Mutual Funds: Assessment of Regulatory Reforms to Improve the
Management and Sale of Mutual Funds (10-MAR-04, GAO-04-533T).
Since September 2003, widespread allegations of abusive practices
involving mutual funds have come to light. An abuse called late
trading allowed some investors, at times in collusion with
pension plan intermediary, broker-dealer, or fund adviser staff,
to profit at other investors' expense by submitting orders for
fund shares to receive that day's price after the legal cutoff.
Other investors were allowed to conduct market timing trades to
take advantage of stale prices used by funds to calculate their
net asset values at funds with stated policies against such
trading. SEC and other regulators have responded with numerous
proposals for new or revised practices. Based on a body of work
that GAO has conducted involving mutual funds, GAO analyzed and
provides views on proposed and final rules involving (1) fund
pricing and compliance practices intended to address various
mutual fund trading abuses that have come to light recently, (2)
fund boards' independence and effectiveness, (3) fund adviser
compensation of broker-dealers that sell fund shares, and (4)
additional actions regulators could take to further improve
transparency and investor understanding of the fees they pay.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-04-533T
ACCNO: A09465
TITLE: Mutual Funds: Assessment of Regulatory Reforms to Improve
the Management and Sale of Mutual Funds
DATE: 03/10/2004
SUBJECT: Brokerage industry
Fees
Financial disclosure
Information disclosure
Investments
Mutual funds
Securities regulation
Stocks (securities)
Abusive practices
******************************************************************
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GAO-04-533T
United States General Accounting Office
GAO Testimony
Before the Committee on Banking, Housing and Urban Affairs, U.S. Senate
For Release on Delivery
Expected at 10:00 a.m. EST
Wednesday, March 10, 2004 MUTUAL FUNDS
Assessment of Regulatory Reforms to Improve the Management and Sale of Mutual
Funds
Statement of David M. Walker Comptroller General of the United States
GAO-04-533T
Highlights of GAO-04-533T, a report to Chairman, Senate Committee on
Banking, Housing and Urban Affairs
Since September 2003, widespread allegations of abusive practices
involving mutual funds have come to light. An abuse called late trading
allowed some investors, at times in collusion with pension plan
intermediary, broker-dealer, or fund adviser staff, to profit at other
investors' expense by submitting orders for fund shares to receive that
day's price after the legal cutoff. Other investors were allowed to
conduct market timing trades to take advantage of stale prices used by
funds to calculate their net asset values at funds with stated policies
against such trading. SEC and other regulators have responded with
numerous proposals for new or revised practices. Based on a body of work
that GAO has conducted involving mutual funds, GAO analyzed and provides
views on proposed and final rules involving (1) fund pricing and
compliance practices intended to address various mutual fund trading
abuses that have come to light recently, (2) fund boards' independence and
effectiveness, (3) fund adviser compensation of broker-dealers that sell
fund shares, and (4) additional actions regulators could take to further
improve transparency and investor understanding of the fees they pay.
In this statement, GAO raises a number of issues for regulators to
consider that could enhance the effectiveness of proposed rule changes.
www.gao.gov/cgi-bin/getrpt?GAO-04-533T.
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Richard J. Hillman (202)
512-8678 or [email protected].
March 10, 2004
MUTUAL FUNDS
Assessment of Regulatory Reforms to Improve the Management and Sale of Mutual
Funds
GAO commends SEC and other regulators for their swift regulatory response
to recently revealed abusive mutual fund practices. However, some proposed
actions need to be thoroughly assessed to ensure equitable treatment for
all investors and others will need to be reinforced with enhanced
compliance, enforcement, and investor education programs to be truly
effective. In particular, to prevent further late trading, SEC has
proposed that all mutual fund orders be received by funds or designated
processors by 4:00 p.m. Eastern Time, but this action may unfairly impact
some retail investors that place orders through financial intermediaries.
Although GAO supports in the short run the proposed hard 4:00 p.m. close
as a way of increasing the certainty that all orders have been
legitimately received, GAO believes that SEC should continue to work with
industry participants, including pension plan intermediaries, to address
concerns that the hard close would adversely affect investors that use
such intermediaries. To address market timing, SEC is proposing that funds
make greater disclosure of market timing, securities pricing, and
portfolio disclosure policies. GAO supports these steps and encourages
regulators to educate investors about the importance of such disclosures.
To improve mutual fund corporate governance and oversight, SEC has also
proposed increasing the proportion of independent directors to 75 percent
and to require independent chairs. SEC is also proposing that fund
advisers appoint compliance officers that report to fund boards. GAO sees
these actions as giving increased prominence to independent members on
fund boards of directors and providing them with additional tools to
effectively oversee fund practices. However, additional actions may be
needed to ensure that independent directors have no relationships with the
fund adviser or its personnel that could impair their independence. SEC
and other regulators have also proposed that the broker-dealers that sell
fund shares make more extensive disclosures about payments they receive
from fund advisers. SEC is also seeking comments on how to revise the fees
they charge investors that also compensate broker-dealers for selling fund
shares. GAO supports these actions as increasing the transparency of these
costs to investors but recognizes that the effectiveness of these
proposals could be enhanced by expanded compliance and investor education
programs.
SEC is also seeking information on how fund advisers use investor dollars
to obtain research under a practice called soft dollars. Given the
increased spotlight that Congress and regulators are placing on the mutual
fund industry, GAO believes the time is right to more effectively address
the conflicts of interest created by soft-dollar arrangements. In
addition, GAO identifies further actions that could be taken to improve
disclosure of mutual fund fees to enhance competition among funds on the
basis of the fees that are charged to shareholders.
Mr. Chairman and Members of the Committee:
I am pleased to be here today to discuss GAO's work assessing the
transparency of mutual fund fees and other fund practices and to discuss
the various proposed or anticipated regulatory reforms designed to improve
the management and sale of mutual funds. In the last 20 years, mutual
funds have grown from under $400 billion to over $7.5 trillion in assets
and have become a vital component of the financial security of the more
than 95 million American investors estimated to own mutual funds. These
funds have also grown to represent a significant portion of American's
retirement wealth with 21 percent of the more than $10 trillion in pension
plan assets now invested in mutual funds.1 As a result, ensuring that
mutual funds have sound governance and trading practices has never been
more important. Recent actions by the Securities and Exchange Commission
(SEC) and NASD would establish new procedures to protect shareholders
against recently disclosed abusive trading practices, revise the structure
and duties of the boards of directors that oversee funds, and place new
responsibilities on the mutual fund and brokerage industries.2
Based on the work that we have performed over the last year, I will
discuss problems we have seen within the mutual fund and brokerage
industries and provide our views on the various SEC and NASD-proposed
regulatory reforms.3 Specifically, I will discuss proposed and final rules
involving (1) fund pricing and compliance practices intended to address
various mutual fund trading abuses that have come to light recently, (2)
fund boards' independence and effectiveness, and (3) fund advisers
compensation of broker-dealers that sell fund shares. In addition I will
discuss additional actions regulators could take to further improve
transparency and investor understanding of the fees they pay.
1These statistics were reported by the Investment Company Institute and
the Federal Reserve Board.
2NASD oversees broker-dealers that sell mutual funds and other securities
to their customers.
3See U.S. General Accounting Office, Mutual Funds: Information on Trends
in Fees and Their Related Disclosure, GAO-03-551T (Washington, D.C.: Mar.
12, 2003); Mutual Funds: Greater Transparency Needed in Disclosures to
Investors, GAO-03-763 (Washington, D.C.: June 9, 2003); Mutual Funds:
Additional Disclosures Could Increase Transparency of Fees and Other
Practices, GAO-03-909T (Washington, D.C.: June 18, 2003); and Mutual
Funds: Additional Disclosures Could Increase Transparency of Fees and
Other Practices, GAO-04-317T (Washington, D.C.: Jan. 27, 2004).
