Segment 1 Of 2 Next Hearing Segment(2)
SPEAKERS CONTENTS INSERTS
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MUTUAL FUNDS: WHO'S LOOKING
OUT FOR INVESTORS?
Tuesday, November 4, 2003
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance
and Government-Sponsored Enterprises,
Committe on Financial Services
The subcommittee met, pursuant to call, at 10:07 a.m. In Room 2128, Rayburn House Office Building, Hon. Richard H. Baker [chairman of the subcommittee] presiding.
Present: Representatives Baker, Castle, Royce, Manzullo, Oxley (ex officio), Biggert, Capito, Brown-Waite, Frank (ex officio), Hinojosa, Lucas of Kentucky, Matheson, Emanuel and Scott.
Chairman BAKER. I would like to call our meeting of the Capital Markets Subcommittee to order.
This morning we have two distinguished panels of experts who will give opinions as to the necessity for modifications or improvements in the current statutory environment for the functioning of free and transparent capital markets within the country.
In recent weeks, due to efforts of State regulators and the SEC, unfortunate news has come to the public attention relative to individuals' conduct not consistent with current statutory law. As distasteful as those revelations are, I am confident that an aggressive enforcement authority at the State level as well as at the SEC will hold those individuals to account for their actions or omissions that are found to be inappropriate.
Page 2 PREV PAGE TOP OF DOC Segment 1 Of 2 That in itself is disturbing enough, given the fact that we have 95 million Americans now invested in the markets. Over half of all working households or all households in the country are directly invested in the markets.
It certainly makes a fine point that we in the Congress have a direct obligation to oversee and assist in the modifications where professional guidance tells us it is necessary, but even beyond the stated criminal conduct which has now been identified, I have further concerns that where actions were taken completely consistent with current law, there are actions that can be taken through non-disclosure that diminish shareholder value without shareholders being aware that it is occurring, and I certainly believe that is an area where the committee should focus its attention.
This committee has previously acted on H.R. H.R. 2420, which sets out modest beginnings for reform. That was first reviewed by the committee back in March of this year, before the revelations were made that we have recently been made aware of. In that light, I am not confident that the content of H.R. 2420 as drafted today is sufficiently broad in scope and for that reason look forward to comments of those who are professionals in this area as to their guidance and recommendations where the committee may strengthen that proposal.
Certainly one area that remains of some degree of controversy but I believe remains very important to overall reform is that of the appointment of an independent chair for the governance of a mutual fund board. I do believe that much of the conduct currently deemed to have been illegal could have been at least stemmed, if not prevented, by strong managerial oversight, aided with an independent chair and perhaps the appointment of a compliance officer as well.
Those are two points which I believe the committee should spend some time and consideration of those recommendations. The risk is far too great to leave these matters unresolved. The worst action the Congress could take would be not to act in any fashion whatsoever.
Page 3 PREV PAGE TOP OF DOC Segment 1 Of 2 The concerns by investors, the lack of certainty, the fear that one cannot place their money in the hands of a professional fiduciary for enhancing their professional future is grave. When we have 95 million Americans investing, that is a tremendous source of capital providing for business expansion and job opportunities, and if that money should sit on the financial sideline it would come at grave cost to our economic recovery. So I believe we have a very strong responsibility to act, to act quickly, and in a manner that is appropriate, given the circumstances that we face.
With that, I would like to recognize Ranking Member Frank for his opening statement.
Mr. FRANK. Thank you, Mr. Chairman.
I should note that the ranking member of the subcommittee, the gentleman from Pennsylvania, who has been very, very diligent in his work here, is diverted by something called an election which they are having in Pennsylvania. I live closer to the airport so I was able to vote at 7 this morning and get here. Unfortunately, we implemented a new system and, instead of pulling levers, I had to color in lines. I was never good at that in third grade and never got much better.
Chairman BAKER. Would the gentleman yield on that point?
Mr. FRANK. Yes.
Chairman BAKER. Mr. Kanjorski brought to my attention the fact of the election today. We did try to accommodate the members.
Mr. FRANK. I appreciate that.
Chairman BAKER. The difficulty was with the panel of members we have this morning. We could not readily reschedule.
Mr. FRANK. I understand, Mr. Chairman. I didn't mean that as a criticism.
Page 4 PREV PAGE TOP OF DOC Segment 1 Of 2 Chairman BAKER. No, but just for the record.
Mr. FRANK. The way Mr. Spitzer is going, he is not worrying about elections any more, so he did not have to show up at the polls like the rest of us did.
There are a serious set of issues here. Mr. Chairman, as you know, you received a letter from 32 of the 33 people on this side urging you to agree with us that the efforts that have been going on for over a year to curtail State activity in the regulatory area be put to bed.
We think that was always mistaken. We think particularly at this point it is a very poor idea. There have been various versions of it, to require everything be disgorged, to keep them out of business altogether.
It first surfaced at the request of some Morgan Stanley people during Sarbanes-Oxley. Subsequently, Mr. Chairman, as you know, not on mutual funds, but dealing with SEC powers, language was included that would curtail State authority. There were arguments about how much. Mr. Spitzer and Secretary of State Galvin of Massachusetts, with whom I work closely, have both told me this would severely impair their ability to go forward.
The problem is that, partly because of that controversy, in July when this committee met to mark up legislation, I believe at your request, Mr. Chairman, the bill that the SEC had requested for enhanced SEC powers was pulled because it included that section. You subsequently had a colloquy with Mr. Donaldson about it.
Now I understand that there is a meeting this afternoon of State regulators and the SEC to begin to work out procedures. I am all in favor of that, but I am very unhappy about it going forward with some sword of Damocles being held over their head, as if it is chained to the wall, not a threat.
I do not think there is any chance of Congress passing it, but there are two problems with the continued pendency of this pre-emption. In the first place, it has held up action on the SEC bill, and there were two bills that we considered on our agenda in July. One would have strengthened some regulations on the mutual fund and do not propose to go further because of some things that we learned, and I agree with the further proposals you have made, and I think we should go forward.
Page 5 PREV PAGE TOP OF DOC Segment 1 Of 2 That bill was held up going to the floor, not on our request. We were not opposing it when it came out of committee. I would agree with you it ought to be strengthened, but we also had the bill that at the SEC's request would enhance their powers. The SEC has been criticized; the head of our regional office in Massachusetts just left. I think it would have been a good idea if we give them those enhanced powers.
That has apparently been held up, while people, including yourself, Mr. Chairman, await the outcome of these negotiations. I do not think we ought to be waiting for a surrender from the State regulators in principle, anyway, but I certainly do not want to see the SEC bill held up while those negotiations go forward, so I would urge you to agree that that SEC bill should go forward. We ought to mark it up right away, if you would just drop that pre-emption piece.
On the mutual fund aspect, that bill came out of committee. Frankly, someone asked us why the Democrats hadn't co-sponsored it. Well, my answer is: It was reported out of the committee. You cannot under the rules cosponsor it. But then I was told that the report of the committee action has just been filed from July. That is a big slowdown. I didn't realize that.
Yes, we could have co-sponsored it, if we had realizedfrankly, the polls were held up. I want to go forward and let's have another markup. The vote was reported out.
I just reviewed your new proposals. They seem to be things on which we can get a consensus, so I would like to move forward, but I do think we have a serious problem with the bill the SEC requested for increased powers being held up and continued to be held up over the pre-emption. I know you said you didn't think, Mr. Chairman, that it would have interfered, but I said Mr. Spitzer, Mr. Galvin, both seem to have done so.
I am glad to see that the chairman and Mr. Spitzer are coming together. The holiday season is coming. It is a time of healing and reconciliation. That is bad news for the press, because more fighting is better for them, but it is good news maybe for everybody else. But I would hope that we would celebrate this new union here, a civil unionbut a unionI do not want to get into other issues. Let's say it is a union of civility, not a civil union. Let's consecrate that with an agreement that this proposed pre-emption was not a good idea.
Page 6 PREV PAGE TOP OF DOC Segment 1 Of 2 So I would urge you again, Mr. Chairman, the chairman of the subcommittee, let's activate the SEC bill, let's have a markup, and let's withdraw the pre-emption part.
The other part I would note with regard to the SEC, I realize they asked for new powers and didn't get them. But much of last year after Sarbanes-Oxley, we fought to give the SEC enhanced staff. We fought very hard to give you more money, and then the SEC requested some flexibility in hiring. The gentleman from Pennsylvania, Mr. Kanjorski, worked with Mr. Baker to give the SEC not just a significant increase in money, probably the biggest increase outside the Pentagon, which always wins, but some flexibility in hiring, subject to the people then hired being fully protected. The SEC did give some of that money back.
I wonder, is there anything we can doand I recognize it is hard to do all this right in a hurry, but weeverything the SEC has asked for that would enhance either its staff capacity or its regulatory powers we tried to support. So I would say to Mr. Galvin, if there is anything further we can do to beef it up, we would be glad to do that.
Last point, Mr. ChairmanI would appreciate just 30 more secondsI want to say a word in defense of politicians. We are not always everybody's favorite role model, but let's be clear that what we have here, the lead has been taken in the mutual fund protection of the average investor not just by State regulators but by State regulators who are elected to office. Mr. Spitzer is elected Attorney General of New York. Mr. Galvin is elected Secretary of the Commonwealth of Massachusetts.
I think it is not accidental that this concerns the average investor, the smaller guy. It is not a systemic issue as much as it is equity for the individual. I do not think it is an accident that elected officials who have to maintain that contact were in the lead on this.
Finally, again, Mr. Chairman, I hope that we can put pre-emption to bed and go forward with good legislation.
Page 7 PREV PAGE TOP OF DOC Segment 1 Of 2 Chairman BAKER. I thank the gentleman.
Mr. OXLEY. Thank you, Mr. Chairman. I would yield to you whatever time you may consume.
Chairman BAKER. I thank the gentleman.
I do feel it appropriate to respond to the gentleman from Massachusetts' comments with regard to holding up legislative reform concerning H.R. 2179.
I did not intend to get into this arena today, but since we have been invited so strongly, I will ask Mr. Cutler at the appropriate time, have any constraints, by failure to pass H.R. 2179, been an inhibition to the SEC's authority to pursue wrongdoers and bring them to accountability?
I would also indicate that in conversations with Mr. Spitzer and others we have sought in good faith to reach an accord which we believe is potentially achievable and make clear that we do not intend nor have we, in any way, inhibited State authority to pursue wrongdoers at any level to investigate, punish, or bring about any penalties.
The only discussion has been and remains with regard to the remedy stage of those negotiations where, as a result of actions taken by Attorney Generals, the national market structure would be modified.
I believe Mr. Spitzer has indicated on occasion that he accepts the view that the SEC should maintain primacy as the securities regulator but does have concerns as to the triggering mechanisms that would be required to institute such a fail-safe.
Having said that, this committee was first on the blockwas out of the block long before there was a scandal, did conduct a hearing and can produce from the records statements from many members in opposition to H.R. H.R. 2420 and its consideration. If we take the elements of H.R. 2179 that were merely enhancements of current authority, did not create new causes of action, did not give any new power that the SEC does not currently have, they were enhancements to the current body of enforcement law, you look at H.R. H.R. 2420, which is by far the more aggressive remedy to the current conflict we face, creating new causes of action, creating new methods of accountability, establishing at one point the necessity for an independent chairperson to govern the Board, which this committee sought to delete, I think we can go back to the record if we so choose and discover who were the folks in favor of reform prior to the current conflict and who were, in fact, obstructing its passage.
Page 8 PREV PAGE TOP OF DOC Segment 1 Of 2 A letter sent to me indicating that I have, in any way, inhibited procedural consideration of something that is in the public good I find absolutely intolerable.
I thank the gentleman for yielding.
Mr. OXLEY. Thank you Mr. Chairman.
Thank you for holding this timely hearing. It is often said that we have become in the past two decades a nation of investors. While that is unquestionably true, I believe it would be more precise to say we are now a nation of mutual fund investors. By an overwhelming margin, these pooled investment products have become the preferred way for some 95 million Americans to access stock markets, so we ought to make sure these investors are well-protected.
It appears that we are now in the early innings of what is now the biggest scandal in the 80-year-old history of the mutual fund industry. We do not know everything yet, but what we do know is troubling. Some have called the revelation shocking. Large institutional investors have been given preferential treatment to the detriment of individual investors and in violation of law in the funds' own stated policies.
According to the firms themselves, some fund managers and executives have essentially been stealing from their own customers. At one large fund company, portfolio managers seemed to be market timing their own funds as far back as 1998, were not terminated and not even disciplined until a September subpoena brought this information to the public's attention.
Perhaps the most troubling aspect of all this illegal conduct is that it appears to be so widespread. We cannot say that a few bad apples have violated the fiduciary duty owed to shareholders. We cannot say that only a handful of firms have mistreated their mom and pop investors who were supposed to be the industries bread and butter, and we cannot pretend that all of the fund companies were aware of this conduct.
This committee was aware of mutual fund and investor issues long before these recent revelations. It has been my view, and certainly one shared by Chairman Baker and others, that the review of fund practices was inevitable, given the committee's work over the past few years. We have examined almost every other segment of the securities industry, including Wall Street's analysts conflicts and IPO allocation abuses, the accounting profession, corporate boards, the stock exchanges, credit rating agencies and indeed hedge funds.
Page 9 PREV PAGE TOP OF DOC Segment 1 Of 2 In this post-Sarbanes-Oxley world, the public demands full disclosure of all relevant information, and rightfully so. Indeed, our system, as we said time and time again, is based on trust; and once that trust is broken, we have a clear breakdown in our system.
The committee's year-long review of mutual funds makes clear that more transparency is needed with respect to fund fees, costs, expenses and operations. There should be more useful disclosures regarding fund distribution arrangements so that investors are aware of any financial incentives that may influence the advice they receive. There should be stronger leadership by fund directors and clearly fund directors receive better oversight of the industry by the SEC.
Chairman Baker's legislation which passed this committee by a voice vote in July addresses these issues in a responsible and measured way. In light of the recent scandals, I think few would disagree that it would be appropriate to consider strengthening this legislation.
Mr. Chairman, congratulations on an excellent effort in this area, and I yield back.
[The prepared statement of Hon. Michael G. Oxley can be found on page 124 in the appendix.]
Chairman BAKER. Thank you, Mr. Chairman.
I would be remiss if I did not acknowledge your constant and continuing interest in the subject and ensuring that good public policy come out of this committee, and I appreciate your leadership.
Chairman BAKER. Does any other member wish to make an opening statement? Anyone at this side?
Mr. Scott is next?
Page 10 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. SCOTT. Thank you very much, Chairman Baker.
I thank you and Ranking Member Kanjorski for holding this hearing today regarding the mutual fund industry.
I also want to thank the panel of witnesses today for their testimony.
When I look back at this committee's earlier hearing on mutual funds, I feel as if we were looking at an industry that, at that time, was squeaky clean, but we now know that there are widespread practices where these funds are clearly not acting in the best interest of long-term investors.
According to an SEC survey, one-fourth of the Nation's largest brokerage houses helped clients engage in the illegal practices of trading mutual funds after hours, and half of the largest companies had arrangements that allowed certain customers to engage in market timing.
Given that more than half of all United States' households now hold shares in mutual funds, any discussion today will have an impact on millions of investors. We must look out for long-term investors, and we must restore and reinforce investor confidence in mutual funds.
Hopefully, this hearing will help us understand whether mutual fund investors are receiving fair value in return for the fees they paid. Late trading, market timing, insider trading, all should be no-nos. We have got to look into this problem forcefully. The American people are looking for help so that we can restore investor confidence in the trading of mutual funds.
Mr. Chairman and the committee, I look forward to this very important hearing this morning.
Chairman BAKER. Thank you, Mr. Scott.
Page 11 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. CASTLE. Thank you, Mr. Chairman; and thank you very much for having this hearing. I put you in the category of one of these crusading people trying to do something about this.
I think it is very important to understand the numbers. I will submit a full statement for the record, but I think it is important to understand the numbers. Because it was just two decades agothat is only 20 years agothat 6 percent of American households had mutual fund shares that were valued at $134 billion. Today, it is 50 percent.
I have heard 95 million people, families, is the right number, but it is 50 percent of our households have $7 trillion at stake. That is about 50 times larger than what existed before. That is more than the debt of this country, which everybody thinks is the highest number in the world.
Mutual funds represent about 10 percent of the total financial assets; and the number of funds have grown in that 20 years from 500 mutual funds in 25 years, really, in 1980 to approximately 8,000 mutual funds today.
Now most of these operate, I would believe, within the bounds of the laws in regulations of this country, but some do not, and investors suffer, and therein lies the rub. I must just say that pride cometh before the fall because, as we went through the corporate matters and the GSC issues, we are the only ones who are really clean, we do not have any problems.
I have heard about stale pricing, market timing, commission overcharges, lack of independent boards of directors, completely interlocking boards of directors, lack of transparencies, nobody really knows who owns what in terms of management ownership or salaries or even the contractual nature by which they operate. There had been enforcement issues which fortunately are starting to be addressed. 12b-1 fees are still being charged by mutual funds which have closed, which is amazing that something like that can happen.
So I think there are tremendous problems as far as the mutual fund industry is concerned. I think these hearings are very, very important. If nothing else, I cannot imagine that the people who are running mutual funds are not paying a heck of a lot of attention to what we are doing, so just the fact of having these hearings is extraordinarily important. I think there will be changes in behavior.
Page 12 PREV PAGE TOP OF DOC Segment 1 Of 2 But I must just say this, Mr. Chairman, before we get into the details of all of this. I think we need to put the tools in place to make sure that 5 or 10 years from now that we have put good laws and rules and regulations in place dealing with everybody at the State and the Federal level.
I am very concerned that as we go through this process, the usual drip, drip theory of people saying we do not need this, we do not need that, will take place and we will get it right. On the other hand, I do not believe that we individually and perhaps collectively have all the knowledge with respect to what has to be done.
I think I know something about the mutual fund industry, and every day I read something new or different. I do not want to say I can write the law. We really need to write this law properly and carefully and make sure that it is enforceable.
Eventually, the end goal, frankly, is protecting our investorswe say the smaller investors, but particularly the non-institutional investors, whether they are small or not, but we must fully evaluate the situation in order to do that.
I have a lot of questions I want to ask. My 5 minutes of questioning will not be enough for that from these individuals.
You know, obviously, where has the SEC been?
I think Mr. Cutler has come forward and helped with that, the illegal practices, we talked about that, the higher redemption fees and how they might affect the market timing. The bottom line, Mr. Chairman, is let's make sure we get something done. You have always been a good leader in this area and I thank the ranking members who care a lot about this issue.
To me, this is an opportunity to do it correctly. Frankly, if we take the time to do it correctly, we will have done the investing public a good amount of good; and I hope to be able to do that.
I yield back the balance much my time.
Page 13 PREV PAGE TOP OF DOC Segment 1 Of 2 [The prepared statement of Hon. Michael N. Castle can be found on page 126 in the appendix.]
Chairman BAKER. I thank the gentleman for his statement.
Mr. Emanuel, did you want to reclaim your time?
Mr. EMANUEL. Thank you, Mr. Chairman; and thank you for holding the hearing today and for those who are attending today to testify.
I want to pick up on what my colleague from Delaware said about the 95 million Americans who are now invested in mutual funds.
Unfortunately, what we have uncovered, whether it is market timing, late trading, or insider trading, that principle has been turned upside down. In fact, what we have seen recently is a managers win-investors lose mentality. I think that what we are doing here can be done in a smart, thoughtful, bipartisan way, as we did during the Fair Credit Reporting Act debate. We can take action to restore that trust for investors so that they don't pull their money out so unnecessarily and hurt themselves even more than they've already been harmed. I think it's also important to emphasize that, although we're facing a crisis, mutual funds are still a safe place to invest. Anything we do either legislatively or regulatorily should strive to restore the basic principle of the fiduciary responsibility.
As we continue to look at this issue, there are two points I want to bring to light:
One is a question I will be asking about the hot IPO. Have State of Federal regulators looked at what happened in the hot IPO market and how mutual funds allocated the shares they received? Was there systemic and endemic abuse back then as it related to that market and the IPOs that were allocated? Were these allocations going to average investors or were they going to the managerial class and special investors?
Another issue I'd like to raise is how I believe this scandal relates is general debate we've been having in Congress about the notion of privatizing social security. I will tell you, if there is anything that has ever shed light on the dangers of privatizing social security, it is what has happened here in the mutual fund industry and the ''managers first'' culture that has developed in the last 5 or 6 years; and I hope those who are rushing headlong to privitize social security would take a deep breath here. This scandal should be a flashing yellow light to all those who advocate the benefits of privatizing what has been a very good system, that is, social security, both as an insurance policy and a retirement policy.
Page 14 PREV PAGE TOP OF DOC Segment 1 Of 2 So for all those who have invested in mutual funds, whether for their life savings or their kids' college savings, we have an obligation to make sure their trust is restored. So I thank you for holding this hearing and look forward to the answers to the questions.
[The prepared statement of Hon. Rahm Emanuel can be found on page 128 in the appendix.]
Chairman BAKER. Thank you.
Mr. ROYCE. Thank you, Mr. Chairman.
We thank our distinguished witnesses for coming here to testify on the oversight of the mutual fund industry.
