[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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                 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

                              ----------                              
                                                                   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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