PAGENO="0001" Part 2 INVESTMENT COMPANY ACT AMENDMENTS OF 1967 ~ HEAR INGS BEFORE THE SUBCOMMITTEE ON COMMERCE AND FINANCE OF THE COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE HOUSE OF REPRESENTATIVES NINETIETH CONGRESS FIRST SESSION ON H.R. 9510, H.R. 9511 BILLS TO AMEND THE INVESTMENT COMPANY ACT OF 1940, AS AMENDED, AND THE INVESTMENT ADVISERS ACT OF 1940, AS AMENDED, TO DEFINE TIlE EQUITABLE STAND- ARDS GOVERNING RELATIONSHIPS BETWEEN INVEST- MENT COMPANIES AND THEIR INVESTMENT ADVISERS AND PRINCIPAL UNDERWRITERS, AND FOR OTHER PURPOSES OCTOBER 16, 17, 18, 23, AND 24, 1967 Serial No. 90-22 Printed for the use of the Committee on Interstate and Foreign Commerce U.S. GOVERNMENT PRINTING OFFICE 85-592 WASHINGTON : 1968 L\ç2~O~ PAGENO="0002" SAMUEL N. FRIEDEL, Maryland TORBERT H. MACDONALD, Massachusetts JOHN JARMAN, Oklahoma JOHN E. MOSS, California JOHN D. DINGELL, Michigan PAUL 0. ROGERS, Florida HORACE R. KORNEGAY, North Carolina LIONEL VAN DEERLIN, California J. J. PICKLE, Texas FRED B. ROONEY, Pennsylvania JOHN M. MURPHY, New York DAVID E. SATTERFIELD III, Virginia DANIEL J. RONAN, Illinois BROCK ADAMS, Washington RICHARD L. OTTINGER, New York RAY BLANTON, Tennessee W. S. (BILL) STUCKEY, JR., Georgia PETER N. KYROS, Maine ANDREW STEVENSON JAMES M. MENGER, Jr. WILLIAM L. SPRINGER, Illinois SAMUEL L DEVINE, Ohio ANCHER NELSEN, Minnesota HASTINGS KEITH, Massachusetts GLENN CUNNINGHAM, Nebraska JAMES T. BROYHILL, North Carolina JAMES HARVEY, Michigan ALBERT W. WATSON, South Carolina TIM LEE CARTER, T~entucky 0. ROBERT WATKINS, Pennsylvania DONALD G. BROTZMAN, Colorado CLARENCE J. BROWN, JR., Ohio DAN KUYKENDALL, Tennessee JOE SKUBITZ, Kansas WILLIAM J. DIXON ROBERT W. LISHMAN SUBCOMMITTEE ON COMMERCE AND FINANCE JOHN E. MOSS, California, Chairman JOHN M. MURPHY, New York HASTINGS KEITH, Massachusetts RAY BLANTON, Tennessee G. ROBERT WATKINS, Pennsylvania W. S. (BILL) `STUCKEY, Ja., Georgia COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE HARLEY 0. STAGGERS, West Virginia, Chairman W. E. WILLIAMSON, Clerk KENNETH J. PAINTER, Assistant Clerk Professional Staff (II) PAGENO="0003" CONTENTS (The same table of contents appears in parts 1 and 2) Hearings held on- Page October 10, 1967 October 11, 1967 149 October 12, 1967 211 October13, 1967 315 October 16, 1967 423 October 17, 1967 525 October 18, 1967 581 October 23, 1967 621 October 24, 1967 671 Text of hR. 9510 Report of- Bureau of the Budget 19 Federal Reserve System 22 Justice Department 20 Statement of- Alger, Fred M., president, Fred Alger & Co., Inc 495 Allen, Edward B., Jr., secretary-treasurer, Allen, Rogers & Co., Inc 508 Augenblick, Robert L., president and general counsel, Investment Company Institute 224 Bogert, H. Lawrence, president, Investment Bankers Association of America 279 Bradley, S. Whitney, Board of Governors, National Association of Securities Dealers, Inc. (NASD). 315 Burgess, Ralph, chief economist, National Association of Securities Dealers, Inc. (NASD) 315 Calvert, Gordon L., executive director and general counsel, Investment Bankers Association of America 279 Calvin, Donald L., vice president, government relations, New York Stock Exchange 525 Cohen, Hon. Manuel F., Chairman, Securities and Exchange Com- mission 25, 149, 671 Cohen, Milton H., counsel, Investment Counsel Sponsored No-Load Funds 566 Davant, James W., chairman of the board, Association of Stock Exchange Firms - 621 Day, J. Edward, counsel, Association of Mutual Fund Plan Sponsors, Inc 423, 433 Day, James E., president, Midwest Stock Exchange 560 Derrickson, Lloyd J., general counsel, National Association of Securi- ties Dealers, Inc. (NASD)., 315 Friendly, Judge Henry J., U.S. Court of Appeals, Second Circuit, New York, N.Y 608 Gardiner Robert M., chairman, Board of Governors, National Asso- ciation of Securities Dealers, Inc. (NASD) 315 Greenburg, Henry A., director and secretary, First Multifund of America, Inc 385 Grinnell, Joseph F., general counsel, Investors Diversified Services, Inc 463 Haack Robert W., president, New York Stock Exchange 525 Hagey, Harry H., Investment Counsel Sponsored No-Load Funds - - 566 Haire, John R., chairman-elect, Investment Company Institute - 224, 233 Horton, Hon. Frank J., a Representative in Congress from the State of New York 211 Jennings, Richard W., professor of law, University of California, Berkeley 633 Johnson, Franklin R., chairman, Investment Companies Committee, Investment Bankers Association of America 279 (II!) PAGENO="0004" Iv Statement of-Continued Page Kendall, Leon T., president, Association of Stock Exchange Firms.. - 621 Kostmayer, John H., coordinator of legislative efforts, Association of Mutual Fund Plan Sponsors, Inc 423, 424 Levering, Walter B., chairman, legislation committee, Association of Stock Exchange Firms 621 Levy, Gustave L., chairman, Board of Governors, New York Stock Exchange 525 Livingston, J. A., financial editor, Philadelphia Bulletin 654 Loeffler, Robert M., director and vice president-law, Investors Diver- sified Services, Inc 463 Loomis, Philip A., Jr., General Counsel, Securities and Exchange Commission 25, 149, 671 Lone, Prof. James H., Chicago, Ill 411 Lyman, Ronald T., Jr., Investment Counsel Sponsored No-Load Funds 566 McConnel, W. Bruce, Jr., chairman, Federal Securities Acts Com- mittee, Investment Bankers Association of America 279 Morency, Joseph N., Jr., legal counsel, Midwest Stock Exchange -- - 560 Mound, Milton, president, First Multifund of America, Inc 385 Quinby, H. Dean, Jr., chairman of the board of directors, Quinby & Co., Inc 214 Ratzlaff, James W., secretary, Investment Companies Committee, National Association of Securities Dealers, Inc. (NASD) 315 Roach, Cornelius, chairman of the board, Association of Mutual Fund Plan Sponsors, Inc 423 Robbins, Rowland A., president, Association of Mutual Fund Plan Sponsors, Inc 423 Rothing, Frank J., senior vice president, Midwest Stock Exchange - - - 560 Simpson, Bruce, director, Qualification and Examination Department, National Association of Securities Dealers, Inc. (NASD) 315 Steadman, Charles W., chairman of the board and president, Stead- man Security Corp 399 Walbert, Richard B., president-elect, National Association of Securi- ties Dealers, Inc. (NASD) 315 Wallich, Henry c.; professor of economics, Yale University 581 Weithers, John G., vice president and secretary, Midwest Stock Exchange 560 Welch, Joseph E., chairman, Investment Adviser Division, Invest- ment Company Institute 224 Williams, Francis S., chairman, Investment Company Institute 224 Additional material submitted for the record by- Allen, Rogers & Co., Inc.: Examples of volume bonus arrangements of funds which have contractual plans 519 Letter dated November 10, 1967, in response to questions froth Chairman Moss 522 Association of Mutual Fund Plan Sponsors, Inc.: Letter dated October 23, 1967, re percentage of third market - - - 446 Letter dated October 30, 1967, re comparison of various investment and savings media (1957-66) 451 Letter dated November 6, 1967, re number of plan sponsors which are exclusively sales organizations 454 Letter dated November 7, 1967, in response to questions sub- mitted by Congressman Hastings Keith 460 Association of Stock Exchange Firms, break-even points on security commission business-1961-66 629 Bache, Harold L., Bache & Co., Inc.: Letter dated November 2, 1967 781 Statement 778 Baum, Daniel Jay, professor of law, Indiana University, statement - - 797 Cox, Robert L., Overland Park, Kans., letter 840 Financial Service Corp. of America, statement 782 First Multifund of America, Inc., proposed amendment to section 7 of S. 1659, H.R. 9510, and H.R. 9511 Folk, Ernest L., III, professor of law, University of North Carolina at Chapel Hill, statement 801 PAGENO="0005" V Additional material submitted for the record by-Continued Herman, Edward S., associate professor of finance, Wharton School, Page University of Pennsylvania, statement 813 Hilsman, J. H., & Co., Inc., letter from J. E. MeClelland, president_ 820 Holden, Kenneth II., mutual fund sales representative, Long Beach, Calif., letter 840 Horton, Hon. Frank J.: Letter dated May 12, 1967, from Wilmot R. Craig, president, Lincoln Rochester Trust Co., re Quinby Plan 213 Letter dated May 23, 1967, from Paul Miller, president, Gannett Newspapers, re Quinby Plan..~ 213 Letter dated October 11, 1967, from Marion B. Folsom, Eastman Kodak Co., re Quinby Plan 213 Interstate and Foreign Commerce Committee: Correspondence between Chairman Staggers and the New York Stock Exchange re incrqased volume bf transactions in the stock markets 534 Correspondence between Chairman Staggers and the American Stock Exchange re inci~eased volume of transactions in the stock markets 558 Correspondence between Chairman Moss and Chairman Manuel F. Cohen, Securities and Exchange Commission, re NASD report 354 Correspondence between Chairman Moss and Hon. William Mc- Chesney Martin, Federal Reserve Board 186 Review of NASD markup policy interpretation of sections 1 and 4, article III, of the Rules of Fair Practice with respect to mark- ups 371 Investment Bankers Association of America: Article from Finance magazine' of October 1967, entitled "The Investor in a Maze" 282 Letter dated November 6, 1967, in response to questions sub- mitted by Congressman Hastings Keith 312 Investment Company Institute: Exhibit 1-Growth of net assets 231 Exhibit 2-Cothparison of various savings and investment methods 231 Exhibit 3-Investment performance of 169 mutual funds 232 Exhibit 4-Assets of major institutions and financial inter- mediaties 248 Exhibit 5-Sales charge patterns among 254 mutual funds (1966) 248 Exhibit 6-Number of companies and their distribution charge scales facing p. 248 Exhibit 7-Trend in commissions as a percent of gross sales 249 Exhibit 8-Trend in total operating expenses including advisory fees as a percent of assets 249 Exhibit 9-Advisory fee rates of 25 mutual funds 250 Letter dated October 27, 1967, in response to questions submitted by Chairman Moss 821 Letter dated November 6, 1967, in response to questions sub- mitted by Chairman Moss 271 Exhibit A-Number of corapanies and their applicable retail dealer concession facing p. 270 Exhibit B-Management companies reporting losses in re- sponse to inquiry concerning operating losses in the last three fiscal years 272 Letter dated November 6, 1967, in response to questions sub- mitted by Congressman G. Robert Watkins 822 Letter dated November 6, 1967, in response to questions sub- mitted by Congressman Hastings Keith - - 273 Schedule A-Information regarding management fee suits - 277 Schedule B-Expense ratios-internally managed versus ex- ternally managed investment companies - - - - 279 Statement in behalf of ICI, by- Demmler, Ralph H 258 Fahey, Robert J 251 Markham, Prof. Jesse 257 PAGENO="0006" VI Additional material submitted for the record by-Continued Investment Company Institute-Continued Table A-Assets and operating earnings of the 25 largest banks Page (1966) - 250 Table B-Assets and operating earnings of the 25 largest stock life insurance companies (1966) 251 Table C-Mutual fund assets and earnings of management compa~1ies (1966) 231 Investment Counsel Sponsored No-Load Funds: Letter dated October 31, 1967, in response to questions submitted by Chairman Moss 572 Letter dated November 3, 1967, in response to question submitted by Congressman Hastings Keith~L 578 Investors Diversified Services, Inc., letter dated November 7, 1967, re earnings of sales representatives 490 Investors Mutual, Inc., Investors Stock Fund, Inc., Investors Selec- tive Fund, Inc., and Investors Variable Payment Fund, Inc., Harold K. Bradford, president and chairman of the board) state- men4 785 Lexington Research & Management Corp., letter from John L. Schroeder, president 833 Livingston, J. A.:". The Business Outlook columns: Aunt Nellie's Stimulated No-load Mutual Funds 656 Mutual Fund Promises Should Be In Writing 657 No-Load Mutual Funds: Brokers Skirt Question~.. 658 Are Mutual-Fund Buyers Like Utility Customers? 659 Midwest Stock Exchange, volume, 1957-1967 564 Military Associates, Inc., letter from Lee Cazort, Jr., president 835 Moss, Hon. John E., letters of complaint about sales charges and losses re mutual funds 651 National Association of Securities Dealers, Inc. (NASD): History, organizational background and functions, NASD 323 Letter dated November 7, 1967, in response to questions by Congressman John E. Moss 350 Letter dated november 7, 1967, in response to questions sub- mitted by Congressman Hastings Keith 378 Letter dated November 7, 1967, re certain specific information with regard to each member of the association having a gross over-the-counter income of $50,000 or less in 1966 335 Letter dated November 7, 1967, re views on proposals to increase the authority of the NASDA in the regulation of mutual fund sales charges 344 Purposes of NASD from the certificate of incorporation 348 Nelson, Martin 0., & Co., Inc., letter from Martin 0. Nelson 834 New York Stock Exchange: Institutional holdings of NYSE-listed stock-1966 554 Letter dated November 2, 1967, re sales charges for monthly investment plan accounts 549 Memorandum dated September 15, 1967, institutional activity, second quarter 1967 551 Memorandum dated October 9, 1967, NYSE large block transac- tions (10,000 shares or more), 3d quarter 1967 555 North American Securities Administrators Association, Inc., letter from Frank J. Daley, secretary 836 Peet, H. 0., & Co., letter from Robert E. Gun~ 836 Pooled Funds, Inc., Norman Abraham, president, statement 794 Pope, Richard L., San Jose, Calif., letter 840 Quinby & Co., Inc.: Answers to frequent questions about The Quinby Plan 224 Biographical sketch of H. Dean Quinby, Jr 223 * Employee roster 223 Status of lapse ratio 219 Schwartz, Donald E., associate professor of law, Georgetown Univer- sity, statement 816 Securities and Exchange Commission: "A regulator's look at quick profit fever-some disquieting reac- tions," an address by Hugh F. Owens, Commissioner, SEC.. - - 740 PAGENO="0007" VII Additional material submitted for the record by-Continued Securities and Exchange Commission-Continued After-tax earnhigs as a percentage of stockholders equity of the Page 25 largest banks, 1966 683 After-tax earnings as a percentage of stockholders equity of the 25 largest stock life insurance companies, 1966 684 After-tax earnings as a percentage of stockholders equity of cer- tain management companies, 1966 684 Broad Street Group: A case study of economies of scale in mutual fund management 686 Comparison of breakpoint in fees paid to advisers with break- points in fees paid to subadvisers of registered investment com- panies whose investment advisers have entered into subadvi- sory agreements with unaffiliated subadvisers (table) 138 Comparison of fees paid to adviser and subadviser of registered investment companies whose investment advisers have entered into subadvisory agreements with unaffihiated subadvisers (table) 137 Exhibit 3-Private Noninsured Pension Funds, 1966 159 Exhibit 3a-Stock Transactions of Financial Institutions, Second Quarter, 1967 165 Exhibit 3b-Stock Transactions of Financial Institutions, 196&. -- 168 Exhibit 4-Correspondence to Chairman Staggers and Congress- man Moss concerning speculative activity in the securities markets 176 Income expenses and profits before Federal income taxes of mutual fund advisory organizations for their fiscal year ended 1966 - - 683 Letter dated October 24, 1967, with an editorial attached, entitled "Support the SEC Mutual Fund Recommendations" by John K. Kyle, editor, Blue Sky News 709 Letter dated November 6, 1967, with enclosures 760 Item 1-showing net assets, total expenses and advisory fees, and fee rates and expense ratios for all active mutual funds which had reported a full year's operations on June 30, 1967 760 Item 2-showing the basic management fee rate, and each level at which that rate is reduced, for mutual funds registered with the Commission 765 Item 3-Commission's June 30, 1967, index of active registered investment advisers, principal underwriters, sponsors and underlying companies (may be found in committee's files). Item 4-showing the income, expenses, and profits of 13 publicly held advisory organizations 775 Item 5-showing the sales loads, and breakpoints for quantity purchases, of mutual fund shares 776 Item 6-showing sales and redemptions of mutual fund shares by size of fund for the 16 months ended September 30, 1967 778 Letter dated November 7, 1967, in response to questions sub- mitted by Chairman Moss 723 Letter dated November 7, 1967, in response to questions submitted by Congressman Hastings Keith 748 Monthly investment plans-the costs and how they compare to contractual plans and voluntary plans 198 Mutual fund investment results compared to the results achieved from~ investments in the common stocks favored by small investors 204 Statements: No. 1 (long) 26 No. 2 (short) 96 Supplementary 691 Stuckey, Hon. W. S., Jr.: Correspondence between Senator John Sparkman and various investment institutions 339 Waddell & Reed, letter from George D. Cleland, Jr., division manager_ 838 Wallich, Henry C., letter dated October 27, 1967, in response to questions submitted by Chairman Moss and information requested by Congressman Watkins re 5-percent sales charge 603 Watkins, Arthur M., Piermont, N.Y., letter 841 PAGENO="0008" PAGENO="0009" INVESTMENT COMPANY ACT AMENDMENTS OF 1967 MONDAY, OCTOBER 16, 1967 HO1J5E OF REPRESENTATIVES, SuBcoMMIrrsE ON COMMERCE AND FINANCE, C0MMIrrEE ON INTERSTATE AND FOREIGN CoM1~n~RcE, Wa8hington, D.C. The subcommittee met at 10 a.m., pursuant to notice, in room 2322, Rayburn House Office Building, Hon. John E. Moss (chairman of the subcommittee) presiding. Mr. Moss. The committee will be in order. We are resuming our hearings this morning on H.R. 9511. We have as our first witnesses the Association o~f Mutual Fund Plan Sponsors, Inc.: Mr. John H. Kostmayer, the coordinator; Mr. J. Edward Day; Mr. Cornelius Roach, chairman; and Mr. Rowland A. Robbins, presi- dent. Will you gentlemen take your seats. You may proceed, Mr. Roach. I wonder if you would introduce, so that each member of the committee- STATEMENTS OP CORNELIUS ROACH, CHAIRMJ~N 01? THE BOARD, ASSOCIATION OP MUTUAL FUND PLAN SPONSORS, INC.; ROW- LAND A. ROBBINS, PRESIDENT; JOHN H. KOSTMAYER, COORDI- NATOR OP LEGISLATIVE EFFORTS; AND J. EDWARD DAY, COUNSEL Mr. ROACH. Mr. Chairman and members of the subcommittee, on my right is Mr. Robbins, who is the president of the Association of Mutual Fund Plan Sponsors. Immediately to my left is Mr. John Kostmayer, who has been coordinator of the legislative efforts on behalf of the association. He is also vice president of First Investors Corporation, a sponsor of contractual plans, and Mr. Edward Day, former Postmaster General, who is appearing here as an expert wit- ness in behalf of the association. I am Cornelius Roach. I am vice president and general counsel of Waddell & Reed, Inc., national distributors of the United Funds group of mutual funds and sponsors of contractual plans for the accumulation of shares of certain of those funds. I have been continu- ously engaged in the mutual fund business for 16 years. I am also chairman o~ the board of the Association of Mutual Fund Plan Spon- sors, Inc. I have already introduced those who are with me today. The Association of Mutual Fund Plan Sponsors is an organization whose members conduct approximately 70 percent of the hu~iness in contractual plans. At the end of 1966, there were 48 sponsors offering the shares of some 65 mutual funds through contractual plans. It is (423) PAGENO="0010" 424 estimated that over 25 percent of the nearly 4 million persons owning mutual funds at the end of 1961 owned contractual plans. These plans called for aggregate payments of $8,556,500,000, of which $4,022,500,- 000 had been paid. Our statistics indicate that since passage of the Investment Company Act in 1940, something in excess of 2 million contractual plans have been sold in this country and that 82 percent of those plans made profits for their investors while simultaneously accomplishing their primary objective as well; namely, putting aside savings amounting to billions of dollars which those investors would otherwise have spent as disposable income. It is this business that the SEC has asked the Congress to destroy. I use that term advisedly; it is not merely an exaggeration of a com- plaint about some minor increase in restrictions. Furthermore, the SEC has asked that you do this without showing the existence of any serious complaints or dissatisfaction on the part of the investing public. As you have been informed, the contractual plan is an arrangement for investment in the shares of a mutual fund by the periodic payment of small sums of money over a term of years. Tn accordance with the provisions of the Investment Company Act of 1940, up to 50 percent of the first 12 payments may be deducted for sales charges. This is the so-called front-efid load. The balance of the sales charges is spread over the remainder of the term. In the aggregate, sales charges upon completion of a plan are not higher than the usual sales charges on the shares of the underlying fund. The SEC asks that you prohibit the future sale of plans with a front-end, load by repealing the section of the Investment Company Act-section 27(a) (2)-upon which the contractual plan is based. That means a complete prohibition of the sale of contractual plans and the consequent destpiction of our business. You can understand, therefore, why we consider it most important that this committee be fully informed about our business and about this proposal and about its effect upon us and the securities business generally; and we are most grateful for this opportunity to furnish this information and to present our view. We appreciate that your time is limited and we intend not unduly to tax your patience. We have nine prepared statements with exhibits, on various facets of the proposal before you,,which I should now like to submit for the record of these proceedings. Mr. Moss. Without objection the statements will be received for the committee files at the present time until they have been fully re- viewed. (The statement and exhibits referred to may be found in the committee files.) Mr. RoAoll. Thank you, sir. In addition, Mr. Kostmayer and Mr. Day will deliver oral statements. You will find copies of these oral statements on top of the envelopes which have been supplied. With your permission, Mr. Chairman, I should now like to call upon Mr. Kostmayer. STATEMENT OP JOHN H. KOSTHAYER Mr. KOSTMAThR. Mr. Chairman and members of the subcommittee, my name is John H. Kostmayer. I am a vice president of First In- vestors Corp., a member of the Association of Mutual Fund Plan Sponsors, Inc., and one of the largest and oldest firms in the contractual PAGENO="0011" 425 plan business, and a member of the Association of Mutual Plan Fund Sponsors. During the past year I have also acted as coordinator of the efforts of the association in connection with the legislation which was proposed by the Securities and Exchange Commission. I come before you today to tell you why we believe that the SEC recommendation to abolish the front-end load, and with it the con- tractual plan, should be rejected. The contractual plan, which evolved in the early 1930's, represents a method of offering mutual fund shares to investors of moderate means who are interested in investing relatively small sums of money on a regular basis. To meet the heavy costs of offering and adminis- tering these plans out of the relatively small sums of money invested periodically and to compensate the salesman for the very considerable amount of time he spends in explaining and selling the plan, sponsors of contractual plans borrowed the sales charge structure generally applied to investment type life insurance; namely, the front-end load. It should be noted that even with the front-end load, most plan spon- sors still lose money on a plan during its first year. The expense of front-end costs was recognized back in 1940 by the Congress that adopted the Investment Company Act. The report of the Senate Committee on Banking and Currency with respect to that act stated that the provision for the 50-percent-front-end load was made in recognition of the heavier initial expense incurred by sponsors in the sale of contractual plans. Contractual plans are a very attractive investment program for a number of reasons. They provide a definite investment goal of a fixed amount; for example, $2,000, $3,000, or $5,000. They can be started for as little as $20 and continued with payments of as little as $10 each month, while purchases of mutual fund shares pursuant to so- called voluntary or level load plans usually require much larger pay- ments. The contractual plan investor can reinvest his capital gains dividends and ordinary income dividends without additional sales charges, while many so-called voluntary plans only permit capital gains dividends to be reinvested without sales charges, but impose a sales charge on reinvestment of ordinary income dividends. Contractual plans provide flexibility in that payments may be made on schedule, accelerated, or postponed, all without penalty. Mr. KEITH. Excuse me, Mr. Chairman. Mr. Moss. Mr. Keith. Mr. KEITH, Is it invariably true that the contractual plan investor can reinvest his capital gains without additional sales charge? Mr. KOSTMAYER. Invariably, Mr. Keith. Mr. KEITH. Is it a matter of law? Mr. KOSTMAYER. I would like to ask Mr. Roach. Mr. ROACH. It is a matter of mechanics, sir. In the periodic invest- ment plan it is a very formal plan, and it simply in its very nature includes the right and does include the right to invest both capital gains dividends and distributions. There is no provision for a payout in the nature of the plan, you see. There is nothing to be paid to the investor. It is all to be reinvested. That is the nature of the plan. Mr. KEITH. But is it not within the realm of possibility, as is the case with many of the voluntary plans, there could be a varying policy. PAGENO="0012" 426 Dreyfus, we found on examination the other day, does not charge for the reinvestment of dividends and capital gains, whereas Eaton & Howard funds do. Now if you were required to lower your commissions on the front- end load, could you not seek additional income by charging for the reinvestment of the capital gains or the dividend income? Mr. KOSTMAYER. Mr. Keith, our counsel informs us that he is under the impression that the SEC has ruled that it would be inconsistent with the 1940 act not to reinvest the income dividends without charge. Mr. KEITH. So it is a matter of rule. Mr. KOSTMAYER. Apparently. Mr. KEITH. Rather than a matter of law. Mr. KOSTMAYER. Apparently. Mr. KEITH. And the SEC has not suggested changing that rule if they do away with the front-end load or reduce the front-end load, but it would seem that that is an opportunity for obtaining additional compensation from the contractual plan buyer out of dividend and capital gains reinvestments in later years. Mr. KOSTMAYER. Mr. Keith, I think that the SEC's position has been, and very strongly held position, that it is completely and totally opposed to taking any sales charges out of reinvested income. Mr. KEITH. They may have that position with reference to the contractual plans, `but they do not have that position with reference to the other plans. Mr. IcOSTMAYER. They don't stipulate, but I think they advocate. Mr. KEITH. If they do, they are not enforcing it. Mr. KOSTMAYER. I don't think they have any legal right to enforce it,' but I think this would be their choice. I think this is their expressed preference. There has been an attack on reinvesting dividends with a sales charge, by the SEC, on shares in voluntray plans. Mr. KEITH. It was revealed here last Friday that there was a split on this in the ~roluntary plans-were you here last Friday? Mr. KOSTMAYER. Right. Mr. KEITH. `Do you not recall the discussion? Mr. KOSTMAYEE. I had left before this discussion took place last Friday. Mr. KEITH. We had some discussion about this, and Eaton & Howard's representative said that they levied a sales charge on rein- vestment and gave it to the agent or the salesman that initially handled the account, if he was still in the business, or if not they gave it to other salesmen, and the thing that prompted it in my mind at that time was I had in the morning ridden down with a man who was delighted with his plan, but he resented the fact that he had to name a broker for the investment of this dividend income, and he felt that when he purchased the plan, he was going to get the additional investment without any sales charge. I ani sure that he was not so advised, but that was his recollection some years later. It just is an interesting thing that the typical fund plan other than contractual, I believe levy a sales charge, but you have once again the competition. Dreyfus with a half of one percent investment company fee does not charge for the reinvestment of dividends, whereas others with a lower fee do charge. PAGENO="0013" 427 Mr. KOSTMAYER. Our thesis, Mr. Keith, that I want to develop here, is that our problem is with the front-end load and the necessity to com- pensate the salesman at the beginning, which compensation based on reinvestment of dividends would not in fact accomplish, but this is certainly something that we can look into. Mr. KEITH. But if you are trying to build a career sales force, which you might have to resort to if the SEC has its way, and if you could, perhaps as life insurance companies do, hire people on a salary to start them out and keep them in the field, and recapture it from the charges against the reinvestment of dividend income or capital gains; you might have some plus factor there. Mr. KOSTMAYER. It certainly would be some plus factor. Mr. KEITH. Thank you, Mr. Chairman. Mr. Moss. You may proceed. Mr. KOSTMAYER. Thank you. All without penalty, and do not lapse in the sense that a life insi~irance contract may lapse. The underlying shares are redeemable at full value on any market day. In addition, the planholder has the valuable right to withdraw up to 90 percent of the then current liquidation value of the mutual fund shares held under his plan, and later to reinvest an equivalent amount without paying any sales charge at all. Finally, and, most significantly, in my experience, the front-end load by itself is a very positive feature of the qontractual plan. The sales charge and cost structure and the fact that early liquidation of a plan will probably result in a loss is explained by the salesman to the investor and is clearly and prominently disclosed in the prospectus which all prospective planholders receive, and they are required by sponsors to acknowledge this receipt in writing. The penalty feature of the front-end load encourages the investor to continue his payments and to save and invest systematically. In my opinion the elimination or substantial modification of the load might well discourage investment persistency, thus destroying the contractual's utility to the investor. The tremendous popularity of the contractual plan is evidenced by the fact that over 25 percent of the nearly 4 million mutual fund shareholders at the end of 1966 were holders of contractual plans. This is no surprise, in view of the unique benefits the contractual plan offers and the highly profitable results which have been achieved for the large majority of investors. These results are set forth in detail in the statement of Mr. Rowland A. Robbins which Mr. Roach has filed with you. Permit me to refer you to a pamphlet entitled "The Origin and l~Iistory of the Contractual Plan," published by our association and prepared under the direction of our former chairman and counsel, the late James M. Landis, who had been Chairman of the Securities and Exchange Commission and dean of the Harvard Law School, and the 1966 supplement to that pamphlet, both of which were also filed with you by Mr. Roach. I now also offer for your files the 1967 supplement to that pamphlet, which has just been prepared and which contains more recent and compre- hensive data. (The supplement referred to may be found in the committee files.) The several statistical studies in the 1967 supplement demonstrate beyond question that by far the largest percentage of in~vestors in con- tractual plans have realized very substantial profits prom their in- PAGENO="0014" 428 vestments-even though they did not all complete their payments or complete them on time. On the other hand, only a very small percent- age have liquidated their plans with losses, and those losses are in- finitesimal in relation to the profits realized by those who have really taken advantage of the investment vehicle which has been made avail- able to them. Perhaps the most significant indication of this fact appears in the chart on page 9 of the 1967 supplement, which shows the history of every plan started by four different sponsors in 1951 or 1953. The study shows that, at December 31, 1966, of the almost 17,000 accounts involved, over 82 percent were either still open or had been liquidated with a gain, and that the profit realized by this 82 percent, who had invested $39.8 million, amounted to almost $33 million. The less than 18 percent of the accounts which `had liquidated at `a loss incurred aggregate losses of $240,000. The losses of all planholders