---------------------------------------------------------------------------
    Raymond James has been an industry leader with respect to client 
disclosure of mutual fund sales and compensation.\16\ Our long-form 
confirmation discloses a comprehensive range of relevant information, 
including many items currently being proposed by the SEC. These 
include:
---------------------------------------------------------------------------
    \16\ SIA notes that many firms take different approaches to 
disclosure and we do not mean to suggest that other approaches are 
inadequate.

 How the sales charge was computed.
 Information regarding possible discounts to which the customer 
    may be entitled.
 Information regarding other available sales classes.
 The fact that Raymond James may be receiving compensation in 
    the form of revenue sharing from the fund or its management 
    company.

    In addition, ever since 1994, Raymond James has produced a 
pioneering document entitled ``Your Rights and Responsibilities as a 
Raymond James Client.'' Each client receives one, and it is available 
on our website. There, we provide additional comprehensive information 
regarding how mutual funds are distributed, the different options for 
purchase, and the existence of revenue sharing arrangements that result 
in payments to Raymond James.
    It is from this perspective that we are comfortable in supporting 
clear, concise, and meaningful disclosure of compensation practices, 
including those we have discussed in this paper. The SEC has proposed 
such disclosure and we, along with others in the industry, will be 
submitting our thoughts as to how these disclosures can be made 
meaningful and useful, without at the same time imposing excessive 
costs on the industry, costs which are ultimately borne by the 
investing public.
    Briefly, we believe that additional disclosure to investors about 
revenue sharing is useful; but we believe that there are better ways to 
provide relevant information without imposing excessive costs that 
investors ultimately have to bear--and without distracting them from 
other important information. Raymond James, along with other firms and 
SIA, are busy working on our suggestions for improvement, so I cannot 
give you all our comments right now--the proposal runs to over 120 
pages with over 200 footnotes. But from Raymond James's perspective, we 
would like to make two suggestions regarding this proposal:

        1. It is time for the SEC to move away from paper disclosure--
        the proposal itself indicates the annual printing costs will 
        add more than a billion dollars a year to the cost of mutual 
        fund sales, ultimately to be borne by the investors. Let us 
        enter the 21st century and put as much as possible of the 
        important disclosures on our websites, where investors can 
        access them readily--and have our confirmations refer the 
        investors to our websites. For those clients who do not have 
        computer access, our confirmation forms can give them the phone 
        number to request a copy of the information on the website.
        2. Don't require transaction-by-transaction breakdown of 
        revenue sharing payments--it would require extraordinary 
        programming costs that again would be borne by investors. 
        Instead, let us use hypothetical examples of the costs that 
        would be borne by investors at different purchase levels: say 
        $10,000, $50,000, and $100,000. That should be enough to give 
        every purchaser a sense of the impact on his investment of 
        these costs.

    I am sure that we will have other comments, but I think that should 
give you a sense of the direction we are trying to move: Provide 
relevant information, but do it in a cost-effective and concise way.
    We believe that the SEC has all the power and authority necessary 
to provide for this kind of disclosure and we would urge that they 
exercise that authority responsibly. Their active rulemaking agenda and 
enforcement docket indicates that they are not shy about using the 
authority that Congress granted to them.
    However, we believe that full and clear disclosure, rather than 
complex over-regulation of payment structures or levels, is the best 
way to approach fund payments to broker-dealers. We further believe 
that, with better disclosure, many of these issues can be resolved 
through the working of the competitive marketplace. So long as fund 
investors and their financial advisors receive clear information 
regarding compensation practices, they will be able to choose from the 
universe of products those that are consistent with their objectives 
and suitable for their investment goals at a reasonable cost. We hope 
to work with the Commission to develop disclosure that is meaningful, 
relevant, and cost effective.
Conclusion
    America has changed from a Nation of savers to a Nation of 
investors. At Raymond James, we believe very strongly that a large 
number of Americans need access to professional investment advice. A 
majority of our citizens can now be counted among the investing 
population, and we know that many of these investors place a 
significant value on consulting with a financial advisor in planning 
for their futures. If compensation and payments to broker-dealers are 
fully disclosed in a manner that is meaningful to the investor, 
investors can determine whether or not that compensation is fair and 
acceptable. This decisionmaking process is greatly facilitated by the 
fact that we operate in a competitive industry that currently presents 
investors with a range of choice concerning not only products, but also 
varying models of service that allow investors to choose the level of 
advice they prefer.
    Because we believe that investor protection is paramount to the 
future of the financial markets and our country's economic well-being, 
we recommend that disclosure and structural reform efforts should aim 
to ensure that:

 Fund shareholders are able to readily access meaningful 
    information about the costs they incur, the various types of 
    payments received by the distributors of funds, including broker-
    dealers and the nature of the services being provided;
 Competitive forces, not Government fiat, set appropriate 
    levels of compensation, whether through fund payments, directed 
    brokerage, revenue sharing, or other structures; and
 Investors are presented with the broadest possible array of 
    fund choices.

    Above all, we believe that it is critically important for Congress, 
regulators, self-regulators, State officials, the mutual fund industry, 
and the securities industry to work together to restore the trust and 
confidence of investors in mutual funds as a product, and in those who 
are committed to providing advice and service to those investors in how 
to make the best use of that product.
    Thank you for your attention.

                               ----------
                 PREPARED STATEMENT OF THOMAS O. PUTNAM
                          Founder and Chairman
               Fenimore Asset Management, Inc. /FAM Funds
                             March 31, 2004

Introduction
    My name is Thomas O. Putnam. I am the Founder and Chairman of 
Fenimore Asset Management, a small investment advisory firm in rural 
upstate New York. Fenimore has been in business for 30 years and 
currently has 30 employees and more than $1 billion in total assets 
under management. At Fenimore, we manage structured portfolios for 
about 400 individual and institutional clients throughout the United 
States.
    Fenimore also serves as investment adviser to the FAM Funds, a 
registered mutual fund company offering two investment portfolios with 
combined assets of approximately $700 million. Each fund has two 
classes of shares: The investor class, which is no load and is sold 
directly by Fenimore, and the advisor class--new as of July 2003--which 
is sold through intermediaries. I serve as co-portfolio manager for 
each of the mutual funds and also as Fenimore's Director of Research. 
In addition to my varied duties at the firm, I also serve as Chair of 
the Small Funds Committee of the Investment Company Institute (ICI).
    I am honored to participate in today's hearing on regulatory 
actions regarding the mutual fund industry and, in particular, fund 
costs and distribution practices. My testimony will focus on the role 
of small fund groups in the mutual fund industry and the impact of 
regulatory reforms on small fund groups. I will also offer the 
Committee my thoughts on some of the specific reform proposals that 
have been advanced.
    Let me begin, however, by expressing my deep disappointment about 
the events that have brought us together today. Investors' trust in the 
entire mutual fund industry has been shaken--and rightly so--by the 
revelations of wrongdoing that have unfolded over the past several 
months. That some industry participants would so blatantly disregard 
their fiduciary duties is both shocking and abhorrent to me. Clearly, 
there is no place in our industry for this kind of behavior, and I am 
pleased that the SEC and State regulators have moved quickly to 
investigate and punish those responsible.
    Enforcement actions are just part of what is needed to ensure that 
the interests of mutual fund investors are fully protected going 
forward. I applaud the SEC's swift action on regulatory reforms to 
address the abuses we have seen with respect to late trading and market 
timing and to place much greater emphasis on fund compliance efforts, 
which will help to detect and prevent future wrongdoing. I am 
particularly pleased that certain of the SEC's proposals build in 
flexibility that may be useful to small funds, rather than taking a 
one-size-fits-all approach (for example, ensuring that independent 
directors have the authority, but are not required, to hire staff).
    This Committee also has played an important role by thoroughly 
examining the recent scandals and thoughtfully considering what steps 
are necessary in response. Finally, mutual fund firms themselves must 
continue to embrace reforms that will protect investors, who have 
placed their savings and their trust in the industry.
    With all that said, however, I must tell you that I have some 
serious concerns about the possible scope of this reform effort. 
Several of the pending legislative proposals, for example, contain 
provisions that go well beyond the abuses that have been uncovered and, 
if enacted, could substantially change the face of the industry. Even 
reforms that are more squarely focused on the abuses could, if drafted 
too broadly, impose considerable costs on individual fund groups and, 
ultimately, on fund shareholders. Such reforms also could prove to be 
cost prohibitive for smaller fund groups, especially those who allow 
access at a lower minimum (for example, at FAM Funds, the minimum 
initial investment is $500).
    As this Committee considers what steps are necessary to respond to 
the recent scandals, I respectfully request that you bear in mind the 
law of unintended consequences. No proponent of mutual fund reform 
wants to damage the long-term competitiveness and creativity of this 
industry, the health of which is so vitally important to millions of 
lower- and middle-income investors. Yet if the scales are tipped too 
far, so that the regulatory restrictions and costs of managing mutual 
funds outweigh the possible rewards, there could be a ``brain drain'' 
as the best and brightest portfolio managers are drawn away from the 
mutual fund industry to more creative and lucrative forms of money 
management. New firms--which historically have developed many of the 
most innovative fund products and services, such as money market 
funds--simply might not enter our industry at all, choosing instead to 
limit their investment offerings to less regulated products. Any 
departure of top talent could well be followed by an adverse effect on 
long-term shareholders, including diminished returns and a departure of 
investors, which would leave fewer investors to shoulder an increased 
share of their funds' expenses. Finally, the creativity to provide new 
investment funds that would be advantageous to lower- and middle-income 
investors might be stifled, if not lost, if a proposal creates a 
barrier to entry for a mutual fund entrepreneur. That would be tragic.
    I hope that these observations about the potential threat of 
overregulation are taken by the Committee in the spirit in which I 
offer them--as constructive commentary, based upon my 30 years of 
experience in this industry and my strong belief that a vibrant, 
competitive mutual fund industry serves our Nation's interests and the 
interests of all mutual fund investors, which represent more than half 
of all U.S. households.
The Role of Small Funds in the Mutual Fund Industry
    To appreciate concerns about the impact that some of the reform 
proposals could have on small funds, I believe that it is important for 
the Committee to understand this segment of the mutual fund industry.
    Many, if not most, investors are familiar with the larger mutual 
fund groups, such as Fidelity and Vanguard. It is no surprise that 
people often think of these fund groups first--they enjoy immediate 
name recognition because of their size and their ability to advertise 
widely. It would be a mistake, however, to think that these groups are 
representative of the entire mutual fund industry.
    In fact, a large part of our industry is comprised of small fund 
groups. This point was very well articulated in recent testimony to 
this Committee by a fellow small fund executive, Mellody Hobson of 
Ariel Capital Management and the Ariel Mutual Funds.\1\ Ms. Hobson 
noted that more than 370 U.S. mutual fund companies have assets under 
management of $5 billion or less. This is out of a total of 
approximately 500 fund companies. To put this fact further into 
perspective, Ms. Hobson explained that if you were to combine the 
assets managed by all of these firms into a single firm, the amount 
under management would be less than half that managed by the single 
largest mutual fund company.
---------------------------------------------------------------------------
    \1\ See Statement of Mellody Hobson, President, Ariel Capital 
Management, LLC and Ariel Mutual Funds, Review of Current 
Investigations and Regulatory Actions Regarding the Mutual Fund 
Industry: Fund Operations and Governance, Before the Committee on 
Banking, Housing, and Urban Affairs, U.S. Senate, 108th Cong., 2nd 
Sess. (February 26, 2004), at 1-2.
---------------------------------------------------------------------------
    If you were to ask 10 small advisory firms how they got into the 
business of managing mutual funds, you would probably get 10 different 
answers. Here is mine. I was working with my father in the family 
manufacturing business in the early 1970's. At the same time, my father 
and I began managing some family money, and we did not suffer losses on 
our investments despite the bear market of 1973-1974. Word got around, 
as it usually does in a small town, and we learned that people were 
interested in what we were doing. We started Fenimore Asset Management 
and slowly built a client base, largely through referrals by existing 
clients. Over time, we had many clients who wanted us to manage small 
sums for them--an account for the benefit of a child or grandchild, for 
instance. The most cost-effective way to manage small sums is through a 
pooled investment vehicle, so in 1987, the firm launched its first 
mutual fund. Almost a decade later, Fenimore launched its second mutual 
fund, an equity income fund, in order to meet the needs of clients who 
wanted an income stream from their investments.
    Small fund groups such as FAM Funds play an important role in the 
mutual fund industry. They provide greater choice for investors and 
help to foster competition. In addition, a small fund group can 
typically provide its shareholders a level of individual service and 
attention that is simply beyond the reach of a large fund group with 
its millions of shareholders. At FAM Funds, for example, we do not 
contract any shareholder service activities to outside vendors. 
Instead, we provide these services through our own team of registered 
representatives. We also make our portfolio managers available to 
address shareholder questions and concerns, and we hold shareholder 
meetings annually at the local high school. In ways such as these, we 
seek to facilitate dialogue, educate, and create understanding between 
our shareholders and those of us at FAM Funds to whom they have 
entrusted their savings.
    Many small fund groups specialize in one or more investment styles. 
At FAM Funds, our specialty is long-term, value-oriented investing. In 
other words, we are old-fashioned stock pickers. Our investment 
philosophy is based on the teachings of Benjamin Graham from his 
classic 1934 book, Security Analysis, which outlines the key elements 
to value investing. Using Graham's methodology, we have developed our 
own proprietary investment criteria to identify undervalued securities 
with good long-term growth potential. We consistently apply a 
thoughtful and disciplined approach to investing that will grow and 
preserve capital over the long term. In this way, we are able to 
achieve our overall purpose of providing financial peace of mind to our 
shareholders.
    Unlike a large fund group, which typically offers funds covering a 
wide spectrum of investment objectives, small fund groups such as FAM 
Funds find a niche and stick with it. We are not trying to be all 
things to all investors or to change our investment offerings to 
capitalize on hot trends in investing, like the technology stock craze 
of a few years back. Rather, small funds tend to succeed by staying 
within their circle of competency.
    A corollary to this is that a small fund group has to be able to 
communicate effectively with investors, so that they understand both 
the benefits and the limitations of what the fund group has to offer. A 
growth-oriented investor, for example, is simply not going to be happy 
with an investment in my firm's value-oriented mutual funds. Nor would 
that benefit my firm, since we depend upon the referrals of satisfied 
clients in order to grow. For this reason, we put a great deal of 
energy into helping our investors understand our process for selecting 
stocks and our long-range investment horizon.
The Impact of Regulatory Reforms on Small Funds
    In my 30 years as a money manager, I cannot recall another time in 
which the SEC has proposed so many sweeping changes to the regulatory 
scheme for mutual funds in such a short period of time. I fully support 
the SEC's efforts, and I commend the Agency for proposing reforms that 
are aimed not only at remedying the immediate problems that have been 
found in the industry, but also addressing potential conflicts of 
interest, strengthening fund governance, and enhancing standardized 
fund disclosures. These reforms will benefit investors for years to 
come. As I stated at the outset of my testimony, however, these 
reforms--if enacted--would come with a hefty price tag.
    It should not be surprising that the aggregate cost of these 
regulatory changes will have a proportionately larger impact on small 
fund groups. Small funds have smaller asset bases to absorb these 
costs, so their shareholders are hit harder than those in large fund 
groups, where the costs can be more spread out.
    In addition, profit margins tend to be much thinner at smaller fund 
groups, which do not have the economies of scale enjoyed by large fund 
groups. Consequently, we must be extremely vigilant about controlling 
costs and keeping our fees at a reasonable level. If we do not, our 
shareholders can always move their money elsewhere. While this is true 
for all mutual funds, the costs associated with shareholder defections 
are more difficult for small funds to absorb. Put another way, small 
funds must be competitive not only to attract investors in the first 
instance, but also to retain their business.
    An example might be helpful. My firm is working to come into 
compliance with the SEC's newly adopted rule that requires each mutual 
fund to have in place a comprehensive compliance program and to 
designate a chief compliance officer to oversee that program. We are 
just able to think about bringing on board an in-house counsel at 
Fenimore who will also serve as the chief compliance officer for each 
of the FAM Funds. And that is because the costs associated with hiring 
this new employee would be partially subsidized by our private client 
business. For fund groups smaller than ours, or whose investment 
adviser does not manage other accounts, that approach will simply be 
too expensive. I expect that such fund groups will have to designate an 
existing employee to take on the additional--and not insignificant--
responsibilities that are required of a chief compliance officer. I 
offer this example not as a criticism of the new requirement, but 
merely as an illustration that even worthwhile reforms can stretch the 
limited resources of small fund groups.
Comment on Select Reform Proposals
    Our differences aside, small fund groups and large fund groups 
agree that the merits of any reform proposal should be measured against 
a single standard, one that has been the hallmark of our industry 
throughout its history. That standard is this: Will the proposed reform 
benefit the interests of long-term mutual fund investors? While well 
intentioned, some reforms that have been proposed fall short of this 
mark. Such proposals include, among others, requiring each fund board 
to have an independent chair and barring a portfolio manager from 
jointly managing a mutual fund and a hedge fund. In addition, I will 
offer my observations with respect to certain other areas in which 
reform proposals have been advanced: Mutual fund fees, Rule 12b-1 under 
the Investment Company Act of 1940, directed brokerage, soft dollars, 
and revenue sharing arrangements.
Independent Chair
    Several legislative proposals and the SEC's proposed package of 
fund governance reforms would require that each fund board of directors 
have an independent chair.\2\ While this requirement may sound good in 
theory, I do not think that a one-size-fits-all approach is necessary. 
A requirement like this one would cause many fund groups--including my 
own--to choose a new board chair even though their current structure 
works well for them.
---------------------------------------------------------------------------
    \2\ See, for example, Investment Company Governance, SEC Release 
No. IC-26323 (January 15, 2004) (Fund Governance Release). Other 
reforms proposed by the SEC include requiring that: Independent 
directors constitute at least 75 percent of a fund's board; fund boards 
perform annual self-assessments; independent directors meet in separate 
sessions at least once each quarter; and funds authorize their 
independent directors to hire staff.
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    At FAM Funds, I serve as Chairman of the Board of Trustees, and the 
remaining trustees are independent. As a practical matter, they already 
have the power to replace me at any time with a new board chair if they 
feel that such a change would benefit the Funds and our shareholders. 
The independent trustees also have appointed a lead independent 
trustee, who serves as a point of contact with Fenimore and plays a 
major role in preparing the agendas for our Board meetings. This 
independent trustee also chairs the separate meetings held by the 
independent trustees before each board meeting.
    I would favor an approach that gives fund boards the ability to 
choose between having an independent chair and a lead independent 
director. It is important to note that the appointment of a lead 
independent director also is consistent with recommended industry best 
practices.\3\ As an alternative to giving fund boards the choice 
between an independent chair and a lead independent director--or 
perhaps even in addition to such a choice--the SEC could consider 
requiring a fund board to elect its chair annually, by a majority vote 
of both the independent directors and the entire board.\4\
---------------------------------------------------------------------------
    \3\ See Enhancing a Culture of Independence and Effectiveness, 
Report of the Advisory Group on Best Practices for Fund Directors (June 
24, 1999) (Best Practices Report), at 25.
    \4\ The SEC requested comment on whether it should require the 
annual election of the board chair. See Fund Governance Release, supra 
note 2. The ICI also supports this approach. See Letter from Craig S. 
Tyle, General Counsel, Investment Company Institute to Jonathan G. 
Katz, Secretary, Securities and Exchange Commission, dated March 10, 
2004 (ICI Fund Governance Letter).
---------------------------------------------------------------------------
    By focusing so much attention on whether fund boards should have an 
interested or an independent chair, we may well be missing the forest 
for the trees. What I think persons on both sides of this debate really 
want are board chairs who are knowledgeable about business, investment, 
finance, and the fund industry, and who are both capable and willing 
leaders. Obviously, who fits the bill will depend upon the composition 
of a particular fund board. For this reason, I feel strongly that board 
members themselves are in the best position to select their chair.
    I also want to share the following observation. Contrary to their 
portrayal in some recent news stories, fund directors are not lemmings 
that blindly follow the lead of management. It has been my experience, 
both at FAM Funds and in the industry, that fund directors take their 
responsibilities seriously. They recognize their fiduciary obligations 
and they try to use their best judgment in fulfilling the many duties 
assigned to them by the Congress and the SEC. If fund directors are 
charged with such important responsibilities, they certainly should be 
treated as responsible enough to choose their own chair.
    I support other measures to enhance the role of independent 
directors, because I know from experience that a strong board is an 
important partner in protecting the interests of fund shareholders. In 
particular, I believe that each fund board should be required to have a 
supermajority of independent directors, as we do at FAM Funds. I do not 
believe, however, that requiring a three-fourths supermajority for all 
fund boards--rather than the two-thirds supermajority recommended by 
industry best practices \5\--would provide any additional benefits to 
shareholders. On the other hand, such a change would cause significant 
disruption for many fund boards, most of which already comply with the 
recommended two-thirds standard. I also support strengthening fund 
boards by requiring independent directors to meet in executive session 
at least quarterly, authorizing independent directors to retain their 
own staff members (although we at FAM Funds believe that our 
independent trustees already have this authority), and having fund 
boards annually assess their performance.
---------------------------------------------------------------------------
    \5\ See Best Practices Report, supra note 3, at 10-12.
---------------------------------------------------------------------------
Joint Management of Mutual Funds and Hedge Funds
    Pending legislative proposals would prevent an individual from 
managing both a mutual fund and any other type of unregistered 
investment company, most notably a hedge fund. Although they purport to 
give the SEC the authority to make exceptions, the authority would be 
so narrow in scope that the proposals effectively would ban the 
practice. Fenimore itself does not manage hedge funds, but some of my 
colleagues on the ICI's Small Funds Committee are very concerned about 
the possible impact on their firms of such a ban.
    My colleagues fear that a ban on joint management would result in 
reduced access for mutual fund investors to skilled investment 
professionals who, if forced to choose, likely would opt to manage less 
regulated and more lucrative types of investment accounts such as hedge 
funds. In addition, the prohibition could eliminate important operating 
efficiencies for investment management firms. My colleagues also 
believe that it could have harsh, disruptive, and anticompetitive 
effects for smaller investment management firms, which have fewer 
employees and might not have the resources to maintain separate staff 
for different types of accounts.\6\
---------------------------------------------------------------------------
    \6\ The negative effects of a joint management ban were well 
articulated in recent testimony before this Committee. See Statement of 
Michael S. Miller, Managing Director, The Vanguard Group, Inc., Review 
of Current Investigations and Regulatory Actions Regarding the Mutual 
Fund Industry: Fund Operations and Governance, Before the Committee on 
Banking, Housing, and Urban Affairs, U.S. Senate, 108th Cong., 2nd 
Sess. (March 2, 2004).
---------------------------------------------------------------------------
    The potential conflicts of interest associated with joint 
management of mutual funds and hedge funds do not seem to call for such 
a drastic all-or-nothing approach. Rather, it should be possible to 
address these potential conflicts and protect the interests of fund 
investors by requiring advisers who manage both types of products to 
adopt appropriate policies and procedures. It is important to note 
that, under the SEC's new compliance rule, such policies and procedures 
would be subject to continuing oversight by the fund's chief compliance 
officer and the fund board.
Mutual Fund Fees
    Notwithstanding statements by Members of Congress and Federal 
regulators that they are not interested in rate setting for mutual 
funds, some proposals have been floated that would seem to move in that 
direction (for example, requiring specific SEC approval before a fund 
may charge its shareholders for any new service). Such Government 
intervention with respect to fees has no place in an industry that is 
as dynamic and competitive as ours.
    I firmly believe that discipline with respect to mutual fund fees 
and costs comes from two things, and two things alone: Competition in 
the marketplace, which is fostered in part by the creation and success 
of smaller fund groups, and transparency, which is fostered by clear 
and meaningful disclosure to investors about the costs associated with 
investing in a particular mutual fund.\7\ I am pleased that the SEC has 
taken steps to provide more meaningful fee disclosure to fund 
investors, in particular by its recent adoption of a rule that will 
require shareholder reports to include more detailed information about 
fund expenses and to present such information in a standardized way, 
thus facilitating comparisons across funds.
---------------------------------------------------------------------------
    \7\ Contrary to the assertions of some industry critics, mutual 
fund boards are not charged with negotiating the lowest possible 
management fee. But rather, fund directors, acting in an oversight 
capacity, must ensure that fees are within a reasonable range. They 
also must evaluate the continuing propriety of fees in light of any 
material change in circumstances. See ICI Fund Governance Letter, supra 
note 4.
---------------------------------------------------------------------------
Rule 12b-1
    Adopted more than 20 years ago by the SEC, Rule 12b-1 under the 
Investment Company Act permits payments for distribution from fund 
assets, subject to several safeguards, which include ongoing board 
oversight of Rule 12b-1 plans. There is widespread agreement that fund 
distribution practices have evolved significantly since 1980 and that a 
thorough review of such practices, and the role of Rule 12b-1, is 
overdue. I am pleased that the SEC has initiated such a review and has 
solicited comments from the public on possible reforms to the rule.\8\
---------------------------------------------------------------------------
    \8\ See Prohibition on the Use of Brokerage Commissions to Finance 
Distribution, SEC Release No. IC-26356 (February 24, 2004) (Rule 12b-1 
Release).
---------------------------------------------------------------------------
    One of the pending legislative proposals calls for the outright 
repeal of Rule 12b-1, and the SEC also specifically requested comment 
on whether it should repeal the Rule. The Rule should be updated to 
reflect today's realities but should not be repealed. Rule 12b-1 
continues to serve an important function by giving investors choice on 
how to compensate the intermediaries whose assistance they sought in 
making their investment decisions. Moreover, many small fund groups 
have been able to remain competitive because they were able to gain 
access to a wider array of distribution channels than they otherwise 
would have through traditional sales load structures.
Directed Brokerage
    In keeping with its commitment to acting in the best interests of 
fund shareholders, the mutual fund industry must be willing to 
reexamine practices that give even the appearance that a fund's adviser 
may be putting its own interests before those of the fund's 
shareholders. One such practice is ``directed brokerage,'' in which an 
adviser may take sales of fund shares into account when selecting 
brokers to execute portfolio transactions for the fund. Although the 
NASD strictly regulates this practice, and prohibits any type of quid 
pro quo between the adviser and broker, directed brokerage involves 
potential conflicts of interest that could easily be avoided by simply 
banning the practice altogether.
    In December, the industry called on the SEC to put an end to 
directed brokerage arrangements.\9\ Consistent with the industry's 
recommendation, the SEC has issued a proposal that would prohibit any 
consideration of broker sales efforts in allocating fund brokerage.\10\ 
I would urge the SEC to modify its proposal, however, so that funds 
executing portfolio transactions through selling brokers would have the 
protection of a safe harbor if they put procedures in place to ensure 
that the direction of brokerage in each instance is based solely on the 
broker's execution capabilities and is not intended as a reward for its 
sale of fund shares.
---------------------------------------------------------------------------
    \9\ See Letter from Matthew P. Fink, President, Investment Company 
Institute, to the Honorable William H. Donaldson, Chairman, U.S. 
Securities and Exchange Commission, dated December 16, 2003 (ICI Letter 
to Donaldson).
    \10\ See Rule 12b-1 Release, supra note 8. The NASD also has filed 
with the SEC a proposal to amend its rules to prohibit broker-dealers 
from selling the shares of any mutual fund that considers fund sales in 
making its brokerage allocation decisions. See Proposed Amendment to 
Rule Relating to Execution of Investment Company Portfolio 
Transactions, File No. SR-NASD-2004-027 (February 10, 2004).
---------------------------------------------------------------------------
Revenue Sharing Arrangements
    Several reform proposals, both in Congress and at the SEC, seek to 
address the criticism that revenue sharing payments by a fund adviser 
to a broker selling the fund's shares are not sufficiently transparent 
to investors. This criticism is a valid one, and I do think reform is 
needed in this area. An investor buying fund shares through a broker 
needs to be made aware of any incentives the broker may have to sell 
those shares. Armed with that information, the investor would be able 
to evaluate the broker's recommendation in light of those incentives. 
Knowledge is power, and providing this type of information to investors 
at the point of sale--as the SEC has proposed \11\--would empower 
investors to make more informed decisions about how to invest their 
hard-earned savings.
---------------------------------------------------------------------------
    \11\ See Confirmation Requirements and Point-of-Sale Disclosure 
Requirements for Transactions in Certain Mutual Funds and Other 
Securities, and Other Confirmation Requirement Amendments, and 
Amendments to the Registration Form for Mutual Funds, SEC Release Nos. 
33-8358, 34-49148, IC-26341 (January 29, 2004).
---------------------------------------------------------------------------
    At the same time, I do not agree that revenue sharing arrangements 
should be eliminated or that fund boards should be required to make 
value judgments about whether such arrangements are in the best 
interests of fund shareholders, as some legislators have proposed. The 
revenue that is being shared under such arrangements belongs to the 
adviser, not the fund, and there are already protections in existing 
law to ensure that an adviser is not indirectly using fund assets to 
finance distribution. The fact that revenue sharing arrangements exist 
simply reflects a basic economic principle that transcends the mutual 
fund industry--that is, competition for access to available 
distribution channels.
Soft-Dollar Arrangements
    The use of soft dollars by investment advisers is another area 
worthy of reform. Current law contains a safe harbor that in effect 
permits a fund's adviser, in certain circumstances, to pay for 
brokerage and research services using commissions generated by the 
fund's portfolio trades. The potential conflicts of interest are clear: 
An adviser may be tempted to (1) select a broker based on such services 
rather than on the broker's ability to deliver best execution or (2) 
pay too much in commissions or engage in unnecessary trading to 
generate soft-dollar credits. In my view, these potential conflicts 
have been exacerbated by the SEC's broad interpretation of the safe 
harbor, which allows soft-dollar ``credits'' to be ``redeemed'' for 
products and services that have attributes of traditional overhead 
expenses and lack intellectual content.
    The SEC could easily stem the potential for abuse in this area by 
narrowing its interpretation of the safe harbor. I support a 
recommendation made by the ICI in December that would significantly 
narrow the safe harbor--and thus the use of soft-dollar credits.\12\ 
Requiring advisers generally to pay for research services directly 
would also promote transparency, making it easier for investors to 
compare the fees charged by different investment advisers. It is 
important to note that any reforms relating to the use of soft dollars 
should apply to all investment advisers, not just those managing mutual 
funds. Otherwise, not all investors would benefit from the additional 
protections that would flow from curbing the use of soft dollars.
---------------------------------------------------------------------------
    \12\ See ICI Letter to Donaldson, supra note 9.
---------------------------------------------------------------------------
Conclusion
    In closing, I would like to reiterate my support for the SEC's 
regulatory actions to address the problems that have been uncovered in 
the mutual fund industry. Going forward, however, I would urge 
policymakers to be mindful of the potential impact of further changes 
on small fund groups. As I hope I have demonstrated, small fund groups 
play a vital role in spurring competition and innovation in the mutual 
fund industry. In the same way that mutual fund investors benefit from 
the competitiveness and creativity of our industry, they also bear the 
costs associated with legislative and regulatory changes affecting the 
industry. For this reason, it is imperative that any such changes be 
guided by this single standard: What is best for our Nation's mutual 
fund investors.
    I thank the Committee for the opportunity to present my views, and 
I offer my continuing assistance as you continue your thoughtful 
consideration of these important issues.

