[17333]
April 8, 2004
TO: BOARD OF GOVERNORS No. 29-04
CLOSED-END INVESTMENT COMPANY MEMBERS No. 24-04
FEDERAL LEGISLATION MEMBERS No. 10-04
INVESTMENT COMPANY DIRECTORS No. 20-04
PRIMARY CONTACTS - MEMBER COMPLEX No. 36-04
PUBLIC COMMUNICATIONS COMMITTEE No. 15-04
SEC RULES MEMBERS No. 53-04
SMALL FUNDS MEMBERS No. 40-04
UNIT INVESTMENT TRUST MEMBERS No. 14-04
RE: SENATE BANKING COMMITTEE HOLDS MORE HEARINGS ON MUTUAL FUNDS
The Senate Banking Committee held additional hearings on reforming the mutual fund
industry. The written testimony of the witnesses appearing at the hearing is summarized
below.
I. March 23, 2004 Hearing on Fund Operations and Governance
The witnesses testifying at the hearing were: Mercer E. Bullard, President and Founder,
Fund Democracy, Inc. and Assistant Professor, University of Mississippi School of Law; William
D. Lutz, Professor, Rutgers University; Robert C. Pozen, Non-executive Chairman,
Massachusetts Financial Services Co. and Visiting Professor, Harvard Law School; and Barbara
Roper, Director of Investor Protection, Consumer Federation of America.1
Testimony of Mercer E. Bullard
In his testimony, Mr. Bullard provided a list of initiatives that he believes Congress
should undertake to restore faith in mutual funds. He testified that there are many areas in
which Congressional action is needed because the Commission either lacks the necessary
authority or opposes mutual fund reforms. The areas that Mr. Bullard focused on include
mutual fund governance, fee disclosure, soft dollars, distribution, and fund advertising.
1 The written testimony provided by the witnesses is available on the Committee’s website at,
http://banking.senate.gov/index.cfm?Fuseaction=Hearings.Detail&HearingID=99.
2
On fund governance, he advocated the creation of a Mutual Fund Oversight Board
(which would have authority over fund directors), the establishment of a federal statutory duty
for fund directors requiring that they find that the fund is a reasonable investment, a
requirement for an independent chairman, a requirement that fund boards be 75% independent,
a prohibition on former directors, officers, and employees of the fund manager from serving as
independent directors, and a requirement that independent directors stand for election at least
once every five years.
With respect to fee disclosure, Mr. Bullard urged Congress to require inclusion of
portfolio transaction costs in the total expense ratio, disclosure of the dollar amount of expenses
paid by a shareholder in the periodic statement, and disclosure of fees of similarly managed
funds and appropriate index funds in the prospectus and to prohibit funds from showing
distribution fees as a separate line item in the fee table if that amount does not include
distribution expenses paid by the fund manager. Mr. Bullard also recommended a ban on soft
dollars.
On distribution, Mr. Bullard advised Congress to prohibit funds from using their assets
to compensate brokers for sales of fund shares, fund managers from compensating brokers in
connection with sales of fund shares, and funds from offering classes of shares that would not
be the best investment option for any rational investor. On fund advertising, he suggested that
Congress require funds to include returns for each individual year where such returns differ
materially from the fund’s one-year performance, performance and expenses of similarly
managed funds and an appropriate index fund, and fund expense ratios with equal prominence
as performance information.
Testimony of William D. Lutz
Professor Lutz testified that, although the SEC’s proposed point of sale and confirmation
disclosures are extremely important in improving disclosure to investors, the proposal does not
go far enough in revealing to investors just what they are paying in fees. Professor Lutz argued
that both documents only offer “data,” which is not “information,” and that data must be
transformed into information that investors can use. He advocated that the SEC test disclosure
documents to ensure that they are communicating the information investors want and need to
make informed decisions. Professor Lutz also stated that investors may be paying significant
transaction costs that are not revealed in any currently available document for investors. He
urged that investors be told that the expenses listed on the disclosure form do not include the
transaction costs over the life of the investment and that these costs may significantly affect the
return of their investment.
Testimony of Robert C. Pozen
Mr. Pozen testified that his company, MFS Investment Management, is trying to
establish standards of best practice in three important areas to fund shareholders: (1) reduced
reliance on soft dollars; (2) individualized expense reports; and (3) enhanced governance
structure. Mr. Pozen stated that MFS has eliminated the use of soft dollars to promote sales of
mutual funds and stopped using soft dollars to pay for third-party research and market data.