This summer we saw officials from New York, from Massachusetts and from the SEC. We saw them unearth a number of alarming market-timing activities within the fund industry. I encourage investigators and I am encouraging prosecutors to vigorously pursue those who have betrayed investors. I also sincerely believe we should use these revelations as an opportunity to improve the fund industry going forward, and I hope all parties involved will work together in a way that punishes the wrongdoers, that corrects inadequacies in regulation and results in a better climate for America's investing public.
To that end, I am encouraged to see that there are a number of proposals being put forward by both interested and disinterested parties. In particular, I am pleased to see that both the SEC and the Investment Company Institute are looking at specific actions that can be taken such as requiring all trading orders to be received by 4 o'clock and devising a mandatory redemption fee for in-and-out investors and exploring fair-value pricing mechanisms and, lastly, improving compliance procedures at fund companies.
In my view, the largest burden must fall on the fund industry itself to create better, more effective compliance policies.
Page 15 PREV PAGE TOP OF DOC Segment 1 Of 2 Once again, Chairman Baker, I thank you for having this hearing today. It is of great importance that this committee remains vigilant in ensuring that the investor marketplace that so many Americans invest in is fair, is transparent, and I look forward to working with my colleagues on this issue and yield back.
[The prepared statement of Hon. Edward R. Royce can be found on page 132 in the appendix.]
Chairman BAKER. I thank the gentleman.
Mr. LUCAS OF KENTUCKY. Mr. Chairman, I am looking forward to hearing the testimony from the witnesses.
Chairman BAKER. Thank you, sir.
Mr. HINOJOSA. Thank you, Chairman Baker.
I want to thank you for holding this third hearing on mutual funds this year and for the additional hearing the subcommittee will hold the day after tomorrow, on Thursday, on the same subject.
Mr. Chairman, I believe that this is going to be a very interesting hearing, based on all the news reports I have read on, one, the development in the mutual funds industry; two, the SEC's involvement; and, three, the role New York State Attorney General Eliot Spitzer has played in the investigation of malfeasance at certain mutual funds.
I was alarmed to read in yesterday's CongressDaily P.M. that Senate Governmental Affairs Chairwoman Susan Collins stated at a hearing before her committee that, ''clearly, much more must be done to protect mutual fund investors, whether it is through legislation, tougher enforcement actions, new and stronger regulations, or all three of those I mentioned.''
Page 16 PREV PAGE TOP OF DOC Segment 1 Of 2 Governmental Affairs Financial Management Subcommittee Chairman Peter Fitzgerald inferred at that same hearing that ''Federal law not only allows but codifies an incestuous relationship between the mutual fund board of directors and their investment advisors and managers.'' If they are correct, then the mutual fund industry is in dire need of reform.
What I would truly like to learn today is if this series of events in the mutual fund industry is merely limited to particular funds or if these recent scandals represent a more serious systemic problem within the mutual fund industry that might require Congress to enact legislation to correct the situation.
Many believe that adequate laws and regulations exist to police late trading and market timing issues raised in the suits against the mutual funds in question. I am not certain that I want the current allegations of abuse to cause an overreaction of legislation nor regulations to sweep up legal late processing with the illegal allegations. However, like most of my colleagues here today, I would like to learn more about market timing and late trading.
Mr. Chairman, I look forward to the witnesses' testimony and to their views on whether adequate laws and regulations exist to police late trading and market-timing issues. For these reasons and more, this hearing is both timely and helpful.
With that, I yield back the balance of my time.
[The prepared statement of Hon. Rubén Hinojosa can be found on page 131 in the appendix]
Chairman BAKER. I thank the gentleman.
Are there other members desiring to make an opening statement?
If not, then it is my pleasure at this time to welcome to our hearing Mr. Stephen Cutler, Director, Division of Enforcement, for the Securities and Exchange Commission, who is accompanied here today by the Investment Management Director, Mr. Paul Roye, of the Securities and Exchange Commission.
Page 17 PREV PAGE TOP OF DOC Segment 1 Of 2 As you are aware, your statement will be made part of the official record. To the extent possible, limit your remarks to 5 minutes for purposes of questions from members.
We welcome you here and look forward to your comments. Thank you.
STATEMENT OF STEPHEN M. CUTLER, DIRECTOR, DIVISION OF ENFORCEMENT, SECURITIES AND EXCHANGE COMMISSION; ACCOMPANIED BY PAUL F. ROYE, INVESTMENT MANAGEMENT DIRECTOR, SECURITIES AND EXCHANGE COMMISSION
Mr. CUTLER. Thank you, Chairman Baker, thank you for having me, Ranking Member Frank and distinguished members of the subcommittee. Good morning. Thank you for having me here to testify today on behalf of the SEC concerning abuses relating to the sale and operation of mutual funds.
Chairman Baker, I know you have been a champion for mutual fund reform; and I commend you for those efforts and for convening these important hearings today.
The illegal late trading and the related self-dealing practices that have recently come to light are a betrayal of the more than 95 million Americans who put their hard-earned money into mutual funds. Quite simply, those Americans haven't gotten a fair shake. For too many of them, the phrase ''trusted investment professional'' was a misnomer, as they weren't worthy of their trust.
The SEC is fully committed to ensuring that those who broke the law are held accountable and brought to justice. That process has already begun. Since Mr. Spitzer announced his action against Canary Partners and Edward Stern in early September, here is what we have done on the enforcement front. We sued Bank of America broker Theodore Sihpol for having allegedly facilitated late trading by some of his clients. We charged Steven Markovitz, senior executive of the Millennium Hedge Fund Group, with late trading and barred him from associating with an investment advisor.
Page 18 PREV PAGE TOP OF DOC Segment 1 Of 2 We also obtained an industry bar and imposed a $400,000 civil penalty on James Connelly, an executive with mutual fund complex Fred Alger Management, Inc., in connection with his alleged role in allowing certain investors to market time his company's funds; and we sued Putnam Investment Management and two of its portfolio managers, Justin Scott and Omid Kamshad, who we allege market timed their own mutual funds.
In each of these cases we have worked closely with Mr. Spitzer, Mr. Galvin, and others who have also filed their own charges.
Today, in conjunction with the Secretary of the Commonwealth of Massachusetts, we are announcing still another enforcement action, this one against five Prudential securities brokers and their branch manager. We allege that the defendants defrauded mutual funds and their investors by misrepresenting and concealing their own identities or the identities of their customers so as to avoid detection by the fund's market-timing police. This allowed them to enter thousands of market-timing transactions after the funds had restricted or blocked the defendants or their customers from further trading in their funds.
In addition to these enforcement actions, on September 4, the Commission sent detailed compulsory information requests to 88 of the largest mutual fund complexes in the country and 34 brokerage firms, including all of the country's registered prime brokers; and just last week we sent similar requests to insurance companies who sell mutual funds in the form of variable annuities.
Let me briefly highlight some of the most troubling findings, but I have to point out these are only preliminary and are still the subject of continued active investigation by the SEC as well as our State colleagues.
First, more than 25 percent of responding brokerage firms reported that customers have received 4:00 p.m. prices for orders placed or confirmed after 4:00 p.m..
Second, three fund groups reported or the information they provided indicated that their staffs had approved a late-trading arrangement with an investor.
Page 19 PREV PAGE TOP OF DOC Segment 1 Of 2 Third, 50 percent of the responding fund groups appear to have at least one arrangement allowing for market timing by an investor.
Fourth, documents provided by almost 30 percent of responding brokerage firms indicate they may have assisted market timers in some way, such as by breaking up large orders or setting up special accounts to conceal their own or their clients identities, as we allege in the case we filed today.
Fifth, almost 70 percent of responding brokerage firms reported being aware of timing activities by their customers.
And, sixth, more than 30 percent of responding fund companies appear to have disclosed non-public information about the securities in their portfolios in circumstances that raise questions about the propriety of such disclosures.
The Commission staff is following up on all of these situations closely.
I should also point out that we have been actively engaged in enforcement and examination activities in other important areas, many of which have already been mentioned here today involving mutual funds.
The first is mutual fund sales practices and fee disclosures. We are looking at just what prospective mutual fund investors have been told about revenue-sharing arrangements and other so-called shelf space incentives doled out by mutual fund management companies and mutual funds themselves to brokerage firms who agree to feature their funds.
We have already issued a Wells Notice of the staff's intention to recommend charges against one firm based on inadequate disclosure of shelf space fees.
Our second area of focus is the sale of different classes of shares in the same mutual fund. Very frequently, a fund will have issued two or more classes of shares with different loads and other fee characteristics. We have brought enforcement actions against two brokerage firms and certain of their personnel in connection with their alleged recommendations that customers purchase one class of shares when the firms should have been recommending another.
Page 20 PREV PAGE TOP OF DOC Segment 1 Of 2 The third area is the abuse of so-called break points. Quite simply, we found numerous instances in which brokerage firms did not give investors the volume discounts they were entitled when they purchased mutual funds.
Yesterday, the NASD and the SEC announced that 450 securities firms were being required to notify customers that they might be due refunds because they were not given break point discounts, that nearly 175 of those firms were being required to conduct comprehensive reviews of mutual fund transactions for missed break points and that a number of those firms were being referred for possible enforcement action. This week, together with the NASD, we will be issuing notices to those firms.
The fourth area is the pricing of mutual funds beyond the context of market timing. We are actively looking at two situations in which funds dramatically wrote down their net asset values in a manner that raises serious questions about the funds' pricing methodologies.
Representative Castle mentioned in his opening remarks 12b-1 fees of funds that have closed, and that is another area that we have been looking at.
Before I conclude, I do want to take a moment to address reports that several months ago an employee in Putnam's call operator unit told our Boston office that individual union members were day-trading Putnam funds in their 401(k) Plan.
The SEC receives on the order of 1,000 communications from the public in the form of complaints, tips, E-mails, letters and questions every working day. That is more than 200,000 a year. We have made and are continuing to make changes in how we handle these complaints, including giving more expeditious treatment to those that raise enforcement issues and instituting a monthly review of all enforcement-related matters that come to us by the division's senior management. We have room to improve in this area, and we are going to improve in this area, but, let there be no mistake, the dedication, commitment and professionalism of our enforcement staff are second to none.
Page 21 PREV PAGE TOP OF DOC Segment 1 Of 2 In our just-concluded fiscal year, 679 enforcement cases were brought. That is a 40 percent jump from 2 years ago. We accomplished this with almost no increase in resources, and included in those totals are some extraordinary achievements: $1.5 billion in disgorgement and penalties designated for return to investors, using Sarbanes-Oxley fair funds; 60 enforcement actions against public company CEOs; nearly 40 emergency asset freezes and TROs; groundbreaking cases against brokerage firms and banks for their roles in the Enron scandal, against an insurance company for its role in facilitating an issuer's financial statement fraud, against the stock exchange for its failure to enforce its trading rules and against a mutual fund management company for its failure to disclose a conflict of interest in its voting of its fund proxies; the largest civil penalty ever obtained in a securities fraud case; and dozens of financial reporting cases involving Fortune 500 Companies and their auditors.
With the recent badly-needed budget increases you have given us, we have now begun to see additional resources. They allow us to identify problems and to look around the corner for the next fraud or abuse.
With respect to mutual funds, I know that the agency's routine inspection and examination efforts will be improved by adding new staff, increasing the frequency of our examinations and digging deeper into fund operations. We are working aggressively on behalf of America's investors to ferret out and to punish wrongdoers wherever they may appear in our securities markets.
At the same time that the Commission is looking backward to identify past wrongdoers, the Commission has been engaged in a comprehensive regulatory response designed to prevent problems of this kind from occurring in the first place.
My colleague, Paul Roye, Division Director of our Investment Management group, can answer any questions you may have about those initiatives; and I ask that the written testimony that he provided yesterday on the Senate side be made part of the full record of this subcommittee as well.
Page 22 PREV PAGE TOP OF DOC Segment 1 Of 2 Chairman BAKER. Without objection.
Chairman BAKER. Thank you very much for your fine statement.
[The prepared statement of Stephen M. Cutler can be found on page 173 in the appendix.]
Chairman BAKER. I now wish to welcome the Honorable
Eliot Spitzer, Attorney General of New York; and on the record I want to acknowledge your good work in bringing to account those who have clearly violated securities law for the benefit of investors. I have nothing but admiration for the work you have pursued for so long and assure you I have no intent to, in any way, inhibit future activities of that sort. Welcome.
STATEMENT OF THE HONORABLE ELIOT SPITZER, ATTORNEY GENERAL, STATE OF NEW YORK
Mr. SPITZER. Thank you, Congressman Baker. I appreciate your having this hearing and your kind words.
Chairman Oxley as well, thank you for your presence and your leadership on these issues.
Also, of course, many thanks to Congressman Frank who is a great friend for many years. I appreciate your kind words and support for State jurisdiction and also your reminder that today is Election Day. I will make sure I get home to vote.
I feel compelled to begin by referring back to a quotation I have used elsewhere, but it is, I think, very instructive here. It is one from Paul Samuelson, who was, of course, not only a Nobel Laureate but a firm and wise observer of our capital markets. He said this about our mutual fund industry 35 years ago when we were beginning to piece together the governing structure of our mutual fund industry. He said and I quote: ''I decided there was only one place to make money in the mutual fund business. As there is only one place for a temperate man to be in a saloon, behind the bar and not in front of the bar, so I invested in a mutual fund management company.''
Page 23 PREV PAGE TOP OF DOC Segment 1 Of 2 Unfortunately, even 35 years ago, wise analysts understood that those who were really going to make money were the managers of the funds, not necessarily those who were investing; and they understood the distinction of the dichotomy, the schism that existed between the managers and those to whom they owed a fiduciary duty, those who were investing. That is the problem we were trying to confront today in several different ways.
Unfortunately, the record is now overwhelmingly clear. Despite protestations of purity I think we have heard for several decades from the mutual fund industry, where the industry tried to distinguish itself from other sectors of the capital markets where they would gladly acknowledge there were significant problems, significant violations of fiduciary duty, unfortunately, now we are seeing widespread abuses.
This is no longer a case of one or two bad apples sullying the entire crate. It begins to appear that the entire crate is rotten. When we have numbers that are being generated by the very worthy analysis of the SEC that demonstrates 25, 50 percent of the various funds were participating in or had knowledge of improper activity, we have got to come to the conclusion the problems are structural, they are systemic, and these are not just one or two individuals who are, unfortunately, tarnishing the reputation of others.
The cost to investors has been huge. From market timing alone, academic studies predict that those studies practices are costing investors upwards of $5 billion a year.
The late-trading costs are harder to calculate, but they are, in addition, very, very significant.
We also have the verythe somewhat different issue, which I will address momentarily, disparate fees, where pension fund advisors seem to be paid less than mutual fund advisors for essentially the same services.
And because you, Mr. Chairman, and others have recited the numbers, the vast numbers involved in terms of investment dollars in the mutual fund sector, the mere 25 basis point deferential in advisory fees paid would correlate to a $10 billion loss for investors.
Page 24 PREV PAGE TOP OF DOC Segment 1 Of 2 The conclusion is that even small, marginal differences in fees paid correspond to enormous losses in return for investors. As a consequence, your efforts here today are critically, critically important.
What begins to emerge, unfortunately, is an image of 28 distinct sets of rules, one for insiders and one for everybody else, a set of rules for those who are big enough to play, because they know who to call, how to craft a separate arrangement, how to send sticky assets into a separate fund to get preferential treatment, whether it is late trading, timing, at the expense of the small investor whom we were supposed to be protecting.
The other unfortunate conclusion is that boards should have known andboards could have known and, even with minimal due diligence, boards would have seen evidence of this improper conduct.
With all due respect to the cases that Mr. Cutler's office has made, Mr. Galvin's office has made and my office has made, these are not hard cases to make. It is like picking low-hanging fruit. What that suggests to me is that not only should we as prosecutors have been there sooner but it begs the question, where have the compliance departments been of these mutual firms?
It is an unfortunate tale that we have seen over and over and over again in every corner of the financial services sector. They come before us and they say, trust us. We have compliance departments. We have self-regulatory organizations.
They have failed. They have utterly betrayed the American public, and they have exhausted the reservoir of trust that existed. It is a sad tale, and how we move forward from here is going to be difficult to figure out.
One emblematic moment for me was about a year ago when the mutual fund industry said, we do not want to disclose to the public how we vote our proxies. They said, we know this is your money, but it would be too expensive to tell you how we are voting your proxies.
Page 25 PREV PAGE TOP OF DOC Segment 1 Of 2 It was an outrage. It was outrageous.
With a straight face they tried to tell us this was a cost they could not absorb. They are wrong. Thankfully, the SEC overrode them, but the mere fact they would make that argument I think demonstrates the arrogance of the industry and, unfortunately, the callous disregard that they had for the fact that they have a fiduciary duty to those whose money they are handling, the American public.
One final point before I get into two areas of where we can move forward, I believe, and that is this: We had, and you referred to this number, 6 million investors several decades ago, 95 million investors today. We have seen a tremendous democratization of the marketplace. Everybody in this room believes it is a wonderful thing. It has kept our capital markets vibrant, permitted the capital to be there for industry to expand. The question is, have we protected the small investors who do not know how to navigate through the very complicated world of the capital markets?
I think the answer we are beginning to see, whether it is the research issues of last year, where research simply was not accurate which was being disseminated to small investors, or this year, where the mutual funds are, as a colleague across on the other side of the Capitol said yesterday, are routinely skimming money off the top, it has got to be our conclusion we are not adequately protecting the tens of millions of Americans whom we have invited into the marketplace and whose capital we want to see flowing into the marketplace.
Let me make two final quick points if I might, sir:
First, with respect to the particular areas of impropriety we have seen, late trading and market timing, the rules were reasonably clear. There we need vigorous enforcement. We will see it. We are beginning to see it. The laws there do not necessarily need to be rewritten, although I am sure that together we will come up with some ideas. A hard and fast 4 o'clock cutoff, even the industry has proposed that. Everybody in the industry understood it. There we have an issue of enforcement.
Page 26 PREV PAGE TOP OF DOC Segment 1 Of 2 The larger issue and the one, Mr. Chairman, your bill was designed to address, and I know it has bipartisan support, is how do we change the governing structure of the mutual fund industry. I think there we need to really step back and ask the question, have the boards properly protected those to whom they owe a fiduciary duty? And the answer is, quite simply, no, they have not. They did not do that job properly.
Although I think H.R. H.R. 2420 is a very good start and moves us in the right direction, there are a few things that I think could be added to it. Some of these ideas are in there in some way shape or form now, but I think it will be articulated with some greater specificity. Let me just roll them off, and I will be done.
The first, we need a uniform, complete, categorized disclosure of the fees that investors pay for advisory services, management marketing services and trading costs. We need it to be done simply, in a way that is straightforward, in a way that is broken out so everybody can understand it and compare it across one fund to another. Much as you go into a supermarket and you see a nutritional chart that tells you how much fat, carbohydratesI confess I do not look at it too often, perhaps I shouldit should be nutritionally sound, there should be an equivalent information disclosure that is readily understood by investors.
We need also to require boards to demonstrate that they have negotiated advisory and management fees that are in the best interest of their shareholders and perhapsI say perhapsrequire that they obtain multiple bids for those services. This is a complicated area, but nonetheless I think we know that the sole bid and nature of these pledges and the fact that you have a Fidelity or an Alger or a Putnam going in and giving to a board only one option and the board then votes on that one option has led to an environment where there is not adequate negotiation over those fees. Hence I think we have the disparity in fee structure that I was referring to earlier with respect to the 25 basis points for services that are paid for.
Page 27 PREV PAGE TOP OF DOC Segment 1 Of 2 Third, we can considerand this would be a complicated issue. We could consider asking management companies or boards to put in a most-favored-nation clause that would stipulate if somebody is providing or getting identical services for a lower fee they be given the lower fee.
It is a standard contract in the private sector. Many people insert it just to ensure they get the benefit of the prevailing market cost of any particular product. It is something that we could consider asking boards to put in, again, as a way to ensure that they get a fair market price.
Perhaps most important we need an independent board chairman. Mr. BakerCongressman Baker, you alluded to this. It is absolutely essential. Without the board chair there simply will not be the presence of mind on the board to exercise the independence that is required.
I think we also need independent directors. I will leave to Congress to figure out how many and how you define that. Clearly, there has not been independence on the part of the boards of the funds themselves. That is an essential component as we move forward.
I would also suggest that we shouldsince there has been an abject failure of compliance that perhaps we would want compliance departments no longer to be buried within the management companies or the advisory companies but to have the compliance departments report solely to the independent board chairs. If we can create that separate reporting line, move compliance into an area where they will be independent, perhaps we could reinvigorate their performance.
I think these are some ideas we have had over time. I look forward to participating with the committee on both sides of the aisle. I know there has been enormous interest on the part of many members on this issue, and I look forward to working with you again.
Let me clear up one issue. I have worked stupendously I hope, despite the occasional barbed comment, with Mr. Cutler with the SEC. We share a common objective, we work together, and we look forward to doing so as we move forward.
Page 28 PREV PAGE TOP OF DOC Segment 1 Of 2 Thank you.
Chairman BAKER. Thank you, sir.
[The prepared statement of Hon. Eliot Spitzer can be found on page 228 in the appendix.]