                               ----------
                   PREPARED STATEMENT OF MARK TREANOR
                 General Counsel, Wachovia Corporation
             on behalf of the Financial Services Roundtable
                             March 31, 2004

Introduction to Financial Services Roundtable
    The Financial Services Roundtable unifies the leadership of large 
integrated financial services companies. The Roundtable's membership 
includes 100 of the largest firms from the banking, securities, 
investment, and insurance sectors. This broad membership, including 
investment advisers, broker-dealers, and administrators of retirement 
plans, makes the Roundtable uniquely qualified to comment on mutual 
fund distribution issues.
Summary of Position on Mutual Fund Distribution
    The Roundtable would like to commend Chairman Richard Shelby and 
the entire Senate Banking Committee for conducting a thorough, 
deliberate examination of mutual fund issues. The Securities and 
Exchange Commission (SEC) is also conducting a comprehensive review of 
mutual fund regulation. Not only is the SEC moving aggressively to 
consider proposals to prevent recurrences of abusive late trading and 
market timing, but also the Agency has proposed or adopted rules across 
the entire spectrum of mutual fund operations. The Roundtable believes 
the regulatory process should be allowed to work before any legislative 
changes are enacted.
    The SEC has put forward for public comment a number of proposals 
addressing distribution issues.\1\ These proposals are discussed in 
greater detail below. In summary, the Agency is seeking to improve 
disclosure to investors and possible prohibitions on particular 
business practices. The comment periods for many of these proposals are 
still open and the Roundtable expects to file comments with the SEC.\2\
---------------------------------------------------------------------------
    \1\ Proposed Rule: Confirmation Requirements and Point-of-Sale 
Disclosure Requirements for Transactions in Certain Mutual Funds and 
Other Securities, and Other Confirmation Requirement Amendments, and 
Amendments to the Registration Form for Mutual Funds, SEC Rel. No. 33-
8358 (January 29, 2004); Proposed Rule: Prohibition on the Use of 
Brokerage Commissions to Finance Distribution, SEC Rel. No. IC-26356 
(February 24, 2004).
    \2\ The Roundtable would be pleased to provide any comment letters 
it files for the Committee's hearing record.
---------------------------------------------------------------------------
    As a result, the Roundtable has not yet taken positions on each 
specific proposal put forward by the SEC. In general, the Roundtable 
favors disclosure over prohibitions, including prohibitions on specific 
types of distribution arrangements. Our goal should be the greatest 
possible choice for investors. Armed with the appropriate information, 
investors can choose how they want to compensate the intermediaries who 
service them. The Roundtable also expresses its views below on 
improving mutual fund disclosure; strengthening fund ethics and 
governance; and protecting fund shareholders.
Introduction to Wachovia
    Wachovia Corporation is one of the largest providers of financial 
services to retail, brokerage, and corporate customers throughout the 
East Coast and the Nation, with assets of $401 billion, market 
capitalization of $61 billion and stockholders' equity of $32 billion 
at December 31, 2003. Its four core businesses, the General Bank, 
Capital Management, Wealth Management, and the Corporate and Investment 
Bank, serve 12 million households and businesses, primarily in 11 East 
Coast States and Washington, DC. Wachovia's full-service brokerage, 
Wachovia Securities, LLC, serves clients in 49 States. Global services 
are provided through 32 international offices.
Distribution of Mutual Funds
    Mutual funds have become the investment vehicle of choice for 
Americans seeking to reach long-term financial goals. Whether directly 
or through retirement plans and other investment channels, American 
investors have turned to mutual funds in order to save and build 
wealth. Mutual funds offer a convenient and affordable way to make 
diversified investments in stocks and bonds. Roughly half of all 
American households own mutual funds; nearly three-quarters of all 
mutual fund shares are owned by individual investors.
    Some investors have the time, sophistication and inclination to 
investigate and evaluate mutual fund options on their own. Other 
investors prefer to have an intermediary help them identify their 
investment goals and funds that may be appropriate to help them meet 
those goals. In fact, 88 percent of mutual fund shares are purchased 
through intermediaries. Brokers, financial planners, insurance company 
separate accounts, retirement plan administrators--all serve as 
important channels for distribution of mutual funds to the public. They 
provide investors a convenient means of comparing and accessing a 
variety of competing mutual fund families.
    In addition to distributing mutual funds, intermediaries may have 
an important role to play in servicing customers' mutual fund accounts 
on an ongoing basis. Many investors prefer the convenience of receiving 
a single statement that presents all of their investments, including 
their investments in various mutual fund families, rather than 
receiving multiple statements from different financial institutions. 
Intermediaries may also help investors understand their statements and 
the performance returns on their mutual fund investments.
    It is proper to compensate intermediaries for these services 
performed at the request and for the benefit of investors. 
Historically, that compensation took the form of an upfront charge paid 
by the investor--known as a ``front-end sales load.'' Sales loads 
typically ranged in amount up to 8.5 percent. Today, compensation may 
take various forms.\3\ ``12b-1 fees,'' so-called after SEC Rule 12b-
1,\4\ are fees deducted from fund assets to pay for distribution. 
Section 12(b) of the Investment Company Act gives the SEC authority to 
regulate a fund's distribution of its securities, in order to protect 
fund shareholders from excessive distribution costs.\5\ Rule 12b-1 
permits funds to adopt written plans for using fund assets to pay for 
distribution. In effect, 12b-1 fees allow investors to pay for 
distribution and related costs over time rather than all at once.
---------------------------------------------------------------------------
    \3\ ``Class A'' mutual fund shares may have a front-end sales load, 
with breakpoints for larger investments. ``Class B'' shares may have no 
front-end sales charge, but may have ``12b-1 fees'' and a sales charge 
deducted if the shares are redeemed within a certain period of time. 
``Class C'' shares may have no sales charges but have 12b-1 fees.
    \4\ 17 CFR 270.12b-1.
    \5\ 15 U.S.C. 80a-12(b).
---------------------------------------------------------------------------
    Fund advisers make payments to intermediaries for distribution, 
sometimes known as ``revenue sharing'' payments. It is important to 
note these payments are made from the assets of the adviser, as opposed 
to the assets of the fund. Furthermore, a broker-dealer's registered 
representatives always remain subject to rules of self-regulatory 
organizations that require that any funds they recommend to investors 
be ``suitable'' for those investors.
    Payments by fund advisers or their affiliates may also compensate 
broker-dealers for performing routine shareholder servicing. These 
functions may include processing fund transactions; maintaining 
customer accounts; mailing prospectuses and confirmation statements; 
and other tasks that mutual funds otherwise perform themselves. 
Payments for these administrative services have helped foster the 
development by broker-dealers of mutual fund ``supermarkets.'' These 
allow investors the convenience of accessing multiple mutual fund 
families in a single place and receiving a single statement covering 
their mutual fund investments.
    The term ``directed brokerage'' refers to the use of fund brokerage 
commissions to facilitate the distribution of fund shares. In general, 
pursuant to rule of the National Association of Securities Dealers 
(NASD), a broker may not condition its efforts in distributing a fund's 
shares on receipt of brokerage commissions from the fund.\6\ The rule 
allows a fund to consider sales of its shares in the selection of 
brokers to execute portfolio transactions for the fund, subject to best 
execution and provided the policy is disclosed.\7\ In approving this 
rule, the SEC added that this should not generate additional expense to 
the fund and fund boards should consider the potential conflict of 
interest inherent in using fund assets to pay for distribution.\8\
---------------------------------------------------------------------------
    \6\ NASD Conduct Rule 2830(k) (Execution of Investment Company 
Portfolio Transactions).
    \7\ Id.
    \8\ SEC Investment Company Act Rel. No. 11662 (March 4, 1981). The 
SEC has proposed to prohibit mutual funds from directing brokerage 
transactions to compensate broker-dealers for promoting fund shares. 
See text accompanying footnote 7 below.
---------------------------------------------------------------------------
Disclosure of the Costs of Distribution
    Mutual fund management fees are paid to investment advisors to 
select portfolio securities and to manage funds. They do not include 
all costs and expenses that have an impact on a fund's net performance. 
Mutual fund investors deserve to know how their assets are being spent 
on items such as fund distribution. When these costs and expenses are 
disclosed, investors can make informed decisions as to whether 
shareholders interests are being served.
    Safeguards already apply to the imposition of 12b-1 fees and they 
are currently disclosed to investors. Under Rule 12b-1, a fund may not 
use fund assets to pay distribution-related costs except pursuant to a 
written plan approved by fund directors and shareholders. A majority of 
fund independent directors must approve the fees each year. Any 
increase in 12b-1 fees must be approved by both a majority of fund 
independent directors and the fund shareholders. A fund that charges 
12b-1 fees must disclose that fact in its prospectus. A fund is 
required to disclose how 12b-1 fees increase costs over time and 
identify them as a separate item in the fund's fee table in the 
prospectus and as part of the fund's annual operating expenses.
    While Rule 12b-1 itself does not limit the level of 12b-1 fees, 
rules adopted by the National Association of Securities Dealers (NASD) 
act to do so. NASD rules limit the amount of aggregate mutual fund 
charges, including sales loads, 12b-1 and service fees.\9\ Pursuant to 
NASD rule, a broker may not sell shares of a mutual fund with a sales 
load in excess of 8.5 percent of the purchase price, whether assessed 
at the time of purchase or the time of redemption, and so long as the 
fund does not charge a 12b-1 fee or a service fee. The sales load of a 
fund with a 12b-1 fee and a service fee may not exceed 6.25 percent of 
the amount invested; the 12b-1 fee and service fee of a fund with a 
sales load may not exceed 0.75 percent per year of the fund's average 
annual net assets plus a 0.25 percent service fee. A fund also may not 
advertise itself as a ``no load'' fund if it imposes 12b-1 fees and/or 
service fees greater than 0.25 percent.
---------------------------------------------------------------------------
    \9\ NASD Conduct Rule 2830 (Investment Company Securities).
---------------------------------------------------------------------------
    As described above, as part of its comprehensive review of mutual 
fund regulation the SEC is seeking comment on potential changes to the 
distribution of mutual funds, including under Rule 12b-1.\10\ The 
public comment periods with respect to the following proposals remain 
open and the Roundtable anticipates that it will respond to the SEC's 
proposals in detail. In general, the Roundtable prefers improved 
disclosure of distribution and other business arrangements to attempts 
to prohibit specified types of arrangements.
---------------------------------------------------------------------------
    \10\ See footnote 1 above.
---------------------------------------------------------------------------
    First, the SEC has proposed amendments to the Rule to prohibit 
mutual funds from directing brokerage transactions to compensate a 
broker-dealer for promoting fund shares.\11\ A fund that directs any 
portfolio securities transactions to a broker that sells its shares 
must have policies and procedures in place that are designed to ensure 
that its selection of brokers is not influenced by fund distribution 
issues.\12\ Alternatively, the SEC is seeking comment on requiring 
greater disclosure of directed brokerage.
---------------------------------------------------------------------------
    \11\ Proposed Rule 12b-1(h)(1).
    \12\ Proposed Rule 12b-1(i).
---------------------------------------------------------------------------
    The SEC has also proposed requiring brokers to provide customers 
with information about distribution-related costs at the time of 
purchase of mutual fund shares. Brokers would have to estimate the 
total annual dollar amount of asset-based sales charges, including 12b-
1 fees, that would be associated with the share purchased, assuming 
their value remains unchanged. Brokers also would be required to 
disclose the existence of differential compensation--broadly speaking, 
whether brokers have a greater financial incentive to sell certain 
mutual funds over others.
    Separately, the SEC is also seeking comment on whether to prohibit 
funds from deducting distribution-related costs, including 12b-1 fees, 
from fund assets; the proposal would provide instead that they be 
deducted directly from shareholder accounts with the deduction 
appearing on account statements.

        Under this approach, a shareholder purchasing $10,000 of fund 
        shares with a 5-percent sales load could pay a $500 sales load 
        at the time of purchase, or could pay an amount equal to some 
        percentage of the value of his or her account each month until 
        the $500 amount is fully paid (plus carrying interest).\13\
---------------------------------------------------------------------------
    \13\ SEC Proposed Rule: Prohibition on the Use of Brokerage 
Commissions to Finance Distribution, Rel. No. IC-26536 (February 24, 
2004), at 9.

    Among the potential benefits of this change identified by the SEC 
are increased transparency to shareholders; reduced payments by long-
term fund shareholders; and reduced payments by existing 
shareholders.\14\ The SEC is also seeking comment on whether to rescind 
the rule.
---------------------------------------------------------------------------
    \14\ Id.
---------------------------------------------------------------------------
Other Mutual Fund Issues
    The Roundtable would like to share its views on improving mutual 
fund disclosure; strengthening fund ethics and governance; and 
protecting fund shareholders.
Improving Mutual Fund Disclosure
    A mutual fund's management fee (the fee paid to the investment 
advisor to select portfolio securities for and manage the fund) does 
not include all costs and expenses that have an impact on a fund's net 
performance. The Roundtable believes that mutual fund investors deserve 
to know how their assets are being spent on items other than 
distribution, such as brokerage. When costs and expenses are disclosed, 
investors can make informed decisions as to whether shareholder 
interests are being served. The Roundtable's member companies agree 
that aggregate fund brokerage commissions, average commission rate per 
share, and turnover information are useful types of disclosure. More 
information could also be disclosed about any services received by a 
fund in addition to trade execution, such as investment research. But, 
the Roundtable believes that efforts to require funds or brokers to 
assign precise dollar values or artificial prices to proprietary 
services that are not commercially available on an independent basis 
(such as an in-house research product) are likely to be unworkable and 
unreliable.
    The Roundtable does not support disclosure of actual dollar amounts 
of compensation paid to individual portfolio managers. Instead, the 
Roundtable does support disclosure to fund investors of the structure 
and methodology of portfolio manager compensation.\15\ This would help 
investors understand portfolio managers' incentives and whether the 
fund will meet their investment objectives.
---------------------------------------------------------------------------
    \15\ See Proposed Rule: Disclosure Regarding Portfolio Managers of 
Registered Management Investment Companies, SEC Rel. No. 33-8396 (March 
11, 2004).
---------------------------------------------------------------------------
Strengthening Fund Ethics and Governance
    In addition to robust disclosure obligations, the Roundtable 
believes mutual funds must have vigorous ethics and governance 
requirements. At the same time, it is important to understand that 
mutual funds differ from operating companies. Mutual funds typically do 
not have employees. Instead, the fund's investment advisor carries out 
its day-to-day operations.
    The Roundtable supports requiring that a supermajority of a fund's 
board of directors be independent of the fund adviser. Independent fund 
directors play a critical role in the protection of fund shareholders. 
Directors approve an advisory contract and oversee the advisor's 
performance. Oversight by fund boards is the most effective method of 
managing potential conflicts of interest that could harm fund 
shareholders. Requiring that a supermajority of directors be 
independent is an important step toward ensuring that the board carries 
out this role.
    The Roundtable believes that a board with a supermajority of 
independent directors can determine the individual best suited to serve 
as chairman and would not support a requirement that the chairman be an 
independent director. If a nonindependent director serves as fund 
chairman, certain governance safeguards could be in place to promote 
the independence of the board as a whole. These include requiring the 
independent directors to choose a lead director and hire their own 
counsel; requiring the board nominating committee to be composed 
entirely of independent directors; and requiring that the independent 
directors set their own compensation. These measures would ensure that 
a nonindependent chairman cannot control a board and that independent 
directors will be able to carry out their responsibilities to fund 
shareholders.
    The SEC has recently taken a step that should enhance the ability 
of fund directors to safeguard shareholders' interests. The SEC has 
adopted rules requiring fund directors to approve written compliance 
policies and programs for both the fund and the fund's advisor. The 
fund's compliance program will be administered by a chief compliance 
officer, reporting directly to the board. This will increase 
accountability and provide fund directors a centralized assessment of 
fund compliance that is not influenced by the management of the fund's 
investment adviser.\16\
---------------------------------------------------------------------------
    \16\ Final Rule: Compliance Programs of Investment Companies and 
Investment Advisers, SEC Rel. No. IA-2204 (December 17, 2003).
---------------------------------------------------------------------------
Protecting Mutual Fund Shareholders
    Recent instances of late trading and market timing in mutual funds 
have undermined investor confidence. Roundtable members care very 
deeply about restoring investor trust and preventing future abuses. The 
Roundtable supports a number of additional protections for mutual fund 
shareholders.
    First, the Roundtable supports vigorous additional efforts by the 
SEC to protect mutual fund shareholders from late trading. From 
intermediaries to funds, more can and should be done to ensure that all 
investors are treated fairly in terms of the price they receive when 
buying and selling fund shares. Roundtable member firms support 
requiring participants in the process of transmitting investor orders 
in mutual funds to adopt forceful safeguards against late trading. The 
Roundtable advocates requiring funds and fund intermediaries, as a 
condition to be eligible to receive mutual fund orders up to the 4:00 
p.m. closing time, to have electronic time stamping systems and abide 
by associated compliance, certification and independent audit 
requirements. The Roundtable believes these requirements would better 
serve investors than the ``hard close'' at the fund only proposed by 
the SEC.\17\ Roundtable members believe the ``hard close'' would be 
disruptive and confusing to investors. Investors buying or selling fund 
shares through brokerage or retirement accounts could face cut-off 
times of 2:30 p.m. or even earlier. The Roundtable suggests that it has 
put forward a more investor-friendly means of preventing late trading.
---------------------------------------------------------------------------
    \17\ Proposed Rule: Amendments to Rules Governing Pricing of Mutual 
Fund Shares, SEC Rel. No. IC-26288 (December 11, 2003).
---------------------------------------------------------------------------
    Roundtable members support vigorous additional efforts by the SEC 
to guard against market timing. The Roundtable supports the enhanced 
disclosure by funds of their market timing policies and practices 
proposed by the SEC.\18\ In general, the Roundtable believes it is 
better to present investors with greater information regarding funds' 
market timing policies than to enforce new ``one size fits all'' rules 
on this issue. The Roundtable also supports the SEC's proposals on the 
wider use of fair value pricing and on disclosure of that issue and of 
disclosure to selected parties of fund portfolio holdings.
---------------------------------------------------------------------------
    \18\ Proposed Rule: Disclosure Regarding Market Timing and 
Selective Disclosure of Portfolio Holdings, SEC Rel. No. 33-8343 
(December 11, 2003).
---------------------------------------------------------------------------
    Finally, the Roundtable supports requiring mutual funds to disclose 
to investors the potential conflicts arising out of the joint 
management of mutual funds and other accounts.\19\ At the same time, 
fund directors must ensure that advisers do not disadvantage fund 
shareholders in favor of other advisory clients. Investors can then 
evaluate the risks in deciding where to invest. A blanket ban on joint 
management of mutual funds and hedge funds would actually harm mutual 
fund investors, as many portfolio managers would likely choose hedge 
funds because they typically offer higher compensation than do mutual 
funds.
---------------------------------------------------------------------------
    \19\ See Proposed Rule: Disclosure Regarding Portfolio Managers of 
Registered Management Investment Companies, SEC Rel. No. 33-8396 (March 
11, 2004).
---------------------------------------------------------------------------
Conclusion
    Roundtable members believe disclosure is a crucial tool to ensure 
that funds serve their shareholders and that shareholders can evaluate 
fund performance effectively. The Roundtable supports improvements to 
make certain that fund disclosures are periodic, timely, robust, 
efficient, uniform, and easy to administer. However, proposals that 
would increase compliance costs without commensurate increases in 
investor protection would only reduce returns for mutual fund 
shareholders. The Roundtable is concerned that mutual funds not be 
undermined as an attractive product for investors.
    The Roundtable is studying the SEC's proposals carefully and 
expects to file comments with the Agency before the comment periods 
expire in April and May. As noted, the Roundtable in general feels that 
improvement to disclosure is a better response to these issues than is 
prohibition of specific business practices. The Roundtable commends the 
SEC for its vigorous efforts to ensure that mutual fund shareholders 
receive the information and protection they need and deserve.
    We look forward to continuing our dialogue with the Agency, and the 
Committee, so investors continue to have confidence in mutual funds as 
an investment vehicle.