He urged the SEC to go back to its initial narrow interpretation of Section 28(e) of the Securities
Exchange Act to reduce the reliance on the use of soft dollars.
3
With respect to individualized expense reporting, Mr. Pozen testified that MFS will
provide every fund shareholder with an estimate of his or her actual fund expenses in dollar
terms on the quarterly statements. He stated that MFS has made this statement cost effective by
making one simplifying assumption: that shareholders hold their funds for the whole prior
quarter. In addition, Mr. Pozen stated that MFS will disclose in every fund’s semi-annual report
the total amount of brokerage commissions paid by the fund during the relevant period as well
as the fund’s average commission rate per share.
On fund governance, Mr. Pozen testified that MFS fund boards have a 75%
supermajority of independent directors, who elect their own chairman. The chairman leads the
executive sessions of independent directors and helps set the board’s agenda for the meeting.
In addition, Mr. Pozen stated that the independent directors of MFS funds appoint a compliance
officer who monitors all compliance activities by MFS, supervises the fund’s activities, and
reports regularly to the Compliance Committee of the Board, which is composed solely of
independent directors.
Mr. Pozen testified that, because the SEC and the management firms were making
serious efforts to develop higher “behavioral norms” for the mutual fund industry, it might be
useful for Congress to monitor these efforts before finalizing a bill on mutual fund reforms.
Testimony of Barbara Roper
Ms. Roper testified that the SEC has done a good job of developing a strong and credible
mutual fund reform agenda. She stated, however, that legislation is “absolutely essential” this
year to fill certain significant gaps in the SEC’s regulatory response. Ms. Roper was of the
opinion that the most serious gap is the SEC’s failure to adopt reforms that would introduce
vigorous cost competition in the mutual fund marketplace.
Ms. Roper testified that legislation is needed to: (1) strengthen the definition of
independent director, authorize the SEC to impose its governance directly, and clarify and
expand the fiduciary duty of fund directors; (2) give the SEC oversight authority over
intermediaries that handle mutual fund transactions to enable the agency to adopt an
alternative late trading solution that does not rely on a hard 4 p.m. close; (3) ban soft dollars;
and (4) direct the SEC to adopt rules to require that portfolio transaction costs be included in the
operating expense ratio, to amend the fee disclosure table to provide comparative operating
cost information, to require that mutual fund investors receive a copy of either the prospectus
or the fund profile at the time when a fund purchase is recommended, to require dollar amount
cost disclosure on shareholder account statements, and to pre-test those disclosures for
effectiveness in conveying key information to investors.
Ms. Roper also asked the Committee to ensure that the SEC has adequate funding and to
include in legislation a provision requiring a GAO study of whether investors would benefit
from the creation of an independent oversight board for mutual funds. She also stated that the
SEC’s reliance on settlements without an admission of wrongdoing should be further studied.
Finally, Ms. Roper focused on a longer-term need to reexamine broker sales practices.
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II. March 31, 2004 Hearing on Examining Soft Dollar Practices
The witnesses testifying at the hearing were: Harold Bardley, Chief Investment Officer,
U.S. Growth Equity, American Century Investments; Geoffrey Edelstein, Managing Director
and Co-Founder, Westcap Investments; Howard Schilit, Founder and CEO, Center for Financial
Research and Analysis; Benn Steil, Senior Fellow and Director of Economics, Council of Foreign
Relations; Grady Thomas, President, The Interstate Group; and Joseph Velli, Senior Executive
Vice President, The Bank of New York.2
Most of the witnesses cautioned against banning soft dollars but supported requiring
additional disclosure. Several witnesses also supported other regulatory measures such as
recordkeeping for soft dollars. Several of the witnesses discussed the detrimental effects of
banning soft dollars on independent research. One witness advocated the “greater use” of soft
dollars while another witness urged that if soft dollars are banned for third-party research,
proprietary research also should be unbundled. One witness warned that abolishing soft
dollars would create entry barriers for new investment advisory firms, affect adversely smaller
investment advisory firms, and diminish the quality and availability of proprietary and third-
party research.
