oversight

Mutual Funds: Greater Transparency Needed in Disclosures to Investors

Published by the Government Accountability Office on 2003-06-09.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

             United States General Accounting Office

GAO          Report to Congressional Requesters




June 2003
             MUTUAL FUNDS
             Greater Transparency
             Needed in Disclosures
             to Investors




GAO-03-763
             a
                                                June 2003


                                                MUTUAL FUNDS

                                                Greater Transparency Needed in
Highlights of GAO-03-763, a report to the       Disclosures to Investors
Chairman, House Committee on Financial
Services and Chairman, Subcommittee on
Capital Markets, Insurance and
Government Sponsored Enterprises,
House Committee on Financial Services




The fees and other costs that                   Although mutual funds disclose considerable information about their
investors pay as part of owning                 costs to investors, the amount of fees and expenses that each investor
mutual fund shares can                          specifically pays on their mutual fund shares are currently disclosed as
significantly affect their investment
returns. As a result, questions have
                                                percentages of fund assets, whereas most other financial services
been raised as to whether the                   disclose the actual costs to the purchaser in dollar terms. SEC staff has
disclosures of mutual fund fees and             proposed requiring funds to disclose additional information that could be
other practices are sufficiently                used to compare fees across funds. However, other disclosures could
transparent. GAO reviewed (1)                   also increase the transparency of these fees, such as by providing
how mutual funds disclose their                 existing investors with the specific dollar amounts of the expenses paid
fees and related trading costs and              or by placing fee-related disclosures in the quarterly account statements
options for improving these
                                                that investors receive. Although some of these additional disclosures
disclosures, (2) changes in how
mutual funds pay for the sale of                could be costly and data on their benefits to investors was not generally
fund shares and how the changes in              available, less costly alternatives exist that could increase the
these practices are affecting                   transparency and investor awareness of mutual funds fees that make
investors, and (3) the benefits of              consideration of additional fee disclosures worthwhile.
and the concerns over mutual
funds’ use of soft dollars.                     Changes in how mutual funds pay intermediaries to sell fund shares have
                                                benefited investors but have also raised concerns. Since 1980, mutual
                                                funds, under SEC Rule 12b-1 have been allowed to use fund assets to pay
                                                for certain marketing expenses. Since then, funds have developed ways
GAO recommends that SEC
consider the benefits of requiring
                                                to apply Rule 12b-1 fees to provide investors greater flexibility in
additional disclosure relating to               choosing how to pay for the services of individual financial professionals
mutual fund fees and evaluate ways              that advise them on fund purchases. Another increasingly common
to provide more information that                marketing practice called revenue sharing involves fund investment
investors could use to evaluate the             advisers making additional payments to the broker-dealers that distribute
conflicts of interest arising from              their funds’ shares. However, receiving these payments can limit fund
payments funds make to broker-                  choices offered to investors and conflict with the broker-dealer’s
dealers and fund advisers’ use of
                                                obligation to recommend the most suitable funds. Regulators
soft dollars. SEC agreed with the
contents of this report and                     acknowledged that the current disclosure regulations might not always
indicated that it will consider the             result in complete information about these payments being disclosed to
recommendations in this report                  investors.
carefully in determining how best
to inform investors about the                   Under soft dollar arrangements, mutual fund investment advisers use
importance of fees. It also                     part of the brokerage commissions they pay to broker-dealers for
indicated that it will be considering           executing trades to obtain research and other services. Although
ways to expand disclosure and                   industry participants said that soft dollars allow fund advisers access to a
improve other regulatory aspects of             wider range of research than may otherwise be available and provide
fund distribution and soft dollar               other benefits, these arrangements also can create incentives for
practices.                                      investment advisers to trade excessively to obtain more soft dollar
                                                services, thereby increasing fund shareholders’ costs. SEC staff has
                                                recommended various changes that would increase transparency by
www.gao.gov/cgi-bin/getrpt?GAO-03-763.          expanding advisers’ disclosure of their use of soft dollars. By acting on
To view the full report, including the scope
                                                the staff’s recommendations SEC would provide fund investors and
and methodology, click on the link above.       directors with needed information about how their funds’ advisers are
For more information, contact Richard Hillman   using soft dollars.
at (202) 512-8678 or hillmanr@gao.gov.
Contents



Letter                                                                                                         1
                             Results in Brief                                                                  2
                             Background                                                                        6
                             Additional Disclosure of Mutual Fund Costs May Benefit
                               Investors                                                                       8
                             Independent Directors Play a Critical Role in Protecting Mutual
                               Fund Investors                                                                 20
                             Changes in Mutual Fund Distribution Practices Have Increased
                               Choices for Investors, but Have Raised Potential Concerns                      29
                             Soft Dollar Arrangements Provide Benefits, but Could Also Have an
                               Adverse Impact on Investors                                                    42
                             Conclusions                                                                      54
                             Recommendations                                                                  56
                             Agency Comments and Our Evaluation                                               57


Appendixes
              Appendix I:    Scope and Methodology                                                            60
             Appendix II:    Comments from the Securities and Exchange Commission                             61
             Appendix III:   Comments from the Investment Company Institute                                   64
             Appendix IV:    GAO Contacts and Staff Acknowledgments                                           67
                             GAO Contacts                                                                     67
                             Acknowledgments                                                                  67


Tables                       Table 1: Fee Disclosure Practices for Selected Financial Services or
                                      Products                                                                10
                             Table 2: Current and Proposed NYSE and NASDAQ Corporate
                                      Governance Listing Standards Compared to those
                                      Currently Required or Recommended for Mutual Fund
                                      Boards                                                                  28


Figure                       Figure 1: Factors Fund Directors Are to Consider in Voting to
                                       Approve or Continue 12b-1 Plans                                        31




                             Page i            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Contents




Abbreviations

ECN          electronic communications network
FSA          Financial Services Authority
ICI          Investment Company Institute
NAV          net asset value
NYSE         New York Stock Exchange
SAI          Statement of Additional Information
SEC          Securities and Exchange Commission
SRO          self-regulatory organization

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Page ii               GAO-03-763 Greater Transparency Needed in Disclosures to Investors
A
United States General Accounting Office
Washington, D.C. 20548



                                    June 9, 2003                                                                        Lert




                                    The Honorable Michael G. Oxley
                                    Chairman, Committee on Financial Services
                                    House of Representatives

                                    The Honorable Richard H. Baker
                                    Chairman, Subcommittee on Capital Markets,
                                     Insurance, and Government Sponsored Enterprises
                                    Committee on Financial Services
                                    House of Representatives

                                    Millions of U.S. households have invested in mutual funds with assets
                                    exceeding $6 trillion by year-end 2002. The fees and other costs that these
                                    investors pay as part of owning mutual fund shares can significantly affect
                                    their investment returns. As a result, questions have been raised as to
                                    whether the disclosures of mutual fund fees and others costs, including the
                                    trading costs that mutual funds incur when they buy or sell securities, are
                                    sufficiently transparent. Some have also questioned the effectiveness of
                                    mutual fund boards of directors in protecting shareholder interests and
                                    overseeing the fees funds pay to investment advisers. Many mutual funds
                                    market their shares to investors through broker-dealers or other financial
                                    professionals, such as financial planners. However, concerns have been
                                    raised over how the payments that fund advisers make to the entities that
                                    sell fund shares affect investors. When mutual fund investment advisers
                                    use broker-dealers to buy or sell securities for the fund, they generally pay
                                    these broker-dealers a commission for executing the trade. Under
                                    arrangements known as soft dollars, part of these brokerage commissions
                                    may pay for research and brokerage services that the executing broker-
                                    dealer or third parties provide to the fund’s investment adviser. Because
                                    the amount of brokerage commissions a fund adviser pays directly reduces
                                    the ultimate return earned by investors in its funds, questions exist over the
                                    extent to which investors benefit from or are harmed by these soft dollar
                                    arrangements.

                                    To address these concerns, this report responds to your January 14, 2003,
                                    request that we review issues relating to the transparency and
                                    appropriateness of certain fees and practices among mutual funds.
                                    Specifically, our objectives were to review (1) how mutual funds and their
                                    advisers disclose their fees and related trading costs and options for
                                    improving these disclosures, (2) mutual fund directors' role in overseeing
                                    fees and various proposals for improving their effectiveness, (3) changes in



                                    Page 1             GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                   how mutual funds and their advisers pay for the sale of fund shares and
                   how the changes in these practices are affecting investors, and (4) the
                   benefits of and the concerns over mutual funds' use of soft dollars and
                   options for addressing these concerns.

                   To determine how mutual funds currently disclose their fees and other
                   costs, we reviewed regulatory requirements and disclosures made by a
                   selection of mutual funds. We discussed various proposals to increase
                   disclosure with staff from regulators that oversee mutual funds, including
                   the Securities and Exchange Commission (SEC) and NASD, and staff from
                   mutual fund companies, industry groups and researchers. We also
                   interviewed officials of 10 mutual fund companies that sell their funds
                   through broker-dealers and a judgmental sample of 15 certified financial
                   planners. To identify the activities that mutual fund directors perform, we
                   reviewed federal laws and regulations, interviewed staff from an
                   association representing independent directors and used a structured
                   questionnaire to interview a judgmental sample of six independent director
                   members of this association. To determine how mutual funds and their
                   advisers pay for distribution, we interviewed various regulatory staff,
                   industry associations and researchers, fund companies, and two broker-
                   dealers that sell fund shares. We also reviewed and analyzed various
                   documents and studies of mutual fund distribution practices. To describe
                   the benefits and potential conflicts of interest raised by mutual funds’ use
                   of soft dollars, we spoke with SEC, NASD, and regulators in the United
                   Kingdom and reviewed studies by regulators and industry experts on soft
                   dollar arrangements. We conducted our work in accordance with generally
                   accepted government auditing standards in Boston, MA; Kansas City, MO;
                   Los Angeles and San Francisco, CA; New York, NY; and Washington, DC
                   from February to June 2003. Our scope and methodology is described in
                   detail in appendix I.



Results in Brief   Although mutual funds already disclose considerable information about the
                   fees they charge, regulators and others have proposed additional
                   disclosures that could increase the transparency and investor awareness of
                   the costs of investing in mutual funds. Currently, mutual funds disclose
                   information about the fees and expenses that each investor specifically
                   pays on their mutual fund shares as percentages of fund assets, whereas
                   most other financial services disclose the actual costs to the purchaser in
                   dollar terms. Mutual funds also incur brokerage commissions and other
                   trading costs when they buy or sell securities, but these costs are not
                   prominently disclosed to investors. To provide more information about the



                   Page 2            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
fees investors pay, SEC has proposed requiring mutual funds to disclose
additional fee-related information, but these would not provide investors
with the specific dollar amount of fees paid on their shares as others have
proposed, nor would these disclosures be provided in the document
generally considered to be of the most interest to investors—the quarterly
statement that shows the number and value of an investor’s mutual fund
shares. Although continuing to consider the need for additional
disclosures, SEC staff and industry participants noted that data on the
extent to which additional fee information would benefit investors is
generally lacking. However, continued consideration of the costs and
benefits of providing additional disclosure appears worthwhile because
some alternatives for providing fee information to mutual fund investors in
quarterly statement could provide some benefit and may cost very little.
Some industry participants have also called for more disclosure of
information about the brokerage commissions and other costs that mutual
funds incur when trading, but standard methodologies for determining
some of these amounts do not exist and regulators and others raised
concerns that such disclosures could be misleading.

Mutual funds also have boards of directors that are tasked with reviewing
the fees that fund investors are charged, but some industry participants
questioned whether directors have been effective in overseeing these fees.
In general, SEC rules require mutual fund boards to have a majority of
independent directors, who are individuals not employed by or affiliated
with the fund’s investment adviser. Among their many duties, these
directors are specifically tasked with overseeing the fees their funds
charge. However, some industry observers say that the process that fund
directors are required to follow under the law fails to produce sufficient
actions to minimize fees. To further reduce fees, some have suggested that
fund directors should be required to seek competitive bids from other
investment advisers. However, industry participants indicated that this
may not result in lower costs and fees for investors and noted that directors
seek to lower fund fees in other ways, such as by requiring the investment
adviser to charge progressively lower fees as the assets of the fund grow.
Regulators and industry bodies have also recommended various changes to
the composition and structure of mutual fund boards as a means of
increasing directors’ effectiveness that many funds have already adopted.
Many reforms being proposed as a result of the recent corporate scandals,
such as Enron, also seek to enhance board of director oversight of public
companies. Such reforms could serve to further improve corporate
governance of mutual funds, but industry participants report that, although




Page 3             GAO-03-763 Greater Transparency Needed in Disclosures to Investors
not all of these proposed practices are currently required for mutual funds,
most fund boards are already following many of them.

Changes in the ways that investors pay for mutual fund shares have
produced benefits for investors but also raise concerns over their
transparency. In 1980, an SEC rule was adopted to allow mutual funds to
begin using fund assets to pay the distribution expenses, which included
marketing expenses and compensation for the financial professionals who
sell fund shares. Although rule 12b-1 was originally envisioned as
providing funds a temporary means of increasing fund assets, the fees
charged under this rule have instead evolved into an alternative way for
investors to pay for the services of broker-dealers and other financial
intermediaries from whom they purchase fund shares. Concerns exist over
whether funds with 12b-1 fees are more costly to investors and whether
current disclosures are sufficiently transparent to allow investors to
determine the extent to which their particular broker-dealer representative
or other financial professionals they use receive these payments. In a
December 2000 report, SEC staff recommended that rule 12b-1 be modified
to reflect changes in how funds are being marketed, but SEC has yet to
develop a proposal to amend the requirements relating to this rule.
Another distribution practice—called revenue sharing—that has become
increasingly common involves investment advisers making additional
payments to broker-dealers that distribute fund shares. Although little data
on the extent of these payments exists, industry researchers say that such
payments have been increasing and have raised concerns about how these
payments may affect the overall expenses charged to fund investors.
Concerns also exist over whether broker-dealers receiving payments to
promote certain funds creates a conflict of interest for their sales
representatives, who are responsible for recommending only investments
that are suitable to their clients’ objectives and financial situation, or
whether this also limits the choices that investors are offered. Under
current disclosure requirements, an investor might not be explicitly told
that the adviser of the fund their broker-dealer is recommending made
payments to that broker-dealer, and some industry participants have called
for additional disclosures to address these potential conflicts.

Soft dollar arrangements allow investment advisers of mutual funds to use
part of the brokerage commissions paid to broker-dealers that execute
trades on the fund’s behalf to obtain research and brokerage services that
can potentially benefit fund investors but could increase the costs borne by
their funds. Industry participants said that soft dollars allow fund advisers
access to a wider range of research than may otherwise be available and



Page 4             GAO-03-763 Greater Transparency Needed in Disclosures to Investors
can also be used to reduce fund expenses. However, others were
concerned that these arrangements can create conflicts of interest between
investment advisers and investors that could increase investors’ costs. For
example, fund advisers might use some broker-dealers solely because of
the soft dollar services they offer rather than because of their ability to
execute the fund’s trades in the most advantageous way. Concerns were
raised that investment advisers might trade excessively to obtain additional
services using soft dollars, which would increase fund investors’ costs. In a
series of regulatory examinations performed in 1998, SEC staff found
examples of problems relating to investment advisers’ use of soft dollars,
although far fewer problems were attributable to the advisers for mutual
funds. In response, the SEC staff issued a report that included various
proposals to address the potential conflicts created by these arrangements,
including recommending that investment advisers keep better records and
disclose more information about their use of soft dollars. Although this
could increase the transparency of these arrangements and help fund
directors and investors better evaluate their fund advisers’ use of soft
dollars, SEC has yet to take action on these proposed recommendations.

This report contains recommendations to SEC designed to increase the
transparency of mutual fund fees and of certain distribution and trading
practices. Since both the extensiveness and the placement of mutual fund
disclosures can affect their transparency and how effectively they increase
investor awareness of the costs of investing in mutual funds, we
recommend that SEC consider the benefits of additional disclosure relating
to mutual fund fees, including requiring the account statements that mutual
fund investors receive provide more information about the fees being paid.
We also recommend that SEC consider developing disclosure requirements
about revenue sharing arrangements so investors may be better able to
evaluate potential conflicts arising from revenue sharing payments.
Finally, we also recommend that SEC evaluate ways to provide more
information that fund investors and directors could use to better evaluate
the benefits and potential disadvantages of their fund adviser’s use of soft
dollars, including considering and implementing the recommendations
from its 1998 soft dollar examinations report.