                            U.S. SECURITIES
                        AND EXCHANGE COMMISSION

                              ----------                              


                        THURSDAY, APRIL 8, 2004

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10:06 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order.
    This morning, the Committee concludes its series of 
hearings examining the mutual fund industry. Since November, 
the Committee has held a total of 10 hearings devoted to the 
fund industry. This extended hearing process reflects the 
complex nature of the issues under consideration. During these 
hearings, we have benefited from expert testimony on the full 
scope of issues confronting the fund industry. These hearings 
have educated the Committee and have created a substantial 
record of reform.
    At the beginning of this process, I stated that the guiding 
principle of reform would be investor protection. I further 
stated that the regulators, industry, and Congress must work 
collectively to restore integrity to our markets and reassure 
investors that mutual funds are a vehicle in which they can 
safely invest their money. It is against this principle that we 
must evaluate reform efforts. Although a few months' time is 
certainly insufficient for final judgment, I do believe that we 
have a preliminary record to measure the SEC's commitment to 
reform.
    Last November, Chairman Donaldson testified before this 
Committee that the SEC would reform the mutual fund industry, 
and he is fulfilling that promise. Under Chairman Donaldson's 
leadership, the SEC has swiftly executed an aggressive reform 
agenda comprised of strong enforcement actions, revised 
compliance and inspection programs, and comprehensive 
rulemakings. The SEC has promulgated more than 10 rules 
addressing fund compliance, governance and ethics, conflicts of 
interest, and disclosure practices. This slate of rules is one 
of the most comprehensive rulemaking initiatives in the SEC's 
history. Through these rulemakings, the SEC continues to 
thoroughly analyze these complex issues and carefully evaluate 
the benefits and consequences of various reform alternatives. 
This Committee has spent a great deal of time reviewing the 
scope, application, and consequences of these rules. Given the 
revelations of wrongdoing in the fund industry, I believe that 
such an expansive rulemaking effort was required. And, Mr. 
Chairman, I support your aggressive leadership. We commend you 
for the road you are going down.
    As we conclude these hearings, Congress must determine, Mr. 
Chairman, whether legislation is necessary in light of the 
SEC's vigorous response. Clearly, Chairman Donaldson and his 
staff have answered the charge for reform. Nevertheless, I 
believe it is incumbent upon Congress to determine how we can 
complement Chairman Donaldson's initiatives and bolster his 
reform efforts. We, in Congress, have an obligation to the 
investing public to ensure that the SEC is armed with the full 
array of powers necessary to fulfill its mission of investor 
protection. If necessary, I believe that Congress stands ready 
to enhance the SEC's authority through the grant of new 
authority. Hopefully, Mr. Chairman, today's hearing will shed 
more light on what Congress should do to complement SEC's 
efforts.
    And while evaluating the scope of the SEC's authority, this 
Committee must also measure the SEC's resolve to continue 
reform. Some issues, such as soft dollars, have not yet been 
addressed through rulemakings, and the difficult tasks of rule 
implementation and compliance remain ahead. I believe that true 
fund industry reform will result from sustained regulatory and 
enforcement efforts that change the culture inside mutual funds 
and broker-dealers. This slate of recent rulemakings is just 
the beginning, Mr. Chairman. Successful implementation and 
compliance may be the true measure of reform.
    I must acknowledge--and I will--the hard work of Chairman 
Donaldson and his staff during the preceding months. Their 
timely, thorough, and diligent responses helped to restore 
investor confidence. Chairman Donaldson, I look forward to your 
testimony today and perhaps where we might need to go.
    Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Chairman Shelby. I 
want to underscore the thorough and comprehensive manner in 
which you have been examining the problems that have arisen in 
the mutual fund industry. SEC Chairman Donaldson testified at 
the Committee's first hearing, as I recall, on this subject, 
and it is appropriate, that he returns today to testify at the 
concluding hearing. Chairman Donaldson, I join Chairman Shelby 
in welcoming you back before the Committee. It is always a 
pleasure to have you here.
    How these mutual fund problems are resolved has important 
implications for more than half of all U.S. households. About 
100 million Americans today own mutual funds. And they count on 
these investments to provide retirement security, to cover 
children's education expenses, or to meet other significant 
financial obligations. Clearly, they must be able to rely on 
the integrity and honesty of the funds to which they entrust 
their savings.
    As Chairman Shelby has said, we place the interests of the 
investor paramount. My recollection is there is an engraving at 
the SEC headquaters from Chairman William O. Douglas that makes 
this very point--this is what the SEC is there for, to protect 
the investor.
    The SEC has noted that a 1-percent increase in a fund's 
annual expense can reduce an investor's account balance in the 
fund 18 percent after 20 years. This is an arena in which small 
amounts, which in and of themselves may not look significant, 
really amount to substantial amounts over a period of time, and 
we need to be aware of that.
    The crisis of investor confidence in our markets was 
precipitated by the collapse of Enron Corporation and other 
major public companies, beginning in late 2001. The mutual fund 
industry continued to assure the public and the Congress that 
it had no major problems. Those assurances, regrettably, took 
on a hollow ring in September 2003, first, when the New York 
Attorney General Eliot Spitzer disclosed that a large hedge 
fund had engaged in improper late trading and market timing 
with several major mutual fund families.
    Since then, regrettably, numerous instances of misconduct 
have come to light. As Don Phillips, Managing Director of 
Morningstar, observed in testimony before this Committee, 
``Sadly, these were not the acts of a few low-level employees, 
but instead were violations of trust that took place at the 
highest levels, including company founders, CEO's, and 
portfolio managers.''
    The Director of Enforcement at the SEC, Stephen Cutler, 
said in November, ``More than 25 percent of firms responding to 
an SEC mutual fund inquiry reported that customers have 
received 4 p.m. prices for orders placed or confirmed after 4 
p.m., 50 percent of responding fund groups appear to have had 
at least one arrangement allowing for market timing by an 
investor. And almost 70 percent of responding brokerage firms 
reported being aware of timing activities by their customers.''
    In the wake of public disclosure of these improprieties, 
the SEC, under the effective chairmanship of Chairman 
Donaldson, the NASD, the State Attorneys General, and the State 
regulators have responded forcefully. The regulators have 
brought enforcement actions, enhanced their examination 
functions, and are engaging in extensive rulemaking.
    Chairman Donaldson has said, ``The Commission is deeply 
committed, to try to restore investor confidence in fund 
investments.'' And his actions and those of his fellow 
Commissioners have demonstrated their determination in seeking 
that goal. Business Week recognized recently, and, ``The SEC 
chief has accomplished more than many expected.''
    From the testimony at our hearings, the Committee has 
learned much about the regulators' and the industry's response 
to the concerns about such issues as: Late trading, market 
timing, selective portfolio disclosure, fee disclosures, fund 
governance, soft dollars, side-by-side management of mutual 
funds and hedge funds, and disclosure of adviser compensation. 
This has helped us to gauge the extent of the problems, their 
impact on investors, and what is being done to prevent future 
abuses.
    The SEC has brought several enforcement actions and engaged 
in a dozen rulemakings affecting mutual funds, which include 
many appropriately strong proposals. The SEC actually is 
reviewing public comments on many of these, so a number have 
not yet been finalized. And we are awaiting the final rules, 
and, of course, the Commission carries a heavy responsibility 
in that regard.
    Our witnesses have brought to our attention matters 
involving transparency, accountability, and conflicts of 
interest. We have had a number of proposals made to the 
Committee on how we might proceed in those areas. There are 
other areas where the SEC has not yet had the opportunity to 
formally address the issue or is studying or soliciting comment 
on the matter.
    I look forward to hearing the Chairman Donaldson's 
assessment of the current situation, whether the full 
dimensions of the problems in the fund industry have surfaced, 
how the SEC is addressing the problems, and what is planned for 
the future, and how the Congress can work with the Commission 
to promote the integrity of the fund industry and to protect 
the fund investors.
    It is obviously of very great importance that we all work 
together in order to assure a framework with respect to 
industry practices that enables the investor to be confident 
that he or she will be dealt with in a fair, straight-forward, 
and honest manner.
    Thank you very much, Mr. Chairman.
    Chairman Shelby. Senator Bunning, you may have arrived just 
in time. We will move back and forth.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Mr. Chairman.
    First of all, I want to thank you for holding the hearing, 
and I want to thank our witness, Chairman Donaldson, for 
testifying.
    As my colleagues know, I was in the securities business for 
25 years. I actually sold mutual funds, so I am very familiar 
with the subject.
    There has been a lot of talk about the mutual fund bill. A 
lot of talk. The House has passed a bill. Some of my colleagues 
on this Committee have introduced a bill. And Senators not on 
this Committee have introduced a bill. Chairman Shelby recently 
indicated that he would lean toward passing a bill this year. I 
am not in the habit of disagreeing with my Chairman, but it 
will be a high hill to climb to convince this Senator that we 
must pass a bill this year.
    Chairman Donaldson came in at a very difficult time. I have 
disagreed with a lot of his actions, but he has been active. He 
has moved to curb abuses and has moved to establish the SEC as 
the regulator for securities once again. I believe the SEC has 
reestablished its authority. If you do not believe me, I ask 
the securities industry people who are filling the audience 
today. We have greatly increased the SEC resources over the 
past few years. This Committee has taken the lead on making 
sure the SEC does have the resources it needs. I believe--and I 
think Chairman Donaldson agrees with me--that the SEC currently 
has the resources to enforce the authority and enforce the law. 
I think they can effectively regulate the mutual fund industry 
under existing statutes. I am sure the securities industry will 
agree with me on that, also. We have given the SEC a lot of 
resources. I believe it is time to let them use them. If they 
go too far or not far enough, then I am sure this Committee 
will be getting involved.
    One area where I think the Commission has already gone too 
far is the independent chairman issue. I completely disagree 
with the Chairman on this issue. If we have independent boards 
and the SEC required boards to be 75 percent independent, we 
should let them pick whoever they want as chairman. Let it be 
their choice. If they believe it is in the best interest of the 
investor to have a management chair, they should be able to 
have a management chair. There have been studies showing that 
funds with independent chairs have a much worse return.
    I also favor the idea of having someone who will be 
accountable. Funds with a management chair do have someone who 
will be accountable if there is a problem with the fund rather 
than saying, ``I was independent. How could I know of any of 
these problems?'' Let the independent boards pick who they 
believe is the best chair for a particular fund.
    Thank you, Mr. Chairman, for holding these hearings, and I 
am anxious to hear from Chairman Donaldson.
    Chairman Shelby. Before I call on Senator Reed, I just want 
to set the record straight as of today. I do not deny that I 
said I was leaning toward legislation. That was days ago or 
weeks ago. Today I am leaning straight up. I am not leaning 
toward legislation.
    [Laughter.]
    Because I think that as we reviewed the testimony that has 
come before the previous nine hearings and we have put together 
what the SEC has been doing, I think at the end of this hearing 
we will see from Chairman Donaldson's testimony and what they 
are going to do, and maybe, Senator Bunning, we should let the 
SEC do its work, continue our oversight, not rule out any 
legislation in the future but not be rushing to judgment on 
legislation.
    Senator Bunning. I think that is a great idea, Mr. 
Chairman.
    Chairman Shelby. Thank you.
    Senator Reed.

                 COMMENTS OF SENATOR JACK REED

    Senator Reed. Thank you, Mr. Chairman. Thank you also for 
holding these many hearings on this very important topic. 
Welcome, Chairman Donaldson.
    The Securities and Exchange Commission has put forward a 
comprehensive package of proposals that would fundamentally 
change how this industry operates, and I look forward to 
hearing from you, Mr. Chairman, about these proposals and 
encourage you to let us know what we can do to assist you, 
particularly if you believe you need additional Congressional 
authority.
    We must continue to keep in mind that mutual funds 
represent one the best ways for individual investors to 
participate in the market. Millions of Americans rely on these 
funds to have easy access to diversification and the management 
skills of an experienced investor adviser. With so many 
Americans investing and benefiting from mutual funds, Congress 
has an important responsibility to ensure that all investors 
are treated fairly and equally.
    Thank you, Mr. Chairman. I look forward to your comments.
    Chairman Shelby. Senator Corzine.

              STATEMENT OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you, Mr. Chairman. And let me 
congratulate you on running a terrific set of hearings with 
respect to this overall topic.
    Chairman Shelby. Thank you.
    Senator Corzine. Those nine hearings that you talked about 
are really quite a tutorial on the industry, the issues, and 
the problems. And I must say I have learned a lot, and as you 
know, along with Senator Dodd, we introduced an original piece 
of legislation, S. 1971, which we intend on using the extensive 
testimony as a basis to upgrade and update many elements of it.
    That said, I want to identify with what both Senator 
Bunning and Senator Reed said with regard to the SEC, which 
does mean maybe leaning into the wind or standing straight up, 
may be is an appropriate point. I think it is one of those 
issues we should have some discussion about today. But I think 
the SEC has done a great job as it relates to the mutual fund 
industry and taking a comprehensive response. Everybody can 
disagree on elements of all kinds of policies, but I think it 
has been quite effective in a very troubled time. And I think 
the reestablishment of the credibility of the SEC has been 
really quite extensive, and I think that comes in part from the 
leadership. And I welcome Chairman Donaldson here and I 
congratulate him for those efforts.
    But there still is a lot to debate about whether making 
permanent some of the very thoughtful ideas and elements of the 
proposals that the SEC has come across, particularly in the 
context of we are where we are today, but if we have 
difficulties down the road, do we end up then not thinking 
through this in as thoughtful and as precise a way and then end 
up having what I think are less effective long-run formulations 
for it. And so there is a case to be made for having some of 
this put into statutory format. So I would like to hear the 
arguments back and forth on why, but I think we have all 
experienced situations where we react to a crisis in a much 
different format than what we do when we have the ability to 
actually think objectively in periods that may be a little bit 
off the front burner. And that is certainly what I would like 
to see us at least examine.
    I thank you, Mr. Chairman, for a very, very effective 
dialogue with regard to this whole effort.
    Chairman Shelby. Thank you.
    Senator Stabenow.

              STATEMENT OF SENATOR DEBBIE STABENOW

    Senator Stabenow. Thank you, Mr. Chairman. I also would 
like to thank you for a very thorough set of hearings, and it 
has been very enlightening for all of us. There is no doubt 
that there has been some troubling findings over the last year 
which have indicated that some funds are not looking out for 
the best interests of their investors. And, in addition, it is 
clear we need more transparency in the industry as we have 
talked about.
    But I am very encouraged by the leadership that we have 
seen both by regulators at the State and the Federal level, and 
I am particularly glad that Chairman Donaldson is before us 
today to update us on the actions that the Commission has, in 
fact, taken.
    There is so much that can be done through the regulatory 
policy process, and I am confident that the actions of the SEC 
and other regulators are beginning to have a corrective impact 
on the problems that we have been uncovering.
    I know that, Mr. Chairman, you have indicated that you want 
to look at the issue comprehensively and then determine if 
there is more that needs to be done legislatively. I appreciate 
that. I appreciate your careful and methodical approach to 
this. We want to make sure that we solve the problems at hand, 
but do so in a way that is measured and appropriate. The need 
to resolve investor confidence in the market for mutual funds 
and in the markets at large remains a paramount concern of 
mine, as I know it does of yours.
    In addition to looking at the mutual fund industry, though, 
I might add that we also need to remain vigilant in looking at 
the implementation of the Sarbanes-Oxley Act, and with the 
Chairman here, I do want to take the opportunity again to say 
that I am particularly concerned about provisions in the Act 
that relate to the anonymous corporate whistle-blower 
provisions. We have talked, you and I, about this, and I am 
concerned that we have not yet seen the aggressive 
implementation or monitoring by both the stock exchanges and by 
the SEC as it relates to those provisions. And I continue to 
urge you to do so.
    And as we look at our provisions there, the whistle-
blowers, who serve as our first line of defense in combating 
corporate fraud and misleading accounting, need to know that 
there is a confidential process and that it is a specific 
process. And I will continue to look forward to working with 
you on that very important piece of the legislation.
    And, again, thank you, Mr. Chairman, for this hearing.
    Chairman Shelby. Senator Carper.

             STATEMENT OF SENATOR THOMAS R. CARPER

    Senator Carper. I will be very brief.
    Chairman Donaldson, thank you for joining us today, and 
thank you for the good work that you and the SEC are doing. I 
have learned in the 3 years I have been in the Senate that 
sometimes you have to pass legislation to accomplish certain 
objectives. Sometimes you can do so by circulating a letter and 
getting a lot of your colleagues to sign on and send that 
letter to a key decisionmaker.
    Sometimes you can accomplish a whole lot by having a 
hearing, other times by having an extended series of hearings. 
And I think what has happened over this series of hearings is 
you and those who work with you at the SEC have had an 
opportunity to make some decisions, study the field, and to 
step forward and say these are the changes that we would like 
to see made. And I think for the most part, what you are doing 
are things that I agree with--not all, but for the most part, I 
agree with you and appreciate the diligence and the 
determination that you have brought to the task. If you need to 
do more, maybe we can have more hearings, give you more time to 
finish those things.
    I look forward to asking you some questions. I will just 
telegraph one of them, and that is the question of the need for 
an independent chairman, the same issue raised by Senator 
Bunning. If that is something that is truly going to be of 
value or not. So having telegraphed that pitch, I look forward 
to hearing from you.
    Thank you.
    Chairman Shelby. Chairman Donaldson, before you start, I 
just want to say what others are saying. We believe that your 
leadership at the SEC has been exemplary. You have been facing 
the tough issues, and you will continue to do this. We want to 
work with you. We are going to continue to work with you, as we 
have in the past, as the Banking Committee, with legislative 
and oversight jurisdiction of the SEC.
    In your remarks today, I hope you will tell us where we 
need to work with you specifically, on oversight or in 
legislation, or defer legislation, or what, because I believe 
we need to see how your regulations are going to work before we 
rush to judgment legislatively.
    You proceed as you wish. Your written testimony will be 
made part of the record in its entirety.