In summary, we commend SEC and other regulators for their swift regulatory
response to recent revelations of abusive mutual fund trading practices.
We believe that many of the actions taken will provide the proper
incentives to industry participants to follow sound practices and also
provide regulators with additional compliance and enforcement tools to
ensure that participants are held accountable for their behavior. However,
some proposed actions need to be thoroughly assessed to ensure equitable
treatment for all investors. In particular, while we agree that SEC's
proposal to address late trading abuses with a hard 4:00 p.m. close
provides increased certainty of the legitimacy of orders, we also
recognize that there are wide-ranging and divergent interests in today's
marketplace that must be accommodated to ensure that all retail and
institutional investors are treated fairly. As such, while we agree with
SEC's proposal for addressing unlawful late trading in the short run, we
believe that SEC should continue to work with the retirement plan
community and cognizant federal agencies to address concerns that this
proposed rule may have certain adverse implications for certain
participants in retirement savings plans.
We also firmly agree with SEC's proposals to enhance the independence and
effectiveness of mutual fund boards. Giving increased prominence to
independent members on fund boards of directors and providing them with
additional tools to effectively oversee fund practices should go a long
way to improve the system of checks and balances needed to avoid future
trading abuses. However, additional attention could be afforded to
ensuring the adequacy of the definition of an "interested person" to
ensure that directors designated as independent directors are truly
independent. We also recognize that other proposals for improving
disclosures of mutual fund and brokerage trading practices will need to be
reinforced with enhanced compliance, enforcement, and investor education
programs if they are to be truly effective.
There are also other areas that warrant SEC's continued attention. SEC is
seeking information on how mutual fund investors pay for advice from
broker-dealers and how fund advisers use investor's dollars to obtain
research. However, given the increased spotlight Congress and regulators
are placing on the mutual fund industry, in our view, the time is right to
address various conflicts of interest created by soft-dollar arrangements.
In addition, further actions could be taken to improve disclosure of
mutual fund fees to enhance competition among funds on the basis of the
fees that are charged to shareholders.
In addition to the work I am discussing today, we are currently studying
other issues related to the security of workers' retirement benefits.
Pensions and retirement savings plans are an important source of income
for millions of retirees. As such, we are reviewing how retirement savings
plans, such as 401(k) plans, have been affected by the mutual fund late
trading and market timing scandals, and how SEC's proposed rules to
address these practices might affect plan participants and plan
administration. On the broader issue of corporate governance, we also are
currently studying what actions pension plan fiduciaries take to address
conflicts of interest in connection with proxy voting issues. As large
institutional shareholders, pension plans have the opportunity to
influence governance of funds and hold company managers accountable for
the business decisions they make.
In reaction to allegations of widespread misconduct and abusive practices
involving mutual funds, regulators have responded with various proposals.
In early September 2003, the Attorney General of the State of New York
filed charges against a hedge fund manager for arranging with several
mutual fund companies to improperly trade in fund shares and profit at the
expense of other fund shareholders.4 Since then, widening federal and
state investigations of illegal late trading and improper timing of fund
trades have involved a growing number of prominent mutual fund companies
and brokerage firms.
Regulators Are Taking Actions to Address Abusive Mutual Fund Practices
Late Trading and Market Timing Are Detrimental to Fund Long-Term
Shareholders
One of the abuses that has come to light recently is late trading. Under
current rules, funds accept orders to sell and redeem fund shares at a
price based on the current net asset value, which most funds calculate
once a day at 4:00 p.m. Eastern Time.5 Many investors, however, purchase
mutual fund shares through other intermediaries such as broker-dealers,
banks, and retirement savings plans. Instead of submitting hundreds or
even thousands of individual purchase and redemption orders each day,
these
4The term "hedge fund" generally identifies an entity that holds a pool of
securities and perhaps other assets that does not register its securities
offerings under the Securities Act and which is not registered as an
investment company under the Investment Company Act of 1940. Hedge funds
are also characterized by their fee structure, which compensates the
adviser based upon a percentage of the hedge fund's capital gains and
capital appreciation.
5SEC rule 22c-1, promulgated under the Investment Company Act of 1940,
prohibits the purchase or sale of mutual fund shares except at a price
based on current net asset value of such shares that is next calculated
after receipt of a buy or sell order.
intermediaries typically aggregate orders received from investors and
submit a single purchase or redemption order that nets all the individual
shares their customers are seeking to buy or sell. Because this processing
takes time, SEC rules permit these intermediaries to forward the order
information to funds after 4:00 p.m.
However, late trading occurs when some investors are able to illegally
purchase or sell mutual fund shares after the 4:00 p.m. Eastern Time close
of U.S. securities markets, the time at which funds typically price their
shares. An investor permitted to engage in late trading could be buying or
selling shares at the current day's 4:00 p.m. price with knowledge of
developments in the financial markets that occurred after 4:00 p.m. Such
investors thus have unfair access to opportunities for profit that are not
provided to other fund shareholders.
The extent to which some investors were allowed to submit late trading
orders may have been significant. In September 2003, SEC sought
information from fund advisers and broker-dealers about their pricing of
mutual fund orders and late trading policies. SEC's preliminary analysis
of this information showed that more than 25 percent of the 34 major
brokerdealers that responded had customers that still received that day's
price for orders they had placed or confirmed after 4:00 p.m. As of March
1, 2004, SEC had formally announced seven enforcement cases involving
broker-dealers and other firms that were allegedly involved in late
trading schemes; other cases may be forthcoming. We will be initiating a
review of the adequacy of SEC's enforcement efforts and the sanctions that
it can and has applied in these cases and will be reporting separately on
these issues later this year. In addition, legislation is under
consideration in the House of Representatives that will expand SEC's
enforcement capabilities by raising the civil penalties for securities law
violations, enhance the investigative procedures available to SEC, and
streamline the process by which fines are disbursed among injured
parties.6
Another abuse that has come to light is known as market timing. Market
timing occurs when certain fund investors place orders to take advantage
of temporary disparities between the share value of a fund and the values
of the underlying assets in the fund's portfolio. For example, U.S. mutual
funds that use the last traded price for foreign securities (whose markets
close hours before the U.S. markets) to value their portfolio when the
U.S.
6See H.R. 2179, Securities Fraud Deterrence and Investor Restitution Act
of 2003.
markets close could create opportunities for market timing if events that
subsequently occurred were likely to cause significant movements in the
prices of those foreign securities when their home markets reopen.
Market timing, although not currently illegal, can be unfair to long-term
fund investors because it provides the opportunity for selected fund
investors to profit from fund assets at the expense of long-term
investors. The following example illustrates how market timing
transactions can reduce the return to long-term shareholders of a fund.
Figure 1: Impact on Fund Net Asset Value (NAV) With and Without an
Investment By a Market Timer
Source: GAO.
Note: The figure shows how a hypothetical mutual fund is affected by an
increase in its portfolio assets with and without a market timer
transaction. In this example, a market timer invests $1,000 in the fund on
day 1 before a 10 percent rise in the value of the securities held by the
fund. On day 2 the market timer redeems the shares yielding a reduction in
the fund's net asset value compared to its value without a market timer
transaction. The example assumes that the portfolio manager is unable to
invest the market timer's cash and thus that amount does not help increase
the fund's gain when the market rises.
As shown in the figure, the loss to long-term holders of the fund in this
case is only $.01 per share. Although the amount by which a single market
timing transaction reduces a fund's overall return can be small, repeated
and large transactions over long periods of time can have a greater
cumulative effect. For example, one fund company whose staff were
accommodating market timing transactions by 10 different investors
estimated that these investors earned $22.8 million through their trading
and that these activities costs its funds $2.7 million over a period of
several years. In addition, the redemption fees that these investors
should have paid but did not, amounted to another $5 million.
