Segment 2 Of 2 Previous Hearing Segment(1)
SPEAKERS CONTENTS INSERTS
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MUTUAL FUNDS: WHO'S LOOKING
OUT FOR INVESTORS?
Thursday, November 6, 2003
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance and
Government Sponsored Enterprises,
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to call, at 10:05 a.m., in Room 2128, Rayburn House Office Building, Hon. Richard Baker [chairman of the subcommittee] presiding.
Present: Representatives Baker, Castle, Kelly, Shadegg, Green, Toomey, Kennedy, Tiberi, Renzi, Kanjorski, Hooley, Sherman, Inslee, Capuano, Frank ex officio, Lucas of Kentucky, Crowley, Israel, Clay, Baca, Matheson, Lynch, Miller of North Carolina, Emanuel and Scott.
Chairman BAKER. [Presiding.] I would like to call this meeting of the Capital Markets Subcommittee to order. I again advise that members are in various stages of travel to the committee this morning, so we will have others arriving. But in order not to unreasonably delay the proceedings, I thought we could start with appropriate opening statements. I am told Mr. Kanjorski will be here momentarily.
The purpose of our hearing this morning is to continue the committee's work with regard to the adequacy of mutual fund oversight and regulation. I am particularly pleased to have the witnesses here today who can give us their particular expert view of recommendations for appropriate action. At the base of our consideration is H.R. H.R. 2420, passed out by the full committee, which sets in motion regulatory reforms the committee felt advised to adopt at that time. In the course of time since the bill was reported out, various inquiries have given the public knowledge of the broader base of concern about mutual fund management conduct. To that end, I will be appreciative of any perspective relative to H.R. H.R. 2420 and to any recommended additions which you might think advisable in light of the knowledge you have gained over the past months.
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It is clear that given the number of Americans who now invest in the mutual fund industry, the number of households who are directly invested in the marketplace, that resolution of this matter takes on a particular sense of urgency. I do believe it is in the best interest not only of consumers, but in the marketplace as well, to have the issues of governance resolved and behind us at the earliest possible moment. The numbers of individual investors are enormous and the flow of capital they provide to the marketplace is very important. To have confidence shaken and to have those investments on the economic sideline is not in anyone's best interest.
To that end, I have discussed with Mr. Frank this morning, Mr. Kanjorski earlier, the desire to move the legislation at the earliest possible convenience and much of that process will depend, of course, on the agreements that can be reached on the various elements that perhaps would be part of a manager's amendment to H.R. H.R. 2420 on the House floor at a later time.
I am particularly pleased that the participants in our first panel were able to be with us today. Mr. Galvin, your work has been extraordinary, and that of Mr. Spitzer as well. Although we have not necessarily agreed on all perspectives, I do believe that it is important for the policymakers and the frontline regulators such as Ms. Schapiro at the NASD, all have some consensus approach to resolution of this problem. I look forward to gaining that agreement on all matters and moving forward expeditiously. I think we all share the same common goal of providing for a fair, transparent marketplace in which all stakeholders are treated the same and where all rules are applied equally. I applaud you for your efforts to this date and look forward to working with both of you in the future.
With that, I would yield to Mr. Kanjorski for his opening statement.
Mr. KANJORSKI. Thank you, Mr. Chairman, for the opportunity to offer my thoughts before we begin our second hearing this week on wrongdoing in the mutual fund industry.
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As you know, Mr. Chairman, the recent troubles at companies like Strong Capital Management, Janus Capital Group and Putnam Investments, among others, have caused me great concern. This unease led me to call upon you in late October to arrange for hearings so that we could identify the steps that participants in the mutual fund industry and their regulators are taking to protect investors's interests and restore investor confidence in light of these scandals.
In my view, we have an obligation to American investors to monitor these developments. I therefore commend you for promptly responding to my request and others and convening these proceedings. With approximately 95 million investors and $7 trillion in assets, the dynamic mutual fund industry constitutes a major part of our securities markets. Heretofore, many experts had extolled the mutual fund industry for working to democratize investing of millions of average Americans, allowing them to easily participate in our capital markets with a diversified portfolio.
During the last 2 months, however, we have learned about several alleged and/or demonstrated incidents of market timing and late trading abuses in the mutual fund industry. Because investor protection is a priority of mine on this panel, I am very concerned that the effects of these events on small investors who likely lost money as a result of these transgressions and probably became further discouraged about participating in our securities markets.
I also believe that all participants in the securities industry have a responsibility to behave ethically and follow the rules. As a result, the announcement of each new case of misdeeds in the mutual fund industry has greatly disturbed me. Many parties are also now taking action to address these problems, including New York Attorney General Eliot Spitzer and Massachusetts Commonwealth Secretary William Galvin. The Chairman of the Securities and Exchange Commission has additionally noted that his staff is ''aggressively investigating the allegations and is committed to holding those responsible for violating the federal securities laws accountable, and seeking restitution for mutual fund investors that have been harmed by these abuses.''
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In addition, the Investment Company Institute has unambiguously reaffirmed that shareholders's interest must be placed before all else. As you also know, Mr. Chairman, I believe that it is very important for us to explore market timing and late trading problems in the mutual fund industry, as we have not previously examined these issues in the 108th Congress. Earlier this year, we considered and improved H.R. H.R. 2420, the Mutual Fund Integrity and Fee Transparency Act.
In general, H.R. H.R. 2420 seeks to enhance the disclosure of mutual fund fees and costs to investors, improve corporate governance of mutual funds, and heighten the awareness of boards about mutual fund activities. Although we held two hearings in the Capital Markets Subcommittee to review numerous topics related to the mutual fund industry before marking up H.R. H.R. 2420 in the full committee, we did not specifically explore the issues of market timing and late trading. In light of the current public revelations about these abusive practices, I am consequently pleased that we are examining these matters now.
Furthermore, Mr. Chairman, I share your concerns that our panel must continue to conduct vigorous oversight to examine whether our regulatory system is working as intended and determine how we can make it stronger. It is my hope that today's proceedings will help us to better understand the current problems in the mutual fund industry. Our goal in any further legislative efforts in these matters should be to ensure that we advance the interest of average investors by preventing these problems in the future and improving the performance of the mutual fund industry in the long term.
In closing, Mr. Chairman, I look forward to hearing from our distinguished witnesses on these important issues. Mutual funds have successfully worked to help middle-income American families to save for early retirement, higher education and new homes. We need to ensure that this success continues.
[The prepared statement of Hon. Paul E. Kanjorski can be found on page 252 in the appendix.]
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Chairman BAKER. Thank you, Mr. Kanjorski.
Mr. Castle?
Mr. CASTLE. Thank you, Mr. Chairman. I do want to get to the witnesses. I will try to be brief. I just want to thank you, and I want to thank Mr. Frank and Mr. Kanjorski. I think you are doing absolutely the right thing. I think these hearings have been invaluable, just the hearings themselves, regardless of whether there is a product from them or not have been invaluable. I think the concept of moving this along as rapidly as possible, as you have indicated about H.R. H.R. 2420 and the manager's amendment should put every one of us up here and everybody out there and everybody who is listening this or paying attention to this on notice that this is going to move quickly. I think we should. I think frankly there are abuses that have to be addressed so that we can prevent these abuses in the future.
On the other hand, I am cognizant of the fact that none of this is very simple. Every time I look at this or listen to one of our witnesses or have a meeting with somebody, I realize the complexities. It is not easy to have blanket rules that apply fairly to everybody. So we are going to have to work really hard to make sure we do it correctly. I think we are doing the right thing by moving forward rapidly, but we need to move forward in a way that is going to be beneficial to everybody involved, with whatever we are going to do versus what the SEC is going to do, or whatever.
I would also like to thank those who have really brought this to light. Mr. Galvin is one of those people. Mr. Spitzer is another. There is some discussion about the state versus the federal. My judgment is there is certainly a role for both. I think frankly if the States did not inspire this, perhaps the SEC would not be quite where they are today. I, for one, appreciate that. I also appreciate those good regulators represented here and otherwise who have come forward to make a difference. It just seems to me that there is potentially a good team effort here if we do all this correctly to take this industry, which is of extraordinary importance to the investing American public. Fifty percent of Americans have some involvement in mutual funds, and that may even be an understatement, if you really understood all your pensions and everything else.
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It is just absolutely vital that we run it correctly. It is not to be run as some sort of a market-timing piggy bank for those who are trading by the second or whatever. It has really always been established to be more of a long-term investment vehicle and we have to return it to them. I think we are taking a lot of very good steps here. So I do appreciate the hearings, and I appreciate all that you are doing. I, for one, stand ready to help in any way I possibly can.
I yield back.
Chairman BAKER. Thank you, Mr. Castle, for that kind statement.
Mr. Frank?
Mr. FRANK. Thank you, Mr. Chairman. I very much agree with what the Ranking Member of the subcommittee, the gentleman from Pennsylvania had to say. I think we are ready to pass legislation that will strengthen the law regarding the protection of investors in mutual funds, both the mutual fund bill and then parts of the SEC's request, which would enhance SEC powers. But it is also clear that much of what has happened shows the importance of enforcement of the laws that are already on the books.
In that regard, particularly since I am going to have to be off at other meetings with some legislation, I welcome a former colleague of mine, of my colleagues Mr. Markey and Mr. Delahunt, the Secretary of the Commonwealth of Massachusetts, Bill Galvin, with whom I served in the Massachusetts House. I am very proud of the work that he has done in very thoughtfully and very seriously uncovering abuses.
I think it ought to be very clear. We in Massachusetts, of course, have followed Mr. Galvin's work very closely. There is sometimes the accusation that officials in the enforcement business are tempted to kind of demagogue or overdo it. Mr. Galvin's work has been meticulous. No one has proven or no one has even alleged any effort of excess. I want to repeat what I said on Tuesday, because sometimes I get the impression that when I say something, not everybody pays sufficient attention the first time. Mr. Galvin and Mr. Spitzer are elected officials. They are elected officials who have pioneered in the enforcement of technically complex, but quite important issues.
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It is not an accident that the areas where they have taken the lead are areas which affect the equity interests of small investors. We have national institutions for the enforcement, and there is an understandable tendency on their part to be concerned about systemic matters; to be concerned about liquidity problems for the whole system. Sometimes in that framework, matters of fairness for individuals when they do not accumulate to a systemic risk, can get lost in the shuffle. Here we have two elected officials, the Attorney General of New York and the Secretary of the commonwealth of Massachusetts and others who have taken their responsibility to protect the individual investor very seriously.
I am glad they have done that. I am glad that we now have a consensus, I hope we do, that the authority that they now have to be participants in the enforcement process ought to remain undiminished. I think that argument ought to be considered settled, that there is no basis for any legislative action that cuts back on the role they have played. We have benefited as an economy, individual investors have benefited, and now I think the next step is for us to pass some legislation that will strengthen the ability of regulators, the SEC, the self-regulatory organizations, and the state authorities.
Sadly, given the great scope of this, there is room for all of them. We will not have too many enforcers. If and when we reach that point, I will be glad to have someone make the argument, but right now our job is to give them even better tools. They have done, particularly the State officials, a very good job of using the tools they have. So the answer is both to leave the current set of enforcement powers in place and to enhance the powers that the enforcers. I look forward to our doing that and I think we ought to be able to do it, at least begin the process on our side, before we bet out of here this fall.
Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentleman.
Are members desiring to give additional opening statements? If not, then I would proceed at this time to the participants on our first panel, again extending welcome to both. At this time, I would recognize Mary L. Schapiro, Vice Chairman and President, Regulatory Policy and Oversight, at the NASD, and certainly no stranger to the committee room. Welcome.
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STATEMENT OF MARY L. SCHAPIRO, VICE CHAIRMAN AND PRESIDENT, REGULATORY POLICY AND OVERSIGHT
Ms. SCHAPIRO. Thank you very much, Mr. Chairman. Good morning.
Mr. Chairman and members of the subcommittee, I very much appreciate the opportunity to testify today on behalf of NASD. NASD is the world's largest securities self-regulatory organization. They have a nationwide staff of more than 2,000 who are responsible for writing rules that govern securities firms, examining those firms for compliance, and disciplining those who fail to comply. Last year, NASD filed more than 1,200 new enforcement actions, levied record fines, and barred or suspended more individuals from the securities industry than ever before.
The reprehensible conduct that has brought us all here today, which cheats the public and degrades the integrity of American markets, will not be tolerated. Any broker or firm that misleads a customer or games the system can expect to be the subject of aggressive enforcement action. NASD strongly supports H.R. H.R. 2420 and calls on Congress for its prompt passage. Indeed, in those areas where NASD has jurisdiction, we have already begun the rulemaking process to implement some of the principles of H.R. H.R. 2420.
We have recently proposed a rule requiring disclosure of two types of cash compensation, payments for shelf-space by mutual fund advisers to brokerage firms that sell their funds, and differential compensation paid by a brokerage firm to its salesmen to sell the firm's own proprietary funds. Customers have a right to know these compensation deals which create a serious potential for conflicts of interest.
Due to their enormous growth in popularity in recent years, NASD has paid particular attention to how brokers sell mutual funds. While NASD does not have jurisdiction or authority over mutual funds or their advisers, we do regulate the sales practices of broker-dealers who provide one distribution mechanism for mutual funds. Our regulatory and enforcement focus has been on the suitability of the mutual fund share classes that brokers recommend, the sales practices used, the disclosures given to investors, compensation arrangements between the funds and brokers, and whether customers receive appropriate breakpoint discounts.
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We have brought some 60 enforcement cases this year in the mutual fund area, and more than 200 over the last 3 years. Through our routine examinations, we have found that in one out of five transactions in which investors were entitled to a breakpoint discount, that discount was not delivered. Thus many brokers imposed the wrong sales charge on thousands of mutual fund investors, in effect overcharging investors by our very conservative estimate of $86 million in the last 2 years alone. NASD has directed firms to make immediate refunds, and in the next several weeks we will initiate with the SEC a number of enforcement actions seeking very significant penalties.
Brokers are also prohibited from holding sales contests that give greater weight to their own mutual funds over other funds. These types of contests increase the potential for brokers to steer customers towards investments that are financially rewarding for the broker, but may not be the best fit for the investor. In September, we brought a case against Morgan Stanley for using sales contests to motivate its brokers to sell Morgan Stanley's own funds. The sales contest rewarded brokers with prizes such as tickets to Britney Spears and Rolling Stones concerts. This case resulted in one of the largest fines ever imposed in a mutual fund sales case.
Over the last 2 years, NASD has brought more than a dozen major cases against brokers who have recommended that investors by class-B shares of mutual funds in which investors incur higher costs and brokers receive higher compensation. We have more than 50 additional investigations of inappropriate B-class sales in the pipeline.
This kind of enforcement effort is continuing with great vigor at NASD. We are now looking at more than a dozen firms for their practices of accepting brokerage commissions in exchange for placing particular mutual funds on a preferred or recommended list. In this effort, we are investigating all types of firms, including discount and online broker-dealers and fund distributors.
A more recent focus of ours has been an investigation into late-trading and market timing. In September, we sought information regarding these practices from 160 firms. Our review indicates that a number clearly received and entered late trades. Other firms are not always able to tell with clarity whether or not they had entered late trades. This imprecision indicates poor internal controls and record keeping, issues we will also pursue.
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As we continue our examinations and investigations into these matters, we will enforce NASD rules with a full range of disciplinary options, including fines, restitution to customers and the potential for expulsion from the industry. Mutual funds have also been a focus of NASD's investor education efforts. This year alone, we have issued investor alerts on share classes, principal-protected funds, breakpoint discounts, and we unveiled an innovative mutual fund expense analyzer on our Web site that allows investors to compare expenses and fees of funds and fund classes, and highlighting when they should look for discounts.