We obtained comments from SEC and ICI, who generally agreed with the
contents of this report. The letter from the SEC staff indicated that as part
of their responsibilities in regulating mutual funds, they will consider the
recommendations in this report very carefully in determining how best to
inform investors about the importance of fees. The letter from the ICI staff
noted that our report presented a generally balanced and well-informed



Page 5             GAO-03-763 Greater Transparency Needed in Disclosures to Investors
             discussion of mutual fund regulatory requirements. However, the ICI staff
             were concerned over how we compare the disclosures made by mutual
             fund fees to those made by other financial products, and noted that mutual
             fund fee disclosures, which in some ways exceed the information disclosed
             by other products, allow individuals to make much more informed and
             accurate decisions about the costs of their funds than do the disclosures
             made by other financial service firms. We agree with ICI that mutual funds
             are required to make considerable disclosures that are useful to investors
             for comparing the level of fees across funds. However, we also believe that
             supplementing the existing mutual fund disclosures with additional
             information, particularly in the account statements that provide investors
             with the exact number and value of their mutual fund shares, could also
             prove beneficial for increasing awareness of fees and prompting additional
             fee-based competition among funds.



Background   Mutual funds are distinct legal entities owned by the shareholders of the
             fund. Each fund contracts separately with an investment adviser, who
             provides portfolio selection and administrative services to the fund. The
             costs of operating a mutual fund are accrued daily and periodically
             deducted from the fund’s assets. These costs include the fee paid to the
             fund’s investment adviser for managing the fund and the expenses
             associated with operating the fund, such as the costs for accounting and
             preparing fund documents. Each mutual fund has a board of directors,
             which is responsible for reviewing fund operations and overseeing the
             interests of the fund’s shareholders, including monitoring for conflicts of
             interest between the fund and its adviser.1




             1
              Although the Investment Company Act of 1940, which regulates mutual fund operations,
             does not dictate a specific form of organization for mutual funds, most funds are organized
             either as corporations governed by a board of directors or as business trusts governed by
             trustees. When establishing requirements relating to the officials overseeing a fund, the act
             uses the term “directors” to refer to such persons, and this report will also follow that
             convention.




             Page 6                 GAO-03-763 Greater Transparency Needed in Disclosures to Investors
The incredible growth of mutual fund assets and in the number of investors
that hold funds has raised concerns within Congress and elsewhere over
the fees funds charge investors. In a report issued in June 2000, we found
that the average fees charged by 77 of the largest stock and bond mutual
funds had declined between 1990 and 1998.2 In our report, we also
concluded that although many mutual funds exist that compete for investor
dollars, they conduct this competition primarily on the basis of their
performance rather than on the basis of the price of their service, that is,
the fees they charge. In updating the results of the analysis from our June
2000 report for a hearing on mutual funds in March 2003, we found that the
average fees for this group of funds had increased slightly, due in part to
some funds paying higher management fees to their investment advisers
because of the effect of performance fees.3

Mutual funds are sold through a variety of distribution channels. For
instance, investors can buy them directly by telephone or mail or they can
be sold by a sales staff employed by the adviser or by third parties, such as
broker-dealer account representatives. To compensate financial
professionals not affiliated with the adviser for distributing or selling a
fund’s shares, funds may levy a sales charge which is based on a percentage
of the amount being invested—called a load—that the investor can either
pay at the time the investment is made (a front-end load) or later when
selling or redeeming the fund shares (a back-end load).4 Many funds that
use broker-dealers or other financial professionals to sell their fund shares
may also charge investors ongoing fees, called 12b-1 fees that are used by
funds to pay these distributors for recommending the fund or for servicing
the investor’s account after purchases have been made. Mutual fund shares
are also available for investors to purchase through mutual fund
supermarkets. These are offered by broker-dealers, including those
affiliated with a fund adviser, that allow their customers to purchase and
redeem the shares of mutual funds from a wide range of fund companies
through their accounts at the broker-dealer operating the supermarket.



2
 U.S. General Accounting Office, Mutual Fund Fees: Additional Disclosure Could
Encourage Price Competition, GAO/GGD-00-126 (Washington, D.C.: June 7, 2000).
3
 U.S. General Accounting Office, Mutual Funds: Information on Trends in Fees and Their
Related Disclosure, GAO-03-551T (Washington, D.C.: Mar. 12, 2003).
4
 Some funds charge what is known as a contingent deferred sales load, which is a charge
that is a percent of the amount invested that declines the longer the investment is held and
usually becomes zero after a certain period.




Page 7                 GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                             SEC is the federal regulatory agency with responsibility for overseeing the
                             U.S. securities markets and protecting investors. Various self-regulatory
                             organizations (SRO) also oversee the activities of securities industry
                             participants. NASD is the SRO with primary responsibility for overseeing
                             broker-dealers. SEC is responsible for oversight of the SROs and it also
                             oversees and regulates the investment management industry.



Additional Disclosure        Various alternatives with different advantages and disadvantages exist that
                             could increase the amount of information that investors are provided about
of Mutual Fund Costs         mutual fund fees and other costs. Currently, mutual funds disclose
May Benefit Investors        information about their fees as percentages of their assets whereas most
                             other financial services disclose their costs in dollar terms. SEC and others
                             have proposed various alternatives to disclose more information about
                             mutual fund fees, but industry participants noted these alternatives could
                             also involve costs to implement and data on the benefits associated with
                             additional disclosures is not generally available. Mutual funds also incur
                             brokerage commissions and other costs when they buy or sell securities
                             and currently these costs are not routinely or explicitly disclosed to
                             investors and there have been increasing calls for disclosure as well as
                             debate on the benefits and costs of added transparency.



Unlike Other Financial       Mutual funds provide various disclosures to their shareholders about fees.
Products, Mutual Funds Do    Presently, all funds must provide investors with disclosures about the fund
                             in a written prospectus that must be provided to investors when they first
Not Disclose the Actual
                             purchase shares. SEC rules require that the prospectus include a fee table
Dollar Amount of Fees Paid   containing information about the sales charges, operating expenses, and
by Individual Investors      other fees that investors pay as part of investing in the fund. Specifically,
                             the table that mutual funds must provide presents (1) charges paid directly
                             by shareholders out of their investment such as front or back-end sales
                             loads and (2) recurring charges deducted from fund assets such as
                             management fees, distribution fees, and other expenses charged to
                             shareholder accounts. The fees deducted from the fund’s assets on an
                             ongoing basis are reported to investors as a percentage of fund assets and
                             are called the fund’s operating expense ratio. The fee table also contains a
                             hypothetical example that shows the estimated dollar amount of expenses
                             that an investor could expect to pay on a $10,000 investment if the investor
                             received a 5-percent annual return and remained in the fund for 1, 3, 5, and
                             10 years. The examples do not reflect costs incurred as a result of the




                             Page 8             GAO-03-763 Greater Transparency Needed in Disclosures to Investors
fund’s trading activity, including brokerage commissions that funds pay to
broker-dealers when they trade securities on a fund’s behalf.

Unlike many other financial products, mutual funds do not provide the
exact dollar amounts of fees that individual investors pay while they hold
the investment. Although mutual funds provide information about their
fees in percentage terms and in dollar terms using hypothetical examples,
they do not provide investors with information about the specific dollar
amounts of the fees that have been deducted from the value of their shares.
In contrast, most other financial products and services do provide specific
dollar disclosures. For example, when a borrower obtains a mortgage loan
the lender is required to provide a uniform mortgage costs disclosure
statement. This disclosure must show both the interest rate in percentage
terms that the borrow will be charged for the loan and also the costs of the
loan in dollar terms. Under the law, the lender must provide a truth in
lending statement, which shows the dollar amount of any finance charges,
the dollar amount being financed, and the total dollar amount of all
principal and interest payments that the borrower will make under the
terms of the loan.5 As shown in table 1, investors in other financial
products or users of other financial services also generally receive
information that discloses the specific dollar amounts for fees or other
charges they pay.




5
The Real Estate Settlement Procedures Act, 12 U.S.C. § 2601-17.




Page 9               GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Table 1: Fee Disclosure Practices for Selected Financial Services or Products

Type of product or service                      Disclosure requirement
Mutual funds                                   Mutual funds show the operating expenses as
                                               percentages of fund assets and dollar amounts for
                                               hypothetical investment amounts based on estimated
                                               future expenses in the prospectus.
Deposit accounts                               Depository institutions are required to disclose itemized
                                               fees, in dollar amounts, on periodic statements.
Bank trust services                            Although covered by varying state laws, regulatory and
                                               association officials for banks indicated that trust service
                                               charges are generally shown as specific dollar amounts.
Investment services provided                   When the provider has the right to deduct fees and other
to individual investment                       charges directly from the investor’s account, the dollar
accounts (such as those                        amounts of such charges are required to be disclosed to
managed by a financial                         the investor.
planner)
Wrap accountsa                                 Provider is required to disclose dollar amount of fees on
                                               investors’ statements.
Stock purchases                                Broker-dealers are required to report specific dollar
                                               amounts charged as commissions to investors.
Mortgage financing                             Mortgage lenders are required to provide at time of
                                               settlement a statement containing information on the
                                               annual percentage rate paid on the outstanding balance,
                                               and the total dollar amount of any finance charges, the
                                               amount financed, and the total of all payments required.
Credit cards                                   Lenders are required to disclose the annual percentage
                                               rate paid for purchases and cash advances, and the dollar
                                               amounts of these charges appear on cardholder
                                               statements.
Source: GAO analysis of applicable disclosure regulations, rules, and industry practices.
a
 In a wrap account, a customer receives investment advisory and brokerage execution services from a
broker-dealer or other financial intermediary for a “wrapped” fee that is not based on transactions in
the customer’s account.


Although mutual funds are not required to disclose specific dollar amounts
of fees paid by individual investors, the amount of information that they do
provide does exceed that provided by some investment products. For
example, fixed-rate annuities or deposit accounts that provide investors a
guaranteed return on their principal at a fixed rate do not specifically
disclose to the purchasers of these products the provider’s operating
expenses. The financial institutions offering these products generate their
profits on these products by attempting to invest their customers’ funds in
other investment vehicles earning higher rates of return than they are
obligated to pay to the purchasers of the annuities. However, the returns



Page 10                          GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                              they earn on customer funds and the costs they incur to generate those
                              returns are not required to be disclosed as operating expenses to their
                              customers.



Various Alternatives Could    In recent years, a number of alternatives have been proposed for improving
Improve Fee Disclosure, but   the disclosure of mutual fund fees, which could provide additional
                              information to fund investors. In response to a recommendation in our
the Benefits Have Not Been
                              June 2000 report that SEC consider additional disclosures regarding fees,
Quantified                    SEC has introduced a proposal to improve mutual fund fee disclosure.6 In
                              December 2002, SEC released proposed rule amendments, which include a
                              requirement that mutual funds make additional disclosures about their
                              expenses.7 This information would be presented to investors in the annual
                              and semiannual reports prepared by mutual funds. Specifically, mutual
                              funds would be required to disclose the cost in dollars associated with an
                              investment of $10,000 that earned the fund’s actual return and incurred the
                              fund’s actual expenses paid during the period. In addition, the staff also
                              proposed that mutual funds be required to disclose the cost in dollars,
                              based on the fund’s actual expenses, of a $10,000 investment that earned a
                              standardized return of 5 percent.

                              The SEC’s proposed disclosures have various advantages and
                              disadvantages. If adopted, this proposal would provide additional
                              information to investors about the fees they pay when investing in mutual
                              funds. In addition, these disclosures would be presented in a format that
                              would allow investors to compare fees directly across funds. However, the
                              disclosures would not be investor specific because they would not use an
                              investor’s individual account balance or number of shares owned. In
                              addition, SEC is proposing to place these new disclosures in the
                              semiannual shareholder reports, instead of in quarterly statements.
                              Quarterly statements, which show investors the number of shares owned
                              and value of their fund holdings, are generally considered to be of most
                              interest and utility to investors. As a result, SEC’s proposal may be less
                              likely to increase investor awareness and improve price competition
                              among mutual funds. According to SEC staff, they are open to consider


                              6
                              GAO/GGD-00-126.
                              7
                               Shareholder Reports and Quarterly Portfolio Disclosure of Registered Management
                              Investment Companies, Securities and Exchange Commission Release Nos. 33-8164; 34-
                              47023; IC-2587068 (Dec. 18, 2002).




                              Page 11              GAO-03-763 Greater Transparency Needed in Disclosures to Investors
additional disclosures if the benefits to investors appear clear, but have
decided to continue pursuing approval of the proposed disclosure format
from their December 2002 rule proposal. This proposal has received a wide
range of comments. Most comments were in support of SEC’s proposed
requirement to include the dollar cost associated with a $10,000
investment. For example, one investment advisory firm commented in its
letter that the new disclosures SEC is proposing would benefit investors by
allowing them to estimate actual expenses and compare costs between
different funds in a meaningful way.

Another alternative for disclosing mutual funds fees would involve funds
specifically disclosing the actual dollar amount of fees paid by each
investor. In our June 2000 report, we noted that such disclosure would
make mutual funds comparable to other financial products and services
such as bank checking accounts or stock transactions through broker-
dealers. As our report noted, such services actively compete on the basis of
price. If mutual funds made similar specific dollar disclosures, investors
would be clearly reminded that they pay fees for investing in mutual funds
and we stated that additional competition among funds on the basis of
price could likely result among funds. An attorney specializing in mutual
fund law told us that requiring funds to disclose the dollar amount of fees in
investor account statements would likely encourage investment advisers to
compete on the basis of fees. He believed that this could spur new entrants
to the mutual fund industry and that the new entrants would promote their
funds on the basis of their low costs, in much the same way that low-cost
discount broker-dealers entered the securities industry.

Although some financial planners, who directly assist investors in choosing
among mutual funds, thought that requiring mutual funds to provide
investors with the specific dollar amounts of fees paid would be useful,
most indicated that other information was more important. We spoke to a
judgmental sample of 15 certified financial planners whose names were
provided by the Certified Financial Planner Board of Standards, a non-
profit professional regulatory organization that administers the certified
financial planner examination. Of the 15 financial planners with whom we
spoke, 6 believed specific dollar disclosure of mutual fund fees would
provide additional benefit to investors. For example, one said that
providing exact dollar amounts for expenses would be useful because
investors don’t take the next step to calculate the actual costs they bear by
multiplying their account value by the fund’s expense ratio. In contrast, the
other 9 financial planners we interviewed said that the factor most
investors consider more than others is the overall net performance of the



Page 12            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
fund and thus did not think that specific dollar disclosures of fees would
provide much additional benefit.

Industry officials raised concerns about requiring specific dollar fee
disclosures. For example, one investment company official stated that the
costs of making specific dollar disclosures would not justify any benefit
that might arise from providing such information, particularly because a
majority of investors make their investment decisions through
intermediaries, such as financial planners, and not on their own. Some
industry officials stated that additional disclosure could confuse investors
and create unintended consequences. For example, one official noted that
specific dollar disclosure might lead investors to think that they could
deduct those expenses from their taxes. Others noted that this type of
disclosure would tell current mutual fund investors what they were paying
in fees, but would not provide the proper context for evaluating how much
other funds would charge, and thus would be unlikely to increase
competition. Another official stated that disclosing fees paid in dollars in
account statements would not be beneficial to prospective investors.

Although the total cost of providing specific dollar fee disclosures might be
significant, the cost might not represent a large outlay on a per investor
basis. As we reported in our March 2003 statement, the Investment
Company Institute (ICI), the industry association representing mutual
funds, commissioned a study by a large accounting firm to survey mutual
fund companies about the costs of producing such disclosures.8 The study
concluded that the aggregated estimated costs for the survey respondents
to implement specific dollar disclosures in shareholder account statements
would exceed $200 million, and the annual costs of compliance would be
about $66 million.9 Although these are significant costs, when spread over
the accounts of many investors, the amounts are less sizeable. For
example, ICI reported that at the end of 2001, a total of about 248 million
shareholder accounts existed. If the fund companies represented in ICI’s
study, which represent 77 percent of industry assets, also maintain about
the same percentage of customer accounts, then the companies would hold
about 191 million accounts. As a result, apportioning the estimated $200
million in initial costs to these accounts would amount to about $1 per

8
GAO-03-551T.
9
 However, this estimate did not include the reportedly significant costs that would be borne
by third-party financial institutions, which maintain accounts on behalf of individual mutual
fund shareholders.