Chairman BAKER. Let me continue with the line you brought up with regard to independent chair and compliance officer. I suggested yesterday to members of the Senate committee that we have a requirement for a fund to create a compliance officer responsibility that reports directly to the independent members of the board.
It would seem from your work that there were clear violations of existing statute. In some cases, individuals who were engaging in wrongdoing were actually told by their managerial superiors to stop and do no longer; and the actions continued anyway. In that case, it almost really doesn't matter what the law says, if you have a person intent on breaking it, and that is why we need strong enforcement authority to go after those folks.
The more difficult area I think is reflected in your comment as to the overall structure and countermeasures that might be needed to be created to keep good people good, so that somebody's always watching the shop. Then, on top of that, a disclosure regime, perhaps the comparability standard you suggest, but the ability of an average investing person to look at what they are being charged and understand the net value returned and to have that comparability between funds.
So three targets: One is to understand from your perspectiveand I think you perhaps initially indicatedare there any changes in statutory provisions with regard to criminal misconduct that the statutes do not currently enable you to pursue; secondly, what other mechanisms beyond the independent chair and the compliance officer might you think advisable as this committee goes forward; and then the review I have suggested in the legislation of a model thousand dollar investment being used as a standard for all fees to be deducted to show the recipient of the fund return exactly what they were charged and for what reason.
Page 29 PREV PAGE TOP OF DOC Segment 1 Of 2 Some have suggested that we need to go to an actual hard dollar calculation per every account. I have some concerns about that because of the complexity of doing so and the cost relatedlegitimate cost related to that calculation, and it is just a boilerplate thousand dollars or $10,000 sample sufficient for your purposes.
Let me express my appreciation for your support of H.R. H.R. 2420 and the independent chair.
You want to hit those three things quickly?
Mr. SPITZER. Sure, I will try.
With respect to existing statutes, I think I can fall back on the Martin Act, which is perhaps particular to New York. We have not had an absence of statutory authority, because we obviously are in a position to invoke New York State law as well.
Having said that, I believe that every case where we have found wrongdoing constitutes straightforward fraud under the Federal securities laws, and I would defer to Steve's views on this as well, but I think we have not disagreed that every case where we have brought charges or have wanted to have brought charges there has been a sufficient predicate in the existing civil or criminal jurisdictions granted under the Federal securities laws and consequently I am not sure we need to expand the straightforward definition of fraud underin 10b of the securities laws that has served us well forI do not know70 or so years, now.
Having said that, I think at perhaps a regulatory level the SEC will consider refining the rules relating to the 4 o'clock cutoff in terms of the NAV or pricing mechanism. I do not want to speak for them, but I think that is an area where some additional rigidity will lend guidance, although I do not want to suggest, in any way, shape or form that any of the misdeeds we have highlighted can be attributed to a misunderstanding of what that law was. There simply is not an ambiguity there that provides a defense for the acts we are charging.
Page 30 PREV PAGE TOP OF DOC Segment 1 Of 2 So, yes, I think there are some forward steps we can take, but I think we also have a broad framework that permits us to charge fraud.
In terms of the director issues, I think let's move forward, certainly, by getting independent directors and independent compliance department, additional disclosures.
I think that the issue that you frame as a $1,000 model portfolio is perhaps better because of its simplicity as compared to the individualized determination of the individual portfolio of the investor. I guess I am tempted to say I am an agnostic on that.
I would like to see what these pieces of paper look like. Maybe it is a matter of doing both.
Maybe it is a matter of driving homeI think the argument that is most powerful to investors is when they see what the compound interest effect is over time of the differential and fees. I have often said that compound interest is the eighth wonder of the world. Many investors will say, the 25 basis points on a $1,000 portfolio is only $5, and I am happy. I am not going to switch from one fund to the next because of five, whatever it might be. I think when investors see what the net impact is over a decade of investing, that is when it is driven home to them how dramatic this impact is.
Perhaps what I would add to that is a time horizon that would show that if fees are set at this point, which they are, right now, your portfolio, based on a projected return at the end of the decade would be why, and if fees were 50 basis points lower or 25 basis points lower, here is what your return will be. Because only then can it be driven home for investors how much this will really cost in a calculation.
And I think these numbers are right. Somebody has estimated if you were to do that 25 basis points over 10 years for a $100,000 portfolio, the impact of that would be $6,000, $6,000 over a 10-year time horizon. So I think at that point people say, wait a minute, if this is $6,000, I will either go to my board and say negotiate harder or I will switch to a different fund with lower fees. So it may not be a static analysis at this 1-year time frame, what is it, but perhaps over a longer time frame, what would the impact be on the investor?
Page 31 PREV PAGE TOP OF DOC Segment 1 Of 2 Chairman BAKER. Let me just address one other question raised earlier. You and I have recently discussed the issue of SEC primacy with the regard to the States Attorney's General's abilities to pursue wrongdoing. I think I have made clear that I have no intent nor make no effort to, in any way, impair your ability to go after wrongdoers. However, there may be a triggering mechanism that we can mutually pursue that would put Mr. Cutler or the appropriate SEC person at the table when a market structure issue is going to be determined. Not that that in any way precludes you from making that judgment, but in consultation with.
Now, we haven't reached agreement, we don't have language, but I merely want to establish on the record we are working together to seek a standard which would be operatively successful from your perspective while enabling the SEC to express its opinion.
Mr. SPITZER. Mr. Chairman, thank you for raising that issue. I suppose in moments of weakness I acknowledge that the SEC is the primary enforcer in the securities markets, and I will concede that point.
Chairman BAKER. Brilliance comes in flashes.
Mr. SPITZER. It does, indeed. I have not been willing to concede that we need to install a new triggering mechanism. I have often believed our press releases are sufficient and Mr. Cutler sees them and reacts. We have, I think, in New York, a good record of enforcing the law and bringing the SEC in to cases when our negotiations with defendants, in the context of injunctive relief, would begin to impinge upon market rules that we believe are the SEC's primary domain.
Having said that, I believe that the current law is sufficient to ensure that there is a fair dynamic between the SEC and state regulators, the 80-plus years where there has been this duality of enforcement. I cannot think of a single case where a State has acted in a way that has created a rule of law or a regulatory conundrum that the SEC has needed to respond to in the context of an enforcement action.
Page 32 PREV PAGE TOP OF DOC Segment 1 Of 2 The concerns that have been raised have led to conversations between the SEC in not only New York, but all the States to make sure that there is an adequate flow of communication back and forth to ensure that we don't, as we move forward in our increasingly integrated capital markets, stumble upon or create such a situation where there would be a problem.
So, to sum it up, I am comfortable that the law, as it now exists, is absolutely adequate; we do not need to try to craft anything legislatively that would address this problem. I am always happy to work with, in fact, believe it is my obligation, and the obligation of any enforcement entity at any level, to work with the SEC and others to ensure that we continue to not disrupt the markets in any way inadvertently. But I believe we are moving towards an understanding of how that communication should work.
Chairman BAKER. And to put further point on it: You do not wish to write national securities law as a States Attorney General.
Mr. SPITZER. No, we have never tried to write national securities law. That is the domain of Congress and the regulatory authority. Congress, at the legislative level, Congressand the SEC at a regulatory level.
Having said that, we, in our injunctive relief, have always and will continue to need to craft measures that respond to the nature of the abuse. Those injunctive measures that we negotiate with individuals who have committed either civil or criminal wrongs obviously cannot, because of the supremacy clause, be inconsistent with Federal law. Sometimes they supplement obligations and we impose additional obligations on malefactors because they need additional compliance programs or other measures ensure they don't break the law as we go forward.
So we have been very careful not to write rules that apply to the national markets. Obviously, last year in the global settlement with investment banks we only did that because we had the SEC with us, and therefore we were crafting a larger rule that applied to a significant number of entities. But we will, in our injunctive relief, obviously need to impose measures on firms that perhaps vary from, though are not inconsistent with rules and regulations that have been crafted by the SEC.
Page 33 PREV PAGE TOP OF DOC Segment 1 Of 2 Chairman BAKER. Thank you.
Mr. Cutler, Mr. Spitzer has exhausted our time, so I will come back to you on the next round.
Mr. FRANK. Mr. Chairman, let me just say to Mr. Spitzer, there is one other area where you are in specific agreement with the SEC when you say you can't think of a single case where State regulators have interfered with the need for a national market. Neither can the SEC. I asked Mr. Donaldson that his last time here; he said he couldn't think of one, he would check the records. And I haven't heard from one yet, so I think that we are in agreement.
But there is still pending a billand there is a legitimate disagreement here and that is still pending with regard to State authority. And I want to get your specific response, because Mr. Spitzer has, in the past, been critical of some of your efforts. And I am glad that we seem to be moving toward some agreement, but the SEC enforcement bill that I mentioned, when it was introduced by Mr. Baker, he spoke highly of the bill, and I thought it did a lot of good things, and as I understood, they were all from SEC.
By the way, that particular bill that we are talking about, the one that is being held up while we still wrestle with the preemption issue, it has on page 11, section 3, Investment Company Act of 1940, increasing penalties, strike 5,000, put in 100,000; strike 50 and put 250; strike 50 and put 500,000. And then enforce the Investment Company Act, strike 5,000 and put in 100,000; strike 250,000 inserting a million.
In other words, this bill contains significant penalty enhancements, which I think we ought to have. And I don't think it ought to be held up over what is dwindling dispute over preemption.
But let me ask you, though. The bill that we have before usand by the way, the proposal that was put forward to restrict State authority didn't just restrict their authority vis-a-vis the SEC. On page 25 of H.R. 2179, it talks not just about the Securities and Exchange Commission, but by any national security exchange or other self-regulatory organization, this bill would preempt your ability to add requirements where a regulatory organizationand let me ask you whether this would be an impediment to your enforcement efforts, Mr. Galvin's, and many other State officials. And I am quoting:
Page 34 PREV PAGE TOP OF DOC Segment 1 Of 2 No law, rule, regulation, judgment, agreement, or order may establish making and keeping records, bonding, or financial or operational reporting disclosure, or conflict of interest requirements for brokers, dealers, et cetera, that differ from or are in addition to the requirements in these areas established by the SEC or any national security exchange or self-regulatory organization.
I don't think we are contestingI hope nobody would try to contest. You can't differ with them, the supremacy clause. As Earl Long once said to the racist: The Feds have got the atom bomb; you don't win that fight.
But where there is silence, where either a regulatory organization or the SEC hasn't done anythingand we are not talking here just about laws, rules, and regulations, but judgments, agreements, or orders. Would enactment of that language significantly interfere with your ability to do your job?
Mr. SPITZER. Yes, it would. And I think you have zeroed in on two of the particular portions of the amendment that would be, in fact, were problematic to me. It was the extension not only from theof drafting that extended the prohibition not only to SEC rules and regs, but also anything emanating from an SRO. And I think that was fundamentally, I won't say perverse, but it was intentionally problematic to me because the SROs have been failed regulatory organizations. I think we can see that.
Mr. FRANK. And I would say since then, as we have seen with some of the SROs, it has gotten problematicer.
Mr. SPITZER. Problematicker. Exactly. I will have check the source for that word, but it has been
Mr. FRANK. We have a certain rulemaking power here.
Mr. SPITZER. Okay. I will defer to you.
The other area, the other words in there that were problematic to meproblematicerwere in addition to. And I think that is where I really stumble, because obviously we cannot do anything inconsistent, we wouldn't want to, we wouldn't try to, we shouldn't. But in addition to is where in injunctive relief we often impose upon malefactors, obligations that do differ in, from and are in addition to, because
Page 35 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. FRANK. In other words, it seems to me that languageand again, that was put forward. That is what is holding up the bill that would enhance the penalties that I just read. It says, in effect, going forward, you can't treat an offender differently than you treat everybody else. I mean, when you talk about itit is not a rule here. And, again, I repeat, I hope we would drop that and go forward and bring forward on to suspension that SEC bill.
Now, on the mutual funds. I want to acknowledge a change of heart here. On the independent compliance officer, I believe that is in the bill; I am all for it. Most of what is in the mutual fund bill went through this committee without objection, and as far as we were concerned, was ready to go to the floor. We did raise some objections to the independent chairman requirement being imposed on mutual funds only. That was the one I had. I must say, it was probably because I had not seen independent chairs elsewhere in the corporate world being much of a safeguard, but I am guided by what you and others have said, and I am now prepared to say, given the crisis we have seen here, we can go forward with that. I also agree with the chairman, who brought forwardthe chairman of the subcommitteesome additional factors that have come out because of your investigation. So we are ready to go forward.
Let me ask Mr. Cutler now. On the question of the SEC and the extentwhat can we do to help? Let me ask you in particular: We fought hard to give the SEC more money and more flexibility. Is that a transitional problem? You just couldn't hire all those people at once? Is it too much money overall? What can we expect? Have we overappropriated for you, or did we just give you too much to eat too quickly?
Mr. CUTLER. I certainly don't think you have overappropriated for us. I mean, I think the Commission was starved for a long time, and with this committee's help, I think we finally got some of the resources that we have needed. We obviously want to go about the process of hiring people in a way that is appropriate and deliberate and thoughtful and intelligent so that we can get the right people in the door to do the job that we need to do. And we are in the process of really ramping up. We obviously couldn't do that the day the money came in the door, but we are well on our way to getting
Page 36 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. FRANK. I figured thatin fact, if you go back to the debates, those of us who were pushing for the additional money over and above what the administration was asking for and appropriated for voting, pointed out that there would be a time lag. So we weren't talking about a couple months, but the 6 or 7 months after that.
But you answered the essential question, which is, the fact that you did give back some of the moneyand I appreciate that. If you can't spend it wisely, yeah, it is a good idea to give it back. That should not be held in the future to mean that there is a permanent limit. It was a temporary inability to spend the money for the staff, and the appropriate staffing levels should then go back as you are able to do that.
Mr. CUTLER. I couldn't agree with you more. No one wanted the agency to spend the money in a way that was unwise; but that doesn't mean we wouldn't want the money or need the money.
Mr. FRANK. As you know, we did collaborate with you in doing legislation that gave you more hiring freedom.
Let me ask now about H.R. 2179, the bill that is being held up as we debate the preemption issue. How important is that? My understanding was that those were mostly thinking that were requested by the SEC. And what is your assessment? How helpful would it be if we were to pass H.R. 2179? Which again I would hope we would do quickly on suspension.
Mr. CUTLER. I think many of the enhancements in that bill are very important to us, but more importantly to the investing public. They increase penalties, they allow us more flexibility to get penalties in administrative proceedings, they allow us to go after money that we otherwise couldn't under current law because of homestead and other exemptions. So there are a lot of important pieces of that bill.
Mr. FRANK. I appreciate that. And as I reread the bill, there are a couple of sections in there that specifically enhance the authority both to get the penalties and increase the penalties with regard to mutual funds. So, yes, I think that something that we ought very much to deal with.
Page 37 PREV PAGE TOP OF DOC Segment 1 Of 2 Finally, for both or all three of the witnesses. We had a mutual fund bill that, as I said, passed this committee unanimously with differences only basically over the independent chairman. I am prepared to concede now we should go forward with that. The chairman has got some other provisions. Are there other statutory changes? Have you, between you, proposed all that you have? Obviously, it is important to note some of these things were already illegal, and that is why H.R. 2179 is important, because it is one thing for it to be illegal, it is another for there to be a serious penalty to the point bothand people should understand, when we are talking about the seriousness of penalties, this applies both to the incentive to the regulator to go after it but also to the deterrent effect. So we want to get thelet me just put it this way. If there are any others, send them forward.
Let me go back to the philosophical pointit is Election DayMr. Spitzer. And I really mean this one very strongly. I think it is very relevant, because in our culture, elected officials are often compared unfavorably in intellect, integrity, devotion to the public duty to high-level appointees. We are necessary to the system, but people sometimes almost wish that we weren't. And there was an argument particularly as you get sort of arcane. After all, we are not talking basic arithmetic here. When we talk about market timing and late trading and there are a lot of fairly complicated and sophisticated things going on. Like trading, maybe not, the difference between 4 o'clock and 4:30 is easily grasped, but some of these other issues are a little more complex.
I would ask Mr. Spitzer if you would reflect on the fact that it was yourself, Secretary Galvin, and some others who were elected officials who took action here. And let me throw out a hypothesis that just really occurred to me as I was thinking about this, and it is just the beginning of a thought. And that is, the SEC plays a very important role. It is the national regulator. It is charged with keeping the system working. And I am wondering whether there might not be a tendency for the appointed national regulators with their very heavy responsibilities to focus more on systemic risk, to focus more on the overall functioning.
Page 38 PREV PAGE TOP OF DOC Segment 1 Of 2 What you and your colleagues in the State level have done here, to a great extent, is to focus on unfairness to individual investors. In some cases, there were losses that offset gains. But the primary thing that comes out of the most recent things is that it is the small mutual fund investor. Someone who is in it through his or her retirement plan, or has relatively small amounts of money, is not sophisticated enough or is smart enough not and try to make stock picks on his or her own, or as in the case of some of us, have so many conflicts of interest; if you try to buy an individual stock, that you had better buy mutual funds so people don't start yapping at you about anything else.
But do you think that there is something to the fact that elected officials would be particularly sensitized to the question of the role of the smaller individual investor, as opposed to a focus on the broader systemic issues? Not that you would do one to the exclusion, but that the necessary focus on the systematic issues could diminish some of the attention given to the little guy.
Mr. SPITZER. I think there may be some merit to that analysis. I think that it is certainly ingrained in the tradition of the attorneys general across the Nation, that our primary focus has been protecting the smaller consumer; the individual consumer has a grievance; and as a consequence, sometimes some of the issues that will arise that will make their way to our plate would fit that paragon and are therefore somewhat distinct from what the SEC might look at.
I think there has beenlet me just add this one last reflection very quickly. I think there has been a very healthy dynamic between States and the SEC over the decades and in reinforcing each other. Where one has perhaps failed to see something, the other picks it up. And I think that is the healthy nature of the federalism that we have established, and I think maintaining that proper balance is something we all strive to do, and working at it is something we are obligated to do.
Page 39 PREV PAGE TOP OF DOC Segment 1 Of 2 Chairman BAKER. The gentleman's time has expired.
Mr. OXLEY. Did the Chairman wish for me to yield briefly?
Chairman BAKER. If the chairman so desires.
Mr. OXLEY. Sure.
Chairman BAKER. Mr. Spitzer, returning to the point at hand relative to the features of H.R. 2179. And Mr. Cutler as well. It does provide enhancements. It does provide national notice of service, for example, doing away with the geographic limit on service. Some good things.
Has the lack of passage of H.R. 2179 failedcaused you to fail in bringing to justice anyone who has been found to violate the law?
Mr. CUTLER. No. I think these are important enhancements. But do I think I have some very powerful and critical tools already? Of course we do. And that is why we are bringing the cases we are bringing.
Chairman BAKER. And then with regard to H.R. 2420, Mr. Spitzer, I think you generally agree it is a good start; it may need enhancements, we may need to do more. Along the lines of your suggestion of the independent Chair, I had others where you should not have simultaneous management of a hedge fund and a mutual fund by the same managers, those kinds of issues. But on its face, H.R. 2420 is plowing new ground.
Mr. SPITZER. Absolutely. And I think it is a wonderful step forward.
Chairman BAKER. I thank the gentleman and I yield back.
Mr. OXLEY. Thank you, Mr. Chairman.
Mr. Cutler, I wonder if you could describe, first of all, to a layman the difference between legal market timing and illegal market timing.
Page 40 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. CUTLER. I am glad you asked, Mr. Chairman, because there is something of a misperception. Some people have a sense that all market timing is illegal. And market timing, just to remind everyone, is the practice of buying into and selling out of funds on a rapid basis, buying into a fund today and selling it tomorrow. And on its face there is nothing illegal about that. And the question is, does it violate, or does the fact that a mutual fund management company is allowing it to take place, does it violate a promise that the mutual fund company made to investors usually embodied in a prospectus that would say something to the effect of, we are not going to allow this practice. And if a mutual fund management company says we are not going to allow it, and then they allow it, that is a violation of law. And certainly among the cases that have been brought so far, that is one type of violative market timing conduct.
Mr. OXLEY. And does that tend to be boiler plate with most of the prospectuses?
Mr. CUTLER. Certainly a good number of them say we don't allow it, we prohibit it. Now, there are some that sayand one example is Putnam, which is a firm that we have already sued in connection with the trading of its portmarket timing of its portfolio managers. What Putnam said was: We don't like timing, and in order to stop it or to discourage it, what we do is we impose redemption fees so that if you are into and then you immediately get out of a fund, we are going to make you pay a 1 percent penalty.
But then the prospectuses go on to say, but you know what? We are not going to impose that kind of restriction on 401(k) plans. And that makes for a much different kind of situation.
Mr. OXLEY. Okay.
Now, Mr. Spitzer, you had said that the fund directors could have short-circuited this with due diligence in terms of market timing. That is correct?
Mr. SPITZER. Oh, absolutely. And the reason for that, sir, is that if you were to look at the redemption rates and the ratio of redemptions to the underlying asset value, what you would often see in some of the funds where there was the most frequent timing by outsidersor insiders, for that matteris that the rate of redemption so far exceeds the underlying asset value that you know that there is a cycle, that there are people trading in and out more rapidly than should be permitted, and, therefore, at a minimum, inquiry should have been triggered.