               STATEMENT OF WILLIAM H. DONALDSON

       CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION

    Mr. Donaldson. Good morning, everyone. Chairman Shelby, 
Ranking Member Sarbanes, and other Members of the Committee, I 
am delighted to be here. I thank you for inviting me to testify 
today.
    Senator Bunning. Could you move the mike a little closer?
    Mr. Donaldson. Yes.
    Senator Bunning. Thank you.
    Mr. Donaldson. The breadth of your hearings have clearly 
and effectively illustrated the complexity of the issues the 
Commission is facing in addressing the problems in the mutual 
fund industry. The hours upon hours that you and the Committee 
have spent performing critical oversight, and the testimony 
from witnesses representing all sectors and aspects of the 
problem have been 
immensely valuable as the Commission works to tackle these 
issues. I thank and commend you for the thorough and thoughtful 
approach that this Committee has brought to the problems.
    Like you, as I said many months ago, I am outraged by the 
conduct that has come to light in the recent mutual fund 
scandals. In large part, I believe that the industry lost sight 
of certain principles, in particular, its responsibility to the 
millions of investors who entrusted their life's savings to 
this industry for safekeeping. As I said last fall when I 
testified--and I believe it bears repeating--these mutual fund 
investors are entitled to honest and industrious fiduciaries 
who sensibly put their money to work for them in our capital 
markets. Investors deserve a brokerage and a mutual fund 
industry built on fundamentally fair and ethical legal 
principles. This has been the Commission's urgent and guiding 
mission as it pursues a very aggressive mutual fund reform 
program to identify and address a range of problems in the 
industry.
    Our regulatory efforts include strengthening the governance 
structure of mutual funds, addressing conflicts of interest, 
enhancing disclosure to mutual fund shareholders, and fostering 
an 
atmosphere of high ethical standards and compliance within the 
industry.
    The Commission has made significant progress and will 
continue to move aggressively to track down and pursue 
wrongdoers while expeditiously considering all of the 
outstanding mutual fund rulemaking proposals: market timing 
disclosure, breakpoint disclosure, the fund governance package, 
the investment adviser's code of ethics rule, disclosure 
regarding the factors considered by the fund's board in 
approving an advisory contract, the proposed amendments to Rule 
12b-1, the hard 4 p.m. close, portfolio manager disclosure, the 
mandatory 2-percent redemption fee, and new confirmation form 
and point-of-sale disclosure, to mention a few.
    While it is important that we act on these rules in an 
expeditious manner, it is, in my view, equally important that 
we get it right. Interested parties must have the opportunity 
to comment, our staff must have sufficient time to fully 
consider possible unintended consequences, and we need 
appropriate time to vet alternative approaches to our proposals 
so that when we adopt final rules we will adopt rules that best 
address the problems we are seeking to solve.
    The complexity associated with some of our proposals, such 
as our proposal on late trading, may take some additional time 
to ensure our solution appropriately addresses the underlying 
problem.
    As you have no doubt seen in your hearings, there are 
divergent views among knowledgeable experts over how best to 
address mutual fund oversight. Because these views often 
conflict with one another, particularly among competitors, the 
Commission's notice and comment process, which Congress so 
wisely required in all Commission rulemakings, is of infinite 
value to our final product. We benefit from a wide spectrum of 
views and opinions put forth in a formal, structured format on 
how to strengthen our proposed rules and regulations, the 
practicalities of implementing these rules and regulations, 
and, most importantly, alternative approaches to address the 
underlying goals.
    My written testimony provides significant detail about the 
agenda the Commission has undertaken. Today, I would like to 
just briefly describe some of these key reforms and then answer 
any specific questions that you have.y
    First of all, on the 4 p.m. rule proposal, to put an 
absolute halt on abusive late trading practices, the Commission 
proposed the so-called hard 4 p.m. rule. This rule amendment 
would provide for a secure pricing system that would be largely 
immune to manipulation by late traders by requiring that orders 
be placed with the fund or its primary transfer agent or 
clearing firm by the time set by the funds.
    To date, the Commission has received more than 1,000 
comment letters on this proposal, many raising concerns about 
how the proposal might adversely impact certain fund investors, 
such as 401(k) plan participants and investors in earlier time 
zones. As an alternative to the proposal, some have advocated a 
system of controls that would better prevent and detect late 
trading. Others have recommended the use of more sophisticated 
technology to create tamper-proof timestamping of trade tickets 
that would help eliminate, or at least better detect, late 
trading. The staff is analyzing this information to determine 
whether there is an effective alternative to the hard 4 p.m. 
proposal that would not disadvantage certain investors and does 
not distort competition in the marketplace. It may very well 
turn out that we adopt a combination of some of the 
alternatives that have been presented to us during the notice 
and comment process. Again, the hard 4 p.m. rule proposal 
illustrates the effectiveness of the Commission's rulemaking 
process, whereby we, and indeed the investing public, are the 
beneficiaries of a wide range of views and perspectives and 
possible solutions.
    It is a complicated situation, and, of all the things we 
are working on, it may be the one that is going to take the 
most time for us to come up with a compromise solution.
    As far as disclosures to fund investors, improved 
disclosure--particularly disclosure about fund fees, conflicts, 
and sales incentives--has been a stated priority for the 
Commission's mutual fund program in the months before the 
trading abuses came to light. The Commission adopted a 
requirement that shareholder reports include dollar-based 
expense information so that investors can easily compute the 
dollar amount of expenses paid on their investment in a fund. 
Some have questioned whether we should have required more 
information, that is, individual account information to each 
shareholder. While the staff and the Commission considered this 
alternative, we were convinced that the dollar-based expense 
information that the Commission ultimately adopted was a better 
course, as it allowed for comparability. We have ongoing 
efforts to examine the entire mutual fund disclosure regime to 
see if it is as good as it can be. However, I firmly believe we 
need to give this particular rule--which will go into effect in 
July--a good chance to operate before we begin to contemplate 
changing it.
    Internal reforms within the Commission. Last year, 
following a thorough internal review of how the Agency deals 
with risk, we initiated a new risk management program and laid 
the groundwork for an Office of Risk Assessment and Strategic 
Planning, the first of its kind at the Commission. The first 
phase has been to organize internal risk teams for each major 
program area. This framework has already been put into place 
and allows for what I like to think of as a bottom up approach 
to assessing risk in each of our divisions. A good example of 
this is through our Office of Compliance, Inspections, and 
Examinations, OCIE. We have empowered our examiners, through 
OCIE's internal risk management team, to look at potential 
problems in the mutual fund industry and broker-dealer industry 
and to formally examine these for potential problem areas.
    The new Office of Risk Assessment will work in coordination 
with these internal risk teams throughout the entire agency and 
push the Agency to proactively identify potential problem areas 
within the mutual fund and broker-dealer industries, focusing 
on early identification of new or resurgent forms of 
fraudulent, illegal, or questionable activities. In addition to 
fostering better communication and coordination between the 
divisions and offices within the Commission, the risk 
assessment initiative will help to ensure a process whereby 
senior managers at the Commission have the information 
necessary to make better, more informed decisions, and to 
proactively adjust operations and resources and methods of 
oversight to address these new challenges.
    We have also greatly enhanced our examination program. 
Budget increases in 2003 allowed us to increase our staff for 
fund examinations by a third, to approximately 500 people. 
These new resources, coupled with the Office's new risk-based 
examinations approach, should greatly improve our ability to 
detect abusive behavior and possible violations of law.
    Another critical aspect of our risk assessment effort has 
been the creation of special multidivisional task forces that 
were designed to bring together staff from various divisions 
and offices to brainstorm, evaluate, and create strategies to 
proactively undertake issues of potential concern in protecting 
our securities markets.
    Four of these task forces, which are under way now, will 
tackle issues that will help us better protect mutual fund 
investors. They are called the Chairman's Task Forces on Soft-
Dollar Arrangements, College Savings Plans--or the so-called 
529 plans--Enhanced Mutual Fund Surveillance, and Disclosure 
Regime. The task forces will meet with the relevant interested 
parties, such as individual investors, industry 
representatives, and fellow regulators, to gather critical 
intelligence and data and ultimately work toward addressing 
problems over the long haul. All of these task forces are 
discussed in detail in my written testimony.
    Because I know that the issue of soft dollars is of 
particular concern to the Committee, just as it is to the 
Commission, I want to draw attention to the Task Force on Soft 
Dollars and our efforts to address this issue.
    The Task Force on Soft Dollars, comprised of SEC staff from 
five divisions and offices, has already met with a number of 
industry representatives as it tackles this very complicated 
issue. Its goal is to fully understand all aspects of how soft 
dollars are used and the pros and cons of various alternative 
reform approaches, including the possible unintended 
consequences. While the task force is working expeditiously to 
provide recommendations, I want to ensure that the staff has 
adequate time to fully consider the issue and meet with 
interested persons so that it can come in with what we hope are 
the best and most informed recommendations possible.
    Like so many of the issues that we are facing, the area of 
soft dollars is very complex, and we have to be cautious, in my 
view, as we move forward with reforms. At the very least, the 
Commission, through the rulemaking process, should consider 
narrowing the definition of qualifying ``research'' under the 
safe harbor so that only ``real'' research that has valid, 
intellectual content, qualifies. I also expect the Task Force 
to consider whether the costs of research and execution should 
be quantified and separated and other ways that make the costs 
of research and the costs of execution more transparent. Some 
have advocated a distinction between third-party research and 
proprietary research. My view is that we should not draw such 
distinctions, but the Task Force will also consider this issue 
and provide recommendations.
    I would like to say a few words about hedge funds. The 
issues surrounding hedge funds are an excellent example of how 
the Commission can be proactive and work to enhance enforcement 
in problem areas before they spread. Indeed, this is why I 
believe our risk assessment and internal reforms are so 
important. While my written testimony describes my concerns in 
detail, I would like to summarize just a few points now with 
the caveat that these are my own views and do not necessarily 
reflect the views of the entire Commission.
    One of the views I often hear in the context of this issue 
is that hedge fund investors are wealthy and sophisticated 
individuals who do not need protecting. This, in my view, is 
not the point. Hedge fund managers are, directly and 
indirectly, providing advisory services for many U.S. 
investors, with significant impact not only on those investors 
but also on the operation of the U.S. securities markets. The 
Commission is the only Government agency that is charged with 
protecting those investors and policing those markets. Hedge 
funds are being purchased by intermediaries on behalf of 
millions of ultimate small investor beneficiaries--retirees, 
pensioners, and others not generally thought of as the 
traditional hedge fund investor. The increased employment of 
hedge funds by pension plans or funds of hedge funds makes it 
critical for investors that the Commission have basic 
information and a resulting insight as to how many hedge fund 
managers are deploying assets under management, how they handle 
their conflicts of interest, how they account for results and 
value their investments, and, most importantly, in my view, 
what impact their market activities have on the other 
participants in our equity markets.
    The SEC is responsible for enforcing the Federal securities 
laws, policing the securities markets, and ensuring fraud 
prevention and detection. This is the Commission's 
responsibility, regardless of whether we are talking about 
mutual funds, self-regulatory organizations, public companies, 
hedge funds, or other market participants. Hedge funds have 
become one of the fastest growing 
segments of the investment management business, with assets 
fast approaching $1 trillion, at a time when returns on other 
investments have not kept pace.
    Other Government entities, particularly the Federal Reserve 
Board and the Treasury, are responsible for monitoring 
potential systemic risks and the safety and soundness issues 
raised by the structure of these vehicles. While their 
oversight priorities are of great importance to our banking 
system, these agencies are not responsible for enforcing the 
Federal securities laws and protecting investors. The data they 
collect is aimed at the discharge of their prudential oversight 
responsibility.
    It troubles me that the Commission, under the current 
rules, is limited in its ability to gather information that 
could help protect millions of investors. What we have found in 
the mutual fund scandal supports this concern. We have seen 
hedge fund managers engaged in illegal behavior that results in 
taking advantage of the long-term retail investors and these 
funds. Critics, in my view, cannot have it both ways--on the 
one hand, to demand that the Commission be proactive and 
prevent and detect emerging but as of yet unforeseen, harms and 
abuses, but, on the other hand, to handicap our ability to 
obtain simple, fundamental information that facilitates our 
identification of such abuses.
    Building on the risk assessment capability we are 
developing in the Agency, we could consider a form of 
registration and an oversight regime for hedge fund managers 
different from that which we use for other, more heavily 
regulated entities, like mutual funds. They could be 
specifically tailored to the unique dynamics of these funds and 
managers. We could thus better target our inquiries on those 
hedge fund managers where there is some reasonable concern that 
they may be violating Federal securities laws.
    I intend to ensure that the Commission's consideration of 
the hedge fund issue, which in many ways is an extension of 
pooled vehicles, be thoughtful and thorough, and that any 
proposal that we put forth will be fully and appropriately 
vetted.
    Let me just touch for a moment on the enforcement efforts. 
Let me note now our four key enforcement areas related to 
mutual funds: one, late trading and abusive market timing; two, 
mutual fund sales practices, including fee disclosure issues in 
connection with the sale of mutual funds; three, the sale of 
different classes of mutual funds; and finally addressing the 
failure of firms to give their customers the discounts 
available on front-end loads for large purchases of Class A 
shares.
    For the enforcement program's current area of focus in the 
mutual fund arena, the staff is continually on the lookout for 
additional mutual fund practices that may be vulnerable or ripe 
for abuse. Accordingly, the staff is closely examining, among 
other things, the status of funds closed to new investors that, 
nevertheless, continue to charge Rule 12b-1 fees, the portfolio 
pricing practices of high-yield bond funds, the role of pension 
consultants and pension plan selection of particular mutual 
funds as their preferred investment vehicle, and the 
reasonableness of management fees charged by certain index 
funds. In all of the foregoing areas, the Commission is 
intently focusing on the roles and conduct of mutual fund 
directors. Have they adequately discharged their 
responsibility? Have they properly overseen the mutual fund 
management company on behalf of mutual fund shareholders?
    As my testimony illustrates, the Commission has embarked on 
an aggressive regulatory and enforcement agenda. I believe our 
efforts will help to ensure that there are strong safeguards in 
place to minimize the possibility of future illegal, 
fraudulent, or harmful activity. We have had ample regulatory 
authority with which to carry out this agenda and, due in large 
part to your support and your constructive approach, we have 
been able to pursue this agenda in an expedited manner.
    Let me once again compliment the Committee, Mr. Chairman, 
for its thoughtful and thorough approach to the oversight of 
this issue. The significant number of hours that you and the 
staff have spent conducting these oversight hearings and 
questioning witnesses from all segments of the industry have 
been immensely helpful to the Commission and represent a 
constructive approach to analyzing the complexity of the 
problems that have plagued the mutual fund industry for quite 
some time. The Commission and indeed the mutual fund investor 
have benefited from your approach.
    If, as the Commission moves ahead with its mutual fund 
reforms, there are critical issues that we do not have the 
ability to address, the Commission will immediately seek your 
assistance to do so; however, I do not believe that at this 
time legislation is necessary, and, in fact, that legislation 
could impede the speed with which we move forward on some of 
the rules that we have put forward.
    Thank you again for inviting me, and I would be delighted 
to answer any questions.
    Chairman Shelby. Chairman Donaldson, just to follow up on 
what you just said, do you believe that the Securities and 
Exchange Commission has the authority and the power it needs to 
adopt the full complement of rules necessary to reform the 
mutual fund industry? At this point in time, do you believe 
that?
    Mr. Donaldson. Let me just say that I think the Commission 
has the tools it needs to address the critical areas. Our 
rulemaking authority under both the Investment Company Act and 
the Investment Advisers Act gives us ample authority to act in 
virtually every area, not only to address the late trading and 
market timing abuses, but also strengthen fund governance, 
enhance ethical conduct, increase compliance, et cetera. The 
notice and comment process provides the great benefit of 
allowing us to receive these great thoughts.
    We have some 10 proposed rules on the docket. We have 
approved an additional two rules. We have a concept release 
out. Our comment period has closed and is closing through all 
the way to the end of May. I believe that by summertime we will 
be in a position to make final rule determinations, with the 
exception of one or two, the hard 4 p.m. close being the most 
appropriate one.
    But to answer your question, I believe we do have the 
authority that we need at this juncture, and I also assure you 
that if we find, as we move ahead, particularly on a longer-
term basis with some of the task forces, that we do not have 
the proper authority, we will come back to you and ask for it.
    Senator Sarbanes. Mr. Chairman, I think if you would pull 
that microphone closer to you, it would be----
    Mr. Donaldson. I am sorry.
    Chairman Shelby. Thank you, Senator Sarbanes.
    Many of the legislative proposals that have been floating 
around in the House and the Senate would essentially either 
codify or ratify areas contemplated by the SEC in your 
rulemaking. Is there a need at all to codify or reaffirm the 
SEC's rulemakings in any respect? Or should we give you that 
time to see how these rules are, first, proposed, adopted, and 
implemented?
    Mr. Donaldson. As I said, we are moving aggressively to 
adopt the rulemakings. I believe we have the necessary 
authority. I believe that there is no need at this juncture to 
codify by new laws what we are doing. As I intimated, I think, 
to stop in this process now and to start a whole new process 
would be counterproductive to what we are doing.
    It is not just me. It was the microphone.
    [Laughter.]
    And as I say, I think that, if we need further help, we 
will come back to you.
    Chairman Shelby. This is digressing a little, but you 
brought up the subject of hedge funds. Right here, in this 
Committee, the Chairman of the Federal Reserve, Alan Greenspan, 
I asked the question about regulating private hedge funds, and 
he said he was not for that. Have you ever discussed this 
proposal with him? Or do you all just have a difference of 
philosophy here?
    Mr. Donaldson. Again, let me, if I might, digress on that a 
bit, because I have spoken with Chairman Greenspan on a number 
of occasions. I also have had our staff meet with the Federal 
Reserve people to discuss the whole issue.
    I referred briefly to this in my testimony. I read Chairman 
Greenspan's testimony, and I think he started out by saying, 
``I am against it,'' and then he said, ``I am not really 
against the rule. I am worried about what you are going to do 
with it.''
    Chairman Shelby. That is right.
    Mr. Donaldson. I think that was his statement, and I think 
we have to draw a distinction between the Federal Reserve and 
the Treasury Department's responsibility here in terms of the 
prudential oversight of the financial system and the banking 
system and the information that they gather for that. That is 
their role.
    We have a different role. Our role is investor protection 
and the policing of securities laws, and we have a very 
different mission. And I believe that the Federal Reserve and 
Chairman Greenspan--looking back to the Long-Term Capital 
days--believes, and I think rightly so, that the liquidity 
provided by hedge funds is an important risk-offsetting 
capability they have, and worried at that time that any attempt 
to legislate that hedge fund could be counterproductive. But we 
are talking about something totally different.
    Chairman Shelby. We are talking about oranges instead of 
apples.
    Mr. Donaldson. Exactly. And I believe that--not to beat a 
dead horse here, but I believe that we must have the simple 
capability to look inside hedge funds and find out what is 
going on, not to protect the wealthy investors, although do 
that, too, but to make sure that the market impact on other 
investors--I call it ``the other side of the trade''--be 
examined.
    Chairman Shelby. Thank you.
    Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Chairman Shelby.
    Chairman Donaldson, we always pay attention to what 
Chairman Greenspan recommends because he has been around a long 
time and has provided some important leadership to the country.
    On the other hand, just 3 years ago, he appeared before us 
and told us that we were paying down the national debt too 
quickly and that we needed to change the trajectory of paying 
off the national debt and, therefore, we could enact a large 
tax cut without worrying about deficits and without impeding 
continuing to pay down the national debt. We would just slow it 
up a bit because it was being paid off too quickly. That was 3 
years ago, and, of course, we know where we are now, you know 
you are working within your own area of expertise, and I simply 
commend you to carry forward in that regard.
    Now, having made that diversionary statement, let me----
    Mr. Donaldson. If I might just interrupt and say I have the 
highest regard for Chairman Greenspan.
    Senator Sarbanes. Oh, yes. We ought not----
    Mr. Donaldson. I guess it is just a matter of who is 
responsible for doing what.
    Senator Sarbanes. Well, yes, but we ought not to get to the 
point where, if people have very good reasons for disagreeing 
with a position of his, they ought not to take it or should 
feel uncomfortable about putting it forward. And I just mention 
this 3-year-ago recommendation and his view that the debt was 
being paid off too quickly.
    Now, let me ask a diversionary question as well. A week ago 
yesterday, you appeared before the House Appropriations 
Subcommittee to discuss your budget. In that testimony, you 
indicated that you had yet to fill hundreds of new staff 
positions made available to you by the substantial budget boost 
that the Commission has received and which Members here have, I 
think almost without exception--I think without exception, have 
been supportive of. In fact, you currently have, according to 
this article in the National Journal, 525 vacant staff slots, 
although you expect to fill 100 of them by the end of May.
    Subcommittee Chairman Frank Wolfe, our colleague on the 
House side from Virginia, said he was shocked the SEC has not 
yet found enough high-quality, capable people to fill these 
jobs. ``I am surprised that you are having trouble,'' Wolfe 
said. ``What you are doing is really exciting, it is important, 
it is public service, and that is a good salary.'' And, of 
course, the starting salaries now are running at about, I 
guess, $75,000, which, of course, for a Government starting 
position is pretty good money. And a senior-level SEC 
accountant with 20 to 25 years' experience could earn an annual 
salary of more than $186,000. I am just putting this out there 
so people know there are some career possibilities down at the 
SEC.
    [Laughter.]
    But how are you coming? This is important. Last year, you 
turned back about $100 million, as I recall, to the Government 
and I think that generally met with approval because, you know, 
there is no sense in you going out and spending the money if 
you cannot spend it wisely.
    But we are now into another budget year. We want to get the 
Commission staffed up. I know you have done pay parity on the 
salaries. I do not think you have done it yet on the benefits, 
as I understand it. I do not think that has been brought to a 
conclusion.
    So how are we doing on this whole issue of staffing the 
Commission and getting you up to full strength?
    Mr. Donaldson. If I do not bore you, let me try and bore in 
a little bit on these figures because they are confusing.
    We received 842 new position authorizations back at the end 
of 2002, the beginning of 2003. But those are not all the 
positions that we have to fill. In total, we have worked to 
fill 1,265 position because we have people leaving the Agency, 
and that has been one of the problems of the Agency over the 
last few years.
    Senator Sarbanes. Well, I gather you have cut that down 
considerably, and I commend you for that. I understand the 
turnover rate has gone down----
    Mr. Donaldson. The turnover rate has gone----
    Senator Sarbanes. Is that correct?
    Mr. Donaldson. It has gone down markedly, and that has been 
the result of the supplemental payments, salary payments, and 
it has been the result of the other benefits that we are 
bringing out. Our comparability with other Government financial 
institutions has been very helpful, as well as, I believe, the 
challenge of the work that is being done.
    But we always will have, even though that departure rate 
has been way down, we always will have a certain number of 
positions that we have to fill. So, you know, we are putting 
water in the tank, but it is leaking out at the bottom.
    We will have filled all of the new authorizations that we 
have by the end of this fiscal year, and I might just comment 
that the relative speed with which we have done that was 
impeded to begin with by the fact that we did not have fast 
hiring capabilities. In other words, we could hire lawyers 
quickly, but we could not hire accountants. You all and the 
Congress helped us get accelerated hiring capabilities. We did 
not get that until July of last year.
    We also are very conscious of the quality of people, you 
know, not just going out and hiring anybody. We are having 
problems in the accounting area, and we are working to address 
those problems. We are working to address some virtual 
accounting approaches that would allow people to operate 
outside of Washington and so forth. We are getting great 
competition from PCAOB and so forth. The availability of 
accountants in the Washington area is low. So we are behind 
there, but we are on track for our hiring, and we will have 
completed our hiring by the end of this fiscal year.
    Senator Sarbanes. I will save my other questions for the 
next round. I think you should send a signal across the country 
to accountants that there are good opportunities here in 
Washington at the SEC, and in that regard, I also should note 
that many of the people in the private sector that come before 
us as witnesses or come to talk with us who are doing 
exceedingly well now in the private sector spent time earlier 
in their careers working at the SEC, and gaining the training 
and the knowledge that came with that experience.
    I agree with you. I know you said to Wolfe that, ``We have 
refused to hire employees simply to fill chairs but, rather, 
are focused on hiring the best and most appropriate people to 
fill these important positions.'' And I think that is a very 
important framework to be working within. But I do think it is 
important that we try to get staffed up to full level and that 
you not come to the end of this fiscal year and again not be 
able to utilize the resources which the Congress is providing.
    Mr. Donaldson. I totally agree with you, and I just want to 
reassure you that we are attending job fairs, we are 
advertising, we are across the country trying to recruit 
accountants as aggressively as we can. It is our number one 
priority.
    Senator Sarbanes. Okay. Thank you.
    Chairman Shelby. Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    I would like to go back to the board, the proposed changes 
that you have suggested. If a board is truly independent having 
75 percent of its members to be independent board members, why 
cannot an independent board choose who they think would serve 
investors the best, be it an independent chairman or an 
interested chairman?
    Mr. Donaldson. Let me try and address that issue. I 
obviously heard your earlier comment on this, and I think it is 
an area where the structure of a mutual fund and the management 
company has an embedded conflict of interest. That embedded 
conflict of interest is that what is good for the management 
company is not always good for the mutual fund shareholders. 
That is particularly true in deciding fees. Mutual fund 
shareholder directors are charged with a responsibility for fee 
setting. The chairman of a management company, when he is also 
chairman of a mutual fund, has a direct conflict of interest.
    Senator Bunning. Mr. Chairman, we are talking about three-
quarters of the board being independent.
    Mr. Donaldson. I understand that, and let me go one step 
further. Some argue that an interested chairman; for example, 
the chairman coming from the management company, has all of the 
knowledge and so forth that an independent chairman would not 
have. My answer to that is that that chairman sits at the 
meeting, he sits and brings all of that expertise, 40 years of 
running a management company, knowing more about the business 
than anybody else, he is able to give his advice to that board.
    But when it comes to conflict of interest and negotiating 
with yourself, I believe that you need an independent person 
who basically is in control of the agenda and basically has an 
independence--
    Senator Bunning. But that does not answer my question, sir.
    Mr. Donaldson. Pardon?
    Senator Bunning. My question is if it has three-quarters of 
independent board members, they have the option of hiring 
whoever they want to run the board. Are you telling me that 
three-quarters would always choose an interested party? Are you 
telling me that they are not independent?
    Mr. Donaldson. I am telling you that I believe that the 
dynamics of the way boards, and particularly the dynamics of 
the way mutual fund boards work, there is, in my view, a 
necessity for the independence of the chairman, and not defined 
by the board itself picking it.
    Senator Bunning. I have some other questions, and you are 
not answering my question. So, I am going to move on.
    Do you know about the study, Bobroff's Mac study, that 
found that funds with interested chairs have performed better 
than those with independent chairs? In fact, I believe Putnam 
had an independent chair when they had all of their problems. 
Do you have evidence to the contrary showing that independent 
chairs perform and board chairs on mutuals perform better?
    Mr. Donaldson. Senator, I am aware of lots of studies that 
come to all a lot of different conclusions. I spent a number of 
years myself in an academic environment where studies were 
done. I believe we are in a totally new environment. I believe 
that the appraisal of independence or lack of independence back 
before we were making these changes is a totally different 
environment.
    Senator Bunning. We had this discussion the last time you 
appeared here about the independence of the SEC making the 
rules. Do you realize that Vanguard, T. Rowe Price, Fidelity 
would all have many people that would have to resign because of 
the rules that you make? How many investors have put their 
savings to these funds because of the reputation of these 
companies and their managers? I think that what you have 
proposed does more harm to the investor than good.
    Mr. Donaldson. I think that the expertise that the 
management company chairman, can still be available to the 
fund. If you bought the expertise of Mr. Johnson at Fidelity, 
40 years in the business, 50 years in the business or whatever, 
he can still sit at the table. You are not taking him out of 
the room. He sits at the table, gives all his expertise, all of 
the reasons, if you bought his funds because of him, he is 
there.
    When it comes to the power of independence, and the power 
of control and asking the tough questions, and controlling the 
agenda, that I believe there has to be an independent chairman.
    Senator Bunning. We have a difference of opinion.
    Thank you.
    Chairman Shelby. Senator Reed.
    Senator Reed. I thank you very much, Mr. Chairman, and let 
me commend you, Chairman Donaldson, for the energy and insights 
you have brought to this task, and the results are obvious. 
Thank you for that.
    Let me follow this independent chair inquiry. Just for the 
record, I think Senator Bunning asked the question about 
empirical studies and facts that you would use to make this 
recommendation. Are there studies that you can refer to or any 
empirical evidence that suggests that an independent head of 
the fund is better than a company head?
    Mr. Donaldson. What immediately comes to mind is the Mutual 
Fund Directors Forum, formed and led by former SEC Chairman 
Ruder, which has very strong views on this issue, very strong 
views from people who are practicing as independent directors 
about the necessity for independent chairmen. I admit that 
there is a difference of opinion on this, and it is not a 
silver bullet. Nothing that we do is a silver bullet.
    What I am saying, at this time in our history of the mutual 
fund business, is that there should be a very clear separation. 
This relationship between a mutual fund and its management 
company is a very conflicted relationship, and it is different 
than a board of directors of a corporation with all different 
independent directors, lead directors, separation of chairman 
and so forth----
    Chairman Shelby. Mr. Chairman, how is it different?
    Mr. Donaldson. Excuse me?
    Chairman Shelby. How is it different?
    Chairman Donaldson. For several reasons. First of all is 
the profitability for the management company, in many 
instances, of things that are of no benefit to the 
shareholders. The use of commissions for research and so forth, 
a very ticklish area. The conflict relative to the fees charged 
and the obligations of the independent director to negotiate; 
you cannot negotiate with yourself. If I am chairman of the 
management company and I am chairman of a mutual fund, I 
cannot--no matter how honest I am--I cannot negotiate with 
myself on this issue, and I believe that we need an independent 
person doing that.
    That does not directly address your comment, Senator, but 
it is a matter of personal feelings, it is a matter of 
judgment, having sat on a number of boards and having seen how 
they operate. I think you should have an independent chair.
    Senator Reed. Chairman Donaldson, under the current law, as 
I understand it, management contracts, underwriting agreements, 
12b-1 plans, other decisions that may involve conflicts are 
voted on separately by the independent directors. Why is that 
not an appropriate response to this problem, particularly if 
you can identify those specific issues where, as you point out, 
an individual cannot negotiate with himself, even the fairest, 
most scrupulous ones.
    Is that a possible alternative to this situation?
    Mr. Donaldson. All of those issues are ones that we have 
under examination right now, and we are trying to reach 
meaningful conclusions on them. I think that having an 
independent person who is not a shareholder of the management 
company, who does not have his personal livelihood in the 
management company, dependent upon the management company is 
very important. We need to have somebody who is not in that 
position, and I think we particularly need it at this time in 
history. I believe that shareholders will benefit from this, 
and I think they will welcome it. The additional expense of 
bringing an independent person into that role would be money 
well spent.
    Senator Reed. Mr. Chairman, I think you can recognize that 
there is an interest in this topic.
    Mr. Donaldson. I know.
    Senator Reed. And I think it is interest driven by both 
sides trying to find the best solution without harming the 
operation of these funds and then ultimately protecting the 
investors. But I think you, again, recognize that this is a 
topic that probably requires even further scrutiny, and I am 
sure you will do it.
    Mr. Donaldson. I obviously know that this is a 
controversial issue. The ICI is opposed. The ICI has been very 
active, and, I believe in many ways they have opposed this. I 
wish we had the time for you to sit down, and maybe we can do 
this before we make any final rules and you can talk to some of 
the independent directors who have been faced with this, who 
have sat in board meetings and get their views on it. I think 
they are almost unanimously of the view that it should be an 
independent chairman.
    Senator Reed. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Sununu.