Page 13                GAO-03-763 Greater Transparency Needed in Disclosures to Investors
account. Apportioning the estimated $66 million in annual costs to these
accounts would amount to about $0.35 per account.

We also spoke with a full-service transfer agent that provides services for
about one third of the total 240 million accounts industrywide.10 Staff from
this organization prepared estimates of the costs to their organization of
producing specific dollar fee disclosures for fund investors. They
estimated that to produce this information, they would incur one-time
development costs between $1.5 and $3 million to revise their systems to
accept and maintain individual investor account expense data, and ongoing
data processing expenses of about $0.15 to $0.30 per fund/account per year.
These ongoing expenses would reflect about 1 percent of the estimated $18
to $23 per year of administrative costs per account already incurred. The
officials also estimated that shareholder servicing costs would increase as
investors would call in to try to understand the new disclosures or offer to
send payments under the mistaken impression that this was a new charge
that they had to explicitly pay. Funds would also incur costs to update and
modify their Web sites so that investors could find this specific expense
information there as well.

Another concern raised regarding requiring mutual funds to disclose the
specific dollar amount of fees was that information on the extent to which
such disclosures would benefit investors is not generally available. For our
work on this report, we attempted to identify studies or analyses on the
impact of disclosing prices in dollars versus percentage terms, but no
available information was found to exist. We also reviewed surveys done
of investor preferences relative to mutual funds but none of the surveys we
identified discussed disclosure of mutual fund fees in dollar terms. In our
June 2000 report, we presented information from a survey of over 500
investors that was administered by a broker-dealer to its clients.11 As we
reported, this survey found that almost 90 percent of these investors
indicated that specific dollar disclosures would be useful or very useful.
However, only 14 percent of these investors were very or somewhat likely
to be willing to pay for this information. SEC and industry participants
noted that having more definitive data on the extent to which investors
want and would benefit from receiving information on the specific dollar


10
   A mutual fund transfer agent maintains shareholder account records and processes share
purchases and redemptions.
11
     See GAO/GGD-00-126, p. 78.




Page 14                 GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                            amount of fees they paid would be necessary before requiring mutual
                            funds, broker-dealers, and other intermediaries to undertake the costly
                            revisions to their systems necessary to capture such information.

                            Another option for disclosure was proposed by an industry official that
                            may not impose significant costs on the industry. The official said that fund
                            companies could include a notice in account statements to remind
                            investors that they pay fees as part of investing in mutual funds. The
                            notice, the official said could remind investors that, “Mutual funds, like all
                            investments, do have fees and ongoing expenses and such fees and
                            expenses can vary considerably and can affect your overall return. Check
                            your prospectus and with your financial adviser for more information.” By
                            providing this notice in the quarterly account statements that mutual fund
                            investors receive, mutual fund investors would be reminded about fees in a
                            document that, because it contains information about their particular
                            account and its holdings, is more likely to be read.



Trading and Other Costs     In addition to the expenses reflected in a mutual fund’s expense ratio—the
Impact Mutual Fund          fund’s total annual operating expenses as a percentage of fund assets—
                            mutual funds incur trading costs that also affect investors’ returns. Among
Investor Returns, but Are
                            these costs are brokerage commissions that funds pay to broker-dealers
Not Prominently Disclosed   when they trade securities on a fund’s behalf. When mutual funds buy or
                            sell securities for the fund, they may have to pay the broker-dealers that
                            execute these trades a commission. In other cases, trades are not subject to
                            explicit brokerage commissions but rather to “markups,” which is an
                            amount a broker-dealer may add to the price of security before selling it to
                            another party. Trades involving bonds are often subject to markups.
                            Commissions have also not traditionally been charged on trades involving
                            the stocks traded on NASDAQ because the broker-dealers offering these
                            stocks are compensated by the spread between the buying and selling
                            prices of the securities they offer.12

                            Other trading-related costs that can also affect investor returns include
                            potential market impact costs that can arise when funds seek to trade large
                            amounts of particular securities. For example, a fund seeking to buy a large
                            block of a particular company’s stock may end up paying higher prices to


                            12
                             These different prices are called the bid price, which is the price the broker-dealer is
                            willing to pay for shares and the ask price, which is the price at which the broker-dealer is
                            willing to sell shares.




                            Page 15                GAO-03-763 Greater Transparency Needed in Disclosures to Investors
acquire all the shares it seeks because its transaction volume causes the
stock price to rise while its trades are being executed. Various
methodologies exist for estimating these types of trading costs, however,
no generally agreed upon approach exists for accurately calculating these
costs.

Although trading costs affect investor returns, these costs are not currently
required to be disclosed in documents routinely provided to investors. ICI
staff and others told us that the costs of trading, including brokerage
commissions, are required under current accounting practices and tax
regulations to be included as part of the initial value of the security
purchased. As a result, this amount is used to compute the gain or loss
when the security is eventually sold and thus the amount of any
commissions or other trading costs are already implicitly included in fund
performance returns.13 Investors do receive some information relating to a
fund’s trading activities because funds are required to disclose their
portfolio turnover, (the frequency with which funds conduct portfolio
trading) in their prospectuses, which are routinely sent to new and existing
investors. However, the frequency with which individual mutual funds
conduct portfolio trading and incur brokerage commissions can vary
greatly and the amount of brokerage commissions a fund pays are not
disclosed in documents routinely sent to investors. Instead, SEC requires
mutual funds to disclose the amount of brokerage commissions paid in the
statement of additional information (SAI), which also includes disclosures
relating to a fund’s policies, its officers and directors, and various tax
matters. Regarding their trading activities, funds are required to disclose in
their SAI how transactions in portfolio securities are conducted, how
brokers are selected, and how the fund determines the overall
reasonableness of brokerage commissions paid. The amount disclosed in
the SAI does not include other trading costs borne by mutual funds such as
spreads or the market impact cost of the fund’s trading. Unlike fund
prospectuses or annual reports, SAIs do not have to be sent periodically to
a fund’s shareholders, but instead are filed with SEC annually and are sent
to investors upon request.




13
 For example, if a fund buys a security for $10 a share and pays a $.05 commission on each
share, its basis in the security is $10.05, and this is the amount that will be used to calculate
any subsequent gain or loss when the shares are sold.




Page 16                 GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Academics and Others Have   Academics and other industry observers have also called for increased
Also Called for Increased   disclosure of mutual fund brokerage commissions and other trading costs
                            that are not currently included in fund expense ratios. In an academic
Disclosure of Mutual Fund   study we reviewed that looked at brokerage commission costs, the authors
Trading Costs, but Others   urged that investors pay increased attention to such costs.14 For example,
Noted that Producing Such   the study noted that investors seeking to choose their funds on the basis of
Disclosures Would be        expenses should also consider reviewing trading costs as relevant
Difficult                   information because the impact of these unobservable trading costs is
                            comparable to the more observable expense ratio. The authors of another
                            study noted that research shows that all expenses can reduce returns so
                            attention should be paid to fund trading costs, including brokerage
                            commissions, and that these costs should not be relegated to being
                            disclosed only in mutual funds’ SAIs.15

                            Others who advocated additional disclosure of brokerage commissions
                            cited other benefits. Some officials have called for mutual funds to be
                            required to include their trading costs, including brokerage commissions,
                            in their expense ratios or as separate disclosures in the same place their
                            expense ratios are disclosed. For example, one investor advocate noted
                            that if funds were required to disclose brokerage commissions in these
                            ways, funds would likely seek to reduce such expenses and investors
                            would be better off because the costs of such funds would be similarly
                            reduced. He explained that this could result in funds experiencing less
                            turnover, which could also benefit investors as some studies have found
                            that high-turnover funds tend to have lower returns than low-turnover
                            funds.

                            The majority of certified financial planners we interviewed also indicated
                            that disclosing transaction costs would benefit investors. Of the 15 with
                            whom we spoke, 9 stated that investors would benefit from having more
                            cost information such as portfolio transaction costs. For example, one said
                            that investors should know the costs of transactions paid by the fund and
                            that this information should be disclosed in a document more prominent
                            than the SAI. Another stated that brokerage commissions should be


                            14
                             J.M.R. Chalmers, R.M. Edelen, and G.B. Kadlec, “Mutual Fund Trading Costs,” Rodney L.
                            White Center for Financial Research, The Wharton School, University of Pennsylvania (Nov.
                            2, 1999).
                            15
                             M. Livingston and E.S. O’Neal, “Mutual Fund Brokerage Commissions,” Journal of
                            Financial Research (Summer 1996).




                            Page 17               GAO-03-763 Greater Transparency Needed in Disclosures to Investors
reported as a percentage of average net assets. Overall they felt that more
information would help investors compare costs across funds, which could
likely result in more competition based on costs, but they also varied in
opinion on the most appropriate format and place to present these
disclosures. The planners who did not think transaction costs should be
disclosed generally believed that investors would not benefit from this type
of additional information because they would not understand it.

Some industry observers and financial planners we interviewed indicated
that investors should be provided all the information that affects a fund’s
returns in one place. This information could include the current disclosed
costs such as the total expense ratio, the impact of taxes, and undisclosed
trading costs. Some financial planners and an industry consultant
suggested disclosing all such expenses in percentages. They also
expressed the importance of including after-tax performance returns. SEC
adopted a rule in January 2001 requiring all funds to disclose their after-tax
returns in their prospectus. A mutual fund industry analyst noted that
when an item is disclosed, investment advisers will likely attempt to
compete with one another to maximize their performance in the activity
subject to disclosure. Therefore, presenting investors with information on
the factors that affect their return and that are within the investment
adviser’s control could spur additional competition and produce benefits
for investors. A financial planner we interviewed also agreed that having
mutual funds disclose information about expenses, tax impacts, and
trading costs, particularly brokerage commissions all in one place would
increase investor awareness of the costs incurred for owning mutual fund
shares and could increase competition among funds based on costs and
lead to lower expenses for investors.

Although additional disclosures in this format could possibly benefit
investors, developing the information needed to provide a disclosure of this
type could pose difficulties. SEC officials said that, if funds were required
to separately disclose brokerage commission costs as a percentage of fund
assets, fund advisers would also likely want to present their fund’s gross
return before trading costs were included so that the information does not
appear to be counted twice. However, the SEC staff noted that determining
a fund’s gross return before trading costs could be challenging because it
could involve having to estimate markups and spread costs. ICI officials
also stated that disclosing gross returns could create the idea of cost free
investing, which is not a realistic expectation for investors. They also
worried that mutual funds could try and market their gross return figures,
which would be misleading.



Page 18            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Mutual fund officials also raised various concerns about expanding the
disclosure of brokerage commissions and trading costs in general. Some
officials said that requiring funds to present additional information about
brokerage commissions by including such costs in the fund’s operating
expense ratios would not present information to investors that could be
easily compared across funds. For example, funds that invest in securities
on the New York Stock Exchange (NYSE), for which commissions are
usually paid, would pay more in total commissions than would funds that
invest primarily in securities listed on NASDAQ because the broker-dealers
offering such securities are usually compensated by spreads rather than
explicit commissions. Similarly, most bond fund transactions are subject
to markups rather than explicit commissions. If funds were required to
disclose the costs of trades that involve spreads, officials noted that such
amounts would be subject to estimation errors. As discussed earlier, ICI
staff and others said that separate disclosure of these costs is not needed
because the costs of trading are already included in the performance return
percentages that mutual funds report. Officials at one fund company told
us that it would be difficult for fund companies to produce a percentage
figure for other trading costs outside of commissions because no agreed-
upon methodology for quantifying market impact costs, spreads, and
markup costs exists within the industry. Other industry participants told us
that due to the complexity of calculating such figures, trading cost
disclosure is likely to confuse investors. For example funds that attempt to
mimic the performance of certain stock indexes, such as the Standard &
Poors 500 stock index, and thus limit their investments to just these
securities have lower brokerage commissions because they trade less. In
contrast, other funds may employ a strategy that requires them to trade
frequently and thus would have higher brokerage commissions. However,
choosing among these funds on the basis of their relative trading costs may
not be the best approach for an investor because of the differences in these
two types of strategies.

Finally, some financial planners and an industry expert stated that
additional disclosure of mutual fund costs would be monitored not by
investors but more so by financial professionals, such as financial planners,
and the financial media. These groups serve as intermediaries between
fund companies and investors, and are the primary channel through which
information on the performance and costs across mutual funds is
distributed. The financial planners and the industry expert believed that
increased disclosures of trading costs could prove beneficial to the
financial professionals that help select mutual funds for their investor
clients.



Page 19            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Independent Directors        Mutual fund boards of directors have a responsibility to protect
                             shareholder interests. Independent directors, who are not affiliated with
Play a Critical Role in      the investment adviser, play a critical role in protecting mutual fund
Protecting Mutual            investors. Specifically, independent directors have certain statutory
                             responsibilities to approve investment advisory contracts and monitor
Fund Investors               mutual fund fees. However, some industry observers believe that
                             independent directors could do more to assert their influence to reduce
                             fees charged by fund advisers. Alternatives are being considered to
                             improve public company governance such as changing board composition
                             and structure, however many practices are already in place within the
                             mutual fund industry.



Mutual Fund Boards of        Because the organizational structure of a mutual fund can create conflicts
Directors Are Responsible    of interest between the fund’s investment adviser and its shareholders, the
                             law governing U.S. mutual funds requires funds to have a board of directors
for Protecting Shareholder
                             to protect the interest of the fund’s shareholders. A fund is usually
Interests                    organized by an investment management company or adviser, which is
                             responsible for providing portfolio management, administrative,
                             distribution, and other operational services. In addition, the fund’s officers
                             are usually provided, employed, and compensated by the investment
                             adviser. The adviser charges a management fee, which is paid with fund
                             assets, to cover the costs of these services. With the level of the
                             management fee representing its revenue from the fund, the adviser’s
                             desire to maximize its revenues could conflict with shareholders’ goal of
                             reducing fees. As one safeguard against this potential conflict, the
                             Investment Company Act of 1940 (the Investment Company Act) requires
                             mutual funds to have boards of directors to oversee shareholder’s interests.
                             These boards must also include independent directors who are not
                             employed by or affiliated with the investment adviser.

                             As a group, the directors of a mutual fund have various responsibilities and
                             in some cases, the independent directors have additional duties. In
                             addition to approval by the full board, the Investment Company Act
                             requires that a majority of the independent directors separately approve
                             the contracts with the investment adviser that will manage the fund’s
                             portfolio and the entity that will act as distributor of the fund’s shares. A
                             mutual fund’s board, including a majority of the independent directors, are
                             also required to review other service arrangements such as transfer agency,
                             custodial, or bookkeeping services.




                             Page 20            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
If the services to the fund are provided by an affiliate of the adviser, the
independent directors also generally consider several items before
approving the arrangement. Specifically they determine that the service
contract is in the best interest of the fund and its shareholders, the services
are required for the operation of the fund, the services are of a nature and
quality at least equal to the same or similar services provided by
independent third parties, and the fees for such services are fair and
reasonable in comparison to the usual and customary fees charged for
services of the same nature and quality.

The independent directors also have specific duties to approve the
investment advisory contract between the fund and the investment adviser
and the fees that will be charged. Specifically, section 15 of the Investment
Company Act requires the annual approval of an advisory contract by a
fund’s full board of directors as well as by a majority of its independent
directors, acting separately and in person, at a meeting called for that
purpose. Under section 36(b) of the Investment Company Act, investment
advisers have a fiduciary duty to the fund with respect to the fees they
receive, which under state common law typically means that the adviser
must act with the same degree of care and skill that a reasonably prudent
person would use in connection with his or her own affairs. Section 36(b)
also authorizes actions by shareholders and the SEC against an adviser for
breach of this duty. Courts have developed a framework for determining
whether an adviser has breached its duty under section 36(b), and directors
typically use this framework in evaluating advisory fees. This framework
finds its origin in a Second Circuit Court of Appeals decision, in which the
court set forth the factors relevant to determining whether an adviser’s fee
is excessive.16 In addition to potentially considering how a fund’s fee
compared to those of other funds, this court indicated that directors may
find other factors more important, including

• the nature and quality of the adviser’s services,

• the adviser’s costs to provide those services,

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



16
   Gartenberg v. Merrill Lynch Asset Management Inc., 528 F. Supp. 1038 (S.D.N.Y.
1981), aff’d, 694 F. 2d 923 (2d Cir. 1982), cert. denied, 461 U.S. 906(1983).