On the other side of the debate, one witness called for the elimination of soft dollars and
suggested that fund managers be obligated to pay trading commissions out of their own assets
as recommended by the March 2001 Myners Report, prepared for the UK Treasury. Another
witness recommended other measures to address “real and perceived soft dollar abuses,”
including (1) narrowing the definition of “research” for purposes of the soft-dollar safe harbor,
(2) prohibiting fund advisers from taking into account sales of fund shares in allocating fund
brokerage, and (3) requiring the SEC to publish an industry execution-only rate for all
registered broker-dealers.
III. March 31, 2004 Hearings on Fund Costs and Distribution Practices
The witnesses testifying at the hearing were: The Honorable Susan M. Collins, Chairman
of the Senate Governmental Affairs Committee; The Honorable Peter Fitzgerald; The Honorable
Carl Levin; The Honorable Daniel K. Akaka; Paul G. Haaga, Jr., Executive Vice President and
Director of Capital Research and Management Company, and Chairman of the Investment
Company Institute; Chet Helck, President and Chief Operating Officer, Raymond James
Financial; Thomas Putnam, Founder and CEO, Fenimore Asset Management; Edward A. H.
Siedle, Founder and President, The Benchmark Financial Services, Inc.; and Mark Treanor,
General Counsel and Head of Legal Department, Wachovia Corporation.3
2 The written testimony provided by most of the witnesses is available on the Committee’s website at,
http://banking.senate.gov/index.cfm?Fuseaction=Hearings.Detail&HearingID=102.
3 The written testimony provided by most of the witnesses is available on the Committee’s website at,
http://banking.senate.gov/index.cfm?Fuseaction=Hearings.Detail&HearingID=103.
5
Senator Susan M. Collins
Senator Collins testified that the most important mutual fund reform that can be made is
in the area of mutual fund fees and expenses, which she described as being “often opaque and
obscure.” Senator Collins stated that, although the SEC has made a good start in improving
cost disclosure, Congress should go further. Moreover, although the legislation that Senator
Collins introduced with Senators Fitzgerald and Levin4 did not require personalized cost
information for investors, Senator Collins believes that such information should be provided to
investors to the extent practical. Senator Collins urged the Committee to report mutual fund
reform legislation so that reforms can endure regardless of who becomes future members of the
SEC.
Senator Carl Levin
Senator Levin testified that Congressional action was needed because the SEC does not
have the authority to undertake certain key mutual fund reforms and Congress should
strengthen the hand of the SEC by taking a stand on these issues and placing mutual fund
reforms in statutory law. Senator Levin stated that the legislation that he and Senators
Fitzgerald and Collins introduced takes the approach of banning rather than simply disclosing
certain practices that involve conflicts of interest. He described several practices that the
proposed legislation would ban, including revenue sharing and directed brokerage. Senator
Levin also stated that the proposed legislation would strengthen the SEC’s position on fund
governance. Finally, Senator Levin mentioned the importance of enacting legislation
establishing a standard for calculating and disclosing mutual fund expenses that incorporates
all materials costs, including brokerage commissions.
Senator Daniel K. Akaka
Senator Akaka commended the SEC for its proposals to improve the corporate
governance of mutual funds and to increase the transparency of mutual fund fees and believes
that the proposals to require an independent chairman of fund boards and to require 75 percent
of fund boards be comprised of independent directors, and the proposal for a confirmation
notice are a solid and measured response to the mutual fund scandals. Senator Akaka,
however, testified that he continues to believe mutual fund legislation is necessary so that
reforms will not be rolled back in the future and to address areas where the SEC needs
additional statutory authority to deal with problems and abuses in the mutual fund industry.
Senator Akaka also stated that additional legislation may be necessary if disclosure of revenue
sharing agreements and portfolio transaction costs are not adequately addressed by the SEC.
Senator Akaka described a number of provisions in the mutual fund reform bill he
introduced, including investment company board requirements, increased transparency of
financial relationships between brokers and mutual funds, and brokerage commission
4 For a summary of the legislation introduced by Senators Collins, Fitzgerald, and Levin, see Institute Memorandum
to Accounting/Treasurers Members No. 6-04, Board of Governors No. 14-04, Closed-end Investment Company
Members No. 11-04, Federal Legislation Members No. 5-04, Investment Company Directors No. 10-04, Operations
Members No. 10-04, Pension Members No. 13-04, Primary Contacts – Member Complex No. 17-04, Public
Communications Committee No. 10-04, SEC Rules Members No. 26-04, Small Funds Members No. 20-04, Unit
Investment Trust Members No. 9-04 [17112] (Feb. 17, 2004).