              STATEMENT OF SENATOR JOHN E. SUNUNU

    Senator Sununu. Let me follow up on that point. I 
apologize. I did not hear all of the answer that you provided, 
Mr. Chairman. I certainly heard the final part of the response 
which is you asserted your belief that an independent chairman 
would benefit shareholders.
    My question is has the Commission begun the process of 
assembling the data and empirical evidence necessary to assert 
that claim that an independent chairman would directly benefit 
shareholders through either lower fees or better performance of 
funds?
    Mr. Donaldson. Well, we are always looking for more data, 
and we are always looking for empirical justification for what 
we are doing. I think that there are arguments on both sides of 
the equation in terms of data and data presentation. I do not 
think one study does it.
    The judgment that I am putting forth here has to do with 
just that--judgment--and the sense of timing here in terms of 
the ills that the mutual fund industry has had. It is not a 
silver bullet. I just think it is one of many actions that will 
address the fundamental conflict that is there.
    Senator Sununu. I genuinely believe you have done a fine 
job as chairman, and I do not want this to be taken the wrong 
way. But I think it is an important point in the Committee, and 
people who have come to these hearings are probably tired of me 
making this point. But judgment without data is a guess, and in 
fact all of the empirical studies that I have seen--and there 
have been several, and we have submitted them for the record 
already--have shown no relationship between having an 
independent chairman and fund performance or fees.
    I believe if we are going to assert that it is a good 
thing, it will help, it will benefit shareholders, I think it 
is very important to assemble empirical evidence or data that 
will at least indicate the kind of benefits that we are trying 
to provide.
    I think that is even more important, given that at least 
the political reason, the emotional reason, one of the 
emotional reasons that we have had so many hearings on this at 
this particular time is because of the so-called mutual fund 
scandals, the problems that we have seen that upset us all of 
fraud or a violation of existing law in mutual funds. In point 
of fact, many, if not most, of those scandals have occurred at 
funds with independent chairmen.
    I just think we really need to provide some objective 
assessment that would indicate the benefits that we are trying 
to achieve.
    Another question, a different topic. I am sure you are 
pleased about that.
    [Laughter.]
    I did not hear it explicitly stated in your testimony 
whether or not you thought that soft-dollar arrangements should 
or should not be banned.
    Mr. Donaldson. I did mention that we have a--
    Senator Sununu. Task force, and that they are working 
hard--yes, I appreciate that.
    Do you have a position on whether or not these soft-dollar 
arrangements should be banned?
    Mr. Donaldson. I think you have to refer to specific soft 
dollars and what they are being used for. We have proposed a 
rule that would not allow soft dollars to be used to promote 
the sale of mutual funds, and that is one of our rule proposals 
that is out for comment right now.
    Senator Sununu. That relates to the distinction between 
qualified and nonqualified?
    Mr. Donaldson. No, it relates to the use of brokerage 
commissions to induce or compensate for the sale of mutual fund 
shares without the mutual fund shareholder knowing that those 
dollars are a hidden inducement to a supposedly impartial 
salesman.
    The other part of soft dollars is the issue of what is in a 
commission rate. The typical rate now for execution and 
research is 5 cents a share, and typically 2 cents of that is 
for execution services, and 3 cents is for something else. And 
I believe that the disclosure, by the broker, of how much of 
that commission is for execution and how much is for research 
is a very important thing that needs to be done and needs to be 
displayed by the mutual fund--how much they are paying for 
executions and then how much they are using soft dollars for 
research and where that money is going.
    This gets into something we did not delve into, which is 
that money, in my view, should be available for third-party 
research people, not just the research coming from a large 
institutional firm. I think it would be a real mistake to 
eliminate the ability to pay for research from third-party 
people. Now, we need to define, under 28(e), what research is. 
I think that under that rule there is too loose a definition of 
research.
    So it is not a simple ``yea'' or ``nay'' on soft dollars; 
it is what they are being used for.
    Senator Sununu. I appreciate that point. I think what I 
hear you saying is that you want to make sure that, one, the 
rules are applied evenly, that we are not discriminating 
against independent research vis-a-vis proprietary research at 
full-service firms, and I think that is extremely important, 
especially given everything that the SEC has already done to 
encourage independent research. I appreciate your response, and 
thank you, Mr. Chairman.
    Chairman Shelby. Senator Corzine.
    Senator Corzine. Thank you, Mr. Chairman.
    Mr. Chairman, I do not want to dwell on this independence 
of the chairman, but I suppose that definition of what 
independence means is also something that needs to be examined 
and fleshed out. Now, I think when you look at these studies, 
you have to ask yourself whether somebody is not necessarily an 
immediate family, but a family member, whether somebody is 2 
years past retirement that had worked their whole career with 
an organization.
    There are lots of ways to define independence, and I hope 
that being one that supports either an independent chairman or 
at least a lead shareholder in the board, that we do more to 
refine what the definition of what an independent shareholder 
is, in this context, so that we could get what I think is 
practical independence, as opposed to pro forma independence, 
which may be allowable under the current rules.
    Do you, moving to another question, believe you have the 
authority to deal with the hedge fund issue in the context of 
how you described it in your testimony and presentation? Do you 
have the statutory authority to deal with that issue?
    Mr. Donaldson. I believe we do. Of course, this would be 
subject to a rule proposal to be viewed or vetted by the 
Commission itself, and that proposal being put out for comment 
and so forth, but I think we do have the authority to do that.
    Senator Corzine. Not here at this moment, but if I could 
have your legal people give us a statement on how you think 
that flows from the Investment Company Act and other places 
where you actually think you have that authority, I would like 
to understand that.
    Chairman Shelby. Senator Corzine, would you request for the 
whole record.
    Senator Corzine. Yes, please.
    Mr. Donaldson. Yes, we would be glad to provide that.
    Senator Corzine. Would you comment--particularly since I 
thought you were particularly articulate about saying it is 
very hard to negotiate with yourself if you are in a mutual 
fund company, and you are the chairman of the board, and you 
are negotiating the fees--we had a similar issue when we have 
mutual funds that have hedge funds, and you have a similar 
manager between the two, and one gets 1-percent management fee 
and the other gets an override or some performance-based fee, 
could you comment on the side-by-side elements of application 
of hedge funds inside a mutual fund.
    Mr. Donaldson. I think that this is an issue that is 
comparable to issues that were around the industry through the 
years that had to do with potential conflicts of interest by 
fund managers as to how they buy securities for their own 
account or whether there is front-running of the fund by 
insiders, et cetera. The side-by-side hedge fund issue is an 
extension of this. Shareholders are entitled, in my view, to 
the knowledge that a fund manager may also be running, or a 
fund management group may also be running, a hedge fund, where 
the compensation is much greater, the personal compensation is 
much greater.
    I believe that there are several ways of getting at that. 
Number one is to disclose the compensation structure for 
managers, not their salaries and so forth, but how they are 
evaluated within the fund complex. And that, I believe, should 
be part of it, and we have work going on on that, I think that 
should be part of the disclosure process.
    Second, I think there needs to be oversight, internal 
oversight, by the new officers that we are recommending be part 
of the mutual fund complex, to sit on that potential conflict 
in terms of the way shares are allocated when funds or 
investments are being made, who gets what first, the order of 
priority in that. Again, that is part of the whole process.
    I think that, if where you are heading is to ask if mutual 
fund management companies should be prevented from running both 
hedge funds and mutual funds out of the same shop, I think that 
could cause a serious ``brain drain,'' if you will, out of 
mutual fund management companies into the more lucrative 
independent hedge fund management positions.
    Senator Corzine. I would love to hear your comments--and I 
know my time has run out--the definition of research, as it 
relates to the whole soft-dollar question----
    Mr. Donaldson. Right.
    Senator Corzine. --I think at least looks to me like the 
nub of the question as opposed to--if you actually were able to 
deal with that, at some point, I would love to hear your views 
on that.
    And turnover rate, which Senator Sarbanes talked about, 
what is the turnover rate now? What was it and what is it now?
    Mr. Donaldson. Turnover?
    Senator Corzine. The turnover rate of personnel. You said 
it slowed down.
    Mr. Donaldson. I think it is, right now, at 1.5 percent 
of----
    Senator Corzine. Annually?
    Mr. Donaldson. And it was as high, as little as 4 years 
ago, as 8 percent, and it has come steadily down, and it has 
come down in the last 2 years precipitously.
    Senator Corzine. Yes, 1.5 percent is pretty good for any 
organization I have ever heard of. If that is what it is, that 
is pretty terrific.
    Chairman Shelby. Thank you, Senator Corzine.
    Senator Santorum.

               STATEMENT OF SENATOR RICK SANTORUM

    Senator Santorum. Thank you. First, I would like to agree 
with Senator Sununu. I think you are doing a fine job, and I 
agree with your testimony that we should not be rushing in here 
in the Congress to legislate in this area, that you are 
proceeding along--I do not agree with everything that you are 
proposing--but I think that the fact that you are moving 
forward and dealing with this in a forum which allows for 
experts in the industry and for the industry to participate, I 
think is a proper setting, before Congress rushes in with, at 
least from my perspective, this is really the best-informed 
approach on this issue. At least the actions that I have seen 
in the other body would indicate that to be the case.
    I do want to add my voice in disagreeing with the issue on 
the independent chairman. I understand what you are trying to 
accomplish. I think Senator Bunning's point, which I think he 
made well, but I will remake it in a little different context, 
and that is if you have three-quarters of the board that are 
independent, if they are truly independent, then it should not 
be a concern that someone is trying to pull one over on this 
board.
    If you do not believe they are independent or you do not 
believe independent directors are, in a mutual fund context, 
somehow or another strong enough to represent the interests of 
the shareholders, that is a different issue, and maybe we need 
to look at the qualifications of independent directors, I do 
not know, maybe the definitions of independent directors to 
make sure that they do have what is necessary to stand up and 
do what is in the best interests of shareholders.
    If what you are saying is, traditionally--and I am 
intimating what you are saying--independent directors have 
really been pawns or puppets of the mutual fund company, well, 
then maybe we need to look at what independent directors really 
should be, as opposed to trying to, in my opinion, give 
independent--your proposal is to try to give independent 
directors more power and then, in a sense, take it away from 
them by limiting the choice of who they can put as chairman. 
That is a limitation on your power.
    You are trying to give them power to be able to run this 
organization as they see best, and then you are limiting their 
power as to who they can select as chairman. I do not 
necessarily see how that comports.
    I think the fundamental issue that you are trying to get at 
is are these people really independent, and that is what I 
think you should focus your attention on, not on who the 
chairman is. You can comment on that, but only if I get my 
other questions in.
    The second point I want to make is on the issue of 
disclosure. Senator Corzine left, and I am going to ask his 
question because that was the question that I had in mind. I 
agree with you on the issue of disclosure, as far as fees, and 
you went on to describe fees would be execution and research. 
Then you said the definition of ``research'' is loose. Can you 
suggest to me how you would tighten that definition.
    Mr. Donaldson. Yes. I think that the safe harbor that came 
in with 28(e) a number of years ago has gradually been 
expanded, if you will, and there are all sorts of things that 
are currently being paid for that are not really research. I do 
not want to get into anecdotal evidence, but whether it is 
newspaper subscriptions or whatever, there are a lot of things 
that are being paid for now that are not fundamentally 
investment research oriented, and it gets particularly 
confusing because of the rise of electronic research. Is it the 
software that delivers the research or is it the machine 
itself ? I mean, there are a whole series of issues.
    What I am saying is that I believe we can tighten up, and 
should tighten up, the definition of what is research. I think 
we can do that under 28(e) without changing 28(e).
    Back on your question, and Senator Bunning's issue, on the 
independent chairman. I want to assure you that my view is just 
that--my view. I am one of five commissioners. I know that the 
commissioners are going to read this testimony. I know there 
are a lot of people on the other side of this issue. I just 
want to assure you that we will be as open as we can be, in 
terms of getting data, examining the issue and so forth.
    I have taken a position on this. It is a personal, deeply 
held position, but again it will be an issue that will be 
brought up in a full Commission meeting, and I do not know 
where the other commissioners are on this issue.
    It finally comes down to, as far as I personally am 
concerned, the issue of how the board agenda and how the 
dynamics and so forth of a board meeting work. A concept that 
is just hard for me to believe is that somebody who has an 
ownership position, and a salary and so forth, can sit in 
judgment on some of these issues. I believe that you must have 
an independent person there who is not the management company 
executive.
    I am repeating myself now, but I will say it again. A 
management company executive who has all of that expertise can 
sit at the table and give all of that expertise to the board. 
It is just who controls the agenda that is of concern to me.
    Senator Santorum. My time is up. Thank you.
    Chairman Shelby. Senator Carper.
    Senator Carper. Chairman Donaldson, let me just follow up 
on what Senator Santorum was saying, at least at the beginning 
of his question, with respect to independent chairmen or 
independent directors.
    You mentioned that you are one of its five commissioners?
    Mr. Donaldson. Correct.
    Senator Carper. In the end, if you end up being in the 
minority of the decision on whether or not an independent 
chairman is to be required, and then the focus should return, 
rightly, to then what comprises independent directors.
    Just talk with us a little bit about what kind of concerns 
that we should be mindful of, and you should be mindful of, in 
terms of what constitutes independent and what does not.
    Mr. Donaldson. A very good question. It is one that we are 
wrestling with right now. The definition of independence is 
somewhat limited. While it does not exclude uncles and aunts, 
and so forth, from being classified as independent, we are 
nevertheless concerned about those individuals.
    We have found that we can get at that in certain instances 
by requiring disclosure; in other words, maybe uncle Joe, twice 
removed, is not technically precluded from being considered an 
independent directors by law. But we can get the mutual fund 
company to disclose uncle Joe's relationship to management in 
their prospectus, and I think that would be reason enough for 
them not to want uncle Joe, twice removed, to be an independent 
director but with the disclosure of the realtionship in a 
prospectus.
    Senator Carper. I once had an uncle Joe.
    Mr. Donaldson. Pardon me?
    Senator Carper. And he was a pretty independent cuss.
    [Laughter.]
    Mr. Donaldson. But in terms of the issue at hand, I believe 
that it is, no matter how honest and full of integrity a person 
is, if he or she has spent their lifetime in a management 
company as an owner of stock, is paid by the management 
company, et cetera, I think it is very difficult for them to 
negotiate with themselves, to have the power of being a 
chairman. That is what I am talking about.
    Senator Carper. Do you have a similar view when it comes to 
a person being the chairman of the board, let us say, for 
General Motors or Dupont or some company like that, being CEO 
of a company, the person who is running the company and also 
being chairman of the board?
    Mr. Donaldson. This will seem to be an inconsistent 
position, but I think it is a different situation.
    Senator Carper. Just explain why.
    Mr. Donaldson. I am not one who believes that one suit fits 
all in the corporate world. I am not one that believes--I think 
there are certain great benefits from separating the 
chairmanship from the chief executive officership. I think 
there are certain times when you want to have a lead director 
fill that role. I think there are certain times when you want 
to have one person be both chairman and CEO. In that world, I 
would not be for one formula. I would be for giving flexibility 
to have a system that is pertinent at a particular time in 
history.
    I think the relationship between a mutual fund and a mutual 
fund management company is a very different situation.
    Senator Carper. One of the violations that has been 
disclosed, in terms of abuses, I think, of customers of mutual 
funds is the violation of the hard 4 p.m. close.
    [Laughter.]
    I understand that in 1968 a requirement was established 
for, I guess, a time stamp. So we have had a requirement that 
was put in place maybe 36 years ago for a time stamp, the idea 
of which was to try to make sure that people did not make 
purchases to the disadvantage of others. That obviously has not 
worked too well.
    We are a lot better with technology today than we were in 
1968. Is there some way to use that technology--whether it is 
with a time stamp or some other device--to be able to, you 
talked about the problems with 401(k)'s and how they might be 
disadvantaged, is there some way to use technology, whether it 
is a 21st century time stamp or not? What are your thoughts on 
that?
    Mr. Donaldson. Very definitely there are ways. Let me go 
back. There have been ways of abusing the old time-stamp method 
of doing things. Time stamps have been altered, tickets have 
been time stamped and then held back and then put in on a late 
trade. So there are ways of--modern ways--of changing that, 
making inalterable kinds of time stamps and so forth, high-
technology ways of doing that. We are examining that right now.
    There is the other issue of the unfairness, if you will, of 
people in different time zones and all of those issues, and I 
think the hard 4 p.m. suggestion by the SEC is under extensive 
examination. There are costs to some of these electronic ways 
of doing things, and we are going to try and come up with the 
best combination.
    I am not sure you were here when I was commenting on this 
before, but this is one of the most difficult problems for us 
to meet with the right solution, a cost-effective solution, but 
we are working on it.
    Senator Carper. Good.
    Mr. Chairman, has my time expired?
    Chairman Shelby. If you want to do another question, do it.
    Senator Carper. Thanks very much.
    You have talked a little bit about soft dollars, and I was 
not originally aware of the practice where, as a mutual fund, I 
can contract with a brokerage house to execute trades and also 
give them some extra money that they would use to pay for 
independent research.
    I am troubled by that practice. I do not think we are going 
to legislate on it, but tell me again what would you would have 
the SEC do with respect to that practice? I think I heard you 
say that you would establish a soft-dollar task force, one of 
the things that they are looking at was this.
    Mr. Donaldson. We are looking at the whole----
    Senator Carper. And the other half of my question, are 
there other soft-dollar practices that you are focusing on?
    Mr. Donaldson. Let me try and answer that in two ways.
    First of all, under the safe harbor of 28(e), the 
definition of what can be paid for with brokerage dollars is 
too loose. Over a period of time, there are things that are 
being supplied to investment managers that are really not 
research. We could fill you in on that in detail.
    The second part of this is the execution commissions that 
funds pay to the broker. That clearly can be broken down. There 
is an average now of 5 cents a share--the common average. What 
part of that is for execution, and what part of that is for 
research?
    And what I am saying is that we need to get to a stage 
where the executing broker tells the institution that 2 cents 
of that 5 cents is for the execution, and maybe it is 3 cents 
if we position some stock and gave an additional service. 
Therefore, you have, let us say, 3 extra cents. The institution 
should be able to direct perhaps a penny of that 3 cents to the 
executing broker for research in the big institutional 
brokerage firm and should be able to direct 2 cents to an 
independent research person, who is again providing real 
research and not Wall Street Journal subscriptions and so 
forth.
    So, I guess what I am saying is that the funds--to get back 
to the mutual funds--in my view, should disclose to their 
customers how these brokerage dollars are being spent, that we 
are spending 2 cents times x million shares for executions, and 
we are spending 3 cents for research. And I believe that is the 
way to get at it.
    Senator Carper. Thanks very much.
    Mr. Chairman, thanks for your indulgence.
    Chairman Shelby. Chairman Donaldson, it is troubling to a 
lot of us up here, you can tell, if you and the SEC were to 
mandate that a director be independent, although you are 
mandating or plan to mandate that 75 percent of all of the 
directors be independent. It looks to me like the directors 
should make that decision, who they want to be the chairman of 
their board, and that they should--and if they are independent, 
and if you define that properly, and I hope you would--make 
that decision because you are taking a lot of their power away 
from them to begin with, if you say you have got to have an 
independent director.
    Let us say the most knowledgeable, the most worthy, the 
strongest person there was not independent, and everybody that 
was an independent--75 percent of the directors--would 
recognize that--they know they could fire the director or elect 
him or take him down--what would be wrong with the directors 
making that decision?
    You see what we are asking, do you not?
    Mr. Donaldson. Yes.
    Chairman Shelby. I know you say that he has got an inherent 
conflict, but ultimately the directors should be looking after 
the mutual fund shareholders, should they not?
    Mr. Donaldson. This gets down to the definition of 
independence.
    Chairman Shelby. Absolutely.
    Mr. Donaldson. And it gets down to the attempt to define 
something by law. I think you can define away a lot of things 
that make somebody clearly not independent. I think it is very 
hard to define, by law, what true independence means, and I 
think that the nature of human relationships is such that 
independence is an ephemeral thing in the final analysis of 
what true independence is. And I think it is quite possible 
that you can have someone who qualifies as independent because 
of laws that have been written, but who really is not 
independent because of the relationships. That is what is in my 
head, based on the experiences that I have had.
    Chairman Shelby. We have these hearings, though, to discuss 
things like this.
    Mr. Donaldson. Obviously, it is a question that you all 
have.
    Chairman Shelby. For the Committee.
    Mr. Donaldson. It is a question that the Commission will 
look at very, very closely. Again, empirical evidence that you 
have or that anybody has, we would like to have it. We are 
going to try and make the right decision, and a decision may be 
made that disagrees with my personal views. That is why we have 
five people on the Commission.
    Chairman Shelby. I want to touch on one more thing that I 
think we are in total agreement on this. We have talked about 
it, personally, and that is we should not legislate or regulate 
fees and that the fees should be set by the market, should they 
not?
    Mr. Donaldson. I can say that that is not only my opinion, 
but that is the unanimous opinion of the five commissioners, 
and this is where we differed in terms of the remedies brought 
against the mutual fund industry. We did not think that we 
should be legislating commissions. We thought the free market 
should.
    Chairman Shelby. You touched on the idea of disclosure, 
which is very important. But the information that the 
shareholders get in the mail regarding their fund, it has to be 
readable, it has to be understandable and so forth. What are 
you contemplating in this area? We had one hearing on that 
alone.
    Mr. Donaldson. We have a staff group, one of the study 
groups that we have put together, that is working on just that 
subject. If we are going down a plank of more, and more, and 
more disclosure, the question is does more disclosure disclose 
less because it is so complicated and so hard to understand, et 
cetera?
    We have panels going now in three cities in the next couple 
of weeks, where we are bringing people together to examine some 
of our proposed actual physical ways of displaying some of this 
information and to see how useful it is to people.
    We have a group going with the AARP, in which they are 
looking at alternative ways of displaying some of this 
information and helping us get it in a way that people can 
understand. And I think that is absolutely the other side of 
this equation. Disclosure can go just so far, and 
overdisclosure obfuscates, as opposed to disclosing. We are 
trying to get at that.
    Chairman Shelby. Thank you.
    Senator Sarbanes.
    Senator Sarbanes. Does Senator Bunning want to go?
    Chairman Shelby. If you want to go, go ahead.
    Senator Sarbanes. And then I will go.
    Senator Bunning. Chairman Donaldson, I quoted a study, and 
I have been informed by your staff that you do have that 
study--the Bobroff Mac Study on Mutual Funds and Independency.
    Before you take a step that we may have to react to in the 
wrong direction, I would appreciate any data that indicates to 
the contrary that the SEC might have in regard to independency, 
independent directors and an independent head of the board. I 
would like to see what you are basing your opinions on, as the 
Securities and Exchange Commission, rather than what we are 
basing our own feelings on, and that is data.
    I would like to see the data come from the SEC to the 
Committee, and I am requesting that you do that.
    Mr. Donaldson. We would be delighted to do that.
    Senator Bunning. Rather than a gut feeling that it just 
does not feel right, I would like to see the data that you base 
your facts on.
    Mr. Donaldson. I totally agree with that sentiment. I 
disagree with your characterization of my views on this as 
being an uninformed gut feeling.
    Senator Bunning. No, no. You obviously have studied the 
issue.
    Mr. Donaldson. What we try to do, before something is 
brought to the Commission, is analyze the pluses and minuses, 
and bring whatever data we have, whatever data we have on the 
other side, testimony by independent directors about the 
dynamics of the board room, all of this brought together, plus 
and minus, and then make a decision.
    Senator Bunning. Well, I hope your Commission, the 
Securities and Exchange Commission, is not like a lot of other 
commissions, that is chairman-dominated; in other words, that 
the four other people--
    [Laughter.]
    Mr. Donaldson. You do not have any worry about that, 
Senator.
    Senator Bunning. Well, I worry about it because I have 
dealt with the Federal Reserve for the last 18 years, and I 
assure you that, in my opinion, the FOMC Committee has been 
chairman-dominated no matter who the chair was, and I have 
lived through three Chairs on the Federal Reserve.
    So, please, because this is a very, very important issue, 
because the information that I have, in regards to mutual 
funds, and my experience over 25 years of selling and owning 
mutual funds, indicate to me that the owner-director or the 
person who is closest to the fund not only outperforms those 
that are independent chairmen, but also has a deeper commitment 
to make sure that that fund performs at the best number it can 
for its stockholders.
    So, I cannot be more positive than I am in requesting your 
information and your data before you do something that there is 
going to be an unbelievable uproar on. So please do that for 
me.
    Mr. Donaldson. Sure. We absolutely will do that. The 
expertise, and the devotion and all that you imply for the 
management company officer who is also the chairman of the fund 
itself would be there sitting there giving that. The only 
difference would be that he would not be running the board 
meeting.
    Senator Bunning. Maybe he will be there.
    Mr. Donaldson. Absolutely. He is part of the 25 percent 
that can be there.
    Senator Bunning. The misfortune or the unfortunate part of 
this is that we may have a chairman who has been the number one 
producer and number one seller because of his performance as 
chairman, and I can go back and do some specific funds, but I 
am not going to do that. And the reason that investors really 
went into this fund is because of the performance that this man 
has had as chairman of this certain fund.
    We have seen them advertised on television many times how 
well they have performed, although performance is not 
necessarily guaranteed for the future.
    [Laughter.]
    I know the disclosure. So, please, let us not have to fire 
somebody who is doing one great job as chairman of the board of 
some mutual fund just because the SEC feels and has data that 
they feel makes a change necessary.
    Thank you.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    Chairman Donaldson, first of all, we did a little research 
in the interim. The quote that I was referring to, which is at 
the entrance to the SEC's public meeting room from Chairman 
William O. Douglas, subsequent Supreme Court Justice, says, 
``We are the investors' advocate.'' ``We are the investors' 
advocate,'' is really the charge for the SEC.
    I want to again commend you. I am just looking at your 
mutual fund initiatives, and some have been finalized, but most 
are in the process of being considered. Amendments to rules 
governing pricing of mutual fund shares, late trading, 
disclosure regarding market timing and selected disclosure of 
portfolio holdings, compliance programs of investment companies 
and investment advisers, enhanced disclosure of break-point 
discounts by mutual funds. Also, concept release on mutual fund 
transaction costs, new investment company governance 
requirements, investment adviser codes of ethics and insider 
reporting of fund trades, confirmation requirements and point-
of-sale disclosure requirements for mutual fund transactions, 
enhanced mutual fund expense and portfolio disclosure, and 
improved disclosure of board approval of investment advisory 
contracts.
    I do not know, there may have been additional ones that 
have been added recently, but that I think is a very active and 
vigorous agenda on the part of the SEC, and I want to commend 
you for it.
    Once you put these things out for comment, everything comes 
in upon you, and I understand that. We, on occasion, have a 
similar experience here, and obviously you have to work through 
these things and end up doing what you think is right, and 
there is a lot to be done.
    On March 12, 2003, Mr. Haaga, representing the ICI, 
testified before the House Financial Services Committee, March 
12, 2003--just over a year ago. This is what he said, in part:
    ``The strict regulation that implements these objectives 
has allowed the industry to garner and maintain the confidence 
of investors and also has kept the industry free of the types 
of problems that have surfaced in other businesses in the 
recent past. An examination of several of the regulatory 
measures that have been adopted or are under consideration to 
address problems that led to the massive corporate and 
accounting scandals of the past few years provides a strong 
endorsement for the system under which mutual funds already 
operate.''
    Now, obviously, either people did not know what was going 
on, there was a complacency because all of these practices now 
that are coming out, most of which are the subject of your 
proposed rulemaking, obviously have raised questions about what 
confidence investors can have, and they need to be corrected or 
they need to be cleaned up, and my perception is that is what 
the Commission is working to do, and I am supportive of your 
efforts to do that.
    I think you need to carry through on it. You put out the 
proposed rules. You get the benefits of the comments in order 
to work through to an even better substantive decision, but I 
do not think the Commission, I do not expect the Commission 
would back off simply because there is a lot of pressure if 
they perceive that what they are trying to accomplish is the 
appropriate thing to do.
    Now, Chairman Shelby and I received a letter, which I think 
we have sent down to you, and you have had a chance to look at, 
from the consumer groups--Consumer Union, Consumer Federation 
of America, Consumer Action, and Fund Democracy--raising a 
number of questions. They say the SEC has responded effectively 
to the majority of issues raised by the recent mutual fund 
scandals. They say, ``Because of that, Congress finds itself in 
the enviably position of not needing to pass sweeping mutual 
fund reform legislation.''
    They do then address some issues, though, that they think 
remain outstanding, which the Congress out to take a look at.
    I do not know if you have had a chance to examine that 
letter.
    Mr. Donaldson. I saw that letter yesterday.
    Senator Sarbanes. I would be interested in your reaction, 
if you had a chance to formulate one. Then they go on and also 
say, ``Almost as important, we urge the Committee to continue 
to monitor SEC implementation of its proposed mutual fund rules 
to ensure that it does not waiver in its commitment to strong 
pro-investor reforms.''
    And I, Mr. Chairman, Chairman Shelby, I think we obviously 
need to do that monitoring.
    Chairman Shelby. We will do it.
    Senator Sarbanes. Not that I have reason to believe that 
the Commission will waiver in its commitment to strong pro-
investor reforms, but simply as carrying out our 
responsibilities. In fact, I hope the Chairman will come away 
from this hearing refortified in his determination to carry 
through on strong pro-investor reforms.
    Do you have, as yet, any view on these suggestions within 
the letter?
    Mr. Donaldson. That letter came across my desk yesterday, 
and I jotted down a few reactions to it that I had. These are 
my reactions to it. We are going to take a good hard look at 
what they said.
    Senator Sarbanes. I thought it was, I mean, these are 
responsible organizations, and I thought it was a thoughtful 
responsible letter.
    Mr. Donaldson. I have no doubt of that. The title of the 
letter is, ``Cost Competition,'' and they say that they 
advocate that ``Congress mandate better mutual fund cost 
competition.'' Many of the ideas that were exposed in that 
letter are thoroughly addressed in the SEC's concept release on 
transaction costs, and I would suggest this consumer group read 
that release.
    It also says, ``although transaction costs are not taken 
into account in computing a fund's total return, there is 
concern that investors would not fully understand the impact of 
transaction costs because those transaction costs are not 
separately disclosed in a fund's expense table.'' We are 
working on that. We are working on the correct disclosure of 
that.
    The letter also advocates better disclosure at the point of 
sale. Again, the SEC has a rulemaking proposal right now 
pending that will provide, for the first time, point-of-sale 
disclosure about certain costs and conflicts.
    I could go through that letter point-by-point. Basically, 
it was a letter that seemed to not have been informed by a 
reading of our agenda that is out there and what we are doing 
right now. We will answer that letter and provide copies of our 
answer to you, but our bigger point is that we are not going to 
back off in any way.
    And we do not view the 10 proposals that we have out 
there--we do not view that as the end of what we are doing. We 
have these teams working now that are going to go into the next 
step here--things we do not catch now, the next step, year 
after year, after year. I want to assure you that that is what 
we are working on, and that is what we are going to do.
    Senator Sarbanes. Are these teams that you keep referring 
to, internal teams at the SEC made up of SEC staff; is that 
correct?
    Mr. Donaldson. They are representatives of the different 
divisions who bring different dimensions to bear. Studying 
this, they have the right to talk to people outside and to 
gather any information and to come up with some recommendations 
for us.
    Senator Sarbanes. When would you expect that the SEC will 
have finished its work, at least on the rules that have been 
put out, leaving aside further rules that you might propose as 
a consequence of further examination or as a consequence of the 
reports of these task forces.
    Mr. Donaldson. We have two rules that were put out that 
have now been adopted by the SEC. They were adopted in December 
and February. That had to do with investment adviser compliance 
programs and shareholder reports and portfolio disclosure. We 
have 10 proposed rules out there now, and the beginning of the 
proposal of those rules started in December, and it ended on 
March 11. We have scheduled times, if you will, for bringing 
these rules up for final approval. That schedule may change, 
depending upon the state of our deliberations.
    I anticipate that by hopefully the end of the summer or the 
beginning of the fall we will have acted on most of these 
proposals. I cannot guarantee that on all of them. And, if we 
are delayed, it will be because we are trying to get a better 
fix, if you will. But I would say that certainly by year end, 
hopefully, by the fall, and possibly by the end of the summer.
    Senator Sarbanes. Does the industry perceive the necessity 
of making significant changes in order to restore investor 
confidence or do you perceive them as resisting this and taking 
an attitude: Well, nothing is really wrong--there were a few 
outliers, but aside from that, we just want to go on doing 
things as we always did things?
    Mr. Donaldson. No, I do not think that is true. I think if 
you can talk about the industry, I think the industry is 
cooperating. I think the trade associations are cooperating. We 
do disagree on a few things. A couple of their recommendations 
we do not think are correct, but, by and large, I think there 
is a new attitude out there, and I think that it has been a 
very cooperative attitude.
    Now, that is not to say that there are not intensive 
lobbying efforts mounted against some of the things that we 
want to do. We recognize that as part of the way the process 
works. But I think, generally speaking, there has been great 
cooperation.
    I might also say, because it is said too little, that, 
although there were some shocking things that happened in terms 
of this late trading, market timing, and selective disclosure, 
and although there was the front office of the funds telling us 
they were trying to cure this stuff when the back office was 
making deals, and that is shocking, there are other funds that 
have not been doing this at all, that are very well run, that 
have controls, et cetera, and I think they deserve a pat on the 
back.
    Senator Sarbanes. Yes, I think that is a very apt 
observation because there are a number of funds that their 
practices have not been brought into question.
    Mr. Donaldson. Exactly.
    Senator Sarbanes. And that is, of course, highly 
commendable.
    Mr. Donaldson. I just want to say that publicly. But I 
think overall, in terms of your observation or your question, I 
think that a new day is afoot here, and I think there is new 
attention being brought to these issues. I think there are 
people in the industry who are as upset as we are and you are 
by what has happened in the industry, and they are doing 
everything they can to not only change their own organization, 
but also working through other organizations to bring about 
change in the whole industry.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Chairman Donaldson, you certainly realize, 
and we do, too, that your chairmanship of the Securities and 
Exchange Commission is at a critical time. I want to say again 
that we appreciate your appearance here again. You have spent a 
lot of time with us, and I am sure in the future we will be 
spending a lot of quality time together as we continue our 
oversight of what your regulations will bring forth, how they 
work.
    We are certainly not ruling out legislation in the future, 
but we are not ruling it in today either because we want to see 
what the SEC does, how it works, and then we will work with you 
and see if there is something in the months to come. This is a 
short year, legislatively, as we all know, but we appreciate 
what you are doing, the start you are doing, the challenge you 
have, and you are always welcome here, and we will get together 
again.
    Mr. Donaldson. Thank you, Mr. Chairman.
    Chairman Shelby. The hearing is adjourned.
    [Whereupon, at 12:13 p.m., the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional material supplied for the record follow:]
              PREPARED STATEMENT OF SENATOR JON S. CORZINE
    Thank you, Mr. Chairman. Mutual funds are the primary means for 
investors to participate in the market. Approximately 95 million 
Americans invest in mutual funds, and investments total near $7 
trillion dollars. The industry, one of our oldest and most revered, is 
entrusted by Americans with their dreams of retiring comfortably or of 
paying their children's college tuition or of buying a first home. In 
addition to being a force for economic growth and wealth creation, the 
mutual fund industry has been, for decades, a standard-bearer for 
ethical behavior, investor protection, and strong oversight and 
governance in our capital markets.
    But as we have witnessed over the past year, this industry has 
found itself at the center of scandal after scandal. To be sure, a 
great deal of confidence has been lost due to the litany of allegations 
of fraud and mismanagement, corporate governance failing, financial 
conflicts of interest, and other abusive practices. Last fall, Senator 
Dodd, the Ranking Member of the Securities Subcommittee, and I 
introduced S. 1971, The Mutual Fund Investor Confidence Restoration Act 
of 2003. This legislation aims to protect the millions who invest in 
these funds by seeking to:

 improve mutual fund governance, internal controls, and ethical 
    compliance;
 enhance cost, fee and other disclosures to shareholders;
 eliminate financial conflicts of interest where possible, and 
    make shareholders aware of where potential others may exist;
 prevent abusive mutual fund practices, such as late trading 
    and market timing and;
 strengthen the oversight of the industry.

    The measures included in the legislation were a response to the 
scandals that arose from investigations by the SEC and the office of 
State attorney generals. To their credit, the SEC has been aggressively 
pursuing changes in the culture of the mutual fund industry through an 
aggressive approach at proposing regulatory initiatives.
    But while their actions are important, we must consider what more--
if anything--can and should be done. And we should give consideration 
to whether codifying these rules will prevent an overreaction during 
future shocks or scandal.
    In short, Mr. Chairman, it is legitimate to consider what role--if 
any--Congress should play in this effort. I personally believe there is 
a role. As a result, shortly after we return from recess, Senator Dodd 
and I will be introducing a new version of our mutual fund legislation. 
The bill will include some of the fund governance, transparency and 
disclosure, and other provisions included in S. 1971. But it will also 
address some of the complex issues that lead to conflicts of interests. 
Some of those can be found in the financial arrangements between fund 
complexes, investment advisers, broker-dealers, and other 
intermediaries to promote the sale and distribution of the funds.
    We will be addressing the issue of directed brokerage, soft-dollar 
arrangements, and revenue sharing, just to name a few. Additionally, we 
will address the SEC's ``hard 4 p.m.'' proposal, and consider an 
alternative that will not disadvantage certain investors, particularly 
401(k) and west coast investors, but will provide the SEC with the 
assurance that these intermediaries have controls, compliance systems, 
and audit trails in place to prevent abusive market timing and late 
trading.
    Mr. Chairman, there is no doubt that real reforms are needed. 
Thankfully, they are already on the way. I commend the efforts of the 
SEC, Chairman Donaldson, and his staff for their aggressive approach 
toward promoting these much-needed reforms. But while the reforms they 
have initiated are important, I am not sure that they vitiate the need 
for statutory action, especially since in some areas, like soft 
dollars, the necessary changes will require ultimately statutory fixes.
    Mr. Chairman, I look forward to working with you, and the other 
Members of this Committee, in the effort to fashion these reforms. And, 
I again thank you for your thoughtful and deliberate approach to these 
important matters.

                               ----------
             PREPARED STATEMENT OF SENATOR MICHAEL B. ENZI

     Thank you Chairman Shelby for holding this series of oversight 
hearings on the mutual fund industry. It is a very similar approach to 
the one the Committee took with the Sarbanes-Oxley Act. The mutual fund 
industry operates unlike any other financial service industry. The 
series of hearings has helped us to understand the industry as well as 
being able to understand how the scandals were able to happen.
     Under the direction of Chairman Donaldson and the rest of the 
Securities and Exchange Commission, I believe that we are on the proper 
course to reforming the mutual fund industry. I cannot recall a time 
when the Commission has acted in a more timely and comprehensive way to 
restore investor confidence. The Commission has undertaken a variety of 
regulatory, enforcement, and examination initiatives to correct the 
significant problems and lax oversight of an industry that millions of 
investors rely upon for their future retirement and investment needs.
     Chairman Donaldson, in your capacity as Chairman of the SEC during 
the past 14 months it is very likely that you have been more active and 
productive than perhaps the last couple decades of SEC Chairmen. The 
extremely hard work that you, the Commissioners, and the staff have 
undertaken to put the SEC back on track should be recognized. I also 
realize that your work on the many issues pending before the Commission 
is not yet done.
     While I applaud the Commission with moving forward quickly on the 
regulatory reforms, the many hearings before us have given me a greater 
insight as to how the mutual fund industry has developed over the 
years. What may be considered unique or unusual practices to typical 
corporation or Wall Street firms, may in fact be practices that are an 
integral part of the operations of the mutual fund industry. 
Accordingly, I urge the Commission to carefully consider proposals that 
would impose a ``hard 4 p.m. close'' for the placement of mutual fund 
orders and the mandatory requirement of an independent chairman. I 
strongly believe that alternatives are available that be in the best 
interests of investors and would not change the dynamic nature of the 
mutual fund industry.
     Being from a western State, I have heard from constituents that 
the hard 4 p.m. close proposal would place western State investors at a 
great disadvantage to their eastern State neighbors. The proposal also 
would pit investors that place mutual fund orders through third 
parties, such as employer-sponsored retirement plans, against those who 
place orders directly with mutual funds. I know that the Commission can 
find a solution that will not place certain investor groups over 
others.
     In addition, I understand that the Commission has established a 
task force to study the soft-dollar issue. I urge the task force to 
commence its review of this area in the very near future. We have heard 
a great deal of testimony before the Committee that there are 
inappropriate uses of soft dollars, however, a complete ban on soft 
dollars would disproportionately effect small, independent research 
firms. The findings of the Task Force are essential in order to 
determine whether legislation is necessary in this very important area.
     Recently, you have given speeches and testified before Congress on 
the Commission's upcoming proposal to regulate hedge funds. I am very 
concerned that the Commission will expend resources on regulating hedge 
funds when it has not yet finished Phase 2 of the Investment Adviser 
Registration Depository for the oversight of investment advisers. In 
addition, I would hope that the Commission is fully confident that it 
can oversee and examine the mutual fund industry prior to expanding its 
oversight into other areas.
     As we know, the oversight of the mutual fund industry by the 
Commission has not been as stringent or as thorough as it should have 
been in the past few years. I do not want to give false hope to 
investors that the Commission can further tax and stretch its resources 
without doing a sufficient job on its primary oversight of the mutual 
fund and investment adviser industries. Millions of retail investors 
are counting on you to do the right thing to safeguard their retirement 
and investment savings.
     Thank you again Chairman Donaldson for appearing before us today.
     Mr. Chairman, thank you again for taking a careful, thoughtful, 
and thorough oversight review of the mutual fund industry. I have 
greatly benefitted from all of the witness' testimony.

                               ----------
               PREAPRED STATEMENT OF WILLIAM H. DONALDSON
           Chairman, U.S. Securities and Exchange Commission
                             April 8, 2004

    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee, thank you for inviting me to testify today at your tenth 
hearing on mutual fund issues since late trading and market timing 
abuses came to light last fall. The breadth of your hearings have 
clearly and effectively illustrated the complexity of the issues the 
Commission is facing in addressing problems in the mutual fund 
industry. The hours upon hours that you and the Committee have spent 
performing critical oversight, and the testimony from witnesses 
representing all sectors and aspects of the problem, have been 
immensely valuable as the Commission works to tackle these issues. I 
thank you and I commend you for your thorough and thoughtful approach.
    Like you, I am outraged by the conduct that has come to light in 
the recent mutual fund scandals. In large part, I believe that the 
industry lost sight of certain principles--in particular, its 
responsibility to millions of investors who entrusted their life's 
savings in this industry for safekeeping. As I said last fall when I 
testified before you, and I believe it bears repeating, these mutual 
fund investors are entitled to honest and industrious fiduciaries who 
sensibly put their money to work for them in our capital markets. 
Investors deserve a brokerage and mutual fund industry built on 
fundamentally fair and ethical legal principles. This has been the 
Commission's urgent and guiding mission as it pursues an aggressive 
mutual fund reform program to identify and address a range of problems 
in the industry. The Commission has made significant progress, and will 
continue to move aggressively to track down and pursue wrongdoers, 
while expeditiously considering and adopting the outstanding mutual 
fund rule proposals.
    As you have seen through your hearings, and we have witnessed 
through our rulemaking process, there is a wide variety of views among 
knowledgeable experts as how best to address mutual fund oversight--
views that very often conflict with one another, particularly among 
competitors. That is why our notice and comment process, which Congress 
so wisely required in Commission rulemakings, is of infinite value to 
us and to the final product. In a deliberate, structured format, we 
benefit from a wide spectrum of views and opinions as to how to 
strengthen our 
proposed rules and regulations, the practicalities of implementing 
those rules and regulations, and alternative approaches to address the 
underlying goals of our proposals.
    As you requested, I will address the Commission's recent 
initiatives to respond to the specific problems of late trading, market 
timing, and selective disclosure abuses. I will also address what the 
Commission has done and is continuing to do to strengthen the mutual 
fund regulatory framework overall, as we work to prevent any future 
breakdowns in the industry.
    With more than 91 million Americans invested in mutual funds, 
representing almost half of all U.S. households, and a combined $7.5 
trillion in assets, mutual funds are unquestionably one of the most 
important elements of our financial system. Investor protection is a 
top priority at the Commission. We are focusing our attention on 
pursuing an aggressive program to identify and address a range of 
problems and challenges in the mutual fund industry--challenges such as 
strengthening the governance structure of mutual funds, addressing 
conflicts of interests, enhancing disclosure to mutual fund 
shareholders, and fostering an atmosphere of high ethical standards and 
compliance within the industry.
    Appropriately, the Commission and its staff have been 
extraordinarily busy addressing challenges with particular focus on 
addressing the specific problems of late trading, market timing, and 
selective disclosure abuses. In my testimony, I will outline: (1) our 
aggressive rulemaking agenda--which has immediately tackled late 
trading and market timing abuses; and our extended efforts to address 
broader structural problems in the mutual fund regulatory framework; 
(2) our vigorous inspection and enforcement efforts; and (3) the 
restructuring of the Commission's overall internal functions and 
operations to better assess and anticipate risk, particularly vis-a-vis 
the mutual fund industry.
The Commission's Rulemaking Initiatives
    Last month, as part of your hearing series, Paul Roye, the Director 
of the Commission's Division of Investment Management, testified 
regarding the aggressive regulatory agenda the Commission has 
undertaken to combat late trading, market timing, and related abuses. 
In addition, he outlined the aggressive overall regulatory agenda to: 
(1) improve the oversight of funds by enhancing fund governance, 
ethical standards, and compliance and internal controls; (2) address or 
eliminate certain conflicts of interest in the industry that are 
potentially harmful to fund investors; and (3) improve disclosure to 
fund investors, especially fee-related disclosure. In each of these 
areas the Commission has moved swiftly to propose rules and to vet them 
through our notice and comment process and, in many instances, through 
meetings with relevant interested parties. We also are moving promptly 
to craft final rules but, because of the complexity associated with 
some of our proposals--such as our proposal on late trading--we may 
take additional time before finalizing our proposed rules. More 
important than acting quickly is making sure we get it right. Let me 
briefly describe our proposals in each of these areas.
Late Trading & Market Timing
    Investors rightfully assume that mutual fund managers and fund 
directors put the investors' interest first. When the late trading and 
market timing abuses came to light, it was clear that many of these 
investors had been let down, as some of those charged with protecting 
investors had willfully disregarded their responsibilities to act for 
the benefit of their investors. To put an absolute halt on late 
trading, the Commission proposed the ``hard 4:00'' rule. This rule 
amendment would provide for a secure pricing system that would be 
largely immune to manipulation by late traders by requiring that orders 
be placed with the fund or its primary transfer agent or clearing firm 
by the time set by the funds.
    Typically, funds price their shares at 4 p.m. eastern standard 
time. Investors submitting orders before 4 p.m. receive that day's 
price; investors submitting orders after 4 p.m. get the next day's 
price. If an investor can place an order to buy or sell fund shares 
after 4 p.m., but still receive the price set at 4 p.m., that investor 
can profit from new information in the marketplace at the expense of 
other fund shareholders. Under the current system, various 
intermediaries, including some pension plan recordkeepers--some of whom 
are not registered with the Commission--can receive the orders by 4 
p.m. We know that the current system has failed because intermediaries 
allowed certain, select shareholders to receive the 4 p.m. price, even 
though their orders were placed after 4 p.m.; consequently, we needed 
to devise a new system to minimize the possibility of this abuse in the 
future.
    To date, the Commission has received more than 1,000 comment 
letters on this proposal, many raising concerns about how the proposal 
might adversely impact certain fund investors such as 401(k) plan 
participants and investors in earlier time zones across the country. As 
an alternative to the proposal, some have advocated a system of 
controls that would better prevent and detect late trading; others have 
recommended the use of more sophisticated technology to create tamper-
proof time stamping of trade tickets that would help eliminate, or at 
least better detect, late trading. The staff is analyzing this 
information to determine whether there is an effective alternative to 
the hard 4:00 rule proposal that would not disadvantage certain 
investors and would not distort competition in the marketplace. It may 
very well turn out that we adopt a combination of some of the 
alternatives that have been presented to us during the notice and 
comment process. Again, the hard 4:00 rule proposal illustrates the 
effectiveness of the Commission's rulemaking process, whereby we, and 
indeed the investing public, are the beneficiaries of a wide range of 
views and perspectives, and possible solutions.
    To address market timing, especially so-called ``arbitrage market 
timing,'' the Commission has stressed that ``fair value pricing'' is 
critical to reducing effectively or eliminating the profit that many 
market timers seek and the dilution of shareholder interests. However, 
because fair value pricing can be subjective, the Commission also 
intends to continue to monitor funds' fair value pricing practices and 
has proposed improved fair value pricing disclosure; enhanced 
disclosure regarding a fund's antimarket timing policies and practices; 
and, to reduce the possibility of abusive market timing, that funds 
impose a mandatory 2 percent redemption fee when investors redeem their 
shares within 5 days of purchase. If the Commission moves forward with 
adopting the mandatory redemption fee proposal, I feel that it must 
contain exceptions--for example, exceptions for individual investors 
who have 
suffered an unforeseen hardship and for money market funds and funds 
that specifically cater to market timers. Along with the mandatory 
redemption fee, the Commission also proposed a process that, for the 
first time, would give mutual funds a weekly pass-through of buyer and 
seller information from intermediaries. That process, which is often 
lost in discussion, is a critical piece of the proposal that would 
allow funds to identify market timers and apply the funds' antimarket 
timing procedures.
Fund Governance, Ethical Standards, and Compliance
    In an effort to enhance oversight of the industry, the Commission 
proposed a comprehensive rulemaking package to bolster the 
effectiveness of independent directors and solidify the role of the 
fund board as the primary advocate for fund shareholders. The proposal 
would enhance the independence of fund boards by including a 
requirement for an independent board chairman and a board comprised of 
75 percent independent directors. Board and chairman independence is 
just part of what we are considering to restore overall accountability 
to the fund board.
    In an effort to reinforce the fundamental importance of integrity 
in the investment management industry, the Commission recently proposed 
that all registered investment advisers adopt codes of ethics. The code 
of ethics would set forth standards of conduct for advisory personnel 
that reflect the adviser's fiduciary duties, as well as codify 
requirements to ensure that an adviser's personnel comply with Federal 
securities laws and report their securities transactions.
    In the area of improving compliance and the oversight of fund 
boards, the Commission, in December, adopted a rule requiring that 
funds and their investment advisers have comprehensive compliance 
policies and procedures in place, including appointing a designated 
chief compliance officer. In the case of a fund, the chief compliance 
officer would be answerable to the fund's board and could be terminated 
only with the board's consent. This rule will have a far-reaching, 
positive impact on mutual fund operations and compliance programs by 
ensuring that funds have a primary architect and enforcer of compliance 
policies and procedures for the fund and, perhaps more importantly, a 
compliance officer who can be the eyes and ears of the board of 
directors. This requirement will provide fund boards with a powerful 
tool to identify and prevent misconduct that could potentially harm 
funds and their shareholders. Funds must begin compliance with this 
final rule by October 2004.
Conflicts of Interest
    In addition to taking steps to enhance mutual fund oversight and 
ethical standards, the Commission has also undertaken a series of 
initiatives aimed at certain conflicts of interest that exist now 
between mutual funds and those who distribute fund shares. For example, 
the Commission voted to propose an amendment to Rule 12b-1 to prohibit 
the use of brokerage commissions to compensate broker-dealers for 
distribution of a fund's shares. This would eliminate a practice that 
potentially compromises best execution of a fund's portfolio trades, 
increases portfolio turnover, and corrupts broker-dealers' 
recommendations to their customers.
    At the same time, the Commission sought comments as to whether 
other changes should be made to Rule 12b-1 or even if it should propose 
to abolish the rule altogether. For instance, should we continue to 
permit 12b-1 fees to be used in lieu of a front-end sales load? Should 
distribution costs be taken directly out of a shareholder's account 
rather than out of fund assets, so that each shareholder pays his or 
her own distribution related costs? Should long-term shareholders even 
be bearing distribution costs? We are anxious to review the comments we 
receive on these questions as we move forward in our reconsideration of 
Rule 12b-1.
    The Commission also has proposed improved disclosure regarding a 
portfolio manager's relationship with the fund. The proposals include 
disclosure regarding the persons managing the fund, the structure of 
portfolio manager compensation, ownership of shares of the funds that a 
manager advises, and comprehensive disclosure of specific investment 
vehicles, including hedge funds and pension funds that are also managed 
by a fund's portfolio manager.

Disclosure to Fund Investors
    Improved disclosure--particularly disclosure about fund fees, 
conflicts, and sales incentives--had been a stated priority for the 
Commission's mutual fund program in the months before the trading 
abuses came to light. Consequently, the Commission took steps to 
significantly improve the information required for individual 
shareholders. First, the Commission adopted a requirement that 
shareholder reports include dollar-based expense information so that 
investors can easily compute the dollar amount of expenses paid on 
their investment in a fund. This is an important step in providing 
shareholders with critical information about their mutual fund 
investments. Some have questioned whether we should have required more 
information--that is individualized account information to each 
shareholder. While the staff and the Commission considered this 
alternative, we were convinced that the dollar-based expense 
information that the Commission ultimately adopted was the better 
course, as it allowed for comparability. We have ongoing efforts to 
continue examining the entire mutual fund disclosure regime to see if 
it is as good as it can be; however, with respect to this particular 
rule--which will go into effect in July--I firmly believe we must give 
the rule a good chance to operate before we contemplate changing it.
    In other efforts to improve disclosure for investors, the 
Commission has:

 issued a concept release on methods to calculate and improve 
    the disclosure of funds' portfolio transaction costs;
 proposed to make more transparent in shareholder reports how 
    fund boards evaluate investment advisory contracts;
 proposed new fund confirmation forms and new point-of-sale 
    disclosure that would greatly enhance the information that broker-
    dealers provide their customers in connection with mutual fund 
    transactions, and highlight the conflicts that broker-dealers face 
    in recommending mutual fund investments; and
 proposed improved prospectus disclosure to address the wide-
    scale failure on the part of broker-dealers to provide appropriate 
    breakpoint discounts on front-end load mutual fund purchases.

