[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]
MUTUAL FUNDS: A REVIEW OF
THE REGULATORY LANDSCAPE
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE AND
GOVERNMENT SPONSORED ENTERPRISES
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED NINTH CONGRESS
FIRST SESSION
__________
MAY 10, 2005
__________
Printed for the use of the Committee on Financial Services
Serial No. 109-26
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24-093 WASHINGTON : 2005
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
RICHARD H. BAKER, Louisiana PAUL E. KANJORSKI, Pennsylvania
DEBORAH PRYCE, Ohio MAXINE WATERS, California
SPENCER BACHUS, Alabama CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio GREGORY W. MEEKS, New York
JIM RYUN, Kansas BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio DENNIS MOORE, Kansas
DONALD A. MANZULLO, Illinois MICHAEL E. CAPUANO, Massachusetts
WALTER B. JONES, Jr., North HAROLD E. FORD, Jr., Tennessee
Carolina RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois JOSEPH CROWLEY, New York
CHRISTOPHER SHAYS, Connecticut WM. LACY CLAY, Missouri
VITO FOSSELLA, New York STEVE ISRAEL, New York
GARY G. MILLER, California CAROLYN McCARTHY, New York
PATRICK J. TIBERI, Ohio JOE BACA, California
MARK R. KENNEDY, Minnesota JIM MATHESON, Utah
TOM FEENEY, Florida STEPHEN F. LYNCH, Massachusetts
JEB HENSARLING, Texas BRAD MILLER, North Carolina
SCOTT GARRETT, New Jersey DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida ARTUR DAVIS, Alabama
J. GRESHAM BARRETT, South Carolina AL GREEN, Texas
KATHERINE HARRIS, Florida EMANUEL CLEAVER, Missouri
RICK RENZI, Arizona MELISSA L. BEAN, Illinois
JIM GERLACH, Pennsylvania DEBBIE WASSERMAN SCHULTZ, Florida
STEVAN PEARCE, New Mexico GWEN MOORE, Wisconsin,
RANDY NEUGEBAUER, Texas
TOM PRICE, Georgia BERNARD SANDERS, Vermont
MICHAEL G. FITZPATRICK,
Pennsylvania
GEOFF DAVIS, Kentucky
PATRICK T. McHENRY, North Carolina
Robert U. Foster, III, Staff Director
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises
RICHARD H. BAKER, Louisiana, Chairman
JIM RYUN, Kansas, Vice Chair PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware GREGORY W. MEEKS, New York
PETER T. KING, New York DENNIS MOORE, Kansas
FRANK D. LUCAS, Oklahoma MICHAEL E. CAPUANO, Massachusetts
DONALD A. MANZULLO, Illinois HAROLD E. FORD, Jr., Tennessee
EDWARD R. ROYCE, California RUBEN HINOJOSA, Texas
SUE W. KELLY, New York JOSEPH CROWLEY, New York
ROBERT W. NEY, Ohio STEVE ISRAEL, New York
VITO FOSSELLA, New York, WM. LACY CLAY, Missouri
JUDY BIGGERT, Illinois CAROLYN McCARTHY, New York
GARY G. MILLER, California JOE BACA, California
MARK R. KENNEDY, Minnesota JIM MATHESON, Utah
PATRICK J. TIBERI, Ohio STEPHEN F. LYNCH, Massachusetts
J. GRESHAM BARRETT, South Carolina BRAD MILLER, North Carolina
GINNY BROWN-WAITE, Florida DAVID SCOTT, Georgia
TOM FEENEY, Florida NYDIA M. VELAZQUEZ, New York
JIM GERLACH, Pennsylvania MELVIN L. WATT, North Carolina
KATHERINE HARRIS, Florida ARTUR DAVIS, Alabama
JEB HENSARLING, Texas MELISSA L. BEAN, Illinois
RICK RENZI, Arizona DEBBIE WASSERMAN SCHULTZ, Florida
GEOFF DAVIS, Kentucky BARNEY FRANK, Massachusetts
MICHAEL G. FITZPATRICK,
Pennsylvania
MICHAEL G. OXLEY, Ohio
C O N T E N T S
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Page
Hearing held on:
May 10, 2005................................................. 1
Appendix:
May 10, 2005................................................. 37
WITNESSES
Tuesday, May 10, 2005
Barbash, Barry P., Partner, Shearman & Sterling LLP.............. 23
Eisenberg, Meyer, Acting Director, Division of Investment
Management, Securities and Exchange Commission................. 4
Miller, Michael S., Managing Director, Planning & Development,
The Vanguard Group............................................. 25
Stevens, Paul Schott, President, Investment Company Institute.... 21
APPENDIX
Prepared statements:
Barbash, Barry P............................................. 38
Eisenberg, Meyer............................................. 56
Miller, Michael S............................................ 70
Stevens, Paul Schott......................................... 80
Additional Material Submitted for the Record
Eisenberg, Meyer:
Written letter to Hon. Richard H. Baker...................... 110
MUTUAL FUNDS: A REVIEW OF
THE REGULATORY LANDSCAPE
----------
Tuesday, May 10, 2005
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance
and Government Sponsored Enterprises,
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to call, at 2:00 p.m., in
Room 2128, Rayburn House Office Building, Hon. Richard H. Baker
[chairman of the subcommittee] Presiding.
Present: Representatives Baker, Ryun, Castle, Biggert,
Kennedy, Feeney, Hensarling, McCarthy, Lynch, and Wasserman
Schultz.
Chairman Baker. I would like to call this meeting on the
Subcommittee on Capital Market to order.
This afternoon the committee meets for continued
examination of practices of the mutual funds industry and the
potential effect on the individual investor.
As all members know, after the passage of the Sarbanes/
Oxley legislation, significant operation reforms were brought
to bear on all sectors of the financial marketplace, including
the mutual fund industry. This, of course, was a warranted
action in light of some 95 million Americans who are now vested
in mutual funds and depending on one's perspective, have some
difficulty in always accessing comparability of the various
mutual funds investments they may hold, and so we return again
today pursuant to the GAO report issued last year, which raised
continuing concerns about areas that have been under
examination previously.
In some cases, fees have continued to go up, turn over
rates, in other words, turning rates remain unacceptably high.
And transparency is still goal, which we all see, but are
having some difficulty in clearly establishing.
Against that backdrop, however, I want to say a word to
those within the ICI, particularly Mr. Stevens, the new
leadership there, for taking a professional and positive step
forward in working with not only the committee, but with
regulators in crafting a higher standard of professional
conduct and expectations for all those who are fiduciaries
within the industry.
As we turn to the SEC, I am pleased that they have acted in
such a prompt manner on so many areas, but there should be a
constant balancing, in my opinion, between the new regulatory
regime and the cost of compliance. I think it often missed in
public discussions that whatever the cost may be ascribed to a
particular compliance activity, that cost is ultimately charged
against the investor's account. And so we have a due diligence
responsibility, a fiduciary obligation to ensure that our
regulatory standards bring about the needed disclosures, but at
the same time are balanced against the cost against that
individual investor's account. And so that ongoing analysis
will likely be required in determining whether the disclosure
regime today or one going forward is appropriate in light of
these charges.
I know there is internal discussion about the effect of the
hard 4 o'clock closing rule and its prejudicial effect on west
coast investors, pension fund managers, large 401(k)s, and that
there may be some technological way to preclude the ill-advised
late trading strategy, but not at the same time preclude
trading by legitimate business interests who happen to be in
the wrong time zone.
I believe there to be some discussion about concerns over
the sale point confirmation activities. Clearly enhanced
transparency is something that most on the committee would find
advisable, but in looking at what has been suggested, it takes
me back to my real estate days in Louisiana where to close a
first mortgage on a home purchase today will vary slightly from
about 75 to 85 pages. I know from firsthand experience that
most people don't read about 74 or 75 pages; they say tell me
where to sign and wait on the 3-day rescission period to pass
so they can get the closing done. We don't want to follow that
path.
I think that disclosure should be concise and clear. It
shouldn't be so complete that it is convoluted, and I think
that one should question the value of disclosures made simply
for the purpose of having forms executed without at the same
time conveying real information to the investor.
I am hopeful going forward that we can continue a good
working relationship with those in authority at the SEC. A
fair, open, transparent market that enables working families to
invest and build for their first home or college education is
certainly a very important goal, and we should do it in the
most professional environment possible, with consequences to
those who just simply choose not to abide by the rules.
With that, I would yield to Ms. Wasserman Schultz for
opening statement.
Ms. Wasserman Schultz. Thank you, Mr. Chairman. And no, Mr.
Kanjorski has not had a magical transformation----
Chairman Bachus. Tis a pity.
Ms. Wasserman Schultz. I will let that one hang there and
send his regrets that he was called away unexpectedly.
Chairman Baker and distinguished guests, it has been nearly
2 years since late trading and market timing scandals shook the
mutual fund industry. In 2003, preliminary investigations found
that up to 10 percent of fund companies were aware that some
customers were late trading, nearly 25 percent of broker
dealers executed orders for customers after 4 p.m., potentially
in violation of SEC regulations, about half of the fund groups
had some arrangements with favorite shareholders to engage in
market timing, close to 70 percent of broker dealers were aware
of timing activity by customers, and almost 30 percent assisted
timers in some way; and finally, some mutual funds executives
may have traded illegally in their fund securities, to the
detriment of other investors.
I hope today's hearing will shed light on the progress both
the SEC and the industry have made to increase transparency,
improve mutual fund governance and end abusive and unfair trade
practices that undermine the integrity of our markets.
More than 90 million Americans rely on these financial
instruments to protect their investments, and investor
protection must always be our highest priority.
I expect that our panelists will have best practices they
can share as they work to implement reform, but I realize there
are still many areas that will need to be refined. I encourage
both my colleagues and our guests to take this opportunity and
engage in a meaningful dialogue. I hope our panelists will
highlight areas that still need to be improved and
strengthened, as well as the steps that we can take together to
get there.
Thank you, Mr. Chairman.
Chairman Baker. I thank the gentlelady.
Mr. Castle, would you have a statement?
Mr. Castle. Well, thank you very much Mr. Chairman, I
appreciate the opportunity.
I have some guests here, by the way, the winning women of
Delaware who are back there, one of whom is the attorney
general in Delaware, Jane Brady, who is with us today. I always
worry, though, when the attorney general starts following me
around, to be very candid.
I think, Mr. Chairman, that you in particular, and this
subcommittee and our committee as a whole, have actually done a
thorough and good job with respect to the mutual funds industry
since the problems arose a couple of years ago. And I think
that the SEC has followed through and done some things
correctly as well. And I think the mutual funds industry has
sort of, after initially sort of burying its head in the sand,
has come toward and made some progress in this area as well.
And I think as a result of that, when you start talking about
some of the illegal trading that was going on, and some of the
almost criminal problems that existed in the past, that we have
made great steps.