Page 21             GAO-03-763 Greater Transparency Needed in Disclosures to Investors
• the volume of orders that the manager must process,

• indirect benefits to the adviser as the result of operating the fund, and

• the independence and conscientiousness of the directors.

Fund company officials and independent directors with whom we spoke
said their boards review extensive amounts of information during the
annual contract renewal process to help them evaluate the fees and
expenses paid by the fund. For example, they stated that they hire a third-
party research organization, such as Lipper, Inc., to provide data on their
funds investment performance, management fee rates, and expense ratios
as they compare to funds of similar size, objective, and style. They also
compare performance to established benchmarks, such as the Standard &
Poors 500 Stock Index. For example, officials at one fund company told us
that, for each of their funds, their board reviews information on the
performance and fees charged by 20 funds with a similar investment
objective, including the 10 funds closest in size with more assets than their
fund and the 10 funds closest in size with fewer assets. In addition to
comparing themselves to peers, they explained that their board reviews the
profitability of the adviser, stability of fund personnel or staff turnover, and
quality of adviser services. Fund officials stated that their boards receive a
large package of information that includes all of the necessary information
to be reviewed for the contract renewal process in advance of board
meetings.

SEC oversight of mutual funds indicates that fund directors generally
conduct their activities in accordance with the law. Staff from SEC’s Office
of Compliance Inspections and Examinations, which conducts
examinations of mutual funds and their investment advisers, told us that as
part of their examinations they review the minutes of past board meetings
to ensure that the directors were told and discussed the relevant
information as part of the board’s decision-making process. The SEC staff
also told us they review the information provided to the board by the
investment adviser to ensure its completeness and accuracy. Based on
their review, SEC staff said that they have not generally found problems
with mutual fund board proceedings. SEC has brought cases against
mutual fund directors but these involved other activities. For example,
SEC settled a case involving a mutual fund’s board of directors that had
knowingly filed misleading information in the fund's prospectus and other
fund disclosures regarding the liquidity and value of the shares of their
money market fund.



Page 22            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Critics Suggest Independent   Some industry experts have criticized independent directors for not
Directors Could Do More to    exercising their authority to reduce fees. For example, in a speech to
                              shareholders, one industry expert stated that mutual fund directors have
Assert Their Influence and    failed in negotiating management fees. Part of the criticism arises from the
Reduce Fees                   fact that during the annual contract renewal process, when boards
                              compare fees of similar funds, the process maintains the status quo by
                              comparing fees with the industry averages thus keeping fees at their
                              current level. However, another industry expert complained that fund
                              directors are not required to ensure that fund fees are reasonable, much
                              less as low as possible, but instead are only expected to ensure that fees
                              fall within a certain range of reasonableness. An academic study we
                              reviewed criticized the court cases that have shaped director’s roles in
                              overseeing mutual fund fees because these cases generally found that
                              comparing a fund’s fees to other similar investment management services,
                              such as pension funds was inappropriate as fund advisers do not compete
                              with each other to manage a particular fund. Without being able to
                              compare fund fees to these other products, the study’s authors say that
                              investors bringing these cases have lacked sufficient data to show that a
                              fund’s fees are excessive.17

                              One method offered by some industry critics for improving the
                              effectiveness of boards in lowering fees for investors was to have fund
                              directors seek competitive bids for their fund’s investment advisory
                              contracts. Advocates of having boards take this action said that pension
                              funds more routinely seek competitive bids from investment advisers for
                              pension fund assets. A former Treasury Department official said that
                              pension funds commonly seek new investment advisers every 2 to 3 years,
                              and, as a result, pension fund investors pay two to three times less in fees
                              than the average mutual fund investors. One academic study we reviewed
                              that compared advisory fees for similarly-sized pension funds and mutual
                              funds found that the average mutual fund advisory fee is twice as large as a
                              pension fund advisory fee.18 The study showed that the average pension
                              fund pays 28 basis points for its advisory fee compared to 56 basis points
                              for mutual funds. The study concluded that the main reason for differences
                              between pension funds and mutual funds was that advisory fees for



                              17
                               J.P. Freeman and S.L. Brown, “Mutual Fund Advisory Fees: The Cost of Conflicts of
                              Interest,” 26 Journal of Corporation Law 609 (2001).
                              18
                                   J.P. Freeman and S.L. Brown.




                              Page 23                  GAO-03-763 Greater Transparency Needed in Disclosures to Investors
pension funds are set in a marketplace in which arm’s-length bargaining
occurs because of the separation of the fund and the investment advisers.

Regulators and industry participants indicated that differences in the costs
and services provided by mutual funds can explain why mutual funds
charge more than pension funds. According to staff of SEC and ICI with
whom we spoke, investment advisers usually perform many other services
for their mutual funds than does the adviser of a pension fund and that their
advisory fee compensates them for these additional services. Among the
services that advisers of mutual funds would provide that a pension fund
adviser would not include around the clock telephone customer service,
preparing periodic account statements and shareholder communications,
and compiling annual tax information for fund investors. Some industry
officials also noted the difference in cost structure between pension and
mutual funds. One official stated that pension funds have one institutional
account, whereas mutual funds have thousands of smaller accounts, which
requires substantial record keeping and customer service expenses.
Mutual fund advisers would also have increased costs because they have to
manage their fund’s daily inflows and outflows, whereas pool of assets that
a pension fund adviser manages are not subject to such frequent
fluctuations.

Based on information we collected, very few mutual funds change their
investment advisers. According to research organizations that monitor
developments in the mutual fund industry, less than 10 funds have changed
their primary investment adviser within the last 15 years. The process of
changing investment adviser is not solely dependent upon the board of
directors. If the fund board of directors made a decision to change an
investment adviser, the board would need to file a proxy statement and
have the shareholders of the fund vote to approve the change.

Industry participants also said that having mutual fund boards put out their
advisory service contracts for bid may not produce expected savings and
could increase fund shareholders’ costs. According to staff at one fund
company, they would not likely bid on contracts to manage mutual fund
assets at the same rate that they bid for pension fund assets because their
costs to manage and administer mutual fund assets are higher. They said
that pension fund assets are offered to investment advisers in a large pre-
existing pool. In contrast, mutual fund assets must be accumulated over
time from many investors. Each time a fund’s board hired a new
investment adviser, the fund’s shareholders costs would also likely go up
because all the accounts would have to be transferred to the new adviser



Page 24            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
and the fund would likely incur additional document preparation, legal, and
customer service costs. For example, we identified a case in which a small
fund had removed its investment adviser, which resulted in a significant
increase of fund expenses. In this case, the fund’s investment adviser
resigned and a majority of the fund’s board of directors voted to take over
the fund’s management. The decision was submitted to the shareholders
for a proxy vote and passed. As a result the fund’s expense ratio went from
1.8 percent in 2001 to 3.4 percent in 2002. The fund attributed this
significant increase to a number of one-time items, which consisted
primarily of legal expenses associated with the removal of the investment
adviser and the management of the fund’s portfolio.

Finally, industry participants indicated that mutual fund shareholders likely
do not expect their fund’s board to change the fund’s investment adviser.
They said that mutual fund shareholders often choose their funds because
of the reputation or services offered by a particular investment adviser and
having their fund’s board seek to move their fund to another company
would not likely be supported by the shareholders. Furthermore, having
fund boards seek new investment advisers is unnecessary because mutual
fund shareholders can choose to redeem their shares of a particular
adviser’s fund and invest them in the funds of other advisers if they are
unhappy with their existing fund or its adviser. In contrast, pension fund
participants cannot move their pension fund investments if they are
unhappy with their fund’s investment adviser or its performance. Instead,
the decisions about which advisers are hired to manage pension fund’s
assets are made by their fund administrators. ICI officials also questioned
whether pension funds actually change investment advisers that frequently.
They said that pension funds often seek long-term relationships with
investment advisers.

Although they do not frequently change advisers, mutual fund directors
engage in other activities to lower fees. Industry officials said that advisers
typically institute management fee “breakpoints” based on the level of fund
assets or performance. These breakpoints reduce the level of management
fees when funds exceed certain asset levels, thus as a fund’s assets grow,
the investment adviser’s fee is reduced for those additional assets above
the levels set in the breakpoint. Directors could also approve performance
fees as a part of an investment adviser’s compensation that would reduce
the fee the adviser was able to charge if the fund’s performance fails to
meet or exceed a specified performance benchmark, such as the Standard
& Poors 500 Stock Index. Industry officials also stated that advisers will at
times offer to waive management fees, and may also waive or cap certain



Page 25            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                             expenses such as certain transfer agency fees. Noting that the fees for
                             mutual funds in the United States are lower compared to those of other
                             countries, SEC and ICI officials attributed this to the role and influence of
                             U.S. funds’ board of directors because such independent oversight is not
                             always required in other countries.



Mutual Funds Already         Changes in the structure of mutual fund boards of directors have been
Employ Many Practices        proposed and adopted in recent years and recent corporate scandals have
                             prompted consideration of additional reforms but industry participants
Being Suggested to Improve   note that most funds have already adopted such practices. In February
Public Company               1999, SEC held a forum on the role of independent mutual fund directors to
Governance                   consider ways to improve mutual fund governance. At the forum, the SEC
                             Chairman at that time requested proposals for improving fund governance.
                             At the same time, ICI created the Advisory Group on Best Practices for
                             Fund Directors. This advisory group identified 15 best practices used by
                             fund boards to enhance the independence and effectiveness of mutual fund
                             directors and recommended that all fund boards adopt them. The ICI
                             recommendations included having

                             • independent directors constitute at least two thirds of the fund’s board,

                             • independent directors select and nominate other independent directors,
                               and

                             • independent counsel for the independent directors.

                             After evaluating the ideas and suggestions of the forum participants, SEC
                             proposed various rule and form amendments designed to reaffirm the
                             important role that independent directors play in protecting fund investors.
                             These amendments were adopted in January 2001. They included requiring
                             funds relying on certain exemptive rules—which includes almost all funds
                             according to SEC staff—to have a majority of independent directors on
                             their boards and to have their independent directors select and nominate
                             other independent directors. SEC also required that any legal counsel for
                             the independent directors also be independent.19




                             19
                              Role of Independent Directors of Investment Companies, Securities and Exchange
                             Commission Release Nos. 33-7932; 34-43786; IC-24816 (Jan. 2, 2001).




                             Page 26              GAO-03-763 Greater Transparency Needed in Disclosures to Investors
As a result of recent scandals such as Enron and Worldcom, various new
reforms have been proposed to increase the effectiveness and
accountability of public companies’ boards of directors. In July 2002, the
Sarbanes-Oxley Act (Sarbanes-Oxley) was enacted to address concerns
related to corporate responsibility.20 In addition to enhancing the financial
reporting regulatory structure, Sarbanes-Oxley sought to increase
corporate accountability by reforming the structure of corporate boards
audit committees. Section 301 of Sarbanes-Oxley requires that directors
who serve on a public company’s audit committee also be “independent”
and be responsible for selecting and overseeing outside auditors. In
response to the scandals at public companies, officials at the two primary
venues where public companies are traded—the NYSE and NASDAQ—
have also proposed changes to the corporate governance standards that
public companies seeking to be listed on their markets must meet.

However, many of the corporate governance reforms being proposed for
public companies are already either required or have been recommended
as best practices for mutual fund boards. Table 2 presents how the
corporate governance practices that are currently required by mutual fund
law or rules or recommended by ICI’s best practices for mutual fund boards
compare to the current and proposed NYSE and NASDAQ listing standards
applicable to public company boards. As the table shows, the mutual funds
boards are already recommended to have in place all of the proposed
corporate listing standards.




20
 Pub. L. No. 107-204, 116 Stat. 745 (codified in scattered sections of 11, 15, 18, 28, and 29
U.S.C.A.).




Page 27                GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Table 2: Current and Proposed NYSE and NASDAQ Corporate Governance Listing
Standards Compared to those Currently Required or Recommended for Mutual Fund
Boards

                                      NYSE/NASDAQ listing
                                           standards                                         Mutual funds
                                                                                    Required by                       ICI
Governance                            Currently           Proposed                    statute or           recommended
requirement                            required         requirement                   SEC rulea             best practice
Board must have a                                                        X                             X               X
majority of independent
directors
Independent directors                                                    X                             X               X
must be responsible for
nominating new
independent directors
Audit committee must                               X                     X                                             X
consist of only
independent directorsb
Standards that define                              X                     X                             X               X
who qualifies as an
independent directorc
Independent directors                                                    X                                             X
required to meet
separately in executive
sessions
Source: GAO analysis of ICI Best Practices, statutes, SEC rules, and NYSE and NASDAQ rule proposals.
a
SEC requires the board of directors of any fund that takes advantage of various exemptive rules to
meet these requirements and SEC staff indicated that, as a result, almost all funds must comply.
b
 Although fully independent audit committees is not a requirement for funds, SEC has adopted a rule
to encourage fund boards to have audit committees consisting exclusively of independent directors by
exempting such committees from having to seek shareholder approval of the fund’s auditor.
c
 Both the NYSE and NASDAQ definitions of director independence currently apply only to members of
the audit committee, but their rule proposals would extend this definition to the full board.


According to industry participants, most mutual fund boards already have
the corporate governance practices recommended by these various
standards in place. Officials of the fund companies and the independent
directors that we interviewed told us that the majority of their boards
consisted of independent directors, and, in many cases, had only one
interested director. For public companies, some commenters have called
for boards of directors to have supermajorities of independent directors as
a means of ensuring that the voices of the independent directors are heard.
As noted above, this practice has already been advocated by ICI’s best
practice recommendations and one fund governance consulting official



Page 28                        GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                        said that a 2002 survey conducted by his firm found that, in 75 percent of
                        the mutual fund complexes they surveyed, over 70 percent of the directors
                        were independent. An academic study we reviewed also found that funds’
                        independent directors already comprised funds’ nominating committees
                        and most funds have self-nominating independent directors.

                        Another change related to board composition that has been proposed for
                        mutual funds would be to have an independent director serving as the
                        board’s chair, but industry participants did not see this as a beneficial
                        change. Some industry critics have stated that the lack of an independent
                        chair allows the board’s activities during the meeting to be controlled by
                        fund management, as the fund’s board chair is typically the chairman or
                        other senior official of the investment adviser. A number of fund
                        companies and independent directors we spoke with indicated that their
                        board did have an independent chair. For the fund companies that did not
                        have an independent chair, they had instead a lead independent director.
                        An official from the Mutual Fund Directors Forum, an independent
                        directors association which provides continuing education and outreach on
                        mutual fund governance, said that the most important factor is the
                        initiative demonstrated by the independent director, whether the individual
                        is the lead or chair. He stated that if the lead independent director is
                        motivated, it doesn’t matter who the chair is, because the lead director will
                        be proactive and effective on behalf of fund shareholders. Other fund
                        company officials indicated that an independent chair could be harmful to
                        the board. One stated that investors are better served by having a fund
                        company executive chair the fund’s board because such an official is better
                        positioned to ensure that all of the information that the adviser needs to
                        share with the independent directors is provided efficiently.



Changes in Mutual       Concerns have been raised over changes in how mutual funds pay for the
                        distribution of their shares to investors. SEC Rule 12b-1 allows mutual
Fund Distribution       fund companies to use fund assets to pay expenses for distributing their
Practices Have          funds through broker-dealers, and has evolved into a means for fund
                        companies to offer investors a variety of ways to pay for the services of
Increased Choices for   financial professionals, such as broker-dealer staff or financial planners.
Investors, but Have     However, 12b-1 fees remain controversial among mutual fund researchers
Raised Potential        because, in addition to increasing a fund’s overall expense ratio, funds with
                        12b-1 fees may be more costly to own in other ways. In a recent study, SEC
Concerns                staff recommended rule 12b-1 modifications to reflect changes in how
                        funds are being marketed, but as of May 2003, SEC had not proposed any
                        amendments. Concerns also have been raised as to whether the disclosure



                        Page 29            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                               of 12b-1 fees is sufficient and whether, another distribution practice—
                               referred to as revenue sharing, in which investment advisers make
                               payments to broker-dealers for selling and marketing their funds—could
                               limit the number of mutual fund choices offered to investors. Revenue
                               sharing also may result in a broker-dealer’s failure to recommend funds
                               from which the brokerage firm is not being compensated by the funds’
                               advisers, which some suggest could conflict with broker-dealers’
                               responsibilities to recommend suitable investments.



