[17180]
March 5, 2004
TO: BOARD OF GOVERNORS No. 19-04
CLOSED-END INVESTMENT COMPANY MEMBERS No. 14-04
FEDERAL LEGISLATION MEMBERS No. 7-04
INVESTMENT COMPANY DIRECTORS No. 11-04
PRIMARY CONTACTS - MEMBER COMPLEX No. 23-04
PUBLIC COMMUNICATIONS COMMITTEE No. 12-04
SEC RULES MEMBERS No. 36-04
SMALL FUNDS MEMBERS No. 29-04
UNIT INVESTMENT TRUST MEMBERS No. 10-04
RE: SENATE BANKING COMMITTEE HOLDS THREE MORE HEARINGS ON MUTUAL
FUNDS
The Senate Banking Committee has held three additional hearings in its series of
hearings on the current investigations and regulatory actions regarding the mutual fund
industry.1 The written testimony of the witnesses appearing at the hearings is summarized
below.
I. February 25th Hearing: Understanding the Fund Industry from the Investor’s
Perspective
The witnesses testifying at the hearing were: Tim Berry, Indiana State Treasurer and
President, National Association of State Treasurers; Gary Gensler, former Undersecretary of the
Treasury for Domestic Finance and co-author of The Great Mutual Fund Trap; James K.
Glassman, Resident Fellow, American Enterprise Institute; Don Phillips, Managing Director,
Morningstar, Inc.; and James S. Riepe, Vice Chairman, T. Rowe Price Group, Inc.2
1 For a summary of the written testimony from the Committee’s first hearing, see Institute Memorandum to Board of
Governors No. 63-03, Closed-End Investment Company Members No. 94-03, Federal Legislation Members No. 24-03,
Investment Company Directors No. 19-03, Primary Contacts – Member Complex No. 102-03, Public Information
Committee No. 40-03, SEC Rules Members No. 159-03, Small Funds Members No. 68-03, and Unit Investment Trust
Members No. 43-03 [16788], dated Nov. 20, 2003.
2 The written testimony provided by these witnesses is available on the Committee’s website at
http://banking.senate.gov/index.cfm?Fuseaction=Hearings.Detail&HearingID=84.
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Testimony of Mr. Berry
Mr. Berry testified that state treasurers, in their oversight of state investments and as
fiduciaries of state and local government pension plans, have a direct stake in issues raised by
mutual fund trading and sales practices. He offered his view that recent rulemaking initiatives
by the Securities and Exchange Commission will go a long way toward rectifying many of the
abuses that have been identified in recent investigations and that the mutual fund industry does
not need a wholly new set of operational rules or new oversight groups. Mr. Berry also
described how state treasurers have pressed for changes in the way that mutual funds operate,
stating that the fundamental goal of these efforts has been to ensure that mutual funds provide
timely and accurate information about costs and fees, performance, and potential risks.
Mr. Berry recommended that Congress act promptly to eliminate the current disclosure
gap with respect to revenue sharing arrangements and other incentives provided by mutual
funds to brokers selling their shares. While acknowledging that the SEC is considering possible
reforms in this area, he called on Congress to require confirmation statement disclosure of all
compensation received by brokers in connection with sales of fund shares. Mr. Berry further
recommended that Congress address the scope and adequacy of financial literacy training in the
United States, noting that many citizens lack the basic skills needed to manage their financial
affairs.
Testimony of Mr. Gensler
Mr. Gensler began by stating that the recent mutual fund scandals have revealed the
need for substantive reform regarding how mutual funds are governed and operated. He
offered a wide-ranging critique of mutual funds, including that fund directors serve on a part-
time basis, are unlikely to “make waves” because they are recruited by advisers, and rely solely
on the adviser for information. He also offered several reasons for the failure of the market to
provide better protection for fund investors, including: (1) the effectiveness of mutual fund
advertising in encouraging investors to chase recent performance, which he called a losing
strategy; and (2) mutual fund costs are “practically invisible” because they are deducted from
monthly returns.
Mr. Gensler stated that although the SEC is pursuing an active reform agenda, Congress
should give serious consideration to: (1) strengthening fund governance (e.g., require 75%
independent directors and an independent chair for all fund boards); (2) restricting payments of
soft dollars and Rule 12b-1 fees; (3) enhancing fund disclosure of transaction costs and revenue
sharing arrangements; and (4) endorsing or enhancing the SEC’s actions on certain issues raised
by the recent scandals (e.g., “hard 4:00 pm” close to address late trading). He stated that the
most important step Congress could take in promoting reform would be to codify “the duties
which independent directors hold to investors and tighten the standards to which they will be
held” (e.g., amend the Investment Company Act of 1940 to include a fiduciary duty for
directors, revise or repeal the Gartenberg standard for review of advisory fees.