But I still worry about the vast majority out there. I
believe the statistics are about 50 percent of Americans are
somehow or another involved in the mutual fund industry, it may
be in an IRA or 401(k), it may be so indirectly almost don't
even know it, but nonetheless, it is a heck of a lot more than,
say, 25 years ago--and obviously 50 years ago, and it is
probably going to increase. The complexity of investing is so
difficult that you sort of want to turn it over to somebody who
knows what they are doing.
But what you don't want do is to turn it over to somebody
in a situation in which you don't know what the fees are that
you are paying, you don't understand what the classes of mutual
funds are, be it A, B, C, D or whatever, you don't really know
what that means in terms of your costs. You don't know where
your costs are actually coming from, how are they paying for
their trading, how are they paying their other costs, or
whatever it may be. I, for one, have been concerned about 12b-1
fees for some time. 12b-1 fees were created solely at a time
when mutual funds were not doing that well in order to help
with advertising and let people know about mutual funds.
And at some point they transferred into a sales load,
indirect, of some kind or another so that mutual funds are sold
and brokers are paid back over a period of 5 or 6 years. I was
amazed to find that a heck of a lot of these are charged on
mutual funds that are closed, which means whatever you do is
selling anything as far as I am concerned. I consider practices
like that to be absolutely dead wrong, and they need to be
addressed as far as our future is concerned.
So my concerns, I guess, more relate not just to the
clearly criminal activity that was going on before, but relate
to just the transparency and the understanding of the average
investor, which I would guess is 90 percent of us who invest in
mutual funds, in terms of what we are getting into, what are we
paying for it, what are the true costs going to be, what is our
net benefit at the far end? Those are things that I think we
need to better understand. And please don't ask me to read the
prospectuses and all that stuff, first of all, I get bored to
tears; and secondly, I stop understanding it about halfway
through page one, so I don't think that is completely the
answer either.
So I just share that sort of every man's concern as to
where we are going. And I do apologize, Mr. Chairman, I have to
go visit the Mint for some interests that they have, another
matter of interest to this committee. At about 2:40 I have to
leave, but I appreciate the opportunity of being here.
Chairman Baker. I thank the gentleman for participating.
Mr. Hensarling, Mr. Kennedy, Ms. Biggert? There being no
requests for further additional opening statements, it is my
pleasure at this time to recognize our first witness, Mr. Meyer
Eisenberg, who is the acting director of the Division of
Investment Management of the Securities and Exchange
Commission.
STATEMENT OF MEYER EISENBERG, ACTING DIRECTOR, DIVISION OF
INVESTMENT MANAGEMENT, SECURITIES AND EXCHANGE COMMISSION
Chairman Baker. Welcome, sir. You may proceed at your own
leisure. Your official statement will be made part of the
official record, and you will have to pull that microphone
close because it is not very sensitive. Welcome.
Mr. Eisenberg. I thank the Chairman, members of the
committee, before Congressman Castle goes, I feel like I am
sort of at Delaware again at the Weinberg Center talking about
corporate governance.
So in any event, Chairman Baker--I gather Congressman
Kanjorski is not here, but I think that in what we are going to
go through, I will try to respond to some of the questions that
have been raised by the chairman, that have been raised by Ms.
Wasserman Schultz and by Mr. Castle, and hopefully I will do
that in some reasonable order.
I am Meyer Eisenberg, I am the acting director--and I
stress acting--of the Division of Investment Management. In
real life, I am a deputy general counsel of the SEC. And I
thank you for inviting me here to testify before the committee
today on the status of the Commission's mutual fund rule making
reforms.
I am pleased to be here on behalf of the Commission to
provide an overview of the regulatory reforms the Commission
has adopted in response to the recent unfortunate spate of
mutual fund industry scandals that have involved some of the
best known names in the industry, not just a few bad apples.
These events sharply dramatized the need for additional
measures to deal with the conflicts of interest inherent in the
organizational structure of most mutual funds, to restore
public confidence in the fund industry, and better safeguard
the interests of fund investors in the future.
I would also like to outline some of the additional
regulatory initiatives that the Commission has undertaken in
this area, that may be of interest to the subcommittee.
Before I begin, however, I would like to take this
opportunity, on behalf of the Commission, to thank you, Mr.
Chairman, for your leadership on the issue of mutual fund
reform. Many of the reforms ultimately adopted by the
Commission address the important concepts included in the
Mutual Fund Integrity and Fee Transparency bill that you
introduced.
I also want to thank committee Chairman Oxley, subcommittee
and committee Ranking Members Kanjorski and Frank, as well as
members of the subcommittee and the full committee for their
leadership during this very disappointing chapter in the
history of the mutual fund industry. Millions of Americans--now
indeed over 91 million Americans--rely on these products to
safeguard and grow their savings so they can achieve their
dreams of a home, an education for their children and a
comfortable retirement. Your support has been vital to their
protection, and to the restoration of confidence in this
important sector of financial services industry.
Mr. Castle is correct, when I first joined the Commission
staff many years ago, before I was in private practice, the
whole mutual fund industry in the mid 1960s was $40 billion.
Today there are over $8 trillion, an exponential increase.
Several of the funds in some of the major fund groups exceed
$40 billion, and many more people are involved than ever
before.
Last year, in the wake of the mutual fund late trading,
market timing and revenue sharing scandals, the Commission
implemented a series of mutual fund reform initiatives. The
reforms were designed to, one, improve the oversight of mutual
funds by enhancing fund governance, ethical standards,
compliance and internal controls; two, address the late
trading, market timing and other conflicts of interest that
were too often resolved in favor of fund management rather than
the interest of fund shareholders; and three, improve
disclosures to fund investors, especially fee-related
disclosures so that people know what it costs when they are
investing.
It is the Commission's hope and expectation that taken
together, these reforms will minimize the possibility of the
types of abuses that we have witnessed in the past 20 months
from occurring again. I would like to briefly review for you
the significant steps the Commission has taken to strengthen
and improve the mutual fund regulatory framework. I have
excerpted this from the longer written statement.
First, with respect to fund governance reform. With respect
to enhancing mutual fund governance and internal oversight, the
centerpiece of the Commission's reform agenda was the Fund
Governance Initiative. In July 2004, the Commission adopted
reforms providing that funds relying on certain exemptive rules
must have an independent chairman, and 75 percent of the board
members must be independent. These governance reforms will
enhance the critical independent oversight of the transactions
permitted by the exemptive rules. Funds must comply with these
requirements by January 2006.
The fund governance reforms were designed to carry out the
specific Congressional instruction in the Investment Company
Act, that the resolution of conflicts of interest be in the
interest of fund shareholders rather than the interest of fund
managers. Our fund governance reforms are also designated to
facilitate the implementation of other fund initiatives that we
have adopted. In reviewing these questions, we need to step
back and recall the statutory direction and the policy
provision of section 1(b) of the 1940 Act as it was originally
enacted 65 years ago. The Act states in that provision, it is
hereby declared the policy and purposes of this title, in
accordance with which the provisions of this title shall be
interpreted, are to mitigate and, so far as is feasible, to
eliminate the conditions enumerated in this section which
adversely affect the national public interest and the interest
of investors.
Section 1(b)(2) of that statement declares that the
national public interest and the interest of investors are
adversely affected when investment companies are operated,
managed or their portfolio securities are selected in the
interest of their officers, directors or other affiliated
persons.
In addition to our fund governance reforms, other mutual
funds reforms that the Commission has pursued include the
requirements for compliance policies and procedures for chief
compliance officers, codes of ethics, a directed brokerage ban
under rule 12b-1, and a voluntary rather than a mandatory 2
percent redemption designed to forestall market timing where it
is not authorized.
The new redemption fee rule mandates that funds enter into
written agreements with intermediaries operating omnibus
accounts that enable funds to easy information from those
intermediaries so that the funds can identify shareholders in
those accounts who may be violating market timing policies.
Under these arrangements, the intermediary and funds would
share responsibility for enforcing fund market timing policy.
There was ample opportunity for industry representatives to
raise issues regarding this provision during and before the
comment period. We would be interested in hearing the problems
and exploring the ways in which those concerns may be resolved
later.
Now that I have outlined the Commission's adopted rules, I
want to focus for a moment on the so-called Hard 4 proposal,
which you raised, Mr. Chairman. To address those problems
associated with late trading, which involves the purchase or
selling of mutual funds at a time that the funds share prices
are after 4 o'clock, but receiving the price for 4:00 and
buying after 4:00, the Commission, in December of 2003,
proposed the Hard 4 rule, that you had to have your order in by
4:00 eastern time. This rule would require that fund orders be
received by the fund, its designated transfer agent or clearing
agency by 4 in order to be processed that day. We received
numerous comments raising concerns about this approach, in
particular, we are concerned about the difficulties that a Hard
4 rule might create for investors in certain retirement plans
and investors in different time zones. Consequently, we are
focusing on alternatives to the proposal that could address the
late trading problem, including various technological
alternatives, electronic stamping and so on.
Chairman Donaldson has instructed the staff to take the
time necessary to fully understand the technological issues
associated with any final rule, and the Commission is likely to
consider this final rule later this year. You see, the comments
of industry, institutions and shareholders are taken seriously,
and proposed rules are, indeed, modified to accommodate real
legitimate concerns.
Let me now turn to the issue of mutual fund disclosure.
Improved fund disclosure, particularly disclosure about fund
fees, conflicts and sales incentive, has been a stated priority
of the Commission's mutual funds program throughout Chairman
Donaldson's tenure, even before the mutual funds scandals came
to light. Thus, the disclosure enhancements have been an
integral part of our reform initiatives. My written testimony
discusses these mutual fund disclosure reform initiatives,
including reforms related to the disclosure of portfolio
holdings, the fund expenses and shareholder reports, disclosure
regarding market timing, fair evaluation, selective disclosure
of portfolio information, and disclosure regarding breakpoint
discounts on front-end sales loads, board approval of
investment advisory contracts, and portfolio manager conflicts,
and compensation.
In addition to these adopted reforms, the Commission
recently requested additional comment on proposed rule-making
brokers--on a proposal requiring brokers to provide investors
with enhanced information regarding costs and broker conflicts,
like when the fund managers direct payments to brokers for
shelf space so that they should be featured, and the ones that
don't pay don't get featured, don't get the preferred
treatment, those kinds of conflicts associated with their
mutual funds transactions, the so-called point of sale proposal
which was referred to.
Chairman Donaldson has stated that he is hopeful that the
Commission can move on this initiative after we have had the
opportunity to review comments and respond to that reasoned
request. Having outlined the Commission's progress in the fund
reform agenda, I want to highlight some additional mutual fund-
related initiatives that Chairman Donaldson has indicated are
on the near horizon. One of the most significant involves the
use of soft dollars for research. Chairman Donaldson has stated
that he believes it is necessary to examine the nature of
conflicts of interest that can arise from the type of soft
dollar arrangement which involves an investment adviser's use
of fund brokerage commissions--which is, after all, a fund
asset--to purchase research and other products and services. He
has placed a high priority on resolving these issues.
Consequently, he has formed a commission task force that is
actively reviewing the use of soft dollars, the impact of soft
dollars on our Nation's securities markets, and whether
allocations of soft dollar payments further investor interest.