12b-1 Plans Provide            Previously, mutual funds distribution expenses were paid for either by
Alternative Means for          charging investors a sales charge or load or by paying for such expenses
                               out of the investment adviser’s own profits. However, in 1980, SEC adopted
Compensating Financial
                               rule 12b-1 under the Investment Company Act to help funds counter a
Professionals but Also Raise   period of net redemptions by allowing them to use fund assets to pay the
Concerns Over Costs            expenses associated with the distribution of fund shares. Rule
                               12b-1 plans were envisioned as temporary measures to be used during
                               periods of declining assets. Any activity that is primarily intended to result
                               in the sale of mutual fund shares must be included as a 12b-1 expense and
                               can include advertising; compensation of underwriters, dealers, and sales
                               personnel; printing and mailing prospectuses to persons other than current
                               shareholders; and printing and mailing sales literature.

                               To be allowed to use fund assets for marketing purposes, funds are
                               required to adopt 12b-1 plans that outline how they intend to use these
                               payments. A fund’s written 12b-1 plan must describe all material aspects of
                               the proposed financing of distribution and related agreements with
                               distributors about how the plan is to be implemented. Before
                               implementing a plan that will allow a fund to begin charging 12b-1 fees, rule
                               12b-1 requires fund shareholders and directors to approve 12b-1 plans and
                               places other requirements on plan adoption. The plans must also be
                               approved by a vote of a majority of outstanding shareholders and by a
                               majority of funds’ directors, including a majority of the fund’s independent
                               directors. Because such plans were envisioned to be of a limited duration,
                               a majority of funds’ directors, including a majority of the fund’s
                               independent directors, must also make various approvals on an ongoing
                               basis, including approving the 12b-1 plans annually. They must also
                               approve any amendment to the plan and approve on at least a quarterly
                               basis the reports of plan expenditures and the purposes of the
                               expenditures. 12b-1 plans must also provide for plan termination upon the
                               vote of a majority of independent directors or a majority of shareholders.




                               Page 30            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
In the adopting release for the rule, SEC presented various factors that
directors should consider when approving a fund’s 12b-1 plan. These
factors were offered to provide guidance to directors in determining
whether to use fund assets to bear expenses for fund distribution. The nine
factors are shown in figure 1.



Figure 1: Factors Fund Directors Are to Consider in Voting to Approve or Continue
12b-1 Plans


    1. The need for independent counsel or experts to assist the
       directors in reaching a determination.

    2. The nature of the problems or circumstances which purportedly make
       implementation or continuation of such a plan necessary or appropriate.

    3. The causes of such problems or circumstances.

    4. The way in which the plan would address these problems or circumstances and
       how it would be expected to resolve or alleviate them, including the nature and
       approximate amount of the expenditures; the relationship of such expenditures to
       the overall cost structure of the fund; the nature of the anticipated benefits, and the
       time it would take for those benefits to be achieved.

    5. The merits of possible alternative plans.

    6. The interrelationship between the plan and the activities of any other person who
       finances or has financed distribution of the company's shares, including whether
       any payments by the company to such other person are made in such a manner as
       to constitute the indirect financing of distribution by the company.

    7. The possible benefits of the plan to any other person relative to those expected
       to inure to the company.

    8. The effect of the plan on existing shareholders.

    9. In the case of a decision on whether to continue a plan, whether the plan has
       in fact produced the anticipated benefits for the company and its shareholders.

Source: SEC Release Nos. 33-6254 and IC-11414.




Page 31                       GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                                 The 12b-1 fees that are used to pay marketing and distribution expenses are
                                 deducted directly from fund assets and are reported as a separate line item
                                 in the fund’s fee table and included in funds’ expense ratios. NASD, whose
                                 rules govern the distribution of fund shares by broker-dealers, limits the
                                 annual rate at which 12b-1 fees may be paid to broker-dealers to no more
                                 than 0.75 percent of a fund’s average net assets per year.21 Funds are
                                 allowed to include an additional service fee of up to 0.25 percent of average
                                 net assets each year to compensate sales professionals for providing
                                 ongoing services to investors or for maintaining their accounts. Therefore,
                                 12b-1 fees included in a fund’s total expense ratio are limited to a maximum
                                 of 1 percent per year. The actual dollar amount of distribution and service
                                 expenses paid under a fund’s 12b-1 plan must be disclosed in an SAI, which
                                 supplements the prospectus, and in the fund’s annual report.

                                 As part of its oversight, SEC staff periodically examines mutual funds and
                                 their advisers for compliance with securities laws and rules and generally
                                 find that mutual fund boards adequately oversee their fund’s 12b-1 plan. An
                                 SEC official told us that SEC examiners check to see that the directors and
                                 shareholders have approved 12b-1 plans and whether the funds have
                                 controls in place to ensure that relationships with distributors are
                                 reasonable, such as having the directors review 12b-1 fees. The official said
                                 that some examinations have found that funds lack adequate control
                                 procedures, but the SEC staff rarely have found serious material
                                 deficiencies.

12b-1 Plans Provide Additional   Rule 12b-1 provides investors an alternative way of paying for investment
Ways for Investors to Pay for    advice and purchases of fund shares. Funds can be sold directly to
Investment Advice and Fund       investors by a fund company or through financial intermediaries such as
Companies to Market Fund         broker-dealers or financial advisers. According to ICI, approximately 80
Shares                           percent of investors’ mutual fund purchases are made through brokers,
                                 financial advisers, and other intermediaries, including employer-sponsored
                                 pension plans. Apart from 12b-1 fees, brokers can be paid with sales
                                 charges called “loads”; “front-end” loads are applied when shares in a fund
                                 are purchased and “back-end” loads when shares are redeemed. With a 12b-
                                 1 plan, the fund can finance the broker’s compensation with installments
                                 deducted from fund assets over a period of several years. Thus, 12b-1 plans
                                 allow investors to consider the time-related objectives of their investment
                                 and possibly earn returns on the full amount of the money they have to


                                 21
                                      NASD Conduct Rule 2830(d).




                                 Page 32                GAO-03-763 Greater Transparency Needed in Disclosures to Investors
invest, rather than have a portion of their investment immediately deducted
to pay their broker.

Rule 12b-1 has also made it possible for fund companies to market fund
shares through a variety of share classes designed to help meet the
different objectives of investors. For example, Class A shares might charge
front-end loads to compensate brokers and may offer discounts called
breakpoints for larger purchases of fund shares. Class B shares,
alternatively, might not have front-end loads, but would impose asset-based
12b-1 fees to finance broker compensation over several years. Class B
shares also might have deferred back-end loads if shares are redeemed
within a certain number of years and might convert to Class A shares if held
a certain number of years, such as 7 or 8 years. Class C shares might have a
higher 12b-1 fee, but generally would not impose any front-end or back-end
loads. While Class A shares might be more attractive to larger, more
sophisticated investors who wanted to take advantage of the breakpoints,
smaller investors, depending on how long they plan to hold the shares,
might prefer Class B or C shares because no sales charges would be
deducted from their initial investments.

Industry officials and analysts generally viewed the alternative marketing
arrangements fostered by rule 12b-1 favorably. ICI and fund company
officials generally agreed that rule 12b-1 plans gave fund distributors more
options for offering investors multiple ways to pay for fund investments.
For example, one company official said that 12b-1 plans have allowed
investors to choose the type of fund in which they want to invest and have
helped stabilize fund assets. Another official said that rule 12b-1 has
provided investors choices on how to pay their broker, which investors
have grown to like. He said that in his fund complex, 50 percent of shares
are now held in Class B shares that charge 12b-1 fees as opposed to other
share classes. A broker-dealer official that distributes funds said that 12b-1
plans are beneficial because the fees provide a revenue stream that
encourages financial advisers to plan for the long-term. A mutual fund
shareholders advocate said that this incentive is good because it would
cause the financial advisers to recommend funds that will work out well for
investors over time, rather than focus on earning front-end loads.




Page 33            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
12b-1 Fees Raise Some Concerns   Although providing alternative means for investors to pay for the advice of
Over Cost of Funds               financial professionals, some concerns exist over the impact of 12b-1 fees
                                 on investors’ costs. For example, an academic study of 3,861 multiple share
                                 class funds available at the end of 1997 found that funds with multiple
                                 share classes and 12b-1 fees also had higher management fees than those
                                 charged by funds with only a single share class, and, therefore, were more
                                 costly to investors before considering the additional expenses used to
                                 compensate their financial professional.22 However, another study found
                                 that funds with 12b-1 fees might provide investors with greater
                                 performance. This study, which reviewed the risk-adjusted performance of
                                 a sample of 568 mutual funds for the period 1987-1992, found that 12b-1
                                 plans increased fund expenses but on average generated higher risk-
                                 adjusted performance than funds with front-end loads. For this reason, the
                                 study concluded that investors should not avoid funds with 12b-1 plans.23

                                 Questions involving funds with 12b-1 fees have also been raised over
                                 whether some investors are paying too much for their funds depending on
                                 which share class they purchase. Earlier in 2003, in federal court in
                                 Nashville, Tennessee, investors filed lawsuits against a brokerage firm
                                 alleging that the firms’ brokers placed the investors’ funds into share
                                 classes with higher 12b-1 fees when other share classes with different fee
                                 structures would have been more appropriate for the investors. A 1999
                                 academic study also found that differing distribution arrangements cause
                                 broker-dealer sales representatives to be compensated differently
                                 depending on the class of shares they sell. These individuals, the study
                                 found, have monetary incentives to steer long-term investors to low load,
                                 high 12b-1 fee share classes and to steer short-term investors to high load,
                                 12b-1 fee share classes.24 However, depending on the time that they are
                                 likely to hold the investment, some investors would be better off investing
                                 in funds that charge a front-end load and have smaller 12b-1 fees than by
                                 purchasing shares in funds without loads but higher 12b-1 fees. The study
                                 noted that this conflict of interest between investors and brokers is most



                                 22
                                  Lesseig, Vance P.; Long, D. Michael; and Smythe, Thomas I. “Gains to Mutual Fund
                                 Sponsors Offering Multiple Share Class Funds,” Journal of Financial Research (March
                                 1990).
                                 23
                                  Dellva, Wilfred L. and Olson, Gerard T. “The Relationship Between Mutual Fund Fees and
                                 Expenses and Their Effects on Performance,” The Financial Review (February 1998).
                                 24
                                  O’Neal, Edward S., “Mutual Fund Share Classes and Broker Incentives,” Financial
                                 Analysts Journal (September/October 1999).




                                 Page 34              GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                                   serious when broker-dealer representatives advise relatively uninformed
                                   investors, who are more likely to seek advice on mutual fund investing.

                                   In addition to concerns over 12b-1 fees, regulators have recently begun
                                   investigations of whether investors are receiving the appropriate discounts
                                   in mutual fund sales loads. In March 2003, NASD, NYSE, and SEC staff
                                   reported on the results of jointly administered examinations of 43
                                   registered broker-dealers that sell mutual funds with a front-end load. The
                                   purpose of the examinations was to determine whether investors were
                                   receiving the benefit of available breakpoint discounts on front-end loads
                                   in mutual fund transactions. The examinations found that most of the
                                   brokerage firms examined, in some instances, did not provide customers
                                   with breakpoint discounts for which they appeared to have been eligible. In
                                   instances where investors were not afforded the benefit of a breakpoint
                                   discount, the average discount not provided was $364 per transaction. The
                                   most frequent causes for the broker-dealers not providing a breakpoint
                                   discount were not linking a customer’s ownership of different funds within
                                   the same mutual fund family, not linking shares owned in a fund or fund
                                   family in all of a customer’s accounts at the firm, and not linking shares
                                   owned in the same fund or fund family by persons related to the customer
                                   in accounts at the firm. The regulators concluded that many of the
                                   problems did not appear to have been intentional failures to charge correct
                                   loads. Among other things, the report noted that, although most of the
                                   firms had written supervisory procedures addressing breakpoints, the
                                   procedures often were not comprehensive.

SEC Report Recommended That        In a December 2000 report on mutual fund fees and expenses, staff in SEC’s
Rule 12b-1 Be Updated to Reflect   Division of Investment Management recommended that SEC consider
Changes in Fund Marketing          reviewing the requirements of rule 12b-1 that govern how funds adopt and
                                   renew their 12b-1 plans.25 The division’s staff noted that modifications
                                   might be needed to reflect changes in the manner in which funds are
                                   marketed and distributed and the experience gained from observing how
                                   rule 12b-1 has operated since its adoption in 1980. The report noted that
                                   the development of multiple fund share classes permit investors to choose
                                   how distribution expenses are to be paid—for example, up front, in
                                   installments over time, or at redemption. Many funds that offer shares
                                   through broker-dealer fund supermarkets also adopt 12b-1 plans to pay for
                                   the fees that the sponsoring broker-dealer charges the funds sold through


                                   25
                                    U.S. Securities and Exchange Commission, Division of Investment Management: Report
                                   on Mutual Fund Fees and Expenses (Washington, D.C.: December 2000).




                                   Page 35             GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                                their supermarket. The division’s report noted that because these 12b-1
                                plans are essential to the funds’ participation in these supermarkets, such
                                plans could be viewed as indefinite commitments. Also since 1980, some
                                fund distributors have been using 12b-1 receivable revenues as collateral to
                                obtain loans to finance their distribution efforts. The SEC staff noted that
                                such changes illustrate that 12b-1 fees have come to be used in different
                                ways than were originally envisioned under the rule and that changes may
                                be needed to reflect current practices. Because of these changes, the
                                report noted that SEC should consider whether it needed to give additional
                                or different guidance to fund directors with respect to their review of rule
                                12b-1 plans, including whether the nine factors published in the 1980
                                release of rule 12b-1 were still valid (shown in fig. 1 of this report).

                                Although SEC has not yet provided additional guidance on or updated rule
                                12b-1 to reflect market changes, SEC staff told us that any amendment of
                                rule 12b-1 could also involve changes to how distribution fees and
                                expenses are disclosed. One fund independent director with whom we
                                spoke said that rule 12b-1 should be amended to allow payment only to
                                broker-dealers with net sales of fund shares and broker-dealers with net
                                redemptions would not be paid. He said that this change would make sense
                                for rule 12b-1 to fulfill its original purpose of increasing fund assets.

Concerns Raised over Adequacy   Some concerns have been raised over the adequacy of 12b-1 fee
of 12b-1 Fee Disclosure         disclosures. A mutual fund shareholder advocacy organization has called
                                for reform in the disclosure of fund distribution expenses to better inform
                                investors of possible conflicts of interest that could compromise the
                                adviser’s responsibility to control fund costs and provide investors a
                                satisfactory return. For example, this group notes that 12b-1 fee disclosure
                                is misleading to investors because a fund’s money can be paying for
                                distribution expenses either through a 12b-1 fee or the adviser’s
                                management fee. However, the group asserts, the fee table in the
                                prospectus could give the investor the impression all distribution expenses
                                are covered by 12b-1 fees, while the fund adviser benefits from all of the
                                expenses paid from fund assets, the group noted. The group also noted that
                                12b-1 disclosures do not inform investors of potential conflicts of interest
                                affecting brokers because, based on the fee disclosures in the prospectus,
                                an investor cannot determine whether his broker received compensation
                                from the 12b-1 fees.




                                Page 36           GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Revenue Sharing           Revenue sharing payments are compensation that investment advisers pay
Arrangements Provide      from their profits to the broker-dealers that distribute their funds. Some
                          broker-dealers whose sales representatives market mutual funds have
Additional Distribution   narrowed their offerings of funds or created preferred lists of funds, which
Options and Are           then become the funds that receive the most marketing by these broker-
Increasingly Used to      dealer sales representatives. In order to be selected as one of the preferred
Compensate Fund           fund families on these lists, the mutual fund adviser often is required to
Distributors              compensate the broker-dealer firms. According to one research
                          organization official, there are significantly fewer distributing broker-
                          dealers than there are mutual fund investment advisers. As a result, the
                          mutual fund distributors have the clout to require advisers to pay more to
                          have their funds sold by the distributing broker-dealers staff. For example,
                          distributors sometimes require investment advisers to share their profits
                          and pay for expenses incurred by the distributing broker-dealers, such as
                          advertising or marketing materials that are used by the distributing broker-
                          dealers.