Market timing may also have been widespread. According to testimony by
SEC's Director of Enforcement, although most mutual funds have policies
that discourage market timing, this strategy was popular among some
individuals and institutional traders who attempted to conceal their
identities from fund companies. He also stated that 30 percent of the
broker-dealers responding to an SEC information request reported assisting
customers in attempting to conduct market timing trades, by using methods,
such as breaking their orders into smaller sizes to avoid detection by the
fund companies. Of the twelve cases SEC formally opened that involved
market timing activities, including five cases that also involved late
trading, two have been settled. In the settlement for one case that
involved both late trading and market timing, SEC ordered the firm to pay
fines and disgorgements of $225 million. In the other case, SEC ordered
the firm to pay $250 million in fines and disgorgements. NASD also has
taken various enforcement cases against broker-dealers involving late
trading and market timing, including one in which a broker-dealer was
fined $1 million and ordered to provide restitution of more than $500,000
for failing to prevent market timing of an affiliated firm's mutual funds.
Additional abusive practices associated with mutual funds have also come
to light. To facilitate late trading and market timing arrangements, some
fund advisers selectively disclosed information about their funds'
portfolio holdings to outsiders. They also allowed these parties to late
trade or conduct market timing in their funds. For example, in one SEC
case a fund manager allowed a hedge fund to engage in market timing in a
fund that he managed. The fund manager also disclosed portfolio
information to a broker that enabled brokerage customers to conduct market
timing transactions in the funds. In another state-administered case, a
hedge fund executive obtained special trading privileges from several
mutual fund companies that allowed him to engage in late trading and
market timing in those funds.
Rule Changes Could Prevent Late Trading and Discourage Market Timing, but
Some Investors Might Be Disadvantaged
In addition to enforcement actions, SEC has also proposed amending
regulatory rules to address late trading, market timing, and selective
disclosure abuses. In December 2003, SEC proposed amending the rule that
governs how mutual funds price their shares and receive orders for share
purchases or sales. 7 Since many of the cases of late trading involved
orders submitted through intermediaries, including banks and pension plans
not regulated by SEC, the proposed amendments to its rules would require
that orders to purchase or redeem mutual fund shares be received by a
fund, its transfer agent, or a registered clearing agency before the time
of pricing (that is, 4:00 p.m. Eastern Time).8
Many organizations that purchase mutual fund shares, particularly those
that administer retirement savings plans, have expressed concerns that
such a "hard close" would unfairly prohibit some of their participants
from receiving the same day's price on share purchases. Because
intermediaries generally combine individual investor orders and submit
single orders to funds to buy or sell, many officials at such firms are
concerned that the time required to complete this processing will not
allow them to meet the 4:00 p.m. deadline. In such cases, investors
purchasing shares from Western states or through intermediaries would
either have to submit their trades earlier than other investors in order
to receive the current day's price or receive the next day's price. A
letter commenting on SEC's proposal from two investor advocacy groups
indicated that implementing the hard close would relegate some retail
investors to the status of "second-class shareholders." Some plan sponsor
organizations and plan record keepers have also raised concerns about the
potential significant administrative costs associated with adopting
systems to accommodate the 4:00 p.m. hard close and other proposed rules.
Because the hard close could affect some investors' ability to trade at
the current day's price, some groups have called on SEC to allow industry
participants to develop systems of internal controls that would serve to
ensure that intermediaries receive individual orders before 4:00 p.m. With
such controls in place, these orders could continue to be processed after
7Securities and Exchange Commission, Proposed Rule: Amendments to Rules
Governing Pricing of Mutual Fund Shares, Release No. IC-26288 (Dec. 11,
2003).
8A fund's transfer agent maintains records of fund owners. Currently, the
National Securities Clearing Corporation, which is the clearing
organization for securities trades in the United States, also operates a
system used by broker-dealers and others to transmit mutual fund orders to
fund companies.
this time. However, SEC officials told us that they were skeptical that
any system that relies on internal controls could not provide certainty
that late trading was not occurring because many of the late trading
abuses happened at firms that purportedly had such controls in place.
However, SEC remains open to the possibility of the development of systems
that could reasonably detect and deter late trading. In its proposals, SEC
requests comments on various approaches designed to prevent late trading.
Such protections could include a system that provides an electronic or
physical time-stamp on orders. Other possible controls could include
certifications that the intermediary had policies and procedures in place
designed to prevent late trades, or audits by independent public
accountants. Because multiple regulators oversee the operations of these
financial intermediaries, any assessment of the reasonableness of
recommended systems or controls would likely require effective
coordination.
SEC is also proposing to take actions to address market timing. On
December 11, 2003, SEC released a rule proposal to provide greater
transparency to funds' market timing policies. Specifically, SEC would
require mutual funds to disclose in their prospectuses the risks to
shareholders of the frequent purchase and redemption of investment company
shares, and fund policies and procedures pertaining to frequent purchases
and redemptions. The proposal also would require funds to explain both the
circumstances under which they would use fair value pricing and the
effects of using fair value pricing.9 Another rule will require funds to
adopt fair value pricing policies that require funds among other things,
to monitor for circumstances that may necessitate the use of fair value
pricing, establish criteria for determining when market quotations are no
longer reliable for a particular portfolio security, and provide a
methodology or methodologies by which the funds determine the current fair
value of portfolio securities. Also, SEC is seeking comment in one of its
proposals for additional ways to improve the implementation of fair value
pricing. In addition, the proposal would require funds to disclose
policies and procedures pertaining to their disclosing information on the
funds' portfolio holdings, and any ongoing arrangements to make available
information about their portfolio securities. These additional disclosures
would enable investors to better assess risks, policies, and procedures,
9Fair value pricing is a process that mutual funds use to value fund
shares (such as for assets traded in foreign markets) in the absence of
current market values. The Investment Company Act of 1940 requires that
when market quotations for a portfolio security are not readily available,
a fund must calculate its fair value.
and determine if a fund's policies and procedures were in line with their
expectations. Disclosure of a fund's procedures in these areas would also
allow SEC to better examine a fund's compliance with its stated procedures
and hold fund managers accountable for their actions.
To further stem market timing, on March 3, 2004, SEC issued a proposed new
rule to require mutual funds to impose a 2-percent redemption fee on the
proceeds of shares redeemed within 5 business days of purchase. According
to the proposal, the proceeds from the redemption fees would be retained
by the fund, becoming a part of fund assets. In addition, the proposal
addresses the pass thru of information from omnibus accounts maintained by
intermediaries. Specifically, the proposal identifies three alternatives
for funds to ensure that redemption fees are imposed on the appropriate
market timers through the use of Taxpayer Identification Numbers. On at
least a weekly basis intermediaries would be required to provide to the
fund, purchase and redemption information for each shareholder within an
omnibus account to enable the fund to detect market timers and properly
assess redemption fees. The rule is designed to require short-term
shareholders to reimburse funds for costs incurred as a result of
investors using short-term trading strategies, such as market timing. The
proposal would also include an emergency exception that would allow an
investor not to pay a redemption fee in the event of an unanticipated
financial emergency.