And we will have the results of that task force from the
Commission, I hope, in short order.
Other upcoming mutual fund initiatives outlined in the
written testimony include a staff recommendation that the
Commission propose a rule to improve disclosure of mutual fund
portfolio transaction costs, a thorough and reasoned review of
rule 12b-1, which was referred to, and a top to bottom
assessment of disclosure.
Let me say a few words about cost benefit, with which I
think you opened this hearing with, Mr. Chairman.
I want to comment briefly on the issue of cost/benefit
analysis, which I understand may be raised by certain industry
representatives.
The Commission is always sensitive to the cost and benefits
imposed by its rules, and therefore engages in an extensive
cost/benefit analysis in all of its rule makings. I want to
emphasize that our Office of Economic Analysis, Division of
Investment Management engage in a careful and thorough review
when preparing the cost/benefit estimates in connection with
these fund rules and submitted them to the Commission for its
consideration.
You must keep in mind, however, that in any analysis of the
cost and burdens and anticipated benefits of a rule is, after
all, only the best estimate of those costs and benefits. The
Commission specifically requested and seriously considered
industry comments, among others, in the course of the proposing
and adopting process involved in the promulgation of these
rules. However, if cost/benefit analysis is to be used as a
strategy to stifle responsible regulatory efforts to address
the types of abuse, the fiduciary responsibilities,
particularly in conflict of interest situations, that we have
seen over the past, the failure to act could, again, undermine
investor confidence and impair the integrity of the market in
the eyes of the investors, both large and small.
Suppose, for example, that under section 404 of Sarbanes-
Oxley, the financial certification rules, and an active
compliance program now required by Sarbanes-Oxley had been
placed at Enron or at WorldCom, there is a distinct
possibility, if not probability, that the scandals that caused
billions of dollars to evaporate overnight, from retirement
plans and from the holdings of investors, might well have been
mitigated or even largely prevented. The benefits would have
undoubtedly outweighed the cost. But how can this be measured
precisely or predicted when you were writing the rule? While
cost/benefit analysis is a critical component of all commission
rule makings, these types of estimates should not be
dispositive when analyzing the utility of a particular
regulation, although they are important in assessing what the
costs or consequences might be.
Legitimate use of cost/benefit analysis is important, but
should not be used to undermine regulatory initiatives designed
to prevent the kinds of conduct covered in the recent scandals.
In conclusion, Mr. Chairman, let me thank you again for
your support and for your leadership in the area of mutual fund
reform. Under your leadership this subcommittee was at the
forefront of recognizing the necessity that reform and
initiating serious consideration regarding what needed to be
done to restore investor confidence in this industry took
place.
Thank you again for inviting me to speak on behalf of the
Commission. I would be happy, I think, to answer any questions
you may have.
[The prepared statement of Meyer Eisenberg can be found on
page 56 in the appendix.]
Chairman Baker. Thank you, Mr. Eisenberg. Let me compliment
you as well for your long-standing service to the SEC and to
the investing community.
I do believe that committee and the Commission and the
Commission staff have all agreed and identified on the points
of concern that continue to be somewhat problematic. I think
the only difference that might exist at all, if there is a
difference, is in the resolution of how we address those
concerns.
Since you spent a little time on the cost/benefit analysis,
let me, by way of example, give you the real estate parallel.
When you sit across the closing table on that first mortgage
loan closing there are innumerable documents which require
innumerable signatures. Most consumers don't really fathom what
they have just signed, nor the consequences of their rights, as
a result of those disclosures.
That has led me to conclude that a concise but clear
consumer disclosure may be distinctly separate from the legal
notification to which that consumer may require access at a
later time. It leads me to conclude that a one- or two-page
document that gives up front disclosure fees and all the
appropriate agreed-upon things which most people would center
on, with a notification of some electronic point where one
could engage additional services at no cost at a subsequent
time, and perhaps engage legal counsel, if necessary, most of
that bulky rights and privileges don't come into play unless
the market goes sour or it is just a fraudulent conduct, which
means usually in retrospect, not at the time of closing.
I would hope in the construct of these disclosure rules
that some sort of mechanism to provide the clear and concise,
with access to the more detailed, would be something that would
be evaluated. I, frankly, do have concern, as a strong
proponent of transparent disclosure, that it is missed
sometimes that the cost of compliance is a direct hit against
the rate of return for the investor. It is not just the
management company that takes the lick, it is passed through.
And we have an obligation, in a fiduciary nature, to those
investors to make the regulatory framework effective, but get
the cost down as much as is practicable.
So I am not suggesting that the Commission should alter or
stop or deter or forget any of the enumerated concerns that you
brought to our attention today--I happen to share all of those
concerns; I do have a considerable concern about the
effectiveness of a very bulky disclosure regime.
There is one other area that I wanted to explore, and it
comes on the business side and regulatory approval side. It has
been brought to my attention--and I think one of the witnesses
later may bring up the subject, so in deference to your
appearing here, to be able to address this question, there was
an ETF exemptive request and it has been represented more than
one, but this particular one was an association with a high-
yield fixed income indices that the request has been pending
now for almost 2 years.
It appears that the regulatory deafness within the
enterprise to respond to changing market conditions has also
taken a hit as the regulatory side has gotten more burdened. Is
this a leading indicator for me that we still need more staff,
or is this something else going on with regard to approval
processes on this exemptive side?
Mr. Eisenberg. Well, let me--I think that what you talked
about, about a summary prospectus in the first--or a summary
that is made available to a shareholder that is a couple of
pages and is comprehensible and is in English and is not in
legalese, I think that is important. I think we agree with
that, that there is an effort now, it may not be two pages, it
may end up being four pages, but the point is to--and this has
been done through focus groups of investors to get us to
understand what it is they are interested in and to get a
bottom line where an investor can tell before, at the point of
sale, and that goes to the point of sale issue, that he or she
can tell what it is that it is going to cost them and what the
conflicts of interest are and what they should be looking at.
There is also an investor education program, which is
ongoing, Web sites and that kind of thing. And you are right,
and I think we agree with you that that is an important
priority, and I think we have tried to do that.
With respect to the lagging exemptions. One of the things--
I just got to this position last month--one of the things I
hope to do is to examine the lag in the processing of
exemptions and to see what we can do to tighten that up. I
think that any bureaucrat will tell you yes, we need more
people, and I believe with what has happened in terms of the
increased regulatory burden and the exponential growth of the
industry and the problems that have been piled on top of it, we
may well need additional people. But we have gotten some
additional people, we have gotten some additional accountants,
we have deployed them, and I think that question of who we need
and whether we need them, both as a Commission and both as a
division, that we may well come back and say yes, we really
need these people. But nevertheless, addressing the gap, a 2-
year gap in processing an application for an exemption, I mean,
I will look into that.
Chairman Baker. Thank you. And one last--because my time
has expired.
With regard to general policy and the responsibility of
independent directors, I was an advocate of independent share,
independent directors, I think that is a healthy thing to have
the friction between the management company and the fund board,
but on the other hand, the responsibilities of that director, I
believe, are policy and broad-based.
Is it the Commission's view, or if you can't speak for the
Commission, your view that the director is really responsible
for everything that happens in the company or in the fund, or
is it a broader fiduciary responsibility, meaning do you have
to get into detailed actuarials and really understand what
contract X meant?
I am concerned about the implications of service for people
who may be overwhelmed with the potential liabilities
contingent on the SEC view of that responsibility.
Mr. Eisenberg. For a long time I was counsel--in my
previous life I was counsel to management companies and I was
also counsel to independent directors, I was independent
counsel to them. And I think that the Commission, and I think
we generally take a broader view that directors are not there
to micromanage what goes on in the fund. I think one of the key
things that a director needs to do is to ask the right
questions and make sure the answers are narrowed down.
The things that you discussed and things that the other
members of the committee have discussed were overall broad
policy questions, like trading, market timing, sticky assets,
the incentives to use fund brokerage for distribution without
disclosing them, those are things that in the normal course
directors should be interested in. And they have helped because
they should have independent counsel, they have got an
independent auditor, and if the independent counsel and the
auditor and now the compliance people do their jobs, they will
find out about these issues and they will be able to act.
And consequently, I think the brief answer to your question
is they are not responsible for micromanagement, they are
responsible for the overall policy and to see to it that the
compliance issues are addressed.
Chairman Baker. That is excellent. Thank you, sir. Mr.
Lynch.
Mr. Lynch. Thank you, Mr. Chairman. First of all, I want to
thank you for all of your work on this issue. I know the spirit
in which a lot of your work has been done, which is to restore
trust and confidence in the industry. And director Eisenberg, I
appreciate the work that you have done on this as well.
I do have some concerns, and I would like to go right back
to the issue the chairman issued about fund governance, and I
would like to back it up just a little bit.
I understand the potential conflict and the spirit of the,
you know, Investment Company Act in your opening remarks, the
principles that guided you, and I actually voted for an
amendment in the last session to have a majority of the
directors be independent. However, the rule that has been
adopted here for companies who enjoy certain exemptions to have
75 percent of the directors be independent and the chairman to
be independent, I am concerned with that, I am concerned with
it greatly.
And I am concerned that this is almost a purge, almost a
purge of trying to get rid of everyone who might be best suited
and most valuable and most knowledgeable from the board itself.
And I am very, very concerned about that. And I think sometimes
what we see is there is a crisis or a scandal, and then the
pendulum swings harder the other way and we sort of cause as
much damage as we are initiating a fix. And I would just like
to get your sense of--is that a valid concern, or should I be
happy with what is going on here? Because frankly I am not.
Mr. Eisenberg. As I said before, I have been on both sides
of this thing. I came back to the Commission about 6 years ago,
and I was going to be there for 2 years and now it has been 6
years because of various things that have happened.
I think, first of all, it is a concern, but I think the
Commission was aware of the concern. And having viewed this
from the inside and having viewed it from the point of view of
the Commission, and also from the point of view of independent
directors, there are two organizations, national organizations
of independent directors. One is the directors forum, and the
other is an ICI-sponsored independent director's council. Both
of those organizations have written and supported both the 75
percent and the independent Chair proposal. It does not seem to
have had the effect that some people feared that it was going
to draw people out of the board room. As a matter of fact, most
of the major fund groups that I am aware of, and there was a
survey taken, they already had 75 percent of independent
directors, and at most, with this proposal, would end up doing
would be to have the affiliated Chair become just a member of
the board and to promote one of the members who are independent
directors or lead directors, to have them be the independent
Chair.
Now why is an independent Chair important? Well, at first,
when you look at this I thought, well, it is not going to make
a hell of a lot of difference; but looking back on my
experience and others that we have spoken to, including meeting
with the independent directors council and with the independent
directors forum, the atmosphere in the boardroom is changed
because there is a critical mass, you can't separate out just
one of these elements, you have to take the reform generally.