All of these issues, breakpoints, after-hours trading, market timing and compensation agreements, are important to NASD because they are important to investors. We are committed to building the integrity of our financial markets and view our mission in the area of broker sales of mutual funds as an important component of that overall goal.
Mr. Chairman, NASD supports H.R. H.R. 2420 and applauds the committee's efforts to bring increased transparency to the mutual fund industry. We look forward to working with Congress and the SEC on technical issues that may arise as H.R. H.R. 2420 moves forward and the SEC proceeds with rulemaking to implement its provisions.
I thank you, Chairman Baker and Ranking Member Kanjorski, for your leadership in this area, and again for inviting NASD to testify today. We are of course happy to answer any questions.
[The prepared statement of Mary L. Shapiro can be found on page 271 in the appendix.]
Chairman BAKER. Thank you very much.
For the introduction of our next witness, I was going to call on Mr. Frank. He has stepped out momentarily. In his absence, it is my pleasure to introduce the Honorable William Francis Galvin, the Secretary of the Commonwealth of Massachusetts, the Chief Securities Regulator for the Commonwealth, and express our appreciation again to you, sir, for your fine work, and look forward to your remarks.
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STATEMENT OF WILLIAM FRANCIS GALVIN, SECRETARY OF THE COMMONWEALTH OF MASSACHUSETTS, CHIEF SECURITIES REGULATOR
Mr. GALVIN. Thank you, Mr. Chairman.
I am Bill Galvin, Secretary of State and Chief Securities Regulator of Massachusetts. I want to thank you, Representative Baker and Representative Kanjorski, for calling today's hearing to examine abuses in the mutual fund industry. I also again want to thank Senators Fitzgerald, Akaka and Collins for the hearing they held on the Senate side earlier this week. By my rapid transactions back and forth, I am beginning to think that I am a little involved in market timing myself.
Representative Baker, while we may not have seen eye to eye on all issues in the past, I do want to thank you for your leadership in this area. Months ago, long before the recent abuses came to light, you put the spotlight on mutual funds, governance fees and conflicts of interest, and you deserve much credit for your foresight and your commitment to America's investors in our securities markets. The bill you crafted, H.R. H.R. 2420, adds important disclosures and addresses areas of abuse that we have seen relating to fund sales practices and operations and I support it. In two specific areas I think it could go further, and I will address those in a moment.
Today, half of all American households are mutual fund investors. Americans have nearly $7 trillion invested in mutual funds. Mutual funds are about more than money under management. Mutual funds are about the hopes and dreams of middle-income Americans, the hope of a financially secure and dignified retirement, the dream of a college education for a child. Mutual funds are where America's dreams are invested. With the decline of interest rates paid on savings, mutual funds have in many instances become the substitute bank of necessity for middle-income Americans seeking a reasonable return on their savings. Investors have placed their trust in mutual funds with the understanding that they would be treated fairly; that fund managers would do their duty as fiduciaries. Unfortunately, we are here today because in too many instances the mutual fund industry has failed to live up to its fiduciary duty.
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The common theme running through all the mutual fund issues that we have exposed in recent months is that the mutual fund industry is putting its own interests ahead of its customers. Mutual funds have often promised trust and competence and delivered only deceit and underperformance. Another reason we are here today is because industry self-policing and government oversight have failed to effectively protect the mutual fund investor. In too many instances, a culture of compromise and accommodation has overwhelmed enforcement efforts. Too often the guilty neither admit nor deny any wrongdoing, and routinely promise not to cheat again until they come up with a better way to do what they just said they would not do again.
The merry-go-round of accusation and non-admissions goes around and around, while investors lose. It has taken the coincidence of dramatic and tragic recent investor losses and aggressive state enforcement by people like Attorney General Spitzer and myself to convert investor outrage to a call for action. Any suggestion that state regulators have hindered federal enforcement of securities law is completely false. Any effort to restrict or preempt state enforcement must be called what it clearly is, anti-investor. Let's be clear. Mutual fund investors should have an equal opportunity for profit and an equal opportunity for risk. Mutual funds should be precisely that, mutual in all aspects.
Unfortunately, that is not the case. Our investigations have revealed that special opportunities exist for certain mutual fund investors at the expense of the vast majority. We have uncovered insider trading at its worst, fund managers exploiting their inside knowledge for personal profit at the expense of their customers. We have uncovered a pervasive pattern of breach of duty and corporate deceit at Putnam Investments, the nation's fifth largest mutual fund company. Simply put, investors were being cheated. In August, my office uncovered a hidden compensation scheme at Morgan Stanley, including cash prizes and other lucrative benefits designed to push Morgan Stanley funds on unsuspecting investors who were seeking honest advice.
Even more recently, this week, my office charged five former Prudential Securities brokers and branch managers with fraud in a scheme that enabled off-shore hedge fund clients to profit at the expense of mutual fund shareholders. The particular complaint alleges in vivid detail how a group of brokers, with the active connivance of managers and a see-no-evil attitude by the company, were able to manipulate the mutual fund trading system for the benefit of certain select clients, to the detriment of the fund. Company policies against market timing and short-term trading were clear. Disciplinary action was nonexistent. For the sake of enriching themselves and their hedge fund clients, the branch managers and registered representatives allegedly engaged in fraudulent tactics and financially harmful trading activity and no one stopped them.
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These enforcement actions are only a few examples of deeper problems in the industry. Mutual funds violate investor trust when mutual funds allow market timing by their employees; when mutual funds allow market timing for certain outside investors, perhaps as an incentive to generate or retain business; when mutual funds allow late-trading in a funds's shares; when mutual funds pay higher commissions to brokers or offer other incentives to sell proprietary or in-house funds to investors, rather than funds that might be more suitable to an investor's needs; and when breakpoint discounts are ignored or concealed.
As in the case involving Putnam, Morgan Stanley and Prudential Securities, state securities regulators are often the best and first to identify investment-related problems and to bring enforcement actions to halt and remedy these problems. H.R. H.R. 2420 is a positive response to the many problems investors in the mutual fund area now face, and I endorse its objectives. I endorse its provision to enhance the independence of fund board members and audit committees; to improve the disclosure of fund fees and expenses; to make board members responsible to oversee soft-dollar arrangements; to require the Securities and Exchange Commission to study soft-dollar arrangements, frankly I think they should be banned altogether, and other disclosure issues; to prevent funds from restricting share redemptions and require funds to hire compliance officers.
The bill can be improved, however. I believe the bill could do more. First, instead of studying and disclosing soft-dollar arrangements, I would ask you to consider an outright ban on them. Funds should simply seek the best price and execution for their portfolio trades. At best, soft-dollar arrangements obscure the true cost of mutual fund overhead and they artificially inflate funds's trading costs. In far too many case, soft-dollar arrangements constitute severe conflicts of interest for fund managers because brokerage firms provide benefits to those managers in exchange for a portion of the fund's trading transactions. Soft-dollar arrangements have been criticized for many years as a fundamentally abusive practice, so this is not a matter that requires further study. Instead, we must act now to draw a bright clear line prohibiting soft-dollar arrangements by mutual funds.
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In addition, it may be appropriate to advocate that section 2(a)(1) of the bill be amended to restore the requirements that each investor receive disclosure of the fund costs and expenses paid by his or her fund account, rather than the costs payable on a hypothetical $1,000 investment. This would make disclosure more meaningful to individual investors. Prompt passage of this bill is important to bring the regulation of mutual funds to the level of regulation that their role in our financial system demands. The laws alone are not enough. They must be vigorously enforced.
Representative Baker, I know that you share my opinion that this sort of behavior, the corrupt culture, is deplorable, outrageous and unconscionable, a serious breach of duty and trust, a betrayal of customers's faith, and that their interests come first. In these cases, I am afraid, greed trumps good business practices. I want you to know that we will not rest until we get to the bottom of this and punish those responsible. Investment in our markets is built on trust. This behavior is equivalent to picking the customers's pockets. Market timing, which is essentially day-trading, sends a simple message to long-term investors, do as we say, not as we do. Fund customers, long-term investors, did not know their money was being managed by day and traders out for themselves.
These charges involve Massachusetts companies. The cases have had a profound impact on the image and reputation of local companies, and that is of great concern to me. I know people who work at these firms and so does my staff. These companies employ Massachusetts residents. They pay state taxes. They give to local charities. The actions of a few at these firms have put the jobs of many at risk, and threaten to destroy the reputations built over many years.
This further underscores that our markets are built on trust, and how fragile that trust can be. For a relatively small amount of money, management winked at corrupt behavior and risked the reputation and future of multi-billion dollar enterprises. This case should be a lesson to others. Our investigation took many weeks. It involved substantially my entire securities division. We deposed people, took pains to corroborate testimony, talked to legal and other experts before deciding to move forward with formal charges. We are very much aware of what impact our actions could have had, and we acted with a sense of sadness as well as a sense of duty to investors in Massachusetts and across the country.
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Representative Baker and members of the committee, I again want to commend you for focusing attention on these issues. With tougher laws and vigorous enforcement, we can give our nation's investors the fairness and honesty they seek and the protection they deserve.
Thank you, and I would be happy to answer any questions.
[The prepared statement of Hon. William Francis Galvin can be found on page 254 in the appendix.]
Chairman BAKER. Thank you, Mr. Galvin.
I would start with you in just making a statement I have made on many occasions for the record in your presence, that I do not contemplate, nor do I think any other member contemplates, any statutory provision that would on its face preclude, hinder, obviate or in any way limit the ability of any state regulator to pursue any cause of action they believe pursuant to investigation worth pursuing.
The only question is with regard to provision 8(b) of H.R. 2179 as to whether that language would in any way have precluded any of the conduct that state regulators have engaged in, there being a difference of opinion. I do not view it as being restrictive in any way. But in trying to come to some accommodation, we recently had the voluntary association of yourself, Mr. Spitzer, the SEC, and NSIA, in trying to come to some closure on how to get to the principle, which is under the provisions of NISMIA, State legislatures are prohibited from enacting State law that would affect national market structure.
The theory, I believe, is consistent, but I would be hopeful, and not necessarily expecting a response immediately, but for your own evaluation, at least a consultative role with the SEC. I understand Mr. Spitzer, at least press reports as of yesterday, was contemplating potential settlements with various mutual fund violators and in the course of that announcement indicated that they would consult with the SEC in reaching final determinations in that matter. I think that would be a great way to get this matter behind us and move on. I think it has become unnecessarily distractive to the much broader and more important goals contained in H.R. H.R. 2420. I certainly would want to extend that concept to you and certainly would appreciate your thoughts if you have any on how we could move forward.
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Mr. GALVIN. If I may respond, Mr. Chairman. First of all, thank you for the thoughtfulness. I do feel that the language of the previous bill that you referred to was problematic. I will tell you also that I think in many respects the problem that is allegedly solved is not a problem. I have not, and I am not aware of any instance where state action has preempted or prohibited the federal Securities and Exchange Commission from taking action, either in Massachusetts or elsewhere. As far as our conduct in Massachusetts, it has been our practice when we think it appropriate, which in most of these cases that is the case, to work closely with the SEC.
Chairman BAKER. I guess my point was, just to give you the reasoning for the approach, when Mr. Spitzer reached the Merrill settlement, it was without the SEC's involvement and there were market structure consequences. When the Merrill settlement was rolled into the Global settlement and the SEC was at the table, the problem went away. So that is the operative condition that from my initial reasoning for bringing up the concept, is just have the SEC at the table.
I think as a matter of practice, if that is what you are telling me you would normally engage in, all we need is some agreement, statement, NSIA leadership somewhere, that conceptually your initial motive in pursuing these matters is not to write national market structure rules, but to go after wrongdoers, and in the course of the remedy phase if it does affect national market structure, coordinate it with the SEC. That is I hope not unreasonable.
Mr. GALVIN. I do not think your stated goal is unreasonable at all. I was just starting to say that our experience has been that we consult with the SEC usually on many cases. But oftentimes, for instance in the Prudential case that I just referred to in my testimony, both the SEC and other regulators have been involved in reviewing that. There were aspects of that case that the SEC chose to charge that we did not. I believe they believe that it is in the better interest of the industry that they pursue aspects of that case, and we certainly consulted with them. Before we brought the complaint, we advised them.
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Similarly in the case of Putnam, I personally called Mr. Cutler and informed him of our plans with regard to Putnam. I do not feel that I have to do that in every instance, and I do not think I should. I have to protect Massachusetts investors. But I do think it is important to consult with people, especially, as you suggest, when a remedy is being crafted that may have significant implications.
The larger cases that you referred to earlier, the Merrill Lynch case, and as you know, Massachusetts was assigned Credit Suisse First Boston in the Global settlement issues. There was consultation at every level, but I think those cases were somewhat unique because we were in fact not only operating for ourselves, but indeed for other jurisdictions, and indeed for the country, in investigating at NSIA's behest, the operations of Credit Suisse First Boston.
My concern is that these enforcement actions are often adjudicatory. They are adversarial. Any language that can be used by those who are accused to say, well, you do not have jurisdiction, will certainly be asserted by them. We have not seen instances, and I have yet to be told of an instance, where there has been a specific problem where something a state has done has prevented the SEC from taking action. I think the reality is that the States often hear about problems, as we did in Massachusetts on a number of issues, first. Most of the cases, if not all of the cases, with the exception of Credit Suisse First Boston, which we brought in the last year, were cases that began in Massachusetts. The conduct began in Massachusetts. We were in a unique position to hear about it. We acted upon it. We pursued our investigation. We certainly did not conceal anything from the SEC. We conducted joint depositions with them in a number of instances.
So I really do not think there is a problem, but I understand your sincere interest in making sure that it does not affect national market issues. I certainly think consultation and further collaboration among the regulators on an informal basis is certainly worthwhile.
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Chairman BAKER. I appreciate that. I am beyond my time, but it is my understanding that your inquiry with regard to the Strong fund, that there was a manager actually timing his mutual fund trades for the benefit of the hedge fund which he operated?
Mr. GALVIN. That would be no. The hedge fund cases that presently we have, although there may be others, in the Prudential case, Strong is not one of ours. Where we had managers actually doing it for themselves was Putnam. The thing that makes it particularly offensive is that the company knew about it for up to 3 years, and these people were left in charge. The company acknowledged on their own, after we issued a subpoena, that they had collaboratively taken about $700,000 in profit, these fund managers. It was clearly insider trading, but they took no action against it. In fact, they concealed it and they denied it, which is one of the reasons that we acted against Putnam so promptly.
I am pleased that you brought up the issue of hedge funds. I would like to invite your attention, Mr. Chairman. One of the things we have seen in our investigations is that for market timing to be worthwhile, there has to be a lot of money moving through. For instance, in the Prudential case that I just referred to, if you read the complaint in detail, it was hedge funds that were moving through. In fact, hedge funds in effect were being flushed through the mutual funds to take the benefit of the profit away from the smaller investors.
I think at least there should be some study directed, perhaps in your bill, H.R. H.R. 2420, given the role that hedge funds play, given the fact that they are largely unregulated, and that they are now interacting with this very large segment of our financial services system, I think that role has to be explored. I would also like to invite your attention to the fact that there are financial holding companies that are totally unregulated, that hold large equity interests in mutual funds, and make a great deal of profit off them. These are largely unregulated.
I think what we have to do is bring the regulation of mutual funds up to the role that it deserves, given the role it plays in our economy and given the role it plays in our financial services system. As I mentioned in my testimony, it is indeed the bank of necessity for many Americans and I think it has to be treated as that.