Unlawful late trading and certain market timing activities, which are not
currently illegal, can be unfair to long-term investors because these
activities provide the opportunity for selected fund investors to profit
from fund assets at the expense of fund long-term investors. SEC's
proposal to address late trading with a hard 4:00 p.m. close appears, in
the short-term, to be the solution that provides the most certainty that
all orders being submitted to the funds legitimately deserve that day's
price. However, we also recognize that this action could have a
significant impact on many investors, particularly those in employer-based
retirement savings plans, who own fund shares through financial
intermediaries. As a result, we urge the Commission to, as a supplement to
their planned action, explore alternatives to the hard 4:00 p.m. close
more fully and to revisit formally the question of how best to prevent
late trading. Since some of the financial intermediaries involved are
either overseen by other regulators or, in the case of third-party pension
plan administrators, not overseen by any regulator, any such assessment
should include the development of a strategy for overseeing the
intermediary processing of mutual fund trades. Having a sound strategy for
oversight of the varied participants in the
mutual fund industry would ensure that all relevant entities are held
equally accountable for compliance with all appropriate laws.
We also commend SEC for proposing to require that mutual funds more fully
disclose their market timing and portfolio disclosure policies. By
increasing the transparency of these policies, industry participants will
have the incentive to ensure that their policies are sound and will
provide investors with information that they can use to distinguish
between funds on the basis of these policies. The disclosures will also
provide regulators and others with information to hold these firms
accountable for their actions. However, such disclosures would likely also
require improving related investor education programs to better ensure
that investors understand the importance of these new disclosures. We also
support SEC's redemption fee proposal as a means of discouraging market
timing. Placing the proceeds of the fee back in the fund itself helps to
ensure that the actions of short-term traders do not financially harm
long-term investors, including pension plan participants who hold such
funds.
Mutual fund boards of directors have a responsibility to protect
shareholder interests and SEC has issued various proposals to increase the
effectiveness of these bodies. In particular, independent directors, who
are not affiliated with the investment adviser, play a critical role in
protecting mutual fund investors. To improve the independence of fund
boards, SEC has issued various proposals to alter the structure of these
boards and task them with additional duties.
Regulators Are Taking Actions to Improve the Effectiveness of Mutual Fund
Boards of Directors
Directors Have a Role in Overseeing Fees
Because the organizational structure of a mutual fund can create conflicts
of interest between the fund's investment adviser and its shareholders,
the law governing U.S. mutual funds requires funds to have a board of
directors to protect the interests of the fund's shareholders. A fund is
usually organized by an investment management company or adviser, which is
responsible for providing portfolio management, administrative,
distribution, and other operational services. In addition, the fund's
officers are usually provided, employed, and compensated by the investment
adviser. The adviser charges a management fee, which is paid with fund
assets, to cover the costs of these services. With the management fee
representing its revenue from the fund, the adviser's desire to maximize
its revenues could conflict with shareholder goals of reducing fees. As
one safeguard against this potential conflict, the Investment Company Act
of 1940 (the Investment Company Act) requires mutual funds to have boards
of directors to oversee shareholder interests. These boards must also
include independent directors who are not employed by or affiliated with
the investment adviser.
As a group, the directors of a mutual fund have various responsibilities
and in some cases, the independent directors have additional duties. In
particular, the independent directors also have specific duties to approve
the investment advisory contract between the fund and the investment
adviser and the fees that will be charged. Specifically, section 15 of the
Investment Company Act requires that the terms of any advisory contracts
and renewals of advisory contracts be approved by a vote of the majority
of the independent directors.
Under section 36(b) of the Investment Company Act, investment advisers
have a fiduciary duty to the fund with respect to the fees they receive,
which under state common law typically means that the adviser must act
with the same degree of care and skill that a reasonably prudent person
would use in connection with his or her own affairs. Section 36(b) also
authorizes actions by shareholders and SEC against an adviser for breach
of this duty. Courts have developed a framework for determining whether an
adviser has breached its duty under section 36(b), and directors typically
use this framework in evaluating advisory fees. This framework finds its
origin in a Second Circuit Court of Appeals decision, in which the court
set forth the factors relevant to determining whether an adviser's fee is
excessive.10 The court in this case stated that to be guilty of a breach
under section 36 (b), the fee must be "so disproportionately large that it
bears no reasonable relationship to the services rendered and could not
have been the product of arms-length bargaining." The standards developed
in this case, and in cases that followed, served to establish current
expectations for fund directors with respect to fees. In addition to
potentially considering how a fund's fee compared to those of other funds,
this court indicated that directors might find other factors more
important, including
o the nature and quality of the adviser's services,
o the adviser's costs to provide those services,
10Gartenberg v. Merrill Lynch Asset Management Inc., 528 F. Supp. 1038
(S.D.N.Y. 1981), aff'd, 694 F. 2d 923 (2d Cir. 1982), cert. denied, 461
U.S. 906(1983).
o the extent to which the adviser realizes and shares with the fund
economies of scale as the fund grows,
o the volume of orders that the manager must process,
o indirect benefits to the adviser as the result of operating the fund,
and
o the independence and conscientiousness of the directors.
Concerns Over Directors' Roles Exist
Some industry experts have criticized independent directors for not
exercising their authority to reduce fees. For example, in a speech to
shareholders, one industry expert stated that mutual fund directors have
failed in negotiating management fees. The criticism arises in part from
the annual contract renewal process, in which boards compare fees of
similar funds. However, the directors compare fees with the industry
averages, which the experts claim provides no incentive for directors to
seek to lower fees. Another industry expert complained that fund directors
are not required to ensure that fund fees are reasonable, much less as low
as possible, but instead are only expected to ensure that fees fall within
a certain range of reasonableness.
In contrast, an academic study we reviewed criticized the court cases that
have shaped directors' roles in overseeing mutual fund fees. The authors
noted that these cases generally found that comparing a fund's fees to
other similar investment management services, such as pension plans, was
inappropriate as fund advisers do not compete with each other to manage a
particular fund. Without being able to compare fund fees to these other
products, the study's authors say that investors bringing these cases
lacked sufficient data to show that a fund's fees were excessive.11
Various Actions Taken or In light of concerns over director roles and
effectiveness, including Proposed to Increase concerns arising from the
recently alleged abusive practices, SEC has Board Effectiveness and taken
various actions to improve board governance and strengthen the
compliance programs of fund advisers. To strengthen the hand ofMutual Fund
Oversight independent directors when dealing with fund management, SEC
issued a proposal in January 2004 to amend rules under the Investment
Company
11J.P. Freeman and S.L. Brown, "Mutual Fund Advisory Fees: The Cost of
Conflicts of Interest," 26 Journal of Corporation Law 609 (2001).
Act to alter the composition and duties of many fund boards.12 These
reforms include
o requiring an independent chairman for fund boards of directors;
o increasing the percentage of independent directors from a majority to
at least seventy-five percent of a fund's board;
o requiring fund independent directors to meet at least quarterly in a
separate session; and
o providing the independent directors with authority to hire employees
and others to help the independent directors fulfill their fiduciary
duties.
Under the Investment Company Act, only individuals who are not
"interested" can serve as independent directors. Section 2(a)(19) of the
Investment Company Act defines the term "interested person" to include the
fund's investment adviser, principal underwriter, and certain other
persons (including their employees, officers or directors) who have a
significant relationship with the fund, its investment adviser or
principal underwriter. Broker-dealers that distribute the fund's shares or
persons who have served as counsel to the fund would also be considered
interested. However, SEC has suggested that Congress give it authority to
fill gaps in the statute that have permitted persons to serve as
independent directors who do not appear to be sufficiently independent of
fund management. For example, the statute permits a former executive of
the fund's adviser to serve as an independent director two years after the
person has retired from his position. This permits an adviser to use board
positions as a retirement benefit for its employees. The statute also
permits relatives of fund managers to serve as independent directors as
long as they are not members of the "immediate family" or affiliated
persons of the fund. In one case, SEC found that an uncle of the funds
portfolio manager served as an independent director of the fund. Giving
SEC additional rulemaking authority to define the term "interested person"
clearly seems appropriate.