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Testimony of Mr. Glassman
Mr. Glassman testified that, while steps need to be taken to ensure that some investors
do not exploit stale pricing at the expense of others, the mutual fund industry is basically
sound. Of greater worry to him is that policymakers could limit choices and raise costs for
small investors by rushing to increase regulations in areas such as fees, board composition, and
disclosure. Mr. Glassman suggested that policymakers could perform a more useful service by
using the bully pulpit to condemn firms who abuse their clients’ trust and laud those that act
responsibly. He pointed to recent outflows of assets from firms facing allegations of
impropriety as proof that investors can exact a greater degree of discipline from fund firms than
can regulators.
With respect to fees and expenses, Mr. Glassman testified that despite clear disclosures
of fees and the best efforts of regulators, commentators, and others, many (if not most) investors
do not know the fees that their funds charge. He stated that investors are simply more
interested in returns and that no amount of disclosure will change that fact. He also criticized
the SEC’s proposed disclosure requirements concerning broker incentives and conflicts in
selling mutual fund shares, stating that they are so complicated as to be unusable. Mr.
Glassman concluded his testimony by stating that policymakers should instead focus on
investor education, calling it the most important step for improving fund governance and
helping small investors.
Testimony of Mr. Phillips
Mr. Phillips testified that mutual funds have a proud history but that the recent scandals
have badly damaged the industry’s credibility. He stated that investors need assurances that:
(1) mutual funds operate on a level playing field; (2) checks and balances exist to safeguard
investor interests; (3) adequate information will be available to allow investors or their advisers
to make intelligent decisions about their funds; and (4) mutual funds represent good value. Mr.
Phillips recommended 10 steps that legislators, regulators, and industry leaders could take to
ensure that mutual funds meet their obligations to the investing public. These steps include:
(1) defining what constitutes abusive market timing and taking meaningful steps to eliminate it;
(2) eliminating soft dollar and directed brokerage arrangements and providing better disclosure
of “pay-to-play” arrangements; (3) eliminating or seriously reconsidering the role of Rule 12b-1
fees, so that payments to selling brokers and fund supermarkets are made directly and not
through a fund’s expense ratio; (4) making fund directors more visible and accountable to
shareholders; and (5) requiring dollar disclosure of actual fund costs.
Testimony of Mr. Riepe
Mr. Riepe began his testimony by stating that T. Rowe Price operates its mutual fund
business in accordance with the fundamental principle that the interests of its fund shareholders
are paramount and, as a result, his firm has been deeply dismayed by the recent revelations of
abusive mutual fund trading practices. He expressed support for regulators’ forceful responses
to these practices and for the SEC’s efforts otherwise to strengthen mutual fund regulation,
including: (1) a “hard 4:00 pm” close (although Mr. Riepe added that an electronic trade
monitoring process should soon be developed that would permit trades to be accepted from
intermediaries post-closing); (2) various measures to address abusive market timing; and (3) a
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ban on directed brokerage arrangements. He also stated that the SEC has begun a “prudent and
timely reevaluation” of Rule 12b-1.
Mr. Riepe stated that the recent disturbing revelations do not evidence a failure of the
fund governance system, but they do indicate that fund directors would benefit from additional
tools to assist them in serving effectively in their oversight role. He further cautioned that
certain proposals to “improve” fund governance, such as mandating that all fund boards have
an independent chair and requiring independent directors to make certifications relating to
matters outside the scope of what they could reasonably be expected to know, are unwarranted,
unrelated to the abuses that have been revealed, and counterproductive.
Mr. Riepe also acknowledged that the challenge of restoring and maintaining investor
trust falls not on regulators but on the fund industry itself. He outlined the various steps that
T. Rowe Price has taken in this regard, including thorough reviews of its policies and practices,
active involvement by the funds’ boards, and communications to educate fund shareholders
about the alleged improprieties and T. Rowe Price’s efforts to protect them from these types of
abuses. In closing, Mr. Riepe observed that the industry must take advantage of the current
problems to make improvements that will guard against future breaches of trust and assure
fund shareholders that their interests come first.
II. February 26th Hearing: Fund Operations and Governance
The witnesses testifying at the hearing were: John C. Bogle, Founder and Former Chief
Executive, The Vanguard Group; Mellody Hobson, President, Ariel Capital Management, LLC;
David S. Pottruck, Chief Executive Officer, The Charles Schwab Corporation; and David S.