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Chairman BAKER. Thank you. Just a real quick one. Mr. Galvin, I am sorry the time has gone so far. As I understand current rule, the Fair fund is a recipient of fines levied by the SEC for distribution back to defrauded investors. Do fines currently levied by the NASD, are they subject to distribution pursuant to the Fair fund, or is that something not now permissible?
Ms. SCHAPIRO. It depends on the particular case, Mr. Chairman. For example in the Global settlement on the research analyst conflicts of interest, all of the NASD fines went to the Fair fund and were not taken in by NASD. In a number of cases that you will see over the coming year, that will also be the case.
We also strive in our own cases directly to get restitution to investors where they are identifiable, and do that through our own.
Chairman BAKER. In the interest of time, let me just request that if there are statutory reasons that we need to address to enable the expansion of the Fair fund reach from an NASD perspective, I would really request that. I am so far beyond the time limit, let me recognize Mr. Kanjorski.
Mr. KANJORSKI. I will take up the appropriate time, Mr. Chairman.
Let me back up from the specifics of the individual things that you are involved in, and ask some questions in terms of in these instances of prosecution of timing and late trading, were they clearly illegal under existing law?
Mr. GALVIN. Mr. Kanjorski, we believe they were, and I will tell you why. Our theory is that they are fraud because in most instances the prospectus that was presented to the average investor said there was not going to be any market timing, there were not going to be rapid trades.
Mr. KANJORSKI. If they had made a disclosure in their prospectus that there would be market timing, would that have freed them?
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Mr. GALVIN. It might have in some of the cases, in some of the fact patterns, but it certainly would not have in the case, for instance, of the fund managers that I just referred to at Putnam who were market-timing their own fund. That was clearly a breach of their fiduciary duty. That was insider trading. It clearly would not in the case of the brokers who were promoting large fund passes-through, because clearly the practices they were engaging in, I am speaking now of the Prudential case, they in fact used 62 different bogus identities to conceal their various transactions. So I think that in general these things are there. If your point is that I think there needs to be a clearer definition of market timing, I would agree with that. I think maybe the bill that is under consideration might provide that opportunity.
One of the problems that I think we have seen in this industry is that they have a very great tendency to parse words. They will parse words even when practices that are clearly unethical, they will describe as not illegal. I think it is time to make sure that there is a parallelism between unethical practices and illegal practices.
Mr. KANJORSKI. Looking at some of the testimony that occurred in the Senate earlier, it seemed to me that there was an indication that almost 25 percent of the industry engages in these practices. From listening to your testimony, you said 3 years of practice at one of these companies. So this is a long-occurring situation, and very pervasive.
Mr. GALVIN. I believe it is. Mr. Cutler in his testimony before the Senate the other day referred to a survey the SEC had completed. The 25 percent statistic was 25 percent that had late-traded, which is clearly illegal, no one is disputing that, and about half that had market-timed.
Mr. KANJORSKI. That being the case, that it has continued for a number of years, that it is pervasive in the industry, I mean, our job is not to guarantee very transaction is performed legally, but it certainly seems to me a governmental and regulatory responsibility that these things do not go unnoticed. So it seems to me that there is a fundamental breakdown in the regulatory system, both at the national level and even perhaps at the state level, of getting to this information. It further seems to me that the reason that happens is that we really do not have inside capacity to understand what these organizations are doing until a whistleblower comes forward or until an extreme situation occurs where we focus a great deal of light on the subject.
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I was incensed to hear that one of the whistleblowers, I think that gave you the case, went to the SEC in March and nothing was done until you took action. So even though it had been pervasive and long-occurring before that, it did not seem to tilt. The explanation made for that by the regulator was, well, we were concentrating on other things. I am not sure that the American public or the Congress intends regulators to pick the flavor of the day, if you will, on what they are going to concentrate on. I can tell you quite frankly I assume that if I put money in a bank, the OCC or the Federal Reserve or the FDIC is regularly auditing and making sure and doing random audits, if not direct audits, to determine whether there is illegality, embezzlement or other activity occurring in that financial institution that threatens the depositor. That obviously is not happening in the securities industry.
It seems to me in some of these instances they just recently had gone through a review by the SEC and were found not wanting. That is short of shocking to me. It sort of says to me what we call regulation is not regulation. It is only emergency action taken after it escapes from confidentiality within the firm to the public and then something is done about it. For all intents and purposes if that whistleblower had not come to you, they would still be operating. They would still be rewarding themselves. Everybody would be going on. And you agree that what they were doing is clearly illegal under existing laws.
Mr. GALVIN. We do. Let me just speak to that. We frequently are benefited by people in the industry. I think that says good things about the industry. I want to leave the impression with the committee that there are very ethical people in the financial services industry. The fact is that people inside the industry get upset when they see these kinds of practices and come forward. I will tell you, since these issues have emerged more publicly even since last Monday's hearing, my office has been inundated with additional information relating to this.
I think the fundamental point you make is valid. Namely, there have to be more audits. There has to be clearer disclosure, required disclosure, both to regulators as well as to investors. There is a parallelism between mutual funds and banks in the sense that they are a repository for such a large part of our national savings. Obviously, there are differences, too, because there is risk involved, and that is part of the whole concept. But I do not think that excuses them from the oversight and presenting the information on a regular basis to regulators and to their investors, so that it can be examined and followed. I think there is where the gaps are presently in the system.
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Mr. KANJORSKI. A lot of these firms are advertising extraordinary profits, when in fact it is not substantiated and they are not doing it. So they are misrepresenting in the marketplace. To limited investors who do not have the time to spend going through annual reports and all the studies, and with a fairly sophisticated knowledge of financial transactions, they rely on these representations as being true and accurate. Now, from your testimony and Ms. Schapiro's testimony, I gather we really do not know. These are open entities out there saying whatever they want to.
What I am trying to get at is, the one thing that we want to protect, it seems to me, is the small, unsophisticated investor, so they can stay in the equity markets without retreating to deposit accounts. Banks had a reputation for making loans and doing nefarious things in the 1920s. We solve it very easily by putting an insurance program into place, which meant that there would be a premium and bad actors would pay higher premiums. Following the insurance, it required auditing and investigation on a very real-time basis. Is there any merit to thinking about instituting a small investors insurance fund that would require more periodic audit and investigation techniques to be used on some of these institutions?
I know that the majority of the institutions are sound, honest, full of integrity. So in a way by doing that we would be punishing the good firms in order to get the bad firms. But we could institute situations like the CAMEL ratings so that the bad actors would be identified. The light of day would be shined on, and there would be an incentive within the industry itself to shine the light on the bad actors and get them out of the field.
I think we have to do something, because I had the thought when I heard the testimony in the Senate. There have got to be guys in New York that are going down to the Harvard Club or some other club and sitting there and saying, damn, look what I did today; I turned a million bucks, and we did this and this, and we were involved. And the guy sitting next to him says, gee, I only ripped off $100,000 today; I have to go back. And some honest guy is sitting there and saying, man, I must be a fool. I am living on just what I am getting paid on my salary and I am not ripping anybody off, and it is pervasive in the industry so I better get into it.
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I think that is what has happened. We have allowed it to happen so long that when I hear 25 percent of an industry is engaging in illegal activity, we have to blow the whistle and we have to find a mechanism that protects the honest, protects those that act with integrity, protects the sound operator, and get at the bad actors. Sometimes the bad actors are not necessarily the funds themselves or the institutions themselves, but sometimes the employees and personnel. But we have to find some mechanism and regulation to get there.
Would you give any thought on that?
Mr. GALVIN. My thoughts are that, again, audits are very helpful. I think there has been a climate of accommodation. I think that is one of the problems, and this is pervasive throughout the securities industry. There has been a history when you come to regulation of accommodation that suggests, well, they don't admit they did anything wrong. They will pay a fine, but they will never admit and deny they did anything wrong. Well, that has to stop. We have to get findings. We are going to insist on findings in these cases in Massachusetts; admissions they did do things wrong. There is no question about it. That way, you can establish what the standards are and you can punish those who are guilty.
As far as an insurance fund, I think the problem with that that I perceive is that we are dealing with risk here. If you are talking about an insurance fund for fraud, that is one thing.
Mr. KANJORSKI. For fraud.
Mr. GALVIN. For fraud, because that might be worthy of some review, but I think it is risk. That is what makes it appealing, that people get in because they are going to get a higher return because there might be some there.
In terms of the way funds present themselves, very often funds present themselves talking about their past performance. I think probably the greatest lack of understanding of the way funds are presented, apart from the sales practices problems that I addressed and Ms. Schapiro addressed also, is the issue of they are talking about past performance. They are not talking clearly about fees. The fees that are being paid and the costs that are incurred, and the classifications of shares, those are the things that I think the average investor is not being given clear and digestible information.
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The fact is that most people who go and look at mutual funds do so because they think it is a safe place to be. They either are unsophisticated or they prefer to be unsophisticated. They decide that somebody else will do the thinking for them. It is reasonable. That is kind of the service that mutual funds are marketing. They are saying there is safety in numbers. But unfortunately what we have uncovered is that everyone is not treated the same. That is the fundamental problem that some of these issues have presented.
Chairman BAKER. The gentleman's time has expired.
Mr. Castle?
Mr. CASTLE. Thank you, Mr. Chairman.
Mr. Chairman, it just occurs to me in all this we have been going through that with the changes in technology, when you get into the issues that are non-pure fraud, the market-timing issues and issues like that, there is just huge change that is rapidly happening, but in our enforcement and everything else, we need to keep that in mind. It reminds me of our currency. We are changing our bills now on a regular basis because of the ability to be able to copy them too easily. The same thing pertains here. A lot of this is computers. I do not think we can introduce legislation to eliminate computers, so we need to make sure that we are ready to deal with this.
I would like to start with Ms. Schapiro, if I can, because I am worried that we are missing the forest for the trees. This is probably a little beyond the subject of this hearing, candidly, but on page nine and also in your oral testimony, under investor education you talk about a number of things that the NASD has dealt with. I think that is important. But it seems to me that all these fees are significant. We obviously want to eliminate the fraud, and I am for doing all those things.
And maybe you just didn't do it because it is not part of this, but you do not mention talking about the tax consequences of mutual funds, which can be a huge problem to an individual investor, much greater than some of these fees issues. For example, 2 or 3 years ago, all these funds had made a lot of money over a long period of time. Then they had a lot of sales, so they had to sell a lot of their securities. Obviously, they had great capital gains and they have to pass them on. So you had the double hit of you paid big taxes if you were an individual, but your mutual fund values also had gone down.
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Also, there is no discussion here of market risk, which is even a much bigger factor perhaps than anything else we have talked about. I assume that the NASD is very cognizant of these things and does some education in that area, and is not ignoring them. It is just not in your testimony. Maybe you would feel a little bit better about that.
Ms. SCHAPIRO. I would be more than happy to provide you with our investor alerts. You make excellent points. We of course talk about the tax consequences. I think we all personally felt the pain of paying taxes on declining-valued mutual funds over the last several years. We talk about the tax consequences there. We also talk about it in the context of changes to the tax law and what that has meant, for example, to variable annuities.
Mr. CASTLE. Not to cut you off, but you do focus on this. You just do not have it in your testimony.
Ms. SCHAPIRO. We focus on that, and we always focus on risk; that people have to understand the risks of all these different investment options that are before them. I would be happy to send out a package of the investor materials.
Mr. CASTLE. Okay, and perhaps the sheet funds which go riskless because they do not want to take any changes; a whole different issue.
Let me switch to Attorney General Galvin, if I can. I am very interested in what you said in your testimony, again on page eight, about the soft-dollar arrangements. The definition of ''soft dollar'' has always eluded me a little bit, which is part of my problem here. But I assume that the soft dollars pertain to the costs of a mutual fund in terms of their actual transactions and that kind of thing. So there are some real costs there. But are soft dollars just the amount above what the real costs would be? How can you just eliminate that? I am very intrigued with the idea of doing that, frankly, so I want to know how we can do it. I am not questioning that. I just want to know how to calculate it.
Mr. GALVIN. I think you have to understand that soft dollars came into play after a 1974 decision by the SEC that further restricted fees. Soft dollars cover research, but they also now have been abused. Clearly, research is necessary for any mutual fund to operate and that is a legitimate cost, but that can be an identifiable cost. There is no reason it should not be identifiable. Now what is happening is soft dollar costs include other things such as office overhead, such as costs of conferences, and other hidden ways that people can get compensation. It gets back to the relationships within the mutual fund sales practices and within the mutual fund itself.
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I think one of the things the present bill, H.R. H.R. 2420, does a very good job of is starting to set up a model for how a mutual fund would operate, a directorship, if you will, explaining the audit committee, who the directors have to be. This issue of soft dollars flows in the same way.
Mr. CASTLE. Not to interrupt you, but you said at the end of this, by prohibiting soft dollar arrangements by mutual funds. Are you saying you prohibit certain abuses, but you include certain things which are allowable by defining them specifically in the legislation?
Mr. GALVIN. Defining it. The way you would have to do it would be to define them. If there is actual cost relating to research, you would have to put that into the cost assignable to the individual account. As opposed to saying, this is soft dollars; it is a fuzzy thing.
Mr. CASTLE. Right. It is too generic. It is too broad.
Mr. GALVIN. And it is abused. That is where some of the problems come in. The relationships here are often inherently engaged in conflict of interest and it creates more problems. When you have a receptacle that you can toss it into, it is a slush fund, if you will.
Mr. CASTLE. Thank you. I will not ask you any more on that, but I am interested in that language. I think we all are. If there is a sense that we can do that, I think it would be a major improvement.
Back to Ms. Schapiro, on the 12(b)(1) fees, which concern me a great deal, as I understand 12(b)(1) fees, they were basically introduced as a marketing-type of fee arrangement for mutual funds up to a certain percentage of something. I find now that mutual funds that have already closed still have 12(b)(1) fees. It seems to me that we have created multiple categories of fees; 12(b)(1) fees are ones that are disclosed. But my question is simply, should we eliminate 12(b)(1) fees? Or should we somehow redefine them so that in certain instances they cannot be charged? It seems to me it just gets more and more confusing. I would rather see one set of fees and not a series of three or four fees, and you add it all up and whatever it may be. I just think it is more confusing.
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Ms. SCHAPIRO. I agree with you completely. I think the single most important thing the SEC and the Congress could do in this area would be to require clear, concise and simple disclosure of all of the costs of owning a mutual fund, front-end loads, contingent deferred sales charges, 12(b)(1) fees, administrative and management fees, directed brokerage, soft dollars.
It is virtually impossible for an investor to understand generically, let alone for their own personal account, what are the fees and expenses that they are paying. They have to look in multiple places in the prospective, in the statement of additional information, in the fee table, to try to find this information, put it together for themselves, and then to try to compare across funds is virtually impossible.
So I truly believe the single most important thing that could come out of all of this would be honest, complete, simple fee disclosure for investors that gives them comparability.
Mr. CASTLE. Thank you, Ms. Schapiro.
Thank you, Mr. Chairman.
Chairman BAKER. Thank you. The gentleman's time has expired.
Mr. Crowley?
Mr. CROWLEY. Thank you, Mr. Chairman.
Attorney General, I know you have relations in some regard with the work of Attorney General Spitzer in New York. Do you think that has been effective in terms of cracking down on the scandals, as limited as they may be, in the mutual fund industry? If so, would you support or oppose legislation that would strip Mr. Spitzer or any State official from investigating and prosecuting these criminal offenses?
Mr. GALVIN. I will start of by saying I am the Secretary of State in Massachusetts. I have the civil jurisdiction with regard to securities regulations. Criminal activity in Massachusetts would be handled by our Attorney General. We often refer matters when we see criminal conduct.