And that is an independent Chair, the 75 percent which gives
you critical mass, you control the agenda, and I think Congress
is a good place to indicate what the chairman of a group can
do--that you control the agenda, and the communication is
better. You also have given them an independent council, which
has the right--says to them, these are the questions you really
ought to ask at the meeting, we want to know from management if
you are going to allocate brokerage, who you are doing it to
and what you are getting for it and so on.
So I think that there was a concern, and Mr. Lynch, I think
it was an important concern, but I think that after it has been
put into effect many of the fund groups are already complying
can it. And some of the sky is falling, kind of--the view that
you may have gotten from some of your constituents has not
proved out. And consequently, I think this is an important
reform, it is part of a package, it shouldn't be disaggregated
from it. And I would say to you that the staff issued a report,
which was transmitted to the Senate committee--Senate
Appropriations Committee which requested it--on the independent
Chair rule. And I would be happy to submit a copy of that
report, which goes through this in detail. After you or your
staff has had an opportunity to review it, we would be happy to
discuss it with you further. And of course that goes for any
other member of the committee, and this is that report.
One more thing, and that is, we have been challenged by the
Chamber of Commerce. The United States was sued, there was an
argument about a month ago in the Court of Appeals for the
District of Columbia. In the brief, of which I was one of the
authors, I admit--we outlined the reasons for that independent
Chair proposal. And rather than taking the time of the
committee now, we would--I can submit excerpts from that brief
for you.
Mr. Lynch. Okay. And could I get a copy of the Chamber's
briefs as well, the arguments----
Mr. Eisenberg. I would be happy to supply the chamber's
briefs as well.
Mr. Lynch. Thank you, Mr. Chairman. I just want to, in
conclusion here. I understand the gentleman's remarks that some
boards were sort of in that position anyway, having 75 percent
independent directors and some are moving in that direction
anyway. I am entirely comfortable if firms are doing that on
their own, and that--in terms of the best result for the
investor, and that leads us to that conclusion. The problem I
have is that when you come up with a hard and fast rule, and
you are now rule bound to exclude certain people, and among
those people may be the very best people qualified to protect
the investor's interest, and that is all I am saying. And it is
75 percent, and the director, and so you--I see a squeezing out
of those people who might be qualified. I see limited seats
available for those people.
Mr. Eisenberg. Let me just say quickly in response to Mr.
Lynch's question that you can still have an affiliated person
or two affiliated people on the board, and that is what
generally does happen. So they are not really being squeezed
out. But there is a chart at the end of my testimony which
shows the conflict of interest that exists. And given what has
happened in the real world, and given where the question is,
the restoration of confidence and of governance, the Act itself
originally said that you have to have at least 40 percent, then
it went to 50 percent. And the reason they picked for 75
percent is basically outlined in the staff's report.
So I agree that--and this may not apply to normal--to
corporations, but when you have the advisor and you have the
fund and you have the directors of the fund charged with
safeguarding that fund and negotiating a management contract,
an underwriting contract, who is going to be the auditor and
all of that, that there is some conflict, and it is better in
practice and it looks better in the perception of the public if
our interests are being protected.
Mr. Lynch. Point well taken, I agree. I thank the gentleman
for his testimony, I thank the Chairman for his patience.
Chairman Baker. The gentleman's time has expired. Mr.
Hensarling.
Mr. Hensarling. Thank you, Mr. Chairman.
Mr. Eisenberg, I want to follow up on a couple of questions
that the chairman asked. And I beg your indulgence, I had to
step out of the hearing room for a while, and it could be that
you already covered some of this material, but for my benefit
it would be helpful.
I wanted to ask you about follow up on a disclosure issue,
kind of a general philosophical question, and then one in
specific. In the chairman's opening testimony, I think he
talked about what he did in a previous life to sell real
estate. I haven't sold it, but I have bought it. And last year,
my wife and I purchased a small inexpensive condo in the area
and I remember being presented with roughly 80 to a hundred
pages of documentation, which clearly I chose not to read. I
did out of curiosity ask my realtor how many home purchasers
actually read the material, and she replied roughly one out of
200.
I inquired who the one out of 200 was, and I was informed
it is typically a first-year law student at one of the local
law schools.
So I guess as a general philosophical question, not only am
I purchaser of real estate, but I am also an investor in a
number of mutual funds. I have a tendency to read one, maybe
two pages of materials. I have a tendency to drop in the round
file the 30 and 40-page disclosure statements I receive from
time to time. So I guess in a general philosophical sense, do
we reach at some point the point of diminishing marginal
utility and perhaps adding more disclosures without letting the
more important ones really surface? Is there a point to where
the less is actually more, and are we getting to the point
where we are actually doing more harm than good to the
investing public by adding more disclosures?
Mr. Eisenberg. Well, less is actually more in this context,
in many cases, and that is why in response to Chairman Baker's
question, that the Commission is in the process of developing
the kind of point of sale and materials which will, briefly and
in plain English, describe what it is the investor is buying,
what it is the investor is paying, and what it is he can
expect. I think that is easier to say than to do. The
Commission convened focus groups of investors to determine what
they thought was important, what they were looking for, what
the expense ratio means and how you can tell that, and where
can you go to review what is being offered to you in terms of
the funds, and there are independent places you can go, the
Commission has a Web site that compares them. And we will try--
and we are embarked now in an attempt to develop the kind of
material that both the Chairman and you have talked about. And
I think we are working with the industry and we are working
with OCIE, the Office of Compliance Inspections and
Examinations and the Investor Education Group. It is a problem
that has been with us for a long, long time because whenever
you have additional regulation, the lawyers--and I was one of
them--get on it and say we have got to disclose this and we
have got to disclose that. And it is true.
And I also say the prospectus is more than just informing
investors of what they are doing, it is also a way of informing
professionals and the Commission and analysts of what it is
that is being offered. But I agree with you, I agree with the
chairman, there should be a brief, clear outline for an
investor that gives him the basic facts.
Mr. Hensarling. Let me change subjects to the independent
board member reforms or initiatives.
You mention in your testimony that was adopted a little
less than a year ago on a 3-2 vote of the Commission?
Mr. Eisenberg. Right.
Mr. Hensarling. There appears to be a fairly consistent
pattern of 3-2 votes on the Commission dealing with a lot of
major initiatives, and it appears to usually be the same three
and the same two.
We have heard a number of concerns about the practical
impacts of the independent board member reforms, but I myself
don't know about the dissenting views. Could you enlighten me
as far as specifically what the minority views were of the
Commission in adopting these rules?
Mr. Eisenberg. Well, the two dissenting commissioners,
Commissioner Glass and Commissioner Atkins have filed a letter
with the report which indicates what their objections are. I
have reviewed those and others have reviewed it, and I think
that their points are not well taken. What they have said
basically is, oh, you people have rehashed this whole business
about the scandal, but you really haven't shown that an
independent Chair would improve the performance or improve the
compliance of the company. We have had our economist look at
that, and it is reported in our staff report to the Senate
committee, basically you can't disaggregate that one function,
the independent Chair, and say it hasn't added to performance,
there are too many variables the economists say--I must say
they speak a different language, but there are too many
variables to reach that conclusion.
And the reason that the Commission did it was not
necessarily in terms of proving that there would be better
performance or not better performance, they did it because of
the structure of the fund industry which sets up a conflict,
and that conflict has to be managed. And that was recognized
from the very beginning in 1940. And given the complexity and
the new products and how many people are investing, those
conflicts had to be managed. And one way of managing it is
through fund governance. And giving that 75 percent independent
directors and an independent Chair are just two elements of a
much broader view of governance, which includes an inside
compliance responsibility which includes an independent counsel
so that they have the technical ability to deal with questions
and the independent auditors.
And if those people do their jobs, then that would
certainly help in terms of resolving those conflicts of
interest, otherwise, the Chair of the fund, if he is
affiliated, is, in effect, negotiating with himself as to what
the advisory fee ought to be, how it ought to be distributed,
where the brokerage should be go. So that is basically the
short answer, the longer answer is in the report.
Mr. Hensarling. I thank the gentleman, thank you.
Chairman Baker. Thank you. Ms. McCarthy.
Mrs. McCarthy. Thank you, Mr. Chairman.
We are probably going to go back to the same question that
everybody else asked you.
In your testimony you talk about the transition cost
disclosure, and I know you have talked about it a number of
times. And I see that the Commission started looking at this in
December of 2003. Do you have any idea of when it is going to
finally come through so that we can look for it?
Mr. Eisenberg. I believe it will be before the end of the
year. I believe Chairman Donaldson has indicated this is a
priority. We have had a couple other things that we have had to
deal with. And I think that we recognize now, and recognized
then that this is something that should be addressed. I regret
that it has taken that long to do this, but if you are going to
do it, you have to do it right, and we will try to do that by
the end of the year.
Mrs. McCarthy. And I hope it is done very simply because I
do happen to read the prospectus, and I still can't find what
it is costing me. So hopefully it will be easy.
Mr. Eisenberg. Yes. This has been an objective of
commissions past that we are going to make it easy to explain.
You are going to have a summary prospectus, you are going to
stick it on the first part. And every time you do that, the
lawyers say well, you need more, you need more.
This is a serious effort to get that kind of information,
the basic information that reasonable people can understand, to
tell them what it is that they are buying and to inform them as
to what the conflicts are that they are facing. I mean, you
would want to know that the broker-dealer who is selling you
this mutual funds interest is getting paid extra in order to
push A rather than B, which may have better performance and so
on, the so-called shelf space because mutual funds are just
like soaps, so if you pay for the shelf space, that is okay,
but mutual funds are not like soap, mutual funds are different,
they are harder to understand because you can't hold them in
your hand. So that is why we need to do that.
Mrs. McCarthy. Should fund advisors or managers have the
same fiduciary responsibilities as others in the financial
sector; is the SEC moving in that direction?
Mr. Eisenberg. I think you are referring to the broker-
dealer investment advisor rule which is now--which we have
tried to deal with.
There are two kinds of responsibilities, and the question
is, when are you an investment advisor? Or when does the
broker-dealer cross the line from just giving advice that is
incidental, to selling the shares that he is selling and become
a financial planner? Or if he has discretion, he in effect
becomes an investment advisor. And that line, which is fairly
fuzzy, we are in the process of really, of defining that. And I
think that is important because broker-dealers have more and
more taken on the aura of being financial planners, of giving
you advice, and not just the things which are normally
incidental to the brokerage, and that is what that rule is all
about.
Mrs. McCarthy. And I appreciate that, because I will say
that when you are working with your broker--and obviously there
has to be some sort of relationship because they will call you
and say hey, we think you should get out of this and go into
it, and hopefully you will say fine, I mean, they are the ones
that actually know why would we have it. I mean, I don't have
time to start looking at what I am supposed to do with it.
So I hope that we can have some rules up there. I mean, I
happen to trust the guys that take care of my funds----
Mr. Eisenberg. Trust, but verify.
Mrs. McCarthy. But I am in Congress, so they might be
looking out for my investments, I have no idea. Thank you. No
further questions.
Chairman Baker. I thank the gentlelady. And Ms. Biggert.