Page 41 PREV PAGE TOP OF DOC Segment 1 Of 2 Could I add one more notion to what Steve said? And this in no way disagrees with him, but this is maybe in addition to what he said.
In addition to the prospectus, there is also the issue of insiders doing this when outsiders are not permitted to do it, which obviously would be impermissible. And also, whether payment was made under the tableand that is not cash under the table necessarily, but whether some other quid pro quo was being offered in order to induce behavior that might have been permitted, might not have been permitted, such as the sticky assets that were referred to, that have been referred to so often, where people would say, we will put $100 million into a bond fund if you let us tie into your international fund. Those sorts of payments also add another issue, that would obviously make this improper and illegal behavior.
Mr. OXLEY. Improper and illegal?
Mr. SPITZER. That is correct.
Mr. OXLEY. Why did the fund directorsin your estimation, why did the fund directors fail in this regard?
Mr. SPITZER. I am notI am always loathe to address issues of motivation. I believe, and I think it is fair to say in some cases they didn't address it because they themselves were the ones who were doing the timing. I think those are the cases that have been most egregious to us and most just jarring in terms of violation of fiduciary duty, where you have the CEO of one fund, who himself was timing his own funds to the detriment of investors, and, in fact, sent the timing policethey have what they call timing police who are supposed to detect it.
He sent the timing police off on one beat and then he traded in a different precinct. I mean, this was a guy who was really Machiavellian in what he was doing in a way that was a gross betrayal. I think there it was an intentional oversight. I think in other cases, it may have been a lack of attention, which is why what we are hoping to do is to get boards and compliance departments to wake up and look at something that they should have been paying attention to, because these issues have been addressed in the academic literature and in the trade journals.
Page 42 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. OXLEY. Mr. Cutler, the obvious question is, where was the SEC during this time? And what tools do you have to be able to spot that kind of activity?
Mr. CUTLER. And I think that is a fair question. I am not charged with responsibility for our examination and inspection program, but I have done some thinking about this. And I suspect that one of the things that was happeningand I am just trying to put this in some sort of contextis that this was going on at a time when the mutual fund industry, interestingly, was beseeching the Commission to give it more tools to combat market timing: We don't like market timers. Help us beat these guys back. Give us more power to impose higher redemption fees. We don't like timing.
And so I thinkand, you know, I am speculating here. My sense is that people weren't at the time thinking, gee, mutual fund companies are going to be complicit in something that they are telling us they are trying to beat back.
Now, I think in hindsight obviously, you know, do we wish that we had identified this problem earlier? Absolutely. And, you know, I am confident that with the additional resources that we have gotten and are in the process of getting and Chairman Donaldson's risk assessment program that we will be in a position to identify these issues like this before they come up.
You know, by definition, once we bring enforcement actions, the wrongdoing has already occurred. Right? And so in some ways, you are always following the misconduct. And I think the challenge that we have is to identify problems like this, potential problems like this before it is ever necessary to bring a law enforcement action.
Mr. OXLEY. As a practical matter, it would be virtually impossible for the SEC or the Congress to essentially outlaw market timing; correct?
Mr. CUTLER. Well, in fact, I don't know that you need to. Because we where it violates a prospectus term, I think that is a violation. As Mr. Spitzer added, where you have got situations where you are trading off something that is to the advantage of the advisor, and potentially to the detriment of shareholders, we have got the power to go after that. And I think Mr. Roye, on behalf of the regulators at the SEC, is working on sort of beefing up what it is that mutual funds would be required to disclose vis-a-vis their market timing policies.
Page 43 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. OXLEY. And that, coupled with a high redemption fee or a substantial redemption fee, in your estimation, would at least begin to solve that problem?
Mr. CUTLER. Again, I am tempted to defer to Mr. Roye, if I could.
Mr. OXLEY. Of course.
Mr. CUTLER. Because he really knows the policy. When people violate the law, that is when I go after them.
Mr. OXLEY. Mr. Roye.
Mr. ROYE. I would be glad to address that.
I think that you hit on several solutions to the problem. I think the way we look at it, there have to be multiple pieces to the solution here. Steve alluded to the disclosures. Quite frankly, the disclosures are not specific enough in some cases. We want funds to disclose exactly what they are going to do to curb market timing activity, when they are going to do it, and when they are going to make exceptions to that policy. So, one very clear disclosure.
Mr. OXLEY. And the SEC can do that, clearly.
Mr. ROYE. And we have the authority to do that, and we are working on form changes currently to effect that change.
Now, if you really want to eliminate market timing, the economists will tell you that the way to do this is to eliminate stale pricing. It is that timing and international funds, where you are buying securities, where the market closed 10, 12 hours earlier, and you have pricing at 4 o'clock, that arbitragers are trying to take advantage of that difference in the pricing, inefficiencies in the pricing. And so what we said to the funds is that they have an obligation to fair value price the securities in the fund's portfolio.
Now, you are moving from an objective market closing price to your estimate of what you think that security is worth in light of significant market moving type of events. We have told funds they have to do this in a staff letter that went out in 2001. We are looking at recommending that the Commission make a very firm statement in this area to eliminate the possibility of market timing activity. And then on top of that, we have been looking at, again, giving the fund industry additional tools to thwart the market timing activity such as mandatory redemption fees.
Page 44 PREV PAGE TOP OF DOC Segment 1 Of 2 Last year we did a letter for the industry allowing them to delay exchanges since a lot of that activity is moving from one fund to another. So we see a multifaceted approach. And then last but not least, a role for the board of directors here in overseeing this activity, monitoring the types of information that Attorney General Spitzer talked about in overseeing this activity.
And then the addition of a compliance officer, which was part of Congressman Baker's bill to oversee and help the board in monitoring that activity.
Mr. OXLEY. Thank you, Mr. Chairman.
Chairman BAKER. Mr. Emanuel.
Mr. EMANUEL. Thank you, Mr. Chairman.
In my opening statement, I made reference to the late 1990s hot IPO market. And I was wondering, Mr. Cutler or Attorney General Spitzer, in any of your investigations or any of the issues that you are looking at, have you seen any preferential treatment during that period of time where the philosophy of managers wins, investors loses dominated how those IPO allocations are done? And I don't want you to tip your hand if you're already investigating.
Mr. SPITZER. And I won't do that. Thank you for the admonition. Last yearand I think Steve would agree with me on thiswe spent a great deal of time looking at the IPO issues related toissues relating to spending distribution of hot stocks and the usesthe improper uses that were made by investment banks and the distribution of those stocks, the ulterior motives that underlay the distribution most frequently in our experience last year to CEOs of client companies, where we believedand I still believe that the spinning is violative of the fiduciary duty of the CEO to the company; it should be a corporate asset, if anybody gets it. But also the question arises, how were the investment banks that are doing the underwriting making the determination about the distribution of those hot stocks; and, as a consequence, as part of the global resolution that was signed, I believe, last Friday by a Federal judge, there is an outright prohibition on the receipt of hot stocks by CEOs of publicly traded companies.
Page 45 PREV PAGE TOP OF DOC Segment 1 Of 2 Now, we did not last year, that I am aware of, nor have we yet investigated the interception of spinning with mutual funds, but certainly it would be a fertile area to examine. And I take your point, and we will do so.
Mr. CUTLER. Well, I guess I would start by saying, first there is an NASD rule that expressly prohibits an individual associated with a mutual fund from receiving a hot IPO.
Having said that, we have already brought cases involving the allocation of IPOs within a fund complex or thatto be more specific, I can point you to a case we brought called Nevis Capital, where what we allege is the managers actually in that case, interestingly, were directing hot IPOs to a fund; and the allegation is that they were doing that to the detriment of some of their other customers for, in some way, their own benefit, that is, that they stood to receive more fees if the mutual fund did well. They thought that that would bring in more investors. So, interestingly, in that case they were favoring a mutual fund over other customers.
We have brought other cases involving the failure of some fund companies, including Van Kampen and Dreyfus to adequately disclose that their performance was heavily influenced by the receipt of IPOs.
The one thing I think we haven't seen is precisely the point that you were making. That is, that managers were taking IPOs instead of giving them to mutual funds. But certainly the area of whether IPOs are equitably allocated by investment advisors has been a topic that the SEC has been concerned about and has brought cases on.
Mr. EMANUEL. As we think about this legislation and the rules of the road we want to write. Do you think there is any conflict of interest in the ownership of the mutual funds? That is, have any of these problems happened because insurance companies or commercial banks have now gone into this area? Do those types of ownership structures create any problems related to the management and the operation of mutual funds?
Page 46 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. CUTLER. Well, certainly among the allegations in the cases brought so far are conflicts between brokerage firms that are affiliated with mutual funds. Indeed, as I mentioned in my oral statement, we have been looking very closely at whether there is adequate knowledge on the part of customers and disclosure to customers that when they are dealing with a brokerage firm that they understand that that brokerage firm may be making money as a result of the sale of the mutual fund that they are recommending.
So, I mean, I take your point. I mean, there are some conflicts here. I don't know how sort of far out they reach, and maybe Mr. Roye has a sense of that.
Mr. ROYE. I was just going to refer to Mr. Spitzer's complaint. If you look at the complaint in the Canary case, a beautifully drafted complaint that the New York Attorney General did, I think it laid out just those kinds of conflicts within the Bank of America situation where you had deals being cut to benefit other parts of that organization at the expense of mutual fund investors; and I will let Mr. Spitzer address that.
Mr. SPITZER. Thank you for the compliment on the drafting. I didn't do it.
But it is vertical integration that often leads to these conflicts, and it is vertical integration that can twist the incentive structure so that you will have an effort to sell improperly, or also, in a more mundane way, vertical integration that will permit information flow such that it facilitates processing of trading patterns. And, indeed, in the Canary context, that was very integral to what happened. It was easier to integrate the information and process the trades because of the vertical integration of ownership. Now, that does not mean that we want to eliminate that vertical integration, but certainly it means that it raises issues that have to be thought through.
Mr. EMANUEL. As we look at this, one of the patterns we should closely study is how ownership structure has related to any conflicts of interest. Obviously, we are not going to regulate that insurance industries can't own mutual funds or commercial banks own investment banks. But we may need to take a look at creating not new walls but new rules of the road relating to cross ownership and the cross selling that goes on, so that the product lines don't create internal conflicts of interest in the future. Do you have any guidance on this issue?
Page 47 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. CASTLE. [Presiding.] Could we keep the answers brief, please, so we can keep moving?
Mr. CUTLER. I would certainly say that where there are conflicts that haven't been managed appropriately we have the powerI know Mr. Spitzer has the power to go after those conflicts and ensure that those who don't appropriately manage them are held accountable.
Mr. EMANUEL. Do I have time for another question?
Mr. CASTLE. We will have a second round, Mr. Emanuel. We would like to get through everybody first, if we could. Since I have deposed the chairman temporarily here, I yield to myself for 5 minutes. I am kidding. I was next anyhow.
Let me ask you this, Mr. Spitzer. You have been pretty critical of the SEC enforcement activities, ripped them, I would say, in some cases, and lately, yesterday in the Senate and here today a little bit you are making nice. It has become sort of Steve and Eliot and everyone seems to be getting along. Is there a reason for this? Do you have a different view of what they are doing? Or is Mr. Cutler doing such a wonderful job that you have been won over? Or are you just mellowing in your older age? It is helpful to us to have you this way.
Mr. SPITZER. No. Well, let me be very serious about this. I have at various times articulated I think a frustration that we might all feel and probably all do feel that if the abuses are as widespread as the evidence is now suggesting they areand indeed I think the SEC's examination and the data that Mr. Cutler revealed yesterday suggests whether 25 or 50 percent in different context of wrongdoing, there is a wealth of wrongdoing that could have been caught and should have been caught by compliance, by boards, by regulators, by prosecutors. There is a frustration we all feel, obviously, that we didn't catch it sooner.
As a consequence, I think at different times I have asked the question not merely because it is fun or meant to be a barbed comment but I think a question that deserves to be asked of law enforcement is what do we have to do differently in order to catch it next time? Therefore, should we be doing something differently so that this problem does not expand to its current proportions before we intercede as well?
Page 48 PREV PAGE TOP OF DOC Segment 1 Of 2 I think it is in that spirit that I have tried, perhaps not always as gently or deftly as I might, to say we have to examine our own processes.
Mr. CASTLE. Let me ask Mr. Cutler sort of a follow-up. How do you feel about where the SEC is right now? I mean, I am also somewhat critical of what I thought was a rather lax enforcement before. Obviously, we are all at a heightened awareness now than we were before. Do you feel that, without even starting to change laws which are clearly going to do with the regulations, do you feel that the SEC is up to where it should be in terms of the enforcement? And do you feel that we should clearly have both a State and a Federal component to this? I happen to agree with that, but I would like to hear your views on that briefly, if you could.
Mr. CUTLER. Sure. Well, first, let me say I don't think enforcement at the SEC has been lax, as I mentioned in my opening remarks. We have an obligation to be everywhere in the marketplace, and I think the 679 cases that we brought last fiscal year reflects that. I do think where we have room to improve is are we doing a good enough job identifying potential problems? That is, once we have identified them, I think that we are second to none in going after them, investigating them, litigating them, bringing the accountable people to justice.
Mr. CASTLE. But identifying is an important part of that isnot to argue with you. But identifying is an important part of that. I mean, that is not something you just sort of gloss over. I mean, clearly if there are market-timing issues, and we saw some problems in New England and places like that, you can't just say, well, we weren't good at identifying them.
Mr. CUTLER. Right, And I agree with you. Identifying is very important, and I think we are taking steps to get much more proactive in that area. I know within the enforcement division itself we have decided actually to bring to the division people that have subject area expertise, that is, people who are more tapped in to what is happening in the trading and markets area, who are more tapped in to what is happening in the mutual fund area, more tapped in to what is happening in the corporate accounting and disclosure area, so that we can be better at seeing around corners. And I am determined to do that. With your help, we have gotten more resources, and I think we are getting there.
Page 49 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. CASTLE. Thank you.
Mr. Spitzer, I am going to go back to a different subject. I own some shares of companies. I get these proxies in the mail about electing directors, and what is my 150 shares worth, and I frankly generally throw them out. We are talking about electing independentyou are talking about electing independent chairmen of the various mutual funds. We can define thatI have no problems with that, somebody who doesn't have ownership or whatever, and we can define the word independent. But the actual election process sort of bothers me.
I assume that most of the mutual funds are incorporated under your State laws, or mine, for the most part, and perhaps others. But, you know, is it going to be done by a proxy business, or is it just going to be independent in that the person doesn't have a direct interest in it but happens to be a good friend of the person who is doing it? The nomination process corporately and mutual fund-wise is so protective of those who are sending out proxies and election statements it is almost impossible, in my judgment, to get the true independents we would like to see.
Personally, I would like to have John Bogle running all of my mutual funds, if I had my druthers, but I don't think that is going to happen. But how do we get that done? I mean, I don't seeI think most mutual fund owners don't even understand they have ownership rights or voting rights in any of these things, much less actually really go to the level of independence that some of us are talking about. I am all for it, but I am worried about being able to really do it.
Mr. SPITZER. I agree with your concern. We have to breathe life into a statute, that you can define independence as aggressively as you wish, but, nonetheless, if you have somebody there who doesn't bring enough aggressiveness to the job it won't mean a great deal. I think this is where we have toand this is perhaps why I was also suggesting we would want to build into the statute some objective rules which would govern precise activities, such as most-favored-nation clause, such as multiple bids.
Page 50 PREV PAGE TOP OF DOC Segment 1 Of 2 In other words, if we really believed an independent board was going to act independently, you could stop right there and say, we want an independent board, boom, full stop; and everything else would follow based upon their behavior. If wewe all share, I think, your concerns to a certain extent, although I think the right people will fulfill that mandate, and certainly prospectively they understand what that job requires. I think if you add to it certain additional requirements, such as I have already mentioned, maybe that will give us certain benchmarks by which we can measure their behavior or minimum thresholds that they would have to satisfy.
Mr. CASTLE. Thank you, Mr. Spitzer.
Mr. Scott is recognized for 5 minutes.
Mr. SCOTT. Thank you very much.
Let me ask yougoing back to the debate with Mr. Frank and Mr. Baker on the deterrence and restitution issue, it seems to me that national markets should have a single regulator; that given the ability of 50 different States to override Federal laws just doesn't seem to make sense; that there should be a uniformity in our markets; but yet, bearing Mr. Frank's point, that we should preserve the State authority to investigate, to prosecute securities fraud, collect the penalties, and discouragement funds. Is that at the end of the daybecause I do know that you and the SEC will be getting together later today. Is that byto look into the future, is that what we are going to wind up with? Doesn't that make sense?
Mr. SPITZER. Yes, it does. That is why I think I began my comments earlier by saying that I have never disagreedin fact I have affirmatively stated, obviously, we need one primary regulatoryit is the SECwe need uniformity in the marketplace, and that is what you seek when you have one primary regulator.
Having said that, you used the word override. We certainlybecause of the supremacy clause, we clearly can't override an SEC reg or Federal statutes, obviously. What we can doand here is where I think you get shades of gray and areas of greater complexity.
Page 51 PREV PAGE TOP OF DOC Segment 1 Of 2 In individual consent decrees, injunctive relief that we get at the end of enforcement action, we will often impose upon a wrongdoerclassic example to be a boiler room operation where they have been selling phony stocks or have been playing games with stock pricing. We would force them to do certain things, have some compliance programs that are not inconsistent with Federal law, do not override Federal law but supplement and set a higher bar for them in terms of their behavior. I think that is what we have tried to do with due delicacy not to obviously disrupt or create a lack of common law in the capital markets. But in those enforcement actions we have often felt it was incumbent upon us to sanction the wrongdoer by imposing that sort of injunctive relief.
Mr. SCOTT. Thank you.
Mr. Cutler and Mr. Roye, I would like to go back to the market-timing issue. It seems to me that you said that, of course, late trading is illegal. Market timing is not illegal. Is that right? It is not illegal?
Mr. CUTLER. Well, it is not per se illegal. That is, there can be circumstances, and you have seen many of them already, in which it is, because of things like quid pro quo arrangements or prospectus disclosure, that the market timing contravened.
Mr. SCOTT. Why wouldn't you recommend that we make it illegal? Is that possible, to make it illegal?
Mr. CUTLER. I will let Mr. Roye
Mr. ROYE. Let me respond to that. I think it is important to note that probably every investor at some point is making a timing decision, trying to determine when to buy a fund, when to get out of a fund, when to move from one fund to another. You have mutual funds that actually cater to market timers. They are sold on the basis of we welcome market timers. You have funds that it doesn't make sense to market time, like money market funds where there is a stable net asset value. You know, there are funds that do have market timing issues. It is disruptive to their performance.
Page 52 PREV PAGE TOP OF DOC Segment 1 Of 2 To this point, we have relied on the funds to articulate what those procedures are that they are going to follow to discourage this activity to protect the rest of the fund's investors. So I think the question becomesit is not per se illegal. We need to recognize that there are circumstances where timing, does make sense but also where it is harmful. And, indeed, where it is illegal we need to come down on it. But where it is harmful, we need to make sure that there is someone monitoring the situation, that they have the appropriate controls in place and that funds have all the necessary tools to deal with that type of activity.
Mr. SCOTT. Also, the market timing seems to me that it would have a verysomething you haven't touched on yet, but a profound impact on foreign markets, particularly in treating with foreign securities after their markets close or before ours close. How serious a problem is that? What is the impact that that has on market timing?
Mr. ROYE. Well, I don't know exactly. I haven't seen any studies that really go into that type of impact. But what I can tell you is that when investors and large investors are moving in and out of the funds, the reason a lot of portfolio managers don't like it, is because it means that they have to sell securities or they have to maintain high cash positions to deal with that kind of activity, and that can adversely impact performance. But I haven't seen any information to indicate that it is being disruptive to foreign markets, and I would have to defer to the economists on that.
Mr. SCOTT. Well, the indication that I have some informationfor example, a strong rally in the U.S. markets after the close of foreign markets could prompt market timers to purchase mutual funds with Asian stocksthat is a possibilityon the expectation that prices in those stocks will rise when the Asian markets open, creating the potential for strong gains in the value of mutual fund shares the next day.
Mr. CUTLER. Maybe I could help here. You are certainly right, that the opportunities to exploit inefficiencies in mutual fund pricing are most acute in funds that hold foreign securities, where Mr. Roye said earlier the closing price in the Tokyo market, for example, would have been 14 hours old before a fund sets its net asset value.
Page 53 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. SCOTT. That is why I am saying, on that evidence alone, it seems to me, the damaging impact it could do to world markets ought to put some emphasis on our ability to make such a practice illegal.
Mr. ROYE. Well, I am not sure you can draw the real connection between that type of arbitrage activity, where investors are moving in and out of the fund to take advantage of that activity. I think that, you know, in order for it to have an impact on foreign markets, you have to have sales of securities in those foreign markets driving those markets down.