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Mr. CROWLEY. Would Attorney General be a promotion or a demotion in your state?
Mr. GALVIN. It is hard to know.
[Laughter.]
Mr. CROWLEY. Okay.
Mr. GALVIN. In any case, we often refer matters when see criminal activity. Our focus, however, is on the civil side and it is primarily two things. One is to try to make the investor whole, and I am very pleased that we have a very good record. We have returned about $20 million to Massachusetts investors that they were defrauded of. The other is to police the industry. We do refer criminal matters when we see them. We refer them to the Attorney General of Massachusetts, to the United States Attorney General. When we were handling the CSFB matter, we were going through e-mails that we felt reflected criminal conduct. We referred that to Attorney General Spitzer and other New York prosecutors because we felt that was the appropriate place for jurisdiction.
I addressed earlier in my remarks the issue of preemption. I would be very concerned about any effort to preempt. I had an extended colloquy with the chairman relating to that. Obviously, there are legitimate concerns about making sure that one group of enforcement does not adversely affect the other, particularly in terms of national market policy. But I am not aware of any instance where that has occurred. The danger I think is much greater on the other side.
If you look at preemption at something that would stifle state enforcement activities, which as I pointed out in my earlier comments, these are often adversarial proceedings. The securities industry is very ably represented in these matters. They are certainly going to allege any opportunity they can or take any opportunity they can to allege lack of jurisdiction. So therefore I would be very concerned about any effort, however well meaning it might be, that might create a situation where State regulators would not be able to perform the task that we now do. I would perceive that as anti-investor.
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Hopefully, these recent cases and these matters where we have worked fairly closely with any range of regulators, from the SROs as well as the SEC, demonstrate that I think we can work collectively together.
Mr. CROWLEY. Thank you, Mr. Secretary.
For both of you, in the hearing before the Senate last week, Chairman Baker sat side by side with Attorney General Spitzer at that hearing. Chairman Baker revived a proposal that would strip out of his bill, H.R. H.R. 2420, which would require an independent chair as head of a mutual fund. I have a few concerns about that. One, wouldn't this mean in essence that Charles Schwab, for instance, could not head his own company? And wouldn't that result in putting inexperienced people on board who do not necessarily know the business and can be more easily hoodwinked, than by veterans who know all the issues?
Secondly, I agree with the U.S. Chamber of Commerce, and it is not often that I say that, when they say, ''to be an effective chairperson, a person must be intimately familiar with the operations of a company. Forcing a mutual fund to utilize a chairman not familiar with the operations of the company could severely impact its progress and success.''
Thirdly, I fear a regulatory slippery slope as many of us as well as industry were told by the Republican staff of this committee, that Chairman Baker and the Republicans would like to extend the independent chair requirement to all of corporate America. I believe that, as well, would be wrong for American business and American investors.
I also understand that the SEC and the GAO told this committee that the inclusion of this independent chair requirement is unnecessary in assisting mutual fund shareholders.
What are your both of your thoughts on the independent chair issue?
Ms. SCHAPIRO. I think the goals of H.R. H.R. 2420 and the corporate governance movement generally to dramatically increase the independence of board members is very, very important, and particularly important in the mutual fund area, where as we have all discussed, so many people count on so few to do a good job. When those few don't, the consequences are pretty devastating and dramatic.
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My experience in observing the corporate world is that the increased independence of corporate board members has had a very important and positive effect post-Sarbanes-Oxley on how corporate America conducts its business.
Mr. CROWLEY. What about the chair?
Ms. SCHAPIRO. I guess I do not have a strong feeling one way or the other. I think it is absolutely worth exploring. I do not think it will hurt. I think people will find good chairs of boards and good board members even if they have to be independent and not affiliated with the mutual fund or the adviser. So I do not see a downside. Whether there is a great up-side, I am not really in a position to judge.
Mr. CROWLEY. Secretary Galvin?
Mr. GALVIN. I would certainly endorse the idea of an independent board. Obviously, what we have seen in terms of governance up to now has been inadequate in terms of protecting the investors because there are inherent conflicts of interest. I think in the case of the chair, it comes down to this. I think it should be advanced as a hypothesis that we have an independent chair. If there are particular circumstances that arise where people of great expertise would be excluded for that, I think that case needs to be made during the course of debate.
I know you are anxious to get the bill out, but it seems to me it will not take too long to ascertain whether that becomes an onerous requirement. It would be a goal that would be worthy of pursuit. If it turns out that you are excluding people of great skill and talent, or unique skill and talent, then it might be something that would have to be reconsidered, which might be offset by having a sufficiently high number of independent directors on the board itself.
Mr. CROWLEY. My time has expired. I thank the Chair.
Chairman BAKER. I thank the gentleman.
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Mr. Tiberi?
Mr. TIBERI. Thank you, Mr. Chairman.
Let me follow up on Mr. Crowley's last question. The current language in H.R. H.R. 2420 creates a two-thirds majority independent board. What I have argued in the past is that those independent directors if they choose, can choose an independent chair. If they choose not to, they can choose not to, but two-thirds of the board shall be independent. Mr. Galvin, what is wrong with that?
Mr. GALVIN. There is nothing wrong with it. I just endorsed it. I think it is an excellent idea, and I think that is the more important point. What I am saying with respect to an independent chair is that that would be a goal. In an ideal world, it would be wonderful. I do not know. I think the problem that Mr. Crowley pointed out is that you might be excluding people of unique skill. I am not making his argument. I am sure he is very capable of making it himself.
Mr. TIBERI. Let me interrupt you. I think we are in agreement here. If we have an independent requirement for two-thirds of the board, aren't those members in the best position to decide who the chair should be?
Mr. GALVIN. I think they are. I guess the question is, are there abuses out there, and maybe there are and maybe there aren't. This is an evolving situation that suggests the chair is a unique person in a unique position. One of the things that came out of the Senate hearing the other day is that there are a number of officers, and I won't name the company because I do not want to mis-name it, where in a given family of funds, individuals sat on the boards of 85 or 100 different funds. How much time could they possibly devote to their duties, and presumably they were being compensated in each and every case. How much time could they actually devote to their duties? So there is a danger here that you are simply stacking the deck with even so-called independent people
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I think one of the other real problems, and it is a genuine one, and I don't know that we can solve it here this morning, is that we are asking independent chairs to step up to their fiduciary duty. We are expecting to do a great deal. I can imagine independent individuals saying, what do I need that for? It is going to be hard to recruit the caliber of people we really want in the number of funds that are out there, but I think it is necessary. I think what we have seen makes it necessary.
To answer your question specifically, sure, if the board is truly independent and they can designate an independent chair, I think that will go a long way. I do not want to simply abandon the concept of an independent chair. I think it just needs to be explored. I can see legitimate arguments, particularly if it is a fund that requires particular expertise. Let's say it is a technology fund, and somebody who has a particular expertise in the market. There may be individuals out there that are uniquely qualified to be the chair.
Mr. TIBERI. But why should we mandate that? Why shouldn't we just let the two-thirds of the independent board do it?
Mr. GALVIN. I am not sure that we should.
Mr. TIBERI. Okay.
Mr. GALVIN. That is my answer to you. I am not sure. I am just saying I would not abandon it as a goal and say it is impossible. Let's explore it. Let those who would be excluded or those who would be concerned about their exclusion, come forward with specifics, as mentioned earlier. This whole subject matter is in some respect complex. This is another example of that. But it does not mean that we cannot get the answers. There are X number of funds out there. We can find out very rapidly where the problems are. The funds I am sure are very ably represented in this room right now. I am sure they can come up with the answers that you need for the discussion.
Mr. TIBERI. Ms. Schapiro?
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Ms. SCHAPIRO. I don't disagree at all. I guess one thing that we could maybe even hope for is that it becomes a point of differentiation to have an independent chairman if those two-thirds elect an independent chair, and that that would be a distinguishing factor for a fund to demonstrate to the world it is taking its corporate governance issues very, very seriously.
Mr. TIBERI. Thank you. You both endorsed H.R. H.R. 2420 as a positive response. We passed it here at the end of July unanimously on a voice vote. Much has happened since then in the mutual fund industry. We may take H.R. H.R. 2420 to the floor next week or the following week. Much may happen in the next month and a half or 2 months. Do you both believe that in general some of the abuses that have occurred, number one, are illegal? And number two, people will go to trial?
Ms. SCHAPIRO. Clearly, the late-trading is illegal. I believe people will go to trial and suffer severe consequences from that. With respect to market timing, as we have talked about, it is a little bit more complicated. Nonetheless, for our jurisdiction which extends only to brokerage firms, not to funds, anywhere where we see that a broker-dealer has essentially colluded with a mutual fund to help a customer evade market timing restrictions that are contained in the fund's prospectus; anywhere we have seen an insurance company work to market-time variable annuity sub-accounts; or we have seen a broker-dealer set up multiple accounts for a customer in order to facilitate their market timing, we will move very, very aggressively, and those people will be subject to strong sanctions.
Mr. TIBERI. Mr. Secretary?
Mr. GALVIN. We believe that every case we brought will have the jurisdiction to complete action. We certainly think that, as I mentioned earlier, in the cases where fund managers funded in their own funds and where they used deceptive identities to trade or where they colluded, as Ms. Schapiro mentioned, we believe we have sufficient authority. I think the benefit of perhaps clearer and more definite language would be to send a message to other people out there in the funds. I go back to what was pointed out earlier. I think the statistics being offered by the SEC about the extent of market timing are indeed shocking. If that is the case, clearly there are many companies out there that need to be told clearly that this is illegal. So I certainly see no damage by doing something like that.
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Mr. TIBERI. Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentleman.
Mr. Miller?
Mr. MILLER OF NORTH CAROLINA. Thank you, Mr. Chairman.
I also want to ask about governance issues. We were here just a few months ago addressing specific practices that many regard as abusive. Now we are here discussing others that we did not know about then. I am very concerned that we will continue to chase specific abuses unless funds are managed in a way, governed in a way that takes into account the investors's interests and not the management's interest.
The concern that I have with independent directors is not whether we have enough of them, but whether they are independent enough. We tend to look at independence as being anyone who does not have certain prohibited employment relationships or certain prohibited family relationships. How can we make sure that we have directors who have the knowledge to exercise independent judgment and who will look closely and skeptically at what the fund is doing, with an eye toward the best interests of the investors? Can we define ''independence'' a little better?
Mr. Galvin?
Mr. GALVIN. I think you normally use the criteria that you just outlined. I think in terms of independence, beyond that, as Ms. Schapiro has noted, it might be a selling point for the companies to identify people of high caliber; people perhaps of either financial or academic accomplishment; people who perhaps have been in another aspect of the financial services industry or in some other corporate location that have demonstrated skill.
I do not know, given the number of mutual funds that we could possibly define it down to such a point that we could say, you have to have X amount of directors with this qualification, and X amount of directors with that. I think what maybe is needed, and again it is very hard to legislate ethics, but there may need to be some sort of a statement that clearly defines more clearly what a fiduciary duty is in the law. In that sense, what we really speak about when we talk about lack of independence among the directors, we are not so much worried about their lack of ability to read or understand. We are worried about the fact that there are conflicts of interest; that they are not putting the interests of the investors first; they are putting the interest of either the fund or the fund managers first, or other special individuals.
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I think maybe some codification of duty by the directors may go further to identify true independence, because that is really what we are looking for. We are looking for their actions to be independent. We are not so much looking for what are their particular skills, what composition do they represent of the investor base, whatever it might be. We are looking really for their duties to be independent, to be thoughtful, to be in the best fiduciary interest of the investors.
Mr. MILLER OF NORTH CAROLINA. Ms. Schapiro?
Ms. SCHAPIRO. The only thing I would add to that is that we talk a lot about the fear that we will not find directors who are both expert and independent. I think we can find independent directors and I think we can train people to be expert. We dropped the ball, to some extent I think, on the issue of educating intelligent, hard-working people who are independent, about how funds work. They may well be in a position to ask some very basic questions that clearly need to be re-asked of this industry and how it operates. Is all this complexity necessary? Are we adequately disclosing our performance? Are we adequately disclosing our fees? Are we doing everything we can to keep the shareholders's interest paramount?
I think we can train people in the intricacies and give them the expertise they need, if they are in fact truly independent and if there is a will to do that. That is an expensive undertaking, but I think it is an important part of advancing the corporate governance here.
Mr. MILLER OF NORTH CAROLINA. Okay. Back in June, I asked about whether there should be some limit on the sheer number of boards that directors can serve on; that this is a little too sweet a deal for somebody serving on 80 or 90 boards, and presumably gets some substantial fee with respect to each board; that if you have that kind of financial stake in it, you are less likely to exercise independent judgment and ruffle management if you owe management that position.
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I felt like I was kind of blown off then. I backed off of that proposal, and I saw in the press clips that Senator Collins raised the same issue this week on the Senate side. Is that something we should look at?
Ms. SCHAPIRO. I think it is worth looking at. I do not pretend to know what the right number is, but I will venture to say that there is no way you can serve on the boards of 40, 50, 60, 100 funds and do an adequate job. There are efficiencies and economies when you are looking at different funds within a fund family, and there are certain issues, the performance of the transfer agent and others, that may translate across all of the funds. But there are many issues about performance that do not. If you are paying careful attention as a board member to issues like performance, you cannot do it adequately serving on that many boards.
Mr. MILLER OF NORTH CAROLINA. Mr. Galvin?
Mr. GALVIN. I would certainly agree. I think whether you want to legislate a number, or you might find that difficult to do, or perhaps authorize the SEC by regulation to come up with some sort of a number or plan might be the better approach on that, but I am sure you are capable of coming up with something, but I definitely think it is something you might want to address.
Chairman BAKER. The gentleman's time has expired.
Ms. Kelly?
Mrs. KELLY. Thank you, Mr. Chairman.
Ms. Schapiro, in the Senate hearing on Monday, Eliot Spitzer stated several conditions that companies have to meet ''to get a settlement with my office.'' They included things like a compliance program that would guarantee that no violations would occur again. He also included the full disgorgement of all fees that were earned related to any fund during the time that the illegal behavior occurred. Did you work with Eliot Spitzer on any of those conditions that he set forth?
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Ms. SCHAPIRO. No.
Mrs. KELLY. I am sorry. Did you say no?
SCHAPIRO. No. To date, the cases that have been announced have largely involved the fund groups themselves. Again, we do not have jurisdiction over the funds, only over broker sales practices with respect to mutual fund distribution. We are working very closely with the State of Massachusetts, with the SEC, and with other regulators on a large number of investigations in the fund area, some of which do involve market timing and late trading, but they also involve inappropriate shares of B-classes, directed brokerage issues, sales contests and so forth.
I think regulators working together here is particularly critical. I see this most acutely from where I sit. As I said, we do not have jurisdiction over mutual funds. We do not have jurisdiction over hedge funds. So it is important for the regulators who do have different jurisdiction to work together so that we can try to bring together as comprehensive a resolution to these issues as possible.
Mrs. KELLY. Mr. Galvin, I would like to ask you a question. The SEC has actively lobbied states to return all fines and make restitution to the investors through the Fair fund. The chairman spoke about that. Do you think investors should be entitled to as much money as possible?
Mr. GALVIN. Yes. I regularly return it to them. I think the problem with the Fair fund which came up in the context of the so-called Global settlement is that no one seriously suggested that the cumulative amount of funds being paid to all entities under the settlement could ever even begin to compensate investors for what they lost. I recall a meeting on Wall Street discussing it. The point was made that we would not be returning cents on the dollar; we would be returning mils on the dollar. I had to remember what a mil was and realize how little it was.