                          The revenue sharing payments that come from the adviser’s profits may
                          supplement distribution-related payments out of fund assets. As noted,
                          funds may annually pay up to one percent of fund assets to distributors
                          pursuant to 12b-1 plans. However, SEC officials state that revenue sharing
                          arrangements, paid out of the adviser’s management fee, can permit broker-
                          dealer distributors to receive payments outside of the 12b-1 limits. Further,
                          broker-dealers have discretion as to how to use these payments, including
                          using them to defray expenses incurred in marketing funds or to invest
                          them in other areas of the broker-dealer’s business.

                          Mutual funds and their investment advisers also may make distribution
                          payments or incur revenue sharing costs when they offer funds through
                          mutual fund supermarkets. Various broker-dealers, including those
                          affiliated with a mutual fund adviser, allow their customers to purchase
                          through their brokerage accounts the shares of funds operated by a wide
                          range of investment advisers. Although these fund supermarkets provide
                          the advisers of participating funds with an additional means of acquiring
                          investor dollars, the firms that provide such supermarkets generally require
                          investment advisers or funds themselves to pay a certain percentage on the
                          dollars attracted from purchases by customers of the firm’s supermarket.
                          For example, funds or advisers for the funds participating in the Charles
                          Schwab One Source supermarket pay that broker-dealer firm up to 0.40
                          percent of the amount invested by that firm’s customers. While some
                          portion of those payments may be paid out of fund assets pursuant to 12b-1
                          plans, those payments also may represent sharing of advisory fees. Some


                          Page 37            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                                 or all of these payments may be for transfer agency and shareholder
                                 services.

                                 According to SEC officials, revenue sharing is legitimate and consistent
                                 with provisions of rule 12b-1. SEC’s adopting release of Rule 12b-1 states
                                 that the rule should apply to both direct and indirect distribution expenses.
                                 However, because there can be no precise definition of what expenses are
                                 indirect, SEC decided that fund directors, particularly independent
                                 directors, would bear the responsibility for determining on a case-by-case
                                 basis whether the use of fund assets for distribution is in compliance with
                                 the rule. SEC further noted that fund advisers can use the revenues they
                                 receive from their management fee to pay for distribution expenses as long
                                 as the adviser’s profits are legitimate and not excessive.

Actual Amount of Revenue         Mutual funds are not required to disclose the revenue sharing payments
Sharing Occurring Is Unknown     made by their advisers as they are other distribution expenses paid by the
                                 funds. As noted above, any sales loads or 12b-1 fees that funds charge are
                                 disclosed in funds’ prospectuses and annual reports. However, the amount
                                 of revenue sharing payments, which are paid out of the fund adviser’s
                                 profits earned from the management fee or income from other sources, are
                                 not typically disclosed to investors, except for possible general disclosure
                                 in a fund’s prospectus or SAI. Funds do disclose 12b-1 payments and may
                                 disclose that they may make other distribution-related payments but do not
                                 have to disclose the total amount paid or identify the recipients of those
                                 payments. As a result, complete data are not available on the extent to
                                 which mutual fund advisers are making revenue sharing payments. An
                                 industry researcher said that the cost of revenue sharing does not show up
                                 in advisers’ financial reports because there is no line item for it and costs
                                 that fund advisers may incur to pay for sales meetings attended by broker-
                                 dealer staff or other promotion efforts are not specifically shown in fund
                                 adviser income statements. According to an article in one trade journal,
                                 revenue sharing payments made by major fund companies to broker-
                                 dealers may total as much as $2 billion per year. These amounts have been
                                 growing. According to the officials of a mutual fund research organization,
                                 revenue sharing costs are hard to quantify but are rising. For example, the
                                 organization reports that about 80 percent of fund companies that partner
                                 with major broker-dealers make cash revenue sharing payments.

Some Industry Participants Are   The increased use of revenue sharing payments is raising concerns among
Concerned that Revenue Sharing   some industry participants. Although revenue sharing payments are
Could Negatively Impact          becoming a major expense for fund advisers, industry research
Investors                        organization officials told us that most fund advisers are not willing to



                                 Page 38            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
publicly discuss the extent to which they are making such payments. A
2001 report on fund distribution practices states that “the details and levels
of revenue sharing vary widely across the industry and are seldom codified
in written contracts.” In one industry magazine article, a mutual fund
industry researcher referred to revenue sharing as “the dirty little secret of
the mutual fund industry.”

One of the concerns raised about revenue sharing payments is the effect on
overall fund expenses. The 2001 research organization report on fund
distribution practices noted that the extent to which revenue sharing may
affect other fees that funds charge, such as 12b-1 fees or management fees,
is uncertain. For example, the report noted that it was not clear whether
the increase in revenue sharing payments had increased any fund’s fees but
noted that by reducing fund adviser profits, revenue sharing would likely
prevent advisers from lowering their fees. In addition, fund directors
normally would not question revenue sharing arrangements because they
are paid from the adviser’s profits, unless the payments are financed
directly from fund assets as part of the adviser’s management fee or a 12b-1
plan. Fund directors, however, in the course of their review of the advisory
contract, consider the adviser’s profits before marketing and distribution
expenses, which also may limit the ability of advisers to shift these costs to
the fund.

Revenue sharing payments may also create conflicts of interest between
broker-dealers and their customers. By receiving compensation to
emphasize the marketing of particular funds, broker-dealers and their sales
representatives may have incentives to offer funds for reasons other than
the needs of the investor. For example, these revenue sharing
arrangements may have the effect of unduly focusing the attention of
investors and their broker-dealers on particular mutual fund choices, which
can reduce the number of funds they consider as part of the investment
decision. That not only may lead to inferior investment choices, but may
also reduce fee competition among funds. Finally, concerns have been
raised that revenue sharing arrangements may conflict with securities self-
regulatory organization rules requiring that brokers recommend
purchasing a security only after ensuring that the investment is suitable
given the investor’s financial situation and risk profile.

Mutual fund officials’ opinions about revenue sharing were mixed. Some of
the fund officials with whom we spoke viewed revenue sharing as a cost of
doing business, which enabled them to obtain “shelf space” for their funds
with major broker-dealers and did not regard these arrangements as



Page 39            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                                    potentially conflicting with investors’ interests. They explained that the
                                    payments are made directly to the brokerage firm and not to individual
                                    staff financial advisers. One fund official said that there would be no
                                    incentive for broker-dealers’ sales staff to push certain funds, unless
                                    managers exerted pressure on sales staff to sell those funds. Officials of
                                    one large broker-dealer with whom we spoke said that their fund sales
                                    platform has an “open architecture” through which all participating funds’
                                    agreements and payments are the same, which creates a level playing field
                                    on which no funds are given priority. One fund official commented that
                                    NASD rules require that broker-dealers sales staff recommend funds that
                                    are most suitable to the individual investor’s financial situation. However,
                                    in letters commenting on certain compensation arrangements among
                                    broker-dealers, ICI has stated that cash compensation creates potential
                                    conflicts of interest between the broker-dealer receiving the compensation
                                    and the customer because the sale of a recommended security could
                                    increase the compensation paid to the broker-dealer’s sales representative.

                                    Although the extent to which revenue sharing payments are affecting the
                                    appropriateness of the fund recommendations that broker-dealers make is
                                    not known, investor’s complaints regarding mutual fund shares they
                                    purchased have recently increased dramatically. According to NASD
                                    statistics, the number of NASD-administered arbitration cases involving
                                    mutual funds have increased by over 900 percent from 121 cases in 1999 to
                                    1,249 cases in 2002. According to NASD staff, about 34 percent of the 2002
                                    cases involved complaints of unsuitable mutual fund purchases. The
                                    extent to which revenue sharing payments are involved with these cases is
                                    unknown and NASD staff said the likely reason behind the increase in
                                    arbitrations involving mutual funds is the decline in the stock market and
                                    the associated declines in mutual fund performance.

Extent to Which Investors Are       Although revenue sharing payments can create conflicts of interest
Told About the Potential Conflict   between broker-dealers and their clients, the extent to which broker-
That Revenue Sharing Creates Is     dealers disclose to their clients that their firms receive such payments from
Unclear                             fund advisers is not clear. Rule 10b-10 under the Securities Exchange Act
                                    of 1934 requires, among other things, that broker-dealers provide
                                    customers with information about third-party compensation that broker-
                                    dealers receive in connection with securities transactions. While broker-
                                    dealers generally satisfy the requirements of rule 10b-10 by providing
                                    customers with written “confirmations,” the rule does not specifically
                                    require broker-dealers to provide the required information about third-
                                    party compensation related to mutual fund purchases in any particular
                                    document. SEC staff told us that they interpret rule 10b-10 to permit



                                    Page 40            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
broker-dealers to disclose third-party compensation related to mutual fund
purchases through delivery of a fund prospectus that discusses the
compensation. However, investors will not receive a confirmation, and may
not view a prospectus, until after purchasing mutual fund shares.
According to SEC staff, the compensation-disclosure requirements of rule
10b-10 in large part are geared toward providing investors with information
that is useful over a course of dealing with a broker-dealer, rather than just
one transaction. Information disclosed following the first transaction in a
security can help the investor determine whether to continue to use that
broker-dealer for future transactions. That is particularly applicable in the
context of mutual funds, given that investors often purchase fund shares
over time in a series of transactions.

Regulators and others acknowledged that additional disclosures may be
necessary to better help investors assess the potential conflicts of interest
associated with mutual fund transactions when distributing broker-dealers
receive revenue sharing payments. According to SEC staff, additional
disclosure is consistent with the principle that investors should be
informed about the financial interest that their broker-dealers have with
respect to mutual fund transactions. Additional disclosure about revenue
sharing also may help investors be more sensitive to the question of
whether they are being presented with an adequate range of investment
choices within a fund class. SEC officials also told us that additional
disclosure of revenue sharing payments may be justified so that investors
can better assess whether the fund’s advisory fees are excessive. SEC
officials, in addition, noted that additional disclosure also might help
promote fee competition among funds.

NASD officials said that mutual funds’ revenue sharing arrangements with
broker-dealers could present a conflict of interest for the broker-dealer.
However, NASD looked at this issue in the past and found no hard evidence
of sales representatives recommending unsuitable funds, but they
acknowledged that making such a determination would be difficult. The
NASD officials told us that it may be time to reexamine this issue. They said
that NASD Rule 2830 prohibits member brokers from accepting
compensation from fund advisers unless the funds disclose these payments
in fund prospectuses. ICI has also endorsed regulatory rule changes that
would require broker-dealers to disclose if they are receiving compensation
from fund advisers, in addition to requiring disclosure of these payments in
fund prospectuses. However, an official at one mutual fund adviser with
whom we spoke said that disclosure of funds’ revenue sharing agreements
would not be helpful because it would include only their largest



Page 41            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                       distributors and might mislead investors about the extent of revenue
                       sharing.



Soft Dollar            Soft dollar arrangements allow investment advisers of mutual funds and
                       other clients to use part of the brokerage commissions paid to broker-
Arrangements Provide   dealers that execute trades on the fund's behalf to obtain research and
Benefits, but Could    brokerage services that can potentially benefit fund investors but could
                       increase the costs borne by their funds. The research and brokerage
Also Have an Adverse   services that fund advisers obtain through the use of soft dollars can
Impact on Investors    benefit a mutual fund investor by increasing the availability of research.
                       This practice also creates potential conflicts of interest that could harm
                       fund investors. Some industry participants argued that when mutual fund
                       investment advisers use fund assets to pay brokerage commissions and
                       receive research or brokerage services as part of soft dollar arrangements,
                       such services improve the investment advisers’ management of the fund.
                       However, others expressed concerns that such arrangements create
                       conflicts of interest that could result in fund advisers paying higher
                       brokerage commissions than necessary, which increases costs to fund
                       investors. Investors’ expenses also could be higher if investment advisers
                       use brokerage commissions to pay for research and brokerage services that
                       they do not need or would otherwise pay for out of their own profits.
                       Expenses to investors would also be higher if investment advisers traded
                       more to generate and receive more soft dollar services. According to SEC,
                       soft dollar arrangements could also compromise advisers’ fiduciary
                       responsibility to seek brokers capable of providing the best execution on
                       fund trades by choosing broker-dealers on the basis of their soft dollar
                       offerings. With these potential conflicts of interest in mind, several
                       interested parties in the United States and abroad have made suggestions
                       for how potential soft dollar abuses could be mitigated, although some of
                       these actions could have other negative consequences.




                       Page 42           GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Soft Dollars Pay for       When investment advisers buy or sell securities for a fund, they may have
Research and Brokerage     to pay the broker-dealers that execute these trades a commission using
                           fund assets.26 In return for brokerage commissions, many broker-dealers
Services                   provide advisers with a bundle of services, including trade execution,
                           access to analysts and traders, and research products. Soft dollar
                           arrangements refer to the exchange of research and brokerage services
                           from broker-dealers to fund advisers in return for brokerage commissions.
                           For example, many full-service broker-dealers offer trade execution
                           services, and in exchange for paying their stated institutional commission
                           rate, advisers conducting trades through them could be entitled to research
                           produced by the broker-dealers’ analysts or receive priority notification of
                           market or company-specific news. In addition to providing this proprietary
                           research, these broker-dealers may also allow the fund adviser to generate
                           soft dollar credits with a portion of the brokerage commissions paid that
                           the fund adviser can then use to purchase other research from third parties.
                           These third parties can be other broker-dealers, independent research or
                           analytical firms, or service providers such as market data or trading
                           systems software and hardware vendors. In a 1998 inspection report that
                           documented reviews of soft dollar practices at 75 broker-dealers and 280
                           investment advisers and investment companies, SEC reported for every
                           $1.70 in commissions paid to a broker-dealer, the adviser would receive
                           $1.00 worth of soft dollar products and services. 27

                           Soft dollar arrangements are not unique to the mutual fund industry. They
                           are widely used by investment advisers who manage portfolios for other
                           clients besides mutual funds, including pension funds, hedge funds, and
                           individual retail clients.



Soft Dollar Arrangements   Many of the features of soft dollar arrangements that exist today are the
Have Evolved Over Time     result of regulatory changes in the 1970s. Until the mid-1970s, the
                           commissions charged by all brokers were fixed at one equal price. To
                           compete for commissions, broker-dealers differentiated themselves by
                           offering research-related products and services to advisers. In 1975, to


                           26
                            As noted previously, instead of commissions, broker-dealers executing trades also could
                           be compensated through markups or spreads.
                           27
                            U.S. Securities and Exchange Commission, Inspection Report on the Soft Dollar Practices
                           of Broker-Dealers, Investment Advisers and Mutual Funds (Washington, D.C.: Sept. 22,
                           1998).




                           Page 43               GAO-03-763 Greater Transparency Needed in Disclosures to Investors
increase competition, SEC abolished fixed brokerage commission rates.
However, investment advisers were concerned that they could be held in
breach of their fiduciary duty to their clients to obtain best execution on
trades if they paid anything but the lowest commission rate available to
obtain research and brokerage services. In response, Congress created a
“safe harbor” under section 28(e) of the Securities Exchange Act of 1934
that allowed advisers to pay more than the lowest available commission
rate for security transactions in return for research and brokerage services
and not be in breach of their fiduciary duty. In order to be protected
against a claim of breach of fiduciary duty under this safe harbor, the
adviser must make a good faith determination that the amount of
commission paid is reasonable in relation to the value of the brokerage and
research services provided by the broker-dealer.

The definition of what research and brokerage services can be obtained
through soft dollar arrangements has evolved over time. In a 1976 release,
SEC issued guidelines for determining when a product or service is within
the meaning of brokerage and research services and available for the safe
harbor under section 28(e). The 1976 guidelines provided the product or
service must not be “readily and customarily available and offered to the
general public on a commercial basis.” In 1986, noting that this standard
was difficult to apply and unduly restrictive in certain instances, SEC
reinterpreted the safe harbor as permitting soft dollar arrangements to
purchase products and services that “provide lawful and appropriate
assistance to the money manager in the performance of his investment
decision-making responsibilities,” which could then include those
commercially available to the public.28 Under the revised interpretation, the
cost of products and services that provide lawful and appropriate
assistance, such as computer hardware and seminars, may be paid for with
soft dollars.




28
 Securities; Brokerage and Research Services, Securities and Exchange Commission
Release No. 34-23170, 51 F.R. 16004 (Apr. 23, 1986).