were, there- fore, less than 1 percent of the payments made, while the profits, realized and unrealized, were over 80 percent of the payments made. Despite these impressive end results, which should be the criteria by which to measure the merits of an investment vehicle, the SEC per- sists in its position that the contractual plan be abolished. It has attempted to minimize the significance of the profit results `by pointing to the fact that a study as of the end of 1968 of the same 17,000 accounts which I just referred to showed that from 25 percent to over 40 percent of the planholders of the four plan sponsors had not pro- gressed in their payments beyond those called for through the third year of their plans. This is true, but the SEC does not report the fact that of this group w'ho, as of the end of 196~, had not progressed beyond the payments called for through the first 3 years of their plans, almost 55 percent had realized or unrealized gains of over $1 million, and the remainder of 45 percent who terminated with losses had losses of $160,000. Incidentally, several companies have initiated followup procedures to reactivate `accounts that have stopped making `payments. In my own company the reactivation figure has reached approximately 70 percent. Further experience `should reduce this problem to nominal proportions. The SEC a:sks tha't you prohibit the front-end load. This would mean denying to a significant segment' of' the investing public the unique benefits afforded by the contractual, plan. The people who make up this market segment are investors of moderate means who would not have the opportunity to invest in equity securities unless the bene- fits of such investments were described to them by salesmen and who would not otherwise invest on a monthly or other periodic basis the relatively small sums of money that they have available for investment. The SEC suggests that this is not so, because so-called voluntary or level load plans offer everythihg that contractual plans do and they are preferable because they do not involve the payment by the investor of a front-end load. Nothing could be further from the facts. Anybody familiar with our business will attest to the fact that m.ost voluntary plans, unlike contractual plans, are not true accumulation plans. The reason is simple. A salesman, because `of the very small com- missions he would receive on the sale of most voluntary plans, will'not seek out this'type of investor. For example, on the sale of a $25-per- month voluntary plan, a salesman receives a little over $1 as his share PAGENO="0015" 429 of the commissions on the first, and every other, $25 payment made. This just isn't enough incetttive to encourage a salesman to seek out these investors. Most voluntary plans are opened when a salesman seeks out a customer who can make a substantial purchase of shares. If the salesman succeeds in making a substantial sale.of shares, he may also offer the voluntary plan for share accumulation accounts as an additional service-as a convenient open account, or even as a plan program for future accumulation. Sometimes, he is disa;ppointed in an effort to make a substantial cash sale and will end up by selling only a voluntary plan. The contractual plan salesman, on the other hand, is willing to devote his time and effort to explaining his offering and its advantages to a responsible citizen who has a reasonably established income, and who may be convinced that it is to his advantage to use some of it to accumulate future capital. The fact that the contractual plan sales- man devotes his time and effort to this end is demonstrated by the SEC report itself, which states that the average sale of a contractual plan requires three visits and the expenditure of a total of 3 to 4 hours by the salesman. Clearly, the investor who requires 3 to 4 hours of educa- tional effort is not the one who walks into a brokerage house office and says that it occurs to him that he needs a monthly investment plan with diversification and professional management, and one that offers him a hedge against inflation. Where the contractual plan is not available, however, most of these people are never approached by a salesman and never have the oppor- tunity to accumulate capital through periodic investment in American business. Nor does the voluntary plan offer the same stimulus to systematic investing which is created by the front-end load feature of the con- tractual plan. This point was raised by representatives of the Associa- tion of Mutual Fund Plan Sponsors with the SEC staff in August of 1963 when the "Report of the Special Study of Securities Markets" was released. Association representatives then suggested that the SEC staff make a study of voluntary plans to see whether they could estab- lish the extent of persistency of payments in voluntary plans as con- trasted with contractuals. This is something that was not done. This is something they did not do, but we have assembled sufficient figures to establish beyond question that contractual plans are much more effective in encouraging people systematically to save and invest than are voluntary plans. For example, in the case of one mutual fund in a 3-year period studied, there were an average of 7.9 payments per year per account on contractual plans, as against an average of eight-tenths of one pay- ment per account on the voluntaries; that is in the same fund. And in the ease of another mutual fund in the same 3-year period, the dis- cre$ncy was still greater-an average of eight payments on con- tractuals, as against an average of seven-tenths of one payment on voluntaries. There are additional studies to a similar effect with which I will not burden you in my oral presentation. If I might digress for just a moment again, the message is clear, I think. Modification of the front-end load will reduce the stimulus to regular investing at great harm to investors. PAGENO="0016" 430 In the SEC report, at the hearings before the Senate Committee on Banking and Currency, and again before this committee, the SEC has reiterated a cliche which it has propounded before-namely, that contractual plans are an unimportant vehicle for the purchase of mu- tual funds because in California, which does not permit the sale of contractual plans, more mutual fund shares are sold per capita than in any other State. The latter fact is undoubtedly true; however, the conclusion which the SEC seeks to draw from it is not. The contractual plan is worthwhile because it is the only effective way by which mutual fund shares can be offered to investors of modest means who have not yet accumulated equity capital to date. In the absence of this plan, such persons are simply not given the opportunity to invest in equities, and that must be true of many thousands of Californians. The citizens of California are avid purchasers of mutual funds. The reasons are understandable. We know, for instance, that the pop- ulation in California includes a much larger percentage of persons who are either retired or ojherwise have accumulated substantial amounts of capital which they are prepared to invest and need not rely upon current income for their investment capitaL The manager of the California region of Mr. Roach's company, Waddell & Reed, Inc., a large mutual fund organization which also acts as a sponsor of contractual plans, estimates that approximately 75 percent of the mutual fund shares sold under his jurisdiction in that State are s~ld to retired people. Then, too, we know that the mutual fund idea in general has been much more widely accepted for a longer period by California securities dealers and salesmen than by those in almost any other State of the country-notably in some parts of the East where many large investment houses delayed, and in some cases still delay for years in perceiving the advantages of mutual fund investment for their customers. In addition, there is one mutual fund, Insurance Se- curities, Inc., in California which accounts for a substantial volume of mutual fund sales in that State, but in a very special form of sales medium. Finally, I understand from reliable sources that because of the closing of the Eastern securities markets in California-this would be at 12 :30 because of the fact that the New York Stock Exchange closes at 3 :30-salesmen have a much larger part of their active day to devote to the mutual fund shares than in most other time zones. As a final comment on the SEC California argument, I would like to give yoh some statistics which the SEC fails to provide in conjunc- tion with the California statistics. During 1966, sales of mutual funds on a per capita `basis in Illinois, Wisconsin, and Ohio-the only other States in which contractual plans could not be sold-were significantly below the national average of $23.08 per capita. In Illinois, they were $18.23; in Wisconsin, $16.59; and in Ohio, which incidentally now per- mits the sale of contractual plans, only $15.17. rfhese figures, I think, show that no conclusions at all with respect to contractual plans can be drawn from the California experience, except that their prohibition was not the cause of the results which the SEC describes. Another basis upon which the SEC seeks to persuade the Congress to abolish the front-end load is that contractual plans are sold to un- educated or disadvantaged segments of the population who are par- PAGENO="0017" 431 ticularly vulnerable to alleged "high pressure" selling. The facts show, however, that this is not the case at all. A nationwide survey was con- ducted by Benson & Benson, Inc., of Princeton, N.J., for Invest- ment Company Institute which provides a profile of the contractual plan investor. The survey showed that the median contractual plan- holder is 43 years old; is a high school graduate or better; is engaged in a profession, or as an executive, or in a skilled or semiskilled ca- pacity; owns a home worth $17,000; carries $13,000 of life insurance; holds cash and savings bonds and securities aggregating $4,500; and has a family income of $11,000 per year. The survey shows conclusively that the contractual planholder has two outstanding characteristics which distinguish him from other mu- tual fund shareholders. Ohe of these is that he is not seeking to invest accumulated capital; instead, he is seeking to accumulate capital by the allocation of current income to an investment medium-in this case, equity securities, which provide him not only the prospect of com- pound accumulation, but also a hedge against inflation and deprecia- tion of the value of the dollar. The other characteristic is that in the majority of instances the contractual planholder is not generally ac- customed to investing in securities; he does not have a brokerage ac- count and would not be likely to do so had he not been sought out by a salesman, and had the advantages of equity investing explained to him. The SEC's statement that 3 to 4 hours per sale are required support this thesis. That contractual plans are sold on an honest and forthright basis should be readily apparent from the fact that from 1940 to the end of January of this year, of a total of 3,656 complaints with respect to se- curities matters received by the National Association of Securities Dealers, only two pertained to contractual plans. The SEC would have you believe to the contrary by its constant allegations, including those mad.e at these hearings, that the front-end load induces "high pressure" selling, although it has failed to substantiate this claim with any evidence at all. Despite the fact that, as the statistics referred to above show, the losses incurred by planholders who terminate their plans in the early years are very small in comparison to the profits realized by or ac- crued to the large majority of planholders, the industry has been con- cerned with methods of preventing losses resulting from early terminations. Although dollar losses may be small, they can still hurt when the cause of the early liquidation of the plan is financial stress, rather than a mere change in investment strategy, and although, as I described earlier, and I think this is important, planholders have the right to withdraw up to 90 percent of the liquidation value of their shares and to reinvest an equivalent amount without additional sales charge at a later date, some planholders in financial stress do not feel they will have such funds available in the future to reinvest and there- fore terminate their plans. The President directed his concern to indi- viduals who suffer financial stress in his special message on consumer protection delivered earlier this year when he said of investors of modest means in contractual plans: They may face a substantial loss if financial difficulties force them to withdraw from the plan at an early date. 85-592-~6&--pt. 2--2 PAGENO="0018" 48~ Before the SEC bill was introduced in Congress, members of the Association of Mutual Fund Plan Sponsors asked Benson & Benson, Inc., of Princeton, N.J., to conduct a survey to determine what propor- tion of planholders who terminated in the early years of a plan at a loss really did so due to financial stress, and how many terminated merely because they chose to put the money to some other use. We asked Prof. Herbert Arkin, chairman of the Statistics Department of the Bernard M. Baruch School of Business and Public Administration in New York, to establish the criteria for this survey before it was undertaken and to analyze it for us afterward. The summary results of this report and analysis are most illumi- nating. They show that only some 45 percent of those Who liquidated early at a loss can properly be included among those who were forced to terminate because of `financial circumstances. As Professor Arkin calculates it in the sample in this particular survey, this amounted to only some ~½ to 5 percent of all contractual planholders who initiated plans within the `period studied. The next paragraph shows that in `a different survey group the figure came to 8 percent. The industry has recognized that measures should be taken to mini- mize early plan terminations and consequent losses, but the SEC's proposal to abolish contractual plans, with the consequent denial to millions of people of the benefits of such plans, is certainly no remedy at all. The remedy is to be found in the `screening of prospective plan- holders in order to be sure that purchasers of contractual plans under- stand, and are c'apable of achieving, the discipline required during the early years to keep up their payments. The remedy is to be found in devising methods of promoting persistency and of reducing the num- bers of those forced to redeem in the early years. Members of the in- dustry have instituted programs along these lines which I would like to describe briefly to you. Each member of this Association of Mutual Fund Plan Sponsors insists that every applicant for a contractual plan answer a series of questions designed to determine for himself whether the contractual plan is in fact a suitable investment medium to meet hi's financial and personal circumstances and whether, in view of his other commitments, he considers himself able to meet `the schedule of payments he under- takes to make. The investor confirms in writing his understanding that he will incur a loss if he discontinues his plan in the early stages at certain times and under certain circumstances, and `that he must take into account his financial ability to continue his plan through periods of low price levels. Each member of this association gives the plan purchaser an absolute right, within 30 days after the acceptance of his application, to cancel the transaction and obtain a refund of the entire amount of his initial payment. Thi's right is made clear in a letter sent by the sponsor com- pany to every plan purchaser something that you will not find in any other part of the financial world. Some companies go further and provide that if an investor does not make his second payment within 60 days after its due date, he will be given another opportunity to terminate his plan and obtain a re- fund of the entire sales charge he has paid. I referred earlier to the fact that under a plan instituted by one plan sponsor, First Investors, 69 percent, almost 70 percent of a group PAGENO="0019" 433 of First Investor's plan holders who had become "inactive"-that is fallen behind in their payments-were reactivated by a follow-up technique employing a series of five letters. Interestingly enough, the average payment made by these plan holders on reactivation was al- most twice the regular monthly payment under the plan. The industry has achieved a great deal by the measures outlined above and should be given the opportunity to do more. We are confident that any problems in the industry can be solved by regulation, and we have always been eager and willing to cooperate in this endeavor. Against the background of the facts I have described to you, I must say to you in all sincerity, and with the deepest respect for the integ- rity of the agencies of our Government, that the SEC proposal repre- sents a complete abdication of its regulatory responsibility. It offers a drastic and simplistic solution for the task of effectual regulation which is the function and the obligation of the Commission. More than 3 years ago, following the publication of the report of its special study which was transmitted to the Congress by the SEC, we filed with the Commission this extensive statement of our position, our problems, our measures for solving them, and the character and merits of our product and our performance. We concluded that presentation by this open invitation to the SEC: We do not believe- And we mean that we do not believe- that our business is perfect. We are not so deluded as to think that it is beyond improvement. We ar~ quite willing to diSCUsS with the Commission any reason- able suggestions for improvement of our methods and operations. We have been prepared, and we are still prepared, to cooperate sin- cerely and earnestly with the Commission in solving any regulatory problems that it think may exist. That presupposes, of course, that our business itself will continue to exist; and I am confident in that sup- position because I am satisfied that the SEC has given you no sound reason to conclude that it should be destroyed. Finally, let me conclude with an observation concerning the market- ing of services, particularly financial services. It is axiomatic that in this and in every business and in every enterprise that higher compen- sation is one requisite for attracting and holding higher caliber per- sonnel. In our business, this axiom is the key to better public service. The SEC has proposed a unique concept; namely, that we upgrade our sales force, the people to do the job on the firing line, by the device of reducing their compensation. Thank you. Mr. Moss. Mr. Day. STATEMENT OP r. EDWARD DAY Mr. DAY. Mr. Chairman and gentlemen, I appear here today as an expert witness retained by the Association of Mutual Fund Plan sponsors to support their opposition to H.R. 9510 and H.R. 9511 and particularly their opposition to the proposed abolition of the so-called front-end load. My remarks will be devoted principally to the close analogy of the contractual plan sales and sales compensation pattern to the long- PAGENO="0020" 434 established, highly uccessful commission system for merchandising life insurance. First, let me summarize my professional qualifications to discuss this life insurance aspect. From 1950 to 1953 I served as insurance commissioner of Illinois in the cabinet of then Gov. Adiai Stevenson. During that time I was elected vice chairman of the Life Insurance Committee of the National Association of Insurance Commissioners and a]so served as chairman of that association's midwestern zone. Following my term as insurance commissioner of Illinois, I became a senior officer of Prudential Insurance Co. of America, one of the two largest life insurance companies in the world, first, for 4 years, as one of the top members of their law department and thereafter, for an- other 4 years, as senior vice president in charge of the 13-State western region. In the former capacity I was active in working out methods for issuance of variable annuities by life insurance companies. In the lat- ter capacity my responsibilities included direction of life insurance sales with supervision of over 4,000 life insurance agents. I have written a number of published articles on life insurance sub- jects, and am a member of the board of directors of several insurance companies. I am frequently called on to make speeches to insurance industry groups on recognition and motivation of life insurance agents. THE FRONT-END LOAD The front-end load used by mutual fund contractual plans typically involves deducting 50 percent of the first year's payments for sales load. On a 10-year, 120-payment, $25 per month plan, which is a very common dollar amount for contractual plans, the 50-percent front-end load would typically equal $150. Under the law, if a 50-percent front-end load is used for the first year, then the sales charge deducted in each subsequent year, for a 10-U year plan, for instance, cannot exceed 4.45 percent per year. The ef- fect of the lower loads in subsequent years is that the investor who is in the plan the full 10 years ultimately pays approximately the same total sales load be would have paid had he invested directly in the underlying mutual fund shares with no front-end load. It is important to realize that only about half of the total front-end load-one-half of $150-or $75-in the $25 a month plan I referred to-goes to the salesman who actually talks to the customer and makes the sale. The balance is used for other expense, such as recruiting,' training, and supervision of sales personnel, advertising, home office overhead and profit. The mutual fund contractual plan salesman thus earns about 25 per- cent of the first year's payments, in contrast to the 55 percent which, as I will describe, is typically earned in the first year as a minimum by the life insurance agent on the sale of an ordinary whole-life policy. This 55 percent is, again, only about half the total first year sales cx- pense on a whole-life policy, the balance being used for incentive com- pensation of the field manager or general agent and for other first year field and home office sales expense. PAGENO="0021" ,43~ THE IMPORTANCE OF SALESMEN Before I pursue the significance of the analogy to life insurance, let me state certain fundamental points of personal conviction: 1. Certain worthwhile products, particularly in the area of finan- cial protection, do not sell themselves. 2. The pUblic is better off, in the long run, by having these worth- while products sold to them. 3. The salesman plays a valuable role in our present-day society. 4. People who are doing the selling must be adequately compen- sated. 5. The more nearly adequate the compensation of the salesman, the better the chance that people of high quality will be attracted to the job and that the salesman will acquire the training, give the time, and practice the fairplay required for the most conscientious approach to the prospect. 6. The cost of providing such compensation to the salesman must be paid by the person purchasing the product. 7. The attack by the SEC on the front-end load principle has im- plications far beyond the mutual fund industry. 8. This attack shows a lack of appreciation of and, as a result, un- justified stultification of the whole system of providing incentive com- pensation to salesmen. 9. The analogy between selling methods for life insurance and for investment plans is more valid today than ever because, in response to public demand, there is an increasing tendency to blend these two types of products. 10. There is social value in structuring any type of savings plan so that the saver is discouraged from withdrawing his payments before he completes the program. 11. It takes character on the part of a buyer to put aside some of his income on a regular basis rather than spending it all. This is partic- ularly true where the individual has limited discretionary income and does not find it easy to undertake a savings program on his own initia- tive. Developing and bringing about such a character decision re- quires individual solicitation and service. Selling any capital accurnu- lation plan serves a valuable social purpose not only in improving the individual situaton of the saver but in helping to add to the national reservoir of capital. 12. In this country hundreds of thousands of salesmen share directly in our profit system by selling on an incentive compensation basis. Selling for profit-on a commission or incentive system-is recognized as a challenging and satisfying way of life for independent-minded men who have the courage to take a chance on themselves. Not every- one wants to earn his bread protected by an umbrella of tenure, reg- ular hours, and a safe place on the organization chart. 13. If sothe paternalistic "mama knows best" group could regulate every transaction by which products or services are sold by salesmen working on an incentive basis, such a group could no doubt prove that every such product or service could be bought more cheaply by some other method. Such a group could no doubt also prove that purchasers are fools ever to pay the list price for everything or to do their shop- PAGENO="0022" 436 ping at other `than discount houses. The group could probably prove in addition `that car buyers are being victimized by having to buy automobiles through dealers and that everyone should be able to buy Chevrolets direct from Detroit. 14. The attack on selling commissions in this proposed legislation evidences an attitude which concerns me. When I was Postmaster General, people frequently wrote to me wanting me to' do something to put an end to privately-owned stamp vending machmes in drug- stores, newsstands and airport waiting rooms. I wa's always amazed at these people, many of them stalwart free en'terprisers, who objected to paying 1 or 2 or 3 cents over the face value o'f `the postage stamps on a 10-cent or 25-cent transaction, for the convenience and service of having the `stamps available for them to buy when and where they wanted them. In our supposedly profit-oriented economy there are to'o many people who seem to resent it if someone makes some money- even though the amount earned is reasonable in relation to the service rendered. Over the past hundred years tens o;f millions of Americans have purchased individual life insurance policies. The overwhelming ma- jority of these people or their families have been `better off for the purchase of these policies. Practically none of these policies sold themselves. They were sold by agents-pr, as they prefer to be called, by life underwriters. It is a truism in the life insurance business that a prospect never comes into the office asking to buy a policy. Efforts have been made and are still being made from time to time to merchandise individual life insurance by mail or by newspaper and magazine ads `without a person- to-person confron'tation between salesman and prospect. But these efforts have on the whole been notably unsuccessful. There is a particular situation which illustrates dramatically that the salesman is essential to life insurance merchandising. In three States legislation has given savings banks authority to write life in- surance. These States are New York, Massachusetts, and Connecticut. These savings bank plans are operated without agents on the theory that purchasers will come into the bank `to purchase an individual life insurance policy over the counter. Compared to the new `business written over the years by life in- surance companies using agents, the results achieved by the savings bank plans have been quite limited. The Massachusetts savings bank life insurance plan. for example, was started in 1901T. For the year 1966 this plan, participated in by 36 banks in the State, had only $18.4 million of total premium income from individual policy life insurance in `force despite somewhat lower costs to the purchaser because of the elimination of agents' commis- sions. This compares with a total of over $13 billion of premium in- come from individual life insurance policies for the li~fe insurance industry as a whole in the United States in 1966. The New York plan is more recent, having been started in 1938~ but it has a much larger number of savings banks participating and in 1965 had less than' $19 million of premium income from individual policy life insurance. PAGENO="0023" 437 LOADINGS IN LIFE INSURANCE For the purposes of this statement it is not necessary to go into the details of the varied and complicated arrangements for compensation of agents who sell individual life insurance policies for commercial companies using the agency system. For any life insurance company licensed in New York State the maximum commission which can be paid-and the usual commission which is paid-to the agent on a sale of an individual policy of life insurance is 55 percent of the first year~s premium. This would normally be for a whole life ordinary insurance policy in contrast to a term insurance or endowment policy. For com- panies not licensed in New York the commission paid to the selling agent on an individual whole life insurance policy typically is 65 percent, and sometimes is as much as 80 percent of the first year's premium. This commission to the insurance selling agent is net to that agent There are in addition other direct selling expenses such as incentive overrides to field sales managers and assistant managers or to general agents, advertising and home office sales expense. Total selling expense on a whole life insurance policy sold by a company doing business in New York will customarily run as high as 100 percent of the first year's premium and for companies not doing business in New York will run as high as 120 percent of the first year's premium. It is a familiar fact to any purchaser of life insurance that an in- dividual whole life policy will typically not acquire any cash sur- render or loan value during the first year after lie takes it out and that such cash surrender value will be small in relation to the amount paid in for several years after the original issue of the policy. The cash surender value represents the current savings element of a life insur- ance policy which is available to be withdrawn or borrowed by the policyholder. SIMILARITY BETWEEN WHOLE LIFE INSURANCE POLICIES AND CONTRACTUAL PLANS I do not claim that a contractual plan and a life insurance policy are identical products. I do not claim that they are bought for iden- tical reasons. But I do say that they are both products that do not sell themselves, that in both cases people are better off for having bought them, and that in both cases they will not be bought unless a salesman with a financial incentive goes out and makes the sale. Life insurance policies and mutual funds sold under a contractual plan each have a special feature which makes a purchaser willing to have substantial deductions made from his payments for selling ex- pense. In the case of the life insurance policy, this special factor is~ the death benefit with the possibility of a very high dollar payment to the beneficiary in the event of death, particularly during the early years. In the case of the mutual fund, the special fe~tture is the expert in- vestment management, the diversification of investment, and the chance that the accumulated contributions will increase substantially in mar- ket value. In this connection, it can be noted that in the period from January 1, 1956, to September 30, 1966, with capital gains reinvested and income PAGENO="0024" 438 dividends taken in cash, the net asset value of the average balanced mutual fund increased 94.7 percent and the net asset value of the aver- age growth mutual fund increased 151.3 percent. Thus, there is a remarkable similarity between whole life insurance policies and th~i mutual fund contractual plan. Both are a means of achieving financial protection by systematic savings. It must be recog- nized that the whole life insurance policy does not merely provide death benefits. It also is a method of saving on a regular, periodic basis. If death benefits were the only reason for life insurance and savings were not a significant element, then everyone would have term life in- surance and pay the much lower rates for term insurance. But the fact is that most ordinary life insurance protection provides for the accumulation of the cash value of the policy as the years go by, enables the policyholder to obtain loans from the insurance company, and also provides for payments to the policyholder during his old age. These provisions could not be in the policy unless the policy had some value or equity. Since most policyholders do not die until they reach old age, in the average and typical case a fundamental purpose of a whole life insur- ance policy is, in fact, a planned method of savings. That is a key pur- pose of a whole life insurance policy. It is the objective of the mutual fund contractual plan in which an individual also makes monthly pay- ments for a stipulated period of time. THE UNSOUNDNESS OF THE SEC'S ARGUMENT AGAINST THE LIFE INSURANCE ANALOGY The SEC, in its memorandum commenting on testimony on this leg- islation before the Senate