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We work actively to return monies to our investors. That is very important for us. The Fair fund is a good-faith effort at doing that, but it is not the most efficient way. For instance just last week in Massachusetts, we had a rather tragic case involving a family that had trusted a relative by marriage who was a broker, and had squandered and taken away the money and spent it, and the family was totally destitute. They had lost all of their money. We were able to get it back for them. If that family had to go through some sort of an administrative proceeding in a Fair fund, obviously I do not think they would be getting back that much money.
We oftentimes return money who are not represented by counsel, do not have lawyers, if we can get it back from them. That does not mean we are opposed to lawyers. I am a lawyer. I think lawyers are fine. We work with counsel. I think it is too simplistic to simply say there is going to be some Fair fund and all the money goes there.
The second point as far as the monies going to the States are concerned, oftentimes the monies going to the States in fact pay for additional investigations. The cost of conducting these investigations is great. In the case of, for instance, the CSFB case that Massachusetts handled, we were confronted with hundreds of thousands of e-mails. I had to go out and recruit students from law schools to read through these e-mails to find material because the cost and the necessity and the scope of these investigations is so great. I think an effort to take all of those funds away would be a mistake.
Mrs. KELLY. Mr. Galvin, you pointed out that without convictions or an admission of guilt, like we saw with the Global settlement, we have seen a lot of civil suits dismissed, as with the Global settlement. Don't you think this is another reason why we should require that all fines get returned to the investors, to maximize that amount of money? Just give me a yes or a no please.
Mr. GALVIN. All fines, no. I cannot give you a yes to that. There are costs involved. I think that the goal should be returning the money to investors, but you have to have the ability to continue prosecutions, and some of that cost has to be built into the settlement.
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Mrs. KELLY. Have you set up conditions to set up settlements? Or are you going to take this stuff to trial?
Mr. GALVIN. On the pending cases?
Mrs. KELLY. On the pending cases.
Mr. GALVIN. No, we intend to take these cases to trial. We are certainly going to demand admissions. If there are settlements, it will be with admissions of wrongdoing. We are certainly not going to have cases where people are able to say, well, we did not do anything, but we will pay a fine. No, not at all.
Mrs. KELLY. Ms. Schapiro, the NASD rule 2830 that you talked about expressly prohibits the award of non-cash compensation, and it prohibits brokers from favoring the sale of any mutual fund on the basis of brokerage commissions that they receive. Isn't the practice of selling mutual funds off of preferred lists where brokers paid more to sell the funds off that list widely practiced? If so, and I just want a yes or a no answer, are there widespread abuses of the NASD rule 2830 that have gone unchecked?
Ms. SCHAPIRO. We have ongoing 12 investigations right now to determine whether funds have been inappropriately included on a broker-dealer's preferred list by virtue of having gotten directed brokerage, which is what 2830 goes to from that fund. We will be announcing a major case very shortly in the next several weeks. As I say, we have 12 major investigations going on.
Mrs. KELLY. Thank you.
My time is up. Thank you, Mr. Chairman.
Chairman BAKER. The gentlelady's time has expired.
Mr. Inslee?
Mr. INSLEE. Thank you.
I want to focus on the relative responsibilities and abilities of the federal and state regulators, if I can. I want to tell you that there is a perception out there on Main Street, at least the Main Street I walk down on my way to work, that the federal regulator has been grievously ineffective relative to the state regulators recently in this whole plethora of industry issues. I think there is some reason for that perception. I think it is not just a casual reading of the headlines. I think there is some actual reason to believe that, that there is some sort of systemic problem with our federal regulator in this regard that has not allowed them to be sufficiently aggressive or timely in these investigations or prosecutions.
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Now, realizing your close working relationship with our Federal government, I am not going to ask you to do too much critical thinking about their lack, or at least perceived lack of aggressiveness on this. But perhaps you can give us some thoughts as a colleague of theirs, if you can, on how to promote at least more timely action from our federal regulator, and share some of the positive experiences of your operation and others that you think the Federal government needs to think about utilizing as well, in the most positive way that you can put your comments. I am looking forward to your advice.
Mr. GALVIN. I think we have to recognize, and I think Mr. Frank alluded to this in his opening statement, that the federal regulators are looking at a bigger picture. They are looking at issues such as liquidity in the market. They are looking at the complete market. All too often, their focus has not been on the impact on small investors in particular.
I think that that is in fact the advantage of the dual system that we now have, that the State regulators are more likely to see, it is a tired analogy by I will make it anyway, the cop on the beat, so to speak, and going to hear about something that has actually happened. In the case of Massachusetts, these issues arose in factual instances that occurred within the confines of the State of Massachusetts.
If I were to make a constructive suggestion to the SEC in terms of enforcement, it would probably be that recognizing that it is a large bureaucracy and probably going to, in the interest of enforcement, grow larger, they have to find streamlined ways of promoting information up the channels to bring actions, and perhaps devolve more authority to some of the regional offices to commence actions. I cannot say for a certainty that that is a problem.
I do sense, however, that like any bureaucracy, and I administer a bureaucracy as well, so I am well aware of its pitfalls, it is sometimes hard to get information up the chain, to let people know how to proceed. Oftentimes, especially in an industry that is so complex and so broad, and having so many individuals employed in it and so many individuals affected by it, there is such an overload of information it is hard to digest it all.
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So I think if I were to make a constructive suggestion, recognizing that the SEC's role has continued to be interested in the overall financial market, in terms of individual instances, it would be best to have some kind of streamlined system of proceeding with information that I am not sure they have right now.
Mr. INSLEE. Ms. Schapiro?
Ms. SCHAPIRO. It is a hard question for me because I am overseen directly by the SEC, and I spent 6 years there as a commissioner. I guess I would say just a couple of things about it. I think it is important that they have a more intensive examination program, that in the fund area in particular the examiners that the SEC employs need to spend more time in the mutual funds and in the advisers, and all regulators have to recapture a sense of skepticism about everything they see. The presumption that everybody is honestly doing business, and most probably are honestly doing business, has to become checked at the door when you are a regulator. You have to walk in, and everybody knows entering trades after 4 p.m. is illegal. I do not think anybody thought that that could possibly be going on on a widescale basis, and yet it was.
So I think more examinations, more skepticism, and then more feeding of the results of examinations into the policymaking groups on a real-time basis so that where rules need to be written, they can be written and the enforcement program can move more aggressively and more quickly. I do believe the SEC's enforcement program, but that is the end of the chain, has worked quite aggressively over the last couple of years under Steve Cutler's leadership. I think some of the issues need to get to enforcement more quickly.
Mr. INSLEE. Do you think this legislation is a vehicle to look at some of these issues? Maybe that is outside your ken, but is there something unique enough about the mutual funds situation that in this legislation we ought to tackle some of those internal regulatory issues?
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Ms. SCHAPIRO. I guess I am not really a good person to answer that question. I think the leadership of the SEC is very focused on tackling just those kinds of issues right now, and I have complete confidence that Chairman Donaldson will be able to do that. I think this legislation is very important for lots of other reasons, though, and Congress ought to move as quickly as possible to enact it.
Mr. INSLEE. Mr. Galvin had one more comment, I think.
Mr. GALVIN. My only comment was I think the audit part of the legislation or the discussions about audits would be very important. I would echo what Ms. Schapiro said, that I think that is a very important tool in the hands of enforcement people.
Mr. INSLEE. Thank you.
Chairman BAKER. The gentleman's time has expired.
Mr. Toomey?
Mr. TOOMEY. Thank you, Mr. Chairman.
I just wanted to focus a little bit on the market-timing issue. The late-trading seems to be pretty straightforward and a clear violation of any sensible set of rules regarding this. It is illegal. Market-timing, my understanding is, generally speaking, not illegal. My first question is, are there common practices of market timing that you think should be illegal? If so, why? That would be my first question.
Mr. GALVIN. I think market timing in general, unless it is a fund devoted to market timing, and I guess there are some entities like that, should be clearly illegal. I believe in the instances that we have uncovered, it was illegal. As we discussed earlier, in many instances it was made available by deception. It would certainly disadvantage the average investor.
Mr. TOOMEY. Could you explain, what is the economic cost to an investor who does not participate in market timing, and created by someone who does?
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Mr. GALVIN. There are a number of consequences. First of all, as I mentioned earlier, it is our feeling, and I think so far the evidence has borne out, that the amount of money being flushed through the system in market timing is dramatic because it makes it worthwhile doing. So therefore, the returns are dramatic. For instance in our case against Putnam relating to market timing by Putnam customers, we had a group of people who were boilermakers affiliated with a 401(k) out of New York. The market timers who were taking advantage of the special rules for them in that case, in some instances were making up to $1 million simply on the market timing. That was coming out of the fund.
Secondly, there are tax consequences, as already has been averred by others this morning, because the fund oftentimes to meet the demands of paying out these people at some time makes sales of stock, keeping its portfolio balanced. So there are definite disadvantages. But beyond the technical disadvantages, and we could go further into what they are, it is fundamental fairness.
Mr. TOOMEY. There is a fairness issue that I think is one issue. But what I want to understand is, and I think if market timing is allowed, it should be available to everybody. If it imposes a cost on the fund, then the cost ought to be borne by the person engaging in the market timing. But what I want to understand is whether or not the fact that one party engages in market timing and even makes a profit from that, does that truly come at the expense of another investor who chooses not to? You mentioned there is a liquidity issue, and there may be transaction costs. Is that it?
Mr. GALVIN. We are not clear. You would have to analyze when the market timing was done, exactly to what extent it was done. As I mentioned, what we are looking at now are hedge funds doing it, large amounts of money passing through. There has to be an impact of that. It gets back to the inadequacy of some of the accounting that is presently done in these funds.
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Beyond the fairness issue, to assess the damage that has been done by it, I think you have to get into deep detail as to when they did it and how they did it, and what the costs were. The general accepted theory is that it is costing investors money. It may not be a great deal of money to each individual investor at that particular time, but then you have to look at not only the cumulative effect on the fund as a whole, but also the interest of the investors who are holding over the long term. Over the long term, it is costing them a more substantial amount of money because it aggregates in that way also.
Mr. TOOMEY. Is it appropriate to deal with that by charging an appropriate fee to people who engage in market timing?
Mr. GALVIN. That is the so-called 2 percent solution. There is a proposal out there that would charge them a 2 percent redemption fee. The problem with those types of things, in my view, is that once you say, well, it is okay if, how do we enforce the ''if''? One of the biggest problems with this whole discussion is it gets extremely complex. We have so many mutual funds out there. We have so many people out there. If we are going to say, you can do it if you adhere to these rules, we have rules. They are in the prospectus. They did not adhere to them. In fact, they worked around them and the companies in many instances helped them work around it.
Mr. TOOMEY. But that essentially is an enforcement problem, not necessarily a problem with the rule itself.
Mr. GALVIN. But it is the same problem. You cannot separate the rule from enforcement, in my opinion, because the rule without enforcement is meaningless.
Mr. TOOMEY. I am not disputing that, but I still think that there is a separate issue here.
I would like to hear what your thoughts are, Ms. Schapiro.
Ms. SCHAPIRO. What I would add to that is that if a fund wants to advertise in its prospectus that it allows marketing timing and it will impose a 2 percent redemption fee, and it uniformly and always imposes that fee on every customer, good customers do not get a special deal and pay only 1 percent or nothing, I have less trouble with that than I do with what seems to be the prevalent problem here, which is a prospectus that states, we discourage market timing and we will take steps against people who market-time our funds, and then look the other way while the best customers market-time the funds.
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To me, the disparity of how people have been treated, that there are special investors and not-so-special investors is really very offensive.
Mr. TOOMEY. Right. It sounds to me what you are saying is that the misrepresentation of what is allowed or tolerated or condoned by the fund is more objectionable than the activity itself.
Ms. SCHAPIRO. The activity can be objectionable, because I think in addition to saying we are going to impose a redemption fee and we are going to impose it consistently, is I think you have to explain to investors what does it mean if you choose to be in this fund, even if you are not going to market time. What is it market-timers are taking out of the fund? What additional cost is their activity imposing on you? I guess it goes back to the earlier conversation that people have to understand the performance. This affects the performance of the fund. If they are going to allow market timing, even with a high redemption fee, everybody else needs to understand what the impact of the activity is on their fund value.
Mr. TOOMEY. I agree with you.
Thank you, Mr. Chairman.
Chairman BAKER. The gentleman's time has expired.
Mr. Emanuel?
Mr. EMANUEL. I want to thank the chair for holding this hearing, as well as the one on Tuesday.
I would like to follow up a little on what the Chairman asked as it related to hedge funds and mutual funds. As we look forward to drafting bipartisan legislation or going forward with some type of legislation, your thoughts in the area of mutual funds being able to have inside the shell hedge funds in the coordination. This is the second case brought today as it relates to a hedge fund and mutual fund, and the type of special treatment for special accounts. We are going to deal with market timing and we are going to deal with late trading, independent boards, and greater transparency.
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My worry here is intermingling of two worlds that have never come together in the past, one marketing to a different clientele than the other. Again, we have a culture that says ''heads I win, tails you lose,'' that we are going to take care of a special client at the expense of all the average investors getting the short end of the stick constantly. I suppose it is not really a question that I just made, and I apologize for that, but your thoughts as we start to think about drafting legislation that affects these two worlds now starting to bounce into each other, or blend and become one.
Mr. GALVIN. I think it is something we have to think about. That is why I mentioned it earlier, and I am glad the Chairman mentioned it as well. You are right. The perception on the part of the average investor is they are investing in this safe fund that they share risk and opportunity. They could not define a hedge fund for you, and hedge funds are largely unregulated, so they are these powerful entities. The fact that we are seeing them surface in the market timing thing suggests that they are the type of entities that get special treatment. They are not the only ones. There may be large pension funds or 401(k) groups, so they are not exclusively the bad people in this situation. But I think the question is, if we are going to acknowledge that mutual funds are such an important part of our financial savings system, as I mentioned earlier, the substitute bank for many people, is it wise to have hedge funds participating on an unrestricted basis?
I do not have an answer for you this morning, because I do not know whether eliminating them would cause a great problem in the marketplace. I am concerned that their action, though, interacting with mutual funds, is potentially problematic, and I certainly think there should be some disclosure. I actually think hedge funds should be a lot more regulated. I also mentioned in my earlier testimony as well the issue of these unregulated entities, holding companies that hold perhaps a hedge fund and also interest in a mutual fund at the same time. Those are things that I think at least ought to be focused upon by the SEC at the very minimum.
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Ms. SCHAPIRO. If I could address the structural issue about hedge funds and mutual funds being potentially harmed by the same manager or in the same family. My personal view is that it is an untenable conflict of interest to have a manager have to select where their best transactions are going to reside, in the hedge fund which may be paying higher fees and in which the manager may in fact even have an interest; or the mutual fund which is dispersed among a lot of people and has less effective voice to it in the whole process. I do not understand how you can have a situation where the same person manages both the hedge fund and the mutual fund.
Mr. EMANUEL. Thank you. Again, it is a structural issue, but it again deals with the conflicts of interest, higher fees, a different clientele, at the expense, my biggest worry, is that it is at the expense of the average mom-and-pop investors who have college savings. This is also the one area, unlike the others, and those are important for setting the rules of the road, that look forward in some sense, although what you are dealing with today is today's problems, but more sense about where the industry is going.
Rather than kind of review this every 2 years, someone gets a clear line of direction that blending or coming together of the mutual fund and the hedge fund industry. My greatest concern here is that what we are trying to do is restore the Good Housekeeping seal to the mutual fund industry that has been tarnished in the last 3 months, so to say, that these cases have been brought, and really are about actions that have been taken over the last 3 or 4 years, because they are so essential to the democratization of the financial and capital markets that we have.