6
disclosure.5 Senator Akaka also stated that his bill would require the SEC to conduct a study to
assess financial literacy among mutual fund investors that would identify the most useful and
relevant information that investors need prior to purchasing shares, methods to increase
transparency of expenses and potential conflicts of interest in mutual fund transactions, existing
efforts to educate investors, and a strategy to increase the financial literacy of investors that
results in positive change in investor behavior.
Testimony of Paul G. Haaga
Mr. Haaga began his testimony by describing the responses by regulators, investors,
Congress, and the industry over the past several months to the revelations of abusive trading
practices in the mutual fund industry. Mr. Haaga testified that government authorities have
been conducting investigations and have taken forceful action against wrongdoers, the
marketplace has sent a powerful message that the trust and confidence of investors can never be
taken for granted, Congress has acted quickly and responsibly by holding a series of hearings,
and mutual funds have conducted their own investigations and reviews to determine whether
any wrongdoing occurred at their firms and to assess the effectiveness of existing policies and
procedures. Mr. Haaga also described the significant regulatory enhancements that the
Institute has recommended and the SEC’s aggressive and wide-ranging mutual fund regulatory
reform agenda.
Turning to the various regulatory initiatives, Mr. Haaga first discussed the proposals to
address the mutual fund trading abuses and then other proposals to reinforce the protection
and enhance the confidence of mutual fund investors. Specifically, Mr. Haaga discussed the
Institute’s support for SEC’s proposals or amendments (1) to tighten existing regulations
requiring all fund purchase and redemption orders to be received by a fund (or its transfer
agent) by the time of pricing, (2) to require funds to have more formalized short-term trading
policies and procedures and to disclose explicitly those policies and procedures, (3) to
emphasize the obligation funds have to fair value their securities under appropriate
circumstances, and (4) to provide a more effective mechanism for board oversight of short-term
trading policies and procedures. Mr. Haaga also discussed other initiatives including fund
governance, brokerage allocation practices, 12b-1 fees, revenue sharing arrangements, and other
disclosure initiatives.
Testimony of Chet Helck
Testifying on behalf of the Securities Industry Association and Raymond James, Mr.
Helck stated that abuses that undermine investor trust and confidence must be met with tough
and firm regulatory action. Mr. Helck was concerned, however, that proposed mutual fund
reforms not have unintended consequences that could ultimately degrade the infrastructure
that makes it possible for the relationship between client and advisor to thrive to the detriment
of the investing public.
5 For a summary of the legislation introduced by Senator Akaka, see Institute Memorandum to Board of Governors
No. 60-03, Closed-end Investment Company Members No. 89-03, Federal Legislation Members No. 22-03, Investment
Company Directors No. 15-03, Primary Contacts – Member Complex No. 96-03, Public Communications Committee
No. 38-03, SEC Rules Members No. 153-03, Small Funds Members No. 64-03, Unit Investment Trust Members No. 41-
03 [16751] (Nov. 10, 2003)
7
Mr. Helck focused on several areas of broker compensation for sales of mutual funds –
revenue sharing arrangements, 12b-1 fees, directed brokerage, and soft dollars. Mr. Helck
testified that revenue-sharing payments often help reimburse broker-dealers for expenses
associated with processing fund transactions, maintaining customer accounts and holding fund
education seminars for financial advisers and their clients. He stated that the impact of 12b-1
fees has been positive by allowing funds to reduce front-end sales charges, contributing to
development of longer holding periods and a more stable investment profile for clients, and
encouraging financial advisors to offer continued service over a period of time. Mr. Helck also
stated that eliminating soft dollars would be contrary to investors’ interests and affect the ability
of smaller, newer companies to obtain financing for their activities. He argued that soft dollars
increase competition among money managers, encourage independent research, and give
investors more choice. Finally, Mr. Helck offered preliminary suggestions to the SEC’s
proposals on confirmation and point of sale disclosures – disclosure should be required on
websites rather than on paper and transaction-by-transaction breakdown of revenue sharing
payments should not be required because of the costs involved.