Mrs. Biggert. I thank the Chairman. I would like to come
back, I think Mr. Castle had talked a little bit about the Hard
4 close. And I know that we had a hearing a couple of years ago
that the question came up, and there was a feeling by people
who testified that that would mean that in some time zones, it
would be like 12 noon that they would have to stop trading the
mutual funds. And I believe that there has been some
development of some technology to have a time stamp technology
that is now capable of doing that. Would that solve the
problem, or are there other alternatives that you need to look
into?
Mr. Eisenberg. I did refer to that, I believe, in the
testimony that yes, that there are technological advances which
would have tamper proof stamps. But it is more complicated than
that because there are some intermediaries which bundle the
orders, and they are not subject to commission regulation. So
that is the reason why there should be some arrangement, in
addition to just the time stamping, because there is nothing
that is foolproof, there has to be some arrangement where those
intermediaries would report and would have to disaggregate
those late traders. I mean, the late trading was so harmful and
the sticky assets that the quick fix was the Hard 4 close. And
I believe it is more complicated than that.
Mrs. Biggert. And I believe it is more complicated than
that. I understand that. I wonder if that technology has been
put into place.
Mr. Eisenberg. It may go a significant way in solving the
problem; it may not solve the problem altogether. And that is
what is being examined right now.
The Chairman has indicated--the Commission has indicated
that they are interested in, one, the technological fix, and
two, whatever we have to do in terms of the intermediaries.
Mrs. Biggert. Well, certainly the SEC has had a lot of
criticism for failing to spot the late trading in the market
timing scandals. But what is happening currently?
Mr. Eisenberg. What is happening currently, that is, under
active consideration, is that the hard close--the question of
whether the hard close is really the solution. And we would
need to work with the industry and with tech people to
determine whether that----
Mrs. Biggert. You said that that would probably be
finalized by the--in this area, later this year?
Mr. Eisenberg. Yes, I think it is important that we do
that. And to a large extent, the fair value of the securities,
to some extent, would help as well.
But those of us who were in the industry, I think, were
pretty surprised at the late trading. I mean, market timing,
you can say, well, some of it was legal. A lot of it was
illegal.
Late trading was pretty clearly illegal, and a lot of
people just did not know that these kinds of shady deals were
going on.
Mrs. Biggert. If I could just turn to another issue that--
there was a settlement, the global settlement. And part of that
was a direction for $52.5 million to set up the Investor
Education Plan, and the investor education entity.
I am very interested in this, because of the financial
literacy that we are working on here in Congress, and with the
U.S. Treasury and the Commission. But is that up and running?
Mr. Eisenberg. I do not have up-to-date information about
that. I would be happy to get back to you on that question.
Mrs. Biggert. I would appreciate it. I think that the board
was set up, but there have been resignations. So I do not----
Mr. Eisenberg. That is right. And my understanding is, they
are going to fill those vacancies and that they are going to
review the work of that body. It got held up because of,
apparently, disagreements within the board. But further than
that, I really cannot say.
Mrs. Biggert. Thank you.
Chairman Baker. Mr. Feeney.
Mr. Feeney. Thank you, Mr. Chairman.
I appreciate the testimony, Mr. Eisenberg. I thought I
would try to touch on a couple of areas that have not been
explored so far.
I have read Mr. Steven's testimony. And he warns about, I
think appropriately, some of the cumulative regulatory burdens
placed on the industry, especially small mutual fund companies
who will bear a disproportionate brunt of regulations if we go
too far overboard. And he suggests at one point that, for
example, treating mutual funds differently from other financial
products has some problems.
With respect to the independence of the board, it seems to
me that we have got a very different story here, because in a
typical corporation, including financial products, the role of
the board of directors is primarily to protect the shareholders
of the company. In this case, it is not only the shareholders
of the company, but the customers of the company who consume
the product.
One of the concerns I had, as opposed to just simply the
typical definition of an independent board member, is that with
some mutual fund companies, we have got members of the boards
serving on four or five or six or eight different types of
family funds; and these are often fairly lucrative positions
with some significant benefits to them.
Has anything that the SEC has done looked into the
propensity or the incentives to the board member that is
serving on, let's say, five or eight funds in a particular
family to essentially become a rubber stamp for management in
return for the ability to serve on multiple boards?
Mr. Eisenberg. The multiple board question is something
that I am familiar with, and that we have looked into. There
are boards who administer 100 different funds. And they often
tend to meet longer and more often than boards with smaller
amounts.
That does not mean that they cannot be effective. What
those boards basically do is they divide up the funds into
categories, and a subcommittee of the board will deal with
those categories. They will interview the portfolio managers
and the management with respect to what is going on.
Say you have an international sector, you have a bond
sector, you have an aggressive growth sector, and an index
sector. And what they will do is divide that up, and then they
will meet together on the fees and on those other issues.
I would hesitate to say that a member, a board member,
could not serve on multiple boards so long as it was effective
and so long as they were not rubber stamps.
One of the things that I think would prevent that is that
the regime now is where you do have certain--you have the
independent counsel and the audit committee and all of that, an
independent chair, that they have the incentive to ask the
right questions; and if they don't get those answers, they will
inquire further.
And I think also the industry recognizes that it is in
their interests to restore confidence. I do not think that
banning somebody from serving on more than 10 mutual fund
boards is something that we are about to do.
I mean, you are not going to believe this, but there is a
limit on what the Government ought to do. And if that really
becomes a problem, then I think we will have to act. But before
we do that, we will do what we did with the independent chair
and the 75 percent. You look to see what is happening, you see
what abuses are occurring, and you try to do something about
it.
Mr. Feeney. I have got two more questions. I see my time is
running out. Would the Chair entertain a motion for unanimous
consent to give me an additional minute?
Chairman Baker. I do not see that anybody is going to
object. Why do not you just take off?
Mr. Feeney. At the most, I could offend three of my
colleagues. That is--I have done a lot more than that on
occasion.
The second question I have concerns the disparate fees that
are often charged by funds between large institutional
investors and small individual investors. Sometimes the cost to
the individual investor is as much as 3-, 4-, 500 percent more.
It seems to me that there is some inherent unfairness, whether
I am managing a dollar for a client that has invested a hundred
million dollars with me, or a dollar for somebody who has got
his or her 401(k) invested with me, you know, the marginal
costs cannot be that great in my view.
And while I am not inclined to limit fees, that is against
my instincts, I am inclined--despite the warnings about 80-page
disclosures, I am inclined to tell people that there are other
customers that are getting an 80 percent discount, for example,
to what they are paying, because I think it would have the
ultimate effect of bringing some more balance and fairness in
the fee structures.
Mr. Eisenberg. Are you talking about the difference between
what an institution or a fund pays for a stock?
Mr. Feeney. No. I am talking about what the management fees
are that customers are charged in--you know, per dollar
managed, large institutions sometimes--well, individual
investors are paying 4-, 500 percent more per share or per
dollar than a large institutional investor in that mutual fund
is paying.
Mr. Eisenberg. When an individual invests in a fund, there
are break points in terms of when his load, if it is a load
fund, when the load goes down, so that, depending on how much
the person is investing, you may get charged a full load or a
partial load or very little.
I think the whole question of whether or not there are
economies of scale, which I take your question to be, that
where there are in fact economies of scale, that there really
ought to be significant break points for that service. And I
think that the disclosure pretty much makes that--should make
that clear.
Now, the other--the question which you may be getting at is
that while there are different advisory organizations that
charge a load, there are some that charge no load, there are
some that have a contingent deferred sales load--you pay 5
percent; you stay in for an extra year, it is 4; and if you
stay in for 5 years there is no commission whatsoever.
So there are different commission schemes that they have
and they need to disclose what those are.
Mr. Feeney. Well, I was under the impression, maybe
wrongfully, that the annual management fee was at times treated
differently between institutional investors and individual
investors, and I may be wrong about that.
Mr. Eisenberg. Because the institution is a much larger
customer and it costs less per dollar to manage a large
institution if you have a billion dollars or half a billion
dollars. If you have someone that comes in with $100,000 or
$10,000, and you have to pay individual attention to that
person's objectives and policies, then that costs more.
Also, you have the difference--you have wrap fees.
I am afraid I am not answering your question.
Mr. Feeney. Maybe--because I may not be able to stay for
the bulk of the rest of the testimony, maybe some of the other
witnesses could address that if they are able.
Mr. Eisenberg. It would be nice if you can ask them that.
Mr. Feeney. I have just done so.
Then finally with respect to 12b-1 fees, my understanding
was that the theory, at least in part, behind allowing 12b-1
fees for advertisement and recruiting new investors is that if
I can take my fund from, say, $100 million of management to $1
billion, if I can multiply it tenfold, the marginal costs per
share, or per dollar, of doing research declines. So the
marginal cost to the individual to manage the fund, to do
things like research, would decline.
In other words, the original investor, the guy who has got
shares when the fund is worth 100 million would be better off
when the fund grows, because the marginal cost per share of
doing research declines and, essentially, their management fees
should decline.
But, in fact, some of these funds have now closed. And I
would like to know the status of what the SEC is doing to
review the appropriateness of 12b-1 funds in general and for
closed funds in particular.
Mr. Eisenberg. I can try and answer that quickly.
There is currently, right now, an ongoing review of 12b-1
fees. 12b-1 fees are fees that come from the fund to facilitate
distribution. And what you are saying is that with--well, if
there is no distribution when it is closed, why do you need a
12b-1 fee at all?
I think that is a legitimate question. It is one which the
Commission is interested in. But we are reviewing 12b-1 fees in
general, because 12b-1 fees originally just were to facilitate
distribution, to pay for advertising and that kind of thing.
They have become, to some extent, a substitute for a load, so
people--for a commission.
The role of 12b-1 fees is much different today than it was
in 1981 when they started. And that is really an area that
needs to be looked at. I agree with you, sir.
Chairman Baker. There being no further members to bring
matters to your attention, I would like to, just for the
record, acknowledge that some members, who did have to leave,
have questions for you. We will submit them in writing, and a
couple of points of clarification, we will follow up with you
on subsequent to the close of the hearing today.
But we express our appreciation to you for coming forward
and continuing to work with us as we try to bring about an
appropriate regulatory regime for this important sector of the
economy. Thank you, sir.
Mr. Eisenberg. I think it is important that we do work with
you, with your staff, and with the committee. We will certainly
respond to any questions. Thank you very much.
Chairman Baker. Thank you, sir.
And as appropriate, I will ask the members of our second
panel to come forward.
I want to welcome each of you to the Capital Markets
Subcommittee this afternoon. As you are each very much aware,
your official statement will be made part of the record. We
request that you make your oral presentation, as best you can,
within the 5-minute period.
And our first witness this afternoon will be Mr. Paul
Schott Stevens, President of the Investment Company Institute.
Welcome, sir.
STATEMENT OF PAUL SCHOTT STEVENS, PRESIDENT, INVESTMENT COMPANY
INSTITUTE
Mr. Stevens. Thank you, Mr. Chairman, and good afternoon.
The subcommittee is aware that mutual funds are one of the
largest financial intermediaries, and, of course, they play an
important role in American's retirement security.