One other area of inquiry, and then I will give up my time. Do I have time for one more question, Mr. Chairman? I asked Attorney General Spitzer and others on the panel the other day about the area of the IPOs and the hot market that existed in the late 1990s. Given that the industry somewhat lost focus on its fiduciary responsibility to its investors and had a culture of heads-I-win and tales-you-lose kind of dominate. Have any of your investigations to date or inquiries to date taken you into the area of how the hot IPO market, and where certain classes of the friends and family got distributed?
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Ms. SCHAPIRO. We jointly chaired with the New York Stock Exchange, at the request of the SEC earlier this year, a blue ribbon advisory committee to look at the IPO market after the market meltdown. We do not actually have a hot IPO market again yet, but it looks to be heating up. That report generated a number of recommendations, including with respect to friends and family programs and limitations on those programs, and a number of other recommendations that are generally geared toward trying to make the initial public offering market a bit more public, and a bit less geared toward the insiders that have traditionally been able to get access to IPOs.
That report resulted in for us a series of rule proposals that will go to our board next week and then be filed after that with the SEC. We would like to encourage Dutch auction activity in the IPO market; much more transparency about who gets IPO shares; much more involvement, quite honestly, of the issuer in the process of setting the price so that it is not just done by the investment bank to generate enormous first-day bounces.
Mr. EMANUEL. But my question is, to date either in that investigation or any of the ones that you have had up in the commonwealth of Massachusetts, have you seen any of the special offerings in the mutual fund industry to personal accounts, rather than to the accounts for the rest of the investors anywhere in that area, or to the management, or to a special investor?
Ms. SCHAPIRO. As you say, we have certainly seen it in the IPO market generally over the last several years and brought a number of cases related to that. We have not seen it, to my knowledge, in the mutual fund area.
Mr. GALVIN. We have not seen it as such. What we have seen, as I mentioned earlier, is fund managers market timing. We have not seen them try to take advantage of their IPOs.
Chairman BAKER. The gentleman's time has expired.
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Mr. EMANUEL. Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentleman.
Ms. Hooley?
Ms. HOOLEY OF OREGON. Thank you, Mr. Chairman, and thank you for holding this meeting.
I have first a question for Mr. Galvin. Strong Financial founder and chairman Richard Strong is under investigation for market timing. The Strong Financial Company manages accounts for 529 college savings plans, including those in my home State of Oregon. State and federal law holds that Strong must place investors's interests ahead of his own, yet by engaging in market-timing trades for himself, his friends and his large clients, it appears that Mr. Strong was looking out after his own financial interest ahead of those who had college savings plans. Of course, the losers are the parents and the students that they were going to send to school.
So I have three questions. How do we ensure that mutual fund companies put their investors's interests ahead of their own? Two, is there a comprehensive investor restitution system that is in place to get these college savings back? And three, should this Congress look to create a comprehensive investor restitution program?
Mr. GALVIN. First of all, clearly, let me start off by saying that the Strong case was not one that I have brought, but I am familiar with it, but the principles and the issues in the Strong case are the same as in some of these other cases, which as you say, is the people running the mutual fund putting their interest ahead of their investors.
Clearly, one of the things that we are going to be looking for is restitution to the fund for whatever has been lost by market-timing practices or any other breach of fiduciary duty. I think that will be an essential for any resolve of these cases. In terms of preventing it in the future, I think the bill that is under consideration goes a long way towards that. It starts to speak of independence. I think the discussion we have had here this morning regarding audits is very important. I would like to echo what Ms. Schapiro said about a skeptical eye being turned on some of these matters.
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I also think in the case of, as you describe, college education funds, usually they are coordinated by some state authority of some kind, making them available to the general public. I frankly think that while we have talked a lot about states's rights here to enforce law, I think we have to talk about state responsibility, too. I think it is important that the state authorities that placed these funds take on that fiduciary duty just as they might in a pension fund to make sure that the fund is policed properly; to make sure that the fund is answering the right questions. I do not think we can absolve the customer in this sense. It is the state that is organizing, and not the individual parent that is trying to plan for their children's future, from responsibility. I think this bill would go a long way toward helping that.
Ms. HOOLEY OF OREGON. Need to look at an investor restitution program?
Mr. GALVIN. I think the program should be built into any violations that are uncovered. I think the cleanest way of getting restitution is to make sure that it is done by those who have actually perpetrated it. Mr. Kanjorski earlier asked about the creation of some kind of an insurance fund. My response to him at that time was if we are talking about fraud, maybe that might be worthwhile; if a fund was completely fraudulent or there was no investment, perhaps. I think in most instances here we are not talking about fraud.
I think this might be an opportunity to restate something I have been saying a lot, and I want to make sure people understand this. Many average people get very nervous when they hear about these investigations. They think about, is the fund going to fail? Am I going to lose all my money? They might make rash decisions, and that would be a mistake. What is different in the fund situation from, for instance, a run on a bank, is that there are assets in these funds. They have invested their portfolios. It is unlikely, while the fund might be weakened by a lot of withdrawals, and that would be a cause of concern, unless there has been out-and-out fraud, it is quite unlikely it is going to go bankrupt. For an investor who is committed to long-term investment, to make a rash decision based on these representations that we have seen, even if they are true, might be a mistake.
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I think that argues all the more for prompt state and federal action, both in terms of enforcement and in terms of changes in the law. I do think it should be a cornerstone of any actions that are brought and resolved, however they might be resolved, through adjudication or by settlement, full restitution to those who have lost money because of inappropriate behavior by fund managers.
I have a quick question for Ms. Schapiro. Obviously, mutual funds are what a lot of people have invested in as a low-risk way to enter the stock market. Three quick questions. You see these mutual fund scandals. They are on top of, now, all of the other corporate scandals. Do you see these scandals affecting the market as a whole? And how do these scandals affect the mutual fund industry and Americans's participation in it? And should we be prepared for more scandals?
Ms. SCHAPIRO. Thank you. I do think they affect the market as a whole, because they affect investor confidence. We need the capital and the contribution of investors to our economy to keep it growing. So I think to the extent that people are scared away by, first, the series of scandals with respect to investment banking and research analyst conflicts of interest, inappropriate allocation of initial public offerings, and now something that everybody thought was safe and sound and fair, mutual fund investing, I think investors are weary and scared, and may well decide that stuffing their money into a pillow and putting it under the bed is a better place to put it. I think that would be a real tragedy, because the fact is that mutual funds really were designed to be wonderful investment opportunities for diversification and professional management for people who could not otherwise afford it.
So I think the mutual fund industry has a lot of work to do to restore confidence in their credibility and in the integrity of the investment vehicles that they offer. I am not sure if that answered all your questions. Or, what other scandals might we see?
Ms. HOOLEY OF OREGON. Should we be prepared for more? Yes or no?
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Ms. SCHAPIRO. Maybe.
[Laughter.]
We are very, very focused, as I know the SEC is, in trying to look around the corners and see what else might be out there. We are doing a much more effective job, I think, than ever before of mining regulatory data; of understanding what the potentials are for problems out there; where all the conflicts of interests lie in this business; and combining conflicts of interest with opacity and complexity, and knowing that that may well be the next area for us to be looking at. We are trying to understand what all of those are and get out ahead of them.
Chairman BAKER. The gentlelady's time has expired.
Ms. HOOLEY OF OREGON. Thank you, Mr. Chairman.
Chairman BAKER. Mr. Lynch?
Mr. LYNCH. Thank you, Mr. Chairman.
I, as well, want to thank both of the witnesses today for coming forward to help the committee with its work. I wish I agreed with our ranking member, Mr. Kanjorski, that this might be the result of the actions of a few bad individuals. It seems, though, that based on the reports that we have read, that this is rather endemic to the industry and that it is not just some renegade firms that are guilty of this conduct, but some fairly reputable firms.
I would just say that if you look at the harm that has been done here and if you look at the measure of trust that has been lost by the industry, there is a real concern here because of the nature of the wrong being done to the investor. The whole system, the whole industry is built on trust, and it appears that the need for these firms to compete in this way, and I am talking specific toward late trading, is to get an advantage for the investor, this small group of investors.
So they are choosing to compete with other firms by giving an advantage to a select group of investors. That is competition. It is illegal competition in many, many cases, and I know there are some borderline descriptions that you have rendered where it perhaps did not amount to fraud, but because what is driving this is competition among advisers and fund managers, not necessarily the fund itself, it would appear to me that the consequences and penalties for late trading and for market timing need to be a fairly serious consequence.
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I just want to ask you both, and maybe I will start with you, Mr. Secretary. What do you see as the best long term, and bear in mind I am not just out to get the bad guy so to speak. What is the best thing for the investor? What is the best thing for the industry and for the long-term success of the mutual fund industry, but getting rid of this practice or this series of practices that have so shaken the trust of the American investor in the mutual fund industry?
Mr. GALVIN. I would respond by thinking, first, that we have to proceed with the prosecutions we have already brought. Secondly, I think we have to make it clear that if there is any ambiguity in the law, while I do not believe there is, I think it can be put to rest by this committee and by this Congress right now that these practices should be clearly illegal. I think establishing a clear responsibility in the area of mutual funds of a fiduciary duty by those who administer and manage them and direct them, also enshrining that in law, would be a great way to guarantee that in the future.
Then I think you have to have vigilant enforcement, not just by the States, but by the Federal government. I think an essential part of that is the audits and accounting that we have spoken about before. I think that we also then have to try to educate those who are participating in mutual funds. We do not expect them to get into the depth of detail of corporate management, how their fund is managed, as much as to be looking out for how their fund selections are made, what the fees they are charged actually represent, in digestible language, understanding not just fees, but also procedures and how the funds operate. I think those are important things that we have to do.
Clearly, to build credibility or restore credibility in an industry like this, it takes an effort not only by the government to come up with clear lines, and bright lines at that, but it takes an effort by the industry itself. I think they have been shaken by this. I think it is in a sense a good thing because they shared in this. They hid it for a long time. It is in our interest to restore their reputation if they are worthy of it. I know you share with me the concern, coming from Massachusetts as you do, that we are the home to many of the financial services companies that employ people in Massachusetts. It is a big part of our economy. It is certainly not something we want to see destroyed.
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By the same token, we do not want to see it stay in business in a way that defrauds not only our own citizens, but the citizens throughout the country. So it is very important to all of us to get this cleaned up. I think that the contribution that Congress can make right now is to make it very clear what the duties of mutual funds are; to bring mutual fund regulation up to the level that it should be, given the responsibility that it has in our financial system.
Mr. LYNCH. Thank you.
Ms. Schapiro?
Ms. SCHAPIRO. Thank you. I am not sure my answer is very different at all. I think we have to pursue these enforcement cases with a tremendous amount of vigor, with very meaningful sanctions against the funds's brokers, to the extent they are involved, and management individuals. People have to be held responsible for direct participation in these schemes or fostering a culture within the organization that permitted them to go on either undetected or, if detected, unaddressed.
I think the second piece of it is rigorous, ongoing examination of fund practices and operations by the SEC on a continuing basis, a tremendous focus there, so that we are looking under the rocks all the time and finding the problems before they blow up.
The third is fund governance. Again, to really echo what Bill has said, the shareholders's interests have got to be paramount here and it is up to the boards and the management of funds to ensure that that is happening.
The fourth, I guess I have said about four times today, I believe we must have clear, more concise and consolidated disclosure of all the expenses and fees associated with buying a mutual fund, and then the impact of all of those on performance, so investors understand exactly what they are getting, exactly what they are paying, and how to compare those across different funds.
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Chairman BAKER. The gentleman's time has expired.
Mr. LYNCH. May I?
Chairman BAKER. Do you want a follow up?
Mr. LYNCH. Please.
Chairman BAKER. Yes, sir.
Mr. LYNCH. Thank you, Mr. Chairman.
I just want to say in closing, and I know that Mr. Crowley had the wish to get 30 seconds himself, but just on the issue of disclosure that I repeatedly hear here. I just hope you realize the body of information that is coming to the average investor, and the complexity of it. I am a recovering attorney as well, and sometimes I just hold my head when I read just an average prospectus from an average fund. I actually have an unwritten rule. When someone tells me they need more disclosure, they ought to come up with an idea of a few of those disclosures that we are providing now that are just pure gobbledygook that are costing the investors, costing these funds. I think a lot of it is a waste of money because it is not coming in an effective way to the investor. It is a waste of printing. It is a waste of money.
Ms. SCHAPIRO. I absolutely agree.
Mr. LYNCH. I want good, effective, valuable disclosures made to the investor. I do not want muddled, legal mumbo-jumbo. I want people to have usable information as a result of these disclosures.
Ms. SCHAPIRO. I think you are completely right. I think what they have right now is mumbo-jumbo, and you have to look in four or five different places to get disclosure about the fees and expenses associated with a fund. It needs to be clear. It needs to be concise. It can fit on one page. It can be done with pictures. There are ways to do it far more effectively than I think it has been done, and in a way that will benefit investors. We do not want to burden them with any more to read. They are already not reading what they are getting. There is a better way to do it, and I think it is really incumbent upon all of us to find that way.
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Mr. LYNCH. Thank you.
Thank you, Mr. Chairman.
Chairman BAKER. The gentleman's time has expired.
Mr. Scott?
Mr. SCOTT. Thank you very much, Mr. Chairman.
I also want to thank you, Mr. Galvin and Ms. Schapiro, for coming before our committee this morning.
Each day, it seems, we are learning more and more about these mutual fund scandals than we did the day before. In today's Washington Post and Wall Street Journal, for example, there are two more revelations of two more companies coming under scrutiny. Investor confidence is just going down. I came across today, according to Reuters, a new poll was released by a wealth management firm, the United States Trust Company, and they found that these scandals are having an extraordinarily profound impact on investor confidence.
Sixty percent of Americans are now losing confidence in investments; 79 percent of those polled questioned the reliability of corporate financial statements and do not trust stock analysts; 67 percent do not trust corporate management; and 65 percent do not trust independent auditors of mutual funds, and that is even despite the recent very significant up tick in the stock market. And now today we find out from a story in The Washington Post of investment banks getting into the act as well. It seems like, as we are trying to handle this, it is like trying to put your hands around a bowl of Jell-O. You kind of squeeze it and another part oozes out.
I want to ask just a couple of questions, going back to the article in this morning's Washington Post. It says that industry sources are quoted as saying that investment banks either played favorites among mutual funds when doling out shares in hot IPOs, or they placed poor-selling IPOs in their own mutual funds. Do you have any idea about how involved investment banks are in manipulating mutual funds? And if so, what do you recommend that we do to protect against this unsavory practice?
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Ms. SCHAPIRO. We are investigating that very activity. I do not have a good answer for you at this point about how pervasive the problem is or how serious it is, but we will pursue our investigations. We will undoubtedly bring enforcement cases in that area. If necessary, we will write rules that will make it easier to enforce in the future.
On your general issue, I think we will not make you happy, probably, by telling you there will be many more headlines. There will be many more discouraged investors, because there are many more cases to come just on this issue of late trading and market timing, from both the state regulators, the SEC and the NASD. So it will be awhile before I think we see light at the end of this tunnel.
Mr. SCOTT. Mr. Galvin, on investment banks?
Mr. GALVIN. I think the investment bank issue, much like the hedge fund issue, raises the question, are these appropriate partners to be under the same tent? I think it goes back to the issue of independent boards of directors and making sure that they truly do not have conflicts of interest. In essence what you are suggesting, the scenario you are suggesting, is a conflict of interest, an investment bank looking to park fully performing IPOs or whatever shares in some other entity to the benefit of the fact that they took the business to promote or produce this IPO, or whatever it might be.