And I don't think that is what we are seeing, but I think what you are pointing to is that this opportunity is what affords the market timing advantage here, and what we are trying to do is to get the funds to deal with that in terms of having accurate values of those securities. We are trying to move them from using these stale prices, if you will, to a more accurate price, which candidly has to be some guesstimate on their part as to what the real value of those securities are to eliminate these arbitrage opportunities. Then you couple that with something like mandatory redemption fees, and maybe we can eliminate the problem you are talking about.
Mr. SCOTT. Could I ask one more quick questionreal quick? I just want to go back to Mr. Spitzer real quick.
You said in your testimony, Mr. Spitzer, that the mutual fund directors rarely negotiate lower fees for their shareholders and that fund managers are rarely replaced. You highlight that the chairman of the board of directors of the fund is almost always affiliated with the management company. These are some real important observations you have made. Can you elaborate very briefly on how widespread this problem is and recommend what forms that this committee or the SEC should take to deal with this problem?
Mr. SPITZER. I cannot give you a quantification, but I will endeavor to get that information to you in short order.
Page 54 PREV PAGE TOP OF DOC Segment 1 Of 2 In terms of a remedy, I think this is what speaks to theor what I think is a very wise idea, which would be to have an independent board share; and I think the definition of independence is something we can grapple with to make sure there is a sufficient buffer between the board share and the management or the advisory company, a critically important step we have to take. Again, because of the inadequate negotiation matters, perhaps the notion for a most-favored-nation clause or an obligation to get multiple bids again to ensure that there is an actual arms-length transaction that reflects the true market valuation of the services being provided.
Mr. SCOTT. Thank you, sir.
Chairman BAKER. [Presiding.] Ms. Biggert.
Mrs. BIGGERT. Thank you, Mr. Chairman.
Before I begin my questioning, I would ask unanimous consent to submit for the record testimony from Hewitt Associates.
Chairman BAKER. Without objection.
[The following information can be found on page 234 in the appendix.]
Mrs. BIGGERT. I think this question will probably be directed to Mr. Roye, but if somebody else thinks he would like to answer, I want to talk a little bit about illegal, late-hour trading.
In Mr. Spitzer's testimony, I believe that you said that you thought that the current rules surrounding illegal late-hour trading were sufficient, but just needed to be enforced. And I have concerns that if we do change the current trading rules outright, it could put at risk the fairness and, potentially, even the cost effectiveness of 401(k) plans for participants. And it is my understanding that current SEC rules require that orders to purchase or redeem fund shares must be received by the fund or their agent before 4 p.m. Eastern Standard Time if they are to receive that day's closing price.
Page 55 PREV PAGE TOP OF DOC Segment 1 Of 2 One option reportedly under consideration would change the current regulations by requiring all entities, and that would include the record keepers, to submit mutual fund trades to the mutual fund by 4 p.m. And in 401(k) plans, this would effectively mean that 401(k) record keepers would have to complete this by the 4 p.m. deadline. And the processing takes quite awhile, so those investors in 401(k) plans would have to make their investment decisions several hours earlier than 4 p.m., and that would put them at a substantial disadvantage with respect to the other fund shareholders.
Could you address this?
Mr. ROYE. Yes, I can. I think you highlight what really ends up being a trade-off here; and as a staff person, I can tell you that we are thinking about the hard 4 o'clock cutoffs and alternatives to that; and I can't speak to what the Commission ultimately does with that. You know, we have a situation where it has been discussed, widespread abuse of the late trading obligation on the part of intermediaries that sell fund shares.
Now, I want to emphasize that some of these intermediaries are regulated by the SEC and some aren't, and indeed some of the pension plan record keepers, they are not subject to SEC jurisdiction. So we have a situation where, if there is widespread abuse, we don't have jurisdiction.
There is a requirement that they comply with the 4 o'clock cutoff, and orders that come in after 4 o'clock are supposed to get tomorrow's price rather than today's price. And they are supposed to have controls in place; indeed, all the mutual fund contracts essentially require the intermediaries to have controls and procedures in place to deal with this, and we found that they don't exist. As the Attorney General pointed out, there has been a massive breakdown in terms of how those procedures and controls are working.
The further you get away from the fund, the greater the risk of abuse; and if we can change the rule so that these orders have to hit the fund by 4 o'clock, then we can eliminate the problem. We are looking at people that we don't regulate, and we see that they don't have the controls in place. We are very concerned.
Page 56 PREV PAGE TOP OF DOC Segment 1 Of 2 But you are correct. There is going to be a trade-off here because it is going to narrow the window of opportunity for certain investors to make their investment decisions.
I guess I would point out that a lot of investors are long-term investors, and hopefully, when they go into a mutual fund, they are taking a long-term perspective, and ultimately, it shouldn't really matter.
I know it is going to impact some investors.
We do have within our regulatory framework currently this issue we have variable insurance products, variable annuity, variable life insurance, they already live with the hard 4 o'clock rule. And investors are buying mutual funds for those products. So that is the trade-off.
Mrs. BIGGERT. You know, isn't it something as simplelike a time stamp when an investor decides to buy at 3:59 and it is stamped, then the calculations can be done?
Mr. ROYE. I will let Mr. Spitzer and Steve tell you how people have circumvented those problems.
Mr. CUTLER. It is pretty easy to time-stamp a ticket and then, as has been revealed in some of these cases, have the customer call back at 4:30 and tell the firm whether they actually want the order to go or whether they want the firm to toss the ticket. And that is what happened here. There is nothing that is fail-safe; but as Mr. Roye said, you know, moving this deadline closer and closer to the fund companies themselves can only help prevent abuse.
Mrs. BIGGERT. Thank you. I see my time has expired and I yield back.
Chairman BAKER. Mr. Matheson, do you have a question?
Page 57 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. MATHESON. Thank you, Mr. Chairman. A couple of questions I wanted to ask.
One is, the Investment Company Institute has come out with their recommendation about this 2 percent redemption on transactions where it has been held for less than 5 days. Do youwhat effect will that have in an effort to eliminate illegal late trading?
Mr. SPITZER. I think the 2 percent notion is a good one whether it is 2 percent, 1 percent, 8 percent. Some calculus will have to be drawn to figure out what the fees should be imposed upon. It goes more to timing than to late trading, the quick in and out, although theoretically it could apply to late trading as well.
What you are really trying to do is eliminate the profit margin, and those who are arbitraging based on timing are really looking for thin margins, but they are doing it over and over again with such speed and such volume that they end up doing quite nicely over time. Two percent per trade, the ICI obviously believes it would be sufficient to discourage it. Some imposition of a fee like that would make sense.
In fact, there have been many funds that imposed a fee when you had a sequence of trades within some time frame. Unfortunately, as Steve just said, any system can be circumvented.
What these funds did was waive the fee for those who were favored investors, who were giving them sticky assets with whom they were in cahoots. So they said, well, we will just ignore the redemption fees and go ahead and do your timing. If it were applied and if it were done fairly it would certainly be helpful.
Mr. MATHESON. Mr. Cutler, you mentioned this survey that had been done of a number of broker-dealers, and some of the issues about percentages, that were aware of market timing having taken place and whatnot were pretty high. You also mentionedin response to Chairman Oxley, you said there is market timing that is appropriate and inappropriate.
Page 58 PREV PAGE TOP OF DOC Segment 1 Of 2 Do you have a sense with your survey how that breaks down in terms of firms that were aware that it was going on, but the type that was okay versus the type that is not okay?
Mr. CUTLER. I would recast that into legal and illegal, as opposed to appropriate and inappropriate. We are looking hard at all of those instances, and it may well be that some of them are not illegal; but I can tell you, in a disturbing number of cases, we believe that there was prospectus disclosure, for example, that would have been inconsistent with the notion of allowing or entering into a market timing arrangement with an investor.
Mr. MATHESON. And do you think you have the tools to bring enforcement action when this is illegalmarket timing?
Mr. CUTLER. Yes, I do. Again, are there otherare there enhancements to those tools, including some of the ones that have been talked about here today in H.R. 2179? Yes. But I think, as you have seen already, we havewe do have the arsenal to go after this sort of misconduct. That is why we brought cases to date, and that is why you will see many more cases in the coming months.
Mr. MATHESON. You have tools in terms of the regulations that are in place, but I also want to touch uponconversation that you had with Mr. Frank about the resources to do so. And we have got over 8,000 mutual funds. You said in your testimony earlier the SEC receives over 200,000 tips in a year. It seems to me, when we were looking in Congress to upgrade the resources going to the SEC, that was actually before this mutual fund issue came into play.
I am curious what your perception is, if you think that the SEC is given adequate resources to truly perform their enforcement function.
Mr. CUTLER. Again, I think we have a big integration function or integration responsibility and challenge ahead of us to make sure that the resources that you have already given us are used intelligently and wisely; and we are still in the process of doing that.
Page 59 PREV PAGE TOP OF DOC Segment 1 Of 2 Where I think the biggest difference will be made is in the examination and inspection program that the Commission has. Up until the recent allocation of resources, there were 350 people that were doing examinations of the 7,000 mutual fundsI think I have got the right number; 8,000, sorry to have understated it8,000 mutual funds across the country. That probably wasn't enough. We now have more people devoted to that function, and that is where you really get your intelligence at the SEC from the people who are, on a daily basis, walking into funds, examining them, walking into investment advisors and examining them. And I think that againI don't oversee that program, but I think we are well on our way to beefing up that program to put us in a better position to be able to see around those corners.
Chairman BAKER. Mr. Manzullo.
Mr. MANZULLO. Thank you. I have a pretty simple question.
Attorney General Spitzer, you had referred to the mutual fund industry as a cesspool in the Senate yesterday. I mean, first you have direct discharge of effluence, then the cesspools, septic and then water treatment. So this is pretty high up on the level of sludge that you used.
Mr. SPITZER. You know your engineering better than I do.
Mr. MANZULLO. I live on a farm, so I know about that stuff. My comment would be, or rather my question is, in the midst of all the fines and the penalties, is there a way that these can be transferred or passed on to the investors themselves in the mutual fund through an increase in some type of a fee or something, some type of fees, or are these personal judgments?
Mr. SPITZER. If I understand your question, can we pass back to the investors some of the funds that we recoup?
Mr. MANZULLO. That actually wasn't the question, but that is a good follow-up on it.
Page 60 PREV PAGE TOP OF DOC Segment 1 Of 2 My first question was, if, for example, Canary agreed to pay $40 million in fines, I don't know how much of that was fine and how much was restitution, but can the fine that the mutual fund itself pays end up actually being paid by the investors?
Mr. SPITZER. I see. Will the investors be footing the bill because their costs will increase? I understand.
I suppose it is always a possibility when you impose a fine on a corporate entity that the owners of that corporate entity, namely the shareholders, whether it is a mutual company or not, will end up being assessed their proportionate share, which is why we try to impose fines upon individuals and individual decision-makers who have been responsible for the wrongdoing.
So, yes, as a theoretical matter, if you were to fine any of the major mutual fund families a significant sum of money, is it conceivable that somehow that gets referred back? We will endeavor to take it out of the fees that are paid, that have been paid into them already, and perhaps not permit them to allocate.
Mr. CUTLER. I think it is actually useful to be pretty precise here. When you charge a fund management company with wrongdoingand that is what, to date, we have been chargingthat is not the mutual funds themselves, that is the advisor to the funds. And it certainly isn't our intention here to have investors foot the bill for the wrongdoing that fund management companies were engaged in.
Mr. SPITZER. If they were to charge them back is the problem. How do you prevent them from charging it back? We will endeavor to make sure that that doesn't happen.
Mr. ROYE. Let me just point out that the Investment Company Act provides that you can't raise the management fee unless you go back to shareholders. The shareholders would have an opportunity, if that were to go on, to weigh in and vote no.
Page 61 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. MANZULLO. I presume by the answers of all three of you that you will closely monitor the payment of those fines, the source of the fines and actually the fund itself for the next several years to make sure that those are not passed on to the fund investors.
Mr. SPITZER. That is correct. And we are all, collectively in the funds that we receive, creating restitution funds that will go back to the shareholders themselves. Of the 40 that was paid by Canary, 30 is in a restitution fund and 10 is the straight fine. That goes to the government, but 30 is going back to the shareholders.
Chairman BAKER. Mrs. Capito.
Mrs. CAPITO. Just to follow up on that, on the restitution fund of the 30 million, how is that disbursed to the shareholder? Do you get a certain percentage, certainly full restitution or is it full restitution?
Mr. SPITZER. We don't yet know. We have only recently closed that transaction, and we are going to figure out what is the most appropriate way to ensure that that 30 million goes back to those that were injured in proportion to theirthe magnitude of their injury. It is an issue that we and the SEC are grappling with simultaneously with respect to the global deal last year where there is a significant restitution fund.
There are tough judgment calls that have to be made in terms of how you determine who the recipients should be, and what proportion to their injury. We are trying to work those issues through right now.
Mrs. CAPITO. This question may reveal my naivete, but let me ask a question in terms of the issues of transparency and the fees that we are investigating and looking at right now, when we are in an up market. Has this become a function of our investigation because we have been in a down market so long? Because even when the market is going up, people aren't complaining about which way their investments are moving.
Mr. SPITZER. Actually, I think not. I don't dispute the premise of your question which is that ordinarily in a down market, people will be a bit more aggressive in their complaints and allegations, perhaps, are more rapidly made.
Page 62 PREV PAGE TOP OF DOC Segment 1 Of 2 The issue of late trading and timing really are a response not to the direction of the market but to the volatility of the marketplace; and the arbitragers who take advantage, up or down, really need volatility. They don't care if the market is trending one way or the another.
The information that was brought to us that triggered the set of inquiries wasn't brought to us because of a particular loss. It was just because of an understanding of the impropriety and the structure of the trades that were being conducted.
Mrs. CAPITO. Thank you. I have no further questions.
Chairman BAKER. If there is no objection from anyone, I think we are going to mercifully say thank you to our first panel. We do appreciate your courtesy in appearing here, and your testimony has been of significant help to the committee and its work. We look to working with you in the days ahead toward an appropriate resolution.
I would like to welcome the patient members of our second panel for their courtesy in appearing here today and moving forward. I would like to welcome back no stranger to the committee hearing room, the Honorable Arthur Levitt, former chairman of the Securities and Exchange Commission, who has been before this committee on many occasions.
STATEMENT OF THE HONORABLE ARTHUR LEVITT, FORMER CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION
Mr. LEVITT. Thank you very much, Chairman Baker and Ranking Member Kanjorski and members of the subcommittee that have lasted so long this morning. I will try to be brief.
I would like to thank you for inviting me to share my thoughts on allegations and, unfortunately, burgeoning evidence of self-dealing in the mutual fund industry.
As regulators and lawmakers examine the sale and operation of mutual funds, I think it is important at the outset to remember that mutual funds represent the very best vehicle from which the individual investor has access to our markets. Regrettably, the industry has taken advantage of this fact. Investors simply do not get what they pay for when they buy into a mutual fund, and most investors don't even know what they are paying for.
Page 63 PREV PAGE TOP OF DOC Segment 1 Of 2 The industry often misleads investors into buying funds on the basis of past performance. Fees, along with the effect of annual expenses, sales loads and trading costs are hidden. Fund directors, as a whole, exercise scant oversight over management. The cumulative effect of this has manifested itself in the form of late trading and market timing and other instances of preferential treatment that cut at the very heart of investor trust. It would be hard not to conclude that the way funds are sold and managed reveals a culture that thrives on hype, promotes short-term trading and withholds important information.
The SEC and other law enforcement, such as the New York Attorney General, no doubt will aggressively investigate and prosecute criminal activity. But for the longer term, it is well past time to consider meaningful change in the administration and governance of mutual funds.
I hope the industry recognizes the grave threat these questions represent to its health, and that it will embark on substantive efforts to reform itself along with the necessary hand of the SEC.
I would also like to thank Chairman Baker for his reform efforts in performing a vast civic benefit; he is often a lonely voice on behalf of investors. I believe that reform may include the following areas:
One of the most effective checks against egregious abuses of the public trust is broken: the strict oversight of truly independent directors. Many so-called independent directors have professional or collegial ties with fund managers or, themselves, are recently retired managers. Fund boards, in my judgment, should have only one inside director. Everyone else on the board should meet a strict definition of independence from the fund complex.
Equally important, the chairman of the fund company must be independent. That is one of the best ways to improve accountability for management practices. He or she should sit on a reasonable number of boards. For board members or chairmen to be compensated for services on as many as 100 boards is simply not reasonable.
Page 64 PREV PAGE TOP OF DOC Segment 1 Of 2 During recent weeks, State and Federal authorities, working together, have uncovered egregious and sometimes criminal violations of the public trust. Such miscreant entities should be required to appoint to their boards an investor ombudsman for a defined period of time. The largest mutual funds pay money management advisory fees that are more than twice those paid by pension funds. It is essential that investment company boards be required to solicit competitive bids from those who wish to undertake the management function. Furthermore, boards should justify to their bosses, fund shareholders, why they chose a particular investment advisor and each year should demonstrate that they have aggressively and competitively negotiated management fees.
Sadly, funds have moved away from a culture of diversification and probity in favor of an almost phrenetic competition to market investment products as if they were soap or beer. The fund industry should themselves proactively ban performance advertising. Such misleading hype encourages bad practice such as portfolio pumping to boost quarterly performance. Companies that don't accept the importance of change to protect their franchise and continue to promote and hype performance should be required to advertise returns only after the effect of fees and taxes has been applied. What millions of American investors currently see in magazines and newspapers is just plain deceptive.
Despite the SEC's efforts to persuade the use of plain English, the language of the industry is still hopelessly arcane. What average investor understands the meaning of 12(b)(1) fees, closed end funds or ABC classes of shares. Mutual funds have a long way to go before they start talking in the language of investors.
Executives, fund managers and directors of a fund complex must be required to disclose their compensation. A fund's shareholder should know how much they are paying someone to invest their money and if the incentives of that manager's compensation is in investors' long-term interest.
In addition, the trading by managers of fund shares or securities that are part of a fund's portfolio should be prohibited in favor of long-term ownership. Having run several large sales organizations, I totally reject the specious argument that such practices are essential to retain competent managers or that such practices hone skills or approve commitment.
Page 65 PREV PAGE TOP OF DOC Segment 1 Of 2 I suspect market timing issues are far greater than the industry acknowledges. For instance, the closing down of unsuccessful funds that are then exchanged for a new fund within the same complex could well be considered an example of a market timing strategy with funds moving back and forth between stock and a money market fund.
In 1940, the Investment Company Act stated that mutual funds are to be organized and operated in the interest of shareholders. We should consider a legislative amendment that precedes those words with a statement that it is the fiduciary responsibility of directors to ensure that funds are organized and operated in such a way.
Not long ago, most investors bought directly from mutual funds themselves. Today, more than 80 percent of funds are purchased through brokers and not nearly enough of them disclose revenue-sharing deals that pay them more to put clients in a certain company's funds. The brokerage system of selling mutual funds continues to be riddled with conflicts, revenue sharing, sales contests and higher commissions for homegrown funds should be banned.
I have long wrestled with the issue of soft dollars. It is clear that the practice of allowing higher commissions in return for broker directed research has created great potential for abuse. At the very least, investors should know what commissions they are paying and what the money is going toward. Disclose it and do it simply.
More broadly, in light of the many abuses of this practice, Congress should seriously consider revisiting the safe harbor it granted to soft dollar arrangements shortly after the abolition of fixed commissions in 1975. ''seek simplicity and distrust it,'' someone once remarked; I can't help but wonder if they worked in the mutual fund industry.
Mutual funds have a lot to answer for. But I have come to know many in the business and most realize that without investor trust, our markets simply can't function. I hope that they will speak out and that they will be the voice of meaningful and yet pragmatic change. In the last year, the voices in corporate America and on Wall Street were largely silent in the face of scandal. Mutual funds, given their very form and function, cannot afford to be. Thank you.
Page 66 PREV PAGE TOP OF DOC Segment 1 Of 2 Chairman BAKER. Thank you very much, sir, for your statement.
[The prepared statement of Hon. Arthur Levitt can be found on page 218 in the appendix.]
Chairman BAKER. Our next witness is Mr. Don Phillips, Managing Director of Morningstar, Inc.
STATEMENT OF DON PHILLIPS, MANAGING DIRECTOR, MORNINGSTAR, INC.
Mr. PHILLIPS. Mr. Chairman, thank you for the opportunity to appear before this distinguished committee.
At Morningstar we currently cover mutual funds in 17 countries. As such, we have seen how the fund industry has evolved in different settings with various structural and regulatory approaches.
As a general rule, funds are structured in one of two ways, contractually or as corporations. The United States has wisely embraced the corporate structure of fund management, which is why the industry is governed by the Investment Company Act and not by an investment product or investment services act.
In the U.S. And other countries where the corporate structure has been embraced, funds have enjoyed great success. The reason is clear. The corporate structure places investors' interests first. The beauty of the corporate structure is, it places the investor at the top of the pyramid. An independent board of directors is created to uphold shareholder interest and to negotiate an annual contract with a money manager to provide services to the fund. As defined by the 1940 act, the fund management company is not the owner of the fund but rather the hired hand brought in to manage the assets.