Page 44              GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Although the Complete          Because soft dollar research is often bundled, only aggregate value
Extent of Soft Dollar Use Is   estimates of soft dollar arrangements are available. According to one
                               industry research organization, the total amount paid in brokerage
Unknown, Soft Dollars          commissions for U.S. stocks totaled $8.6 billion in 2001, up from $7.7 billion
Could Represent a              in 2000.29 Of this amount, industry participants estimate that 15 percent of
Significant Portion of         total annual brokerage commissions, or roughly $1 billion, is used to obtain
Trading Commissions            third-party research. However, this figure does not include the value of
                               proprietary research, which cannot be unbundled as easily as third-party
                               research. Moreover, in light of recent declines in fund assets, concern has
                               been raised that advisers are under increased pressure to use soft dollars to
                               pay for research rather than incur additional fund expenses.

                               Soft dollar products and services appear to represent a substantial portion
                               of the cost of brokerage commissions on individual trades. Industry
                               participants estimate that on average broker-dealers charge commissions
                               of between $.05 and $.06 per share traded. In contrast, one industry expert
                               has noted that it costs less than $.01 per share to execute a trade through
                               an electronic communications network (ECN). ECNs are registered
                               broker-dealers that operate as electronic exchanges. Because ECNs do not
                               offer as many of the services offered by full service broker-dealers and
                               execute trades electronically, the cost of executing trades through these
                               brokers is lower. However, the estimated costs of trading on an ECN may
                               not be representative of trading in all securities because most activity on
                               ECNs involves widely traded, liquid stocks. Other estimates of the portion
                               of individual brokerage commissions represented by soft dollars and
                               execution services varied. One academic study, for example, attributes 67
                               percent of the cost of brokerage commissions on individual trades to soft
                               dollars that pay for proprietary or third-party research.30 However,
                               recognizing that a portion of brokerage commissions goes towards broker-
                               dealer profits, a consulting firm that specializes in mutual funds estimates
                               more conservatively that soft dollars constitute 33 percent of brokerage
                               commission costs.

                               Advisers who offer mutual funds use soft dollar arrangements to varying
                               degrees. According to one SEC official, many fund companies do their own


                               29
                                Greenwich Associates, Commission and Soft-Dollar Practices in U.S. Equities (May 3,
                               2002).
                               30
                                M. Livingston and E.S. O’Neal, “Mutual Fund Brokerage Commissions,” The Journal of
                               Financial Research (Summer 1996).




                               Page 45              GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                            research and thus have less use for broker-dealer or third-party research.
                            Fixed-income funds, because their trades largely do not involve paying
                            commissions, may not generate many soft dollar credits that could be used
                            to obtain third-party research. However, one adviser of fixed-income funds
                            with whom we spoke said that his firm does receive proprietary research
                            from the full-service broker-dealers with whom they trade. Nine of the ten
                            fund companies with whom we spoke also used soft dollars to varying
                            degrees. One of the fund companies indicated that they did not engage in
                            any soft dollar arrangements. However, this company specializes in
                            indexed funds, which do not require research, and therefore seeks
                            execution-only trades when it engages in portfolio transactions. Officials
                            from other firms indicated that they limited the items that they obtained
                            with soft dollars to research reports and analysis. On the other hand, some
                            fund companies with whom we spoke indicated that their funds engaged in
                            greater use of soft dollar arrangements for a variety of research and
                            brokerage services permissible under section 28(e), including computer
                            monitors and analytical software.



Disclosure of Soft Dollar   Fund advisers and investment companies must make some disclosure of
Use to Mutual Fund          their soft dollar arrangements, but these disclosures are not specific and
                            not required to be routinely provided to mutual fund investors. Under the
Investors Is Limited
                            Investment Advisers Act of 1940, advisers must disclose details of their soft
                            dollar arrangements in Part II of Form ADV, which is the form that
                            investment advisers use to register with SEC and are required to send to
                            their advisory clients. Specifically, Form ADV requires advisers to describe
                            the factors considered in selecting brokers and determining the
                            reasonableness of their commissions when the adviser has discretion in
                            choosing brokers. If the value of the products, research and services given
                            to the adviser affects the choice of brokers or the brokerage commission
                            paid, the adviser must also describe the products, research and services
                            and whether clients may pay commissions higher than those obtainable
                            from other brokers in return for those products. The adviser is also to
                            disclose whether research is used to service all of the adviser’s accounts or
                            just those accounts paying for it and any procedures the adviser used
                            during the last fiscal year to direct client transactions to a particular broker
                            in return for products and research services received. However, SEC staff
                            told us that the Form ADV disclosures tend to use standardized language
                            that is difficult for advisory clients to evaluate.




                            Page 46            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
The information that investment advisers disclose about their choice of
broker-dealers and their use of soft dollars in their Form ADV is not
required to be routinely provided to mutual fund investors. As noted
above, investment advisers are required to provide their Form ADV to their
advisory clients. However, in the case of mutual funds, the client is
considered to be the legal entity that is registered as the investment
company with SEC and not the individual shareholders of the mutual fund.
SEC rules also require advisers to disclose the aggregate brokerage
commissions paid by the investment adviser with fund assets, the criteria
for broker selection, and the products and services obtained through soft
dollar arrangements in their SAI. 31 However, SAIs are only sent to
investors upon request, and industry officials noted that investors rarely
request SAIs. As a result, mutual fund shareholders do not routinely
receive information about the extent to which their funds’ advisers receives
and uses soft dollar credits when making purchases or sales of the
securities in the mutual funds that they own.

In addition to oversight of fees and fund distribution expenses, mutual fund
directors also have a responsibility to monitor advisers’ soft dollar
arrangements to ensure best execution on portfolio trades. According to
SEC, fund directors typically have access to more detailed information
about an adviser’s soft dollar practices than described in the Form ADV,
including a list of brokers used and the total commissions dollars paid to
each broker, the average commission rate per share by broker, the list of
brokers with which the fund adviser has soft dollar arrangements and a
description of research and brokerages services received by the fund.
Additionally, directors often receive the advice of independent counsel
about an adviser’s soft dollar practices. Both SEC examiners and fund
directors evaluate soft dollar arrangements in the context of whether
advisers are getting best execution on portfolio transactions. Directors and

31
  The information that investment advisers are required to file with SEC that comprises the
SAI is contained in Form N-1A, which is the registration statement for open-ended
management investment companies. Information about soft dollar arrangements are also
contained in Form N-SAR, which is the form registered management investment companies
file with SEC on a semi-annual basis. Disclosures regarding brokerage practices are found
in items 20, 21, 22, and 26 of this form. In particular, item 26 requires the fund to answer yes
or no as to various considerations that affected the participation of brokers or dealers in
commissions or other compensation paid on portfolio transactions of the fund. These
considerations include sales of the fund's shares; receipt of investment research and
statistical information; receipt of quotations for portfolio valuations; ability to execute
portfolio transactions to obtain best price and execution; receipt of telephone line and wire
services; affiliated status of the broker or dealer; and arrangements to return or credit part
or all of commissions or profits thereon to the fund and other affiliated persons of the fund.




Page 47                GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                             industry participants with whom we spoke indicated that boards evaluate
                             how advisers use soft dollars, whether these charges are reasonable, and
                             whether these arrangements affect best execution of portfolio
                             transactions.



Soft Dollars Benefit         Some industry participants argue that the use of soft dollar benefits
Investors in Various Ways,   investors in various ways. They note that the prevalence of soft dollar
                             arrangements allow specialized, independent research to flourish, thereby
but Could Also Increase
                             providing money managers a wider choice of investment ideas. As a result,
Investor Costs or Raise      this research could contribute to better fund performance. The
Conflicts of Interest        proliferation of research available as a result of soft dollars may also have
                             other benefits. For example, an investment adviser official told us that the
                             research on smaller companies for which soft dollars pay helps create a
                             more efficient market for such companies’ securities, resulting in greater
                             market liquidity and lower spreads.

                             However, concerns have been raised about soft dollar arrangements
                             because they could increase the costs that investors incur when investing
                             in a mutual fund. For example, soft dollars could cause investors to pay
                             higher brokerage commissions than they otherwise would, because
                             advisers might choose broker-dealers on the basis of soft dollar products
                             and services, not trade execution quality. As a result, soft dollar trades
                             might have both higher brokerage commissions and worse trade execution.
                             One academic study, for example, shows that trades executed by broker-
                             dealers that specialize in providing soft dollar products and services tend to
                             be more expensive than those executed through other broker-dealers,
                             including full-service broker-dealers.32 Soft dollar arrangements could also
                             encourage advisers to trade more in order to pay for more soft dollar
                             products and services. Overtrading would cause investors to pay more in
                             brokerage commissions than they otherwise would. These arrangements
                             might also tempt advisers to “over-consume” research because they were
                             not paying for it directly. In turn, advisers might have less incentive to
                             negotiate lower commissions, resulting in investors paying more for trades.
                             Some believe soft dollars are used to purchase research and brokerage
                             services for which advisers should pay out of their own profits and not out
                             of fund assets. As a result, the investor assumes the direct financial burden
                             for the advisers’ costs.

                             32
                              J.S. Conrad, K.M Johnson, and S. Wahal, “Institutional Trading and Soft Dollars,” Journal
                             of Finance (February 2001).




                             Page 48               GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Concerns have also been expressed that the range of products and services
that advisers are obtaining with client commissions might be too broad.
Critics of soft dollar arrangements have argued that the 1986 principle has
legitimized the use of investor dollars to pay for products and services with
only marginal research applications, such as computer terminals,
telephone bills, and magazine subscriptions. Using soft dollars for such
services could harm investors because advisers have an incentive to freely
obtain such services that they would otherwise have to pay for out of their
profits.

SEC noted that mutual fund advisers tend to abide by the spirit of section
28(e) more diligently than other investment advisers. In 1996 and 1997, SEC
examiners conducted an examination sweep into the soft dollar practices
of broker-dealers, investment advisers and mutual funds. In their 1998
inspection report, SEC staff documented instances of soft dollars being
used for products and services outside the safe harbor, as well as
inadequate disclosure and bookkeeping of soft dollar arrangements.
However, SEC staff indicated that their review found that mutual fund
advisers engaged in far fewer soft dollar abuses than other types of
advisers. They attributed mutual fund adviser compliance to the role that
independent directors play in overseeing and approving advisers’ soft
dollar arrangements. The SEC staff also indicated that active involvement
by legal counsel in the affairs of mutual funds may contribute to the relative
lack of soft dollar abuses among mutual fund advisers as well.

Investment advisers also receive services in exchange for part of the
brokerage commissions they pay with fund assets that directly reduce the
costs borne by mutual fund investors. In these cases, instead of the adviser
receiving research or brokerage services, the adviser, at the request of the
fund board, could direct the broker-dealer executing a trade to use a
portion of the commission paid to pay an expense of the mutual fund. For
example, the executing broker-dealer could mail a payment to the fund’s
custodian for the services rendered to the mutual fund that could reduce
the amount the fund itself would have to directly pay the custodian out of
fund assets. Alternatively, the executing broker-dealer could rebate part of
the brokerage commission to the fund in cash. Such directed brokerage
arrangements do not fall under the section 28(e) safe harbor and do not
present the same conflicts of interest as traditional soft dollar
arrangements, because the investor, not the adviser, is directly benefiting
from them. An industry participant has indicated that such arrangements
are not very common in the mutual fund industry.




Page 49            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Regulators and Industry         As a result of its 1998 inspection report on its soft dollar examination
Participants Have Proposed      sweep, SEC staff made several proposals that could help investors better
                                evaluate advisers’ use of soft dollars. In the examination sweep, SEC
Alternatives for Mitigating     examiners found inconsistencies in how advisers and broker-dealers
Potential Conflicts Involving   interpreted the section 28(e) safe harbor. Staff also found poor record
Soft Dollar Use                 keeping and internal controls for soft dollar arrangements and that advisers
                                were not adequately disclosing their soft dollar usage. As a result, SEC
                                staff recommended that Form ADV be modified to require more meaningful
                                disclosure. To facilitate this disclosure, SEC staff also recommended that
                                SEC publish the inspection report and issue additional guidance to clarify
                                the scope of the safe harbor. SEC published the inspection report to
                                reiterate guidance with respect to the scope of the safe harbor and to
                                emphasize the obligations of broker-dealers, investment advisers, and
                                investment companies that participate in soft dollar arrangements. This
                                recommendation may help industry participants apply the standards
                                articulated in the 1986 interpretive release more consistently and ensure
                                that investor dollars only pay for research and brokerage services within
                                the scope of section 28(e). Additionally, SEC staff recommended that SEC
                                consider adopting a bookkeeping requirement. A bookkeeping requirement
                                would enable advisers to disclose more easily to investors the products and
                                services for which soft dollars are paying. It would also ensure that
                                directors are able to receive information that fairly reflects the adviser’s
                                soft dollar arrangements. SEC staff told us that if the expanded disclosure
                                and other changes envisioned in their sweep report were implemented,
                                clients of investment advisers also would have more specific information
                                that could allow them to evaluate the appropriateness of their own
                                adviser’s use of soft dollars. The Department of Labor, which oversees
                                pension funds, and the Association for Investment Management and
                                Research, which administers professional certification examinations for
                                financial analysts, have also called for improved disclosure of soft dollar
                                usage by investment advisers.33




                                33
                                 See Department of Labor Advisory Council on Employee Welfare and Benefit Plans, Report
                                of the Working Group on Soft Dollars/Commission Recapture (Nov. 13, 1997); and
                                Association for Investment Management and Research, AIMR Soft Dollar Standards (August
                                1999).




                                Page 50              GAO-03-763 Greater Transparency Needed in Disclosures to Investors
However, SEC has yet to implement some of these recommendations due
to staff turnover and other high priority business. Except for publishing the
inspection report and issuing interpretative guidance that classifies certain
riskless principal transactions as falling under the section 28(e) safe
harbor, SEC has not issued further guidance regarding soft dollars.34 A soft
dollar bookkeeping requirement has been discussed as part of a larger SEC
initiative on bookkeeping, but no formal proposal has been presented.
Finally, the SEC issued a proposed rule on Form ADV modifications in
April 2000, which solicited comments on several changes that could force
advisers to make more meaningful disclosures of soft dollar arrangements.
However, this rule has not been adopted.35 SEC staff told us that they have
not taken further actions on these proposals due to staff turnover and the
press of business in other areas.

Some industry participants are not convinced that greater disclosure would
benefit investors. Form ADV is sent to advisory clients, not fund investors.
Thus, the proposed disclosure requirements do not address the needs of
fund investors. Investors do have access to information on a fund’s soft
dollar arrangements through the SAI, which is available upon request.
However, representatives of one fund company with whom we spoke
indicated that investors very rarely request SAIs. Industry participants also
noted that it might be difficult for investors to evaluate an adviser’s best
execution policies, which are not uniform across funds. Moreover, more
disclosure might lead investors to infer that soft dollar arrangements are
necessarily harmful and therefore adverse to their best interests.




34
 In SEC Interpretation: Commission Guidance on the Scope of Section 28(e) of the
Exchange Act, Securities and Exchange Commission Release No. 34-45194 (12/27/2001),
SEC clarified that the term “commission” for purposes of the Section 28(e) safe harbor
encompasses, among other things, certain riskless principal transactions.
35
 Proposed Rule: Electronic Filing by Investment Advisers; Proposed Amendments to Form
ADV, Securities and Exchange Commission, Release No. IA-1862; 34-42620 (Apr. 5, 2000).




Page 51               GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Some proposals would seek to restrict or ban the use of soft dollars in
order to encourage brokerage commissions to fall. As a result of
recommendations from a government-commissioned review of
institutional investment in the United Kingdom, the Financial Services
Authority (FSA), which regulates the financial services industry in that
country, issued a consultation paper that argued that soft dollar
arrangements create incentives for advisers to route trades to broker-
dealers on the basis of soft dollar arrangements and, further, that these
practices do not result in a good value for investors.36 As a result of these
findings, the paper proposed banning soft dollars for market pricing and
information services, as well as various other products. This
recommendation would provide a more direct incentive for advisers to
consider what services are necessary for efficient fund management, which
could lower investors costs by reducing the extent to which advisers use
client funds for services that the adviser does not need. The paper also
recommended that advisers quantify, or unbundle, the cost of all other soft
dollar products and services and rebate those costs to investors’ accounts
with hard dollars, which would result in investors having lower trading
costs in their funds.

Whether implementing the actions envisioned by the FSA’s proposals is
feasible is not certain. For example, FSA staff acknowledged that
restricting soft dollar arrangements in the United Kingdom could hurt the
international competitiveness of their fund industry because fund advisers
outside their country would not have to comply with these restrictions.
Such restrictions could also encourage UK advisers to move their
operations elsewhere. In addition, SEC staff told us that implementing the
FSA proposal would be more difficult here without legislative change
because the United States has the statutory safe harbor under Section
28(e), whereas the United Kingdom does not.