Committee on Banking and Currency, at- tempted to avoid the impact of this life insurance analogy. Under- standably the SEC cannot admit that the analogy is valid for if they did their whole case for trying to destroy contractual plans would collapse. But, with all due respect, I feel that the SEC's attempted rebuttal in * regard to permanent life insurance is inconsistent even on its face. The SEC says that The buyer of a mutual fund contractual plan * * * seeks to save money * * * * * the front-end load does much to defeat the planholder's basic objective: saving and investing. Later on, the SEC rebuttal says that: To keep the premium (on permanent life insurance) from rising as the assured ages, savings must be accumulated from the early premiums. It is obvious then that less goes into such accumulated savings on permanent life insurance as a result of the front-end load on life in- surance sales. Therefore, to paraphrase the SEC, we might say, if we were adopting their point of view: The front-end load on life insurance likewise does much to defeat the pur- chaser's saving objective. The SEC in its rebuttal memorandum completely ignored the fact that there is full disclosure of selling costs in contractual plans and none at all in life insurance. To say that the front-end load, whicl~ the contractual plan purchaser is told all about, defeats the planholder's PAGENO="0025" 439 basic objective, amounts to saying that people are too dumb to be trusted to make their own decision as to an objective even when all the pertinent facts are given to them in writing. That does not strike me as a particularly democratic attitude. I doubt if the public really expects to be led by the hand and mothered every minute by Government particularly when all the perti- nent facts are available to permit them to make a choice. There are other important reasons why the life insurance analogy is valid here and must be dealt with. First, annual premium deferred annuities now sold by life insurance companies are sold with a front-end load of as much as 50 percent. They involve no death benefit. They are merely accumulation plans during the period before annuity payments begin. There are well over a million of these individual annuities in force, not too many less than there are contractual plans. I would like to know how the SEC dis- tinguishes the front-end load on these annuity plans from the front- end load on contractual plans. Second, many mutual fund contractual plans are sold with comple- tion life insurance. This combination product is, iii effect, a life in- surance endowment policy with cash values invested in common stocks. Third, more and more of the leading life insurance companies are moving into the selling of variable annuities, which are life insurance company annuities backed by investments in common stocks. Many of these variable annuities are offered under a front-end load plan. The decision by many of `the companies in the life insurance industry to move into selling common stock investment plan's confirms and rec- ognizes the public's interest in and demand for contractual plans such as `we are talking about here. Fourth, many experts feel it will not be long before life insurance companies generally will be selling variable life insurance with the death benefit and cash values varying to reflect' investment results of investments in common stocks. Granted, the primary motivation for purchasing life insurance might very well be support for dependents. However, that objective can be met by the purchase of terni life in- surance which provides pure insurance protection with no savings element. The fact is that the cost of providing the pure death benefit on a year-to-year basis-that is, the mortalIty cost-in a life insurance policy is remarkably low-far lower than most people realize. For a whole life policy issued to a man age 40 at standard rates by a typical large life insurance company, this pure mortality cost-entirely aside from loadings, expenses, taxes, and profit-is only $1.20 per $1,000 of life insurance coverage in the first policy year. For this policy the mortality cost is only $4.40 per $1,000 of coverage in the 10th policy year when the man is age 50. The premium for `this policy is $20 per $1,000 of coverage each year. Since there is no cash value at the end of the first year, 94 percent of the gross premium is available for expenses, including commissions, and for taxes and profit. Actually, more than this 94 percent of the gross premium on the policy involved is typieally used, even by conservative life insurance companies, for first-year expense. To meet total first year expense, which w ill often be over 100 percent of the first y ar premium, the company, in effect, borrows more money PAGENO="0026" 440 from its surplus or from the pooi of funds built up by older policies. As a result, and because of the lapse factor, a life insurance company often will not recoup its investment in a new policy for periods rang- ing from 6 to 12 years. Most of this first-year expense is selling expense. The reason I em- phasize the willingness of even the most conservative life insurance companies to invest so much in selling expense is to show that in the life insurance business the front~end load principle is universally ac- cepted as essential. In addition, the low proportion of the first-year life insurance load- ing which is made up of the mortality cost proves that the `SEC h~s by no means succeeded in dismissing the contractual plan-mutual fund analogy when it says the purchasers of life insurance "immediately receive the full measure of the contemplated death protection." The portion of the early year premiums that go to providing that death protection under whole life policies is very small indeed. The SEC's report on investment company growth attempts to dis-~ tinguish the life insurance analogy by arguing that while there is a very large difference in the compensation of the salesman as between `a contractual plan and a voluntary plan, there are only very moderate differences in commission to the life insurance salesmen depending on the type of policy he `sells. The report premises this argument on the unsubstantialted theory that customers for life insurance decide to spend a certain annual amount on premium rather than being inter- ested in a given face amount of coverage. The fact is that for a $10,000 policy to a standard risk age 40, the agent's first year commission will, for a typical New York-licensed company, be $29 if the policy is a 10-year term, $126 if it is whole life, and $195 if it is a 10-year endowment. It borders on the ridiculous for the SEC report to say (p. 246) that "the front-end load effectively precludes many dealers and their sales- men from giving adequate sales presentations of level load accumula- tion plans to persons of modest means." This is like saying that the substantial first year commissions paid by New York Life Insurance Co. precludes their agents from giving to prospects adequate sales presentations of savings bank life insurance plans under which no commissions at all are payable. Just who would be compensating these mutual fund and life insur- ance salesmen for telling prospects about alternative plans which pro- vide no margin or negligible margin for compensation of the salesman? Does the SEC claim that prestige department stores should pay their salesmen to tell the customers they could get most' items cheaper at Sears Roebuck? ADEQUATE COMPENSATION FOR SALESMEN The SEC report never faces up to the question of adequacy of com- pensation for salesmen. It is the position of the contractual plan in- dustry that the front-end load is the only means by which adequate sales compensation can be achieved for contractual plans. The SEC does not deny this. It does not present an alternative method for pro- viding adequate compensation. PAGENO="0027" 441 The SEC acknowledges that high turnover rates among salesmen are chronic in the securities industry generally and "particularly acute for the large contractual plan sales organization." It is also recognized that about two-thirds of the contractual plan salesmen earn less than $1,000 a year in the securities business. A study of the turnover of sales personnel in 1961 revealed that over `40 percent of the sales force were hired and almost as great a per- centage ceased working for the sales organizations during that year. Thus, in view of the high turnover of personnel and the low compen- sation for salesmen, it would seem evident that a substantial reduction of the sales load would only further aggravate the problem. High turnover rates and low compensation have also been prevalent in the life insurance industry, which also utilizes the front-end load principle. This is no doubt due in large part to the fact that selling is `hard work when the selling is other than to customers who come in seeking to buy the product. According to statistics prepared by the Life Insurance Manage- ment Association, ~`5 out of every 100 who enter the business of selling life insurance fail to make it past the first 2 years. The discussion of the compensation problem in life insurance sell- ing has been frank and realistic. Some of the foremost leaders of the life insurance industry have advocated the revision of expense limits in the New York insurance law so that salesmen can be paid more than 55 percent of the first year's premium. One of these top leaders is Leland J. Kalmbach, chairman of the Massachusetts Mutual Life Insurance Co. In a speech in December 1964, when he was serving as chairman of the prestigious life insurance trade association, the Life Insurance Association of America, he said: There has been a steady decrease during recent years in the proportion of new Ordinary [life insurance] business sold by companies operating in the State of New York * * * I might interpolate to point out that if a company is licensed in New York, the commissions it can pay in any State have to be in accordance with the New York limits. Northwestern Mutual, a Wis- consin-domiciled company, since it is licensed in New York State, can only pay the New York permissible limits on insurance it sells in California' or New Mexico. The statement that Mr. Kaimbach made: There has been a steady decrease in the proportion of business sold by corn- panics operating in the State of New York. All of this Suggests that the New York limitations on compensation are having an adverse effect on the rate of growth of the companies subject to those limitations. Other life insurance leaders have been saying the same thing. The New York Association of Life Underwriters has been working diligently to get the New York Legislature to increase the limits on compensation of life insurance salesmen. CONCLUSION Life insurance, like contractuals, has always had its detractors. Every year or so someone comes out with a book that claims that permanent life insurance is overpriced, is a poor buy, and that every- PAGENO="0028" 442 one should "buy term and invest the difference." I have read many of these things. I am f~tmiliar with the arguments of the hecklers, and I have long been familiar with the amount of life insurance loadings, but I have most of my own savings in permanent life insurance. Need- less to say, I have paid the full loadings on all my purchases of hfe insurance. Although I am fairly good most of the time at self-discipline and am not poverty stricken, I am as susceptible as most people to the urge to spend everything that comes in and, therefore, the forced savings aspect of life insurance is of real substance to me. I am utterly sincere when I say, as an individual and not just as an expert witness, that the far-reaching implications of the attack in this proposed legislation on the whole concept of sales commissions concerns me deeply. Let me explain that briefly, Mr. Chairman. You may be wondering why I talk so much about life insurance and what these implications are that I am referring to. In my opinion, if the Congress of the TJnited States takes the posi- tion that the front-end load principle is immoral and indefensible, it has implications far beyond this bill. It strikes at hundreds of thou- sands of salesmen who earn their pay under front-end load plans. A major portion of those salesmen are life insurance men, If Congress says this type of compensation is improper and un- justifiable, other regulatory agencies, including those having jurisdic; tion over insurance, are liable, to decide that they need to take action. For years I have tried to do my bit in defending the salesman against those who seem to be saying he does not play a worthwhile or justifiable role in our society in defending him against those who would just as soon drive a lot of salesmen with low or moderate incomes completely out of business. We are moving here, it seems to me, to a form of paternalism that demeans the rank and file citizen. This bill seems to say to John Doe that even when all the facts and figures are disclosed to him, he is not to be trusted to make an intelligent choice among alternatives-that he must have the choices limited by a Government agency that decides what is good for him. I cannot buy that. Even the Washington Post cannot buy it. I do not think we are ready to read salesmen, who sell on commis- sion, out of our society. Thank you, Mr. Chairman. Mr. Moss. Mr. Day, let me tell you something. I was in selling as the first effort at making a living, and I sold on commission for a long time. I was a sales broker before coming to the Congress. I have no desire to drive them out of business, but I must candidly state that I am most singularly unimpressed by your statement today. I think that it has not constructively dealt with the subject before us. The fact that you have an outrageous turnover in the insurance industry does not convince me that it is justified, and there are very thoughtful persons in the industry, leaders in the industry, who feel that the failure to come up with a more workable system of compensa- tion, not the level, the level attracts them, but the need to better com- pensate them during an inadequate period of training, and to improve the agency system so that the whole philosophy is not to go out and recruit so that you have, we will say 25 percent are coming, 50 percent PAGENO="0029" 443 are working and 25 percent are going, because you know you will pick up a few of their relatives and a few of their friends on some policies and get some business, but it is very minimal income that they are going to earn during that period. I do not think that justifies it. If you want to you can characterize it as "mamma knows best" or paternalism, but I do not think it is a fair or adequate system of com- pensation, and I do not think increasing the amount which might be permitted would cure the basic defect in the sales organization of most life insurance agencies. And I am not convinced that the testimony has indicated it would solve the problem of turnover here in the sale of front-end load systems. Now Mr. Kostmayer, you made some very interesting allusions to the makeup of the population in my State. I think it is younger than the average in its overall population makeup, not older. I am gOing to do a very careful job of a cross section of the popu- lation of California, and ask permission at the appropriate time to include it in this record, but I do not think it will bear out your conclusion that the phenomenal success of mutual funds there is be- cause of those who are retiring there. I think most of those retiring in California come there with retirement income. They are not the investors. Now I have some knowledge of the area you represent, where there is a very good market for mutual funds, an excellent market, and I do not think it is being sold to the older folks only. I think there are a lot of young investors in it. So I cannot accept that as being an accurate analysis of the reason for the success in California, not- withstanding the fact that a front-end load has been foreclosed. I have a number of very close friends in this business, very suc- cessfully, and I will ask them about some of their age groupings and try to get a little fuller understanding. But it would certainly be contrary to your statement in my opinion. When I served in the legislature there, I used to be told all the time that our great problem there was that the people who came there to retire were so poor that they were all on relief, which hardly matches the picture you have drawn of these older folks who come in and start to buy mutual funds. I think it is far more helpful to the committee if, in citing things of this type, there be a careful research, so that it becomes fully reliable for us. We are seeking the facts. We are not wanting to hurt anyone here on this committee. I do not think there is a member of it who has any desire to injure needlessly any segment or sector of the American economy. In your statement, Mr. Kostmayer, you also stated that you rec- ognized the need for measures to be taken to minimize early plan terminations and consequent losses. I would like to know what sug- gestions have been made to the Commission and what suggestions you might offer this committee to minimize these losses from early plan terminations. Mr. KO5TMAYER. Several of the things, Mr. Chairman, that I men- tioned in my formal paper have been suggested to the Commission and are recommended to the co~nmittee for consideration. We think PAGENO="0030" 444 it would be desirable to have all plan sponsors required to offer the 30-day unconditional refund. We think that a 30-day period in which the new buyer can think it over his choice, and recover if you will, sir, from any undue persuasiveness on the part of the salesman can be a wholesome factor in continuity of payments. We suggest the possibility that the 60-day refund to people who *do not make their second scheduled payment on time might be worth your consideration. We believe that measures such as direct mail campaigns and possibly others that could be developed be utilized throughout the business, to reactivate accounts as soon as those ac- counts fall behind in their payments. I think this an area in which we certainly have room for improve- ment, and in which we have made some improvement, but certainly ought to make more. It is almost human nature for people to neglect payments when there is something that is present and available which is more attrac- tive to spend money for. We think this area deserved attention and this was actually called to our attention primarily by the SEC's inves- tigations, but we think that these sort of administrative procedures, given a fair chance to demonstrate their effectiveness, might do much to correct the things of which you are critical. Mr. S~ruoKEY. Will the chairman yield for a question? Mr. Moss. Yes, sir; Mr. Stuckey. Mr. STUCKEY. This has been one of the objections that the SEC has raised to the front-end load-your high-pressure selling and all- and you yourself are saying that this is a recommendation that you would like to see done. Isn't it pretty much a common practice now that most of your funds do have a 30-day unconditional refund offer, just exactly what you are referring? Mr. KosTMA~R. Yes, Mr. Stuckey; I would say that probably plan companies representing 70 percent of the business now make this offer. Mr. STUCKEY. Then the question is: How long does it take for the effects of overpersuasiveness to wear off-lO days, 60 days, 90 days? In other words, if this is a common practice now, it looks like to .me that in 30 days he can get his refund back, 60 days or even 90 days, that the pressures would be off of him in that length of time. I agree with you in your recommendation, but there again aren't most of the mutual funds doing this now? Mr. KosmrAyEii. Most are doing it. but it is not required that they do it, and we think it might be wholesome if all were required to do it. Mr. STUCKEY. Isn't this something that could be self-regulatory, or even for that matter written in? I am in complete agreement with you. Mr. KOSTMAYER. I think that is certainly a possibility; yes, sir. Mr. STUCKEY. But it is fairly common practice. Mr. KosTMA~R. It is fairly common practice, and I think very helpful. * Mr. STUCKEY. If 70 percent of your companies are doing this now, has there been any public outcry, objections as to high-pressure selling? Mr. KOSTMAYEE. No, sir; there have been no complaints about high- pressure selling or about any other aspect of the contractual plan busi- ness except from the SEC. There have been no public complaints. PAGENO="0031" 445 Mr. STUCKEY. Let me ask you this then. Do you have any idea of the percentage of contractual plan sales, and there again we are going back to your high-pressure selling, do you hate any idea of the percentage of contractual plan sales that result directly from recommendations by say satisfied planholders? Mr. KOSTMAYER. Yes, sir; I think I can give you pretty general fig- ures based on my own company. Mr. STUCKEY. In other words, this is getting out of the pressure sell- ing. This is just purely from recommendations. Mr. KOSTMAYER. Right. Mr. STUCKEY. From those who are satisfied. Mr. KOSTMAYER. I would say that people who either buy because they are buying a second time or buy because they have been-a sales- man has been recommended by* someone who already owns the plan constitute three-quarters of all of our volume. Does that respond to your question? Mr. STUCKEY. Yes. Mr. Moss. Mr. Roach, among other items which the Securities and Exchange Commission has raised is the question of the use of broker- age and portfolio transactions to provide an extra commission for dealers who distribute investment company stock. This, as you know, is described as a give-up. It is iniy understanding that your members have your own sales organization so that this practice is not present. I also understand that some of your members, and I think you yourself are members of the Pacific Coast Stock Exchange. Mr. ROACH. That is correct, sir. Mr. Moss. Just how do you treat the brokerage or commission on portfolio transactions? Does it accrue to the advantage of the fund? Mr. ROACH. Under the investment advisory agreement between United Funds, Inc., and Waddell & Reed, Inc., the compensation other- wise payable by United Funds, Inc., to Waddell & Reed, Inc., is reduced by an amount related to the "net income" of Kansas City Securities Corp. Kansas City Securities Corp. is a subsidiary of Waddell & Reed, Inc., and is a member firm of the Pacific Coast Stock Exchange through which a portion of the portfolio transactions on behalf of United Funds, Inc., and others are executed on that exchange. For the purpose of the agreement the net income of Kansas City Securities Corp. is determined in accordance with generally accepted accounting principles except that in such determination there is sub- tracted provision for 4Federal income taxes as if Kansas City Secu- rities Corp. were to file a separate Federal income tax return, whether or not Kansas City Securities Corp. has filed or is to file such a sepa- rate return. The total amount of management fees payable by United Funds, Inc., to Waddell & Reed, Inc., for each month is reduced on an annual basis by an amount equal to the higher of (A) 100 percent of the net income of Kansas City Securities Corp., resulting from commissions and discounts on portfolio transactions executed by Kansas City Se- curities Corp., for United Funds, Inc., since the beginning of the then current fiscal year of Kansas City Securities Corp., or (B) 50 per- cent of the net income of Kansas City Securities Corp., from all sources since the beginning of its then current fiscal year. In computing (A) above, the expenses of Kansas City Securities Corp., for the periods in question are allocated in the same ratio as commissions and dis- PAGENO="0032" 446 counts on portfolio transactions executed by Kansas City Securities Corp., for United Funds, Inc., bear to the gross revenues and income of Kansas City Securities Corp., from all sources. Reductions under either (A) or (B) are made monthly after giving credit for the aggregate amount of previous reductions, but no adjustment is made in any month where the aggregate amount of previous reductions exceeds the higher of (A) or (B) for the period then elapsed since the beginning of the then current fiscal year of Kansas City Securi- ties Corp. The reduction in the management fee has been computed on the basis set forth above since September 1, 1966. Mr. Moss. This is for the purpose of reducing the management fee charged against the fund; is that correct? Mr. ROACH. That is correct. Mr. Moss. As members of the Pacific Coast Stock Exchange, can you deal with the third market in making portfolio purchases or sales? Mr. ROACH. Yes. Mr. Moss. Mr. Keith. Mr. KEITH. To what extent do you use the third market? Mr. RoAch. In the past several years, as you know, there has been an increasing use of the third market, and I believe that we have used it about in the same proportion that other similar companies have used the third market. Mr. KEITH. That isn't very responsive. Mr. ROACH. Well, it isn't very responsive, but I can provide precise figures. Mr. KEITH. Can you tell me roughly and then perhaps provide more precisely at a later date? Mr. ROACH. In what- Mr. KEITH. Could you give us a percentage estimate? Mr. R0ACII. This would be a guess, and I would prefer to provide the precise amount; but I would say somewhere between 5 and 10 percent of our transactions would be third-market transactions, but I would like to have an opportunity to find out precisely what that is, and give you a letter and let you know. This is not an area in- Mr. Moss. Would you like to hold the record at this point so we can include that letter in context then with the hearing. Mr. ROAcH. I will be very happy to do so. Mr. Moss. All right; fine. (The information requested follows:) WADDELL & REED, Kansas City, Mo., October 23, 1967. In re HR. 9510 and HR. 9511 report of proceedings before the Subcommittee on Commerce and Finance. Hon. Joux E. Moss, The Honse of Representatives, Washington, D.C. DEAR ME. Moss: In response to the question, Lines 19 and 30, Page 446 of the above record, "To what extent do you use the third market?" and ~`Cou1d you give us a percentage estimate?", please be informed that for the nine month period from January 1 to September 30, 1967, file volume of third market transactions transacted by Waddell & Reed, Inc., were as follows: 1. Stated as a percentage of total brokerage commissions-6.58%. 2. Stated as a percentage of total dollar transactions-10.62%. Very truly yours, CoRNELIus RoAcH, GeneraZ Counsel. PAGENO="0033" 447 Mr. KEITH. One note, Mr. Roach. You say, and just to set the record straight, I recognize that you do provide a tremendous opportunity for people to get into equities, but not all these people who do buy mutual fund plans would necessarily spend what was left over. Mr. ROACH. Of course. Mr. KEITH. You say on page 2 "Those investors would otherwise have spent as disposable income." Mr. ROACH. It should have been a qualification of possibly rather than flat. Mr. KEITH. Generally speaking they might end up with life insur- ance. Mr. ROACH. They might. Mr. KEITH. They might end up in cooperative banks or savings and loans. Mr. Kostmayer, you mentioned on page 3 "In addition the plan- holder has the valuable right to withdraw up to 90 percent of the current liquidation value in mutual fund shares." Do you charge any interest on that? Mr. KOSTMAYER. No, Mr. Keith. Mr. KEITH. Is that so? Mr. KOSTMAYER. Right. Of course, I should point out to keep this perfectly accurate that when money has been withdrawn- Mr. KEITH. It is no longer working. Mr. KOSTMAYER. Right. Mr. KEITH. It is not a loan. Mr. KOSTMAYER. It is not a loan. Mr. KEITh. It is simply they can redeem up to 90 percent. Mr. KOSTMAYER. That is correct. Mr. KEITH. So they don't get the earnings. I misunderstood that. It isn't at all parallel to a life insurance company allowing the policy- holder to borrow the cash value. Mr. KOSTMAYER. No; it is not really the same thing as a policy loan, not at all. Mr. KEITH. I have a note here we are not so much concerned about the good guys. What about the others. This is along the lines of Mr. Stuckey's point. Roughly 70 percent of the people in this business give their customers an opportunity to change their minds after 30 days. Mr. KOSTMAYER. That is correct. Mr. KEITH. It is probable that the people who practice high-pres- sure tactics are the same kind of people who would not be eager to re- fund the money. Mr. KOSTMAYER. I don't think it really relates to that, Mr. Keith, so much as the fact that certain of the big plan sponsors have chosen, for perfectly good reasons of their own, not to join this association, and the 30-day offer of refund is a requirement of membership, and I have no reason to assume that they- Mr. KEITH. In other words, all of your members do this. Mr. KOSTMATYER. That is correct, sir. Mr. KEITH. That is a requirement. Mr. KOSTMAYER. It is required. Mr. KEITH. And in your view the presence of this requirement is not a deterring factor to others joining the association. There is some other reason if they don't join. 85-592-68-pt. 2-3 PAGENO="0034" 448 Mr. KOSTMAYER. I have no reason to think that this has been the factor to keep them out, correct, and I certainly have no reason to be- lieve, knowing the natures of the organizations who have not joined,. that they have stayed out because they are in fact the bad guys as clis- tinguished from the good guys. Mr. KEITH. Well, I think that misrepresentation must take place upon occasion, such as overly optimistic portrayals of the benefits of the plan. It doss in almost any business. You learn by trial and error as to what salesmen have character, ability. Mr. DAY. May I comment on that, Mr. Keith, on that point? Mr. KEITH. Certainly. Mr. DAY. I think the thing that bears importantly on that is that your contractual plan salesman in a typical $25 a month plan would collect only the first 2 months payments at the time he makes the sale,. so that means he gets $12, $6 for each of the payments. Now it seems to me that it would be poor tactics on his part to use as a typical matter a type of high pressure, misrepresenting salesman- ship, so that as soon as he goes away, that is soon going to wear off, and the fellow is going to wish the salesman had never bought the plan, because he is going to end up with only peanuts as far as compensation is concerned. The salesman has to use the type of sales efforts so that it will stick,. and he gets this first year payment, which he only gets after the whole year of payments has taken place, which as you know is somewhat of a contrast to life insurance, where it is very frequent practice to attempt to get the full first-year premium at the time the sale is made.. This man typically only gets the commission based on 2 monthly con- tractual payments. Mr. SPRINGER. Would the gentleman yield for a question on that? Mr. KEITH. Yes, certainly. Mr. SPRINGER. Might I ask whoever is qualified here two questions,.. which is one question really in two parts. How much of the total sales- men in the country involved in this have front-end load payment, what percent of the total salesmen? Mr. KOSTMAYER. I think it is difficult, Mr. Springer, to answer it in terms of total salesmen. About 25 percent of all of the mutual fund sales are made with front-end loads, and this comes to roughly some 10 percent of the total volume. Mr. SPRINGER. But you don't know what percent of the people in- volved are salesmen in this field? Mr. KOSTMAYER. No. Mr. Roach, do you have any figures on that? Mr. ROACH. I would estimate that of the some 90,000 registered rep- resentatives who are engaged in the offering or are entitled and authorized to offer mutual funds and contractual plans, of that num- ber, I would say somewhere around 25,000 are actively engaged in offering contractual plans. Mr. SPRINGER. Between 25 and 30 percent. Mr. ROACH. That is right. Mr. SPRINGER. Now what total of all the volume of the sales of mutual funds involve front-end load? Mr. KOSTMATYER. Numerically it is about 25 percent. In terms of volume it is about 10 percent. Mr. SPRINGER. In terms of dollars it is 25 percent. PAGENO="0035" 449 Mr. KOSTMAYER. No; in terms of numbers of people it is about 25 percent, in terms of dollars about 10 percent. Mr. SPRINGER. About 10 percent. Mr. KOSTMAYER. Right. Mr. SPRINGER. Of the total amount of dollars involved in all mutual fund sales? Mr. KOSTMAYER. I might just add one sentence to that, sir; contrac- tual plan salesmen go out to seel contractual plans with a front-end load. In the process of doing this, they encounter investors who also have cash to invest, and who in turn buy mutual fund shares outright, so that the amount of business that results from contractual plan activ- ity is considerably in excess of the contractual plan business done, but the figures are 25 percent in numbers of people, 10 percent in dollar amounts. Mr. SPRINGER. Thank you, Mr. Keith. Mr. KEITH. When somebody starts payments again as a result of solicitation by mail to reinstitute their plans, do they g~t back in on a first year commission basis? Mr. KOSTMAYER. That all depends, Mr. Keith, upon when they have stopped making payments. Mr. KEITH. Let's just say that in the third