While today's fund executives live by the letter of the 1940 act, they don't always embrace its spirit. Go to any industry gathering and you rarely hear investors referred to as shareholders and even less frequently as owners. Instead, they are customers. In the vernacular of today's industry leaders, fund management companies are manufacturers of products that are sold through distribution channels such as mutual fund supermarkets to customers who operate presumably on the premise of ''buyer beware.'' .
Page 67 PREV PAGE TOP OF DOC Segment 1 Of 2 In effect, today's fund leaders have inverted the relationship envisioned by the framers of the 1940 act. Rather than being at the top of the pyramid, fund investors today find themselves at the bottom of the food chain. While the U.S. Fund industry does have a good long-term record of serving investors, this record owes not to the superior moral nature of fund executives, but rather to the industry's high level of transparency that has been brought about by the corporate structure of funds.
In Morningstar's opinion, H.R. H.R. 2420 aptly sought to bolster this transparency. Its adoption, especially in its strengthened version, would go a long way towards better protecting the 95 million shareholders who put their faith in mutual funds.
As for other issues this committee might consider in the efforts to protect investor interest, Morningstar would like to submit the following four principles:
One, apply the same disclosure standards to investment companies as to publicly traded operating companies. If mutual funds are indeed corporations, let us treat them as such. Unless there is a compelling reason to draw the lines differently, there is no good reason to treat publicly traded investment companies, mutual funds, any different than publicly traded operating companies, stocks.
However, because equity shareholders have historically had a louder voice than have fund shareholders, it is not surprising that disclosure standards for stocks remain far higher than those for funds in many areas. It is time for someone to speak up for shareholders and level the playing field.
Every week we speak with mutual fund portfolio managers who tell us that before they buy stock in a company, they look to see how management is compensated. They want managers who eat their own cooking and whose interests are aligned with theirs. An equity investor has access to detailed information on the compensation and on the purchase and sales of aggregate holdings of senior executives and other insiders at an operating company.
Page 68 PREV PAGE TOP OF DOC Segment 1 Of 2 Stunningly, fund investors are denied access to the very same data about the managers of their funds. Such sunlight might well have been beneficial in the recent cases of several Putnam portfolio managers and Strong Funds Chairman Richard Strong, who have been accused of market timing their own funds. Could you imagine these executives engaging in such actions if they knew it would become public information that they were trading so rapidly?
Why should such information that has long been disclosed on corporate insiders not be available on fund insiders? It is time to level the playing field.
Two, bring more visibility to the corporate structure of funds and the safeguards it provides. The typical mutual fund investor is largely unaware of the corporate structure of funds. In fact, the names and biographical data of fund directors are not even included in many fund prospectuses, but instead are relegated to the seldom-read statement of additional information.
To remedy this situation, Morningstar suggests that each fund prospectus begin with an explanation of the fund's corporate structure such as the following:
''when you buy shares in a mutual fund, you become a shareholder in an investment company. As an owner, you have certain rights and protections, chief amongst them an independent board of directors whose main role is to safeguard your interests. If you have comments or concerns about your investment, you may direct them to the board in the following ways: by bringing more visibility to the fund's directors and by alerting shareholders to their role in negotiating an annual contract with the fund management company.'' the balance of power may begin to shift from the fund management company executives where it now rests to the shareholders and directors where it belongs.
In addition, we believe it is highly beneficial, if not essential, that the chairperson of the fund board be an independent director. In an operating company, there is only one party to which directors, be it independent or not, owe their loyalty, the stockholders.
Page 69 PREV PAGE TOP OF DOC Segment 1 Of 2 In a mutual fund, there are two parties to which the nonindependent directors owe their allegiance. One is the fund shareholders, the other is the stakeholders in the fund management company; only the independent fund directors have a singular fiduciary responsibility to fund shareholders.
We also believe that this independent chairperson should be responsible for reporting to the fund shareholders in the fund's annual report, to address the steps the board takes each year in reviewing the fund's management performance and the contract that the fund has with the fund management firm. Only by having more visibility for the role of directors can they truly fulfill their function.
Three, insist that fund management companies report to fund shareholders as they would to owners of a business. There is particular room for improvement in the way costs are communicated to investors. For many middle-class Americans, mutual fund management fees are now one of their ten biggest household costs. Yet the same individual who routinely shuts off every light in their house to shave a few pennies from the electric bill is apt to let these far greater fund costs go completely unexamined. Getting these fees stated at a dollar level that corresponds with an investor's account size is an important first step.
We have truth-in-lending laws that detail to the penny the dollar amount a homeowner will pay in interest on his mortgage. Isn't it time for a truth-in-investing law that would bring the same common-sense solution to mutual funds, the retirement vehicle of choice for a whole generation of Americans?
Four, ensure that all shareholders are treated fairly. Our final point is one that we wouldn't have thought needed to be raised 6 months ago, but in the wake of the recent fund trading scandals, it has become a significant issue.
Morningstar supports fair-value pricing policies and the consideration of higher redemption fees for short-term trades. In addition, we support a hard close for mutual fund pricing. If a trade order is not in the fund's possession by 4 p.m. Eastern, it should be transacted at the next day's price.
Page 70 PREV PAGE TOP OF DOC Segment 1 Of 2 By bringing more visibility to the corporate structure of funds and by leveling the playing field between publicly traded operating companies and investment companies, this committee can demonstrate to American investors that mutual funds will continue to operate on one of the cleanest level playing fields in all of finance.
Thank you for the opportunity to speak before you.
[The prepared statement of Don Phillips can be found on page 221 in the appendix.]
Chairman BAKER. Our next witness is Mr. Mercer E. Bullard, President and Founder of Fund Democracy, Inc.
STATEMENT OF MERCER E. BULLARD, FOUNDER AND PRESIDENT, FUND DEMOCRACY, INC.
Mr. BULLARD. Thank you, Chairman, and thank you for the opportunity to speak before the committee today. What I would like to do is, first, I would like to applaud you for addressing these issues before mutual fund regulation became the regulatory issue du jour, and I hope that the committee and the House and the Senate can get together and now get some effective fund legislation done.
What I would like to talk about is to clarify a little bit about what is an issue of some confusion, and that is the nature of these different frauds and how to look at them and think about what is the proper role of Congress in dealing with them.
One fraud is actually almost a year old. That is the Commission overcharges scandal that the SEC and other regulators discovered earlier this year where they found that in 30 percent of the cases in which fund shareholders were entitled to receive discounts on commissions, they did not receive them. This kind of systemic failure is the first example of fund directors and fund managers simply not doing their jobs.
Page 71 PREV PAGE TOP OF DOC Segment 1 Of 2 What could be more fundamental than making sure that your shareholders are not being overcharged? And what is even more shocking, as you heard Mr. Cutler talk about today, about actions being taken by the NASD and the SEC to require these broker-dealers to find out who they overcharged and, imagine that, repay them the amount they overcharge.
The question is, how is it, 6 months after this fraud was uncovered, these fund boards are not doing the same thing? If you were a fund director, wouldn't you think the first thing that you would do when you found out your broker was overcharging your shareholders would be to say, Well, not only is this disgraceful, and I am considering firing you as a distributor, but I would like you to pay back the amount that you stole from my shareholders. Obviously they haven't done that, or else the NASD and the SEC wouldn't have to be forcing broker-dealers to repay the amount they overcharged their investors. Perfect example, number one, the fund director is not doing their job.
The second example is late trading. Late trading resulted because the SEC as a practical matter said, You don't have to get your order in by 4 o'clock because, as Congresswoman Biggert pointed out, there is a problem with some 401(k) plans getting orders in time to meet that 4 o'clock deadline. The regulatory issue is whether it is received by 4:00, not whether the fund receives it by 4:00. All that fund directors have to do to the extent that the fund was receiving orders after 4 o'clock is make sure there are procedures in place to ensure that they were received before 4:00 and cannot be canceled, and then to do spot checks to make sure that was happening. The pervasiveness of this fraud demonstrates that simply was not happening. And this again, like the Commission overcharges, is fundamental compliance.
The third example is market timing. The market timing we are most concerned with is market timing that violated fund prospectuses. If you are a fund director, the first thing you should read would be the fund prospectus, and when you see a requirement in there, it immediately becomes incumbent to be sure that that requirement is being complied with. You do that by having procedures in place designed to enforce that requirement and by doing spot checks.
Page 72 PREV PAGE TOP OF DOC Segment 1 Of 2 It is very simple doing spot checks. You ask to see the cash flows of the fund, and if the intermediaries won't provide it, you insist on receiving it. Once again, the pervasiveness of this fraud demonstrates fund directors were not doing it.
The worst example is the case of stale pricing, which you heard Paul Roye tell you earlier is flat out illegal. It is illegal to keep that 14-hour-old Japan stock market price when you know there are events that have affected its value and it is obvious there are events that affected its value. That is why 28 members of the boilermakers' union were market timing funds, because they knew the value of the fund was now underpriced. It is incredible to me that apparently the fund directors and the SEC didn't know.
And what is most embarrassing about the stale pricing is that this was something that had been raised in the popular press for years. There were academic studies, at least four that I know of, where the academics went in and looked at the actual cash flows of these funds; and what they identified was that there was a massive amount of exploitation of stale prices. These were a matter of record and have been a matter of record for years.
Since 1997, the SEC has been on notice that this is a significant problem; and until 2001, it did not come out and say that it was illegal. So what we have is a consistent failure to deal with open and notorious frauds, and the main problem is, at the fund management level and at the fund director level they are not doing their jobs.
I applaud Chairman Baker for seeking to increase the independence of boards, but like Chairman Levitt, I think something more is needed. His idea of an ombudsman, as well as the SEC's proposal about a chief compliance officer and my proposal about a mutual fund oversight board, essentially share that same characteristic, which is that someone needs to be breathing down the necks of fund directors to tell them what their fiduciary duties are and to make sure they are doing them.
With respect to the ombudsman and the compliance officer, the key there is they cannot be appointed by or be employees of the manager; they have to be completely independent for them to fulfill that role. But at a minimum, I think Congress is going to have to take some kind of step that changes the structure in a way that gives fund boards that kind of oversight.
Page 73 PREV PAGE TOP OF DOC Segment 1 Of 2 Thanks very much. I would be happy to take questions.
In particular, Congressman Emanuel, I thought the answers to your questions about possible conflicts in IPOs was inadequate, and I would be happy to follow up on that if you would like.
[The prepared statement of Mercer E. Bullard can be found on page 46 in the appendix.]
Chairman BAKER. Our next introduction is requested to be made by Congressman Royce.
Mr. ROYCE. Thank you, Mr. Chairman. I would like to once again welcome fellow southern Californian, Mr. Paul Haaga, to the committee room. As you know, Mr. Haaga has previously appeared before this committee, and I would like to thank him for returning. He is the Executive Vice President and a Director of Capital Research and Management Company. And Mr. Haaga comes before us today, not as a former SEC official or a current investment executive, but rather in his capacity as Chairman of the Investment Company Institute.
I look forward to his testimony, and I yield back, Mr. Chairman.
Chairman BAKER. Thank you. Please proceed at your leisure.
STATEMENT OF PAUL HAAGA, JR., CHAIRMAN, INVESTMENT COMPANY INSTITUTE
Mr. HAAGA. Thank you for the kind introduction, Mr. Royce. I can safely say that it is the nicest thing anybody outside of my family has said to me in the last couple of months.
Thank you, Chairman Baker and distinguished members of the subcommittee. My name is Paul Haaga, and I am here as Chairman of the Investment Company Institute's board of governors. While I appreciate the opportunity to appear before you today, I am appalled and embarrassed by the circumstances that cause you to convene this hearing. The abuses described to you this morning involving the conduct of some fund officials and others are shocking and abhorrent.
Page 74 PREV PAGE TOP OF DOC Segment 1 Of 2 The Investment Company Institute commends SEC Enforcement Director Cutler, Attorney General Spitzer, and Secretary of State Galvin and urge that their vigorous enforcement efforts continue.
On the regulatory side, SEC Chairman Donaldson and his fellow commissioners and Investment Management Director Paul Roye have provided a strong blueprint for regulatory reform. We commend the SEC and the Congress for responding swiftly, and we pledge our full cooperation in crafting necessary reforms.
As we wrote in a USA Today commentary a few weeks ago, serving investors, above all other interests, is mutual funds' first and only commandment. It is the reason that so many individuals have become mutual fund investors. Yet we now know that some have ignored this commandment.
The abuses we have learned about are inconsistent with our fiduciary obligations, incompatible with our duties to shareholders, and intolerable if we are to serve individuals as effectively in the future as we have in the past. Simply stated, if we don't put shareholders first, we will no longer be the investment of choice for 95 million Americans, and we will no longer deserve to be.
Nothing I say here today will, by itself, restore investor confidence in mutual funds. For that, we will need action in several areas. First, government officials must identify and sanction everyone who violated the law. Second, shareholders who were harmed must be made right. Third, strong and effective regulatory reforms must be put in place to ensure that these abuses never happen again. Everything is on the table.
We pledge to you and other government officials our complete cooperation.
Now these necessary actions will be very visible and will be taken over the coming weeks and months, but the most important action will be the least visible. It won't happen on any timetable and in fact, our efforts to achieve this goal will never end. And that action is making sure that everyone involved with mutual funds adheres to the founding principles underlying the Investment Company Act of 1940. It is just three words, investors come first. I and the Institute pledge not just cooperation, but leadership in this last, most important endeavor.
Page 75 PREV PAGE TOP OF DOC Segment 1 Of 2 Thank you again for the opportunity to testify here today. I would be happy to respond to your questions.
[The prepared statement of Paul G. Haaga Jr. can be found on page 195 in the appendix.]
Chairman BAKER. Thank you very much, Mr. Haaga. I do appreciate your appearing and your statement today. Not that we can reach legislative accord this morning with just the opinions of this panel, but I suspect we will be addressing this subject frequently over the next few weeks. We have another hearing scheduled on Thursday with another distinguished group of panelists.
But it seems that there are some themes that are pretty clear if we start with H.R. 2420 in its current form, that disclosure of a portfolio manager's fees and their holdings, prohibition on simultaneous management of a mutual fund while operating a hedge fund, require that there be aand defining fundamental objectives of the fund, using that legal jargon that the firm's market timing policy be defined as a fundamental objective so it is principally, prominently disclosed to the potential shareholder; not only establishing a compliance officer, which is now in H.R. 2420, but having that officer report to an independent board.
And sort of outstanding at the moment relative to the construct of independent members is whether it is maintained at a majority, whether it is three-quartersthe number at the moment is not decidedbut certainly that the compliance officer should report to those independent members, that there be an independent chairman; that we consider recommendingI don't think we should establish by statute, but recommend to the SEC that they establish an enhanced redemption fee for the short-term trades at whatever level they think appropriate to have a market effect; require the SEC to clarify fair value pricing rules, so you can't use a stale price and profit from that arbitrage; enhance and perhaps, as contained in H.R. 2179, some increase of penalties for clearly established mutual fund violations; publication of the fund's code of ethics so people can pick it up and read it and see what their policy is.
Page 76 PREV PAGE TOP OF DOC Segment 1 Of 2 And then perhaps sort of the bumper sticker for the whole effort along the lines of what Mr. Levitt indicated is language thatsomething to the effect that consistent with the high standards of fiduciary conduct, the funds should be operated in the interest of investors, not in the interest of directors, officers, investment advisors, underwriters or brokers; to set in place a clear statutory statement of the standards for ethical conduct.
Now that is just what I picked up this morning in the discussions. Let me throw it out.
Mr. Haaga, I will certainly give you an opportunity to object or suggest where modifications might be appropriate. And I am making this request in this context.
Perhaps the single most important thing for us to resolve is getting closure. And if, by the end of this session, if it were possible to get a bill out of the House and the Senate to bring resolution to this chapter of difficulty, I think it would be very helpful to the recovery of the markets next year. If we leave this unattended and unresolved into February or March of next year, I don't think that is a good thing for our economy.
So I base those suggestions on, how do we get closure quickly on a package that makes sense, that we can work with the Senate on over the next few weeks?
Mr. HAAGA. What are you doing the rest of the afternoon? We will come over and talk. I would love to discuss these things in order and have everybody comment on them.
Let me just say that we were in favor of most of the provision in H.R. H.R. 2420 as introduced. We suggested some changes. I won't characterize them as minor or major, but some changes.
We continue to certainly support the core principles involved in the bill and have a few concerns about a few things that need attention. But I think we are very close. And as you said rather than negotiate it here, I would like to meet with the staff and the members and go over it.
Page 77 PREV PAGE TOP OF DOC Segment 1 Of 2 Let me tick off a couple of things in there. You talked about a bumper sticker. I think it was a solution here to establish that funds are operated in the interest of shareholders and not in the interest of managers. That is section 1 in the preamble to the 1940 act, so we don't need to enact that. We need everybody to read it a few times.
Chairman BAKER. Fiduciary standard, that is a little different from a financial company's perspective than a mutual fund's perspective. If I am going to do something that affects your material financial wealth, I had better have a good explanation or I am responsible. So that many of the judgments made in the recent months, it appears, were not consistent with a professional standard of fiduciary performance that is the addition that I made to Mr. Levitt's suggestion.
Mr. HAAGA. The boards have been mentioned a number of times here, so let me say something general about them.
You know, not every failure is a failure of all systems and not every system failure is a structural failure. Sometimes it is one of operation in a perfectly good structure. These problems that have been talked about today are ethical problems first; compliance problems to a lesser extent, but ethical problems first. It pains me to say that. I would much rather say it is a structural problem. I would rather say, if we organized ourselves differently, it would not have happened, but I can't. I would like to.
I hope as we go into these solutions, we don't fall into the trap of thinking that structural changes are going to solve everything. That is not to say there may not be changes in rules, in structures, et cetera, but let us remember exactly what the problem is and not take our eye off the ball. There were ethical lapses by some in the industry.
Chairman BAKER. Let me make clear, as best you understand it today, H.R. 2420, as passed by the committee absent the independent Chair, is a starting point for ICI today. You may consider additions to the bill as appropriate, but H.R. 2420 as it is currently constructed is something the ICI could support?
Page 78 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. HAAGA. Yes.
Chairman BAKER. Did any of the other gentlemen want to comment on the list?
Mr. LEVITT. I would just comment that the notion of fiduciary responsibility does not address, in my judgment, the structural makeup of the industry, but goes to the very point that Mr. Haaga made that this is an ethical problem and this is an ethical response by clearly stating it as a fiduciary responsibility.
And I also believe it is absolutely essential that managers' compensation must be revealed and that the trading of stocks or funds by managers' trading, as opposed to owningI have no problem with owning, I have a vast problem with trading. And as I said before, I reject as totally specious the argument that this is a way they can hone their skills. That just isn't so. So I think these two elements together would be very important enhancements that go directly to Mr. Haaga's correct observation that this is an ethical rather than merely a structural problem.
Chairman BAKER. Does anyone else want to make a comment?
Mr. BULLARD. I think those are excellent recommendations.
I would say with respect to the compliance officer, as I recall H.R. H.R. 2420, it is modeled to some extent on the SEC proposal, in which case I think the key issueit is important that they report to the board, but it is probably more important that they not report to the fund manager. There has to be some complete separation so that they are an employee of the fund and have absolutely no allegiance or reporting obligation regarding the advisor
Chairman BAKER. As suggested, it would be reported to the independent board member.
Mr. BULLARD. As far as separation of the hedge funds, I think that is an excellent proposal, and particularly if it goes deep enough to cover not just portfolio managers, but the research analysts where you can also have conflicts.
Page 79 PREV PAGE TOP OF DOC Segment 1 Of 2 And as to the redemption fee, I suspect that the SEC would probably want some kind of statutory authority, especially if what you are looking for is for them to acquire a redemption fee. The problem with redemption fees has always been that it is not clear they are consistent with fund shares being redeemable securities; and to give them the greatest leeway, what you might want to do is give them rule-making authority either to require or to permit redemption fees as they see fit.
Chairman BAKER. Thank you very much.
Mr. EMANUEL. Thank you, Chairman Baker.
Mr. Bullard, since you mentioned my earlier question about the hot IPO market and ''spinning'', did you want to address those issues?
Mr. BULLARD. In the response, there was no mention of the fact that in the late 1990s the SEC increased the amount of the percentage of an IPO that can be put into an affiliated fund from 5 percent to 25 percent. And I thought that was ill-advised at the time. And of course this was being done by, in some cases, the managers of those same funds.
So it goes to your second question, too: Are there some sorts of structural relationships between the manager and the fund that may pose a problem? What we don't know is, even after they increase that to 25 percent, what has been the impact of that? Is there a higher correlation of IPOs being stuffed into affiliated funds or not? Do we know whether it had an impact on the setting of the IPO price?
And, you know, my view is, when the SEC grants exemptions, which it has been quite liberal in doing lately, it should have a follow-up mechanism where it is going to check to see whether this is harming shareholders.
I don't know the answer to this, but it would not surprise me if stuffing IPOs in affiliated mutual funds had something to do with the Internet bubble we experienced. But because the SEC hasn't looked at that issue, we don't know the answer.
Page 80 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. EMANUEL. Okay, thank you.
Chairman Levitt, do you see any reason for us to look into ownership issues relating to mutual funds, insurance companies, and banks, or is that really not a problem? Should we be addressing some of the cross-selling issues using the Canary and Bank of America case as an example.