As part of their proposal to alter the structure of fund boards, SEC is
also proposing that fund directors perform at least once annually an
evaluation
12Securities and Exchange Commission, Proposed Rule: Investment Company
Governance, Release No. IC-26323 (Jan.15, 2004).
of the effectiveness of the board and its committees. This evaluation is
to consider the effectiveness of the board's committee structure and
whether the directors have taken on the responsibility for overseeing too
many funds. The proposal also seeks to amend the fund recordkeeping rule
(rule 31a-2) to require that funds retain copies of the written materials
that directors consider in approving an advisory contract under section 15
of the Investment Company Act.
According to the SEC proposal, the changes to board structure and
authority are designed to enhance the independence and effectiveness of
fund boards and to improve their ability to protect the interests of the
funds and fund shareholders they serve. Specifically, SEC noted that
commenters on a 2001 amendment believed that a supermajority of
independent directors would help to strengthen the hand of independent
directors when dealing with fund management, and help assure that
independent directors maintain control of the board in the event of
illness or absence of other independent directors. Also, SEC concluded
that (1) a boardroom culture favoring the long-term interests of fund
shareholders might be more likely to prevail if the board chairman does
not have the conflicts of interest inherent in his role as an executive of
the fund adviser, and (2) a fund board may be more effective when
negotiating with the fund adviser over matters such as the advisory fee if
it were not led by an executive of the adviser with whom it was
negotiating. SEC also noted that separate meetings of the independent
directors would afford independent directors the opportunity for frank and
candid discussion among themselves regarding the management of the fund.
In addition, it saw the use of staff and experts as important to help
independent directors deal with matters beyond their level of expertise
and give them an understanding of better practices among mutual funds.
According to SEC's proposal, having fund directors perform selfevaluations
of the boards' effectiveness could improve fund performance by
strengthening the directors' understanding of their role and fostering
better communication and greater cohesiveness. This would focus the
board's attention on the need to create, consolidate, or revise various
board committees such as the audit, nominating, or pricing committees.
Finally, according to SEC staff, the proposed additional recordkeeping
rule would allow compliance examiners to review the quality of the
materials that boards considered in approving advisory contracts.
In response to concerns regarding the adequacy of fund board review of
advisory contracts and management fees, on February 11, 2004, SEC also
released proposed rule amendments to require that funds disclose in
shareholders reports how boards of directors evaluate and approve, and
recommend shareholder approval of investment, advisory contracts. The
proposed amendments would require a fund to disclose in its reports to
shareholders the material factors and the conclusions with respect to
those factors that formed the basis for the board's approval of advisory
contracts during the reporting period. The proposals also are designed to
encourage improved disclosure in the registration statement of the basis
for the board's approval of existing advisory contracts, and in proxy
statements of the basis for the board's recommendation that shareholders
approve an advisory contract.
In addition, to facilitate better board governance and oversight, SEC
adopted requirements to ensure that mutual funds and advisers have
internal programs to enhance compliance with federal securities laws and
regulations. On December 17, 2003, SEC adopted a new rule that requires
each investment company and investment adviser registered with the
Commission to
o adopt and implement written policies and procedures reasonably
designed to prevent violation of the federal securities laws,
o review those policies and procedures annually for their adequacy and
the effectiveness of their implementation, and
o designate a chief compliance officer to be responsible for
administering the policies and procedures.
In the case of an investment company, the chief compliance officer would
report directly to the fund board. These rules are designed to protect
investors by ensuring that all funds and advisers have internal programs
to enhance compliance with federal securities laws.
To ensure that fund investment adviser officials and employees are aware
of and held accountable for their fiduciary responsibilities to their fund
shareholders, SEC also released a rule proposal in January 2004 that would
require registered investment adviser firms to adopt codes of ethics.
According to the proposal, the rule was designed to prevent fraud by
reinforcing fiduciary principles that must govern the conduct of advisory
firms and their personnel. The proposal states that codes of ethics remind
employees that they are in a position of trust and must act with integrity
at all times. The codes would also direct investment advisers to establish
procedures for employees, so that the adviser would be able to determine
whether the employee was complying with the firm's principles.
In addition to these actions, SEC had previously adopted rules that became
effective in April 2003 that require funds to disclose on a quarterly
basis how they voted their proxies for the portfolio securities they hold.
SEC also required client proxies to adopt policies and procedures
reasonably designed to ensure that the adviser votes proxies in the best
interests of clients, to disclose to clients information about those
policies and procedures, to disclose to clients how they may obtain
information on how the adviser voted their proxies, and to maintain
certain records relating to proxy voting. In adopting these requirements,
SEC noted that this increased transparency would enable fund shareholders
to monitor their funds' involvement in the governance activities of
portfolio companies, which may have a dramatic impact on shareholder
value. We are currently reviewing whether pension plans have similar
requirements to disclose their proxy voting activities to their
participants and will be reporting separately on these issues later this
year.
In our view, these SEC proposals should help ensure that mutual fund
boards of directors are independent and take an active role in ensuring
that their funds are managed in the interests of their shareholders. Many
fund boards already meet some of these requirements, but SEC's proposal
will better ensure that such practices are the norm across the industry.
Although such practices do not guarantee that funds will be well managed
and will avoid illegal or abusive behavior, greater board independence
could promote board decision making that is aligned with shareholders'
interests and thereby enhance board accountability. While board
independence does not require eliminating all nonindependent directors, we
have taken the position in previous work that it should call for a
supermajority of independent directors.13 Our prior work also recognized
that independent leadership of the board is preferable to ensure some
degree of control over the flow of information from management to the
board, scheduling of meetings, setting of board agendas, and holding top
management accountable. To further ensure that board members are truly
independent, we would support the Congress giving SEC rulemaking authority
to specify the types of persons who qualify as "interested persons."
Having compliance officers report to fund boards and having advisers
implement codes of ethics should also provide additional tools to hold
fund advisers and boards accountable for ensuring that all fund
13U.S. Comptroller General David M. Walker, Integrity: Restoring Trust in
American Business and the Accounting Profession (document based on
author's speech to the American Institute of Certified Public
Accountants), Nov. 2002.
Regulators Have Responded to Broker-Dealer Compensation Issues
activities are conducted in compliance with legal requirements and with
integrity.
In addition to addressing alleged abusive practices, securities regulators
are also introducing proposals that respond to concerns over how
brokerdealers are compensated for selling mutual funds. Specifically, SEC
is seeking comments on how to revise a rule that allows mutual funds to
deduct fees to pay for the marketing and sale of fund shares. In addition,
to address a practice that raises potential conflicts of interest between
broker-dealers and their customers, SEC and NASD have also proposed rules
that would require broker-dealers to disclose revenue sharing payments
that fund advisers make to broker-dealers to compensate them for selling
fund shares. SEC has also recently proposed banning a practice called
directed brokerage that, if adopted, would prohibit funds from using
trading commissions as an additional means of compensating brokerdealers
for selling their funds.