year- Mr. KOSTMAYER. Oh, no, sir, they would then go back on the lowered commission that follows the first year front-end load. Mr. KEITH. Suppose some salesman was given that account to service, and he goes out and as a result of his effort they reinstitute that as an active account? Mr. KOSTMAYER. In the third year? Mr. KEITH. In the third year. Mr. KOSTMAYER. There is no further front-end load. It has been paid and that is over and done with. Mr. KEITh. Unless he by chance signs up for a new plan. Mr. KOSTMAYER. Yes, which we would not allow him to do unless he were current in his payments on the old plan. Mr. KEITH. Supposing that you had an unscrupulous agent, and he said "Well, perhaps you could do better if you went with Aerospace Industries Mutual Plan. You might like that one even better." Is there any switching like that that takes place? Mr. KOSTMAYER. No, sir, I think there is none because the plan- holder's reaction to this sort of dishonest approach would be "I'm terribly sorry but I have already paid a front-end load, and I don't want to do it again." I think if there were only level loads that this switching would take place. Mr. KEITH. Can you buy no-load funds on the installment plan? Mr. KOSTMAYER. Yes, I think you can buy no-load plans any way you choose to, but you have to make the effort and initiate the activity yourself. Mr. KEITH. Is there any management company that anticipates direct selling by mail and having a sales commission schedule considerably less than that of the present contractual plan, we will say 3 or 4 percent~ and selling it by extensive advertising and mail solicitation? Mr. KOSTMAYER. I don't know of any, Mr. Keith, which is not a corn plete answer to your question, but the inhibitions on advertising an~ PAGENO="0036" 450 promotion are such that it seems to me unlikely that any serious entre- preneur would undertake this. Mr. KEITH. The advertisements with reference to savings banks life insurance, are not of a similar sort to those required by the SEC Mr. KOSTMAYER. I gather not from those that I have seen. Mr. KEITH. And it would seem to me to be perhaps, if the SEC's philosophy is appropriate, and I am not yet of a mind that it is, that there should be some advertising to stress the difference between the commission schedules that are available to the man who would like to buy but doesn't really want to entertain a salesman, and so he could be solicited perhaps through the mail and through advertising in the press. I might say, to draw a parallel, having been in the life insurance business, and I believe I have sold a lot of life insurance for savings banks, because I would make the pitch and the man would buy the idea, and he would go to the savings bank, and I suspect you people in the contractual plan business have sold a lot of mutual funds for those who are not in the contractual end of the business, Mr. KOSTMAYER. I am sure of it. Mr. KEITH. And a lot for the no-load funds as well. I recall shortly after I got out of the service that there was a big movement in the Legion to reinstitute national service life insurance, and I appeared before the local Legion chapter and said that this would not be wise, because if the good agent were out there soliciting a veteran, he would be morally obligated to encourage that man to reinstitute his national service life insurance, and inasmuch as most of the prospects were veterans, he would just be doing service work, and he would starve and there would be fewer agents out to sell the idea of national service life insurance. This is an important factor in this particular end of the business, to have these agents or salesmen out, because although only 10 percent of the dollar volume comes, the motivating ideas are per- haps great contributing factors. Mr. STTJOKEY. Will the gentleman yield for a question? Mr. KEITH. Certainly. Mr. STUCKEY. I would like to ask this, before our time runs out, and I know we are pushed. Thank you, Mr. Keith. The SEC has stated that the charges are too high. Now if your charges are too high, as they have stated, then what I would like for you to do, and with the consent of the committee you can have this submitted to us, and that is compare the charges with other industries, and I tried to bring this out with the banking industry and with other related industries earlier, and it seems that we are not getting any- where with it. I would like for a comparison to be drawn, if it could be, between the charges that are made by the mutual funds compared with other related industries, and by that I mean banks, private investment coun- sel, savings accounts, a person going to an individual broker, and if it would be possible, could we have a comparison of various savings and investment methods to be drawn over a 10-year period of time. Take from now and go back 10 years. I believe that the average investment in a mutual fund is $4,500 in round figures. Let's take say $4,500, 10 years ago originally kept in cash, its total value today, and its purchasing power expressed in dol- PAGENO="0037" 451 lars today, and let's do that with say a savings account. Say take 5 percent. Let's do it with banks. Let's do it with private investment capitai, and let's do it with a person on his own investing this money in the market himself. I think this will give us a comparison as to whether the 5-percent charge is too high or whether it is reasonable. As I say, take the original investment, then the total amount, the dollar value in 10 years, and also the purchasing power expressed in dollars. I would like to see that comparison if it is possible that this be furnished. Mr. KOSTMAYER. We will be delighted to furnish that Mr. Stuckey. We may have some problem with the private investment counsel but the other aspects of it I think we can get to it immediately. Mr. STUOKEY. The reason I am asking for this is because the SEC, their whole basis for the 5 percent that I have been able to see is that they say compared with related industries. Mr. KOSTMAYEE. Right, sir. Mr. STUOKEY. And with related businesses yourS percent is too high. Mr. KOSTMAYER. We will do this. Mr. SrUCKEY. And any other businesses that you would like to have in here, insurance companies or otherwise, I would like to see this, because I think this would give us-and I hate to use these words- but I think it would give us a guideline to sort of look at and compare to see if the 5 percent is inline. Mr. KOSTMAYER. We will do that. Mr. Moss. Without objection the record will be held at this point to receive the information. (The following letter was received by the committee:) ASSOCIATION OF MUTUAL FUND PLAN SPONSORS, INC., New York, October 30, 1907. Hon. WILLIAM STUCKEY, Ho'use of Representatives, Washington, D.C. DEAn REPRESENTATIVE STuCKEY: During the bearings held on October 16, 1967 before the Subcommittee on Commerce and Finance with respect to ER. 9510 and H.R. 9511, you asked me whether a comparison could be made of various investment and savings media by looking at the vaitte now of a given amount of money which during the past ten years was: (1) kept in cash; (2) deposited in a saving bank account at 5% interest; (3) invested by private investment counsel; (4) invested by the individual investor; and (5) invested in mutual fund shares (pp. 455-56 of the Transcript). You suggested that $4,500 be used as the starting amount. In response to your question, I enclose a chart entitled "Comparison of Various Savings & Investment Media, 10 Years 1957-1966," which was filed as Exhibit 2 to the Statement of the Investment Company Institute before the Subcommit- tee in connection with the pending legislation. This chart not only furnishes the information called for by items (1), (2) ahd (5) above, but also shows the results after the past ten year period, of a purchase at the beginning of the period of Series "E" Government Bonds. Although $10,000, rather than $4,500, is used as the initial amount in the chart, I think it is appropriate as the basis for the comparison which you desired. Unfortunately, we have been unable to find any published statistics or indices which provide any basis for showing how an investor would have fared had he entrusted his money with private investment counsel or invested it by himself as referred to in items (3) and (4) above. To this extent, I regret that I am unable to answer your question. If you should have any further questions, please let me know. Very truly yours, JoHN H. KOSTMAYER. PAGENO="0038" I T~T~~1 I 0 $5 $10 $15 $20 $~25 ThOUSANDS OF DOLLARS Mr. KEITH. Mr. Day, I would like to know how you can be a member of the board of directors of several insurance companies without a little bit of conflict of interest if these are really competing companies. Mr. DAY. How do you mean, Mr. Keith? Mr. KEITH. I note on page 2 of your statement, where you listed your qualifications: I have written a number of published articles on life insurance subjects and am a member of the board of directors of several insurance companies. Mr. DAY. I see what you mean. Six of those are all in the Zurich group of insurance companies which are all one fleet, as you know. Mr. KEITH. I am sorry to have exposed the relationship there. Isn't that a little misrepresentation. Aren't these all pups of the same parent? Mr. DAY. Well, I am on the boards of two other companies. Mr. KEITH. What are the other two? Mr. DAY. They are not in any conflict with the Zurich operations. Mr. KEITH. What are the other two? Mr. DAY. One of them is the People's Life Insurance Co., which is `the largest home office company here in the District of Columbia. The other one is a reinsurance company. Mr. KEITH. I will .agree that there is no conflict there. Thank you. If you had an internally managed company, you could use, I suspect, the resources of that company to recruit, train, and pay salesmen over this lean period, is that correct? Mr. DAY. Well, you could, but the money has to come from some- place. It has got to come from money that is received in from the people who are buying the product, whatever type of- Mr. KEITH. It could come out of the management company. They are the ones that are really standing to gain by the increase in port- folio. 452 EXH~T2 COA~ESO~ OF ~ ~ :& Jfl~E~T R~T~~S 10' YEARS. 1957~1966 Kept in cash SeriesE Government Bonds `5% Compound Interest QUarterI~ Savings Account Average of 35 mutual funds seeking growth of capital Average of 80 commonstock mutual funds including 35 emphasizing growth of capital Average of 42 balanced mutualfunds - p~stffi.nt~medM~enc~ a~Wdenda8m~.~em.ntco~ PAGENO="0039" 453 Mr. DAY. Well, that is true, but I assume you don't suggest that they just make a contribution which they, never expect to get back. Mr. KEITH. No; but I suggest that- Mr. DAY. It i.s similar to- Mr. KEITH. Similar to the ideas that have been adopted by many of the high-grade insurance companies, they pay salaries to the start- ing agent. Mr. DAY. They do indeed and I want to comment on that. Mr. KEITH. Recently they have gotten into a' lot of career under- "writing. Mr. DAY. Yes; I wanted to comment on that statement of the `chairman's, because it is the usual pattern to have financing plans for new agents, and to subsidize them and assist them during their train- ing and orientation period, and the period when they are trying to get started. But just as that is done in a life insurance company, the only place that money can come from is either out of the investment income or out of the money that has been paid in by some other policyholders. `There is no brooding omnipresence of money up there that is not going to cost anybody anything. Mr. KEITH. That I imagine is quite well kept track of by the insur~ ance commissioner of the State involved, and that he has certain regu- lations with reference to the success or failure of these agents and they had better get out of the business of they don't produce. You have got to make the plan work. But even as it is good business for an insurance company `to take it out of the investment income, it all comes out of the policyholder's pocketbook. Mr. DAY. Well, the investment income is not used for that purpose. in a life insurance company. I said these are the only two sources of money they have, but they do not use investment income for sales expense. That is used to support the reserves. Mr. KEITH. It comes out of the policyholder's pocketbook in the average mutual company, and the expenses come out of the policy- holder's pocketbook. In the case of a mutual company it is one and the same thing. Mr. DAY. That is correct. It comes from the amount that i's paid m by `policyholders-to a large extent by the policyholder buying that par- `ticular policy as to whic'h the sale is made-but it is also subsidized over a period of years, and, in effect, loaned to the sales expense of that particular policy, by taking it out of funds that have been received on policies previously sold. Mr. KEITH. The point I am trying to make here is, that if you have an internally managed company, where it is good for the management company, to get increased increments of capital so that they are in a position to pay out when shareholders want their money, they have got to have money coming in. It is good company business to hire and train and pay for qualified people to come into the business to keep capital coming into the fund. Mr. DAY. Well, I don't believe the commission would work that way, Mr. Keith, because while there is discussion here and in this proposal about the management fees, the fact of the matter is there isn't enot~gh made or potential for profit out of simply managing the fund to be PAGENO="0040" .454 able to use the profits on running the fund to pay for a sales force to go out and bring more money in to be managed. Mr. KEITH. In an internally managed company, that is what you have. Mr. DAY. Well, they couldn't pay commissions and pay these load- ings to salesmen to keep the salesmen actually going around calling on the customers. There wouldn't be enough money for it in there. Mr. KEITH. if you have got a billion dollar fund, and you get invest- ment income on it, the expense for advising Massachusetts Investors Trust, is 0.18. Mr. KOSTMAYER. It is in that range, I know. Mr. KEITH. And you take that figure and contrast it with, we will say, 0.50, what could you have for a sales force? Mr. KOSTMAYER. Mr. Keith, may I make one point in this connection? Mr. KEITH. Yes. Mr. KOSTMAYER. There is no necessary connection between a contrac- tual plan company and a fund under management. Not all contractual plan companies are adjunct of mutual fund operations, and it is par- ticularly true that new companies coining into this business frequently enter as sales organizations and contractual plan companies only, and have no other resources on which to call. Mr. KEITH. Yes, I can see that; hut it is one big ball of wax, nonethe- less. We don't find at this table salesmen. We find at this table people speaking for the investment companies, really, and it might be inter- esting, Mr. Chairman, to have a salesman appear here. These gentle- men are speaking for the salesmen, but they are also speaking for the management companies as well. Mr. KOSTMAYER. In the case of my own company, Mr. Keith, I sup- pose that 80 or 85 percent of our revenues are derived from sales com- missions on the contractual plans and mutual fund shares, so that when we talk about changing the front-end load, we are talking about changing practically all of our income. Mr. Moss. Would you yield at that point? Mr. KisrrH. Certainly. Mr. Moss. How many of your member groups are exclusively sales organizations? Mr. KOSTMAYER. I do not know, Mr. Chairman. We can find out for you. Mr. Moss. I think it would be very interesting. Mr. KOSTMAYER. Certainly of the smaller ones, I think a high per- centage would be. Mr. Moss. Well, that is one of the facts I think we would be inter- ested in, how many of the large ones are exclusively sales. Mr. KOSTMAYER. We will certainly find out and report to you. (The following letter was received by the committee:) ASsocIATIoN OF MUTUAL FUND PLAN SPONSORS, INC., New York, N.Y., No'veinber 6, 1967. Hon. JOHN E. Moss, Hov~se of Representatives, WasMngton, DXI. DEAR Mn. Moss: During the testimony presented by the Association of Mutual Fund Plan Sponsors, Inc., at the hearings held on October 16, 1967, before your suh-committee on Commerce and Finance with respect to HR. 9510 and H.R. PAGENO="0041" 455 9511, you asked me for information concerning the number of plan sponsors which are "exclusively sales organizations" (transcript P. 463). I told you I would find the answer and report it to you. I have checked the information available to me with respect to the more than forty (40) companies which offer contractual plans. I find that three of those companies are exclusively sales companies, and do not either directly or indirectly act as the investment advisor for any mutual fund whose shares are used as the underlying investment in the contractual plan. In addition, however, at least two large plan sponsors, First Investors Corporation and Investors Planning Corpora- tion of America, derive a very significant part of their revenues from selling shares of mutual funds for which they are not investment advisors. I should emphasize that despite the fact that most contractual plan sponsors are not exclusively sales organizations, the SEO's proposal to abolish the front- end load would destroy the contractual plan business as a whole and would have a most severe impact on almost all mutual fund organizations which include the sale of contractual plans. Abolition of the front-end load would also deny. to in- vestors a valuable means for the periodic accumulation of mutual fund shares. Some of the largest companies which sponsor contractual plans, including a significant number of publicly owned companies, derive very substantial revenues from this source, and elimination of the front-end load would seriously affect their financial positions, even though they might continue to derive revenues from other sources. In fact, some mutual fund sales organizations effect most of their sales in the form of contractual plans, and the elimination of contractual plans would in all likelihood result in such a limitation on the inflow of new capital to the related mutual funds as to cause a substantial excess of redemp- tions over inflow of new capital. In the case of smaller mutual funds, the elimination of the contractual plan could well mean the entire destruction of the mutual fund complex. For in- stance, there are twenty-one contractual plan sponsors whose contractual plans relate to mutual funds with assets of $50,000,000.00 or less. It is well known that it is very difficult for investment advisors to receive substantial revenues from the management of mutual funds of that size. For instance, assuming an annual advisory fee of one-half of one percent, a fund of $10,000,000.00 of net assets would have a management fee of $50,000.00 a year, and a fund of $40,000,000.00 would have a management fee of $200,000.00 a year. From those fees, the invest- ment advisor has to pay all its own expenses and many expenses of the mutual fund as well. The revenues derived from the sales of contractual plans and the new cash inflow to the mutual funds from this source are essential to the existence of these mutual fund organizations. In addition, new groups organizing mutual funds very often couple these with contractual plans and depend upon contractual plans as an essential source of revenues to assist them in establishing their programs. The elimination of the contractual plan would mean that many of these mutual funds would never be organized and the benefits of a wider variety of mutual funds to choose from would not be made available to potential investors. Finally, and most important, elimination of the front-end load would deny to a vast group of potential investors the opportunity to invest in mutual funds or to invest in any equity vehicle at all. It is only because of the incentives offered by the front-end load that mutual fund salesmen have been able to bring the benefits of mutual fund investing to many persons of moderate means who would not otherwise have learned about this vehicle. Let me take this opportunity again to express my appreciation to you and your colleagues for pei~mitting our association to testify before your subcommittee. If you should have any further questions or should you desire any further in- formation, please do not hesitate to let me know. Sincerely, JOHN H. KOSTMAYER. Mr. KEITH. Well, we get back to the question that I have raised throughout these hearings, as to which came first here, the investment company or the sales organization. I noted that in one bit of testimony it was said-I think it was Mr. Cohen's though it may not have been-that the investment company sought out sales forces to sell shares so that there could be more assets PAGENO="0042" 456 with which the investment company could operate and receive their compensation; and then. he went on to say, that the mutual funds con- tract with the management company for their services, but actually it can be said that it is the management companies initiate the contracts with the mutual funds in the initial phase of the operation: And so what we, as a committee, are concerned with is one ball of wax, and that is the way the Commission's recommendations came in. It is a hard point to make, as individual witnesses testified from their particular points of view, but we see it as a whole. It does not mean just because I am turning the pages of your testi- mony so quickly that I have necessarily bought all you have had to say. A small point. On page 14: First, annual premium deferred annuities now sold by life insurance corn- panies are sold with a front-end load of as much as 50 percent. Generally speaking, those front-end loads on annuity policies which are those without any life insurance benefits are less than 50 percent, I believe. Mr. DAY. Some companies use 50. There is a great range, it is true. Mr. Knrrii. Generally speaking, they are less than 50 percent, I be- lieve, because there is no life insurance element. Mr. DAY. Are you referring, Mr. Keith, to the front-end load or to the commission to the agent? The commission to the agent even in a contractual plan is only 25 percent. Mr. KEITh. This was life insurance. Mr. DAY. Yes; I know. Mr. KEITH. To which you are referring here, and in the annuity policies, generally speaking, you have some cash values in the early years of the contract? Mr. DAY. Oh, yes. Mr. KErrhl. And in the first year as well? Mr. DAY. Yes, at least 50 percent. But the 50 percent that I am referring to as the front-end load, only part of which would be, in the annuity plan, the actual commission of the agent. The commission of the agent in an individual annuity plan would typically, in fact, as far as I know universally, be lower than the commission on an ordinary whole life policy because your total load on an ordinary life policy is 100 percent or more. Mr. KEITH. I guess I did not read the fine print. If that refers not to the commission but to the total load- Mr. DAY. Only to the total load; yes, sir. Mr. KEITH. You have to watch these insurance men. Now then, you conclude, "I cannot buy that. Even the Washington Post cannot buy it." Has the Washington Post taken a stand on this particular mat- ter- Mr. DAY. Yes; they had an editorial some months ago that said, in effect, that when people are told very clearly what is being taken out for sales expense, that that is all that is necessary. Mr. KEITH. Well, the administration of which you used to be a part apparently in one area differs with the Washington Post. Mr. DAY. I am sort of an in-law of the present administration. Mr. KEITH. I have no further questions at this time, Mr. Chair- man. PAGENO="0043" 457 Mr. Moss. Mr. Watkins? Mr. WATKINS. Thank you, Mr. Chairman. I differ a little bit with my distinguished chairman. I think, Mr. Day, your testimony has been most enlightening, even though it is a contrast. I think you have given us a very fine view of the insurance business and just what happens there. I just wonder many times, after listening here today and reading some of the other briefs, why I did not go into the insurance business instead of the motorized business that I am in, instead of being in a grease pit. But I think your testi- mony has been most helpful to me. I certainly feel as though, without an opinion at this time as to how I feel about the SEC's decision, I do not know, it is just amazing to me to sit here and listen. How do you sell your insurance if you do not sell it with salesmen? I am just not junior and I have been buying insurance, a little of it. In fact, in the early days the banks made me buy it so I could protect my loans. Mr. KEITH. Will the gentleman yield? Mr. WATKINS. No, you talked long enough. Mr. KEITH. I want to know if you bought term insurance or if you bought permanent insurance. Mr. WATKINS. Straight life. It was cheaper and I could hock it more easily. It was mostly in hock. But we must have salesmen, I do not think there is any qeustion about it. The big question here is that the SEC feels as though it should be paid differently and they want to rule the business out, and I have heard you make a remark and I would like to question Mr. Kostmayer on that. You would be out of business. What do you mean you would be out of business if you hock this sales plan out? Mr. KOSTMAYEE. Well, sir, I am now talking specifically about, of course, the contractual plan business. Mr. WATKINS. You said the business would be through? Mr. KOSThtAYER. Yes, sir. The SEC's proposal is that the sales charge, which is allowable over the life of the contractual plan which is now a total of 9 percent, be reduced to 5 percent. That is approxi- mately in half. And that the front-end load be eliminated. Now what this means, Mr. Watkins, is simply this: That instead of being allowed to take 50 percent of each payment in the first year, we Would be allowed to take 5 percent of each payment. In other words, the SEC has proposed that our first-year revenues be reduced to 10 percent of what the,y presently are, assuming that the payments would be persistent, which we think they would not. Mr. WATKINS. Let me ask you one other question. I will address this to Mr. Kostmayer. What does the average salesman make in this business? Mr. KOSTMAYER. Well, sir, I would say that the average sales- man- Mr. WATKINs. Per year. I do not mean per week or month. What does he make in a year? Mr. KO5TMAYER. Oh, maybe $1,000, $1,500, because we have many part-time salesmen. I would say that the average full-time salesman probably makes- Mr. WATKINS. What does a full-time salesman make? PAGENO="0044" 458 Mr. KOSTMAYER. Oh, maybe $7,000 a year, $7,500 a year. Mr. WATKINS. How do you get men at that price? Mr. KOSTMAYER. It is difficult. Mr. WATKINS. And part-time, they get about $1,500? Mr. KOSTMAYER. At the most, on the average. Mr. WATKINS. That is on this basis here? Mr. KOSTMAYER. Yes, sir. Mr. WATKINS. That you are paying them now. What would they get if the SEC plan went in? How much would they make? You say you could not get them. I imagine if they are getting $7,500 and $1,500, you could not hire a man, could you? Mr. KOSTMAYER. We could not hire a man and we could not retain our present career men, the men who make a living in the business, who stay with it. Mr. WATKINS. That is the $7,000 a year man? Mr. KOSTMAYER. That is right. He could not possibly stay in the business. Now it is conceivable that those who come and go in the night and to whom the income is less important might be able to remain in the business, but it would certainly destroy the core, the hard core of the retail sales organizations in this line of endeavor. Mr. WATKINS. I think that is important, Mr. Chairman. Mr. Moss. So does the chairman. Mr. WATKINS. I think it is important testimony. Mr. Moss. And if the gentleman would yield? Mr. WATKINS. I yield. Mr. Moss. The chairman would point out that in the State of Cali- fornia, approximately 10 percent of the population of this Nation, without a front-end load, that it accounts for in excess of 20 percent of the sales of mutual funds, and I think most of these gentlemen have some affiliations that operate quite profitably in California. Am I correct? Mr. ROACH. Our sales organization does very well. Mr. Moss. Very well? Mr. ROACH. They are very happy with California. Mr. Moss. That is correct, and so this is another example of the fact that you can do all sorts of things with statistics, and you can have some very interesting exercises, but to forecast that you are going out of business merely means that you would change the format of opera- tion, not that you go out of business. I have a great confidence in the ability of business to survive and to adapt, and I have been, in 20 years as a legislator, the recipient of ad- vice on so many occasions that I can no longer count them, that if I cast my vote in a certain `way I would be putting someone out of busi- ness, and looking back in retrospect, I do not know of a one that has gone out of business because of those votes. Mr. KOSTMAYER. Mr. Chairman, let me restate my-pardon me, sir. Mr. WATKINS. Go ahead. Mr. KOSTMAYER. I wanted to restate my reply. Mr. WATKINS. We are going to have a quorum call in a minute and we are all going to have to go. Mr. KOSTMAYER. I did not mean to reply that the companies which are in this business will, as businesses, go out of business. I meant to say that the contractual plan portion of it would be destroyed. PAGENO="0045" 459 I agree with you, Mr. Chairman, that these companies might~ use their organizations for other purposes, to sell life insurance, for ex- ample, to sell mutual fund shares, and this kind of thing. Mr. Moss. Well, the fund salesmen in my State have to be selling funds. Mr. KOSTMAYER. I said fund shares and life insurance. Mr. Moss. That is what I say. And I think that a meaningful com- parison might be to take the number of persons engaged in selling of funds in California and compare their overall average income with a like block in a State that has, we will say, a somewhat comparable, if you can find it, and I do not think you can, volume of sales of fund shares. In view of the fact that we are highest of all in the Nation, why that comparison would be difficult, so we would have to take the one with the second highest volume and see what the average of the sales force, the income there is. That would be a meaningful, relevant statistic. Mr. WATKINS. Mr. Chairman, would you yield just a second? Mr. Moss. I will yield back to you. Mr. WATKINS. I am going to check on Pennsylvania. Mr. Moss. I think it would be very helpful. Mr. KEITH. Will you yield just a minute? Mr. WATKINS. Yes, go ahead. Go right along. I am with you. Mr. KEITH. I have been here right along. Mr. WATKINS. I know you have. I thought perhaps you would send me a sick card. I was out for about a week or 10 days and was very sick and you did not send me a card and I am hurt by it. And the chairman too. (Off the record.) Mr. KEITH. Is it not true that the average salesman in these plans is not a full time aggressive career salesman? The average salesman is a man who sells stocks and bonds and mutual funds other than contrac- tual plans and for him to call on the weekly wage earner, as contrasted with the man who can buy 100 shares of this, that, or the other thing, he has to have something that the wage earner can buy. Mr. KOSTMAYER. I think this is correct, Mr. Keith. The typical mutual fund salesman is selling other things. We may be selling face amount certificates, life insurance, over-the-counter* securities, listed securities, and contractual plans, and I think the real question is wheth- er the elimination of the contractual plan would deprive a particular market of a valuable service, and not whether or not it would reduce the salesman's income. Mr. KEITH. It would reduce his income somewhat? Mr. KOSTMAYER. Certainly. Mr. KEITH. But it would more, as you say, deny the schoolteacher, the fellow-well, for example, we had a guest in here, a constituent of mine, whose husband runs a gas station. Mr. WATKINS. Sells insurance? Mr. KEITH. No; but she bought a mutual fund, and would not ordi- narily have been called on by somebody selling stocks and bonds where, in order to make a dollar for the time spent, they would have to sell a lot of stocks and bonds. So you are serving in addition to those who can buy large amounts the retired person or the person who teaches school. PAGENO="0046" 460 In my hometown one of the schoolteachers sells mutual funds, and makes $1,500 to $2,000 a year. She is known in the community. She is bright. And it supplements her income. So it would no k~nger be wQrth her while, with the contacts that she has, if she was going to get only 5 percent. Mr. KOSTMAYER. Yes, that certainly is true. Mr. KEITH. Thank you. Mr. WATKINS. You are welcome. Mr. Kostmayer, you said here 30 days in answering a question. I understood you to say that you would even go so far as 60 days you would give ~1l the money back. Mr. KOSTMAYER. Yes, sir; that is under a slightly different set of circumstances. The 30-day right of refund is unconditional. It is simply an offer to the new purchaser. If that new purchaser is late in making his sec- ond payment, we feel that since he has embarked upon