    While neither I nor my fellow Commissioners have finalized our 
positions regarding each of these rule proposals, we all agree that the 
areas they address are of critical importance to the protection of 
mutual fund investors. The staff is reviewing and analyzing the 
comments received on these various rule proposals in order to finalize 
its recommendations for the Commission's consideration in adopting the 
rules. We have received comment letters from fund shareholders, 
Senators, Congressmen, fund complexes, directors, officers, and broker-
dealers to name just a few. While not all commenters have agreed with 
the staff's proposals, just as the Commissioners do not always agree 
with one another, a healthy, intellectual, reasoned debate will better 
inform the staff and improve the final product as we move toward final 
adoption of these rules.
    And, just as we embarked on an aggressive agenda to propose these 
rules, we will be just as aggressive in our agenda for considering the 
final rules. This spring and summer, the Commission will be considering 
all of these outstanding mutual fund rulemaking proposals: market 
timing disclosure, breakpoint disclosure, the fund governance package, 
the investment advisers code of ethics rule, disclosure regarding the 
factors considered by the fund's board in approving the advisory 
contract, the proposed amendments to Rule 12b-1, the hard 4:00 close, 
portfolio manager disclosure, the mandatory 2 percent redemption fee 
and flow through of information between funds and intermediaries, and 
new confirmation form and point-of-sale disclosure. However, while it 
is important that we consider adoption of these rules in an expeditious 
manner, it is equally important that we give interested parties an 
opportunity to comment and our staff sufficient time to consider fully 
possible unintended consequences and vet alternative approaches to our 
proposals so that we adopt the final rules that best address the 
problems we seek to solve.

Inspections and Enforcement Efforts
    Complementing our regulatory reforms are vigorous inspection and 
enforcement programs for detecting wrongdoing and enforcing the Federal 
securities laws. As I have mentioned before, the mutual fund abuses 
that we have witnessed represent a fundamental betrayal of American 
investors, and the Commission has punished, and will continue to 
punish, the malefactors swiftly and with every tool available to us. 
The detection and enforcement piece of the Commission's agenda relating 
to mutual funds currently is focused primarily on four types of 
misconduct, each of which may show that the interests of financial 
services firms or their employees were being placed above the interests 
of investors.
    The first area of priority is late trading and abusive timing of 
mutual fund shares. Since the disclosure of these practices last 
September, the Commission has conducted a broad investigation and has 
brought numerous enforcement actions charging hedge fund managers, 
broker-dealers, investment advisers, and their associated persons with 
engaging in such abuses to the detriment of fund investors. While our 
examinations and investigations are ongoing, the enforcement actions we 
have brought thus far have involved some of the most well-known names 
in the mutual fund industry, including Putnam Investments, Invesco 
Funds Group, Alliance Capital Management, Massachusetts Financial 
Services, FleetBoston Financial, and Bank of America. The settlements 
obtained by the Commission in several of these cases have resulted in 
significant corporate governance and compliance improvements, as well 
as substantial payments that will be used to compensate harmed 
investors.
    Among these recent settlements was the Commission's order against 
Massachusetts Financial Services, Inc. (MFS). On February 5, 2004, the 
Commission filed a settled enforcement action against MFS, its chief 
executive officer, and its president and chief equity officer, for 
violating the Federal securities laws by allowing widespread market 
timing trading in certain MFS mutual funds in contravention of those 
funds' public disclosures. The Commission censured MFS and ordered it 
to pay $225 million, consisting of $175 million in disgorgement and $50 
million in penalties. The Commission's Order further requires MFS to 
undertake certain compliance and mutual fund governance reforms 
designed to enhance the independence of mutual fund boards of trustees 
and strengthen oversight of MFS's compliance with the Federal 
securities laws.
    For their roles in the misconduct, the Commission prohibited MFS's 
CEO and president from serving as an officer or director of any 
investment adviser and from serving as an employee, officer, or trustee 
of any registered investment company for 3 years. In addition, the 
Commission's order places certain restrictions on the duties the CEO 
and president can perform during that period. The Commission also 
suspended both the CEO and president from association with any 
investment adviser or registered investment company for 9 months and 6 
months, respectively, and ordered each to pay a penalty of $250,000 and 
disgorge over $50,000 in ill-gotten gains derived from MFS's market 
timing practices. All of the money paid by MFS, its CEO and its 
president will be distributed to harmed shareholders.
    Our second area of examination and enforcement priority focuses on 
mutual fund sales practices, including fee disclosure issues in 
connection with the sale of mutual funds. In particular, we are looking 
at what prospective mutual fund investors are--or are not--being told 
about revenue sharing arrangements and other incentives provided by 
mutual fund companies to broker-dealers selling their funds. Customers 
have a right to know how their broker-dealer is being paid to sell a 
particular fund. And when these payments are being made from fund 
assets, customers should understand that their own investment dollars 
are being used to foot the bill for the mutual funds' premium ``shelf 
space'' at the selling broker's office. Such fees may increase costs to 
investors as well as create conflicts of interest between investors and 
the financial professionals with whom they deal. The Commission brought 
the first case targeting these undisclosed payments in November 2003 
against Morgan Stanley. In settling the matter, Morgan Stanley agreed 
to pay $50 million in disgorgement and penalties. We are continuing to 
examine and investigate industry participants for similar practices. 
The potential disclosure failures and breaches of trust spotlighted in 
the Morgan Stanley case are not necessarily limited to Morgan Stanley, 
or even to broker-dealers.
    The Enforcement staff is also looking very closely at the role and 
responsibilities of mutual fund companies themselves in these 
arrangements. In fact, last week, the Commission filed a settled action 
against MFS related to the company's use of mutual fund assets--namely, 
brokerage commissions on mutual fund transactions to pay for the 
marketing and distribution of mutual funds in the MFS Fund Complex (MFS 
Funds). The Commission issued an order that found MFS failed to 
adequately disclose to the Boards of Trustees and to shareholders of 
the MFS Funds the specifics of its ``shelf-space'' arrangements with 
brokerage firms and the conflicts created by those arrangements. As 
part of the settlement, MFS agreed to a series of compliance reforms 
and to pay a penalty of $50 million, which will be distributed to the 
MFS Funds. In addition, as I previously stated, the Commission has 
proposed to ban the use of brokerage commissions to compensate broker-
dealers for the distribution of fund shares.
    Our third area of priority in the mutual fund examination and 
enforcement arena is the sale of different classes of mutual fund 
shares. Many mutual funds offer multiple classes of shares in a single 
portfolio. For each class of shares, a mutual fund uses a different 
method to calculate and collect distribution costs from investors. 
Class A fund shares are subject to an initial sales charge (front-end 
load); discounts on front-end loads are available for large purchases 
of Class A shares. Since the sales fee is paid up front, Class A shares 
incur lower (or no) ``Rule 12b-1 fees,'' fees the mutual fund pays for 
distribution costs, including payments to the broker-dealers and their 
registered representatives selling fund shares.
    Last July, the Commission brought an action against Prudential 
Securities for abuses in this area. In that case, the Commission found 
that Prudential's supervisory system for overseeing practices in this 
area was inadequate. Prudential had in place policies and procedures 
requiring registered representatives to advise their clients of the 
availability of different classes of mutual funds and fully explain the 
terms of each. Prudential branch managers were also expected to approve 
all purchases greater than $100,000 and confirm the suitability of the 
choice of fund class. The Commission found, however, that Prudential 
failed to adopt a sufficient supervisory system to enable those above 
the branch manager to determine whether these policies and procedures 
were being followed. In resolving the Commission's action, Prudential 
was censured and agreed to pay disgorgement and a civil penalty. The 
Commission's action against the registered representative and branch 
manager, which charges them with fraud, is pending.
    The fourth examination and enforcement priority area with respect 
to mutual funds is to address the failure of firms to give their 
customers the discounts available on front-end loads for large 
purchases of Class A shares. Last year, examiners at the SEC, NASD, and 
NYSE completed an examination sweep and outlined the results in a 
public report. This sweep culminated in the filing, on February 12, 
2004, of enforcement and disciplinary actions against a total of 15 
firms for failure to deliver mutual fund breakpoint discounts during 
2001 and 2002. The 15 firms agreed to compensate customers for the 
overcharges, pay fines in an amount equal to their projected 
overcharges that total over $21.5 million, and undertake other 
corrective measures. The NASD has ordered all firms to repay their 
customers any amounts overcharged.
    While these are areas of focus in the mutual fund arena, the 
Examination staff, in coordination with the Enforcement staff, are 
continually on the look out for additional mutual fund practices that 
may be vulnerable to or ripe for abuse. Accordingly, the staff is 
closely examining, among other things, the status of funds closed to 
new investors that nevertheless continue to charge Rule 12b-1 fees, the 
portfolio pricing practices of high yield bond funds, the role of 
pension consultants in pension plans' selection of particular money 
managers, the use of ``fair value'' pricing, the use of affiliated 
service providers, and the fees charged by certain index funds. And in 
all of the foregoing areas, the Commission is intently focused on the 
roles and conduct of mutual fund directors. Have they adequately 
discharged their responsibilities? Have they properly overseen the 
mutual fund management company on behalf of mutual fund shareholders?

Internal Restructuring
    The third key element in enhancing the protection of our Nation's 
mutual fund investors--indeed of enhancing the protection of all of our 
Nation's investors--is the internal restructuring of the Commission's 
management and functions. One of my primary goals since coming to the 
Commission has been to help restore the Commission's credibility as the 
investors' watchdog. This, of course, means reforming how the 
Commission operates. I will briefly summarize these reforms for you.
    Last year, following a thorough internal review of how the Agency 
deals with risk, we initiated a new risk management program and laid 
the groundwork for the 
Office of Risk Assessment and Strategic Planning, the first of its kind 
at the Commission. The first phase has been to organize internal risk 
teams for each major program area. This framework has already been put 
into place and allows for a bottom up approach to assessing risk. A 
good example of this is through our Office of Compliance Inspections 
and Examinations. We have empowered our examiners, through OCIE's 
internal risk management team, to look at potential problems in the 
mutual fund and broker dealer industries and to examine formally for 
these potential problem areas.
    The new Office of Risk Assessment will work in coordination with 
the internal risk teams and will push the Agency to identify 
proactively potential problem areas within the mutual fund and broker-
dealer industries, focusing on early identification of new or resurgent 
forms of fraudulent, illegal, or questionable activities. In addition 
to fostering better communication and coordination between Divisions 
and Offices within the Commission, the risk assessment initiative will 
help to ensure a process whereby senior managers at the Commission have 
the information necessary to make better, more informed decisions and 
to adjust operations and resources to address these new challenges.
    We also have greatly enhanced our examination program, as our 
Director of the Office of Compliance Inspections and Examinations, Lori 
Richards, shared with you a few weeks ago. In 2003, budget increases 
allowed us to increase our staff for fund examinations by a third, to 
approximately 500 staff. These new resources, coupled with the Office's 
new risk-based examinations approach, should greatly improve our 
ability to detect abusive behavior and possible violations of the law.
    In addition to the overarching risk assessment effort has been the 
creation of a number of multidivisional task forces designed to bring 
together staff from various divisions and offices to brainstorm, 
evaluate and create strategies to proactively undertake issues of 
potential concern in protecting the Nation's securities markets.
    Four of these task forces will tackle issues that will help us 
better protect mutual fund investors and monitor the mutual fund 
industry. They are the Chairman's Task Forces on: Soft-Dollar 
Arrangements; College Savings Plans (or 529 plans); Enhanced Mutual 
Fund Surveillance; and Disclosure Regime. The Task Forces will meet 
with the relevant interested parties--such as individual investors, 
industry representatives, fellow regulators, and others--to gather 
critical intelligence and data, and ultimately work toward addressing 
problem areas.
    Let me start with the Task Force on Soft Dollars, because I know 
this issue is of particular concern to some of you on the Committee, 
and I want to assure you that it is also a very high priority for the 
Commission in the context of our mutual fund reforms.
    The Task Force on Soft Dollars, comprised of SEC staff from five 
divisions and offices, has already met with a number of industry 
representatives as it tackles this complicated issue. Its goal is to 
fully understand all aspects of how soft dollars are used, and the pros 
and cons of various alternative reform approaches, including possible 
unintended consequences. While I would like to have those 
recommendations as soon as possible, I also want to ensure that the 
Task Force has adequate time to fully consider the issue and the 
benefit of meeting with interested persons so that it can come to us 
with the best and most informed recommendations possible.
    Like so many of the issues we are facing, the area of soft dollars 
is complex, and we must be cautious as we move forward with reforms in 
this area. I believe that at the very least, the Commission, through 
the rulemaking process, should consider narrowing the definition of 
qualifying ``research'' under the safe harbor so that only ``real'' 
research that has valid, intellectual content, qualifies. I would also 
expect the Task Force to consider whether the costs of research and 
execution should be quantified and other ways in which the costs of 
research could be made more transparent. Some have advocated a 
distinction between third-party research and proprietary research. My 
view is that we should not draw such distinctions, but the Task Force 
will also consider this issue and provide recommendations. As you are 
aware, the Securities Exchange Act contains a statutory safe harbor, 
Section 28(e) of the Exchange Act, which protects use of soft dollars. 
So, the Task Force will also consider whether Section 28(e) of the 
Exchange Act should be repealed. While I have not yet reached that 
conclusion, if the Task Force and the Commission ultimately arrive at 
that conclusion, I will not hesitate to seek Congress' assistance in 
that endeavor.
    Because there are growing concerns with disclosure and transparency 
with respect to 529 tuition savings plans, or college savings plans, we 
have established a task force on college savings plans. This task force 
is charged with examining the issue of college savings plans, including 
a focus on the structure and sale of college savings plans and 
disclosures to plan participants, particularly with respect to fees and 
expenses. More specifically, I have asked the Task Force to review 
disclosure and transparency for investors in these plans, the extent of 
the Commission's oversight of these plans and whether the costs and 
fees associated with these plans 
outweigh the tax advantages of these plans for families saving for 
their children's educations.
    Another critical area where the Commission will be more proactive 
is mutual fund surveillance. In this vein, we have formed a Task Force 
on Self-Reporting Regimes for Mutual Funds to look at both the 
frequency of reports made by mutual funds to the Commission and the 
categories of information to be reported. Further, this Task Force will 
examine how new technologies can best be used to enhance our oversight 
responsibilities. The Task Force will draw on the expertise of our 
fellow regulators at the NYSE, NASD, and NASAA, as well as others 
knowledgeable in the area of surveillance and reporting.
    Another critical area for Commission review is our disclosure 
regime. Because the Federal securities laws are largely disclosure 
based, investors receive a large volume of disclosure documents, 
especially when they invest in a mutual fund. The Task Force on 
Disclosure will examine the value of the various disclosures provided 
by mutual funds, brokers and issuers to investors as required by our 
rules and regulations. The Task Force will also explore what types of 
disclosures best serve investors, the timing of the disclosures, 
delivery versus access to the disclosures, and how best to harness 
technological advances in assisting investors. In addition, the Task 
Force will analyze whether there is data that the Commission should 
collect and publish on a periodic basis that would be useful to 
investors in making comparisons among the various investment options 
available to them. This Task Force will reach out to investors to help 
guide it through the important task of ensuring that investors are 
receiving the proper mix of disclosure in a format meaningful to them.

Hedge Funds
    Before closing, I would note that hedge funds have played 
significant roles in some of the most notorious mutual fund scandals 
that have come to light recently--the Bank of America/Canary Hedge Fund 
case is one example. So, I would like to summarize my personal concerns 
related to hedge funds, with the caveat that my views on hedge funds 
are my own and do not reflect the views of the entire Commission.
    The issues surrounding hedge funds are an excellent example of how 
the Commission can be proactive and work to enhance enforcement in 
problem areas before they spread. The Commission is responsible for 
enforcing the Federal securities laws, policing the securities markets, 
and ensuring fraud prevention and detection. This is the Commission's 
responsibility regardless of whether we are talking about mutual funds, 
self regulatory organizations, public companies, hedge funds, or other 
market participants. Hedge funds have become one of the fastest growing 
segments of the investment management business--with assets fast 
approaching $1 trillion--at a time when returns on other investments 
have not kept the same pace.
    Other Government entities--primarily the Federal Reserve Board and 
the Treasury--are responsible for monitoring potential systemic risks, 
and the safety and soundness issues raised by the structure of these 
vehicles. While their oversight priorities are of great import to our 
banking system, these agencies are not responsible for enforcing the 
Federal securities laws and protecting investors. The data they 
collect is aimed at the discharge of their prudential responsibilities. 
Any regulatory action the Commission ultimately takes will focus on the 
protection of investors, rather than safety and soundness issues.
    I would also like to address the need for protecting investors in 
the hedge fund context. One of the points I often hear about not 
regulating hedge funds is that hedge fund investors are wealthy and 
sophisticated individuals who do not need protecting. This is not the 
point. Hedge fund managers are, directly and indirectly, providing 
advisory services for many U.S. investors--with a significant impact 
not only on those investors, but also on the operation of the U.S. 
securities markets. The Commission is the only Government agency that 
is charged with protecting those investors and policing those markets. 
Further, hedge funds are being purchased by intermediaries on behalf of 
millions of ultimate smaller investor beneficiaries--retirees, 
pensioners, and others not generally thought of as the traditional 
hedge fund investor--through their pension plans or funds of hedge 
funds, again making it critical for investors that the Commission have 
basic information and a resulting insight as to how many hedge fund 
managers are deploying assets under management; how they handle 
conflicts of interest, how they account for results and value their 
investments, and most importantly, what impact their market activities 
have on the other participants in our equity markets.
    Moreover, hedge funds often promise performance in all types of 
market conditions, and typically include hefty performance fees for 
their managers. This combination can motivate unscrupulous hedge fund 
managers to attempt behavior or conduct that circumvents or crosses the 
legal boundaries of the securities laws.
    As we move forward to debate this issue, there are a few questions 
that I think we need to consider: How are hedge fund managers pricing 
the securities in their portfolios? What practices are in place 
regarding hedge funds' use of and access to inside information? How do 
hedge fund managers conduct their securities trading? What prevents 
hedge funds from front-running mutual funds or other large investors? 
What are hedge funds' activities regarding initial public offerings? 
How hedge funds answer these questions not only has an impact on the 
investors in the hedge funds, but also more importantly has a 
significant impact on all investors in our markets, including those 
investors that have exposure to hedge funds indirectly, whether through 
their retirement and pension plans or through funds of hedge funds.
    It troubles me that the Commission, under the current rules, is 
limited in its ability to gather information that could provide answers 
to these questions, and could help protect millions of investors. I 
fundamentally believe that the Commission has a legitimate interest in 
obtaining the information, and imposing appropriate recordkeeping and 
other regulatory requirements, if needed, to protect investors 
receiving advisory services from hedge fund managers. Further, what we 
have found in the mutual fund scandals supports this concern. We have 
seen hedge fund managers 
engaged in illegal behavior that results in taking advantage of the 
long-term retail investors in these funds. Critics cannot have it both 
ways--on the one hand, to demand that the Commission be proactive and 
prevent and detect emerging, but as of yet unforeseen, harms and 
abuses, but on the other hand, to handicap our ability to obtain 
information that facilitates our identification of such abuses.
    Let me be clear: I believe hedge funds play a vital role in our 
financial markets, and I would reject any regulatory proposal that 
would in any way impede the ability of hedge funds to function as they 
currently do, so long as we have the ability to ensure that their 
managers are not taking advantage of millions of investors. This is a 
point the Commission staff made clear in its report on hedge funds last 
fall.
    Mindful of the balance between fulfilling our responsibility to 
protect investors and protecting hedge funds' vital role in our 
financial markets, I have asked the staff to move forward with a 
rulemaking proposal that would enhance the Commission's ability to 
prevent, detect and deter abusive, fraudulent conduct in the hedge fund 
segment of the investment management industry. As part of this 
rulemaking, and building on the risk assessment capability we are 
developing in the Agency--including our new risk identification and 
mapping programs, we could consider both a form of registration for 
hedge fund managers and an oversight regime different from that which 
we use for other, more heavily regulated industries, like mutual funds. 
They could be specifically tailored to the unique dynamics of these 
types of managers. We could thus better target our inquiries on those 
hedge fund managers where there is some reasonable concern that they 
may be violating the securities laws.
    As with all rulemaking proposals, this one will have to be voted 
upon by the Commission and would go through the notice and comment 
process so as to consider the views of all interested persons on this 
subject. I intend to ensure that the Commission's consideration of the 
hedge fund issue is thoughtful and thorough, and that any proposal will 
be fully and appropriately vetted.

Conclusion
    As my testimony--taken together with previous testimony from the 
Commission staff--demonstrates, the Commission has embarked on an 
aggressive regulatory and enforcement agenda to combat the current ills 
plaguing the mutual fund industry. I believe our efforts will help 
ensure that there are strong safeguards in place to minimize the 
possibility of future illegal, fraudulent, or harmful activity. We have 
ample regulatory authority with which to carry out this agenda, and--
due in large part to your support and your constructive approach--we 
have been able to pursue this agenda in an expedited manner.
    Please allow me to once again complement the Committee, Mr. 
Chairman, for its thoughtful and thorough approach to the oversight of 
these issues. The significant number of hours that you and the staff 
have spent conducting oversight hearings, and questioning witnesses 
from all segments of the industry, has been immensely helpful to the 
Commission, and represents a constructive approach to analyzing the 
complexity of the problems that have plagued the mutual fund industry. 
The Commission--and indeed the mutual fund investor--has benefited from 
your approach and your efforts, and I thank you.
    If, as the Commission moves ahead with its mutual fund reforms, 
there are critical issues that we do not have the ability to address, 
the Commission will immediately seek your assistance to do so; however, 
I do not believe that legislation is necessary at this time.
    Thank you again for inviting me to speak on behalf of the 
Commission to discuss our efforts to protect the investing public. I 
would be happy to answer any questions that you may have.

         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED 
                   FROM WILLIAM H. DONALDSON

Q.1. Does the SEC have a standard format in which electronic 
evidence from mutual fund operators is collected and reviewed? 
Is there a need for such a standard?

A.1. Electronic data, such as electronic mail, is an important 
component of many enforcement investigations, including those 
involving mutual funds. To facilitate efficient review of two 
common forms of electronic data, the Division of Enforcement 
has established ``preferred formats'' for the production of 
electronic mail and imaged documents. Parties producing 
electronic mail or imaged documents are requested, but not 
required, to utilize these preferred formats. These two 
categories of electronic data account for the large majority of 
electronic productions made to the Enforcement staff. In 
addition, under Exchange Act Rule 17a-25, when the Commission 
requests transaction data from a registered broker-dealer, the 
firm must submit the information electronically in an industry 
standard format known as the Electronic Blue Sheet format. 
``Blue Sheeting'' is the primary means of transmitting trading 
data to the SEC and self-regulatory organizations.
    The Enforcement Division does not require production of 
electronic data in a particular format in order to accommodate 
parties producing the data and, where feasible, limit the 
associated burden. In addition, because conversion of 
electronic data to a format other than the one in which it is 
maintained may cause a loss of information, it is often 
beneficial to accept production of electronic data in its 
native format. This is one of the reasons that the Enforcement 
Division uses preferred formats rather than required formats. 
In the staff 's view, because maintaining flexibility 
concerning the format in which electronic data is produced can 
yield more complete information, a mandatory format for 
production of electronic data is unnecessary.

Q.2. In his testimony before this Committee on February 25, 
Gary Gensler argued that Congress should amend or repeal the 
Gartenberg Standard. This legal standard essentially says that 
to be found excessive, an adviser's fee must be so large that 
it has no relationship to the services rendered and could not 
have come from `arm's-length' bargaining. Do you believe that 
Congress needs to pass legislation that would statutorily 
create a new, stronger standard for reasonableness of adviser 
fees?

A.2. Section 36(b) of the Investment Company Act of 1940 
imposes on fund investment advisers a fiduciary duty with 
respect to their receipt of compensation from funds.\1\ 
Congress adopted Section 36(b) in response to concerns that 
fund advisory fees were not subject to the usual competitive 
pressures because funds typically are organized and operated by 
their investment advisers.\2\ As interpreted by the courts, 
directors' responsibilities under Section 36(b) involve the 
evaluation of whether the compensation that is paid to a fund's 
investment adviser is ``so disproportionately large that it 
bears no reasonable relationship to the services rendered and 
could not have been the product of arm's length bargaining,'' 
otherwise known as the Gartenberg standard--a reference to one 
of the leading court cases interpreting section 36(b).\3\ Based 
on the Gartenberg standard, when approving and renewing 
investment advisory agreements, particularly the compensation 
to be paid to the investment advisers, fund directors typically 
consider the following relevant factors:
---------------------------------------------------------------------------
    \1\ Section 36(b) specifically authorizes the Commission, and any 
fund shareholder, to bring an action in Federal district court against 
the fund's investment adviser for a breach of fiduciary duty ``with 
respect to the receipt of compensation for services, or of payments of 
a material nature'' made by the fund to the investment adviser (or to 
an affiliated person of the investment adviser).
    \2\ See SEC, Report on the Public Policy Implications of Investment 
Company Growth, H.R. Rep. No. 2337, 89th Cong., 2d Sess. 10-12, 126-27, 
130-32 (1966). See also, Division of Investment Management, Protecting 
Investors: A Half Century of Investment Company Regulation 317-19 (May 
1992).
    \3\ Gartenberg v. Merrill Lynch Asset Management, Inc. 694 F.2d 
923, 928 (2d Cir. 1982). See also, Gartenberg v. Merrill Lynch Asset 
Management, Inc., 740 F.2d 190 (2d Cir. 1984).