12b-1 Fees Have Increased Investor Choice but Alternatives Could Provide
Additional Benefits
Approximately 80 percent of mutual fund purchases are made through
broker-dealers or other financial professionals, such as financial
planners and pension plan administrators. Prior to 1980, the compensation
that these financial professionals received for assisting investors with
mutual fund purchases was paid either by charging investors a sales charge
or load or paying for such expenses out of the investment adviser's own
profits. However, in 1980, SEC adopted rule 12b-1 under the Investment
Company Act to help funds counter a period of net redemptions by allowing
them to use fund assets to pay the expenses associated with the
distribution of fund shares. Under NASD rules, 12b-1 fees are limited to a
maximum of 1 percent of a fund's average net assets per year.14
Although originally envisioned as a temporary measure to be used during
periods when fund assets were declining, the use of 12b-1 fees has evolved
to provide investors with flexibility in paying for investment advice and
purchases of fund shares. Instead of being offered only funds that charge
a front-end load, investors using broker-dealers to assist them with their
14Specifically, NASD rules limits the amount of 12b-1 fees that may be
paid to brokerdealers to no more than 0.75 percent of a fund's average net
assets per year. Funds are also allowed to include an additional service
fee of up to 0.25 percent of average net assets each year to compensate
sales professionals for providing ongoing services to investors or for
maintaining their accounts.
purchases can now choose from different classes of fund shares that vary
by how the broker-dealer is compensated. In addition to shares that
involve front-end loads with low or no 12b-1 fee-typically called Class A
shares, investors can also invest in Class B shares that have no front-end
load but instead charge an annual 1 percent 12b-1 fee paid a certain
number of years, such as 7 or 8 years, after which the Class B shares
would convert to Class A shares. Other share classes may have lower 12b1
fees but charge investors a redemption fee-called a back-end load-if
shares are not held for a certain minimum period. Having classes of shares
allows investors to choose the share class that is most advantageous
depending on how long they plan to hold the investment.15
Because 12b-1 fees are used in ways different than originally envisioned,
SEC is seeking public comment on whether changes to rule 12b-1 are
necessary. In a proposal issued on February 24, 2004, SEC staff noted that
modifications might be needed to reflect changes in the manner in which
funds are marketed and distributed. For example, SEC staff told us that
rule 12b-1 requires fund boards when annually re-approving a fund's 12b-1
plan, to consider a set of factors that likely are not relevant in today's
environment.
In the proposal, SEC also seeks comments on whether alternatives to 12b1
fees would be beneficial. One such alternative would have
distributionrelated costs deducted directly from individual customer
accounts rather than having fund advisers deduct fees from the entire
fund's assets for eventual payment to selling broker-dealers. The amount
due the brokerdealer could be deducted over time, say once a quarter until
the total amount is collected.16 According to the SEC proposal, this
alternative would be beneficial because the amounts charged and their
effect on shareholder value would be completely transparent to the
shareholder because the amounts would appear on the shareholder's account
15Concerns over whether broker-dealers are helping investors choose the
best type of fund shares for their needs have been raised recently. For
example, in May 2003, SEC took an enforcement action against a major
broker dealer that it accused of inappropriately selling mutual fund B
shares to investors who would have been better off buying another class of
shares.
16SEC's proposal provides an example where a shareholder purchasing
$10,000 of fund shares with a 5-percent sales load could pay a $500 sales
load at the time of purchase, or could pay an amount equal to some
percentage of the value of his or her account each month until the $500
amount was fully paid (plus carrying interest). If the shareholder
redeemed the shares before the amount was fully paid, the proceeds of the
redemption would be reduced by the unpaid amount.
statements. According to a fund official and an industry analyst, having
fund shareholders see the amount of compensation that their broker is
receiving would increase investor awareness of such costs and could spur
greater competition among firms over such costs.
We commend SEC for seeking comments on potentially revising rule 12b-1.
Such fees are now being used in ways SEC did not intend when it adopted
the rule in 1980. We believe providing alternative means for investors to
compensate broker-dealers, like the one SEC's proposal describes, would
preserve the beneficial flexibility that investors currently enjoy while
also increasing the transparency of these fees. An approach like the one
SEC describes would also likely increase competition among broker-dealers
over these charges, which could lower the costs of investing in fund
shares further.
Regulators Respond to Revenue Sharing Payment Concerns
Regulators have also acted to address concerns arising from another common
mutual fund distribution practice called revenue sharing. Revenue sharing
occurs when mutual fund advisers make payments out of their own revenue to
broker-dealers to compensate them for selling that adviser's fund shares.
Broker-dealers that have extensive distribution networks and large staffs
of financial professionals who work directly with and make investment
recommendations to investors, increasingly demand that fund advisers make
these payments in addition to the sales loads and 12b-1 fees that they
earn when their customers purchase fund shares. For example, some
broker-dealers have narrowed their offerings of funds or created preferred
lists that include the funds of just six or seven fund companies that then
become the funds that receive the most marketing by these broker-dealers.
In order to be selected as one of the preferred fund families on these
lists, the mutual fund adviser often is required to compensate the
broker-dealer firms with revenue sharing payments. According to an article
in one trade journal, revenue sharing payments made by major fund
companies to broker-dealers may total as much as $2 billion per year.
According to the officials of a mutual fund research organization, about
80 percent of fund companies that partner with major broker-dealers make
cash revenue sharing payments.
However, revenue sharing payments may create conflicts of interest between
broker-dealers and their customers. By receiving compensation to emphasize
the marketing of particular funds, broker-dealers and their sales
representatives may have incentives to offer funds for reasons other than
the needs of the investor. For example, revenue sharing arrangements might
unduly focus the attention of broker-dealers on particular mutual
funds, reducing the number of funds considered as part of an investment
decision-potentially leading to inferior investment choices and
potentially reducing fee competition among funds. Finally, concerns have
been raised that revenue sharing arrangements might conflict with
securities self-regulatory organization rules requiring that brokers
recommend purchasing a security only after ensuring that the investment is
suitable for the investor's financial situation and risk profile.
Our June 2003 report recommended that SEC consider requiring that more
information be provided to investors to evaluate these conflicts of
interest; SEC and NASD have recently issued proposals to require such
disclosure. Although broker-dealers are currently required to inform their
customers about the third-party compensation the firm is receiving, they
have generally been complying with this requirement by providing their
customers with the mutual fund's prospectus, which discloses such
compensation in general terms. On January 14, 2004, SEC proposed rule
changes that would require broker-dealers to disclose to investors prior
to purchasing a mutual fund whether the broker-dealer receives revenue
sharing payments or portfolio commissions from that fund adviser as well
as other cost-related information. Similarly, NASD has proposed a change
to its rules that would require broker-dealers to provide written
disclosures to a customer when an account is first opened or when mutual
fund shares are purchased that describe any compensation that they receive
from fund advisers for providing their funds "shelf space" or preference
over other funds. SEC is also proposing that broker-dealers be required to
provide additional specific information about the revenue sharing payments
they receive in the confirmation documents they provide to their customers
to acknowledge a purchase. This additional information would include the
total dollar amount earned from a fund's adviser and the percentage that
this amount represented of the total sales by the brokerdealer of that
advisers' fund shares over the 4 most recent quarters.
We commend SEC and NASD for taking these actions. The disclosures being
proposed by SEC and NASD are intended to ensure that investors have
information that they can use to evaluate the potential conflicts their
broker-dealer may have when recommending particular fund shares to
investors. However, such disclosures would likely also require improving
related investor education programs to better ensure that investors
understand the importance of these new disclosures.
SEC Has Also Proposed Eliminating Another Potential Mutual Fund Conflict
Other Areas Requiring Continued SEC Attention
SEC has also taken another action to address a practice that creates
conflicts of interest between fund shareholders and broker-dealers or fund
advisers. On February 11, 2004, SEC proposed prohibiting fund advisers
from using trading commissions as compensation to broker-dealers that sell
their funds. Such arrangements are called "directed brokerage," in which
fund advisers choose broker-dealers to conduct trades in their funds'
portfolio securities as an additional way of compensating those brokers
for selling fund shares. These arrangements represent a hidden expense to
fund shareholders because brokerage commissions are paid out of fund
assets, unlike revenue sharing, which is paid out of advisers' revenues.
We support this action as a means of better ensuring that fund advisers
choose broker-dealers based on their ability to effectively execute trades
and not for other reasons.