Testimony of Edward A. H. Siedle
In his testimony, Mr. Siedle was critical of the mutual fund industry and testified that
mutual funds pay excessive management fees because fund boards are failing to fulfill their
fiduciary duties. Mr. Siedle recommended that the fiduciary duty of mutual fund directors be
strengthened and that a “most favored nation” clause be included in advisory contracts. He
argued that this clause would guarantee funds the lowest management fee by requiring fund
managers to charge the same management fee to a fund that they would charge to another
client for managing the same amount of assets. Mr. Siedle also supported requiring a
supermajority of independent directors and an independent chairman on fund boards. Mr.
Siedle recommended that the use of commissions for marketing be prohibited and that the
practice of soft dollars be restricted. He urged Congress to repeal the safe harbor for soft dollars
but if they continued to be permitted, the amount of soft dollars should be disclosed and
included in the management fees.
Testimony of Thomas O. Putnam
The testimony of Mr. Putnam focused on the role of small fund groups in the mutual
fund industry and the impact of regulatory reforms on them. Mr. Putnam described the
benefits of small fund groups, including providing greater choice for investors and helping to
foster competition. Mr. Putnam testified that he had serious concerns about the possible scope
of the changes facing the industry and that small fund groups may find that the considerable
costs associated with those changes are prohibitive.
Commenting on specific reform proposals, Mr. Putnam stated that requiring all fund
groups to have an independent chair would impose an unnecessary, one-size-fits-all approach.
Mr. Putnam also testified that many small fund groups are concerned about a ban on joint
management of mutual funds and hedge funds, which can drive top portfolio managers out of
the mutual fund industry, and have harsh, anti-competitive effects for small investment
management firms without the resources to maintain different managers for different types of
accounts. Mr. Putnam stated that Rule 12b-1 should be updated but not repealed because it
continues to serve an important function by giving investors choice on how to compensate the
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intermediaries whose assistance they sought in making their investment decisions. He also
testified that many small fund groups have been able to remain competitive because they were
able to gain access to a wider array of distribution channels than they otherwise would have
through traditional sales load structures.
Mr. Putnam also supported the SEC’s proposal on directed brokerage but recommended
that a fund be provided with a safe harbor if it had procedures to ensure that the direction of
brokerage was not intended as a reward for fund sales but based solely on a broker’s execution
capabilities. Although supporting disclosure of revenue-sharing arrangements, Mr. Putnam did
not believe that these arrangements should be eliminated or that fund boards should be
required to make value judgments about whether such arrangements are in the best interests of
fund shareholders. Finally, Mr. Putnam supported narrowing significantly the existing soft
dollar safe harbor.
Testimony of Mark Treanor
On behalf of the Financial Services Roundtable, Mr. Treanor testified that the regulatory
process should be allowed to work before any legislative changes are enacted. Mr. Treanor
stated that the Roundtable has not yet taken a position on each of the specific SEC proposals on
mutual fund distribution but it generally favors disclosure over prohibitions, including
prohibitions on specific types of distribution arrangements.
On other mutual fund issues, Mr. Treanor stated that aggregate fund brokerage
commissions, average commission rate per share and turnover information are useful types of
disclosure and that more information also could be disclosed about any services received by a
fund in addition to trade execution. Mr. Treanor stated, however, that efforts to require funds
or brokers to assign precise dollar values or artificial prices to proprietary services that are not
commercially available on an independent basis are likely to be unworkable and unreliable.
Mr. Treanor also testified that the Roundtable does not support disclosure of actual dollar
amounts of compensation paid to individual portfolio managers but supported disclosure to
fund investors of the structure and methodology of portfolio manager compensation. On fund
governance, Mr. Treanor testified that the Roundtable supports requiring a supermajority of
independent directors on fund boards but not a requirement that the chairman be an
independent director. On measures to prevent late trading, Mr. Treanor stated that the
Roundtable advocates requiring funds and fund intermediaries to have electronic time
stamping systems and abide by associated compliance, certification and independent audit
requirements as a condition to be eligible to receive mutual fund orders up to the closing time
rather than requiring a “hard close.” Finally, Mr. Treanor testified that the Roundtable supports
requiring mutual funds to disclose potential conflicts arising out of the joint management of
mutual funds and other accounts rather than a blanket ban on such joint management.
Jennifer S. Choi
Associate Counsel