The Institute has the privilege of serving as the national
association of U.S. mutual funds, and our members have total
fund assets approaching $8 trillion. They serve approximately
87 million shareholders.
At the end of 2004, mutual fund assets accounted for nearly
one-quarter of all retirement market assets in the United
States. The importance of mutual funds is unquestionable, and I
certainly commend the subcommittee for providing this timely
forum to take stock of where we are and to consider mutual fund
regulatory policy going forward, so that it will continue to
serve in the best possible way the interests of fund investors.
Now, I am personally very honored to have this, my first
opportunity as the president of the ICI, to testify before the
subcommittee, so ably led by you, Chairman Baker, my fellow
Louisianan. Under your leadership and that of Ranking Member
Kanjorski, the subcommittee truly has been active across an
exceptionally broad range of important issues affecting not
just mutual funds, but all of our capital markets.
Prior to joining the Institute as its president, I spent
much of my career in private law practice and served for many
years as counsel to mutual funds, to independent fund director
and fund boards, to investment advisors, and to fund
distributors. Indeed, I attended my first mutual fund board
meeting almost 25 years ago.
From this longer-term perspective, I believe that our
collective response to the market timing and late trading
abuses that first came to light in 2003 is reassuring. Our
legal and regulatory system has worked as designed to identify,
correct and prevent misconduct, as has the congressional
oversight process. Strong corrective market forces have been at
work as well.
As an industry, I believe we have recognized the
seriousness of these abuses and worked very hard to implement
the comprehensive reforms developed by the SEC under the
leadership of Chairman Donaldson. The result has been to
sustain the traditionally very high degree of public confidence
in mutual fund investing and, thus, to preserve for average
Americans an indispensable tool to achieve their long-term
financial objectives.
This goal, assuring that mutual funds remain a vibrant and
competitive and effective tool for average investors, is one of
utmost importance, but it cannot be taken for granted. In
considering future regulatory action affecting mutual funds, I
believe it is critically important to bear in mind, in addition
to the protection of investors, which is paramount, certain
business and competitive realities in the financial services
marketplace.
The SEC, in particular, must give due consideration to
potential unintended consequences of burgeoning regulatory
requirements that uniquely affect mutual funds. My written
testimony analyzes two specific instances, one related to
disclosure concerning fund portfolio managers and a second
concerning proposed point-of-sale disclosures concerning mutual
funds.
Now, individually, these and numerous other requirements
may serve valid and useful purposes, but if, however, when
taken as a whole, the SEC's uniquely applied mutual fund
regulations and the associated costs and risks discourage
investment advisors from entering or staying in the fund
business. If they discourage portfolio managers from managing
mutual funds as opposed to other investment products, or if
they cause intermediaries to favor less regulated financial
products over mutual funds, then the SEC's regulatory regime is
not effectively serving the interests of American investors.
Now, closely related to this issue is a concern about the
escalating costs of compliance with the SEC's mutual fund
regulations. To be clear, the Institute and its members firmly
support sound regulation and strong compliance. It is necessary
in crafting regulations for mutual funds, however, that the SEC
have a full understanding of the potential consequences,
including the actual cost implications of different regulatory
approaches and their impact on funds, fund managers and fund
distributors. To do so, we believe the SEC must conduct a
substantially more informed and rigorous cost-benefit analysis
of its proposed regulatory requirements.
Now, we for our part pledge to assist the SEC in this
process, by conducting our own cost-benefit research to
contribute to the body of learning that informs mutual fund
regulatory policy. Only in this way, working together, can we
assure that the costs of new requirements will not outweigh
their benefits or add unnecessarily to the growing and unique
regulatory surcharge applicable to funds.
Now, we also recognize that success of the mutual fund
industry relies in large part on a strong and well-managed
regulator. An effective SEC is essential to help sustain the
high level of trust and confidence that investors have in
mutual fund investing. Toward this end, for many years, the ICI
supported adequate funding for the Commission.
As Chairman Donaldson has recognized, however, more money
and more staff are not the whole answer. The larger and more
difficult challenge is for the SEC to assure the effectiveness
of its regulatory and law enforcement efforts. To his credit,
Chairman Donaldson has committed to pursuing internal reforms
that will improve the performance of the SEC. As part of these
internal reforms, there are three areas we believe deserve
priority attention.
They are better coordination among the different SEC
divisions and offices that deal with mutual fund issues, better
coordination of and other improvements to the inspection
process regarding funds, and improvements to the efficiency and
productivity of the Division of Investment Management,
especially in processing applications for exemptive relief.
To ensure the success of any future regulatory initiatives,
it is important that the industry and the regulators move
forward collaboratively, and to that end, maintain an open,
ongoing and constructive dialogue. Such an approach will
inevitably yield the best results for investors.
I greatly appreciate the opportunity to testify on these
important issues. The Institute looks forward to working
closely with you, Chairman Baker, with the subcommittee, with
Chairman Donaldson and all at the SEC to achieve our shared
objective, a strong mutual fund regulatory regime that protects
fund investors and helps ensure that mutual funds remain a
vibrant and effective tool for them to achieve their financial
goals.
Chairman Baker. Thank you very much, Mr. Stevens.
[The prepared statement of Paul Schott Stevens can be found
on page 80 in the appendix.]
Chairman Baker. Our next witness is Mr. Barry P. Barbash,
partner, Shearman & Sterling. Welcome.
STATEMENT OF BARRY P. BARBASH, PARTNER, SHEARMAN & STERLING LLP
Mr. Barbash. Chairman Baker, thank you for inviting me here
today to discuss the costs and benefits of the SEC's recent
regulatory initiatives in the mutual fund area. I commend the
subcommittee for its desire to assess at this early juncture
the effects of the SEC's recent actions.
I see myself as bringing to the discussion today a fairly
unique perspective in the fund industry, as I have had, within
the last decade, the privilege of working on both sides of the
regulatory process. I feel compelled to note that Mike
Eisenberg has the same background, just in the name of full and
fair disclosure. I served as the division director of the
Division of Investment Management at the SEC for 5 years before
I joined the law firm of Shearman & Sterling, where I head up
the asset management practice group.
My practice is broad and diverse, representing all of the
relevant constituencies in the asset management industry. I
represent no particular client or clients in speaking with you
today. My views are mine and mine alone.
In my practice I have witnessed firsthand the costs and
complex undertakings involved in complying with the new mutual
fund regulations adopted by the Commission over the last 2
years. At the same time, my prior experience as division
director enables me to appreciate the challenges regulators
face and the great responsibility they bear in responding to
improper conduct and in crafting rules to protect the interests
of investors.
I will speak briefly today about three areas that in my
judgment have been affected significantly by the Commission's
initiatives: mutual fund disclosure, the role of mutual fund
independent directors, and the development of novel and
innovative investment management products and services.
Many of the SEC's recent regulatory measures have resulted
in more material about more subjects appearing in mutual fund
prospectuses and statements of additional information. This
bulking up of these disclosure documents runs counter to what
mutual fund investors, fund sponsors and sellers of mutual fund
shares all agree must be a fundamental principle of fund
disclosure. That principle is, what works best for fund
investors is straightforward disclosure on the basic topics
that are central to investing in a fund: performance, fees,
expenses, risks and key objectives and strategies.
I agree with high-level policymakers at the SEC, including
Chairman Donaldson, that the time is again ripe for a renewed
effort to make prospectuses a more useful tool for investors.
To my mind, a new and enhanced mutual fund prospectus should
have two core components. It should be short, addressing only
the most important factors about which typical fund investors
care in making investment decisions, and it should be
supplemented by additional information available
electronically, specifically through the Internet, unless an
investor chooses to receive the additional information through
other means.
In seeking to make prospectuses more useful, the Commission
and its staff should, in my judgment, also carefully consider
when and in what form the prospectus should be delivered to
prospective fund investors. These were topics that we did not
consider in the late 1990s when I headed a review of mutual
fund prospectuses.
The question often asked by those of us involved with the
mutual fund industry is, for what are the independent directors
of a mutual fund responsible? Many independent directors, with
whom I deal regularly, see the SEC's new rules and recent
actions by the SEC staff as answering the question by four
words: Everything the fund does.
I believe that answer is inconsistent with the long-
accepted notion that fund directors best serve as overseers and
not micromanagers of business. I suggest that the subcommittee
consider supporting those who serve as funds' independent
directors, by asking that the SEC reevaluate all of its rules
contemplating action by those individuals.
The goal of such a reevaluation would be to center the
efforts of directors on matters of overarching importance to
the interests of fund shareholders, such as conflicts of
interest faced by the fund investment advisors, distributors,
or other service providers.
The SEC's resources in regulating the investment management
business over the recent past seems to have been principally
devoted to rules proscribing or limiting activities of mutual
funds, compliance matters and enforcement. Although all of
these activities have clearly been of critical importance, they
appear to have caused the Commission and its staff to spend
less of their resources facilitating innovative opportunities
for the investing public.
Innovation in investment management products and services
often necessitates obtaining exemptive relief from provisions
of the Investment Company Act of 1940. The SEC staff's
consideration of that type of relief appears to have bogged
down of late, resulting in some industry participants
abandoning their efforts to develop new products and services.
How can the SEC enhance its efforts in supporting
innovation in the investment management industry? I believe two
actions are crucial. First, the Commission should strongly
embrace what Commissioner Cynthia Glassman recently described
as the Commission's mission; that mission, according to the
commissioner, is to strike an appropriate balance between two
goals--shielding investors from harm and maintaining the
integrity of the securities markets on the one hand, and not
unduly interfering with investor choice or impeding market
innovation on the other, a balance that seems to be missing of
late and needs to be reestablished.
Second, the Commission should dedicate staff with special
expertise in markets and products to the Division of Investment
Management exemptive review process. Just as the Commission has
sought to keep abreast of potential problems in the financial
markets and the securities and investment businesses by forming
a risk management unit, it needs to encourage creative
development in the investment management business by organizing
a new product review unit.
In closing, I appreciate this opportunity to assist the
subcommittee in its review of the SEC's recent mutual fund
regulatory activity. I hope that by sharing my perspectives and
experiences with you, I have been able to illuminate some
unintended but troublesome consequences arising out of the
SEC's regulatory activity. The subcommittee's thoughtful
reconsideration of the cumulative effects of the new fund
regulations should help to ensure that the interests of mutual
fund shareholders are furthered and not impaired by that
regulation. Thank you.
Chairman Baker. Thank you, sir.
[The prepared statement of Barry P. Barbash can be found on
page 38 in the appendix.]
Chairman Baker. Our next witness is Mr. Michael S. Miller,
managing director, Planning and Development, for The Vanguard
Group.
Welcome, sir.
STATEMENT OF MICHAEL S. MILLER, MANAGING DIRECTOR, PLANNING &
DEVELOPMENT, THE VANGUARD GROUP
Mr. Miller. Thank you, Chairman Baker. As you know, my name
is Michael Miller. I am a managing director of The Vanguard
Group, based in Valley Forge, Pennsylvania.