It gets back to how do you ensure independence. I think that is why setting a fiduciary duty in statute, creating a requirement for independent directors that is based upon that, is probably the most effective thing you can do.
I share your concern about investor confidence. As I mentioned to the gentlelady earlier, I am concerned that people are going to rush in now and say, I will take my money out. That is not the right thing for them to do right now. It is going to hurt them more. We do not want to see them hurt any more than they have already been hurt. So it does mean that moving on this legislation and moving on these prosecutorial efforts has to go forward as rapidly as possible.
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I think it is fair to say that it is now clear, or it should be clear to the industry at every level that is involved with mutual funds, that they need to come clean, too. Don't wait for them to catch us. Don't wait for them to see the law change so they have to adhere to it. Why not, if they are knowing of some issues that they have, I think it is much better for them to come clean to their investors right now over the next few weeks land address these issues, than waiting for you to change the law or us to enforce it.
Mr. SCOTT. I had a gentleman and former Securities and Exchange Commission chairman who wrote an excellent book with a take on the street, and he said the deadliest sin that he felt was fees. I want to ask you this question as well. The cost of buying and selling mutual funds is often disguised as high fees charged by the providers. Some funds are able to get away with overly high fees because investors do not understand how fees can reduce their returns. What do you recommend to clearly explain the potential costs of fees to investors up front?
Mr. GALVIN. Again, we have talked a lot about disclosure. Mr. Lynch mentioned making it digestible. I think we have perhaps a model when people purchase homes in this country now, they have the benefit of when they sign up for a mortgage, they are presented with a document. It is usually not a single page any more, but not too many pages, anyway, that lays out the numbers. I think that is really the type of disclosure you need, something that lays out the numbers in understandable form. What does this actually cost you?
I think we have to also think about, as this bill seeks to address or at least raises the topic of soft-dollar costs and how those fees are set. I think that is an important part of any fix in this whole area.
Lastly, we have spoken, I know the NASD has and I have, and the Morgan Stanley case illustrates it, relating to contests and extra compensation for selling certain funds. I think that is important, too. I think it is important for brokers and those who sell funds to tell the customer if they are getting extra money to push a certain fund. If someone is getting extra money, that needs to be on the table. That is a material fact that the person is making a decision to purchase needs to know.
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Mr. SCOTT. Thank you. I am going to ask one more follow-up question.
Mr. GALVIN. Sure.
Mr. SCOTT. One of my major efforts and concerns on this committee is financial literacy and financial education. I quite firmly believe that, as the old prophet Isaiah said, people without vision will surely perish. If we in this country cannot collectively come up with a strong vision of America as being literate financially, we are going to have more of these rows. I see some downturn to that. We are grappling with that and putting forward some legislative initiatives on financial literacy and investor education.
I am concerned that many investors, and this is especially true for minority investors which are trying to encourage more in the minority community, to get involved in investing. Of course, with these scandals coming up, it is making it more difficult. But I am concerned that we are not fully educated about the risk of investing. What do you recommend that we can do to ensure that investor education is an effective tool, and not just throwing money at the problem?
Mr. GALVIN. I think you have to put it in simple terms. People have got to understand, you are going to give me this amount of money, that it has to be clearly stated when there is a risk. We have had cases in Massachusetts, which come up all too often, when people to into federally insured banks where they have money in the bank, and there is another table, same color, same logo, off to the side, and they are selling mutual funds or some other kind of risk investment.
Now, there are requirements of disclosure, but you sometimes need a magnifying glass to see that down there. To the unsuspecting or unsophisticated investor, it looks like an employee of the bank. I think we have to make sure that is a clear demarcation line. You do hear oftentimes on the tail-end of commercial and presentations for reputable risk investment, you may lose all of your principal. We have to get that point across, not to scare people, but to have them understand there is a fundamental difference.
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I also think, and I know this is your ultimate purpose, in fact, to encourage people to invest.
Mr. SCOTT. Absolutely.
Mr. GALVIN. So that being the case, it is important that we do not scare people away. One of the greatest concerns I have as I have brought these enforcement efforts is that I do not want to see people scared away from the financial services industry or investment, because investment in general is a very good thing. This has been a bad thing for the industry and the industry has done bad things to people, but it is time for us to make sure they do better things and to put in place the protections that people who do not have a lot of time, who are simply looking for a reasonable place, people of modest means looking for a reasonable place to park their savings, are treated fairly.
That is why, I know we have talked back and forth about definitions, but it comes down to honesty and fairness. That is really what we are talking about. We cannot legislate, you cannot legislate and I cannot enforce something that says you are going to make money, because you may not. You may lose money. But we can insist that people be treated fairly and honestly. That I think we have an obligation to do.
Mr. SCOTT. Thank you very much.
Chairman BAKER. The gentleman's time has expired.
I want to address one thing that was brought to the committee's attention by Mr. Crowley a little earlier, referencing a Republican staff comment and quotes attributable to me relative to the assertion that I would be proposing independent chairmen for public operating companies. It kind of threw me back a bit. So I went back to the prior explanation in the committee markup of the bill and just will read this, because I am surprised I made sense. I went back and looked at it to make sure.
The content of the independent chair proposition comes to this bill in recognition that an operating company, a company traded on the New York or American Exchange, is inherently different in structure from that of a mutual fund. A CEO and a CFO for a publicly traded corporation that is an operating company has one clear set of responsibilities, and that is to its shareholders. There are not conflicting sets of shareholders. Mutual funds are managed by corporations, corporations that have a different set of shareholders. Take company X which has been awarded the management contract for mutual fund 101. Company X has its own set of shareholders. Company X may manage 100 different mutual funds. They do that work for the benefit of company X's shareholders.
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If the person running the mutual fund is also the person running the management corporation, he has a conflicted set of shareholders. On the one hand, if fees are increased for the mutual fund management company, that decreases returns for the mutual fund. If he keeps fees low for the mutual fund participant, that decreases the revenue to the mutual fund management company. So the mutual fund director is in a distinctly different and unique position from the CFO or the CEO of an operating company, hence the reason for suggesting the chair should be independent.
If the management company is not performing appropriately, charging excessive fees, or is just not doing its job in the proper rate of return for the mutual fund shareholders, do we really believe the chairman of the board of the mutual fund is going to suggest to his board dismissal of his own corporation as manager?
That was the statement made, and I do not know from where Mr. Crowley reached his conclusion, but just on the record, I have no intent, and have not to my knowledge ever suggested that anyone other than a mutual fund structure should have an independent chair, but it did bring to light what I think are good policy reasons. The growth of the industry over the decade has been enormous, with now over 8,000 funds with trillions of dollars under management. One fund, one management company has 277 different funds.
I do not know where the maximum management time begins to diminish. I am not suggesting a fund and a board. There are efficiencies that occur from multiple funds being managed by the same board. Clearly, the industry growth I think exacerbates this managerial question, and hence my belief that inclusion of the independent chair in this proposal ultimately is in the best interest of the market as it is currently constituted. I will yield to the other gentleman since this is basically a second round on my part, if you choose to make any comment.
Mr. MILLER OF NORTH CAROLINA. Mr. Chairman, I would like to take advantage of that, particularly since I did honor the red light earlier in my questioning.
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I have one more question along the lines of what the chair was just asking, and also consistent with my earlier set of questions about governance. One alternative to an independent chair, and I think both of you thought there might be some circumstances in which it might be better not to have an independent chair, as we have defined ''independence.''
The mutual fund industry itself has suggested that their best corporate governance practices should require that there be not just a set of independent directors, all of whom are supposed to be independent, all of whom are supposed to exercise independent judgment, but that there be a lead independent director who is supposed to be the point of contact between management and the independent directors; that that be the person they consult with, and that there be focused responsibility for skepticism, for independent judgment, and that that director have the authority to place items on the agenda, to call meetings, to obtain outside advice on behalf of all the independent directors.
Do you know if that is being widely used in the industry? Has that been an effective method of assuring greater independence by the board? Is there a reason why that should not be part of what we require if we do not in fact require that the chair be independent?
Ms. SCHAPIRO. I cannot speak to the mutual fund industry. I know generally in corporate America, lead independent directors are being very widely used and I think to good success.
As I said earlier, I am confident there is no harm in requiring an independent chairman, but I am not really in a position to judge whether that is a necessity. I think it is a good idea. If there is not going to be an independent chairman, then I think at a minimum you must have a lead director who is independent.
Mr. GALVIN. I think it is an excellent idea. It is an approach. I think it comes back to having a process internally within the mutual fund that guarantees it is steering the right course. I think that is what it comes back to. It really addresses the fact that there are all these mutual funds out there, and how possibly, even with the best-armed enforcement effort, are you going to police every single aspect of it. I think you have to enshrine some sort of fiduciary duty, but having a point person in the structure of the management who would have the responsibility of making sure it is adhering to the principles of fiduciary duty I think would make a lot of sense.
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Mr. MILLER OF NORTH CAROLINA. Thank you, Mr. Chairman.
Chairman BAKER. Mr. Scott, anything further?
Mr. SCOTT. Yes. I would like to just ask one point to each of you, if you could get to a response to this. We have talked about hedge funds a little earlier. We do know an increasing number of mutual fund companies now have begun to offer hedge funds in recent years. We have found in the articles this morning and beyond that Alliance Capital's managers ran both mutual and hedge funds. How common is it for these managers to run both funds? And shouldn't there be regulations to prevent what appears to me to be an outright conflict of interest?
Ms. SCHAPIRO. We do not have authority to prohibit a mutual fund from also operating a hedge fund, since we do not regulate them directly. My view is that it is an untenable conflict of interest for a manager to operate a hedge fund and a mutual fund at the same time. It should not be permitted.
Mr. SCOTT. Do you see that that might be an area for our legislation to address, too?
Ms. SCHAPIRO. Perhaps, yes. The SEC obviously needs to look carefully at the issue, but it may well be an issue that should be addressed legislatively.
Mr. SCOTT. Thank you.
Mr. Galvin?
Mr. GALVIN. I definitely think that hedge funds need to be looked at. I think they are a potential problem. They should not be under the same tent as mutual funds. I think we have to also acknowledge their affect on the overall financial system. I think for a long time they have been kind of a stealth player in that system. I think what these mutual funds reveal, the scandals have revealed, is that they have been involved in mutual funds as well. They have been the beneficiary of some of these market-timing instances.
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I think the regulation of mutual funds should be put in a pristine situation, and therefore it should not be put under the same circumstances as hedge funds. I mentioned earlier some of these other entities, financial holding companies that hold both. I think there has to be a demarcation line drawn. The whole concept of mutual funds by the way it has been sold to the investing public, is totally distinct from hedge funds, which by definition are designed for people of very high income who can sustain great risk.
Mr. SCOTT. Thank you very much, Mr. Chairman.
Chairman BAKER. Thank you, Mr. Scott.
That is one of the elements that I outlined at the hearing on Tuesday, that we hope to have included in a manager's amendment. The slight distinction that we are contemplating is rather than prohibition against mutual funds and hedge funds being operated by the same company, just being managed by the same individual so that it would be permissible for a company to have a mutual and hedge fund operation, but to have distinctly different managers in charge of each activity. But it is one of the elements which we hope to reach consensus on, Mr. Scott, and include in some sort of amendment to the underlying H.R. H.R. 2420. I thank the gentleman.
And let me express to each of you our appreciation, not only for your appearance here today, but for your good work over the past months. We look forward to continuing to work with you in the days ahead. Thank you very much.
I will ask our participants on our second panel to come on up. Let me welcome each of you to our second panel this morning. As I am sure you are now painfully aware, we have debated at quite a length the need for additional regulation of our mutual fund industry. I look forward to your testimony. Your prepared remarks will be made part of the record. To the extent practical, attempt to limit your comment to 5 minutes, and we will certainly engage in questions at the conclusion of your testimony.
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It is my pleasure to first introduce Mr. Charles Leven, Vice President, Secretary and Treasury of the American Association of Retired Persons. Welcome, Mr. Leven.
STATEMENT OF CHARLES LEVEN, VICE PRESIDENT, SECRETARY AND TREASURER, AMERICAN ASSOCIATION OF RETIRED PERSONS
Mr. LEVEN. Thank you very much. I guess it is now good afternoon, so I will change my statement a little bit.
Chairman Baker, Ranking Member Kanjorski and members of the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, my name is Charles Leven. I am a Vice President of AARP's board of directors. I appreciate this opportunity to testify on behalf of the AARP's over 35 million members on a matter of great importance to the financial security of all Americans. That is the savings that they have invested in and entrusted to the mutual fund industry.
Mutual funds control 21 percent of U.S. corporate equity, representing an estimated $19 trillion in assets. More than 95 million Americans are invested in mutual funds, representing more than half of all American households. Mutual funds are the investment of choice for millions of our members and for mid-life and older Americans in general. The consequence of lost or diminished investment savings can, and for far too many, may have been immediate, profound and lasting.
AARP supports the efforts of this subcommittee under your leadership, Chairman Baker, to improve investor awareness of mutual fund costs, and to improve the independent oversight and governance functions of fund boards of directors. The legislation you introduced and which is now pending before the House, the Mutual Fund Integrity and Transparency Act of 2003, H.R. H.R. 2420, would put into effect an overdue upgrade in investor protection for the ordinary saver-investor. These reforms were already warranted by the continuing evolution in market practices and the growth in market choices.
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Real damage has already been done to the economic security and financial well-being of many Americans in or near retirement. This has been in part due to the market's natural cycles that has tracked the general economy downward over the last couple of years. But some of the damage was caused by corporate financial reporting, accounting transgressions and market manipulations. Apart from corporate reporting and accounting scandals, mounting allegations of illegal or, at best, unethical practices by mutual fund management companies, executives and brokers highlights the need for prompt remedial action.
Startling results reported just this week from an SEC survey revealed the apparent prevalence with which mutual fund companies and brokerage firms had arrangements that allowed favored customers, including themselves, to exercise after-hours trading privileges and market-timing options, as well as to participate in other abusive practices. These apparent violations of the fiduciary duty owed to investors has caused real harm, both in confidence and in lost dollars. These allegations come on top of other more recent examples of conflicts of interest in the industry.
We must do more to protect the individual investor. With regard to initiatives designed to increase fund transparency, we strongly support H.R. H.R. 2420's provisions to require, among other new obligations, that fees be disclosed using dollar-amount examples; fee disclosures be enhanced so they can encapsulate all fees, including portfolio transaction costs and the structure of compensation paid to portfolio managers and retail brokers be disclosed, to include the holdings in the funds managed; disclosure of breakpoint discounts to investors be improved; and directed revenue sharing, brokerage and soft-dollar arrangements be made to conform to the fiduciary duties to the funds and their investors.
We are increasingly concerned that lay investor confidence in the mutual fund industry not be allowed to deteriorate further, specifically in its ability to reliably provide fairly priced benefits of investment diversification and expert management. While greater transparency is essential to fair competition among funds for investors, we believe it does not provide a sufficient check on the cost of fund governance. Most funds are not established by investors, but rather are incorporated by advisory firms, who then contractually provide research, trading, money management and customer support services, and who also have some representation on the fund's board. But the advisory firms have their own corporate charters and are accountable to their own boards of directors, posing as we see a range of potential conflicts of interest in the cost of services provided to the fund.
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We see these failures of mutual fund governance not simply as a lack of statutory or regulatory authority, but as a failure of compliance and enforcement. We support the provisions in H.R. H.R. 2420 designed to strengthen the role and independence of boards of directors, and further target directors's energies where potential conflicts of interest between the fund adviser and fund shareholders are greatest.