Mr. LEVITT. I think it is a problem. I think, to the extent to which you diffuse the management structure by placing it as a subsidiary of a company, which has other interests, or to the extent to which it has become part of a brokerage firm or a bank, that is part of what I call a culture of salesmanship, as opposed to a culture of safety and preservation.
The aggressive selling that we have seen in certain brokerage firms and banks I believe is the tip of the iceberg. The kinds of inducement, in terms of compensation, continue to be a problem that plagues the brokerage industry, and I suspect is pervasive in the banks, as well.
I am not sure that there is any role for Congress to play at this point. I think that the undoing of the prohibitions of Glass-Steegel had the kinds of unintended consequences that many predicted, but I clearly believe that this makes the problem even greater for American's investors and commenting further, with respect to IPO's, once again it is anotherit is another conflict, it is another instance where individual investors see that large investors are favored over small, and I think that, for Congress and for Americans, is an unfortunate by-product of all of this.
Mr. EMANUEL. Thank you. I would close, Mr. Chairman, by reiterating something I mentioned in my opening remarks. As we continue to look at these issues, and as some of my colleagues push to privatize about social security, I would hope that the issue will give them pause. This scandal should be a flashing yellow light to the privatization advocates. We have many issues to deal with here, but the notion of privatizing Social Security is one that should go by the wayside.
Page 81 PREV PAGE TOP OF DOC Segment 1 Of 2 Thank you Mr. Chairman. I yield back.
Chairman BAKER. Mr. Castle.
Mr. CASTLE. A few things: Mr. Bullard's comment about the U.C. Internet and the SEC, you should look at. I think that's absolutely correct.
There are a whole heck of a lot of people out there who are, in my judgment, becoming traders who were never traders before, who are probably market timing or doing some things we probably need to pay attention to.
I would like to discuss our own involvement, and that is we, the customers and customer awareness, and I would hope that what we are talking about makes a difference as far as we are concerned.
Basically, the no load funds, inevitably have the same earnings or higher earnings than do the load funds, so if you have an advisor, maybe you want to use the load funds, but people should understand they may be getting hit with 4 or 5 percent they do not need to. The costs are generally printed. Anybody who does any reading about mutual funds can understand about where Vanguard is where they are concerned about costs. The publications, certainly Mr. Phillips' publications, Morningstar has all kinds of information in it.
The Wall Street Journal, USA Today, magazines, do this on a regular basis. There is a lot of literature that is out there. Even some of the advertising out there, some of them will say all of our assets are invested in this fund, I would have to assume it is true, and if it is, that is a factor that I would consider.
I saw an article one time saying that if a fund was named for an individual, it probably did much better. That was probably before Mr. Strong came along, and I am not sure I endorse that anymore. We were all in this together. This is a huge part of America's finances today. I am just really surprised at the figures of costs that have gone up in mutual funds, more so than the numbers of mutual funds. They have just gone up tremendously, and I try to get to the bottom of this. Unfortunately, I do not have time for all the questions I would like, but Mr. Levitt, because you mentioned it, I will deal with you.
Page 82 PREV PAGE TOP OF DOC Segment 1 Of 2 You mentioned at the end of your testimony that you have always wrestled with the issue of soft dollars. I have, too, because soft dollars is a little hard for me to understand. It is clear that the practice of allowing higher commissions in return for brokerage directed research has created great potential for abuse. At the very least, investors should know what commissions they are paying and what the money is going towards.
Is my recollection correct that that comes out of the NAV, the net asset portion of it, as opposed to a separate cost when you are dealing with those soft dollars in which they are paying excessive amounts to the brokers who trade for them? Or if you do not know the answer, does somebody know the answer to that?
Mr. LEVITT. I think ultimately, yes.
Mr. CASTLE. In other words, it is a hidden cost is my point?
Mr. LEVITT. It is a hidden cost and it is ill-defined. It is justified in all kinds of ways. The most frequent response from proponents is that, you know, Congress gave us a safe harbor, and my answer to that and I do not have an absolute formulaic response to it, because it cuts in many ways, but I think Congress should revisit that safe harbor, and, at the very least, the definition of where those dollars are going should be much more clear.
Mr. CASTLE. Well, let me ask this of you and perhaps others, just to expand on that. You see the fees. You see them stated. You will see them in the literature that I referred to. You have a 12(b)(1) fee, other costs of doing business, 1.3 percent of doing business or something like this.
Is it my understanding those soft dollars are beyond any of those costs?
Mr. LEVITT. Yes, the directors realize
Mr. CASTLE. And maybe there are hidden costs that we are not even seeing.
Page 83 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. LEVITT. Directors take the trouble to ask whether those dollars are going toward the purchase of furniture or whether they are going toward research and what kind of research and whether they are justifying other kinds of paybacks.
Mr. CASTLE. Right.
Mr. LEVITT. And I do not think they do.
Mr. CASTLE. Right.
Are there other soft dollar or other hidden costs beyond the other stated costs that come out before they value what the mutual funds are worth, can any of you answer that?
Mr. PHILLIPS. Yes, there are.
What you see for expenses are the dollar costs that were spent for management fees, for operation fees, but none of the trading costs are included in that.
Mr. CASTLE. Which is part of the soft dollars?
Mr. PHILLIPS. For the brokerage costs and the soft dollars would be appended to that are not included in the expense ratio, nor is the friction. When a manager is trying to buy a lot of shares with a thinly-traded stock, let's say $10, they may push the price up to $11 before they accumulate their entire position.
When their forced buying stops, the stock may settle back to 10. The reverse may happen when they go to sell.
Mr. CASTLE. And all of this is not a tight negotiation. Theoretically they are exchanging it because of better research or information on IPOs.
Mr. LEVITT. That is why the advertising is so deceptive, in terms of talking about performance above all else. They know perfectly well that performance is no indicator, nopast performance is no indicator of future performance.
Mr. HAAGA. Let me clarify something.
Page 84 PREV PAGE TOP OF DOC Segment 1 Of 2 I am a regular in this room. I was here in March on a panel with several fund industry executives, several opponents of mutual funds or critics of mutual funds, I call them, I do not think anyone is an opponent of the concept, but the one thing we all agreed that the structure of soft dollars need to be reviewed.
Mr. CASTLE. Is there a revelation of what they are? We do not seem to find out what they are at this point?
Mr. HAAGA. Certainly, we know what soft dollars are. Chairman Oxley and Bachus wrote a letter to the SEC about soft dollars among other items back in March, and again in June, instructing the SEC to do a study. Let me also point out: Mr. Levitt mentioned furniture and whether soft dollars were being used to buy furniture, or other items beyond research.
The SEC did a sweep of investment advisors and identified a number of cases in which soft dollars were being misused.
Not one of those cases involved an investment advisor to a mutual fund. Mutual funds have enough problems without adding issues that aren't problems to our list.
Mr. LEVITT. You are saying there is no abuse of soft dollars in your judgment?
That is the industry's position.
Mr. HAAGA. Excuse me.
That there is no abuse of soft dollars? I think we could always improve the structure of soft dollars.
What I am saying is, and I will say it, again: The SEC did a sweep of advisors, including a number of advisors to mutual funds and found no abuses. The soft dollars system, the rules relating to soft dollars, should be changed and should be tightened up. We believe that. That is what I said.
Page 85 PREV PAGE TOP OF DOC Segment 1 Of 2 Chairman BAKER. Would the gentleman yield on one of your expense questions?
Mr. CASTLE. I will be happy to yield if you will yield back after that for one question.
Chairman BAKER. Oh, sure.
Just on the expense disclosure you were making reference to the portfolio transaction costs are really a big chunk potentially that are not clearly disclosed.
There is a statement in the annual report, as to the percentage of turnover, but you do not know correspondingly the expense ratio assigned to that brokerage fee. It can be as high as 2.5 percent. It can be far in excess of the operating expense percentage rate and in one fund I made reference to in testimony yesterday, in 2002, had $2 billion in assets under management, had $9 billion worth of turnover and there was no explanation, for 440 percent turnover rate. I cannot imagine what the expenses associated with that level of turnover meant to the average investor. It is a huge problem. I yield back to the gentleman.
Mr. CASTLE. Well, a lot of these funds are over 100. 400 percent is really high. A lot of them are well up there, at 50, 60 percent. That is a lot of turnover in the course of the year.
Just a question very briefly of all of you, because my time is up. Is there anyone here, any of the four of you, who would suggest to the investors, the half of Americans out there who are invested, that the mutual fund industry is so tainted at this point, not individual funds but in general, that we need to consider whether we need to be in mutual funds, or not?
We went through this with corporations and others as well. I do not think you are, but, if you are, I would like to hear that.
Mr. LEVITT. Absolutely not. I think mutual funds are a superb vehicle for America's investors, and I think what all of us are talking about are restoring public confidence in an industry that has been badly tainted by recent revelations and by shifts in both investor sentiment and management practices that were part of the bubble of the 1990s and bring us to an unhappy place with respect to not just funds and corporations and markets themselves, all of which have fallen into great public disrepute, and it is our communal job to restore that and doing what we have to do, and Mr. Baker has come up with a bill that I think certain refinements would go a long, long way toward the restoration of that confidence.
Page 86 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. CASTLE. Thank you.
Chairman BAKER. Thank the gentleman.
Mr. HAAGA. Could I answer that one, as well?
Chairman BAKER. Certainly.
Mr. HAAGA. We talk a lot about the 95 million mutual shareholders. That is a lot of people and who we are here representing in addition to the Investment Company Institute and the nearly 170,000 people who work in the mutual fund industry and several million advisors and brokers who use mutual funds with their clients. I can tell you that the great, great majority of them are just as appalled as I am and just as concerned about recent allegations. They are not engaging in these practices and they want us to fix it and so I hope we will all take that into account when choosing the adjectives and adverbs that we throw around at the industry.
Chairman BAKER. I thank the gentleman.
Mr. SCOTT. Yes.
Thank you very much, Mr. Chairman.
To Honorable Levitt, you are the former Securities and Exchange Commission chairman, and with that, you bring a wealth of knowledge and experience, as we debate this issue of trying to bring credibility back to investors in mutual funds.
You wrote a book, last year, I believe it was, called Take on the Street, and, in that book, you mention that the deadliest sin in owning mutual funds was the high fee cost.
I find that to be very interesting, particularly in view of the late trading issue or 10 percent of companies, fund companies, are guilty of that, 25 percent of dealer brokers are guilty of that, with the multitude of market timing issues that are violated, and I was just interested why, why you would single out that one as the deadliest sin?
Page 87 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. LEVITT. Well, I consider it the deadliest sin because that is the one that American investors least understand, and it is the one unfortunately that the industry, the mutual fund industry, in their advertising, least addresses, but the impact of what appears to be very minor adjustments in fund costs is devastating and is really hidden, in terms of prospectuses and documents which are so difficult for the typical investor to understand.
I think, just in my judgment, there is no issue that goes more to the heart of whether an investor makes or loses money in a fund than what kind of fee structure there is. It is like running a 100-yard dash but starting out 10 yards behind the line. It is a great burden to absorb and I think it is the one that investors understand the least of all factors surrounding investment and mutual funds.
Mr. SCOTT. That leads me to mythe second point of my question: I am very interested in financial literacy and have put quite a bit of work in this committee, along with some others, in dealing with financial literacy, because I really believe that education is the key, that so many of the problems that we have now is because of a lack of financial literacy, and, certainly, in the area of investor education.
What recommendations would you make, from your experience, as to what we could do?
Mr. LEVITT. I think that you are absolutely right.
My experience has been that a dollar spent on educating investors has vastly greater velocity than a dollar spent on developing regulations or a legislation, and I would urge industries that have fallen into recent public disfavor, such as the accounting industry and the investment company industry, to devote a much greater portion of their marketing money towards educating investors how to be smarter investors, how to understand these statements, how to know the difference between load and no load funds and what a broker brings to the table and doesn't bring to the table and what a sector fund means and the risks involved in that sector funds and what it means if a fund has bad performance, closes down, creates another fund with a different name with the same dollars and what are the implications to the investor.
Page 88 PREV PAGE TOP OF DOC Segment 1 Of 2 I think those dollars would be well spent in educational programs, and I would encourage both the investment company industry and the accounting industry, that are in the spotlight these days, to carefully consider reallocation of marketing dollars toward educating investors.
Mr. SCOTT. Within our Broker Accountability Act and also within the legislation that we are putting forward on financial literacy, one of the features we are putting in is a 1-800 number for constituents, for consumers, for people to gain information or get access to information.
We are sort of developing this, as a result of the issue of predatory lending, to get information out there before the action is done.
That is a requirement, also, with our Broker Accountability Act.
Do you feel the application of a 1-800 number that is marketed and made accessible to the markets would be an approach that might be worth looking at?
Mr. LEVITT. I think it is one part of a much larger program, and I think it is useful. At the Commission, we had such a number, and employees of the Commission and commissioners themselves spent time down there answering that 1-800 number, and I think it would be awfully useful to have managements of mutual funds be on the receiving end of 1-800 calls, to get a much greater feel of what it is like to be the man or woman in the street. There is no better way to understand what motivates, what misleads, what directs, what impassions investors than to be in the trenches.
Mr. SCOTT. Great.
I enjoyed your book, Take on the Street. It is a good book, and I recommend it, as well.
Mr. LEVITT. Thank you.
Mr. SCOTT. I will give you that little commercial plug.
Page 89 PREV PAGE TOP OF DOC Segment 1 Of 2 Finally, I want to ask you: We are grappling with an issue of investor restitution and how we deal. I am working with Chairman Baker on a bill that sort of deals with a way to bring the SEC together with having a kind of a single regularity. It just seems to me that having fifty States, with the possibility of overriding Federal policy in this area, doesn't make sense, and I do know we have some very outstanding Attorney Generals, and Attorney General Spitzer does a very good job, but I would like to get your take on that.
It seems to me there ought to be room, and I am working both with Chairman Baker and our ranking member, Barney Frank, and I think that we are at a point where we are dealing with a conclusion of being able, but there just seems to me that there is some very substantive value in having a single regulatory function operating out of the Securities and Exchange Commission, while at the same time, protecting and allowing the States to maintain their authority, to prosecute, to investigate, and to deal with the collection of funds.
Would you not think that is the best solution?
Mr. LEVITT. After your endorsement of my book, you make it so awkward for me to have to disagree with you, but as you said those words, I kept thinking of something that is going on in New York City, down at 6 Center Street as we talk, where a remarkable District Attorney of the State of New York is bringing a case against Dennis Kozlowski and has brought a myriad of cases, and there are Attorney Generals and securities directors around the United States that have a feel for the trenches and the individuals in those communities that cannot quite be replicated by a single regularity.
The way this should work, in my judgment, the beauty in our system in America, is to fuel the juices of competition by having a multitude of markets, not just one market. We have a dealer and auction and electric markets.
While I very much favor splitting off regulation from marketing in the New York Stock Exchange, I certainly would oppose a single regulator. Having run a market myself, the competition between regulators I believe is healthy, and by the same token, I think that, if coordinated appropriately, if you can work together in a cooperative reasonable way, Federal regulators have the resources, they have the law, they have the people power, but they can be supplemented in some instances by States and regulators who have a feel for the community and provide a better measure of investor protection than doing it just unilaterally in one single jurisdiction, in my judgment.
Page 90 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. SCOTT. Let me ask you: How do you respond to the concerns of our Federalour Fed Chairman, Greenspan, who testified before this committee, just the opposite of what you have said, and your present chairman of the SEC, who says that?
What is the difference, what is thewhat makes you feel that their thoughts on this would not hold water?
Chairman BAKER. Mr. Scott, if I can jump in and maybe help a little bit. I think the gentleman's point can be aided by the observation we are not discussing the ability to investigate Prosecutor Fine.
What the gentleman's concerns have been aimed at is with regard to the remedies and only where the remedy affects national market structure, should the SEC be consulted and be maintained in a position of primacy with regard to a single national Federal securities market, and that is where he and I have joined together, not knowing exactly where the phone call is to be made between Mr. Spitzer and the SEC when he is negotiating a settlement, but if he is going to cross over the line at the end of the day and change a regulatory structure that impacts national markets, the SEC needs to be consulted in the event that should take place, but in no way does it limit or hope it limits his ability to pursue wrongdoers however he sees fit, and I thank the gentleman for yielding.
Mr. LEVITT. I think consultation is always desirable. I speak from a perspective of someone who ran a brokerage firm, who is greatly concerned about redundant regulation dealing with the NASD, the New York Stock Exchange, the American Stock Exchange, and the SEC. I also ran a self-regulating organization, and I also was a Federal regulator, and I have seen the system, and I believe that this system works and works well.
Are there offsets to it? Yes. Are there redundancies fueled occasionally by over zealous prosecutors who are seeking political gain? Yes. There is that danger. But the offset, in my judgment, is worth it, and I think a reasonable amount of coordination between the chairman of the SEC and State regulators can and has, in the past, addressed these issues.
Page 91 PREV PAGE TOP OF DOC Segment 1 Of 2 It occasionally will move in the wrong direction, but by and large, I would not favor a legislative fix to this, at this point.
I think we are working pretty constructively on the two major areas of abuse that society faces today, and I would not like to send a message to the public that we, in any way, are trying to muscle any of those that they regard to be their protectors. Tomorrow morning on television, the question was asked of viewers if they had a case of securities fraud to whom would they make the first call, would it be to their State regulator, would it be to the NASD, would it be to the SEC. I will be curious to hear what the answer would be.
Mr. SCOTT. So, right now, you support joint jurisdiction?
Mr. LEVITT. I support the system as we have it now.
Mr. SCOTT. All right.
What would be your response to broker dealers and the patchwork of overlapping and conflicting State and local regulations, right now?
Mr. LEVITT. One of the mandates that I gave to the SEC was in the newly-formed Bureau of Inspections and Examinations to eliminate that overlap, and the SEC can do that by bearing down on self-regulating organizations and asking the question: Are you redundant, in terms of your inspections, and, if you remember, layoff.
That can be controlled, and I think it is a priority of the Commission to keep that from being burdensome to the industry.
Chairman BAKER. Mr. Scott, if I can, move on to the next.
Mr. SCOTT. Yes.
Chairman BAKER. Chairman Oxley?
Mr. OXLEY. I thank you, Mr. Chairman, and welcome to our second panel.
You are all familiar with the legislation that is pending, it was passed out of the committee, H.R. 2420, and I think all of us would agree that it is a good first step in trying to correct some of the problems, and this is something that Chairman Baker and I and others have worked on for quite some time.
Page 92 PREV PAGE TOP OF DOC Segment 1 Of 2 First of all, let me ask each one of you if there is anything in that legislation that you do not agree with, or is there something else that we could add before we go to the floor?
Let me begin with you, Mr. Haaga.
Mr. HAAGA. There are no broad topics in the current version of H.R. 2420, broad provisions, with which we disagree.
I think we want to talk about some of the language, particularly the language that specifies the duty of directors and make sure those provisions are drafted correctly and appropriately. But other than that, I think we are ready, but we do need to sit down with a pencil to tighten certain language.
Mr. OXLEY. One of the controversial areas that was considered, as you know, was thean appearance of the board chairman. Has the ICI changed its position on that particular issue, which I understand was opposed to that change?
Mr. HAAGA. Let me talk about that, for a minute. I think we agreed with so much and supported so much of H.R. 2420 that I think people picked up on one area that we substantially disagreed with, and I think it has gotten too much attention. I have talked to our directors.
Now, I am talking about American funds. I have talked to them about whether they want an independent chairman, and their response is that I think the response of many in the industry would be: For all practical purposes, directors are officially independent. They have a separate vote, a separate executive session of independent directors when they are going over the principal issues in which possible conflicts of interest lie. The contracts committee and approving the advisory agreement are separate meetings chaired by a lead director. That lead director, in effect, functions for all practical purposes as an independent chair, except in the circumstances where we are dealing with the administrative or non-controversial or non-conflict issues. So I think I would. We still do not think it is an improvement or a good idea to require it.
Page 93 PREV PAGE TOP OF DOC Segment 1 Of 2 All mutual funds, have a two-thirds majority of independent directors, if the independent directors would like to vote for an independent chair, they certainly can. I would also add that it is no silver bullet. Three of the eight fund groups that have had the problems that have been cited so far, had independent chairs. One even had an independent compliance staff that reported solely to the board, so I think we want to be careful there.
Having said all of that, I would like to discuss with the staff and with the committee chair and others some way to get through this and get some agreement here and figure out how we can structure this thing, because I think we are getting held up on something that we can solve.
Mr. OXLEY. Mr. Bullard?
Mr. BULLARD. Yes, I would make one significant recommendation. If I recall correctly, the bill that was passed only required the Commission to do a study on whether commissions should be required to be excluded in expense ratio, and I think that isthat should be changed to either it should be required to be included in expense ratio, or even better yet, as Mr. Phillips suggested, all portfolio transaction costs should be included in expense ratio.
That expense can be larger than the entire expense ratio combined, and it is inexcusable that that is not something that the SEC has come out in front on and I would like to see the industry come out in front as well because that is an area where expenses vary greatly across different funds, so I do not know how you can compare funds when you do not have the tools with which to do it?
Mr. OXLEY. What about the issue of independent board chairman?
Mr. BULLARD. I am in favor of that. It, also, is not a cure-all. It goes without saying that all things being equal, an independent chair will be more independent.