An important part of my responsibilities involves providing
oversight of our firm's compliance functions. I am also
responsible for a number of other areas, including corporate
planning and strategy, portfolio review, which includes new
fund initiatives and research, and shareholder communications.
Vanguard is the world's second largest fund company with
more than 18 million shareholder accounts, and approximately
$830 billion invested in our U.S. Funds. We have a unique
mutual ownership structure at Vanguard where our mutual funds,
and therefore, indirectly, the fund shareholders own The
Vanguard Group, which provides the funds with all management
services at cost. Under this structure, all profits are
returned to our fund shareholders in the form of reduced
expenses.
Investor trust and confidence in the fund industry have
been tested over the past 20 months, and the relationship
between regulators and regulated firms has been strained. Amid
an atmosphere that at times could be characterized as mutual
mistrust, interactions between regulated firms and regulatory
officials at times has been somewhat a game of gotcha or
regulatory one-upsmanship.
In the face of intense public pressure, new rules have been
proposed and adopted at a record pace, failing in some cases to
allow for accurate study by the Commission or the industry to
evaluate the practical impact of the measures. I believe that
we are now at a turning point.
Nearly 2 years after the market timing and late trading
problems at some firms, investors continue to regain confidence
in mutual funds. No doubt investors in the markets have been
reassured by the swift enforcement actions by regulators. The
marketplace, too, has been swift and unforgiving in delivering
punishment to firms that betrayed investors' trust.
As we turn to the next chapter in the evolution of mutual
fund regulation, the Commission and the industry must work
together to ensure that the regulatory framework that governs
our industry fully serves the millions of investors who rely on
mutual funds to build their financial futures.
In the wake of an extraordinary period of regulatory
activity, adjustments and some fine tuning will be necessary,
and the SEC will surely be asked to interpret new rules and
regulatory requirements. The Commission and the fund industry
share responsibility for getting these interpretations right.
Hippocrates once advised physicians to declare the past,
diagnose the present, foretell the future, and to make a habit
of two things--to help or, at least, to do no harm. We would do
well to follow his teachings today. That some misguided or
unprincipled people at hedge funds, distributors and mutual
fund companies engaged in abusive business practices has been
well documented, and the regulators have responded.
Today, fund company legal and compliance staffs are dealing
with at least 25 new regulatory requirements that have been
proposed and/or adopted in the past 4 years alone. With so many
new requirements, fund companies are facing difficult resource
allocation issues. At times it seems that these new demands on
operating budgets and senior management time and attention
unduly strain financial resources and leave little time to
develop new and better ways to serve investors' needs.
And I am speaking on behalf of the industry's second
largest firm. I can only imagine the difficulties and tough
decisions that many smaller firms must be facing. A regulatory
system that is in overdrive can create undesirable and
unintended consequences, ultimately punishing everyone in an
effort to address the abuses of the few.
After we have a chance to step back and review the events
of the past 20 months, I think we will find that some of the
new rules adopted in haste may not serve investors well. All of
this regulatory activity has been well intended, but actual
experience must be taken into account. If new requirements are
helpful in some measure, but exact a cost in human and capital
resources that far exceeds the benefits to investors, we--and I
refer here to both regulators and the regulated--have failed in
our obligation to strike an effective cost-benefit balance for
investors.
To operate collaboratively, we must maintain mutual respect
and an open dialogue. Unfortunately, the events of the last 2
years have led to a breakdown in the constructive
communications that had existed between the industry and the
regulators. We must reestablish these lines of communication.
In large part, the fund industry owes its success to the
legacy of good rulemaking and sound and reasonable
interpretation of the law by the SEC over the years. Recently,
the fund and securities industries have worked with the NASD,
with the SEC staff participating on many issues, including
sales charge break points, transaction costs, distribution
arrangements and point-of-sale disclosures.
There is so much sense to putting our heads together to
develop solutions to our most challenging issues. The search
for simple answers in a complex world is difficult and may not
always be possible. Fund firms have become increasingly complex
as they seek to meet the needs of investors.
Mutual funds appeal to a wide range of investors, from
individuals saving for retirement to Fortune 500 companies.
Funds and fund operations have evolved to adapt to the varied
needs of these different investors. Regulators and fund
companies must therefore engage in thoughtful and constructive
dialogue to pursue and achieve a disciplined process to
developing effective rules that protect all investors.
There will not be unanimous support within the industry for
every specific rule change or proposal. It would be naive to
expect otherwise. But there must be an open dialogue and
rigorous debate if we are to achieve an effective outcome for
the benefit of fund investors.
Working collaboratively, we can ensure that regulatory
measures are designed with a thorough understanding of the
intricacies of the business. Working together, we can also
avoid the pitfalls too often faced by regulatory efforts.
A regulatory response that is disproportionate or poorly
tailored to the problem it seeks to solve can do more damage
than good. And no amount of regulation will ever replace a
commitment from the industry to integrity and high ethics.
But over-regulation does not prevent bad people from doing
bad things. There will always be people who figure out how to
evade the rules. Such individuals should be subjected to strong
and swift enforcement actions.
We must be wary of changing the rules without providing
adequate time for the industry and the regulators to consider
the ramifications of the changes. Recently with the regulatory
system in overdrive, the fund industry has too often been given
too little time to consider and comment on regulatory changes.
Less than 60 days simply is not enough time to digest all of a
proposed rule's operational and other implications.
We need not look too far in the future to see some
opportunities to become reengaged. In recent testimony before
the U.S. Senate, SEC Chairman Donaldson described two issues
that offer opportunities for us to join in productive dialogue:
mutual fund disclosure reform and mutual fund distribution.
Advances in technology and the high adoption rate of the
Internet by mutual fund shareholders create new avenues for
better disclosure and distribution to shareholders.
We also hope regulators and the industry will take more
time to reengage in new business development, work where the
SEC plays a critical role. Just as fund firms have been coping
with the weight of new regulations, so too has been the SEC. As
a result, firms trying to develop new offerings that could
provide greater flexibility and lower costs to investors have
encountered delays and bottlenecks.
The pace of new product review and evaluation needs to be
reexamined. Many of our new regulations seek to achieve similar
objectives. As a result, at times we now have multiple and
sometimes redundant solutions pursuing a single problem. We
should look at all of these solutions closely and in concert
with each other. We should consider what works well and what
does not, then take the best of it and leave the rest.
Vanguard has always been willing and eager to come to the
table with our regulators to discuss any issue at any time. And
I am confident that any serious and responsible firm in our
business would make this same representation.
We are willing to share the expertise of all of our
experts, all of our people, for the benefit of this industry
and, more importantly, for the investors we serve.
Thank you, Mr. Chairman, for this opportunity to testify.
[The prepared statement of Michael S. Miller can be found
on page 70 in the appendix.]
Chairman Baker. Thank you, Mr. Miller. I will start with
you.
With regard to your analysis of perhaps unwarranted
rulemaking or unjustified rulemaking. One of the reasons for
the hearing is to get from industry perspectives on the
modifications made and the consequences of the rulemaking
environment for us to assess what could be done to make the
market efficient while ensuring transparency.
If there are specific actions that you have identified from
a Vanguard perspective, that you could make known to the
committee at some future point, as to the consequences of a
particular action and why it was, in your corporate view, not
warranted, those are the examples of rulemaking which we would
like to assess.
But let me quickly add, as Mr. Eisenberg indicated in his
comment earlier, it cannot be simply a cost-benefit analysis
that makes a rule justifiable or not; it is the context in
which the cost-benefit is engaged.
And perhaps there are two classes of rules that I see. One
is the practical impairment to business process--the 4 o'clock
hard rule comes to mind, that that merely geographically or
technologically precludes someone from engaging in the same
business enterprise that others are engaged in, and is
prejudicial merely by where you happen to be. That is something
that obviously has need of repair.
The other issue with regard to point-of-sale disclosure is
on the other end of the extreme, which is a business judgment
to require certain ethical conduct to ensure the investor is,
presumably, made an informed investor by this disclosure, needs
to be looked at in the context of what does it cost that
investor for you to prepare that analytical, get it in his
hands, in relation to the overall earnings of the fund. That is
what troubles me there.
If you can be more specific about the points at which you
have found the process not to be balanced or where the
timeliness given to a particular consideration was not
sufficient, that is really where we want to go with this, to
make sure that we are getting it between the sidelines as well.
Mr. Miller. Maybe, Mr. Chairman, I can give you an answer
that is a broad answer, but I think it goes directly to what
you are asking. And that is, let us step back; Mr. Eisenberg
talked about this, and Mr. Stevens and Mr. Barbash also talked
about this.
If we consider the entire disclosure regime that we are
facing today, I think we all concede that there is too much
paper. There is too much disclosure. We want investors to be
aware, we want investors to be knowledgeable, but we want
investors to read the information that we give them. They won't
read it when we make it so weighty and so overwhelming that
they are deterred from picking it up and giving it a read.
I think that what we need today--and we have to look at
this in the context of the last couple of years--I am very
sympathetic to the SEC. I am very sympathetic to the industry
and the pressures that have built up over these last couple of
years, the pressures to do more and more, enact more and more
rules; and the pace of activity has been at times frantic.
It has been a record pace. I think someone told me that in
a given year, a normal year, if we had such a year, you would
have two or three rules of substance that would be proposed for
comment by the SEC and perhaps adopted.
Over the last few years, as I indicated in my testimony, we
have had 25-plus rules proposed or adopted. It is just an
overwhelming burden that the SEC has had to manage, the
industry has had to manage.
I think today, if we can somehow take a breath, step back,
look overall at this disclosure regime and work with the SEC,
work with the Commission staff to find a way to make a more
manageable set of information that we provide to investors,
that would serve investors well, it would serve the industry
well.
Really, it is a win-win-win. It is a win for the SEC, it is
a win for the industry, it is a win for investors.
So it is not a specific answer, but it goes to this whole
aura of disclosure. We all know that we need to have
disclosure, we all know that disclosure is good, but if we do
not make it workable and manageable, as an industry, we suffer.
I think the Commission suffers. I know the investor suffers.
Chairman Baker. Well, I think to a great extent the
Congress has played a role in encouraging the SEC's actions,
with the awareness of the business practices that were
discussed over 2 years ago; and certainly the Agency has been
trying to catch up in a regulatory sense to the world as it has
passed them by. Principally, the mutual fund industry was, I
think, one of the last places anyone was going to look for any
misconduct; their reputations had been so good for so long.
There were a lot of other arenas that were getting the
headlines until the unfortunate news broke, perhaps to explain
the Agency's intense actions.
But I leave the door open for any specific things that you
might want to bring to our attention.
Mr. Barbash, you talk a little bit about the
appropriateness of the disclosure regime today, and suggest
that a more prospective reporting--perhaps I should use the
word ``forward-looking'' statement--might more appropriate and
helpful to investors. I have used the example on the public
operating company side; the current paper-based, rules-based
reporting system gives you information that it is at least 90
days old, maybe over that, and tells you where the company was
and not where they are going.
You seem to be indicating there might be value in not
requiring that, but perhaps having more focus on what the
investment strategy is, going forward. Was I understanding you
properly in your written testimony?