a program of 190 months that clearly this is the wrong vehicle for him. We ask him to get out and accept a refund in full. Mr. WATKINS. Now just one other thing. Contracts, in talking about insurance and you can answer this very probably, I do not think anybody understands an insurance contract. I consider myself normally intelligent. When you get through reading the fine print and everything that is written I wish the SEC would try to say something about that. Let them put in less words. I am confused and I think everybody in America is if he tries to read his own insur- ance policy. Mr. KEITh. Trust your agent. Mr. WATKINS. There is the question whether insurance salesmen are honest. I think all salesmen are honest until one goes crooked. My boys sometimes spread it on a little bit in the trucking business in truck sales and all, but any good firm always changes it when they come back. I want to say in conclusion, because we do have to go I think, Mr. Chairman. Mr. Moss. That is correct. Mr. WATKINS. I want to thank Mr. Roach and Mr. Kostmayer and Mr. Day and you gentlemen for being here. Your testimony is most helpful and I am going to study it. My mind is not made up as to how I will vote or what will happen. Mr. Moss is a great friend of mine, very persuasive, and so is my friend on the right here too. I do not know what I will do, but I ap- preciate your testimony. Thank you for coming in. Mr. Chairman, may I be excused? Mr. Moss. Yes, you may. And I want to thank you gentlemen also. (The following letter was received by the committee:) AssoCIATIoN or MUTUAL FUND P~LAN SpoNsoRs, INc., New York, N.Y., November 7, 1967. Hon. HAsTINGS KErra, If owse of Representatives, Washington, DC. DEAR ~En. IcEmi: I am pleased to reply on behalf of the Association of Mutual Fund Plan S~ionsoi~s, to questions numbers 8-40 contained in your letter of October 27, 1967. The following are our answers: PAGENO="0047" 461 Q-8. A specific objection to the front end-load is that people have been forced to redeem in the early years of their plan at a loss to pay unavoid- able hardship expenses arising from illness, unemployment, or death. What percentage of planholders have been forced to liquidate for hard- ship reasons? How many of these have liquidated at a loss? What is the aggregate loss stistained by such persons in a typical twelve month period? A-8. Benson & Benson, Inc., of Princeton, New Jersey, have conducted a survey, referred to in my testimony before the Sub-committee, which contains some information that is informative in connection with your question. Professor Herbert Arkin, Chairman of the Statistical Department of the Bernard W. Baru~h School of Business and Public Administration, established the criteria for this survey before it was undertaken and analyzed it for us afterwards. The report was designed to determine what proportion of pianholders who terminated at a loss in the early years of the plan did so for reasons of hardship. The result of the Benson & Benson survey and analysis show that only some 45% of planholders who liquidated at a loss can properly be included among those who were forced to liquidate for hardship reasons. In the test period which Professor Arkin used these amounted to only 41/2% to 5% of all contractual planhoiders who initiated their plans within that period. We have applied Professor Arkin's figures to a broad group of some 17,000 accounts' started by four different sponsors in 1951 through 1953, and our study shows that of the approxi- mately 18% of those accounts which had terminated with losses as of December 31, 1906, only some 8% constituted persons who were forced to liquidate for hard- ship reasons. In the period for which these 17,000 accounts were considered, the aggregate loss sustained by all persons who terminated with losses was $240,000. Applying Professor Arkin'.s factor of 45%, this would mean aggregate losses of $108,000 in that entire period for those planholders who were forced to liquidate, or an average of $79.00 for each such account which was terminated with a loss. The figures set forth above relate to planholders who were forced to liquidate for hardship reasons and who suffered a loss. We do not have any comparable statis- tics with respect to planholders who may have been forced to terminate their plans due to financial hardship and who have nonetheless profited from their plans. As I mentioned in my testimony, there is available to all planbolders the right to withdraw up to 90% of the current liquidation value of the mutual fund shares held under their plans and subsequently to reinvest an equivalent amount without paying any sales charge at all. As a result, if a person suffered a finan- cial hardship and bad profited from his contractual plan investment, he could take full advantage o'f the 90% withdrawal right and have at least as much money available to meet that financial emergency as he had originally invested, and ~perhaps significantly more. To the `extent that contractual planholders with profits terminate their plans due to financial hardship rather than taking ad- vantage of the withdrawal privilege, this may reflect a choice on the part of those planholders to terminate their investment programs for some other unrelated purpose, although we have no statistics in this regard. You asked us to furnish you the aggregate losses sustained by persons who terminated due to hardship in a typical 12-month period. We have examined the records of one leading contractual plan sponsor which issued 13,205 plans in 1965. By December 31, 1966, 281 such plans had terminated with losses of $62.200.00. Applying Professor Arkin's factor of 45%, this would mean that 126 plans were liquidated due to hardship reasons, with aggregate losses of $28,000.00 which represents under 1% of the plans considered. Q-9. How can prospective purchasers of mutual fund plans be made effectively aware of the existence of level load voluntary plans so that they can compare the relative merits of contractual and voluntary plans? A-9. The prospectuses used by all contractual plan sponsors of which we are aware include at some point, either in the body of the prospectus of the sponsor or in the prospectus of the investment company whose shares underly the con- tractual plan and which usually accompanies the sponsor's prospectus, a description of the voluntary plan offered with respect to the shares of that mutual fund. For instance, I enclose a prospectus of my company, First Investors Cor- poration, with respect to the shares of Fundamental Investors. You will note that PAGENO="0048" 462 on page 1 of the First Investors prospectus there is a reference to, and on page 3 of the Fundamental Investors prospectus. there is a detailed description of, the systematic share accumulation account, which is the voluntary plan offered by Fundamental Investors. This practice of furnishing to contractual planbolders in the prospectus which must be delivered to them a description of the voluntary plan with respect to the shares of the same mutual fund goes far beyond practices of which we are aware in other businesses. For instance, as former Postmaster General Day testified before this Subcommittee, 3 states have savings bank life insurance which is offered without the use of agents and relates sales charges. No one requires that the agents offering regular life insurance policies with the full front-end load include in the literature delivered to the prospective pur- chasers any reference at all to the availability of savings bank life insurance in those three states, or any reference to the availability of term life insurance as an alternative to the whole life insurance product which is being sold. Q-1O. What is the median loss sustained by contractual planholders who liquidate at a loss? What would the median experience of this group have been if they had invested in voluntary plans? A-1O. We have examined the records of the 17,000 accounts opened by 4 sponsors in 1951 and 1953 which are referred to above and we find that the median loss sustained by holders of those accounts who liquidated at a loss in the period from December 31, 1966 was $114.00. You asked if we could inform you of the median experience of such a group of contractual planholders if they bad invested in voluntary plans. Unfortu- nately. I find it impossible to furnish an answer which would be informative. As I indicated before the Subcommittee, we believe that voluntary plans are not truly comparable to contractual plans. They are quite different vehicles. Most important in this regard is the fact that holders of voluntary plans, with- out the incentive created by the front-end load, have much poorer records of persistency than do holders of contractual plans. Our studies indicate, for in- stance, that some contractual planholders in some periods have been 10 times as regular in making payments as have voluntary planholders with respect to the shares of the same mutual fund. As a result, if the people who had purchased the 17,000 contractual plan accounts to which I have referred had instead commenced to voluntary plan programs, it is almost certain that they would have made far fewer payments on those programs than they had made on the contractual plan programs. It is therefore impossible to prepare any kind of meaningful statistics. My associates and I very much appreciated the opportunity to appear before the Subcommittee of which you are a member. Please tell us if there is any further information which we may be able to furnish to you in connection with the hearings. Sincerely, JOHN H. KOSTMAYER. Mr. Moss. The committee will now stand adjourned. We will have no further questions for you. The committee will adjourn now to meet again at 3:00 this afternoon in the same room, at which time Mr. Robert M. Loeffler, vice president, Investors Diversified Services, will be our first witness. The committee is now adjourned. (Whereupon, at 12:30 p.m., the committee adjourned, to reconvene at 3 p.m., the same day.) AFTERNOON SESSION Mr. STIJOKEY. The committee will come to order. This afternoon we will hear the witness and a statement of Mr. Robert M. Loeffler on behalf of the Investors Diversified Services, Inc. If you would like, you can summarize your statement and have it entered into the record if there is no objection. PAGENO="0049" 463 STATEMENT OP ROBERT M. LOEPPLER~ DIRECTOR AND VICE PRESI.. ]IENT-LAW, INVESTORS DIVERSIFIED SERVICES, INC., ACCOM- PANIED BY J~OSEPH P. GRINNELL, GENERAL COUNSEL Mr. LOEFFLER. Thank you, sir. (Mr. Loeffler's prepared statement follows:) STATEMENT OF ROBERT M. L0EFFLun, DIRECTOR AND VICE PRESIDENT-LAW, INVESTORS DIVERSI~IED SERVICES, INC. Mr. Chairman and members of the committee, my name is Robert M. Loeffler. I am Vice-President-Law and a director of Investors Diversified Services, Inc. ("IDS") of Minneapolis, Minnesota. I appreciate the opportunity to appear before you today to present the views of IDS with respect to certain of the provisions of HR. 9510 and H.R. 9511. IDS created four mutual funds for which it acts as investment manager and exclusive distributor. Collectively the assets of these funds amount to approxi- mately $6 billion. This aggregation of assets is the largest in the field and consti- tutes approxiniately 15% of the total assets of the mutual fund industry. The shares of these funds are sold exclusively by the IDS sales force of approxi- mately 4,000 men and women working full time as sales representatives of IDS. Our sales currently average approximately 15% of the total sales of mutual fund shares. IDS today has approximately one million mutual fund customer accounts and distributes fund shares in all 50 states. THE MUTUAL FUND AS AN ±NVESTMENT SEIIVICE The creation of funds by management companies is the tradition of the industry, a fact which should be borne in mind. Funds are created by investment management organizations as a means of making their services more widely available and with the expectation of making a profit. Were it otherwise, the mutual fund industry as we know it today would not exist. Rarely, if ever, do mutual funds just spring into being and then go searching for an investment manager and distributor. Essentially a mutual fund is a means by which an investment management ~organization offers to the public an investment service-a managed, diversified account with many other services included. This service is specifically designed to reach and accommodate a market composed of customers who have relatively small amounts of money to invest. Without the small customer, this industry would be dead. Without this indñs'try, the small customer would have no place to participate in the equity market without substantially greater risk and cost. Currently, the median amount that a new IDS customer invests is $1,280. These investments are then pooled, and each customer shares pro rata the dividends, the gains and the losses and pays his pro rata share of the cost of the service. Mutual funds are designed to permit new customers to enter without affecting the value of the investment of existing customers. Existing customers may withdraw their full pro rata share without affecting the investment of others-the redemption feature unique to the open-end fund. A mutual fund typically is a corporation separate in legal existence from its sponsor. There is nothing in the law that requires this. The origin of the sepa- rately incorporated fund predates the Investment Company Act of 1940. The purpose was to insulate the assets of the customers from any legal labilities of the sponsor. When the Investbent Company Act was enacted, it provided in effect that: if a fund was not separately incorporated it must, nevertheless, have a committee or some other equivalent of a board of directors; at least 40% of the directors or committee members (other than for a no-load fund) must be unaffiliated with the fund manager; and there must be a written contract between t~ie fund and the manager which must be approved at least annually by either the participants in the fund or by a majority of the unaffihiated directors; a~iy change must be approved by the participants. Today, with rare exception, a majority or more of the directors are unaffiliated with the fund sponsor. Their function is to oversee the operations of the manager and to make certain that it is fulfilling its obligations and commitments to its 85-592-08--pt. 2-4 PAGENO="0050" 464 customers, the fund shar~iolders. At IDS, 10 of the 12 directors of each of the four funds are unaffihiated with IDS. This system has now been altacked as inadequate to protect the customer from overcharging by the fund's creator and manager. I think this attack is ill- founded. The fact is that there is no other industry in the United Staes, at least insofar as I have been able to discover, whose customers have the unique protection that the customers of this industry have. Here the customers have disclosed to them In writing the precise cost of the service before purchasing it, and all material facts relating to it. The customers of few industries have even that today. Then, in addition, by law, they have the additional protection of an independent committee in the form of the unaffiliated directors, with the power and duty to oversee the operation, and to represent them with respect to any future changes in the charge for the service. So far as I am aware, since 1940 no management fee has ever been raised. On the other hand, there have been substantial and significant reductions. CREATION OF THE IRS MANAGEMENT FUNDS Probably no two funds complexes conduct their operations in exactly the same manner. I think it would be helpful to describe how the IDS groUp of funds op- erates within the present legal framework and economic environment. IDS was incorporated In 1894 in Minnesota. Until 1940 it w~s engaged solely in issuing and distributing installment savings contracts, known as face amount certificates, with a guaranteed fixed return at maturity. They were sold directly by sales representatives of IDS. The IDS Investment department was responsthle for the investment of the certificate reserves. In 1940, after the passage of the Investment Company Act, IDS organized its first mutual fund, Investors Mutual, to be distributed exclusively by the IDS sales force directly to individual investors. Investors Mutual Is a balanced fund: 35 to 40% of its assets are invested in fixed income securities, bonds or preferred stocks, the balance in common stocks, generally of a strongly blue chip character. Income has been one of the prime objectives of the fund. Today Investors Mutual has 440,000 accounts and $3 billion in assets. It is the largest nmtual fund in the world. Tn 1945 IDS formed Investors Stock Fund, a common stock fund empha- sizing income as well as growth. Today Stock Fund has 370,000 accounts an~L $2 billion in assets. It is the fourth largest mutual fund in the United States. At the same time that Investors Stock Fund was formed, IDS formed Investors Selective Fund. It is a small fund and its assets are invested in bonds and preferred stocks. Today it has 6,300 accounts and $39 million in assets. In 1957 IDS formed Investors Variable Payment Fund. It is a common stock fund like Investors Stock Fund, but with current income only an incidental objective. Today it has approximately 190,000 accounts and $830 million in assets. THE IDS DISTRIBUTION SYSTEM IDS is itself a broker-dealer registered with the SEC under the Securities Exchange Act of 1934 and with the "blue sky" agencies of the various states. However, the only products sold by IDS sales representatives are the face amount certificates issued by a subsidiary of IDS, the shares of the IDS managed funds and insurance policies issued by another sub~ldiary. No one other than IDS representatives sells these products. This system in which our own sales force deals direètly with our customers is known as direct distribu- tion. We do not distribute to customers through other broker-dealers, a system known as dealer distribution. Organization of the LDFJ $ales Force IDS has a sales forc~ of approximately 4,000 fuiltime career representatives; they have no other employment or source of earned income. They are not moon- lighters who work at one job during the day and then go out to make occasional securities sales to friends or relatives in the evening. The IDS sales representatives are carefully selected, trained and supervised by an extensive organization headed by the Vice-President Sales and his staff in Minneapolis, and by nine Regional Vice Presidents, 170 Divisional Sales Managers and 675 DistrIct Sales Managers in the field. Selection and Training of 1135 Sales Represent atives The Divisional Sales Managers seek out potential IDS representatives. They interview and test them and check their references and backgrounds. All of this PAGENO="0051" 465 information, with the results of personality and aptitude tests, Is evaluated by IDS against its experience to assess the applicants' qualifications. There is nothing casual about this process. In 1966, for example, 4,200 appli- cants sought to become IDS sales representatives, completed the business, per- sonal and family history forms, and took the aptitude tests. Of these 4,200 applicants, only 1,111 were appointed and licensed as IDS sales representatives. After a new man is selected, and before he is hired and commences dealing with the public, he is extensively trained and thoroughly acquainted with* the products offered by IDS, its sales standards and policies. After this training he must pass the federal and state examinations required to secure necessary licenses. When a new man is finally licensed and sent into the field, his sales manager closely supervises and assists him in getting off to a good start and insures that he adheres to IDS' sales standards. IDS is not interested in keeping marginal salesmen. If a salesman fails to earn $5,000 in his first year, he is usually asked to consider seeking new employment. In addition to the training of new men, each sales manager conducts conS tinning training sessions for his full staff to keep them currently informed of changes in the IDS product line and of proper selling practices. This training continues throughout the career of each sales representative in this fashion and also at periodic regional and home office meetings and confer ences. Recently, 1,250 IDS representatives from throug~hout the country par- ticipated in a three-day working conference at the company's home office in Minneapolis. &tles $upervision IDS has developed an extensive supervisory system. Along with their responsi- bility for training, our divisional and district sales managers have specific, de- tailed and continuing responsibility for supervising the sales activities of their representatives. Their performance in supervising is measured on a regular basis. In addition to supervision in the field, a department with more than 40 people at the IDS home office examines all applications submitted by the sales force to make sure there has been no violation of IDS' procedures and sales policies. Each application is referred to an electronic index system to determine what, if any, activity has occurred under that name on that or related accounts within the previous six months. The purpose of this procedure is twofold-to detect any indi- cations of deviation from IDS sales policies and to make sure that the customer is being charged the lowest applicable sales charge to which he is entitled by reason of previous purchases. IDS has 11 Oustomer Relations Representatives continuously in the field to audit the operations of the divisional offices and monitor the activities of the sales force through personal interviews of customers selected at random. Mutual funds do not necessarily fit into the financial planning of all customers at all times. IDS sales representatives also sell life insurance and savings certificates issued by subsidiaries of IDS. The IDS ~hilo'sophy is that sound financial programs for the customers it serves are based on four cornerstones: (1) money in the bank, (2) insurance, (3) a systematic savings program, and (4) investment in equity securities through mutual funds-in that order. In addition to sales interviews, the hIS salesman is required to make numerous follow-up and servicing call's to discuss his customer's current plans and objec- tives and to insure that the `customer is satisfied in his `dealings with IDS. Our experience is that a diligent sales representative will average two sales ir~terviews and four service and follow-up calls in a day. This means 12 sales interviews in a six-day week. Experience ha's shown that a successful IDS `salesman averages five sales interviews per sale. The Economics of the ID~ &aes Operation IDS has one million mutual fund accounts. A profile of the average IDS customer is a's follows: (1) he is a married man of approximately 50 years of age; (2) he is a high school graduate with some college or other professional training; and (3) he has an income of approximately $8,000 a year. On the basis of experience, we can expect his account to remain on the books for over 17 years. The maximum sales charge at IDS is 8% and the minimum is 1% depending on the size of the investment. A customer's existing investments in any of the PAGENO="0052" 466 funds are aggregated with any new purchase to determine the applicable sales charge. Furthermore, various options and privileges are available to IDS customers which significantly reduce the effective sales charge as a percentage of the total amount paid in. At IDS, capital gains distributions and investment income dividends may be reinvested without charge. In 1966, at IDS $238,382,000 was invested in that way. Also a shareholder of one IDS fund may transfer his investment to another IDS fund without sales charge or other fee. $140,211,000 was so transferred in 1966. The effect of these various options and privileges is significant. The gross commission income of IDS in 1966 was not 8% of sales, but 6.6%. It was only 4.6% of new money invested, which included reinvested dividends and capital gains. And it was only 3.9% when free intra-fund transfers are included. The trend in all these percentages has been downward. These are averages not applicable to particular investors. Nevertheless, these options are available to and are availed of by our customers, and with impressive results. For example, if in 1945, when Investors Stock Fund was organized, a customer bad invested $1,000 at an 8% sales charge, his total cost would have been $80. By reinvesting his dividends and capital gains distributions at no charge, as 95% of Stock Fund investors do, be would have dramatically reduced the effective percentage sales charge on the money he paid in: At the end of the fifth year he would have paid in a total of $1,245 and the effective sales charge on the money paid in would have dropped to 6.4%. At the end of the tenth year he would have paid in $1,989 and the effective sales charges on the money paid in would have dropped to 4.1%. At the end of the seventeenth year, the usual life of an IDS mutual fund account, he would have paid in $3,547, and the effective sales charge on the money paid in would have dropped to only 2.2%. At the end of the twenty-second year, October 31, 1966, he would have paid in $5,422 and the effective sales charge on the money paid in would have been less than 1.5%. In other words, this customer paid a sales charge of $80 to make an initial in- vestment of $1,000, and paid nothing to invest an additional $4,422. If he had then redeemed his shares he would have received $9,558 with no commission charge, all generated from his original $1,000, and the effective, charge on all money in and out would have been 0.53%. This is a far cry from an 8% sales load. The results of 1135' fund sales operations are set forth in the following table showing gross sales charges, expenses, and net income or loss for each of the years 1962 through 1966 and for the period ended August 31, 1967. 1962 1963 1964 1965 1966 8 months Aug. 31, 1967 Sales charges Expenses Net income (loss) before income taxes Net income as percent of sales $23, 378, 844 24, 695, 836 ~ (1,316,992) (0. 38) $22, 815, 100 23, 935, 204 (1,120,104) (0. 32) $32, 243,610 32, 443,694 (200,083) (0. 04) $40, 384,875 39, 287, 374 1,097,501 0. 18 $35,916, 149 34, 096, 444 1,819,705 0. 34 $18, 064, 581 18, 279, 895 (215,314) (0. 08) The following table shows the average~gross income of 1135' sales representa- tives and district sales managers for each of the past five years and as projected for 1967 from the first six months. They have no other source of earnings and must pay their business expenses from the gross set forth below: AVERAGE GROSS INCOME FROM SALE OF ALL PRODUCTS Sales representatives 1 District sales 2 1962 1963 1964 1965 1966 1967 (projected) $7,853 7,571 8,753 9,159 8,077 7, 233 $14,734 13,683 15,687 16,767 14,292 13, 556 lOnly representatives with more than 18 months of experience are included. 2 Divisional sales managers, the next level of sales managers, usually have higher incomes than do district sales managers. PAGENO="0053" 467 It is apparent from the foregoing that the present level of sales charges is determined by the economics of distribution, and is necessary to maintain an adequately compensated, adequately trained and properly supervised sales force. Moreover, as shown above, when viewed with all of the privileges included, the effective charge to the customer ends up to be low indeed. Section 12 of the Bills 1i~eIating to the Sales Load Section 12 of the Bills would amend Section 22 of the Investment Company Act to limit the maximum sales charge to 5% of the net amount invested-4.7~% of the offering price. IDS would be happy to see the sales charge on smaller sales lower than ~% if it were economically feasible. We have made studies seeking means by which the maximum sales charge could feasibly be reduced. To date, we have not been able to find a way-and at the same time maintain an adequately compensated, adequately trained, and properly supervised sales force. This does not mean that our efforts in this direction have ceased, but the present level is dictated by economic reality. What would be the consequences of this proposal? Our studies show that with a 5% maximum the average income of an IDS sales representative in 1966 would have been reduced by $2,900 to $5,200, or over 35%. This simply would be inadequate to retain trained sales representatives or permit us to attract and properly train new ones. I will not urge that the loss of income to sales representatives alone is sufficient reason to reject this particular proposal. There are other social consequences of a serious nature. To begin with, enactment of the proposal would undoubtedly mean that thousands of full time trained securities salesmen specializing in mutual funds will leave the business. Their loss would signifi- cantly reduce the availability of this particular investment medium to millions of people. Moreover, most of these persons, those with relatively little to invest, are the very ones for whom mutual funds are probably the most appropriate and safest form of equity investment. There is another and equally serious consequence which must be mentioned. This proposal would have its heaviest impact on well-trained, full-time career sales representatives like those at IDS. These are the men it would drive from the business, leaving the field to the so-called moonlighter, the part-timer who has another job and sells funds to raise some extra cash. I do not believe this would be either socially desirable or wise. The Securities Exchange Act Amend- ments of 1964 sought to up-grade the training and qualifications of securities salesmen. This industry and my company joined with the SEC in support of that legislation. The current proposal is utterly contradictory to and inconsistent with those objectives. Therefore, we oppose it. IDS MANAGEMENT SERVICES In accordance with the Investment Company Act of 1940, IDS has entered into Investment Advisory and Services Agreements with each of its mutual funds. These contracts have been approved by the shareholders and their continuation has been subject to their approval or that of the funds' independent directors. The name given these contracts is significant. Over and a~bove the furnishing of investment advice, these contracts require IDS to perform-at its own ex- pense-all of the administrative services necessary to the operations of the funds and to assume the expenses of any services performed for the funds by others. Thus, IDS furnishes the funds wih office facilities and supplies, and perform or pays for all accounting and auditing services. In addition, IDS is stock transfer and dividend di~bursement agent for the funds, prepares the funds' reports and proxy statements, pays for their custodial services and is responsible for the funds' compliance with the record keeping and reporting requirements of state and federal law. This means that the management fee paid to IDS by each fund is the only expense of that fund. All of the advisory and administrative services furnished by IDS must meet the approval of the directors of the funds. Each has twelve directors of whom only two are, in any way, associated or affiliated with IDS. The men who serve on these boards are experienced in business, financial and legal affairs. They in- PAGENO="0054" 468 elude lawyers, college presidents and businessmen. The number of independent directors on the ID~ funds boards exceeds the requirements of the Investment Company Act, The funds have a full-time president, vice-president general-counsel and see- retary-trea surer. These officers do not report to IDS and are not affiliated in any way with IDS. They are accountable solely to the boards of the funds. These officers continuously monitor IDS' services. They have access to all records and are provided with periodic and special reports in form and content established by them. Any revision of procedures or standards of business, and any significant changes in existing policies, are discussed with the funds' officers and directors. The fund directors meet monthly. An executive committee of each board meets weekly. At each meelug of the fund hoards IDS makes a formal report. This report includes, among other things, a complete analysis of the stock market and the performance of the funds, as well as a discussion of the economic outlook, the market outlook and the investment strategy to be employed on behalf of each of the funds. Contract Neçiotia4ions In the past five years four new sets of contracts were entered into with the funds. In 1966 the contracts were amended to provide for a reduction of the manage- ment feE~s equivalent to the entire net `profits attributable to fund securities trans- action's realized by an ID'S subsidiary which `had become a inembcr of the Pacific Coast Stock Exchange for this purpose in 1965. The other three contract revisions were the outgrowth of protracted nego- tiations. In each instance the funds appointed a negotiating committee composed of independent directors and the funds' General Counsel. For these negotiations IDS furnishes complete financial information concerning IDS' `business relation- ships with the funds. In addition, all available information with respect to other mutual funds and mutual fund managers is obtained an'd `considered. IDS also formed a negotiating committee to meet with the committee repre- senting the funds. Negotiations of the new contract which went into effect in 1963 extended from April 9, 19432 to November 7, `1962. The negotiation's of the 1964 contract changes extended from January 15, 1964 to June 23, 1964. The nego- tiations of the 1967 contract extended from May 19, 19436 to September 14, 1966. During the periods of negotiations, these committees met several times each month, sometimes separately and sometimes jointly. During these meetings var- ious offers and counter offers were made and discussed and various alternate arrangements considered. The ultimate agreement as to each contract w-as the result of genuine arm's length negotiations. Other Factors Affecting Management Fees There have been other developments which have contributed to reduction of management fees in the industry generally. As the m'utual fund industry-in'clud- ing IDS-grew rapidly after World War II, particularly during the middle and later fifties, management fees grew proportionately. The industry, fund managers as well as fund directors, began to reexamine what until then had been the stand- ard fee of .50% of net assets annually. Some fees were reduced. By the early 1960's the level of mutual fund management fees was challenged in litigation brought on behalf of the shareholders of various mutual funds. Most of these suits were resolved `by reductions in fees, generally by the adoption of sliding scales which provided for lower fee charges as the funds' assets grow. As the industry grew, there was greater public awareness of mutual funds and the various levels of charges. This awareness increased competition among funds with respect to fee rates, and funds with higher charges met pressure to reduce their expenses to those of their competitors. This pressure was increased by the publicity surrounding the Wharton School Report `and the 1963 SEC Special `Study of the Securities `Markets. The ResuZts at IDS For all of these reasons-fund negotiations, increased competition, shareholder litigation, and greater public awareness-management fees generally, and at IDS in particular, have been steadily and substantially reduced in recent years. PAGENO="0055" 469 The effect on the expense ratios of the 105 managed funds is as follows: Expense ratio: Percent 1962 0. 