Page 94 PREV PAGE TOP OF DOC Segment 1 Of 2 I think the best argument the industry makes is who do you want setting the agenda? Does it need to be someone who is advisable from the advisor or running the meeting or can it be someone who isn't necessarily as knowledgeable?
My indication is the advisors and employees should be at the beck and call of the chairman, whether he is independent or not, and I do not think the chairman of this committee needs to be a mutual fund expert any more than the chairman of a mutual fund. The mutual fund's job is to make sure the shareholders are protected. Your job is to make sure the public interest is served and once you do, you go out and make sure you get the experts you need to get the job done.
Mr. OXLEY. Mr. Phillips?
Mr. PHILLIPS. I think visibility is perhaps even more important. We have had the case with Putnam with a number of whistleblowers, but none of them thought to go to the fund trustees, which says that we may have the right structures, but somehow they are not working in practice. I had the opportunity to speak several years ago with a gentleman who was on the board of a major mutual fund complex and oversaw a number of funds, and he was an independent director. He was also on the board of a publicly traded company and he made the comment to me that being on the board of a publicly-traded company, his identity was well-known and he received at least a dozen or so letters per month. He said he didn't always enjoy receiving those letters.
In the aggregate, they made him a better director because they put him in touch with shareholders, but in working with mutual fund boards, he had never once referred a single letter from shareholders. There is no communication right now between investors and the independent directors who are supposed to be representing their interests. If we do not find a way to open up those communications and get some more visibility to the directors, it doesn't matter if they are independent or not. If they spend none of the time with the shareholders, ultimately they will end up reflecting the views of management, not the views of shareholders.
Page 95 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. OXLEY. Why is that a failure? Whose fault is that? Is it the investors fault that they do not take enough time to get involved? Is it the structure? Is it a combination of those? Whatand, obviously, the issue that we have is: Is it something that can be legislated?
Mr. PHILLIPS. I think it is incredibly healthy if we all think of mutual companies as investment companies and not investment products, even though top regulators oftentimes and other industry experts will refer to fund investors as customers. Mutual fund is not a product that you consume. The same way Ford Motor Company is not a product. When you buy corn flakes, that is a product. You do not have a board of independent directors to protect you on your consumption of corn flakes. There is a big difference between the two. Investors are more trained to be consumers. They do not think of themselves as owners. I think we need to put that front and center. The identity of the role of the independent director is something that has been relegated to the deep, deep, footnotes in marginal documents that an investor wouldn't typically receive.
I think we need to bring this front and center. In my mind, one of the things that was so great about the 40 Act, and the reason it served the industry so long and so well is it came at a time when no one trusted mutual funds and the framers of that Act went out of their way to ensure investors that if they were to put their trust in a mutual fund, that their interest would be put paramount.
I think the structure of the investment company is magnificent. As Jack Bogel said in this Sunday's New York Times, as an instrument for long-term investing, there exists in the mind of man no better vehicle than the mutual investment fund, but we need to get back to the spirit of it and the structure that that imposes as an investment company.
Mr. OXLEY. Thank you.
Mr. Levitt, welcome back to the committee.
Page 96 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. LEVITT. Thank you.
I couldn't agree more with Don with selling mutual funds as soap and beer and corn flakes is just wrong.
About 10 years ago, the head of one of the top 25 mutual funds in America met with me and I asked him about the difference between directors of corporations and investment companies, and he said, frankly, investment companies do not need any directors whatsoever, and I guess that has conditioned my thinking about this. I very much support the notion of a lead director, and I think the most valuable additions to this very sound legislation in my judgment would be adding fiduciary responsibility to the mandate of the 40 Act and maybe most importantly, the revelation of compensation of managers and a ban on trading by managers. I think theseagain, when I say a ban on trading, I do not mean they shouldn't own shares in the entities they manage, but they should not be allowed to trade in and out of them, and the revelation of their compensation I think is terribly, terribly important.
These are the additions I would suggest.
Mr. OXLEY. Well, obviously, you know, we have gone through that recently with the whole issue of publicly traded companies and more transparency and I think what you suggest certainly from our perspective makes a great deal of sense, in that more transparency normally provides for better governance and better understanding of the entire process.
Thank you all for an excellent panel.
Chairman BAKER. Thank you, Mr. Chairman.
Mr. FRANK. Thank you, Mr. Chairman.
Mr. Haaga, you said you thought that the issue of the independent chairman, was getting too much attention. Well, I will explain to you why, the one issue in which there was any difference over the bill last time, and my advice is, give it up.
Page 97 PREV PAGE TOP OF DOC Segment 1 Of 2 I am skeptical. I must say it doesn't make much difference one way or the other and I heard the static you gave. If, in fact, we did a survey of the companies and tried to find out what differentiated them, whether they had a separate CEO and chairman wouldn't matter much. I would have to say I was not a great connoisseur of corporate boards before taking on this position as ranking member.
I am singly impressed with them as a group. On the whole, the role of the corporate boards in almost all the standards I have seen is what Murray Camptom imputed to editorial writers. They come down from the hills after the battle is over and shoot the wounded.
I am all in favor if people think it would help, we could have one. I think that is all we are going to need, but I also have a question for Mr. Levitt, because he was an extremely distinguished chairman of the Securities and Exchange Commission, and one of the issues that is now before us is the bill, H.R. 2179, that is being held up because of the dispute, although it is a lessening dispute over pre-emption, and I would be interested in how importantI do not know if you were familiar with all the details of all of that, but there were a series of requests, too, from the SEC for more enforcement, including, I think you were here when I read some of the serious increases, with regard to the Investment Company Act; it would significantly increase the penalties that could be levied, generally by a 500 percent figure, and it would also make it easier to bring them administratively. How important is the penalty structure, as a part of this operation, Mr. Levitt?
Mr. LEVITT. I think the penalty structure is part of it but not necessarily the most important part of it.
Mr. FRANK. Well, I understand, but we get more than one peck. It is not a case of whether you get only one peck; I mean, there are several things, several things that you get, so I would be interested in an evaluation of the penalty structure in and of itself. There are two separate bills, a bill on mutual funds that the committee voted out that has been held up, not at our request, and then there was the SEC bill that didn't get voted on. They were not competitive. If we get time to do both, it wouldn't take very long.
Page 98 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. LEVITT. I am just not familiar with those bills to be able to give any meaningful comment. I am familiar with
Mr. FRANK. That is not a rule around here, you know.
Mr. LEVITT. I have beenin terms of penalties I have seen extracted in cases of egregious fraud, I have often felt that they were far less effective, in terms of the deterrence of fraud than humiliation and embarrassment.
Mr. FRANK. Okay. Let me ask because I agree we have a problem with the culture here, and it is helpful to have a separate CEO, but how do you build in, you were talking about this, Mr. Bullard, how do you build in this sense, Mr. Levitt, you talked about it, too, when you said we do not need directors.
Part of it is going to happen from the publicity. I must say as a mutual fund investor myself, I am now more aware of questions I should ask. I do not spend a lot of time on that, but I buy mutual funds and I ask questions. I will now be asking these questions and I think a lot of other people will, too, particularly those who buy mutual funds as fiduciaries for others. We have already seen this, with regard to pension funds and others, and people who kind of bundle other people's money and buy mutual funds will be more aware, so I think the transparency issue is going to work very well, but what would we do to try to institutionalize this, obviously, there are penalties, all these other things, but those are also signs there have been failures of the system. Howwhat would you build into the structure?
We have one bill brought out of committee, there will be others. Are there any structural proposals you would make over and above what we are already seeing to make it better? Let's start withyeah, go ahead.
Mr. BULLARD. What I propose is there be a mutual oversight fund board appointed by the SEC that would have examination and enforcement authority, and the need for that is that regulators in general are very good at enforcement and interpreting and objective rules, and, when it comes to boards, what you are dealing with is the traditional area of State, corporate law, which is the meaning of a fiduciary duty, and the SEC is simply not going to be the best vehicle for setting forth fiduciary guidelines for fund boards that go to the level of detail you would need to combat the late trading. You need a group that is going to say we have this trading issue.
Page 99 PREV PAGE TOP OF DOC Segment 1 Of 2 Here is what you need to do to satisfy your fiduciary duties, and to work with those boards and across all boards give them consistent guidance, as to what the expectations are, as to reviewing fees, reviewing trading, reviewing prospectus disclosure like market timing, and it is has to be a group of experts and a group that has enforcement authority. It would not be rule making authority. It would be the answer to what is a decades old problem in the industry and that is fund directors have been whipping posts of the fund industry for decades, and one thing I can say in their defense is there has been a real absence of strong guidance, exactly what they were expected to do at a minimum.
Mr. FRANK. Mr. Levitt, you ought to be allowed to comment on that.
Mr. LEVITT. I think thatI have said before that so much of this is a function of a cultural change that has swept America, and we are basically a friendly Nation. We go on boards of companies where we tend to know the chairman and other board members and we are reluctant to speak up whenonce we are there.
I do not know that that, in and of itself, is going to change, and I am not certain that any piece of legislation is guaranteed to change board behavior, but I think, if the responsibility is spelled out very specifically, as being a fiduciary responsibility, if the guidelines for those that are the custodians of the investment company assets, the fund managers, are bound by specific restrictions that could be imposed, either by regulation or legislation, I think that is about as far as you can
Mr. FRANK. Let me finish with this, Mr. Chairman. I just want to break in. Seems to me what you are saying in part is since there is not enough natural orneriness around, since we all are intimidated by disagreeing face to face. It is not a pleasant thing. People do not like to do that, they shy away from that.
The question is how do you build that in, and I think the question is you build it in by imposing legal liability. That is what we did, that is what the chairman of the industry did of the accounting industry. You basically say, I do not mean to be a bad guy here, but I got to protect myself, and when we kind of make it easier for people to be confrontational, I got to do that, and I say that because some of the criticisms we have heard of some of the people in the corporate world is: We make it too hard to find directors, because once you make them liable and once you hold them responsible, it is too hard to find directors.
Page 100 PREV PAGE TOP OF DOC Segment 1 Of 2 I think what you are saying, it has already been too easy to find directors and it ought to be too hard to find directors and people ought not to take on directorships, unless they are able to be different than the normal social views.
Mr. LEVITT. I also do not think we are looking in the right places for those directors. It hasn't been written in stone that you have to be a CEO to be a director. As a matter of fact, I believe that CFO's and CIO's and educators and others and people of good judgment, chances are they will be as good at their direct to recall responsibilities as overburdened CEOs.
Mr. FRANK. I understand, but I would also stress, you have helped me understand what is at stake here, and I think, as I think about this, I would be less willing to yield to an argument that would make it too hard to be a director. It ought to be hard to be a director.
Mr. LEVITT. Yes.
Mr. FRANK. And we have to build in institutional mechanisms to overcome this natural tendency to, A, one, pick your friends and then to get along.
Chairman BAKER. Thank you, Mr. Frank.
Mr. ROYCE. In addition to the issue of deterrence and adding criminal penalties as a way to change behavior, one of the real questions I have here is, on the question of compliance procedures: In these specific instances, where were the compliance procedures? Why weren't they strong enough for the funds or for the investment advisors?
In the chairman's bill, we have taken certain actions to set up a chief compliance officer, so we will have that in place, but I was going to ask Mr. Haaga: In your view, how can the industry right itself in this area of compliance?
Page 101 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. HAAGA. I think I would like to answer that question and also say something about directors, in light of the previous comments.
The SEC has requested comments about a potential rule proposal requiring a specific compliance officer, it was both an SEC proposal and a provision in H.R. 2420, I think that is a very substantial assistance in this area and that we supported the rule, we support the legislation, and we look forward to complying with it.
On behalf of directors, I have just got to say: This whole discussion is unfair to independent directors in a lot of what is being written and what is being said.
I strongly disagree with Mr. Spitzer's characterization that this was a director problem, that they should have known. This was taking place in an areain the delayed trading and market timing at an areaand a level where directors just cannot be aware of.
That is our internal compliance shops that ought to have been picking that up and in many cases were picking that up. Probably the only word that I have used more often than shocked or appalled in the past couple of months is surprised. I have been involved for 32 years, and this is the first time I have ever heard of someone being involved in late trading. I am sorry that happened, but I have a hard time blaming independent directors for not finding something that 32-year veterans couldn't find because they simply didn't know it was happening.
Mr. ROYCE. But the compliance officers would find it, that is their charge to find it.
Mr. HAAGA. I cannot guarantee that. I will say that it will be an enhancement and that they will find more things, and I am sure they will find late trading in the future. We do not need two wake-up calls.
Mr. ROYCE. Let me ask you another question, because we had the suggestion here in the earlier panel that, perhaps, mutual funds should actively bid out management contracts to multiple advisors.
Page 102 PREV PAGE TOP OF DOC Segment 1 Of 2 On the surface, I think this sounds good, but are there issues involved here where we should be concerned about this proposal, in terms of its effect?
Mr. HAAGA. This issue comes up every so often over the years and it has a nice ring to it. It happens to be impractical. I think people who buy our mutual funds and set up their accounts with our companies are not expecting us to move management to another company. Let's remember that it is not just the shareholders. It is also advisors that they use and it is also the 401K Plan trustees who have selected the mutual funds and moving the investment advice away to someone else is certainly inconsistent with their expectations.
The observation that is always made is, you know, mutual funds are not mobile and if mutual funds were mobile among advisors, then there would be better bargaining. That overlooks the fact that even though mutual funds are not mobile, investors are mobile and I think we have all seen the studies and seen the charts. The three largest selling fund groups would be three groups that have way below average expenses. Something like 80 percent of all investors are in funds that have below average expenses.
So I think the results clearly prove that investors are mobile, investors are moving to the funds that are giving them the best results and the most appropriate, not lowest, but most appropriate expenses, and I do not think we havewe do not have to additionally make the mutual funds mobile, but I think it is a terrible
Mr. ROYCE. But would it be a disincentive for starting new funds?
Mr. HAAGA. That would be one of the many problems involved in the proposal.
Mr. ROYCE. Mr. Levitt?
Mr. LEVITT. I would like to make a comment on that. I think Mr. Haaga represents one of the finest best managed funds in America, so I would not take his observations to apply across the broad spectrum.
Page 103 PREV PAGE TOP OF DOC Segment 1 Of 2 What I would suggest is that directors carefully consider alternatives and define the fact that they have considered alternatives to justify the retention of management.
I do not believe that the continuation, the failure to change managers in the overwhelming number of instances is any more of a failure than the failure of analysts, sell-side analysts, who 98 percent of the time recommend buys rather than sales. That doesn't happen in a vacuum, and I think that it is, should be, the responsibility of directors to justify their selection, rather than merely going along with it.
Mr. ROYCE. And, soand so you would move down thatdown the path towards encouraging this.
Would you mandate it legislatively?
Mr. LEVITT. Generally speaking, I am reluctant to consider legislative mandates. Every time I have put something in stone, in terms of governance or issues of that kind, I have looked back and found that I have endured unintended consequences.
Mr. ROYCE. Thank you, Mr. Levitt. Let me ask one more question, if I could, Mr. Chairman, and I wanted to ask Mr. Haaga, Attorney General Spitzer, in his testimony here, pointed out that fund investors are charged some 25 basis points a year more than pension investors.
Are individual fund investors being treated in your view unfairly here or are there legitimate reasons for this cost differential that exists between the two investor classes?
Mr. HAAGA. I think there are very legitimate reasons. Among other things, we are dealing with a retail investment vehicle. We are not dealing with simple portfolio management. The sum of the cost differential is in the total expense, not just in the advisory fee, relates to the fact this is a big chunk of mutual fund expenses are paid to an individual advisor that advises the shareholder. Pension plans do not have that. They do not have individual advisors.
Page 104 PREV PAGE TOP OF DOC Segment 1 Of 2 It is interesting to note that where mutual funds or some mutual funds organizations manage funds, manage and serve as administrators and do the whole management thing for some funds and then simply serve as a subadvisor, only as a portfolio manager for a fund, which is an area which is much more comparable to managing the pension fund. It is just portfolio management, and, in those cases, their subadvisory fees tend to be very close to what is being charged to the Pension Fund because, in those instances, the services are much better.
I guess I can go through a bunch of examples in our own firm and will not burden us with it, but I guess we can talk to the committee.
I would say we have 6,000 employees. 200 of them are portfolio counselors or research analysts, actually about 200 and a quarter.
The other 6,000 are providing a lot of services and most of them are involved in providing services to mutual funds. To only look at what the cost of the 250, is missing a huge point.
Mr. ROYCE. Mr. Chairman, thank you.
Chairman BAKER. Thank you, Mr. Royce.
I just have one sort of clarifying question. Mr. Spitzer indicated yesterday that pursuant to charging some individual firms with trading abuses, finding them in law to be guilty, that he would then move to discourage all advisory fees during the time in which the alleged allegations took place.
Given your comment earlier today, in favor of restitution for wronged individuals, is that an appropriate remedy in your view in those cases where you have reached a final accord in a court?
Mr. HAAGA. I would love to be responsive, but I cannot. I do not really know the facts involved, and, really, that is going to be between the Attorney General and the individuals, and I will go back to my previous comment about nearly 200,000 people. When you take money from an organization, you take it from everybody, so I hope maybe we can find some ways to punish the wrongdoers financially and not merely punish someone who is appalled by the wrongdoing, and that is all I will say on that.
Page 105 PREV PAGE TOP OF DOC Segment 1 Of 2 Chairman BAKER. And I do not want to see folks get fined for defrauding an investor and have it go to a governmental agency. I want it to go back to the people. That seems to be a radical thought, but I really think we ought to give it a try.
Mr. HAAGA. That I can support unequivocally.
Chairman BAKER. Do you have anything else, Mr. Scott?
Mr. SCOTT. Thank you, Mr. Chairman.
I want to get your response, Mr. Haaga, and then from some of the others on two of the fundamental areas that is causing a lot of credibility thoughts with the investors of mutual funds.
One is the late trading, and the other is the market timing, and I wanted to get your response on how you felt we should deal with these, and, specifically, to one recommendation that you may feel, particularly with the late trading.
If we required that all orders be received by the fund, rather than by the dealer broker or his intermediary prior to the 4:00 p.m. Closing date at net asset value, would that eliminate illegal late trading?
Mr. HAAGA. I can never say for sure it would eliminate it, but I cannot see how you could do it.
You would need collusion and you would need it at the fund group, and we receive these things through technical systems and so I think about it, but I am having a hard time imagining. I use the term ''slamming the window shut'' and I think it really does.
Mr. BULLARD. Okay. Since we have already had allegations of collusion with fund companies, there is no reason to believe that a 4 o'clock cutoff time would prevent the same type of collusion with respect to that cutoff time. The more important questions is whether people are going to comply with the rule. There will be marginal improvement. One reason is that it will put intermediaries out of the potential business of evading the rules, but as Congresswoman Biggert pointed out, that will impose costs on 401K plans and it will impose disproportionate costs and disadvantages to people invested in those plans, as opposed to individual investors or other institutional traders. So the real question is here: Why do we have a compliance failure, because the rules were clear before, and, if they are clear later, it is not necessarily going to make compliance better.
Page 106 PREV PAGE TOP OF DOC Segment 1 Of 2 Mr. HAAGA. I disagree with that, but I won't repeat everything I said.
Mr. Scott, if you don't mind, I would like to clarify or respond to a question that you asked earlier and that deserves a further response. You asked about the impact of the whole market-timing phenomenon on non-U.S. markets. Our firm, I won't say specializes, but we are well-known for our investments outside the U.S., or global international funds, and we have offices all over the world. To the extent that this marketthese market-timing problems have made global and international funds less attractive and made them earn less money for shareholders and brought less money into them, there is going to be less U.S. money that is invested outside the U.S., particularly in emerging markets, which is a big area of our investment, and that will have an impact. So we need to fix the international funds for the U.S. investors to help the non-U.S. markets.
Mr. SCOTT. All right. I appreciate that. I think that those two issues, the late trading and the market timing, are probably two of the biggest concerns.
Let me ask about redemption fee on short-term mutual sales. Would that help with the market timing or would it have too burdensome an impact on the institutional and noninstitutional customers?
Mr. HAAGA. Well, it will have a burdensome impact. And thatwe have come to that reluctantly. I think all of us have. But we have concluded that it is necessary toin addition to all the other remedies that exist in the market-timing area, that this is something that is worth doing despite the imposition on shareholders.
There have been some studies about market timing that show that within the first one or two days you get at some enormous overwhelming majority of the advantages of market timing, you eliminate them; and so I think keeping a very short period we strike the right balance. It doesn't eliminate liquidity or doesn't reduce liquidity too much for shareholders. It lets them change their minds a few days after they invest it. But, at the same time, it gets at most of the market-timing problem.
Page 107 PREV PAGE TOP OF DOC Segment 1 Of 2 Chairman BAKER. Thank you, Mr. Scott.
Gentlemen, I certainly appreciate your participation at our hearing today. Your perspectives are very helpful to the committee's considerations. We look forward to working with you in the days ahead and hopefully coming to a speedier resolution rather than slower resolution on these important matters.
Thank you very much, and our meeting is adjourned.
[Whereupon, at 2:06 p.m., the subcommittee was adjourned.]
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