SEC is considering actions to address conflicts of interests created by
"soft-dollar arrangements" and has taken actions to enhance disclosures
related to the costs of owning mutual funds, including considering making
more transparent costs included in brokerage transactions. Although SEC
has taken some actions, we believe that additional steps could be taken to
provide further benefits to investors by increasing the transparency of
certain mutual fund practices and enhancing competition among funds on the
basis of the fees that are charged to shareholders.
Soft Dollar Arrangements Provide Benefits, but Could Adversely Impact
Investors
Soft dollar arrangements allow fund investment advisers to obtain research
and brokerage services that could potentially benefit fund investors but
also increase investor costs. When investment advisers buy or sell
securities for a fund, they may have to pay the broker-dealers that
execute these trades a commission using fund assets. In return for these
brokerage commissions, many broker-dealers provide advisers with a bundle
of services, including trade execution, access to analysts and traders,
and research products.
Soft dollar arrangements are the result of regulatory changes in the
1970s. Until the mid-1970s, the commissions charged by all brokers were
fixed at one equal price. To compete for commissions, broker-dealers
differentiated themselves by offering research-related products and
services to advisers. In 1975, to increase competition, SEC abolished
fixed brokerage commission rates. However, investment advisers were
concerned that they could be held in breach of their fiduciary duty to
their clients to obtain best execution on trades if they paid anything but
the lowest commission rate available to obtain research and brokerage
services. In response, Congress created a "safe harbor" under Section
28(e) of the Securities Exchange Act of 1934 that allowed advisers to pay
more than the lowest available commission rate for security transactions
in return for research and brokerage services. Although legislation
provides a safe harbor for investment advisers to use soft-dollars, SEC is
responsible for defining what types of products and services are
considered lawful under the safe harbor. Since 1986, the SEC has
interpreted Section 28(e) as applying to a broad range of products and
services, as long as they provide `lawful and appropriate assistance to
the money manager in carrying out investment decision-making
responsibilities.'
Some industry participants argue that the use of soft dollars benefits
investors in various ways. The research that the fund adviser obtains can
directly benefit fund investors if the adviser uses it to select
securities for purchase or sale by the fund. The prevalence of soft dollar
arrangements also allows specialized, independent research to flourish,
thereby providing money managers a wider choice of investment ideas. As a
result, this research could contribute to better fund performance. The
proliferation of research available as a result of soft dollars might also
have other benefits. For example, an investment adviser official told us
that the research on smaller companies helps create a more efficient
market for securities of those companies, resulting in greater market
liquidity and lower spreads, which would benefit all investors including
those in mutual funds.
Although the research and brokerage services that fund advisers obtain
through the use of soft dollars could benefit a mutual fund investor, this
practice also could increase investors' costs and create potential
conflicts of interest that could harm fund investors. For example, soft
dollars could cause investors to pay higher brokerage commissions than
they otherwise would, because advisers might choose broker-dealers on the
basis of soft dollar products and services, not trade execution quality.
Soft dollar arrangements could also encourage advisers to trade more in
order to pay for more soft dollar products and services. Overtrading would
cause investors to pay more in brokerage commissions than they otherwise
would. These arrangements might also tempt advisers to "over-consume"
research because they would not be paying for it directly. In turn,
advisers might have less incentive to negotiate lower commissions,
resulting in investors paying more for trades.
Regulators also have raised concerns over soft dollar practices. In 1996
and 1997, SEC examiners conducted an examination sweep into the soft
Additional Actions to Address Conflicts Raised by Soft Dollars Could be
Beneficial
dollar practices of broker-dealers, investment advisers, and mutual funds.
In the resulting 1998 inspection report, SEC staff documented instances of
soft dollars being used for products and services outside the safe harbor,
as well as inadequate disclosure and bookkeeping of soft dollar
arrangements. SEC staff told us that their review found that mutual fund
advisers engaged in far fewer soft dollar abuses than other types of
advisers. To address the concerns identified, the SEC staff report
proposed recommending that investment advisers keep better records and
make greater disclosure about their use of soft dollars. A working group
formed in 1997 by the Department of Labor (DOL) to study the need for
regulatory changes and additional disclosures to pension plan sponsors and
fiduciaries on soft dollar arrangements recommended that SEC act to narrow
the definition of products and services that are considered research and
allowable under the safe harbor.17 The working group also recommended that
SEC prepare a specific list of acceptable purchases with soft dollars that
included brokerage and research services.
Although SEC has acknowledged the concerns involved with soft-dollar
arrangements, it has taken limited actions to date. SEC staff told us that
the press of other business prevented them from addressing the issues
raised by other regulators and their own 1998 staff report. However, in a
December 2003 concept release on portfolio transaction costs staff
requested comments on what types of information investment advisers should
be required to provide to mutual fund boards regarding the allocation of
brokerage commissions for execution purposes and soft dollar benefits.18
In addition, SEC staff told us that they have formed a study group with
representatives of the relevant SEC divisions, including Investment
Management, Market Regulation, and the Office of Compliance Inspections
and Examinations, to review soft dollar issues. This group also is
collecting information from industry and foreign regulators.
Regulators in other countries and other industries have acted to address
the conflicts created by soft dollars. In the United Kingdom, the
Financial Services Authority (FSA), which regulates the financial services
industry
17U.S. Department of Labor, Report of the Working Group on Soft
Dollars/Commission Recapture (Nov. 13, 1997) available at
http://www.dol.gov/ebsa/publications/softdolr.htm. DOL oversees pension
plans.
18SEC's concept release "Measures to Improve Disclosure of Mutual Fund
Transaction Costs" specifically requests comments on ways to improve the
qualification and disclosure of commission costs as well as other
transaction related costs.
in that country, has issued a consultation paper that argues that these
arrangements create incentives for advisers to route trades to
brokerdealers on the basis of soft dollar arrangements and that these
practices represented an unacceptable market distortion.19 As a result of
recommendations from a government-commissioned review of institutional
investment, FSA has proposed banning soft dollars for market pricing and
information services, as well as various other products.20 FSA notes that
their proposal would limit the ability of fund managers to pass management
costs through their customers' funds in the form of commissions and would
provide more incentive to consider what services are necessary for
efficient funds management, both of which could lower investor costs.
However, FSA staff has acknowledged that restricting soft dollar
arrangements in the United Kingdom could hurt the international
competitiveness of their fund industry because fund advisers outside their
country would not have to comply with these restrictions.
In addition, DOL has placed more restrictions on pension plan
administrators use of soft dollars than apply to mutual fund advisers. SEC
requires mutual fund boards of directors to review fund trading activities
to ensure that the adviser is obtaining best execution and to monitor any
conflicts of interest involving soft dollars. However, section 28(e)
allows fund advisers to use soft dollars generated by trading in one
fund's portfolio to obtain research that does not benefit that particular
fund but instead benefits other funds managed by that adviser. In
contrast, DOL requires plan fiduciaries to monitor the plan's investment
managers to ensure that the soft dollar research obtained from trading
commissions paid out of plan assets benefits the plan and that the
benefits to the plan are reasonable in relation to the value of the
brokerage and research services provided to the plan.
Some industry participants have also called on SEC to restrict soft dollar
usage. For example, the board of the Investment Company Institute (ICI),
which is the industry association for mutual funds, recently recommended
that SEC consider narrowing the definition of allowable research under
Section 28(e) and eliminate the purchase of third-party research with
softdollars. According to statements released by ICI, SEC's definition of
permitted research is overly expansive and has been susceptible to abuse.
19Financial Services Authority, Bundled Brokerage and Soft Commission
Arrangements (April 2003).
20P. Myners, Institutional Investment in the United Kingdom: A Review
(Mar. 6, 2001).