Mr. Barbash. Well, I call for--what I call for would be a
document that gets to the basic points. It is shorter, goes to
the point about what are the key investment objectives and
policies of an investment company, and then would take
advantage of the Internet to provide additional information to
others who would want more information.
So a shorter document would be the fundamental prospectus,
and then it would be supplemented by other material that would
be electronically available, so that interested parties would
have mutual fund prospectuses and other information available;
there would be access to a range of other information that
would be on file with the SEC.
Chairman Baker. There is a parallel reason for asking the
question.
In the financial institution world, within the FDIC, there
is a software capability that operates behind the screen, the
user doesn't know is there, Extensible Business Reporting
Language, XBRL in the trade, and you enter your data, and then
on the other side of the screen, whether it is a regulator, a
competitor, a shareholder, or an analyst, they can get access
to their data in real-time, in the format to which they are
entitled.
One of the things that seems to be difficult in this
industry is comparability and having the average investor sit
down with three different mutual fund annual reports and figure
out who really did better. There has got to be a way, using
technology, to provide for that kind of comparability, not only
peer to peer, but peer to sector, however you want to compare
it.
I think that is what the typical investor--all he wants to
know is, I am putting up $10,000; what happened to it, and how
can I find out whether I can do better elsewhere?
Is there a technology comparable to XBRL in the mutual fund
world?
Mr. Barbash. I can't really speak to technology, because I
am technologically challenged. If I said otherwise, you would
hear from all kind of constituencies complaining about what I
said.
But when we were looking at the prospectus back in the
1990s, one of our goals was greater comparability. We recognize
what you recognize, which is that investors do want comparable
information.
The biggest change, frankly in the last 6 years, is
technological. There is so much more information that is
available that can be used. And I would hope, as the SEC goes
forward, it looks hard at technology and sees what is available
and what can be done.
I think there is a very technologically savvy industry, the
industry can also provide insight on that.
Mr. Stevens. Mr. Chairman, I think it is a very key
question. It seems to me the Internet is the way out of a real
dilemma that the Commission has had for a long time. If you
think historically, how we got where we are, there is, over
time, more and more disclosure, which has quite appropriately
been expected of mutual funds. It grew so large at one point we
cut the prospectus in two, we created what we know as the
prospectus, then there was the SAI.
It continued to grow, and we put a summary in the first
part of that, the prospectus, and now it is continuing to grow
further, and with it increasing frustration. I think the
industry and the SEC and commentators, and members of this
subcommittee obviously, believe that we are wandering very far
from what is a useful disclosure format for most investors.
The Internet will allow, I think, for precisely what you
described at the beginning of this hearing, will allow the SEC
to focus on quality information that is concise, that is
delivered to an investor, but also provide for the marketplace
generally, for analysts, for commentators, for investment
advisors, and for the do-it-yourself investor, a quantum of
information on the Internet which can be maintained, which is
current, and as I understand the technologies, is subject to a
kind of search engine so that you can go to five different Web
sites and pull down exactly the same information about five
different families of funds.
Now, I would tell you that if you look at mutual fund
investors, it is going to be the exception rather than the rule
that people are going to want to have that. Most are going to
want to have that clear and concise document.
Indeed, 80 percent of funds are purchased with the help of
financial advisors. And it is their role to do most of that
sifting and finding out. It is the exception, not the rule,
where someone wants to look at three different prospectuses and
make the choice for themselves.
Chairman Baker. It is really innoculatory. It is for when
things go bad. As long as the industry is returning 15 percent
ROE, nobody is going to ask any questions. But it is when your
fund, or the industry generally, has a downturn that everybody
starts calling lawyers and finding out, well, why did you not
tell me this?
Maybe the answer is to have access to a point, a data
point, where you can go find out anything you want, but the
two-pager, as I requested, already up to four pages as a result
of our testimony this morning, it tells you this is not a
complete recitation of your rights and responsibilities, go to
SEC.gov, or whatever it is, and there we will give you all that
you want. So that you are not telling everybody, you have been
fully informed, you have been given only the meaningful and
minimal in order to get you in the game, if you want to go this
route.
Mr. Stevens. I believe that the key issue that will be
before the SEC is, when we have reached the point of Internet
familiarity and facility across a broad investor population,
that the rule can switch, that is to say, that for an
individual, the presumption will be, they can access that
information over the Web, it would be delivered and available
to them that way. But if they want to opt out, if they want to
get the paper information, if they want to have it delivered in
some other fashion, they can so indicate and the system can
work for them.
That sort of reverses what is currently the presumption,
that everyone wants the paper and that minimizes utilization of
the Internet. So I think that is a very important issue.
And, of course, it has cost-benefit implications of
significant degree not only in terms of our ecosystem--think of
all of the trees me might spare--but also the effort that goes
into producing disclosure documents which must be, to the
industry's regret and the SEC's, I think, never opened in too
many cases and never read.
Chairman Baker. You raised one area I wanted to ask you
about; that is the cost-benefit thing again. I am hesitant to
say that it is the only measure by which a rule's effectiveness
should be judged, but I think it is a component which should
not be ignored. And going forward, as the rules are developed,
should there be impacts that the Congress should be made aware
of in our new communicative role here?
In the post-Sarbanes-Oxley world, the committee feels
responsibility to oversee and assess the effectiveness of the
rules environment in which the market now functions, so if
there are specific things or actions which have been taken
which do not yield appropriate public benefit, we are reliant
on those stakeholders and the industry to bring those to our
attention--and, of course, with public explanation as to why
these rules should be reevaluated.
I certainly respect the work the SEC has done over a very
difficult 2-year period. But it is not likely that everything
that has been done is necessarily in the consumer's best
interest. And to again state the obvious, that higher
regulatory costs comes off the investor's return; it does not
magically appear from the industry. You have the right and
ability to pass it on to your investor community, and you do.
So we have to look at this from sufficient information for
a reasonable man to make a sound judgment, but at the same
time, not taking $5 of his $10 investment to put it in
regulatory costs. Therein is the problem.
I hope you will take advantage of that opportunity to
communicate with the committee as we go forward, because this
is going to be an ongoing and difficult road, I am sure.
Mr. Stevens. May I respond?
As I look at cost-benefit analysis, you want to look at the
benefits, too. I agree with Mr. Eisenberg. Some very simple
things can have enormous benefits. They might even have very
substantial costs, but the benefits could clearly outweigh
them. It is the balancing of both of those.
Some of them can be quantitative and tangible, some of them
are going to be intangible, if you will, and are subject to
more normative judgments. What I think is important, though, is
that the Commission at least try its best to look at what the
quantitative implications are. And I would say, in that regard,
that that is an area where it is going to need assistance.
I think commenters on rules, like the Investment Company
Institute, have an obligation to come forward with that kind of
analysis. To the extent we have not in particular cases, it
seems to me that that is a defect that we need to remedy in our
own input to our regulator.
Indeed, it is now a priority for our research department.
We have hired a new senior economist at the ICI that is going
to be doing, as a priority, cost-benefit analysis of
rulemaking.
But I think, to be candid on the other side as well, if you
look at the way that they have calculated costs in specific
instances--and the redemption fee rule is a terrific example--
the analysis is simply inadequate by any measure. And when that
is the case, I wonder if the Commission really has had
sufficient information to consider, from a public policy
perspective, is this the best way to go or might there be
better alternatives for us to consider?
Now, the issue of requiring funds to enter into contracts
with every one of their intermediaries as a way of resolving
the problem of market timing and imposing redemption fees was
not one that had been proposed in an earlier rule; they simply
asked questions, Gee, is that a good approach? And we at the
Institute had told them, No, it is not a good approach, it is
not promising, but it is the one that they have finally arrived
at in the rule that they have adopted.
We are working to communicate our views to the Commission
in that regard. I offer it simply as an example of where the
analysis of the costs and benefits in relative terms can fall
down in a substantial way.
Chairman Baker. I appreciate that.
Mr. Miller. Chairman Baker, I also--I am going to step back
again and--I think we should respond to your specific request.
But I think it is also, again, important to step back and look
at the entire regime, the entire regulatory landscape.
When I hear about cost-benefit analysis, when I think what
that means to the industry, I think in terms of everything that
has been enacted, all of the rules that been proposed that have
gone into effect, everything that the fund companies have to do
today to comply with those rules. Some of those rules are good,
but again I think that taken in the context of the overall
picture, taken in the context of what is the cost of all of
those things, it is people.
I mean, there are more lawyers, there are more compliance
people working today, that is clear. It is technology; I
suggest, probably millions of dollars are being spent at
Vanguard today on technology that in some ways is there in
response to new rules that have been enacted, the PATRIOT Act,
things that happened before the scandals of a couple of years
ago.
So all of those things in context. It is postage, it is
paper, it is more and more communications to the fund
shareholders. And, again, my hope would be that if we could
step back, if we could work jointly with the Commission, the
industry and the Commission hand in hand, have that dialogue,
step back--maybe it is a blue ribbon panel; I do not know what
it is precisely--but a way that we can look at these issues
together, so that at the end of the day, hopefully, we have a
more orchestrated regime from a compliance standpoint across
the industry. Perhaps a few less rules, but no less in the way
of the governance of the industry and investors, no less
protection for investors. Then, I think, at the end of the day,
again we have that win-win-win for the Commission, for the
industry, for the investor.
Chairman Baker. Well, it is a certainty that we have
entered into a new economic arena in most financial service
sectors, clearly in the mutual fund industry, and we cannot go
back. We now have an overwhelming number of congressional
constituents who are direct investors in your industry. That
brings about a clear political accountability. So,
unfortunately for the industry, the Congress is certainly not
going to go away.
On the flip side of that, with renewed assurances that the
regulatory structure is adequate--and I suspect your view is,
it is more than adequate today--that a confidence comes back to
consumers to again place their money in your hands. That is a
good thing. It is a good thing not only for the investor, but
for the economy generally. And the balancing act going forward
will be to ensure that the regulatory inhibitions do not
forestall someone making a good investment decision or, worse
yet, takes part of their investment dollar and needlessly
spends it on regulatory compliance when they are not reading
the documents in the first place.
So it will continue to be a balancing act for us. And I
hope that communication you talked about with the SEC from each
of your perspectives will also be sent in our direction so we
can do a better job of public policy analysis going forward,
because this is an important part of our economic performance.
It is a key, pivotal part of our growth going forward, and it
is too important to idle off into a bureaucratic morass.
So for those reasons alone, I am sure other members of the
committee will join in supporting whatever steps might be taken
from a Commission or from an industry perspective to ensure we
reach the right balance.
I just want to express my appreciation to each of you for
your participation. Your remarks will be an important part of
our work going forward. I am certain, as members indicated to
me that they had other obligations, there will be written
questions from other members coming to your desk in the next
few days.
Chairman Baker. Thank you for your courtesies, and our
meeting stands adjourned.
[Whereupon, at 4:00 p.m., the subcommittee was adjourned.]
A P P E N D I X
May 10, 2005
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