Ruder, former SEC Chairman and Professor, Northwestern University School of Law.3
Testimony of Mr. Bogle
Mr. Bogle testified that it is time to “rebalance the scale on which the respective interests
of fund managers and fund shareholders are weighed.” He stated that in order to tilt the scale
so that a preponderance of the weight is on the side of shareholders, Congress must mandate
that a fund board has: (1) an independent chair; (2) no more than one interested director; (3) a
staff or independent consultant that provides objective information to the board; and (4) a
fiduciary duty to assure that funds are organized, operated, and managed in the interests of
their shareholders. Mr. Bogle also called for better information for fund investors, including:
(1) annual statements showing the actual dollar amount of annualized fund expenses and
portfolio transaction costs paid by each investor; (2) mandatory reporting of “dollar-weighted”
investment returns; (3) complete disclosure of all compensation paid to fund executives; and
(4) an express requirement that advisers provide, and fund directors consider, the amount and
structure of fees paid to the adviser by institutional clients.
Testimony of Ms. Hobson
Ms. Hobson began by describing her firm and reminding the Committee that small
mutual fund companies like Ariel are the norm in the industry, rather than the exception. She
3 The written testimony provided by these witnesses is available on the Committee’s website at
http://banking.senate.gov/index.cfm?Fuseaction=Hearings.Detail&HearingID=85.
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stated that, despite her profound disappointment about the abuses that have occurred, she still
takes enormous pride in being part of the mutual fund industry. She also expressed her belief
that most mutual fund companies do not ignore their fiduciary obligations, have not lost their
connection to their customers, and have not abandoned the basic principles of sound
investment management.
On the issue of Rule 12b-1, Ms. Hobson stressed the importance of Rule 12b-1 fees in
providing small fund companies with access to broad distribution channels. With regard to
fund fees, Ms. Hobson rebutted claims that such fees are excessive when compared to
management fees paid by institutional investors, and she emphasized that research by the SEC,
the General Accounting Office, and the Institute has concluded that total costs to fund
shareholders have in fact declined. She noted that the fee table appearing in fund prospectuses
was redesigned in 1998 with extensive input from focus groups on how to make it as accessible
and useful as possible, and that the SEC has testified before Congress that the fee table provides
an extremely useful and accurate way to compare fees among competing funds.
On the issue of fund governance, Ms. Hobson said that although the Ariel board has an
independent chair, she believes such a designation is “irrelevant” because independent
directors already make the major decisions for the funds they oversee. As to addressing
problems through more disclosure, she said that approach could impede rather than enhance
decision-making by investors. She noted that when the SEC reformed fund prospectuses in
1998, it urged great caution about adding new disclosure requirements because too much
information discourages investors from further reading or obscures essential fund information.
Finally, Ms. Hobson urged the Committee to: (1) concentrate a considerable part of its efforts
on how to clarify and increase understanding of the critical information already disclosed to
investors; (2) not permit heightened mutual fund oversight to erode the competitive position of
small firms; and (2) be mindful that if regulatory burdens on mutual funds increase too much,
companies may find it more attractive to market less regulated investment products and
services.
Testimony of Mr. Pottruck
Mr. Pottruck testified that mutual fund supermarkets have revolutionized investing for
millions of Americans, helping the fund industry to remain extraordinarily competitive and
supporting the existence of funds managed by small companies. He argued that fund
supermarkets are an indispensable tool that must be preserved and strengthened – not
weakened by reform proposals, no matter how well intentioned. Mr. Pottruck stated that
Schwab fully supports many of the reforms undertaken by the SEC, but he expressed concern
about the proposal to require that each fund board have an independent chair. He also stated
that individualized fee disclosure would be enormously expensive and would not facilitate the
type of comparisons among funds that investors need.
Much of Mr. Pottruck’s testimony focused on the SEC’s proposal for a “hard 4:00 p.m.”
close. He stated that the proposal would do nothing to increase transparency, minimize
conflicts, or maximize convenience for investors, but that it would undermine the goal of
competition and deprive investors of choice. Instead, he stated that Schwab’s “Smart 4”
solution, which the testimony discusses in detail, would crack down on late trading without
disadvantaging different groups of investors. The “Smart 4” solution would allow a fund
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intermediary to submit fund orders after the market close, provided that the intermediary
adopts several specific protections to prevent late trading.