Specifically, we strongly recommend the final measures include provisions requiring that a super-majority, somewhere between two-thirds and three-fourths of fund board members, should be independent. The board chairman should be selected from among the independent members, and the independent directors be responsible for establishing and disclosing the qualification standards of independence, and for nominating and selecting all subsequent independent board members.
In summary, the importance of the mutual fund market as a critical component of the economic security of all Americans, especially older persons, should not be underestimated. We urge prompt, bipartisan passage of H.R. H.R. 2420 by the House. Full disclosure of expenses and requirements for stronger fund governance will help hold fund advisers accountable for their trading practices, which should reduce costs to investors.
We believe these changes will introduce more vigorous price competition in the mutual fund marketplace. We look forward to working with you, Chairman Baker and Ranking Member Kanjorski, and with the other members of this subcommittee, in further perfecting and working to enact this important piece of investor protection legislation.
I would be happy to take any questions you may have.
[The prepared statement of Charles Leven can be found on page 264 in the appendix.]
Chairman BAKER. Thank you very much, Mr. Leven.
Our next witness is Dr. Eric Zitzewitz, Assistant Professor of Economics at Stanford University Graduate School of Business. Welcome, sir.
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STATEMENT OF ERIC ZITEWITZ, ASSISTANT PROFESSOR OF ECONOMICS, STANFORD UNIVERSITY, GRADUATE SCHOOL OF BUSINESS
Mr. ZITZEWITZ. Thank you.
Chairman Baker, Ranking Member Kanjorski, members of the subcommittee, thank you for the opportunity to discuss the issues of late trading and stale-price arbitrage, as I am going to refer to what is otherwise known as market timing in mutual funds.
My name is Eric Zitzewitz. I am an Assistant Professor of Economics at Stanford's Graduate School of Business. I am the author of three studies related to the issues being examined by the subcommittee. I have also worked with the industry on the issues of fair value pricing and estimating the extent and cost of stale-price arbitrage trading. I will draw on my research and experience, as well as the work of other academics in the course of my testimony.
Let me begin by summarizing some of the main conclusions of my research. My analysis of daily flows for a sample of funds reveals flows consistent with stale-price arbitrage in the international funds of over 90 percent of fund companies, and consistent with late trading in 30 percent. In 2001, a shareholder in the average international fund in my sample lost 1.1 percent of their assets to stale-price arbitrage trading and another .05 or five basis points of their assets to late trading. Losses are smaller, but still statistically significant in funds holding small cap equities or liquid bonds such as municipals, convertibles, and high-yields.
The source of these losses is arbitrageurs buying funds for less than their current value and selling funds for more than their current value. The source of that opportunity is the way we calculate our net asset values. We are calculating them using historical prices that in some cases are 12 to 14 hours old for international funds. We need to fix that problem. This is the source of the arbitrage problem. This is the most serious component of the market timing that people are talking about.
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Dilution rates have declined since the beginning of 2003, but not to zero. Even for September 2003, after the announcement of the investigation by state and federal regulators, international fund shareholders were still diluted at an annual rate of 0.3 percent. In April 2001, the SEC sent a letter to the fund industry remind it of its obligation to use fair value pricing to eliminate stale prices, especially in their international funds. Despite this, my statistical analysis of fund net asset values reveals that in 2003, over 50 percent of fund families removed less than 10 percent of the staleness from the net asset values of their international funds. This implies that they are fair valuing extremely rarely, if at all. The average fund is removing just over 20 percent of the staleness in their net asset values.
Short-term trading fees and monitoring by the fund family alone are imperfect solutions to the problem. I find that dilution due to stale-price arbitrage is only 50 percent lower in funds with fees. This is because arbitrage can wait out the fees, because the fees cannot be applied in all channels and because the collection of fees is not always enforced. The SEC survey by Mr. Cutler reports that almost all fund families monitor for stale-price arbitrage, and yet dilution is still substantial in at least some of those funds.
One important point to make, though, is that industry averages mask substantial heterogeneity. Just under 10 percent of fund families are fair-valuing their funds, frequently enough to remove over 70 percent of the staleness. Another 10 to 15 percent are removing about 50 percent. Although almost every international fund has been diluted by stale-price arbitrage, about 75 percent of dilution is concentrated in the 25 most affected international funds. I have found that fund families with more independent directors and lower expense ratios experience less dilution, were more likely to use fair value pricing, and short-term trading fees to limit arbitrage activity.
Policymakers and regulators face two challenges. Number one, ensuring that affected investors are fairly compensated, and number two, ensuring that these and similar problems cease and do not reoccur. The first is a non-trivial issue. Simply relying on the reimbursement calculations of the affected firms may be insufficient, since affected firms will certainly be tempted to apply a narrow definition of damages, which could lead to an under-compensation of investors. Policymakers obviously may choose to provide some guidance here.
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I will devote my attention for now to the second issue. I believe that a complete solution to the market-timing and late-trading issues needs to involve three components. Number one, a pricing solution. The most direct method of eliminating stale-price arbitrage is to eliminate the staleness in NAVs via fair value pricing. It is already standard practice to use fair value pricing for corporate and treasury bonds, except we do not call it fair value pricing. We call it evaluated or matrix pricing, but it is basically the same thing. Fair value needs to be extended to international and perhaps small cap equities, and evaluated bond pricing should be extended to currently excluded asset classes such as convertibles and high yields.
The SEC allows for fair value pricing, but as I noted, it has been underutilized by the industry. A cynical view might be that funds have dragged their feet on fair value to preserve the ability to allow favored customers to arbitrate their funds. This may be true in some cases, but adoption of fair value has also been limited by the vagueness of the SEC's April 2001 letter. In particular, the SEC reminds funds of their obligation to fair value after a significant event, but does not define the term. Some funds have used such a narrow definition of a ''significant event,'' such as an earthquake or a 3 percent move in the value of international securities, that they end up fair-valuing extremely rarely. In some cases, this may be due to the perceived legal risk of fair valuing more frequently. In some cases, the perceived legal risk may be used as an excuse.
In his testimony on October 9, 2003, SEC Chairman Donaldson listed as one response to these issues, emphasizing the obligation of funds to fair value under certain circumstances. It is vital that the SEC define, perhaps not exhaustively, what these circumstances are. In order for fair value to be effective, this definition will need to be broader than it is currently.
Allowing fair value pricing to be done using an ad hoc process is dangerous, since it invites manipulation. A better approach is to use a model that updates the most recent market price for recent changes in market indicators, and I list some in the written testimony, on a security-by-security basis. The model could be calibrated using historical calculations and should be subjected to rigorous testing both before implementation and on an ongoing basis.
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I should emphasize that short-term trading fees or restrictions are not substitutes for fair value pricing. The greatest danger I see in the current debate is that this will not be recognized. Fees have not been fully effective historically for the reasons I mention. Even if the investment company institutes a proposed 2 percent fee for trades within 5 days is perfectly enforced in every channel, which is far from certain, arbitrageurs could simply wait until day six to sell. A quick simulation I ran revealed that a mandatory 5-day hold, which is stronger than a 5-day trading fee, reduced arbitrage excess returns from only 48 percent to 24 percent per year, hardly enough to be a serious deterrent. Even a complete ban on selling within 90 days would only reduce arbitrage excess returns to 5 percent per year. These are still going to be attractive excess returns to hedge funds. My guess is that average investors would not appreciate such a ban. Fees may be a good idea, but they are not a substitute for eliminating stale prices.
A related danger I see in the current debate is that the SEC might allow funds to use solutions that allow them to deny arbitrage opportunities to some investors, but allow them to others. Fair value pricing removes arbitrage opportunities equally to all investors. Other solutions such as short-term trading fees, monitoring by the fund company, and allowing funds the option, and I stress option, to either delay exchanges or return gains from short-term trades, can be applied or not applied as funds see fit. The limitation of many of the current popular solutions, this limitation of them, has clearly contributed to the recent scandal.
The second component is a third-party monitoring solution. Fair value pricing addresses stale prices, price arbitrage, but there is no pricing solution for late trading. Furthermore, no fair value pricing formula will be perfect. Therefore we need to provide tools for boards, regulators and even shareholders to monitor trading activity in funds.
One possibility would be to require funds to publicly disclose daily in-flows and out-flows, perhaps with a 2-month lag to alleviate any front-running concerns. This would allow anyone, including data and advisory firms, to use the formula for my and other academic studies to estimate dilution. An alternative would be to require the disclosure of this information to regulators, boards and a limited number of third-party firms who would disclose only the most egregious cases. My guess is that either way, this idea will meet with significant resistance from some in the industry. But you should ask yourselves, is there any good reason why these disclosures should not be made?
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Third, I believe part of the solution is governance. What I have to say here is not terribly unique, except to add that I support these proposals to make boards more effective.
With that, I will conclude and I welcome your questions.
[The prepared statement of Eric Zitewitz can be found on page 281 in the appendix.]
Chairman BAKER. Thank you, Doctor.
Let me start. You suggest that there should be a model developed that would accurately determine fair value pricing that could be adaptable to market conditions. Do you have from your work such a conceptual model developed? Or is that something that would have to start from scratch, that we would ask the SEC to engage in over some period of time?
Mr. ZITZEWITZ. Actually, I have helped a firm develop a model, so I should mention that in the interest of full disclosure. There is also a competing model. Those models are being used by some fund families. Those fund families I mentioned that are removing a lot of the staleness from their fair value prices, in large part that is how they are doing it. Some of them have their own proprietary models as well.
Chairman BAKER. So simply having the SEC develop a rule at our request, that would initiate utilization of modeling for the purposes of establishing fair value pricing, in your opinion, would not be premature.
Mr. ZITZEWITZ. No, I think that would be feasible. In fact, I think you might even want to go further and mandate a performance standard. You should be removing X percent where X is something like 80 or something like that, I think that would be feasible, of the staleness from your fair value prices, because I think there is a danger that you mandate the use of a model, but if you do not specify how frequently it is used, some funds will not remove the staleness.
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Chairman BAKER. Sure. If there any interim definition of ''significant event'' that could be offered to help a more frequent updating to eliminate staleness? Or is that not worth the effort?
Mr. ZITZEWITZ. No, I think we may want to get specific here. Using an S&P basis for a definition for a significant event is imperfect, but if we were to use one, something like a 75 basis point movement in the S&P, if that were a significant event, of course there could be others like earthquakes and so forth.
Chairman BAKER. I was being a little more maybe politically creative there. If you define ''significant event'' as a triggering mechanism in the appropriate way, but offer as an alternative an appropriate modeling standard, the industry would probably pursue modeling with some degree of enthusiasm if the significant triggering event was drafted properly. Am I communicating?
Mr. ZITZEWITZ. I see. I understand and agree.
Chairman BAKER. Okay, great.
Mr. Leven, I appreciate the testimony given, and it is highly supportive of H.R. H.R. 2420. Contentious discussion tends to still focus on the necessity or desirability of the independent chair. You and the AARP have taken the position that the chair of the board should be selected from the independent members, and therefore support the concept of an independent chair.
Mr. LEVEN. That is correct.
Chairman BAKER. I do believe that shareholder investors in mutual funds perhaps do not understand today adequately enough the authority and influence of the chair, particularly in light of board members not being able to give the necessary attention, perhaps, to each individual fund for which they are assigned managerial responsibilities. As I indicated to the earlier panel, I am aware of one management company that has 277 separate funds. I do not know how they do the work.
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Does this rise to a level of concern for AARP, where if H.R. H.R. 2420 were to be considered and a manager's amendment were to be constructed, that the AARP would contact membership relative to the importance of the adoption of that amendment?
Mr. LEVEN. Obviously, I cannot speak for the total board. Certainly, I will take it back to the board and to our executive committee for their point of view. I suspect strongly that I would support that. Whether the board will remains to be seen, of course.
Chairman BAKER. You have an independent board, I take it. That is a joke. I am just kidding.
[Laughter.]
Mr. LEVEN. Oh, very independent. I am the chair of the audit committee, which is even more independent. I would suggest to you that an independent chairman obviously is not going to be an expert in all areas of what he is going to do. What he is going to do is what any intelligent person would do. You would either call in experts from outside or hire experts from outside. An independent board clearly has full authority to do that.
Chairman BAKER. Removing one's own personal financial interests from the considerations you make is a key principle of independence, I think, and in making sure that you are not disenfranchising the interests of one set of shareholders to enrich another. That point has not been sufficiently made, apparently, in the course of our debate, but any help we can get from any interested party is certainly appreciated.
Mr. LEVEN. We do support it. We will do our best to examine it and see whether appropriate support is required or necessary as we go forward.
Chairman BAKER. Let me read through the list that is being contemplated now for additions to H.R. H.R. 2420, and ask either of you to make comment about any one or group of the recommendations: reinstatement of the independent chair you have already commented on; require that all funds not only have a chief compliance officer, which is required by the bill, but that the compliance officer report only to the independent chair and the other board members; further refine the definition of ''independent'' so it precludes individuals with relationships with the management that would compromise their independence, for example a family member of the manager.
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Disclose the compensation of fund executives and portfolio managers, as they are disclosed for public operating companies, not to set a new standard, but simply extend the standard now required for public operating companies to the mutual fund managing company; disclose all purchases, sales and aggregate holdings of fund shares and portfolio securities of management and directors, as they are disclosed for public operating companies in specific section 16 reports under the 1934 Act; disclose on the fund Web site fund codes of ethics and reported violations of the code of ethics; prohibit short-term trading by portfolio managers and fund executives for their own account.
Prohibit joint portfolio management of mutual funds and hedge funds by the same manager, not necessarily the same fund company; increase enforcement penalties applied to mutual fund violators; allow funds to choose whether they are going to permit market timing, but make the policy determination defined as ''fundamental,'' which means they will have to then make the policy clearly disclosable in the prospectus and unchangeable without shareholder consent; require the board of directors to certify the valuation procedures; permit funds to charge more than the current limit of 2 percent for short-term redemptions, but not mandate statutorily such a charge. This gives the funds the choice to permit investors to decide whether they wish to invest in a fund that is going to have a more restrictive short-term trading limit or not. And finally, a strengthening of the fiduciary duty that directors have to fund shareholders.
Anything we are missing? That is on top of H.R. H.R. 2420.
Mr. LEVEN. I did not hear independent audits, but I am sure it is in there.
Chairman BAKER. If it is not, we will make sure that that is on the list.
Any comment, doctor?
Mr. ZITZEWITZ. I already mentioned a couple of things that I might add to that, right? I think disclosure of daily flow data could be very valuable and I think you could allay any concerns about front-running with a delay and that disclosure. I think absent that, investors have no way of knowing whether their fund is being diluted. The range in which their funds have been diluted in the past, at least, it is bigger than the expense ratio range. So we spend all this effort educating them on expense ratios, and they have no way of knowing whether their fund is being diluted or not. I think that is something important to fix.
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Then we also talked about perhaps needing to go a bit further in terms of requiring fair value pricing.
Chairman BAKER. Yes. Although it was not on the pre-printed list, the fair value pricing is certainly something that rises to our attention.
I want to express my appreciation to both of you for your patience in waiting through the long hearing today. Your recommendations are certainly important to the committee's work, and we look forward to working from this point forward into what we hope will be a prompt, but more importantly, an appropriate review and final passage of legislation to assure shareholders that they are being fairly and equitably treated, all appropriate disclosures are made, and that all the rules apply equally to all participants.
I thank you very much. If you have no further comments, our meeting stands adjourned. Thank you.
[Whereupon, at 12:50 p.m., the subcommittee was adjourned.]