53 1963 0. 50 1964 0.44 1965 0. 40 1966 0. 34 8 mos. 1967 (annualized) 0.30 The resultant actual cost to a typical customer with a $5,000 account in an IDS managed fund is as follows: Management fee: 1962 $26.50 1963 - 25. 00 1964 22.00 1965 20. 00 1966 17. 00 8 mos. 1967 (annualized) 15. 00 The effect has been to reduce the cost per dollar of investment for an IDS customer from 1962 to date by over 43%. These reductions, in total, produced management fees in 1966 which were $9,300,000 less than they would have been on the basis of IDS' 162 contracts. A typical IDS customer with a $5,000 account, paying an annual management fee of $15, could not obtain the services provided by IDS-including diversifica- tion of risk and professional investment management-outside the mutual fund industry at comparable costs. Most investment advisers and banks do not accept advisory accounts of less than $100,000. Those that do set minimum fees which would be prohibitive to the typical mutual fund customer. In Philadelphia, for example, the major bank with the lowest fees would charge at least $460 per year to handle a $100,000 account. At 105 the management cost to a fund shareholder with a $100,000 account is $300. More to the point, however, is that an IDS customer need not have $100,000 or $10,000 or even $1,000 to invest. Bank common trust funds are the only investment medium generally offered which are comparable to a mutual fund; how~ver, the management charges imposed for participation in common trust funds are all substantially higher than those charged by IDS. Furthermore, the banks almost without exception impose a minimum annual charge regardless of the amount of money invested. In Philadelphia this ranges from $75 to $200, and in Minneapolis from $125 to $175. If IDS were to impose a minimum charge of $75 on each fund account, the cost to our fund shareholders would be prohibitive. $ectioa 8 of the Bills Relating to Ma'n~agement Fee9 Notwithstanding the effectiveness of the present system, Section 8 of the Bills would amend Section 15 of the Investment Company Act to provide that there be a statutory requirement that management fees be "reasonable," and that the courts, in a suit either at the instigation of the SEC or any fund shareholder, be empowered to determine the reasonableness of a fee, in effect to set the fee. At first blush this proposal may appear innocuous enough. Moreover, it places one who opposes it in the uncomfortable position of appearing to oppose reason- able fees. This proposal is, however, by no means innocuous. I know of no responsible or competent business man-and the SEC has ac- knowledged that "on the whole investment companies are managed by com- petent persons"-who believes his prices for goods or services should be or are unreasonable. This proposal raises a serious question: Who is to have the power to set prices for the products or services, the business man himself or someone else not engaged in the day-to-day running of a business, who does not have the responsibility, who need not answer for the results and consequences of his actions? This particular proposal constitutes a dramatic innovation in our economic system. I do not suggest that this alone determine in any way the question of whether the proposal is wise or unwise; but I do believe that awareness of that fact is important. During the history of our jurisprudence courts have always been reluctant to substitute their judgment on business matters for the business judgment of PAGENO="0056" 4~0 directors. This proposal would reverse this tradition and direct the courts to substitute their judgment for that of businessmen. Certainly the pricing of a product or service is at the heart of any business operation. I do not question the competence of a court to determine the reasonableness of a price. Courts, and juries as well, have often been required to do so. They have done so, however, generally in situations where it was necessary to resolve a controversy between private litigants and where the determination would normally affect only the litigants and then only with respect to a particular completed transaction. The practical effect of the proposal in H.R. 9510 and 9511 is to put the courts in the business of regulation; it would impose upon the courts the responsibility and necessity to set prices at which an industry must offer its services in the future. This has never been regarded as the func- tion of our judiciary. In another respect this proposal is an even more far reaching innovation. This industry is not a public utility. It enjoys no anti-trust exemption permitting a price-fixing agreement among mutual fund managers. It is a non-protected industry where free entry exists. I know of no statute in the history of the United States absent war time, which gave either a federal agency or a court the power to prescribe the price for a product or service in a competitive industry, and thereby the power to regfilate the profits of an in- dustry in accordance with whatever in its judgment it deems to be appropriate or reasonable. This Bill does just that, and I believe it is the first in our history to do so. Moreover, not only the courts would be engaged in the business of regulating management fees. As a realistic matter this proposal gives to the SEC itself the power virtually to set management fees through threat of litigation and its con- trol over proxy and prospectus requirements. As I mentioned before, I do not suggest that the fact that this proposal is a significant innovation in our social and economic system determines whether the proposal is wise or unwise. I do submit, however, that there is imposed on the proponent of such legislation the obligation to provide at least some reliable indication of what the probable consequences of the innovation would be. The SEC has not even undertaken to do so. It has given this Committee no evidence whatever of the probable consequences of its proposal either to the industry or to the millions of people whom the industry serves. If this proposal is enacted, management fees, histead of being governed by the interplay of economic forces and negotiations, as now, would be set by the SEC or a court without the consent of those engaged in the business. Here are some of the questions that arise. If, as a consequence, management fees were reduced below what competitive forces would otherwise produce, what would be the results? Will the quality of the service suffer? Will the entrance of new companies into the business be in- hibited? Will the sponsorship of new funds by those management companies al- ready in the business be deterred? Will newer entrants who have not yet achieved a profitable level of operations be discouraged from continuing? Will the devel- opment of new services for fund customers be retarded? Will there be endless litigation or instead will absolute uniformity in both fees and services in the industry result? Contrast these uncertainties with the known results of the present system. Concentration in the industry is diminishing. The variety and availability of services is increasing. The quality of the service is improving. And the cost of the service to the consumer, the fund shareholder, is decreasing. We urge you not to replace the dynamic force of a competitive system that is working with a new and untried system having unknown and unforeseeable consequences. CONTRACTUAL PLAN5 The IDS contractual plan-Investors Accumulation Plan-might well have been discussed in my comments on IDS' distribution system because it is a form of distribution. However, in view of the particular concern which the SEC has expressed about contractual plans because of the front-end load feature, this subject is treated here separately. In September of 1965, after several years of study, IDS introduced a con- tractual plan for the accumulation of mutual fund shares. We decided to do this because new methbd.s were required to meet the needs of the expanding market PAGENO="0057" 471 of younger investors. They lack the cash necessary for lump sum investment, but desire to build their resources through the systematic investment of a portion of their monthly income in equity securities. From our experience we were convinced that a front-end sales charge would be necessary to enable our salesmen to reach customers in this market. The purpose of the front-end sales charge is to provide the initial sales compensation necessary to enable the salesman to work with investors whose monthly invest- ment is so small-the average is only about $30.00-that the regular sales charges would be inadequate. Before deciding to offer an accumulation plan with a front- end load, IDS weighed all of the competing objectives: the objective of the customer to pay the lowest feasible sales charge and to minimize his potential losses in the event of early termination; the objective of the salesmen to receive adequate compensation; and the objective of the company to make a profit. We concluded that it would be possible to satisfy-at least in part-all of these c~bjectives by modifying the contractual plan then standard in the industry. Under existing law, contractual plans involving periodic payments can include an initial sales charge of up to 50% of the first 12 monthly payments, and substantially all do. IDS decided to offer a plan with an initial sales charge, not of 50%, but of 20% with the difference spread over the next three years' payments. Thus the IDS plan has a sales charge of 20% of the first year's payment, 18% of the 2nd and 3rd years' payments, ~% of the 4th year's payment, and 4.2% of the remain- ing payments. These plans are designed to extend over a 121/2 year period and the overall sales charge is 8%. If an IDS planholder, for any reason, or for no reason, wants to terminate his plan in its first sixty days, or is over a month late in making his second payment, the plan automatically terminates and all of his payments, including the sales charges, are refunded. To insure that these plans are not sold where a regular mutual fund investment would be feasible, IDS will not accept an application involving monthly payments of over $100.00. We have had only limited experience with our version of the front-end sales charge. Thus far, however, our confidence in its soundness seems justified. From October 1, 1965 to December 31, 1966, 58,251 accumulation plans were sold. Of these plans, 3,048 or 5.2% were cancelled and the full amount of the customers' payments refunded. Of the remaining 55,203 plans, 1,398 or only 2.5% have been terminated and 53,805 or 97.5% have remained active. Section 16 of tho Bill Relating to Uontractnal Plans Section 16 of the Bill would amend Section 27 of the Investment Company Act to prohibit the so-called front-end load on installment payment plans for the accumulation of fund shares. [f this proposal becomes law, it would mean the end for the IDS plan. We have studied the impact of the proposal. We estimate that with our 20% front- end load, and IDS plan must be in force for three years before IDS recovers its costs and begins to make a profit. If the SEC's proposal were in effect, IDS could never make a profit on this operation. Although IDS experience is limited and the persistency so far has been very good, we are not happy that some loss, however small, has been borne by any of our customers. IDS believes that close supervision of sales practices, strict adherence to its sales policies, and the design of the plan itself have contributed greatly to minimizing losses due to the front-end load. When IDS began the distribution of its accumulation plan it believed that the potential benefits to the public far outweighed any potential harm. This Com- mittee must weigh the same question. We urge you not to abolish a system of distribution necessary to make the mutual fund form of investment available to a large market for which it is particularly suitable. IDS PROFITS FROM MUTUAL FUND OPERATIONS The SEC would like to separate the economics of the mutual fund business into two parts-Investment management and distribution. It says the industry charges too much and makes too much from management, and charges too much for distribution, although It concedes that we make little, if anything, from the latter function. This distorts the picture. When the mutual fund business is viewed as it really is-an integrated operation-a vastly different picture is seen. PAGENO="0058" 472 The following table shows IDS's after-tax profit from mutual fund operations for each of the past five years and for 1967, as annualized from the first eight months, and measures that profit against gross income from mutual fund opera- tions, mutual fund assets and mutual fund sales. 8 months 1962 1963 1964 1965 1966 1967 (annualized) Profit from mutual fund operations $4, 633, 579 $4, 152, 025 $5, 850, 418 $7,375,497 Ratio of profit (percent): To gross income___ 11.85 10.52 11.4 12.23 To average net assets - 15 - 11 - 14 - 15 To mutual fund sales (excluding rein- vestment of divi- dends and capital gains) 1.33 1.30 .120 Companies of comparable size elsewhere in the financial community are vastly more profitable. For example, banks and insurance companies with comparable assets enjoy profits four times those earned by IDS from its fund operations. The facts will not support the SEC's charge of overpricing and excessive profits in the fund business. They do not justify the claim of need for drastic restructuring of the industry, with admittedly incalculable consequences, which the SEC pro- posals would produce. Mr. LOEFFLER. Mr. Chairman, members of the committee, with me is Mr. Joseph F. Grinnell, general counsel of Investors Diversified Services. As you have suggested, rather than read the entirety of the state- ment, in deference to the committee's time I will endeavor to sum- marize it and make certain points which I feel perhaps should be particularly made and stressed rather than cover the entirety of the statement. Mr. STUCKEY. Without objection. Mr. LOEFFLER. I am a director and vice president-law of Investors Diversified Services, of Minneapolis. I think I should first describe just a little bit about IDS, as Investors Diversified Service is corn- monly referred to. IDS is the creator and sponsor of four mutual funds for which it serves as the investment manager and as the sole and exclusive distribu- tor of the~ funds' shares. The assets of these four funds collectively total about $6 billion, and constitute about 15 percent of the total assets of the mutual fund industry. IDS distributes the shares of these funds through its own sales force of approximately 4,000 men and women who work full time solely as career sales representatives of IDS. The sales of the IDS sales force amount to approximately 15 percent of the total sales of the mutual fund industry. They distribute throughout all of the 50 States. I would like to comment first on the Commission's proposal with respect to the sales load, particularly to reduce the sales load to a statutory maximum of 5 percent. Before doing so, I should mention that IDS is a fully integrated distribution system. By that~ I mean that IDS performs all of the distribution functions from that of principal underwriter down to the direct sale to the customer and subsequently the servicing of the customer account. It is all performed byIDS. $7, 624, 910 $6, 550, 000 13.48 13 15 12 1.22 1.42 1.6 PAGENO="0059" 473 A description of the IDS distribution system is contained in the written statement, particularly on pages 6 to 10, but I shall not go into that at this moment. Mr. KEITH. Did you start off this way or is this something that finally developed? Mr. LOEFFLER. IDS has always distributed in this manner. IDS was formed in 1894, and was from then through 1940 a distributor of securities through its own direct sales force. In 1940 it founded its first mutual fund, and began the distribution of the shares of those mutual funds through its sales force in the same manner as it had theretofore operated. I am not sure that throughout its entire history the IDS sales rep- resentatives were full time. That has been the practice of IDS for many years now. The SEC has grounded its proposal for a statutory maximum of 5 percent on what it refers to, as I understand it, the theory of perverse competition. In substance it seems that the Commission's charge has been that the underwriters, the principal distributors of mutual funds, those who establish the offering price and then seek to market the shares of a particular fund, do not compete with each other for the customer dollar which, if they did, would have the tendency to bring the sales charge down. Rather, the Commission says it is a perverse competition, that these competitors compete with each other for dealer favor, for the favor of the dealers who in turn sell the funds' shares, and therefore the competition tends to push the sales load up, in order to enable the underwriter to pay more to the dealer. I make that point because it is totally inapplicable to IDS. We do not compete for dealers. Dealers do not sell the funds' shares distrib- uted by IDS. Only the IDS sales representatives sell the shares of the IDS-distributed and IDS-managed funds; so there is no competition for dealer favor. Mr. STtTOKEY. Do you, in a sense, do your own underwriting? Mr. LOEFFLER. Yes, sir; the entire part. Mr. STiJCKEY. Do you mean to say that you no longer sell as broker- dealers individual shares of stock? Mr. LOEFFLER. The IDS sales representatives sell mutual fund shares of the IDS-managed funds only, and those funds may be- Mr. STUOKEY. But do they not sell- Mr. LOEFFLEE. Other securities? Mr. STUOKEY. Yes. Mr. LOEFFLER. They sell a face amount certificate, which is issued by an IDS subsidiary. They sell life insurance, which is issued by a wholly owned life insuratice subsidiary of lIDS. They sell no other securities. Mr. STUOKEY. Only IDS? Mr. LOEFFLER. Only IDS products; yes, sir, and these products may be purchased only from the IDS sales representatives. Mr. KEITH. Is this life insurance business, that you have, the typi- cal stock company? Mr. LOEFFLER. Yes, sir. Mr. KFJTH. Or is it something geared in especially with your mu. tual fund business? PAGENO="0060" 474 Mr. LOEFFLER. No, sir. It is all forms of life insurance, ordinary life, term life, reducing life, sold independently of a purchase of fund shares. Mr. KEITh. No tie-in sales? Mr. LOEFFLER. No, sir. Mr. KEITH. There are some that have tie-in sales, are there not? Mr. LOEFFLER. There are, although I am not terribly familiar with them, sir, and I am a little reluctant to comment. I am not sure that they would strictly be what you call a tie-in in the sense that neither may optionally be purchased separately from the other. I am just not sure. I think a tie-in means that you cannot purchase one without the other, at least as I usually understand the term, but I may be wrong on that, sir. I may say on this, in response to your question, the IDS sales philosophy is based on what they call a four cornerstone approach, and that is that the average person should have money in the bank for immediate emergencies, cash, that he should have life insurance, that he should then have some fixed savings program of a fixed type, and then that he should have some equity investments such as a mutual fund as a hedge against inflation. That is the basic sales philosophy of the IDS sales representatives, and they are in a position to offer any form of these various investments. Mr. KEITH. It was not inadvertent when you left out life insur- ance? Mr. LOEFFLER. No, sir; life insurance I think is second. After cash in the bank, life insurance is in the foremost of the program. Mr. STITCKEY. Is this a contractual type of plan that the salesmen are selling? Mr. LoEFFLER. We also have a contractual plan, although I was not referring to that at the time. I can comment on that separately. It is slightly different than the industry format. Mr. STUOKEY. So you would offer just every type I guess except a no-load? Mr. LOEFFLER. Everything except a no-load, yes, sir, within the IDS family of packages, family of products. Mr. STUOKEY. Right. Mr. LOIDFFLER. I thought it necessary and essential to point out the fact that IDS does not compete for dealer favor because the IDS maximum sales load is 8 percent, and it graduates down from 8 per- cent. A description of the effect of various options on the average commission income to IDS is contained in my written statement, particularly on pages 10 to 13. Rather than go into those, however, at this moment, the particular point I wanted to make related to the question of why, if IDS does not have to compete for dealer favor, does it necessarily have a sales load as high as 8 percent as the starting maximum. The answer to that is solely a question of economic necessity, and this is the primary point which I did wish to make and to stress. On page 13 of the written statement, if you have it before you, are the statistics with respect to the gross income, expenses, and then net income to IDS from distribution of mutual fund shares. This shows the data for the years 1962 through 1966, and for this year to PAGENO="0061" 475 date; it shows that throughout that period, for 5 of those years, IDS lost money from distribution in 3 of the 5 years, made a slight profit in 2 of the 5 years, and in 1967 so far is again in a loss position. Out of a total gross income from the sales load, from the commission charges of over $172 million during that period, the net income to IDS was $65,000. It becomes abundantly clear that there is no profit to IDS from the distribution of fund shares, notwithstanding a maxi- mum of 8 percent sales load as the starting point. Mr. KEITH. Except of course as you get additional funds over which you can- Mr. L0EFFIJER. Fromthe management fee? Mr. KEITH. Yes. Mr. LOEFFLER. We do realize a profit from the management fee. Otherwise, we would not even be in the business. Mr. KEITH. This is the kind of point I have been making right along through these hearings, that the genesis and the sustenance of these mutual funds is in the investment company. Mr. LOEFFLER. Yes, sir; and this is a subject which I would like to get to as a separate point. Perhaps I could get to it later unless you would wish me to get into it at this moment. Mr. KEITH. Not at all. Go ahead. Mr. LOEFFLER. The question on the distribution side that immedi- ately arises in view of this result to IDS is what do our sales repre- sentatives make, since the major expense is the commission to the sales force, the sales representatives and their supervisors. Are they making exorbitant or excessive incomes? On page 14 of the statement, is the average income of the sales representatives of IDS and of the district sales managers of IDS for the period from 1962 to date. The difference between a sales representative as shown there and a district sales manager is that a district sales manager will spend ap- proximately 50 percent of his time in sales and about 50 percent of his time supervising other sales representatives, generally an average of about five sales representatives to a district sales manager. As indicated there, the average income to an IDS sales representa- tive in 1966 was $8,000 per year, and for a district sales manager was $14,000. These are full-time career sales representatives. I think it is abundantly clear that this is a minimum, amount necessary to attract and to keep well-trained, qualified career sales representatives. As an actual matter and in practice, what happens is that the sales representatives, those who are qualified and able, naturally move on to becoming district sales managers, because $8,000 normally will not retain a good man on a permanent basis, and that is the progression which occurs. The entirety of the point which I wish to make from this is that it is abundantly clear that the reason for the level of our sales loads is strictly a matter of economic necessity. It is a matter of the economics of distribution, the amount which is necessary to maintain an ade quately compensated and an adequately trained and a properly super- vised sales force. I might say that we would be happy, too, if we could cut that max- imum and reduce it. It would be good business and we would like to do V PAGENO="0062" 476 so. We have studied ways in an endeavor to do so, but we simply have' not yet, to date in any event, been able to `devise a means by which we could reduce the maximum perhaps, and level it out. I would like to turn for a moment to a comment on the impact of this proposal. First of all, of course, the proposal to reduce the maximum sales load to 5 percent would mean a reduction in the income of `the sales representatives, a reduction of approximately 35 percent, and we sim- ply would not be able to keep them on that `basis, but that alone is not the only consequence. Mr. KEITH. Excuse me a second if I may, Mr. Chairman. It is quite significant, it seems to me. These men are really part-time salesmen insofar as mutual funds are `concerned. They are full-time salesmen, but they spend a part of their time on mutual funds and a part of theirtime on life insurance. Mr. LOEFFLER. Yes, in that sense they are. When they call on a cus- tomer, they are in `a position to offer the full line of ISD products, which includes life insurance. The $8,000 figure is the income of the average sales representative from all sources. Most of that is from the sale of mutual fund shares. When I say most, I believe that over percent, 72 percent of their income is from the sale of mutual fund shares. Mr. STUOKEY. You do not think then, if it were lowered to 5 percent,. that this would tend to increase sales? Mr. LOEFFLER. No, sir. If we thought it would we would do it now. What it would eliminate in particular would be the ability of the sales representative to call on the small investor, he who has only a small amoun't to invest.' Mr. Moss. Let me express my apologies to you. It was necessary that I be in attendance at another subcommittee which I chair, in order' to get out a rather pressing report. Mr. LOEFFLER, Yes, sir. Mr. Moss. `I do apologize. Mr. LOEFFLER. The further point that I wanted to make, before' leaving this question of the impact of the `Commission's proposal on the sales load, is this: Not `simply that it would reduce the income of' the `sales representatives. That is of concern to us and it is of concern to our sales force, of course. But the heaviest impact of the proposal would be upon the full-time career security sales representatives such as `those at IDS. These would be the men who would have to leave' the business and seek employment elsewhere or other means of income. The impact would be to leave the field primarily to the part-time se- curities salesman, to what you might call the moonlighter, the man who has a regular job, a regular income and salary, and then sells mutual funds at night as a means of supplemental income, and the tendency of this bill would `be to leave the field to them. This, I think, is directly inconsistent with what were the objectives' of the 1964 Securities Act Amendments, which sough't to upgrade the training and the qualification and the supervision of security salesmen. My company, and I think the industry generally, cooperated with the Commission in support of that act and of those objectives, but the impact of this proposal runs directly t'o the contrary. PAGENO="0063" 477 Mr. WATKINS. Mr. Chairman? Mr. Moss. Mr. Watkins. Mr. WATKINS. I would like to ask a question of you, if you would care to answer it, if you are in a position to. Do you think that the Congress of the United States has any legal right to regulate this money? Mr. LOEFFLER. By legal right, if you mean constitutionally- Mr. WATKINS, Constitutionally, do they have a legal right to do it? Mr. LOEFFLER. I see no constitutional question, sir. Mr. WATKINS. You see none? Mr. LOEFFLER. No, sir. Mr. WATKINS. Thank you. Mr. Moss. As a matter of fact, you are operating under a congres- sionally imposed ceiling at the present time, are you not? Mr: LOEFFLER. With respect to contractual plans, that would be so; yes, sir. I would like if I may to make a few comments with respect to the Commission's proposal relating to the management fee. The proposal, as I am sure you are familiar, is merely to put into the statute a statutory requirement that management fees be reasonable. Certainly I, and I think all responsible businessmen, would feel that manage- ment fees should be reasonable, and indeed any businessman would feel that the price for his product or his service should be reason- able. The question really is one of upon what system shall be rely to produce a reasonable price level? Basically there are, of course, two systems which can be utilized. One is a system of free competition, such as generally prevails in the United States and in most industries. The other system is a system of regulation. The proposal, in effect, is to substitute a system of regulation for the system of free competition which presently prevails in the industry. And that is the question. I do not say that critically. I say it only in order to pose what I be. lieve is the issue. The SEC states that the reason-well, let me first make one further comment on that. When I describe the proposal as regulation, it is for this reason: This proposal would give to the courts or to the Commission, which one is immaterial, the power to establish the price for the investment services being sold, the power to establish the price independently of a price which might have been agreed upon between the suppliers of the service, the management companies, and the purchasers of the service. Now whenever a third party who is not a party to the trans- action, such as the court as it would be in this case, is given the power to set the price, that is regulation, and that is what we would have here. The SEC, in support of its recommendation that we go to a regula- tory system with respect to management fees, has taken the position and charges that the present system is not working in the interest of the consumers, the ultimate consumer, the fund shareholder who uses the services and pays the charge. The Commission's charge is that it is not working effectively because, if it were, as the funds have grown in size over these past few years, the inevitable conse- PAGENO="0064" 478 quence would have been to reduce the charge to the investor, to re- duce the management fee, the rate, the per dollar rate, My conviction is-and this is what I wish to point out-that the present system is working. I think had the SEC made its charge 10 years ago, there might have been a great deal more validity to the charge, but I think that the charge is predicated upon circum- stances which might have obtained 10 years ago, but which no longer obtain in the industry. Let me refer specifically to the present situation as it exists at IDS. During the past 5 years, since 1962, four new sets of contracts re- lating to the management fee have been put into effect, each one suc- cessively reducing the per dollar rate