We learned of another proposal related to soft dollars and brokerage
commissions from an industry participant who was concerned that the
general practice of full-service broker-dealers charging about $0.05 to $0.06
per share in commissions and then offering discounts in the form of soft
dollars was serving to keep commissions artificially high. His first
suggestion would be to ban soft dollar arrangements to obtain products


36
 See P. Myners, Institutional Investment in the United Kingdom: A Review (Mar. 6, 2001);
and Financial Services Authority, Bundled Brokerage and Soft Commission Arrangements
(April 2003).




Page 52              GAO-03-763 Greater Transparency Needed in Disclosures to Investors
and services with marginal research applications, forcing advisers to pay
for these products with their own profits rather than with fund assets and
therefore reducing the trading costs borne by fund investors. Another
suggestion he had would have broker-dealers quantify the execution-only
portion of their brokerage commissions. If this information were collected
by SEC and reported as industry averages, mutual fund directors would
have more information to use to evaluate their fund’s trading activities.

However, many industry participants are skeptical about whether soft
dollar arrangements contribute to investors paying higher brokerage
commissions. For example, according to SEC officials and an industry
participant, many broker-dealers claim that they would not negotiate lower
commission rates with investment advisers regardless of whether an
adviser was willing to forfeit soft dollar products and services in return.
One group with whom we spoke suggested that soft dollars might be more
of a volume rebate for brokerage than a factor influencing commission
rates. Moreover, surveys of investment advisers and broker-dealers
conducted in the United Kingdom found that third-party soft dollar
arrangements were a very minor factor on which broker-dealers competed
for business and advisers selected broker-dealers. These results suggest
that advisers’ incentive to compromise their fiduciary responsibility to seek
best execution in return for generous soft dollar arrangements might be
overstated.

Concern has also been raised about how the value of some soft dollar
products and services could be fairly determined. Because proprietary soft
dollar products and services are bundled, their values as individually
purchased items are difficult to estimate. For example, SEC officials noted
that it is hard to put a meaningful value on the cost of information
exchanged in a phone call between a fund adviser and a broker-dealer.
Nevertheless, brokerage commissions pay for this type of informal access.
Some industry experts, including SEC, have noted that attempts to require
the industry to quantify the value of soft dollar services could have a
disproportionate impact on third-party research. Third-party research is
free from the potential conflicts of interest that have recently tainted some
proprietary research from brokerage houses. Additionally, several fund
companies have indicated that they find research provided by specialized
research firms does provide valuable insights into investment decisions.
Because broker-dealers use soft dollar credits to purchase third-party
research, its value is more easily determined than proprietary research. As
a result, some have expressed concern that this distinction could make
third-party research more vulnerable if regulatory changes were enacted.



Page 53            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
              Some have suggested that limiting the products and services that could be
              obtained with soft dollars might have some unintended consequences.
              According to some fund officials, this option could shift a greater financial
              burden onto advisers, who might be tempted to raise management fees as a
              result. While having investment advisers pay directly for research and
              brokerage services rather than receive them through soft dollars could
              increase the transparency of these arrangements, the increased costs to the
              adviser could cause advisers to seek fee increases or at least prevent
              further reductions in the fees advisers do charge.



Conclusions   Although mutual funds disclose considerable information about their costs
              to investors, some industry participants urge that additional disclosures are
              needed to further increase the awareness of investors of the fees they pay
              as part of investing in mutual funds and to encourage greater competition
              among mutual funds on the basis of these fees. The SEC staff’s proposal to
              require funds to disclose the actual expenses in dollars based on an
              investment amount of $10,000 would provide investors with more
              information on fund fees and in a form that would allow for direct
              comparison across funds. If adopted, this will provide investors selecting
              among different funds with useful information prior to investing. However,
              additional disclosures could also improve investor awareness and the
              transparency of these fees. Providing existing investors with the specific
              dollar amounts of the fees paid on their shares and placing fee related
              disclosures in the quarterly account statements that investors receive
              would put mutual fund disclosures on comparable footing to many other
              financial services that already disclose specifically in dollars the cost of
              their services. Seeing the specific dollar amount paid on their shares could
              be the incentive that some investors need to take action to compare their
              fund’s expenses to those of other funds and make more informed
              investment decisions on this basis. Such disclosures may also increasingly
              motivate fund companies to respond competitively by lowering fees.

              Given the cost of producing such disclosures and the lack of data on the
              additional benefits to investors, the SEC staff have indicated that they were
              not certain that specific dollar disclosures are warranted. However, we
              believe that actively weighing the costs and benefits of providing additional
              disclosure is worthwhile. In addition, other less costly alternatives are also
              available that could increase investor awareness of the fees they are paying
              on their mutual funds by providing them with information on the fees they
              pay in the quarterly statements that provide information on an investor’s
              share balance and account value. For example, one alternative that would



              Page 54            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
not likely be overly expensive would be to require these quarterly
statements to present the information that SEC has proposed be added to
mutual fund’s semiannual reports that would disclose the dollar amounts of
a fund’s fees based on a set investment amount. Doing so would place this
additional fee disclosure in the document generally considered to be of the
most interest to investors. An even less costly alternative could be to
require quarterly statements to also include a notice that reminds investors
that they pay fees and to check their prospectus and with their financial
adviser for more information. If additional fee disclosures such as these
were used to supplement the existing information already provided in
prospectuses and semiannual reports, both prospective and existing
investors in mutual funds would have access to valuable information about
the relative costs of investing in different funds.

Mutual fund directors play a critical role in overseeing fund advisers
activities and have been credited with ensuring that U.S. mutual funds have
lower fees than those charged in other countries. However, the popularity
of mutual fund investing and the increasing importance of such
investments to investors’ financial well being and ability to retire securely
also increases the need for regulators and industry participants to
continually seek to ensure that mutual fund corporate governance
practices remain strong. The recent corporate scandals have resulted in
various corporate governance reforms being proposed to improve the
oversight of public companies by their boards of directors. We have
supported regulatory and industry efforts to strengthen the corporate
governance of public companies. Although many of the reforms being
sought for public companies are already either embodied in regulatory
requirements or recommended as best practices by the mutual fund
industry group, additional improvements to mutual fund governance, such
as mandating supermajorities of independent directors, are likely to
continue to be considered by regulators and industry participants, which
should further benefit mutual fund investors.

Although the ways that funds use 12b-1 fees has changed over time, these
fees appear to have provided investors with increased flexibility in
choosing how to pay for the services of the individual financial
professionals providing them with advice on fund purchases. As a result,
they appear to provide benefits to the large number of investors that
require assistance with their financial decisions. The revenue sharing
payments that funds make to broker-dealers illustrate that mutual funds
must compete to obtain access to the distribution networks that these
firms provide. How and the extent to which these payments affect the



Page 55            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                  overall level of fees that fund investors pay is not clear. However, by
                  compensating broker-dealers to market the funds of a particular company,
                  they can introduce a conflict with the broker-dealer obligation to
                  recommend the funds most suitable to the investor’s needs. Further, even
                  if the payments do not conflict with this obligation, the payments can result
                  in financial professionals providing investors with fewer investment
                  choices. Regulators acknowledged that the currently required disclosures
                  might not provide needed transparency to investors at the time that mutual
                  fund shares are being recommended for purchase. Having additional
                  disclosures made at the time that fund shares are recommended about the
                  compensation that a broker-dealer receives from fund companies could
                  provide investors with more complete information to consider when
                  making their investment decision.

                  Fund investors can benefit when their fund’s investment adviser uses soft
                  dollars to obtain research and brokerage services that benefit the fund or to
                  pay other fund expenses. However, investment advisers may also use soft
                  dollars for services that may just reduce the adviser’s own expenses. The
                  SEC staff has recommended various changes that would increase the
                  transparency of soft dollar practices by clarifying the acceptable uses of
                  soft dollars and providing fund investors and directors with more
                  information about how their fund’s adviser is using soft dollars. However,
                  the rule proposal to expand advisers’ disclosure of their use of soft dollars
                  was issued about 3 years ago and has not yet been acted upon. In addition,
                  the SEC staff have not developed and issued a formal rule proposal to
                  implement its recommendation to require increased soft dollar
                  recordkeeping by broker dealers and advisers that would increase the
                  transparency of these arrangements. SEC relies on disclosure of
                  information as a primary means of addressing potential conflicts between
                  investors and financial professionals. However, by not acting on these soft
                  dollar-related measures, investors and mutual fund directors have less
                  complete and transparent information with which to evaluate the benefits
                  and potential disadvantages of their fund adviser’s use of soft dollars.



Recommendations   To promote greater investor awareness and competition among mutual
                  funds on the basis of their fees, we recommend that the Chairman, SEC
                  increase the transparency of the fees and practices that relate to mutual
                  funds by




                  Page 56            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
                      • considering the benefits of additional disclosure relating to mutual fund
                        fees, including requiring more information in mutual fund account
                        statements about the fees investors pay;

                      • evaluating ways to provide more information that investors could use to
                        evaluate possible conflicts of interest resulting from any revenue
                        sharing payments their broker-dealers receive; and

                      • evaluating ways to provide more information that fund investors and
                        directors could use to better evaluate the benefits and potential
                        disadvantages of their fund adviser’s use of soft dollars, including
                        considering and implementing the recommendations from its 1998 soft
                        dollar examinations report.



Agency Comments and   SEC and ICI generally agreed with the contents of this report. Regarding
                      our recommendation that SEC consider additional ways to provide fee
Our Evaluation        information to investors in account statements, the letter from the director
                      of the Division of Investment Management notes that the SEC staff agreed
                      that mutual fund shareholders need to understand the amount of fees that
                      mutual funds charge and indicated that they would consider whether some
                      form of fee disclosure could be included in account statements as they
                      continue to evaluate the comments they have received on their proposed
                      disclosure changes. Regarding our recommendations on increasing the
                      amount of information disclosed about revenue sharing and soft dollar
                      arrangements, the SEC staff also indicated that they intend to consider
                      ways in which additional information about these practices could be
                      disclosed.

                      The letter from the president of ICI notes that our report’s discussion of
                      mutual fund regulatory requirements is generally balanced and well
                      informed. However, his letter indicates concern over how we compare the
                      disclosures made by mutual fund fees to those made by other financial
                      products. According to the letter, ICI staff are convinced that current
                      mutual fund fee disclosures allow individuals to make much more informed
                      and accurate decisions about the costs of their funds than do the
                      disclosures made by other financial service firms. In particular, they
                      indicated that they are not aware of any other financial product that is
                      legally required to provide standardized information that reveals the exact
                      level of all of its fees and expenses and projects their impact in dollar terms
                      over various time periods.




                      Page 57            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
We agree with ICI that mutual funds are already required to make
considerable disclosures that are useful to investors for comparing the
level of fees across funds. Although our report notes that, unlike mutual
funds, other financial products generally do disclose their costs in specific
dollar terms, we do not make a judgment as to whether the overall
disclosures provided by these products are superior to that provided for
mutual funds. Instead, we believe that supplementing the existing mutual
fund disclosures with additional information, particularly in the account
statements that provide investors with the exact number and value of their
mutual fund shares, could also prove beneficial for increasing awareness of
fees and prompting additional fee-based competition among funds.

The ICI’s staff’s letter also indicates that our report presents a thorough and
useful discussion of the role played by independent directors in overseeing
mutual fund fees. However, they expressed concern that mutual fund
independent directors are not usually given sufficient credit for protecting
fund shareholder interests. ICI noted that independent directors have
helped keep the industry free of major scandal and that mutual fund
governance standards, as set by the Investment Company Act of 1940,
places strict requirements on funds that exceed the voluntary standards
with which public companies are expected to adhere. We agree with ICI
that independent directors have played important roles in overseeing funds
and, in each of the issues addressed by our report, we discuss the actions
taken by mutual fund directors to oversee the issues and that SEC reviews
generally find that directors have fulfilled their duties in accordance with
the law. However, given recent scandals and concerns related to corporate
responsibility in the financial sector and the growing importance of fund
investments to the financial health and retirement security of investors,
continued debate by the Congress and among regulators and industry
participants about the effectiveness of existing mutual fund corporate
governance standards is appropriate. SEC’s and ICI’s written responses are
shown in appendixes II and III.


As agreed with your offices, unless you publicly announce the contents of
this report earlier, we plan no further distribution of this report until 30
days from the report date. At that time, we will provide copies of this report
to the Chairman and the Ranking Minority Member, Senate Committee on
Banking, Housing, and Urban Affairs, and the Ranking Minority Members,
House Committee on Financial Services and its Subcommittee on Capital
Markets, Insurance, and Government Sponsored Enterprises. Copies also
will be provided to the Chairman, SEC; the President, ICI; and other



Page 58            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
interested parties. The report will also be available at no charge on GAO’s
home page at http://www.gao.gov.

If you or your staff have any questions regarding this report, please contact
Mr. Cody Goebel or me at (202) 512-8678. GAO staff that made major
contributions to this report are shown in appendix IV.




Richard J. Hillman
Director, Financial Markets
 and Community Investment




Page 59            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Appendix I

Scope and Methodology                                                                           A
                                                                                                A
                                                                                                ppep
                                                                                                   nen
                                                                                                     d
                                                                                                     xIeis




             To describe mutual fund fee and trading cost disclosures and other
             financial product disclosures and the related costs we reviewed SEC rules
             and studies by academics and others, and various mutual fund company
             fund literature including prospectuses and SAIs, as well as prior GAO work.
             To evaluate the benefits of additional mutual fund cost disclosure we
             collected opinions from a judgmental sample of 15 certified financial
             planners with the use of a structured questionnaire.

             To describe the role of mutual fund independent directors we reviewed
             federal laws and regulations, academic studies, and prior GAO work. We
             collected opinions from officials representing an independent directors
             association and from a judgmental sample of independent directors with
             the use of a structured questionnaire.

             To obtain information on mutual fund distribution practices we
             interviewed officials of ten mutual fund companies, two broker-dealers,
             ICI, NASD, SEC, mutual fund research organizations, and investor
             advocacy organizations and individuals. We also reviewed and analyzed
             various documents and studies of mutual fund distribution practices.

             To address the benefits and potential conflicts of interest raised by mutual
             funds’ use of soft dollars, we spoke with the FSA and other industry
             experts on soft dollars. We also reviewed studies by regulators and industry
             experts on soft dollar arrangements. Some groups we spoke to had made
             specific recommendations for regulatory changes to soft dollar
             arrangements. To the extent possible, we discussed the potential
             advantages and disadvantages of these recommendations with officials of
             the ten mutual fund companies, two broker-dealers, ICI, NASD, SEC,
             mutual fund research organizations, and investor advocacy organizations
             and individuals.

             For each of the topics we reviewed in this report we gathered views from
             staff at SEC, mutual fund company officials, broker-dealers, ICI, mutual
             fund research organizations, and investor advocacy organizations and
             individuals. We conducted our work in Washington, D.C.; Boston, MA;
             Kansas City, MO; Los Angeles, CA; New York, N.Y.; and San Francisco, CA,
             from February to June 2003, in accordance with generally accepted
             government auditing standards.




             Page 60           GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Appendix II

Comments from the Securities and Exchange
Commission                                                                               AppenIx
                                                                                               di




              Page 61   GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Appendix II
Comments from the Securities and Exchange
Commission




Page 62              GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Appendix II
Comments from the Securities and Exchange
Commission




Page 63              GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Appendix III

Comments from the Investment Company
Institute                                                                                 Appen
                                                                                              Ix
                                                                                               di




               Page 64   GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Appendix III
Comments from the Investment Company
Institute




Page 65            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Appendix III
Comments from the Investment Company
Institute




Page 66            GAO-03-763 Greater Transparency Needed in Disclosures to Investors
Appendix IV

GAO Contacts and Staff Acknowledgments                                                               Appen
                                                                                                         V
                                                                                                         Id
                                                                                                          xi




GAO Contacts      Richard J. Hillman (202) 512-8678
                  Cody J. Goebel (202) 512-7329



Acknowledgments   In addition to the individuals named above, Toayoa Aldridge, Jonathan
                  Altshul, Marc Molino, Robert Pollard, Barbara Roesmann, David Tarosky,
                  and Sindy Udell made key contributions to this report.




(250132)          Page 67           GAO-03-763 Greater Transparency Needed in Disclosures to Investors
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