ICI recommends that SEC prohibit advisers from using soft dollars to
obtain any products and services that are otherwise publicly available in
the marketplace, such as periodical subscriptions or electronic news
services. In a letter to the SEC Chairman, ICI wrote that its proposal
would reduce incentives for investment advisers to engage in unnecessary
trading and would more closely reflect the original purpose of Section
28(e), which was to allow investment advisers to take into account a
broker-dealer's research capabilities in addition to its ability to
provide best execution.
Beyond these proposals, some industry participants have called for a
complete ban of soft dollars. If soft dollars were banned-which would
require repeal of Section 28(e)-and bundled commission rates were required
to be separately itemized, fund advisers would not be allowed to pay
higher commissions in exchange for research. Advocates of banning soft
dollars believe that this would spur broker-dealers to compete on the
price of executing trades, which averages between $.05 and $.06 per share
at large broker-dealers, whereas trades conducted through other venues can
be done for $.01 or less. Critics fear that this ban would reduce the
amount of independent research that advisers obtain, which would hurt
investors and threaten the viability of some existing independent research
firms.
To address concerns over soft dollars, our June 2003 report recommends
that SEC evaluate ways to provide additional information to fund directors
and investors on their fund advisers' use of soft dollars. Because SEC has
not acted to more fully address soft dollar-related concerns, investors
and mutual fund directors have less complete and transparent information
with which to evaluate the benefits and potential disadvantages of fund
advisers' use of soft dollars. However, such disclosures could potentially
increase the complexity of the information that investors are provided and
require them to interpret and understand such information. As such, an
enhanced investor education campaign would also likely be warranted.
Although disclosure can improve transparency, it may not be sufficient for
creating proper incentives and accountability. In our view, the time for
SEC to take bolder actions regarding soft dollars is now. Allowing the
advisers of mutual funds to use customer assets to obtain services that
would otherwise have to be paid for using advisers' revenues appears to
create inappropriate incentives, and inadequate transparency and
accountability.
We commend SEC for initiating an internal study of soft dollar issues. As
part of this evaluation, we believe that SEC should consider at a minimum
the merits of narrowing the services that are considered acceptable under
the safe harbor. Concerns that SEC's current definition of permitted
research is overly expansive and susceptible to abuse have been recognized
for years. Acting to narrow the safe harbor could reduce opportunities for
abusive practices. It could also lower investor costs by reducing adviser
incentives to overtrade portfolio assets to obtain soft dollar research
and services. We also believe that SEC's study should consider the
relative merits of eliminating soft dollar arrangements altogether. The
elimination of soft dollars, which would require legislative action, could
create greater incentives for broker-dealers to compete on the basis of
execution cost and greater incentives for fund advisers to weigh the
necessity of some of the research they now receive since they would have
to pay for such items from their own revenues.
New and Proposed Rules Could Provide Added Transparency of the Costs of
Investing in Mutual Funds
SEC recently adopted rules and rule amendments aimed at increasing
investor awareness by improving the disclosures of the fees and expenses
paid for investing in mutual funds. In February 2004, SEC adopted rule
amendments that require mutual funds to make additional disclosures about
their expenses.21 This information will be presented to investors in the
annual and semiannual reports prepared by mutual funds. Among other
things, mutual funds will now be required to disclose the cost in dollars
associated with an investment of $1,000 that earned the fund's actual
return and incurred the fund's actual expenses paid during the period. In
addition to allowing existing investors to compare fees across funds, SEC
staff indicated that placing these disclosures in funds' annual and
semiannual reports will help prospective investors to compare funds'
expenses before making a purchase decision.
In addition to this action, SEC amended fund advertising rules in
September 2003 to require funds to state in advertisements that investors
should consider a fund's fees before investing and direct investors to
consult the fund prospectus for more information.22 Additionally, in
21Securities and Exchange Commission, Final Rule: Shareholder Reports and
Quarterly Portfolio Disclosure of Registered Management Investment
Companies, Release Nos. 338393; 34-49333; IC-26372 (Feb. 27, 2004).
22Securities and Exchange Commission, Final Rule: Amendments to Investment
Company Advertising Rules, Release Nos. 33-8294; 34-48558; IC-26195 (Sep.
29, 2003).
November 2003, NASD proposed amending rules to require that mutual funds
advertising their performance present specific information about the
fund's expenses and performance in a more prominent format. These new
requirements are aimed at improving investor awareness of the costs of
buying and owning a mutual fund, facilitating comparison of fees among
funds, and make presentation of standardized performance information more
prominent. Specifically, NASD's proposal would require that all
performance advertising contain a text box that sets forth the fund's
standardized performance information, maximum sales charge, and annual
expense ratio. In doing so NASD's proposal would go beyond SEC
requirements by requiring funds to include specific performance and
expense information within advertising materials.
Another cost-related rulemaking initiative by SEC staff seeks to improve
the disclosure of breakpoint discounts for front-end sales loads. In March
2003, SEC, NASD, and the New York Stock Exchange issued a report
describing the failure of some broker-dealers to issue discounts on
frontend charges paid to them by mutual fund investors. Mutual funds with
front-end sales loads often offer investors discounts or "breakpoints" in
these sales loads as the dollar value of the shares purchased by investors
or members of their family increases, such as for purchases of $50,000 or
more. To better ensure that investors receive these discounts when
deserved, SEC is proposing to require funds to disclose in their
prospectuses when shareholders are eligible for breakpoint discounts.
According to the SEC proposal, such amendments are intended to provide
greater prominence to breakpoint disclosure by requiring its inclusion in
the prospectus rather than in the Statement of Additional Information,
which is a document delivered to investors only upon request.
However, these actions would not require mutual funds to disclose to each
investor the specific amount of fees in dollars that are paid on the
shares they own. As result, investors will not receive information on the
costs of mutual fund investing in the same way they see the costs of many
other financial products and services that they may use. In addition,
these actions do not require that mutual funds provide information
relating to fees in the document that is most relevant to investors-the
quarterly account statement. In a 1997 survey of how investors obtain
information about their funds, ICI indicated that, to shareholders, the
account statement is probably the most important communication that they
receive from a mutual fund company and that nearly all shareholders use
such statements to monitor their mutual funds.
Our June 2003 report recommends that SEC consider requiring mutual funds
to make additional disclosures to investors, including considering
requiring funds to specifically disclose fees in dollars to each investor
in quarterly account statements. SEC has agreed to consider requiring such
disclosures but was unsure that the benefits of implementing specific
dollar disclosures outweighed the costs to produce such disclosures.
However, we estimate that spreading these implementation costs across all
investor accounts might not represent a large outlay on a per-investor
basis.
Our report also discusses less costly alternatives that could also prove
beneficial to investors and spur increased competition among mutual funds
on the basis of fees. For example, one less costly alternative would
require quarterly statements to present the same information-the dollar
amount of a fund's fees based on a set investment amount-recently required
for mutual fund semiannual reports. Doing so would place this additional
fee disclosure in the document generally considered to be of the most
interest to investors. An even less costly alternative would be to require
that quarterly statements also include a notice that reminds investors
that they pay fees and to check their prospectus and ask their financial
adviser for more information. Disclosures such as these could be the
incentive that some investors need to take action to compare their fund's
expenses to those of other funds and thus make more informed investment
decisions. Such disclosures may also increasingly motivate fund companies
to respond competitively by lowering fees.
This concludes my prepared statement and I would be happy to respond to
any questions at the appropriate time.
For further information regarding this testimony, please contact Richard
J. Hillman or Cody J. Goebel at (202) 512-8678. Individuals making key
contributions to this testimony include Toayoa Aldridge, Barbara Roesmann,
George Scott, and David Tarosky.
Contacts and Acknowledgements
(250187)
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