Testimony of Mr. Ruder
Mr. Ruder testified that the most important way to increase protections for mutual fund
investors is to enhance the power of independent directors and to motivate them to perform
their duties responsibly. He recommended several governance reforms, including that: (1) at
least 75% of a fund’s board and its chair be independent; (2) fund complexes be required or
urged to adopt a board committee structure that would include nominating, audit, and
compliance committees composed entirely of independent directors; and (3) authorizing
independent directors to hire independent consultants and/or staff. He described as
unnecessary proposals to require certifications by fund directors or the establishment of a
mutual fund oversight board.
Mr. Ruder urged Congress to proceed cautiously with any mutual fund reform
legislation, noting the SEC’s expertise in dealing with the industry’s complexities and the fact
that the agency is using its rulemaking and enforcement powers to remedy industry problems.
He did call, however, for legislation to repeal the soft dollar safe harbor in Section 28(e) of the
Securities Exchange Act of 1934, and he said that the SEC should deal with soft dollar payments
by rule. With regard to advisory fees, he recognized that directors could be more active in
attempting to reduce such fees but he strongly rejected any government interference in setting
fee levels. Rather, Mr. Ruder said, the proper way to achieve better control over advisory fees is
through fund governance reforms, director education, and increased disclosure regarding the
fee setting process.
III. March 2nd Hearing (first panel): Fund Operations and Governance
Testifying on the hearing’s first panel, which focused on fund operations and
governance, were: William Armstrong, former U.S. Senator and Independent Chairman,
Oppenheimer Funds; Vanessa C.L. Chang, Independent Director, New Perspective Fund
(member of the American Funds family); Marvin L. Mann, Independent Chairman, The Fidelity
Funds; and Michael S. Miller, Managing Director, The Vanguard Group.4
Testimony of Mr. Armstrong
Mr. Armstrong testified that “we ought to throw the book” at executives in the mutual
fund industry who have violated shareholder trust, but he urged Congress to go slow in
considering new requirements that could end up costing shareholders more than the abuses
they were meant to correct. He likewise cautioned that the SEC is the appropriate agency to
4 A second panel addressed the SEC’s proposed “hard 4:00 p.m.” close and possible alternatives to prevent late
trading. Appearing on that panel were: Anne E. Bergin, Managing Director, National Securities Clearing
Corporation; William A. Bridy, President, Financial Data Services, Inc. (a wholly-owed subsidiary of Merrill Lynch &
Co.), on behalf of the Securities Industry Association; Raymond K. McCulloch, Executive Vice President, BB&T Trust,
on behalf of the American Bankers Association; and David L. Wray, President, Profit Sharing/401(k) Council of
America, on its own behalf and that of several other organizations. Their testimony is not summarized in this memo.
The written testimony provided by witnesses from both panels is available on the Committee’s website at
http://banking.senate.gov/index.cfm?Fuseaction=Hearings.Detail&HearingID=95.
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oversee the fund industry and that Congress should increase SEC funding rather than establish
a new mutual fund oversight board. Mr. Armstrong also suggested that consideration of many
worthwhile proposals (e.g., the appointment of an independent board chair) might be better left
to the discretion of fund boards and management.
Mr. Armstrong offered his support for several reform proposals, including:
(1) requiring a supermajority of independent directors on fund boards (although he noted that
simultaneously tightening the definition of “interested director” could cause real problems for
fund boards); (2) a “soft close” approach to prevent late trading, coupled with strict monitoring
of intermediaries; and (3) enhanced disclosure in areas such as market timing and the structure
of portfolio manager compensation. In contrast, he expressed his opposition to several other
proposals, including: (1) requiring that each fund board include at least one financial expert;
(2) imposing a fiduciary duty on directors to review soft dollar, revenue sharing, and directed
brokerage arrangements; (3) requiring various certifications by independent directors or the
board chair; and (4) mandating disclosure of the dollar amount of portfolio manager
compensation.
Testimony of Ms. Chang
Ms. Chang testified that she is greatly dismayed by abuses in the mutual fund industry
and, in particular, that some industry participants apparently chose to benefit themselves at the
expense of fund investors. She stated that their behavior is contrary to her own experience with
fund directors and advisory personnel, whom she has found to be smart, responsible, and
outspoken. Ms. Chang described for the Committee both how funds operate and the role of
independent directors, stating that it is important to understand each before evaluating
proposals to reform fund governance.
Ms. Chang stated that some of the reforms that have been proposed would improve the
fund governance system, while others threaten to add more cost and burdens on boards and
fund shareholders without any benefit. She expressed support for, among other things:
(1) broadening the definition of “interested person” to draw a clearer line between independent
directors and persons with ties to the fund’s adviser or other service providers; (2) requiring
75% of a fund board to be independent; and (3) self-assessing annually the board’s performance.