of cost to the investor. One of them related to an IDS subsidiary which became a member of the Pacific Coast Stock Exchange, for the purpose of being able to handle portfolio brokerage transactions for the funds. At the time that that was done, the contracts were amended to provide that the manage- ment fee would be reduced by an amount equivalent to 100 percent of the net profits from the handling of the fund brokerage transactions. The other three contract changes during the past 5 years were the result of rather extensive negotiations between IDS and those directors of the mutual funds who are unaffiliated in any way with IDS. There have been other factors which have influenced the present trends of management fees. These include increased public awareness, increased awareness on the part of the managers, the general maturity of the industry, and increased competition. As a result of all of these factors and these contract changes, on page 21 of the written statement which I have submitted are the figures showing the effect at IDS, and the benefits which have accrued to the million fund accounts which IDS has. In 1962 the expense ratio for the IDS funds was 0.53 percent. That covered all expenses of the funds, fifty-three hundredths of 1 percent. Under the IDS contracts IDS absorbs all expenses of the funds out of the management fee so the management fee and the expense ratio are exactly the same. In this current year, the expense ratio has been reduced down to 0.30 percent. That is a reduction of 43 percent. What does this mean to the individual shareholder, to our individual lIDS customer ~ In 1962 it cost $26.50 total expense for the maintenance of an ac- count of $5,000, which is our average account. In 1963 it was $25. In 1964 it was $22, in 1965 $20, in 1966 $17 and currently this year it is running at a rate of $15, a 43-percent reduction. There have been sub- stantial economies. These have been passed on to the funds share- holders. It is our conviction that this present system is working and is work- ing well and effectively. Mr. Moss. Would you tell me where in this system the force of competition enters? Mr. L0EFFLER. Yes, sir. It has its bearings in many ways. One is when we sit down to review our management contract annually; we are very much aware of the cost of equivalent type services, primarily the charges being PAGENO="0065" 479 charged by other fund mangers. There are approximately 100 spoil- sors of mutual funds, each competing with the others for the investor dollar. We sit down and we review this, and we have it very definitely pointed out to us if another fund manager is using a different system, providing a service here that we do not provide, or charging a lower cost; in turn when we reduce our fees we know that others are having that called to their attention, and so the competitive forces do work. We have it called to our attention from our sales representatives also. They are out meeting the public, selling these funds to their customers. Each sales representative generally represents or servIces about 250 accounts. These are generally customers of his who live in the community in which he lives. Most of his new accounts come from referrals from them. He in turn looks at this. Mr. Moss. My question goes to the forces of competition in pro- viding the management services to the fund, and other than the fact that there is an awareness on the part of a board of directors or the directors of the fund of general practices in the industry, where does the arm's length competition come in? Do they cover offers from other managers? Mr. LOEFFLER. They have had no occasion to do, sir. Mr. Moss. Well you are saying then that all management- Mr. LOEFFLER. They have the power to do so. Mr. Moss. Can you cite me any instance in any fund where that has happened? Mr. LOEFFLER. I think there was a reference here the other day, sir, to a fund which changed its investment managers a couple of years ago. Generally speaking, sir, it does not happen, and I do not mean to contend, and would not suggest, that the unaffihated directors of the funds-that is, those who have no affiliation with the manage- ment company-should sit down and say, "We can get a better deal from another management company or from a bank or someone else over here who will manage this for 2 cents less. Therefore, we shift over here." Mr. Moss. They do not really know, do they, because they do no~ invite any competing offers- Mr. LOEFFLER. It is all published, sir. Mr. Moss (continuing). Or proposals? Mr. LOEFFLER. This information is all published. Mr. Moss. Do they entertain any proposals? Do you go out and submit proposals to other funds? Mr. L0EFFLEii. To other funds? Mr. Moss. To undertake management activities for them? Mr. LOET?FLER. No, sir. Mr. Moss. You do not. Mr. L0EFFLER. We have never considered this. Mr. Moss. Do you know of anyone else who does? In other words, we are going to use terms here. I think if we are going to talk about competition, let's bring it down to- Mr. LOEFFLER. That would be one form of competition and I am not contending that that form- Mr. Moss. I am using it more or less in the orthodox sense. Do you actually compete in that market for that particular account? Let's 85-592-68-pt. 2--5 PAGENO="0066" 480 say it was an advertising account. We know that there is good sharp competition to get it. Now it is in a different sense that you use the word "competition" here, is it not? Mr. LOEFFLER. It is a different form of competition that I am ad- dressing myself to; yes, sir. Mr. Moss. Let's say it is less competitive competition. You are say- ing it is competition of performance. Mr. LOEFFLER. No, sir. That would be only part of it. No, sir. I think if I might try to clarify what I am referring to, there are ap- proximately 100 managers of mutual funds, 100 different companies which are managers. What we compete for essentially is the investor dollar of the customer, the ultimate customer. In doing so, the price of our product to that customer is an aspect of that product. We do not sell to the customer solely on a question of price, as in many other types of commodities which are not sold on price alone, but it is an aspect of it. We compete with 100 other sponsors of mutual funds who compete for the customer favor, the ultimate consumer, for his dollar, and the cost of our service, which is clearly disclosed on the prospectus, is an aspect of the service that we are selling. It is an aspect of the product. Mr. Moss. I have no doubt that as it shows in the prospectus that it is an aspect of the service. I am not always certain how much empha- sis might be placed on that, how much of a comparative discussion would be undertaken with a prospective buyer. I would assume that the good salesman would duck that point and go on more to the items of more immediate benefit to the buyer rather than getting into the technical details of management and things of that kind. Mr. LOEFFLER. No, sir; but the cost he is required to point out, and it is an a~pect of it. Mr. Moss. It is there. Mr. LOEFFLER. it is there. Mr. Moss. And so it is recognized, but in a comparative sense is it discussed? Mr. LOEFFLER. It may or may not be, sir. Mr. Moss. I don't think a salesman with a relatively unsophisticated buyer would enter into a discussion of that type since it might tend to discourage or confuse him. Mr. LOEFFLER. I think the cost is very low so we would regard it as a virtue. Mr. Moss. I think you have an excellent plan. I am not criticizing it. Mr. LOEFFLER. I understand. Mr. Moss. We are just getting into a discussion of the type of com- petition. Mr. LOEFFLER. Yes, sir. Mr. Moss. That is brought into play here, because really it was an expression on the part of the SEC that the element of competition as they had hoped it would develop had not developed. Mr. LOEFFLER. Yes, sir. My contention is that there is an effect from it. Let me go on if I may to clarify that, sir. Mr. Moss. Certainly. PAGENO="0067" 481 Mr. LO]~FFLER. In addition to that form of competition, we do have these very extensive and prolonged negotiations with a committee of the fund board. There is reference to them in my written statement at some length. During those discussions and those negotiations, the charges made by every other fund manager are reviewed at some length. Are we being competitive? Are we meeting them? When we reduce ours, I know this happens elsewhere, and it is the pressures of this and the combination of all these circumstances which result in the continuous lowering of the charge. I think the fact that we have reduced the cost to our investor, per dollar of investment, by more than 43 percent in the last ~½ years would indicate that something must be working, and working effec- tively. Else I think I run the charge that IDS has become an eleemosy- nary institution, and if so, then we would have a great deal of difficulty in answering to our own 14,000 public shareholders. I think that the results indicate the operation and effectiveness of the system. If I might go on more directly to the Commission's proposal on this, the question would immediately arise, I am sure, that if we be- lieve, as we do believe, that our charges are reasonable, and that we wouid have no difficulty in justifying and sustaining a challenge upon those charges under a standard of reasonableness, why do we object to putting that standard and that requirement into the statute. I would like to ad& tress myself to that briefly, hopefully briefly, with respect to a few points. As I ha cc said, once that is i)ut in~o the stature, it substitites thc regulatory systeni for the pres~nt system, and the question become$ then, who is going to determine the reasonablene~s of the price level? It no longer becomes those who are engaged. in the business sad who have the responsibility for the conduct of the business, but it becom~; some third party who is not a party to the transaction. Under this proposal initially a judge, any one of a thousand judges throughout the United States-I am sorry, sir, did I interrupt? Mr. WATKINS. No, you go right ahead. You are hitting on my ques- tion that I asked you. Please continue. Mr. LOEFFLER. Now there are several aspects of this particular pro- posal which are quite unique. I do not suggest that the mere fact that it is unique answers the question as to whether it is wise or not, but I think it is important to a determination of that to recognize these facets of the proposal, in order to evaluate it. The first is that it creates a unique function for our judiciary. His- torically, our courts have taken the position that they will not substi- tute their judgment for the business judgment of directors or those engaged in running the business, absent some showing of malfeasance or something of that nature. This proposal not merely empowers the court to substitute its judg- ment for that of the directors of a corporation. It directs and mandates that the court substitute its business judgment upon the pricing of a product for the business judgment of the directors who had thereto- fore agreed to it. Again, I am not questioning whether the courts might or might not be competent to do so, but this historically has not been and is not generally the function of our judiciary. There is a second aspect of this proposal which again is unique and which I think we should be aware of, and that is that it is a complete PAGENO="0068" 482 innovation in our present economic system in this sense. It puts a regu- latory pattern or system on an industry which is not a utility, which is an industry in which open and free competition exists. There are 100 fund sponsors today. New ones are entering the business daily. There is no restriction upon the entrance to the business. Neither is it a utility in the sense that one must be franchised, nor that only one exists, nor that the customer must purchase the service as a matter of absolute necessity. So far as I have been able to discover, this would be the first statute in the history of the United States, other than in wartime, where Con- gress would have imposed a regulatory system on a competitive industry. There is a third point which I think also should be borne in mind in evaluating this proposal, and that is the effect that it has as a nullifi- cation of State corporate law. A fund management contract will have been offered by the management company and agreed to by it. The purchase is purchased after disclosure to the fund shareholders. The contract is approved annually by fund directors, and any change ap- proved by the stockholders of the fund themselves. Now then, this proposal directs the court to completely disregard the effect which State law gives to shareholder approval of a fund con- tract. It nullifies State law and the effect which State law gives to shareholder approval. This applies to all 50 States. Now the point which I would like to make is this. This is premised by the SEC on the contention that when shareholders vote upon a mat- ter submitted to them by the management of a corporation, in the ab- sence of a proxy fight the vote is meaningless and routine. Therefore, the Commission says no effect should be given to it. Well, if there is validity to that argument and to that position, it is certaintly equally applicable to shareholder approval of transactions of all publicly owned corporations. There is nothing unique or distinctive about mutual funds in this regard as distinguished from any other publicly held corporation. Now if Congress is going to declare as a finding, which it does when it accepts that position, that shareholder approval in a publicly owned corporation is a meaningless act, and should not be given the effect which the laws of our 50 States give to it, then such a congressional declaration portends the same sort of action generally, because if the shareholders of mutual funds need to be protected from the effect of their own vote and own approval, so do the shareholders of General Motors, of A.T. & T., and of any other publicly held corporation. I think that this finding, whether it be wise or unwise, be that as it may, has portent far beyond the mutual fund industry. It has implica- tions in the general corporate law, the creation of a Federal common law in this area or a Federal corporate law nullifying the corporate law of our 50 States. Again, I mention this only because I think there should be awareness of it as a consequence of this proposal. Mr. WATKINS. May I interrupt you? Then you do agree? You said before that you had no quarrel. In your testimony now it seems you do have a little quarrel. Mr. L0EFFLER. I beg your pardon, sir. I think I may have misspoken myself. I said I had no quarrel with the proposition that management fees should be reasonable. PAGENO="0069" 483 Mr. WATKINS. That wasn't my question. I asked you a question, if you thought under the law it was constitutionally proper to interfere with this fee. I know and you know that under section 22 of the In~ vestment Company Act of 1940, I am questioning whether they have the right. Under that act it was a voluntary self-regulatory body to permit its members to distribute mutual funds and shares of the price including unconscionable or grossly excessive sales charge. Mr. LOEFFLER. Let me clarify, sir. When I answered your question before- Mr. WATKINS. I understood you to say no, that you had no quarrel with it. Mr. LOEFFLER. I think that Congress constitutionally has the power to do this, to enact such legislation. I am not saying that I agree that it should. Mr. WATKINS. I don't agree that they have the power. Mr. L0EFFLER. There may be some question about it. Mr. WATKINS. There is some question in my mind and I could be wrong, of course. Mr. LOEFFLER. As a lawyer I had not personally felt that there was a constitutional question as to congressional power on the issue. Mr. WATKINS. You go right ahead. Mr. LoEirrLER. But I certainly do not agree that it would be wise to do, that it would be wise legislation. Mr. WATKINS. All right; you go ahead. Mr. LOEFFLER. There is one additional point which I would wish to make with regard to this proposal. Again it is one of which I think there should be awareness. In reality and in practice and effect, this bill would give the SEC, either apart from or in addition to the courts, the power to set management fees. It could do this through a threat, through the threat of litigation, and through the control that it has over proxy and prospectus requirements. The SEC would, I think, and certainly any lawyer who has dealt on a continuous basis with the SEC would, I believe, recognize that the SEC would realistically and pragmatically have the power to impose its will as to what management fees should be under this pro- posed statute. I am not being critical of the SEC when I say that it would have that power, and that it would have that effect. I think under the statute it would probably be the duty of the SEC to at- tempt to do so. The point I wish to make is this. The effect would then be to give the power to set the price for an industry to an agency Yet, at the same time the statute sets up no procedures, no mechanics, and no safeguards with respect to the exercise of that power. It is an inevitable consequence, but yet the statute does not address itself to the consequences that would occur. This, again, I think, is a matter of ii hich the committee must be aware in evaluating the proposal and the merits of it. I think the consequences of all of this, of this proposal, would undoubtedly pro- duce a great deal of uncertainty. It would undoubtedly breed a rash of litigation, and it would undoubtedly make it difficult for those engaged in the business to obtain competent and qualified directors, if their judgment is to be disregarded, and they are then to be sub- jected to the litigation that would undoubtedly ensue. PAGENO="0070" 484 The conclusion which I would draw from all this, and my comment in conclusion is that on behalf of IDS, we would urge the committee not displace a system which we believe is working well and is working effectively, with a new and an untried system, having unknown and unforeseeable consequences. Mr. Chairman, this would conclude the remarks which I had on the points which I particularly wanted to stress in my oral comments. I shall be pleased to answer, or to attempt to answer, any questions which the committee might have. Mr. WATKINS. Mr. Chairman, I have a question. Mr. Moss. The Chair will recognize the gentleman from Pennsyl- vania. Mr. WATKINS. Thank you, Mr. Chairman. I just wonder what your opinion would be. Let's suppose now, let's take for granted that this bill is passed, what effect would it have upon you in employ- ing salesmen? Could you employ salesmen on this basis of 5 percent? Mr. LoErri~R. No, sir; I don't believe that we could~ We would have to go to some kind of a part-time salesman system, I think. Mr. WATKINS. You would have to do away with your regular trained salesmen and go to part-time salesmen. Mr. LOEFFLER. We would have some who undoubtedly could con- tinue under that, some, but we could not maintain the distribution sys- tem that we now have in the manner in which we operate on that scale; no, sir. Mr. WATKINS. In other words, I could be working for a grocery store and selling insurance at night. Mr. LOEFFLER. Yes, sir. I think we would almost have to go to that kind of a system. Mr. WATKINS. Would you be left in a position where you would say that that person would not be trained properly to consummate sales? Mr. LOEFFLER. I don't think we could train them the way we do to- day; no, sir. Mr. WATKINS. You don't? Mr. LOEFFLER. If I might elaborate one moment. We figure that it costs IDS approximately $15,000 before we have a sales representa- tive trained, validated, and on a permanent basis. We subsidize the salesman during his first year and in his training period. Our training material-one set of it would stack to here [indicating]-is extensive because our endeavor is to get men who remain full-time career sales representatives. We simply couldn't do it and the kind of men we want couldn't earn their living. Mr. WATKINS. I wouldn't think so, not from your figures which you give us on one of these pages, 12 or 13, where you say that $7,233 is the salary, the complete salary for a man for a year. You would be reduc- ing that salary. Mr. L0EFFLER. That would be reduced to $5,200 a year under the 5- percent proposal. Mr. WATKINS. From $7,233 to $5,200~I Mr. LOEFFLER. No, sir; I take it back. The reduction to $5,200 would be from the 1966 figure of $8,100. From the 1967 figure it would be much less. Mr. WATKINS. In other words, it would injure your business. Now would you go as far as to say you would get out of the business if this PAGENO="0071" 485 happened? Let's say the law went into effect. Would you have to get out of business or could you continue? Mr. LOEFFLER. I think we would struggle along somehow, but I don't know how; but I think we would find some way. It would just have to be done in an entirely different manner and I think it would be done in a manner which would not enable us to provide the same protections to the investing public that we now do under the requirements of the 1933 act and the 1964 act amendments. We just couldn't do both. We couldn't maintain quality sales and a well-trained sales force and try and stay in business under that schedule. Mr. WATKINS. Thank you very much. That is all right now, Mr. Chairman. Mr. Moss. Mr. Blanton. Mr. BLANTON. I have no questions. Mr. Moss. Mr. Keith. Mr. KEITH. Thank you, Mr. Chairman. Do I understand you to say that the shareholders of mutual funds have the usual State common law protection or statutory law protec- tion that a shareholder has in the ordinary corporation? Mr. LOEFFLER, Yes, sir; the law is exactly the same. Mr. KETTH. But is the scheme the same? Mr. LOEFFLER. Yes, sir. Mr. KEITH. I think that might be what this is all about. Mr. LOEFFLER. Well, then, perhaps it would be helpful if I elaborated a bit, sir. Mr. KEITH. I think it would be. Mr. LOEFFLER. Let us say, for example, that X Corp., whatever it is, adopts a stock option plan. That would be approved by the directors of the corporation, and the approval would he by those directors who are not eligible to participate in the stock option plan. Probably some of the directors would be eligible, but the majority would not be. Mr. KEITH. Let's keep the situation as closely parallel to- Mr. LOEFFLER. To mutual funds? Mr. KEITH. To the mutual fund industry. We are talking about- Mr. LOEFFLER. A management contract? Mr. KEITH. The management contract. We are talking about the directors of the fund having to buy services elsewhere, and a minority stockholder having the right to sue. Mr. LOEFFLER. Yes, sir. Mr. KEITH. And to prove in court that there was a conflict of in- terest involved, and that the principals should declare that conflict of interest and lean over backward to protect the shareholders. Mr. LOEFFLER. I don't think we will have any quarrel on this at all. sir. Perhaps I can clarify that. Mr. KEITH. You are speaking from an industry point of view, not just from IDS. Mr. LOEFFLER. Yes, sir, from a legal point of view that would be ap- plicable generally and particularly to the industry, as a lawyer. When the management contract is approved, and it must. be approved annual- ly, the approval must be given by those directors of the fund who are not in any way affiliated with the management company. Now let me be a little more specific. PAGENO="0072" 486 Mr. KEITH. You mean the unaffihiated directors. Mr. LOEFFLER. Yes, sir. Mr. KEITH. Who appoints them? Mr. LOEFFLER. Well, they are nominated normally. The usual proce- dure is that a board, in submitting its slate of directors to the share- holders annually, the board nominates the board, so they would be in effect continuously self-appointing. May I be specific on that, sir? Mr. KEITH. Would they be likely to be reappointed if they chose to hire another firm than that which currently uses it, because the other firm offered to give them the same services at less cost? Mr. LOEFFLER. They would have the power within themselves. May I be a little bit more specific, sir? Let me take lIDS, for example. The lIDS funds each have 12 directors. Of those 12 directors, two are affiliated with lIDS. None of the other 10 directors are affiliated in any way with lIDS. Now when those funds select the slate of directors for the succeed- ing year, the nomination is made by the 12. Obviously the majority of those directors, and therefore the control of the board for that purpose, is among those who have no affiliation with lIDS. The power resides in those who have no affiliation with lIDS because they are the majority. Mr. KEITH. I understand that, but this does not seem to me to be the usual situation that obtains in the usual corporate structure. It seems to me to be a unique arrangement worked out by this committee earlier in its history to provide for the continuation of the mutual fund industry. But it seems to me that the standard to which they must refer- namely, either stockholder approval or unconscionable compensation- the stockholder is not in the same situation. He has a yes or no vote ordinarily on the approval or disapproval of the management fee, and he is not dealing with the same situation as exists in the usual stock- holder case. Mr. LOEFFLER. Let me perhaps add then, sir, if in fact the approval of the management contract is by a board of directors of the funds, of which a majority are affiliated with the management company, in other words, so that you really hav&- Mr. KEITH. Even if this law didn't exist as it is at the moment. Mr. LOEFFLER. No, sir. Even if the Investment Company Act didn't exist, the law would be the same in this area. Mr. KEITH. All right. Mr. LOEFFIJER. The Investment Company Act does not create this situation. This would be the law without it. Mr. KEITH. The law would still be there, but I think that they would have to turn to prove-there was a case that was pointed out to me about the American Tobacco Co., where they had an arrangement with the president of the company, a formula under which this individual was getting $5 million a year. A stockholder took this case to court and was able to prove that this wasn't reasonable cOmpensation, be- cause he was not giving any services in connection with this, and the compensation was cut down considerably. Are you familiar with this case? Mr. LOEFFLER. I am familiar with the case. The effect was slightly different, sir. PAGENO="0073" 487 Mr. KEITH. Well, the law to which they turned was- Mr. LOEFFLER. State law. Mr. KEITH. A State statute, and even though the law there may be different than it is here, the law here I believe talks about un- conscionable, does it not? Mr. LOEFFLER. The unconscionable provision in the Investment Company Act, sir, relates to another matter. It relates to the sales load area. Mr. KETTH. The sales load area. Mr. LOEFFLER. It does not relate to- Mr. KEITH. Not to this. Mr. LOEFFLER. No, sir. Mr. KEITH. So the only subject we are really talking about is whether or not there is a bona fide similar parallel between the shareholders of a mutual fund and the stockholders of a corporation. Mr. LOEFFLER. I think it is exactly the same, sir. I think they have exactly the same- Mr. KEITH. There is in these many volumes of hearings that have been presented to us a dissertation on this subject, but that is one of th~ arguments I think that Mr. Cohen has advanced for this legis- lation, that there is not truly an arm's-length relationship, and you are insisting that there is the usual arm's-length relationship. Mr. LOEFFLER. Yes, sir. If there is not an arm's-length relation- ship, sir, then a stockholder wouldn't have to prove waste. Then he can go right to the fairness of the contract. That is the law today, if there is not an arm's-length relationship. Mr. KEITH. I am not an attorney, and I am not sufficiently acquaint- ed with it. We will later on with the advice of counsel get into this, whether or not there is truly this arm's-length relationship which you brought out. You drew the parallel, and having raised the question, I would like to explore it in some depth. Mr. LOEFFLER. Yes, sir; it is a rather complicated subject to try and clarify briefly. Mr. KEITH. You pointed out about the reduction in rate to improve the product. What is the relationship if any to reduction in rate in the cases that were brought by Pomerantz and others? Mr. LOEFFLER. I think what happened, if I may go back on this- Mr. KEITH. Was there any reduction in rate industrywide as a result of the Pomerantz suits? Mr. LOEFFLER. Yes, sir; I think they had effect. Mr. KEFrJI. Mostly as to the shedding of light on the subject, rather than competition? Mr. LOEFFLER. Well, I think they were unrelated to the competitive aspect. Mr. KErril. It invited the shareholders' attention. Mr. LOEFFLER. I think it invited the industry's attention. I think what had happened actually, sir, was that this industry grew enor- mously during the 1950's It was really a very young industry The effect, as is true in almost any situation such as that, is that generally your competitive effects and your price adjustments lag behind an enormous sudden growth. I think they were just coming into play in the 1960's when this rash of litigation broke out. I think there is a possi- PAGENO="0074" 488 bility that the litigation held up what would have been the normal flow, because as you can imagine, no lawyer wants to cut the fee when he has pending litigation challenging the fee itself. Not until the liti- gation was over could things go back to what would be the normal expected economic consequences. Mr. KEITH. If you were counsel for Dreyfus Fund, would you recom- mend that they reduce their fee from one-half of 1 percent to some- thing lower than that? Mr. LOEFFLER. I would never have recommended to them that they do it voluntarily while the litigationwas pending. Mr. KEITH. That was some years ago. Mr. LOEFFLER. No, sir; it was just settled recently and I think the settlement is pending on appeal today, but as to whether they should do it now or in the future is a subject which I will have to leave to counsel for Dreyfus `Corp. I am not particularly familiar with their situation. Mr. KEITH. They have stockholders in the management company and their loyalty is to the shareholders. Mr. LOEFFLER. So does IDS, sir. We have over 14,000 public share- holders. Mr. KEITH. Yes, and they would have to prove to their shareholders that they would get more fees by cutting that rate than the fees that they are now getting, in order to justify it. Mr. LOEFFLER. I don't think it is- Mr. KEITH. If you take the whole ball of wax and the cost of the load in order to get this operation into the market the really great benefits have been in the improvement in portfolio and investment policies. Mr. LOEFFLER. Yes, sir. Mr. KEITH. We are only talking about relatively small amounts it seems to me. Mr. LOEFFLER. Yes, sir; that is very true. What we are talking about is- Mr. KEITH. $10 or $15 perhaps per shareholder. Mr. LOEFFLER. In our particular situation it is $3 a thousand per shareholder. Mr. KEITH. Yes. Now you used the word "mutual" whereas most of the funds are not really mutual in the same sense that a mutual life insurance company is. Mr. LOEFFLER. Yes, sir; that is true. Mr. KEITH. Did you start out being a mutual literally? Mr. LOEFFLER. No, sir; a mutual fund is really a term which refers to the portfolio only. Mr. KEITH. Right. Mr. LOEFFLER. To the portfolio otily. Mr. KEITH. It is to `the mutual interest of the portfolio shareholders and the management company shareholders to have a good return, but their interests ~re sometimes capable of separation. Mr. LOEFFLER. Yes, sir. Mr. KEITH. Is there any State that has a law speaking to the point of a business calling itself a mutual when it isn't a mutual, do you know? PAGENO="0075" 489 Mr. LOEFFLER. Not that I know of, sir. Technically under the Invest- ment Oompany Act these funds are open end investment companies. Mr. KEITH. Yes. Mr. LOEFFLER. Open end investment management companies I believe is the technical phrase, and the term "mutual fund" is just a term that has come along. Mr. Kj~ia~i. You mentioned face amount certificates. Mr. LOEFFLER. Yes, sir. Mr. KEITH. Is this a product that is generally sold throughout the industry or are you one of the few that still does it? Mr. LOEFFLER. No, sir. IDS sells, I guess, 95 percent or more of the face amount certificates. There are one or two other small face amount certificates companies, but principally it is an IDS product. Mr. KEITH. And what volume of business do you do in face amount certificates? Mr. LOEFFLER. I think currently ISA, the IDS certificate com- pany, the face amount certificate company, which is Investors Syndi- cate of America, has about $800 million in assets, something over $2 billion in face amount certificates outstanding, and I think our sales currently of face amount certificates are running in the neighborhood of approximately $160 million a year in face amount. Mr. KEITH. Would you briefly describe to the committee what your face amount certificate approach is, and what the compensation is? Mr. LOEFFLER. The face amount certificate is in effect an installment savings contract. A customer purchases a face amount certificate and he pays in so much a month. Upon maturity, he is guaranteed a fixed amount, and that is the reason it is called a face amount certificate. Its assets are virtually all invested in fixed income securities. It pays a guaranteed yield plus a supplemental yield in the discretion of the directors of the company. I would equate it, sir, in effect to the savings portion of an ordinary life insurance policy. That is really what it is. Mr. KEITH. What about the compensation to the agent selling it? Mr. LOEFFLER. To the sales representative who sells it? The com- pensation to the sales representatives who sell face amount certificates is, well, I started to say it was about akin to that of the sale of an ordinary life policy of the same amount. It is not. It is less than that, I believe. Mr. KEITH. But the law is very specific, I believe, the law with ref- erence to a face amount certificate load. Mr. LOEFFLER. Yes, sir. There are provisions in the law, as it is to- day, which would allow the deduction of 50 percent of the first year's payments, which can be used then for commission to the sales rep- resentative. The IDS certificate, however, does not do that. It deducts 20 percent from the first year's payments rather than the 50 percent. Mr. KEITH. Are they uniform payments over a period of years? Mr. LOEFFLER. They are uniform over a period of either 15 years or 22 years. Mr. KEITH. So what are your total commissions, generally speaking? Mr~ LOEFFLER. Well, let me say the amount deducted doesn't neces- sarily all ~o to commissions but covers the total costs. In the case of one certificate, that is the 15-year certificate, it comes to 5.69 percent. In the case of the 22-year certificate, it comes to 3.74 percent. PAGENO="0076" 490 Mr. KEITH. One final question that I have at this time. Do you charge for the reinvestment of capital gains and/or dividends? Mr. LOEFFLER. No, sir; IDS does not charge. Mr. KEITH. I thank you, Mr. Chairman. Mr. Moss. Do you operate in California? Mr. LOEFFLER. Yes, sir; we do. Mr. Moss. Are your salesmen succesful out there? Mr. LoEFFT~Eu. I assume so, sir. Success is a relative term. Mr. Moss. How do their earnings compare with salesmen in the Nation generally? Mr. LOEFFLER. I tried to get those figures before lunch, sir, but I didn't get them back in time. I would be happy to supply them to you, but I am afraid offhand I just don't know the answer. Mr. Moss. I think it would be very helpful to have them supplied for the record, and we will hold it at this point to receive them. (The following letter was received by the committee:) INVESTORS DIVERsIFIED SERVICES, INC., Minneapolis, Minn., November 7, 1967. Hon. JOHN E. Moss, Chairman of the Eubcommittee on Commerce and Finance of the House Com- mittee on Interstate and Foreign Commerce, Rayburn House Office Building, Washington, D.C. DEAR SIR: On the occasion of my testimony before your subcommittee on October 16, 1967, concerning H.R. 9510 and H.R. 9511, you asked that I supply certain additional information, first with respect to the earnings of our Cali- fornia sales representatives and district managers as compared to the earnings of our sales representatives and district managers throughout the country and, secondly, with respect to the earnings of our sales representativl~s relating these earnings to their length of service. I am pleased to give you this information. First with respect to the average gross income of our sales representatives and district managers throughout the country, my written statement contains the following figures: AVERAGE GROSS INCOME FROM SALE OF ALL PRODUCTS Sales repre- sentatives 1 District sales managers 2 1962 1963 1964 1965 1966 1967 (projected) $7,853 7,571 8,753 9,159 8,077 7,233 $14,734 13,683 15,687 16,767 14,292 13,556 I Only representatives with more than 18 months of experience are included. 