 The nature and quality of all of the services provided 
    by the adviser (either directly or through affiliates), 
    including the performance of the fund;
 The adviser's cost in providing the services and the 
    profitability of the fund to the adviser;
 The extent to which the adviser realizes economies of 
    scale as the fund grows larger;
 The ``fall-out'' benefits that accrue to the adviser 
    and its affiliates as a result of the adviser's 
    relationship with the fund (for example, soft-dollar 
    benefits);
 The performance and expenses of comparable funds; and
 The volume of transaction orders that must be 
    processed by the adviser.

    While the Gartenberg standard establishes a test for when 
advisory fees become excessive, the court cases provide that 
the decisions of independent directors regarding advisory fees 
will not be second-guessed if the directors are fully informed 
\4\ and considered all appropriate factors in determining the 
reasonableness of fees.\5\ I agree that the amount of mutual 
fund fees generally should not be set by courts or by the 
Commission. Fees should be determined by the marketplace, and 
investor consideration of mutual fund costs can be facilitated 
by transparent disclosure of fund fees and expenses and the 
effective and diligent oversight of independent fund directors. 
That is why the Commission is focused on improving fund 
disclosure--particularly disclosure about fund fees, conflicts, 
and sales incentives--and enhancing the mutual fund governance 
structure.
---------------------------------------------------------------------------
    \4\ Like fund directors, fund investment advisers are subject to 
fiduciary duties under State and Federal law in connection with the 
approval and renewal of investment advisory contracts. See, e.g. 
Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979). 
Fund investment advisers are subject to duties of care and loyalty and 
must affirmatively disclose to a fund's board of directors all facts 
that are material to the board's approval and renewal of the investment 
advisory contract. See, e.g., SEC v. Capital Gains Research Bureau, 
Inc., 375 U.S. 180, 191-92 (1963); In the Matter of Kemper Financial 
Services, Inc. et al., Investment Advisers Act Release No. 1476 (March 
2, 1995); In the Matter of Joan Conan, Investment Advisers Act Release 
No. 1446 (September 30, 1994). In particular, a fund's investment 
adviser is required by the Investment Company Act to furnish ``such 
information as may reasonably be necessary'' for the fund's directors 
to evaluate the fund's investment advisory contract. See Section 15(c) 
of the Investment Company Act of 1940.
    \5\ See, e.g., Schuyt v. Rowe Price Prime Reserve Fund, Inc., 663 
F.Supp. 962, 971 (S.D. N.Y. 1987) aff 'd., 835 F.2d 45 (2d Cir. 1987). 
``The legislative history of the [Investment Company] Act clearly 
indicates that it is not the role of the Court to `substitute its 
business judgment for that of the mutual fund's board of directors in 
the area of management fees.' '' Id. (quoting S. Rep. No. 194, 91st 
Cong., 1st Sess., reprinted in 1970 U.S. Code Cong. & Ad. News 4902).
---------------------------------------------------------------------------
    The Commission has taken several recent steps to 
significantly improve the information required for individual 
shareholders. For example, the Commission adopted a requirement 
that shareholder reports include dollar-based expense 
information so that investors can easily compute the dollar 
amount of expenses paid on their 
investment in a fund.\6\ This is an important step in providing 
shareholders with critical information about their mutual fund 
investments. In other efforts to improve disclosure for 
investors, the Commission has:
---------------------------------------------------------------------------
    \6\ See Shareholder Reports And Quarterly Portfolio Disclosure of 
Registered Management Investment Companies, Investment Company Act 
Release 26372 (February 27, 2004) [69 FR 11244 (March 9, 2004)].

 issued a concept release on methods to calculate and 
    improve the disclosure of funds' portfolio transaction 
    costs; \7\
---------------------------------------------------------------------------
    \7\ See Request for Comments on Measures to Improve Disclosure of 
Mutual Fund Transaction Costs, Investment Company Act Release 26313 
(December 18, 2003) [68 FR 74820 (December 24, 2003)].
---------------------------------------------------------------------------
 proposed to make more transparent in shareholder 
    reports how fund boards evaluate investment advisory 
    contracts; \8\
---------------------------------------------------------------------------
    \8\ See Disclosure Regarding Approval of Investment Advisory 
Contracts by Directors of Investment Companies, Investment Company Act 
Release 26350 (February 11, 2004) [69 FR 7852 (February 19, 2004)].
---------------------------------------------------------------------------
 proposed new fund confirmation forms and new point-of-
    sale disclosure that would greatly enhance the information 
    that broker-dealers provide their customers in connection 
    with mutual fund transactions, and highlight the conflicts 
    that broker-dealers face in recommending mutual fund 
    investments; \9\ and
---------------------------------------------------------------------------
    \9\ See Confirmation Requirements and Point-of-Sale Disclosure 
Requirements for Transactions in Certain Mutual Funds and Other 
Securities, and Other Confirmation Requirement Amendments, and 
Amendments to the Registration Form for Mutual Funds, Investment 
Company Act Release 26341 (January 29, 2004) [69 FR 6438 (February 10, 
2004)].
---------------------------------------------------------------------------
 proposed improved prospectus disclosure to address the 
    wide-scale failure on the part of broker-dealers to provide 
    appropriate breakpoint discounts on front-end load mutual 
    fund purchases.\10\
---------------------------------------------------------------------------
    \10\ See Disclosure of Breakpoint Discounts by Mutual Funds, 
Investment Company Act Release 26298 (December 17, 2003) [68 FR 74732 
(December 24, 2003)].

    With respect to fund governance, the Commission recently 
proposed a comprehensive rulemaking package to bolster the 
effectiveness of independent directors and enhance the role of 
the fund board as the primary advocate for fund shareholders. 
The proposals included a requirement for (i) an independent 
board chairman; (ii) 75 percent independent directors; (iii) 
independent director authority to hire, evaluate, and fire 
staff; (iv) quarterly executive sessions of independent 
directors outside the presence of management; (v) an annual 
board self-evaluation; and (vi) preservation of documents used 
by boards in the contract review process.\11\ This significant 
overhaul of the composition and workings of fund boards is 
intended to establish, without ambiguity, the dominant role of 
independent directors on a fund's board.
---------------------------------------------------------------------------
    \11\ See Investment Company Governance, Investment Company Act 
Release 26323 (January 15, 2004) [69 FR 3472 (January 23, 2004)].
---------------------------------------------------------------------------
    As a result of the Commission's initiatives to improve fund 
disclosure and fund governance, I do not believe that it is 
necessary at this time for Congress to revise the statutory 
standards regarding fund fees. I believe that the best way to 
ensure that funds charge fair and reasonable fees is through a 
marketplace of vigorous, independent, and diligent mutual fund 
boards, coupled with fully informed investors who are armed 
with complete, easy-to-digest disclosure about the fees paid 
and the services rendered.

       RESPONSE TO WRITTEN QUESTIONS OF SENATOR CORZINE 
                   FROM WILLIAM H. DONALDSON

Q.1. The last time you appeared before this Committee, Senator 
Miller submitted questions to you on the National Securities 
Clearing Corporation's (NSCC) proposed rule. And then 
subsequent to that he submitted a comment letter on December 
22, 2003, on the proposed rule. We understand the rule is still 
pending before the SEC. In Senator Miller's questions and 
letter he expressed reservations about a rule that would allow 
the NSCC to open up shop in an entirely new industry 
(Separately Managed Accounts) from what its been doing since 
its creation. As he said in his letter, we question a rule that 
would allow a quasi-government SRO to take business away from 
private companies that have invested millions to work out their 
SMA business and eventually make a profit in it, especially 
when, if this rule is approved, the NSCC would carry a kind of 
SEC ``stamp of approval'' that will inevitably give them a 
competitive advantage over the private companies.
    We have since learned that SEC procedures would allow this 
rule to go into effect without a single Commissioner ever 
having reviewed, much less voted, on it. We find that very 
troubling, Mr. Chairman, on a matter as important as this one 
is, and we would like your assurance today that you and your 
colleagues on the Commission will personally review any 
decision/recommendations the Commission staff puts forward on 
the NSCC rule.

A.1. NSCC is a subsidiary of Depository Trust and Clearing 
Corporation (DTCC), which is owned by its bank and broker-
dealer members. NSCC provides coordinated comparison and 
clearance services to the financial markets. It currently is 
the sole clearance system for equities, as a result of 
consolidation of many competitors that has taken place over the 
past two decades. NSCC has developed many new services upon 
request of its members, in order to reduce processing costs by 
providing standardized interchanges of information 
inexpensively, on a widely available basis. Some of these new 
services involve regulated clearing agency activities; others 
do not. Where possible, NSCC has engaged in these activities 
internally rather than through an affiliate, to use existing 
systems to reduce costs. The SMA Service is only one of such 
services offered by NSCC.
    The SMA Service is an information messaging system for 
separately managed accounts, which is similar to the 
information messaging system NSCC currently provides for mutual 
funds in its Mutual Fund Profile Service. The Mutual Fund 
Profile Service automates the flow of information between users 
through a centralized system using standardized formats. It 
allows users to, among other things, exchange accurate and 
timely information of daily prices and dividend rates, firm and 
fund member profiles, individual security data, and projected 
and actual distribution declarations.
    NSCC is a private, member-owned entity that is organized as 
a not-for-profit corporation under the laws of the State of New 
York. It is registered with the Commission as a clearing agency 
(pursuant to Sections 17A and 19 of the Securities and Exchange 
Act of 1934) and as such is a self-regulatory organization 
subject to extensive Commission oversight. It was not created 
by any U.S. governmental action.
    As a registered clearing agency, NSCC is required under 
Section 19(b) of the 1934 Act to file any proposed rule change, 
which includes the offering of new service, with the Commission. 
Commission approval of a proposed rule change means only that 
the Commission has found that the proposed rule change is 
consistent with the requirements of the 1934 Act and rules and 
regulations thereunder applicable to the clearing agency. It is 
not a determination as to the relative market value of any 
service proposed to be offered by the clearing agency nor is it 
an endorsement of the service. If users of a service value the 
fact that the service is offered by a registered clearing 
agency, it is most likely because the clearing agency is 
subject to extensive Commission oversight and review and not 
because the Commission has given a stamp of approval to the 
service.
    With regard to the Commission's review of the proposed rule 
change, the Commission has authority pursuant to Section 4A of 
the 1934 Act to delegate any of its functions to a division of 
the Commission. Section 200.30-3(a)(12) of the Commission's 
regulations delegates to the Director of the Division of Market 
Regulation the authority to approve proposed rule changes filed 
by self-regulatory organizations. However, because of the 
interest expressed by you, and by other Members of Congress, 
and because of the comments the Commission has received 
regarding the proposed rule change, I can assure you that I and 
the other Commissioners will be kept apprised of any 
recommendations made by Division staff regarding the proposed 
rule change.

Q.2. We understand that the rule is silent on the fees that 
will be charged when and if this rule is approved. As Senator 
Miller said in his letter, we are curious about where the 
funding is coming from to subsidize the high priced legal and 
lobbying talent, among other expenses, that the NSCC has 
expended in the course of this effort. Apparently, the NSCC's 
own comment letter sought to answer my question, and said that 
the money to fund this effort is coming from ``the general 
funds'' of the Corporation (p.29), as though that is some other 
source other than mutual fund-related fees. In your response to 
us, we would like to know, precisely, what the source for the 
NSCC's funding for this effort is, and whether any of it comes, 
directly or even indirectly, from mutual fund fees?

A.2. Regarding further clarification for the funding of the SMA 
Service and whether any of the money used to fund the service 
is coming from fees NSCC collects for its mutual fund services, 
NSCC has funded the start-up costs for the SMA Service out of 
its general corporate funds as it generally does with new 
services. NSCC's general funds are comprised of revenues NSCC 
receives from all its services, including mutual fund services. 
NSCC retains only the revenues that are required in order to 
maintain an adequate revenue base for current operation costs, 
product and service enhancements and developments, and earnings 
as directed by the board. In accordance with this policy, 
NSCC's Board, comprised of representatives of its owner-users, 
determines when to reserve revenues as general corporate funds 
and which new product development efforts shall be funded from 
reserved revenues. To the extent that revenues in excess of 
NSCC's costs to provide its services are not so reserved, the 
Board has followed the practice of refunding these excess 
revenues to its members in proportion to the fees paid by them. 
Mutual fund revenues represent less than 25 percent of NSCC's 
total revenues.
    It is important to note that NSCC designs its services to 
be self-supporting and so there is an expectation that any 
start-up costs of the SMA Service will be paid back to the 
general fund from SMA Service fees. As a result, the fees NSCC 
will charge for the SMA Service will initially be higher than 
they would be if the SMA Service were an existing service of 
NSCC. Additionally, the start-up costs for the SMA Service are 
not very high. NSCC will use its existing connectivity for the 
service and has only had to incur costs for the systems 
development of the service.
    With regard to NSCC funding its lobbying and legal expenses 
related to the SMA Service, NSCC has informed the Commission 
that it has not invested a significant amount of money in 
lobbying or legal expenses. It has not lobbied for the SMA 
Service, and it has hired legal counsel only to respond to 
questions from Congress and to the comments submitted to the 
Commission as part of the public process on the rule filing.

        RESOPONSE TO WRITTEN QUESTIONS OF SENATOR ENZI 
                   FROM WILLIAM H. DONALDSON

Q.1. In response to questions asked by Senator Sarbanes, you 
stated that the SEC was having difficulty hiring accountants. 
How many SEC staff have been hired away by the PCAOB? In 
addition, how has the PCAOB's ability to compensate staff more 
than the SEC hurt the SEC's ability to recruit accountants and 
staff ?

A.1. The PCAOB has hired approximately 7 SEC staff since its 
inception. Most of these employees were instrumental in 
starting the Board and ensuring that it was able to meet the 
statutory commencement deadlines of the Sarbanes-Oxley Act.
    Hiring accountants with the experience and skills we need 
continues to be a challenge. This is because there is high 
demand for seasoned accountants in the private sector--not just 
from the PCAOB. While we did lose some staff to the PCAOB early 
on, we do not believe the salary differences between us and the 
PCAOB have proven to be a significant factor in our hiring 
difficulties. This is primarily because we have not been 
seeking the same types of accountants as the PCAOB. We have 
been seeking journeymen level accountants with at least 5 years 
of experience to review SEC filings and more senior accountants 
with experience in dealing with complex accounting issues to 
fill positions in the Division of Enforcement and the Office of 
the Chief Accountant; whereas we understand that the PCAOB is 
seeking very senior accountants with 10 or more years of 
auditing experience. This difference means that we are drawing 
from different pools of available candidates.
    We currently hope to complete hiring for all of the 
accountant positions we have received by the end of this year.

Q.2. The intent of Congress in enacting the Investment Company 
Amendments Act of 1970 was to relieve independent directors of 
personal liability other than for ``personal misconduct.'' Do 
you think Congress should change this concept and impose a 
personal liability on independent directors for violations by 
the investment adviser?

A.2. Section 36(a) of the Investment Company Act, as amended in 
1970, states

        The Commission is authorized to bring an action in the 
        proper district court of the United States, or in the 
        United States court of any territory or other place 
        subject to the jurisdiction of the United States, 
        alleging that a person serving or acting in one or more 
        of the following capacities has engaged within 5 years 
        of the commencement of the action or is about to engage 
        in any act or practice constituting a breach of 
        fiduciary duty involving personal misconduct in respect 
        of any registered investment company for which such 
        person so serves or acts--

        1. as officer, director, member of any advisory board, 
        investment adviser, or depositor; or
        2. as principal underwriter, if such registered company 
        is an open-end company, unit investment trust, or face-
        amount certificate company.

        If such allegations are established, the court may 
        enjoin such persons from acting in any or all such 
        capacities either permanently or temporarily and award 
        such injunctive or other relief against such person as 
        may be reasonable and appropriate in the circumstances, 
        having due regard to the protection of investors and to 
        the effectuation of the policies declared in Section I 
        (b) of this title.

    Section 36(a) permits the Commission to bring an action 
against a director for a breach of fiduciary duty involving 
``personal misconduct,'' which generally is a higher standard 
than required for a civil action under State law. However, as 
originally enacted, the Investment Company Act only permitted 
the Commission to sue directors whose breaches involved ``gross 
misconduct.'' Thus, the 1970 Amendments to the Investment 
Company Act expanded the Commission's ability to bring cases 
against directors. The term ``personal misconduct'' is not 
defined in the statute or explained in the legislative history.
    Mutual fund directors' fiduciary duties arise primarily 
from the law of the state in which they are organized. Fund 
directors are subject to fiduciary duties of care and loyalty. 
The duty of care generally requires that directors act with 
that degree of diligence, care, and skill that a person of 
ordinary prudence would exercise under similar circumstances in 
a like position.\1\ The duty of loyalty generally requires fund 
directors to exercise their powers in the interests of the fund 
and not in the directors' own interests or in the interests of 
another person or organization (for example, the investment 
adviser).\2\ Under State law, the business judgment rule can 
protect fund directors from liability for their decisions, so 
long as the directors acted in good faith, were reasonably 
informed, and rationally believed that the action taken was in 
the best interests of the fund.\3\
---------------------------------------------------------------------------
    \1\ See, e.g., Hanson Trust PLC v. ML SCM Acquisition Inc., 781 
F.2d 264, 273 (2d Cir. 1986) and Norlin Corp v. Rooney, Pace Inc., 744 
F.2d 255, 264 (2d Cir. 1984).
    \2\ See the policy directives contained in Sections 1(b)(2), (4), 
and (6) of the Investment Company Act of 1940 Act. See also, Norlin 
Corp v. Rooney, Pace Inc., 744 F.2d 255, 264 (2d Cir. 1984), citing 
Pepper v. Litton, 308 U.S. 295, 306-07 (1939).
    \3\ See, e.g., Salomon v. Armstrong, 1999 Del. Ch. LEXIS 62, 23 
(Del. Ch. March 25, 1999). See generally Dennis J. Block et al., The 
Business Judgment Rule--Fiduciary Duties of Corporate Directors (5th 
ed. 1998).
---------------------------------------------------------------------------
    In addition to these fiduciary duty standards, the 
Investment Company Act imposes direct obligations on fund 
directors. For example, the Act requires fund directors to 
assign fair valuations as determined in good faith to certain 
portfolio securities,\4\ to request and evaluate such 
information as may reasonably be necessary to evaluate the 
fund's advisory contract; \5\ and to select a fund's 
independent auditor.\6\ The Commission could sue fund directors 
if they fail to appropriately perform these assigned duties, 
regardless of whether the violation involved ``personal 
misconduct.'' \7\ Additionally, as raised in your question, the 
Commission has authority to sue fund directors for aiding and 
abetting a violation by the fund's adviser.\8\ The Commission 
also can obtain a cease and desist order against fund directors 
if they are, were, or would be a ``cause'' of a violation under 
the Investment Company or Investment Advisers Acts, or their 
rules, due to an act or omission a director knew or should have 
known would contribute to such violation.\9\ I do not 
believe, however, that it would be appropriate to impose a 
direct personal liability on independent directors for 
violations by the investment adviser.
---------------------------------------------------------------------------
    \4\ See Section 2(a)(41) of the Investment Company Act of 1940.
    \5\ See Section 15(c) of the Investment Company Act of 1940.
    \6\ See Section 32(a) of the Investment Company Act of 1940.
    \7\ See Section 9(b)(2) of the Investment Company Act of 1940.
    \8\ See Section 9(b)(3) of the Investment Company Act of 1940.
    \9\ See Section 9(f) of the Investment Company Act of 1940; Section 
203(k) of the Investment Advisers Act of 1940.

Q.3. In your testimony today, you stated that you are 
requesting the staff to move ahead with a proposal to oversee 
the hedge fund industry. To date, the SEC has not finalized 
Phase 2 of the Investment Advisor Registration Depository. In 
addition, the SEC has not fully hired all of the staff 
necessary to oversee the mutual fund industry. Based upon your 
testimony, it appears that the SEC would have to expend 
significant monies to make changes to the registration 
depositories for hedge funds and to hire the appropriate staff 
to oversee and examine hedge funds.
    How can the SEC move forward on hedge funds when it has not 
finished its job in those areas and exactly how much money will 
the SEC need to regulate hedge funds?

A.3. Portions of the IARD system necessary to register hedge 
fund advisers have been fully operational since 2001. Part 2 of 
the system, which is currently under development, will add 
additional system functionality that will permit investment 
adviser disclosure statements to be filed.
    The SEC has moved forward with hiring additional examiners 
to oversee mutual funds and investment advisers, and we are 
targeting more examinations of funds and advisers posing the 
greatest compliance risks. Hedge fund advisers face several 
conflicts of interest that raise compliance risks, including 
side-by-side management and soft dollars, and our ability to 
examine these firms is critical if we are to detect and deter 
frauds. We now have 495 staff allocated to examining funds and 
advisers nearly a 30 percent increase from fiscal 2002. We are 
focused on hiring the best, most appropriate people to meet 
staffing needs, and have refused to hire employees simply to 
fill chairs. By the end of the year, we fully expect that we 
will achieve current targeted staffing levels. As a preliminary 
matter, our staff has estimated the pool of SEC-registered 
advisers would increase by approximately 10 percent if we 
impose our current adviser registration requirements on hedge 
fund managers, though the number could be higher. Our 2005 
budget request incorporates $18.7 million for additional 
staffing positions necessary to implement recent Commission 
initiatives as well as possible regulation in the hedge fund 
adviser area.

Q.4. Recently, the SEC proposed a set of minimum standards for 
market linkages in its NMS rule proposal. With respect to the 
proposed rule to establish a hard 4 p.m. close, is one of the 
alternatives that the SEC is considering the establishment of 
minimum standards for electronic timestamping to allow the 
market to establish the best way to accurately timestamp mutual 
funds orders? If not, what are the obstacles to establishing 
minimum standards.

A.4. The Commission is considering a number of alternatives to 
the amendments it proposed last fall to respond to late trading 
in mutual fund shares. As you know, that proposal would permit 
a purchase or redemption order for mutual fund shares to be 
priced as of the day it is received, if the fund, its 
designated transfer agent, or a registered clearing agency 
receives the order by the fund's designated pricing time 
(typically 4 p.m. eastern time). The Commission received more 
than 1,000 comment letters on the proposal. Many commenters 
recommended that the rule provide an exception for fund 
intermediaries, such as retirement plan administrators and fund 
service providers, that implement certain controls such as an 
unalterable, automatic timestamp on each order received. Other 
commenters have suggested the Commission require an order to 
purchase or redeem fund shares be submitted to a central 
clearinghouse by the fund's pricing time in order to receive 
same-day pricing. The Commission and its staff are meeting with 
representatives of broker-dealers, retirement plan sponsors and 
administrators, fund companies, and fund service providers 
about the alternatives that they recommended, and they have 
explained their approaches in more detail, including 
requirements for a timestamp. We are considering these and 
other comments in order to substantially eliminate the 
potential for late trading while minimizing the costs of the 
regulations on funds and their investors.

Q.5. Mr. Chairman, your establishment of the Office Risk 
Assessment and Strategic Planning and the four task forces are 
a very good move forward for the Commission to be proactive on 
many issues rather than being reactive. I am particularly 
interested in how the Task Force on Disclosure Regime would 
operate. Often it seems that the investors are overwhelmed with 
the many disclosures they receive and I am afraid many of the 
disclosures end up in the trash can. What is the timetable for 
the Task Force and how comprehensive will it be? For example, 
will it also cover disclosures required by the self-regulatory 
organizations?

A.5. The Commission has a long-term mission of improving the 
quality of disclosure to investors and other market 
participants, including financial intermediaries. The 
Commission seeks to ensure that its disclosure regime will be 
an effective one, and has charged the disclosure task force 
with evaluating that regime and recommending improvements.
    To be effective, a disclosure regime must contemplate the 
manner in which information is communicated to the users of the 
information and the impact of the disclosure obligation on the 
provider of the information. The Task Force on Disclosure will 
therefore examine the value of the various disclosures provided 
by mutual funds, brokers, and issuers to investors as required 
by our rules and regulations. It will also explore what types 
of disclosures best serve investors, the timing of the 
disclosures, delivery versus access to disclosures, and how 
best to harness technological advances in assisting investors. 
In addition, the Task Force will analyze whether there is data 
that the Commission should collect and publish on a periodic 
basis that would be useful to investors in making comparisons 
among the various investment options available to them. The 
Task Force will report periodically to the Commission and will 
provide recommended courses of action.

        RESONSE TO A WRITTEN QUESTION OF SENATOR MILLER 
                   FROM WILLIAM H. DONALDSON

Q.1. On February 5, 2004, The Wall Street Journal reported that 
the SEC is planning a formal review of the role of SRO's in the 
marketplace. The article was focused on the New York Stock 
Exchange, but we wonder if any final consideration of the 
NSCC's proposal, to compete with private sector companies 
already active in the Separately Managed Account (SMA) arena, 
should at least wait until your ``concept release'' exploring 
the relative benefits and drawbacks of various SRO models, 
including, we would hope, the NSCC example, as well as any 
public comments that might ensue. Do you agree?

A.1. SRO issues the Commission will consider first likely will 
primarily relate to the recent problems of transparency and 
self-policing in the securities markets, which would not have a 
significant impact on the structure or operations of clearing 
agencies.
    Pursuant to Section 19 of the 1934 Act, the Commission is 
not empowered to put final consideration of a proposed rule 
change on hold. Under Section 19(b)(2), once a proposed rule 
change has been published for notice and comment the Commission 
is required either to approve a proposed rule change if it 
finds that such proposed rule change is consistent with the 
requirements of the Act and the rules and regulations 
thereunder or to disapprove the proposed rule change if it 
cannot make such a finding unless the SRO extends the time 
period. The Commission's action regarding SRO's does not appear 
to give a clear basis for the Commission to put on hold the 
approval/disapproval process of an SRO proposed rule change.



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