She spoke in opposition to proposals that would require: (1) every fund board to have an
independent chair, a decision she said should be left to the board’s discretion; and
(2) independent director certifications on a number of matters, which she said would badly
confuse the oversight responsibilities of fund directors with the operating responsibilities of
management. Ms. Chang concluded her testimony by asking the Committee, when it evaluates
proposals relating to fund governance, to be mindful of the fact that the vast majority of
independent fund directors take their responsibilities seriously.
Testimony of Mr. Mann
Mr. Mann testified that an engaged and well-functioning board of trustees is able to
undertake the responsibility of overseeing a large number of funds and do the job well. He
suggested that there are five general characteristics of such a board: (1) highly qualified and
experienced trustees who have the disposition to act independently; (2) the ability to make the
significant time commitment necessary to prepare for and fully participate in board meetings;
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(3) the ability to exercise a strong voice in setting agendas for board and committee meetings;
(4) access to information and resources (e.g., independent legal counsel, commitment by the
adviser to keep the board fully informed); and (5) effective and flexible structures and
processes, such as a well-defined committee structure. He remarked that such a board need not
have an independent chair and, moreover, that the key structural component in assuring that
independent trustees control the board is making sure that they constitute a substantial majority
of the board, as the SEC has proposed. Mr. Mann also observed that funds within a complex
share a substantial number of common elements (e.g., fair value pricing procedures, brokerage
allocation processes) and that a well-functioning unified board can leverage its knowledge of
the common elements and also resolve issues relating to those elements in a uniform way.
Mr. Mann objected to imposing certification requirements on independent directors,
saying that such requirements would: (1) not serve any practical purpose; (2) blur the line
between the board’s oversight function and the day-to-day management and operation of the
fund; and (3) have a chilling effect on the board’s ability to recruit and retain independent
trustees. He also expressed his personal belief that the following reforms would improve the
regulation of mutual funds and of the financial markets generally: (1) dollar disclosure in
quarterly account statements of the fees and expenses that an investor actually paid on his or
her investment (this requirement would apply to all types of investment vehicles and accounts);
(2) repeal of the soft dollar safe harbor in Section 28(e) of the Exchange Act and regulatory
action to require that mutual fund brokerage commissions reflect only execution costs; (3) a
prohibition on the use of Rule 12b-1 payments as a substitute for sales loads, and the deduction
of installment loads directly from shareholder accounts; (4) a prohibition on revenue sharing
and other cash payments to intermediaries; and (5) an “unbundling” of fund fees so that a
fund’s advisory fee represents only charges for portfolio management services, which would
make it more directly comparable to the management fees paid by institutional investors.
Testimony of Mr. Miller
Mr. Miller’s testimony focused on the issue of joint management of mutual funds and
other accounts and, in particular, on a proposal to prohibit an individual from managing both
mutual funds and hedge funds. He stated that while Vanguard does not manage or offer hedge
funds, it hires external investment advisers to provide portfolio management services to certain
of its mutual funds. Mr. Miller observed that managing money for multiple clients is, and has
always been, an inherent feature of a successful asset management firm. He also observed that
any firm managing mutual fund assets is required to be a registered investment adviser and –
consistent with the Investment Advisers Act of 1940 and its fiduciary duties – should have
substantive policies and procedures to help ensure that its investment professionals manage
multiple accounts in the interest of all clients.
Mr. Miller described a ban on side-by-side management as an extraordinary step that
would disadvantage mutual fund shareholders and fail to protect them fully. Specifically, he
stated that such a ban would: (1) force portfolio managers to choose between mutual funds and
hedge funds, thereby reducing the pool of top investment professionals available to mutual
fund investors; (2) negatively impact an investment firm’s continuity and stability, which is a
key factor in long-term investment success for the firm’s clients, including mutual fund clients;
and (3) fail to address potential conflicts that may arise with the management of accounts other
than hedge funds. Mr. Miller suggested that a better approach would be to require mutual fund
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directors to review and approve stringent procedures to address conflicts of interest and to
review the adviser’s performance under those procedures. He stated that enhanced compliance
obligations, when combined with additional support for independent directors (e.g., providing
independent directors with the authority to hire staff or other experts to help them fulfill their
fiduciary duties) would sufficiently protect mutual fund investors from potential conflicts of
interest present in the management of multiple accounts.
Rachel H. Graham
Assistant Counsel