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Before the Committee on Banking, Housing and Urban Affairs, U.S. 

United States General Accounting Office:


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 Highlights:

Highlights of GAO-04-533T, a report to Chairman, Senate Committee on 
Banking, Housing and Urban Affairs 

Why GAO Did This Study:

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.

What GAO Found:

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 

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.

What GAO Recommends:

In this statement, GAO raises a number of issues for regulators to 
consider that could enhance the effectiveness of proposed rule changes.

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

[End of section]

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.[Footnote 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.[Footnote 

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.[Footnote 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.

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.

Regulators Are Taking Actions to Address Abusive Mutual Fund Practices:

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.[Footnote 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.

Late Trading and Market Timing Are Detrimental to Fund Long-Term 

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.[Footnote 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 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 broker-dealers 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.[Footnote 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. 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:

[See PDF for image]

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 funds net assert 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.

[End of figure]

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. [Footnote 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).[Footnote 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 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 

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.[Footnote 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 a 
portfolio security. 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, 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.

Regulators Are Taking Actions to Improve the Effectiveness of Mutual 
Fund Boards of Directors:

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.

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.[Footnote 
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:

* the nature and quality of the adviser's services,

* the adviser's costs to provide those services,

* the extent to which the adviser realizes and shares with the fund 
economies of scale as the fund grows,

* the volume of orders that the manager must process,

* indirect benefits to the adviser as the result of operating the fund, 

* 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.[Footnote 11]

Various Actions Taken or Proposed to Increase Board Effectiveness and 
Mutual Fund Oversight:

In light of concerns over director roles and effectiveness, including 
concerns arising from the recently alleged abusive practices, SEC has 
taken various actions to improve board governance and strengthen the 
compliance programs of fund advisers. To strengthen the hand of 
independent directors when dealing with fund management, SEC issued a 
proposal in January 2004 to amend rules under the Investment Company 
Act to alter the composition and duties of many fund boards.[Footnote 
12] These reforms include:

* requiring an independent chairman for fund boards of directors;

* increasing the percentage of independent directors from a majority to 
at least seventy-five percent of a fund's board;

* requiring fund independent directors to meet at least quarterly in a 
separate session; and:

* providing the independent directors with authority to hire employees 
and others to help the independent directors fulfill their fiduciary 

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 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 self-
evaluations 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:

* adopt and implement written policies and procedures reasonably 
designed to prevent violation of the federal securities laws,

* review those policies and procedures annually for their adequacy and 
the effectiveness of their implementation, and:

* 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.[Footnote 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 activities are conducted 
in compliance with legal requirements and with integrity.

Regulators Have Responded to Broker-Dealer Compensation Issues:

In addition to addressing alleged abusive practices, securities 
regulators are also introducing proposals that respond to concerns over 
how broker-dealers 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 broker-dealers for selling their 

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.[Footnote 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 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 12b-1 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.[Footnote 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 
12b-1 fees would be beneficial. One such alternative would have 
distribution-related 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 broker-dealer could be deducted over time, say once a 
quarter until the total amount is collected.[Footnote 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 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 

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 broker-dealer 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 

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.

Other Areas Requiring Continued SEC Attention:

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 

Soft Dollar Arrangements Provide Benefits, but Could Adversely Impact 

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 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.[Footnote 17] The working group also recommended that 
SEC prepare a specific list of acceptable purchases with soft dollars 
that included brokerage and research services.

Additional Actions to Address Conflicts Raised by Soft Dollars Could be 

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.[Footnote 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 in that country, has issued a consultation paper that 
argues that these arrangements create incentives for advisers to route 
trades to broker-dealers on the basis of soft dollar arrangements and 
that these practices represented an unacceptable market 
distortion.[Footnote 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.[Footnote 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 

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 soft-dollars. According to statements 
released by ICI, SEC's definition of permitted research is overly 
expansive and has been susceptible to abuse. 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 

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.[Footnote 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.[Footnote 
22] Additionally, in 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 front-end 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 

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.

Contacts and Acknowledgements:

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.


[1] These statistics were reported by the Investment Company Institute 
and the Federal Reserve Board.

[2] NASD oversees broker-dealers that sell mutual funds and other 
securities to their customers.

[3] See 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).

[4] The 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. 

[5] SEC 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.

[6] See H.R. 2179, Securities Fraud Deterrence and Investor Restitution 
Act of 2003.

[7] Securities and Exchange Commission, Amendments to Rules Governing 
Pricing of Mutual Fund Shares, Release No. IC-26288 (Dec. 11, 2003).

[8] A 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.

[9] Fair 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.

[10] Gartenberg 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).

[11] J.P. Freeman and S.L. Brown, "Mutual Fund Advisory Fees: The Cost 
of Conflicts of Interest," 26 Journal of Corporation Law 609 (2001).

[12] Securities and Exchange Commission, Proposed Rule: Investment 
Company Governance, Release No. IC-26323 (Jan.15, 2004).

[13] U.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.

[14] Specifically, NASD rules limits the amount of 12b-1 fees that may 
be paid to broker-dealers 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.

[15] Concerns 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.

[16] SEC'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.

[17] U.S. Department of Labor, Report of the Working Group on Soft 
Dollars/Commission Recapture (Nov. 13, 1997) available at http:// DOL oversees pension 

[18] SEC'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.

[19] Financial Services Authority, Bundled Brokerage and Soft 
Commission Arrangements (April 2003).

[20] P. Myners, Institutional Investment in the United Kingdom: A 
Review (Mar. 6, 2001).

[21] Securities and Exchange Commission, Final Rule: Shareholder 
Reports and Quarterly Portfolio Disclosure of Registered Management 
Investment Companies, Release Nos. 33-8393; 34-49333; IC-26372 (Feb. 
27, 2004).

[22] Securities and Exchange Commission, Final Rule: Amendments to 
Investment Company Advertising Rules, Release Nos. 33-8294; 34-48558; 
IC-26195 (Sep. 29, 2003).