[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) 512�091800
Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001
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).
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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.
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\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\
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\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.
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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.
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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.
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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\
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\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.
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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\
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\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).
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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).
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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\
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\18\ Canary Complaint, supra note 1, at par. 46.
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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\
---------------------------------------------------------------------------
\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.
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\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.
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\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:
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\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
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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:
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\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\
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\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.
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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.
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\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.
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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).
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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
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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\
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\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\
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\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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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
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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.
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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.
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\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.
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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.
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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.
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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).
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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.
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\2\ See SEC Release No. IC-26288 (December 11, 2003).
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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\
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\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.
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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.
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\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.
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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.
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\8\ See SEC Release Nos. IA-2209; and IC-26337 (January 20, 2004)
(``SEC Code of Ethics
Proposal'').
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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\
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\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\
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\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.
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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.
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\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.
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\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.
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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\
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\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.
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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.
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\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.
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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.
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\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.
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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\
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\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\
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\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.
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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.
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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\
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\1\ Burks v. Lasker, 441 U.S. 471, 484 (1979).
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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\
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\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
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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\
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\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\
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\4\ SEC Report of the Division of Investment Management of Mutual
Fund Fees and Expenses, (January 2001): 5.
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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\
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\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.
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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\
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\6\ Morningstar Principia Pro as of December 31, 2003.
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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.
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\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\
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\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.
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\9\ Malkiel, Burton G., ``Returns from Investing in Equity Mutual
Funds 1971 to 1991,'' Journal of Finance 50 (June 1995): 549.
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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.
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\10\ Morningstar Principia Pro as of December 31, 2003.
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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.
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\11\ Carhart, Mark M., ``On Persistence in Mutual Fund
Performance,'' Journal of Finance 52 (March 1997): 57.
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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\
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\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.
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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.
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\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.
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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\
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\1\ ``Putnam Led Industry With $28.9 Billon of Withdrawals,''
Bloomberg, January 28, 2004.
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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.
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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\
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\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.
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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\
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\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\
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\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.
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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.
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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.''
---------------------------------------------------------------------------
\1\ National Association of Securities Dealers, Inc. (1994).
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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\
---------------------------------------------------------------------------
\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).
---------------------------------------------------------------------------
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).
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
\7\ Role of Independent Directors of Investment Companies, Rel. IC-
24816 (January 2, 2001).
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
\11\ Investment Company Act Rule 270.38a-1, Id.
---------------------------------------------------------------------------
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.
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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.
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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.
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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.
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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\
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\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.
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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.
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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 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.)
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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\
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\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).
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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:
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\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.
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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.
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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).
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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\
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\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.
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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.
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\16\ NASD Rules 6950-6957, approved by the Commission on March 6,
1998, and as amended on July 31, 1998.
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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.''
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\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.
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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.
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\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).
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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.
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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.)
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
\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\
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\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.
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\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.
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\11\ File No. S7-12-03.
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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.
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\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.
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\14\ Investment Company Institute, 2003 Mutual Fund Fact Book, 43rd
Edition.
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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.
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\15\ Ibid.
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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.
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\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.
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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\
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\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.
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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).
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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\
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\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:
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\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\
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\17\ Id., at p. 3.
The staff report set forth the following recommendations for the
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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\
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\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.
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\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.
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\20\ Compliance Programs of Investment Companies and Investment
Advisers, Advisers Act Release No. 2204 (December 17, 2003).
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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\
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\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.
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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.
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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\
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\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).
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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.
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\2\ Report of the Committee On Banking, Housing, and Urban Affairs,
S. Rep. 94-75 (1975).
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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).
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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\
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\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
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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\
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\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.
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\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).
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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.
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\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.
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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).
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\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.
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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.
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\4\ See S. Rep. No. 75, 94th Cong. 1st Sess. 248 (1975); Securities
Exchange Act Release No. 23170 (April 23, 1986).
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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\
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\5\ U.S. Equity Investors: Soft-Dollar Market Trends, Greenwich
Associates, 2003.
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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).
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\6\ See Investment Advisers Act Release No. 2204 (December 17,
2003).
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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.
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\7\ Amendments to NYSE Rule 472 and NASD Rule 2711, and SEC
Regulation AC.
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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.
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\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.
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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.
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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.
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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).
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\4\ See Investment Advisers Act Release No. 2107 (February 5,
2003).
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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.
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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.
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\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.''
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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.
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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).
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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.
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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\
---------------------------------------------------------------------------
\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).
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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\
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\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\)
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\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.
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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:
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\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.
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\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.
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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.
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\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\
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\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).
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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.
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\5\ See Best Practices Report, supra note 3, at 10-12.
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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\
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\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.
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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\
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\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;