2 Divisional sales managers-the next level ~f sales managers-usually have higher income than do district sales managers. The comparable figures for our California representatives and district man- agers are as follows: Sales repre- sSntatives District sales managers 1962 1963 1964 1965 - 1966 19672 (1) (1) $9 193 9,027 7,269 6,112 $20,024 20,561 16,752 13,871 1 Not presently available. 2 Projected. PAGENO="0077" 491 Secondly, with respect to average earnings of our sales representatives and district managers by length of service, the figures are as follows: AVERAGE EARNINGS, TOTAL SALES FORCE Service years 1962 1963 1964 1965 1966 0 to 1 1 to 2 2to3 3to5 5tolO UverlO (1) $6, ~64 6,936 7,976 9,082 9,194 (1) $6, 103 6,938 7,615 8,939 8,841 (1) $7, 323 7,784 9,593 10,866 10,291 (1) $7, 353 8,435 10,033 12,139 11,592 (1) $6, 290 7,167 8,742 10,788 10,679 I Not available. I hope this information is helpful to you and to your subcommittee and I want to assure you that if any further information would be helpful to you I would be pleased to try to supply it. Sincerely yours, RoBEaT M. LOEFFLER, Vice President-Law. Mr. Moss. You indicate that the probable reduction in earnings of your salesmen would be to a figure of approximately $5,200 if the recommendations of the- Mr. LOEFFLER. Yes, sir; this is on the basis of 1966 figures. Mr. Moss. And is this just a straight statistical study or do you make some assumptions as to what is going to happen in competition and its impact on you? What all goes into arriving at this $5,200? It intrigues me. Mr. LOEFFLER. This assumes that we had been able to make the same sales, which we in fact made during the calendar year 1966. Mr. Moss. And it is just a simple statistical projection of the same number of sales at a lower return per sale. Mr. LOEFFLER. Yes, sir. Mr. Moss. That is all. Mr. LOEFFLER. Yes, sir; that is what it was. Mr. WATKINS. Mr. Chairman. Mr. Moss. Mr. Watkins. Mr. WATKINS. I wonder if you could refresh your memory? I don't know whether my homework is just exactly right. You testified before the Senate Banking and Currency Committee on the SEC bill that we have before us. Mr. LOEFFLER. Yes, sir. Mr. WATKINS. Do you recall or do you feel this way today or are these your remarks and do you still feel as you did then? You said this: I know of no statute in the history of the United States, absent wartime,. which gave either a federal agency or a court the power to perscribe the price for a product or service in a competitive industry in accordance with what- ever in its judgment it deems to be appropriate or reasonable. Do you remember making those remarks ~ Mr. LOEFFLER. Yes, sir; I made that statement. Mr. WATKINs. Do you feel the same way now? Mr. LOEFFLER. I feel exactly the same way now. Mr. Moss. It is repeated on page 25. Mr. WATKINS. I just wanted it clarified. 1 haven't read his whole report. I haven't read it at all, Mr. Chairman. PAGENO="0078" 492 Mr. LoEF13~n~R. It is in my written statement. Mr. WATKINS. I have been listening to the gentleman ever since h~ started. Thank you very much. Mr. Moss. Of course, we are going to do a little research job on that. Mr. LOEFFL1~R. Yes, sir. Mr. Moss. And find out how good your recollection is. Mr. LOEFFLER. I am sure you will. I think I should say, Mr. Chair- man, that I made that statement first in January, saying, "so far as I can offhand think of." I had a lot of research done, and in February i~epeated the statement again in a public forum, in which I think I phrased it in terms of "so far as I have been able to discover," and by the time we got to the Senate committee, I think I was able to state it more flatly, as I did there. Mr. WATKINS. Thank you very much. Mr. LoEFi~'r~ER, It was not made without considerable research. Mr. Moss, The statement is made without any qualification, so just on its face it falls because we had the Civil Aeronautics Act of 1938. If you want to qualify it, why, then we can get into narrowing the field, we might have a different answer. Mr. LOEFFLER. That is a franchised industry, sir. Mr. Moss. Well, is it franchised? It has some certifications. Mr. LOEFFLER. Yes, sir; that is what I mean by franchised. It is regulated. Mr. Moss. In 1938, yes. In any event- Mr. LoEn~'LER. I am sure you will be doing your research. Mr. Moss. Absent the qualification or any further qualification you might like to make- Mr. LOEFFLER. When I explained that I only wanted to convey that I did not make the statement lightly, having- Mr. WATKINS. Don't back off. You did research on it. Mr. Moss. Is selling one of your responsibilities? You are vice president of- Mr. LOEFFLER. No, sir. I am vice president-law. Mr. Moss. And so your evaluation of impact on sales represents the consensus within your company rather than- Mr. LOEFFLER. Yes, sir. Mr. Moss (continuing). Rather than a conclusion arrived at from any personal experience. Mr. LOEFFLER. Yes, sir; this is based really upon my conversations with those in the company and studies which they have made and which I have seen. Mr. Moss, I am in the process of trying to- Mr. LOEFFLER. I am also a director. Mr. Moss (continuing). Of trying to get a study which I recall being made, which illustrates a very interesting phenomenon. That sometimes when sales commissions are high, the earnings per man tend to reduce, and that if you lower them a little, you sometimes increase the earn- ings per man. You retain the best producers. Mr. WATKINS. Mr. Chairman, would you yield just a minute? Mr. Moss. Yes, I will be very happy to yield. Mr. WATKINS. I am rather disturbed, Mr. Chairman, working on this figure that these people would make, that we are going to put a PAGENO="0079" 493 lot of people on welfare if we pass this bill. In other words, they will get from welfare just about as much money as they would make. Mr. Moss. Let me say to the gentleman from Pennsylvania I am not quite as apprehensive as he is. I haven't the pessimism as to the Ca- pability of these people to go out and produce. I have worked around salesmen a long time. I have found that they are an amazingly resilient group, and the really able ones are going to make a living come hell or high water. Mr. LOEFFLER. We just hope they will be able to continue- Mr. Moss. Even the SEC is not going to stop them. Mr. LOEFFLER. We just hope they will be able to do it for us. Mr. Moss. I think they can. Mr. WATKINS. I don't want to question the distinguished chairman, but how in the world can you say a man is making a living taking care of a family with $5,200? Mr. Moss. Mr. Watkins, the Chair is attempting- Mr. WATKINS. California is much better than down my way. You can't do it. Mr. Moss (continuing). The Chair is just attempting to point out the fact that the figure of $5,200 for the purposes of this committee or for the purposes of any objective analysis of the impact of this legislation is a meaningless figure. That it is more charitably described as an exer- cise in statistics, and that is all it is. Mr. WATKINS. In other words, there is another way of making money. Mr. Moss. It represents no other value judgments, no element of experience, nor anything else as a basis for projecting the $5,200. Mr. LOEFFLER. I don't think it was that cold a statistic, sir. Mr. Moss. You just take x number of sales in 1966, and if we were to pay at a lower rate of commission just on those sales to the same sales force, that the same general incentive and the same type of direction, that this is what it would produce. Mr. LOEFFLER. It was the judgment of those in our sales department, sir, that a reduction would not have had an offsetting increase in volume of sales. Mr. Moss. But that isn't always necessarily true. Mr. LOEFFIZER. This is the judgment factor. I realize that, sir. Mr. Moss. We can go to many of our regulated industries, where we have heard the direst of predictions of the pattern of earnings in the event of certain reductions, and amazingly we have witnessed a spurt in growth and earnings following the reductions. Now, I don't say that this is normal in selling, but I say that you cannot safely make these assumptions you have made without going beyond just the figures of 1966 and the impact of a new standard on 1967 or 1968. Mr. LOEFFLER. We are subject necessarily to what happens in the general economy. Mr. Moss. Well, you are also subject to what happens in competition, you are also subject to what happens in motivation of the salesman and the quality of salesmen. Mr. LOEFFLER. Yes, sir; we would not disagree with that. Mr. Moss. What is the rate of turnover of your sales force? Mr. LOEFFLER. The turnover of our salesmen in the initial year, that is those who have just been validated and are in their first year, after PAGENO="0080" 494 the end of 1 year we would have 70 percent of those. After the sales representative has remained with IDS for a couple of years, has de- cided for himself as well as for the company that this is the career he wishes to pursue, then our turnover drops off to less than 10 percent. Mr. Moss. You have 10 percent after the second year, is that correct? Mr. LOEFTLER. No, sir. Mr. Moss. You said after the first year you lose 30 percent. Mr. LOEFFLEL Yes, sir, and then we lose another 25 percent of the remaining 70 percent during the second year. Mr. Moss. So you lose 25 percent of the 70 percent. Mr. LOEFFLER. Of the 70 percent during the second year. Mr. Moss. In the second year. Mr. LOEFFLER. Yes, sir, and then that is generally the end of it. Mr. Moss. Or roughly about 16 percent or 15 percent. Mr. LOEFFLER. Something like that. Then after- Mr. Moss. So you lose about half in the first 2 years. Mr. LOEFFLER. Yes, sir. Mr. Moss. And from there on you say your rate is about 10 percent a year. Mr. LoEF~i?LEn. No. Mr. Moss. Of that half. Mr. LOEFFLER. It is less than that, sir. Mr. Moss. Less than that. The figure of 10 was yours, not mine. Mr. LOEFFLER. I think I said less than 10 percent. I meant to say less than 10 percent, sir. Mr. Moss. So you have a fairly good turnover in your in-and-outers. Mr. LOEFFLER. No, sir; I wouldn't call them in-and-outers. They never come back. Mr. Moss. Let's say the hoped- Mr. WATKINS, He is trying to `break you down. He is clever. Mr. LOEFFLER. I understand. Mr. Moss. These are the young hopefuls. Now are they considered, their earnings in the average which you cited for us? Mr. LOEFFLER. We did not take into `the averages which I cited the income of any sales representatives who had been with the company less than 18 months. Mr. Moss. You took none of the less than 18 months. Mr. LOEFFLER. No, sir. Mr. Moss. All right, when does this last 25 percent occur, how much of it in the last 6 months of this 24-month period? Mr. LOEFFLER. I don't think I could answer. Mr. Moss. You see, if we are going to use statistics here, I want to use them rather precisely. Mr. LOEFFLER. We tried to make them meaningful, sir. That was the reason we left out these first 18 months. Mr. Moss. Yes, I appreciate that. Mr. LOEFFLER. We subsidize the first ones. We also have a pension program for our sales representatives. Mr. Moss. And now from the second year to the third year and the fourth year, what is the rate of progression on earnings? Do they continue to show improvement in producing? PAGENO="0081" 495 Mr. LOEFFLER. Generally speaking, they do, yes, sir. Mr. Moss. They don't just reach a plateau and stay there. Mr. LOEFFLER. Well, at some point. Mr. Moss. When you lose 10 percent do you because they get better opportunities? Mr. LOEFFLER. Usually because they have better opportunities. Mr. Moss. Or because some of them stop producing? Mr. LOEFFLER. Some retire and some get better opportunities. Some are sought by competition. If you would like, I have some figures here on that, sir. Mr. Moss. I think it would be very helpful. Mr. L0EFFLER. Yes, sir. Mr. Moss. I don't think it is necessary to take the time now. If you will just simply supply them to us for the record. Mr. LOEFFLER. All right, I can do it very briefly. Of the sales rep- resentatives who have been with the company from 1 to 2 years, the average earnings-this is 1965-was $7,300; 2 to 3 years, it went up to $8,400; 3 to 5 years, up to $10,000; 5 to 10 years, up to $12,000; and then over 10 years the average is $11,500. If you would like, I can supply these in writing. Mr. Moss. I think it would be helpful to supply them for the record. (See letter dated November 7, 1967, on page 490.) Mr. Moss. I think that is all I have at this time. I want to express on behalf of the committee our appreciation for your appearance here. It has been very helpful to us, and I assure you that your views will be very carefully considered. Mr. WATKINS. I join with my chairman in those remarks. Thank you for being so courteous. Mr. LOEFFLER. Thank you, sir. Mr. Moss. Now we have Mr. Fred M. Alger, president of Fred Alger & Co., Inc. STATEMENT OP FRED M ALGER, PRESIDENT, FRED ALGER & CO., INC. Mr ALGER Mr Chairman, members of the subcommittee, I am Fred M Alger, president of Fred Alger & Co, mc, a nonregistered insti tutional investment adviser. Thank you for granting me the honor and privilege of this opportunity to appear before you to express my thoughts on the proposed amendments to the Investment Act of 1940 and the Investment Advisors Act of 1940, numbered H.R. 9510 and H.R. 9511. My company renders investment advice to corporations and indi- viduals. One of our clients is Security Management Co., Inc., a Kan- sas-based management company which manages two funds, the Secu- rity Equity Fund, Inc., and the Security Investment Fund, Inc. Both funds are corporations registered as open-end investment companies pursuant to the Investment Act of 1940. Since we began advising the Security Management Co., in January of 1965, the Security Equity Fund, which is a growth fund, has had the best cumulative investment performance of all mutual funds in the United States, recording a gain of 200 percent, more than 10 times that of the Dow Jones industrial average during the same period. S5-592-~8----pt. 2*6 PAGENO="0082" `496 In January of 1965, when we first began managing it, the Security Equity Fund had net assets of $400,000 and today, 3 years later, it has net assets of $60 million. The growth of this fund results from both increased sales and performance. The shares of the fund are solely mar- keted by independent broker-dealers who, based upon our perform- ance, have decided to sell our shares. Mr. Chairman, in the interest of conserving the committee's time, I would like to request that my statement be made a part of the record of this hearing and that I be permitted briefly to summarize my position. Mr. Moss. If there is no objection, the statement will be included in the record at this point and we will be pleased to hear your summary. Is there objection? Hearing none, the statement is accepted for the record. Mr. ALGER. Thank you. (Mr. Alger's prepared statement follows:) STATEMENT OF FEED M. ALGER, PRESIDENT, FRED ALGEE & Co., INC. Mr. Chairman, members of the subcommittee, I am Fred M. Alger, President of Fred Alger & Company, Inc., a non-registered institutional investment ad- viser. Thank you for granting me the honor and privilege of this opportunity to appear before you to express my thoughts on the proposed amendments to the Investment Act of 1940 and the Investment Advisers' Act of 1940, numbered HR-9510 and HR-9511. My company renders investment advice to corporations and individuals. One of our clients is Security Management Company, Inc., a Kansas-based manage- ment company which manages two funds, the Security Equity Fund, Inc., and the Security Investment Fund, Inc. Both funds are corporations registered as open-end investment companies pursuant to the Investment Act of 1940. Since we began advising the Security Management Company in January of 1965, the Security Equity Fund, which Is a growth fund, has had the best average growth performance of all mutual funds in the United States. In ~anuary of 1965, when we first began managing it, the Security Equity Fund had net assets of $400,000 and today, three years later, it has net assets of $60 million. The growth of this fund results from both increased sales and performance. The shares of the fund are solely marketed by independent broker-dealers who, based upon our performance, have decided to sell our shares. I wish to address myself to Sections 8, 12 and 25 of UR-9510. First I will address myself to Section 12 of the Bill, which is the proposal to limit the sales charge on the sale of mutual fund securities to 5%. This reduction in the sales charge, in our opinion, would virtualjy put all independent broker-dealers out of business. It would render it impossible for Security Equity Fund to successfully market its shares. It will do so because it will reduce the commissions paid to the independent broker-dealers to a level where they can no longer afford to sell our shares. The present average sales charge on the sale of a mutual fund share is 8.5%. This 8.5% charge is normally divided as follows: 2% goes to the underwriter for printing and distribution costs, but the SEC has conceded that, even at this rate, underwriters generally lose money on the distribution of shares. Another 2% goes to the independent broker-dealer who maintains an office and place of bust~ ness out of which his salsemen operate. The SEC did not evaluate the costs of the independent broker-dealers, but from my conversations with numerous repre- sentatives of broker-dealers I can state that their profit is generally marginal. The remaining 4.5% goes to the salesman who actually sells the mutual fund share. Mr. Robert M. Gardner, former president pro4em of the. NASD, pointed out at the Senate hearings on this same subject that, based on the present rate of commission, four out of five salesmen average less than $10,000 income per year. It is apparent that the cost of the underwriter in distributing the shares, and the cost of the broker-dealer will necessarily remain relatively constant. Therefore, if you allow the sales charge load to be reduced to a maximum limit of 5%, there will be less than 1.5% available to pay the salesman for his efforts, certainly not enough for him to remain in business. PAGENO="0083" I am frequently called upon to speak with the representatives of independent broker-dealers. They have all told me that if the sales charge is reduced to 5%, they will not be a~ble to sell the shares of either Security Equity Fnnd, Inc., or other small or medium~sized funds, hut will be forced to go out of business or seek employment as part of the captive `sales force of one of the few very large mutual fund's that may survive with a 5% sales charge. Thus, a reduction in the sales charge will immediately cause a `reduction in the number of independent broker-dealers availaible to sell the securities of small and medium~sized aggres- sively managed funds, such as Security Equity Fund. The independent broker-dealer is just what the name implies. He may, based upon the wants of his clients and the performance of the various funds, choose, with relative freedom, the funds which he wishes to sell. Generally, there are three types of mutual funds offered: A growth fund, such as Security Equity, which has, as its primary objective, capital gains; an income fund, which has as its primary objective the production of income, and a balanced fund, which strikes a balance between the production of income anc~ capital gains. A mutual fund is one of the few products which can prove its superiority statistically. There are several surveys which show which funds in each category have the best 1, 3, 5 or 10-year record. Therefore, the independent broker-dealer by referring to these services, can readily determine which are the best perform- ing funds. It is obvious that the best performing fund's are usually the easiest to selL However, a salesman will not sell a fund, in spite of its performance record, if he is not adequately paid for his effort. By reducing the sales charge to a 5% ceiling, you will bring about a reduction in the number of independent broker-dealers and, a resultant lessening of compe~ tition within the mutual fund industry. The lessening of competition will occur `because many aggressively managed and well-performing funds will go out of business `because they ran no longer afford the `costs of marketing their shares. A's an example, in January of 1t~5, when we began to render financial advice to the management company of Security Equity Fund, Inc., it had net assets of only $400,000, and was not able to afford its own sales force. Therefore, in order to market its securities it relied upon the services of independent broker- dealers. Today, three years later, the Security Equity Fund has capital assets in excess of $00 million. The growth of Security Equity Fund resulted from, first, the willingness of the independent broker~dealers to sell our shares, and, second, the outstanding performance of the fund. The fund has had the cumulative average growth performance record in the mutual fund industry over the past three years. Security Equity has proved to be a superior product but this security could not have been offered for s'ale to the public if it had not been permitted to levy the 8.5% sales charge. If three years ago there bad been a `limit of 5% sales charge, there would be no Security Equity Fund, Inc., and the public would have been deprived `of the opportunity to purchase the mutual fund that has bad the `cumulative average growth performance record in `the United States' over the past three years. The only fund's that the public would have had offered to them would have been those funds which were sufficiently large to afford the luxury of a captive sale's force. The salesman who i's a member of a captive sales force sells only one pro'duct. The `salesman will sell that product without regard for its' performance. There is no incentive to this salesman to review the statistical records of various mutual funds and, based upon their respective investment go'als, i.e., gro'wth, balance, or income, `sell that fund which has the best `performance record. He is just `w'hat the name implies-a captive-and, as a captive, he is going to present only one `point of view. This is not in the best interest of the purchasing public. The independent broker-dealer prefers to sell that product which has the best per- formance record. It is the independent broker-dealer who rewards competitive investment per- formance by exposing the public to a better product. The incentive i's a natural one. A better pro'duct is easier to sell and results in a satisfied customer. A sales- man wh'o is a member of a captive sales force sells only one product and you can be certain that if his is not the be'st product, he will not bring that to the attention of the potential buyer. If you reduce `the sales charge load to' 5%, you will put the independent broker- dealer out of business and thereby eliminate small, `aggressively manage'd mutual funds. PAGENO="0084" 49~ Next, I would like to address myself to SEC's ~roposa1~ in Sections 8 and 25, that further regulation's be imposed upon the fees tharged by investment advisers. The SEC claims that management fees are excessively high and proposes that the Act be amended to provide that an investment adviser may be sued for the return of his fee if it is "unreasonable". The essence of the SEC criticism is that a management company will charge a mutual fund 0.5% annually for the manage~ meat of the fund while a private account of the same amount will pay consider- ably less for comparable service. It is unfair and misleading to compare the fees charged by a mutual fund management company with those of banks, trust companies and similar insti- tutions. The quality and `degree of service rendered are essentially dissimilar. While the fiduciary institutions give, at best, monthly supervision to their accounts, `a firm of our size gives close attention on a daily basis. Further, the institution can allocate its cost of supervision over the entire spectrum of their operations and need not support this fiduciary function `solely by income derived from their advisory services. In addition, there are corollary benefits that they derive from handling said funds. Our firm charges, for the management of private account's, 1% of average assets per year, or 10% of total appreciation during `the same period of time, whichever sum is greater. Our firm purposely has injected an incentive feature to encourage us to actively and diligently manage our portfolios. We have one security analyst for every three and one-third portfolios. We review the securities in every portfolio every `day. In fact, we conduct an hou'r~by-ho'ur `review of market condition's and t1~e `market price of each and every security which we hold. Thus, in our opinion, when the SEC compares fees of mutual fund management com- panies to some large private accounts it is not referring to fully managed high- performance accounts. Rather, it is referring to those accounts which are rela- tively inert, not fully managed-in our sense of management-and not competi- tive. There is published almost daily in newspapers a comparison of the per- formances of publicly held mutual funds. This places a burden on the manage- ment company which does not exist for banks, trust companies and other private managers, whose performance records are rarely, if ever, a matter of public record or interest. The provisions of the Invesment Company Act of 1940 provide that the share- holders of a mutual fund must approve the contract with the management com- pany. Therefore, `there is full disclosure, and the shareholders are fully aware of the terms and conditions of the contract. I do not believe that management companies make an excessive profit. As a comparison, the eighth largest advertis- ing `company, a `service organization, last year `made a larger profit than the second largest mutual fund management company in the United States. The SEC further wishes to amend the definition of investment advisors to prevent firm's such as ours being `paid on the `ba'sis of an incentive fee `contract, yet the SEC admits that performance should be a factor in determining fees, when it states on page 145 of its report, and I quote: "The sustained investment performance of a company would be an appropriate consideration in evaluating the reasonableness of its advisor's compensation." We use incentive fee ,contracts for some of our private portfolios. Our contract is designed to reward us in proportion to how well we perform for our client in relation to what he might have made, had his money been unmanaged. The incentive feature of a contract goes to the very essence of why an individual hires someone to manage his port- folio. The SE'C, on page 73 of its report, attempts to justify its opposition to percentage fees and incentive contracts, and I quote: "Management fees based on a percentage of assets `tend to avoid conventional limitations on executive salaries." This statement is misleading for we all know that today top mai~age- ment personnel are not limited to `salary and are granted `stock options, the value of which is clearly tied to performance. Our firm is hired for the specific purpose of increasing the value of its client's portfolio. Why not encourage it to do so by permitting it to share in its growth? Our firm cannot hope to benefit from an incentive contract unless it, in fact, benefits its client. Incentive fees put a premium on performance and doing the best job possible for the client. Set fees will tend to put a premium only on hold- ing on to an account and not performing so poorly as to lose it. Incentive fee Contracts are fully consistent with the spirit of American business and govern- ment, which rewards an individual for excellence in performance. In closing, I wish to state that in my opinion the Investment Act of 1940 and the Investment Advisors' Act of 1940 provide more than adequate protection PAGENO="0085" 499 to the individual investor. The Acts provide for full disclosure by the mutual fund company. A mutual fund company produces a product-its shares-and offers them for sale to the public. The public purchases the shares for one of three purposes-growth, income, or a balance between growth and income. The SEC has refused to accept that a mutual fund share is a product, because it says if it did so its entire report is without meaning. To quote the SEC: "Some suggest that any conflicts that may exist between the interest of the fund managers and underwriters and those of their customers-the mutual fund in- vestors-are no different from the usual conflicts of interest between buyers and sellers . . . (that) the fund . . . has little . . . independent significance for it is essentially the brand name under which a particular investment advisor sells its services to the public . . . If this view were accepted, the questions raised by the special study. . . might be of little significance. The Commission believes it would be most unwise to accept the foregoing analysis for regulatory pur- poses." (Pages 75 and 76 of their Report). I believe that a mutual fund share is a product which is offered for sale `by a mutual fund company in a highly competitive market. The buyer has the oppor- tunity to select from a large number of products. The full disclosure provisions of present legislation more than adequately protect the prospective buyer. In addition, the NASD with Congressional approval, presently regulates the market- ing practices of mutual funds, underwriters, independent broker-dealers and their salesmen. I believe that the NASD and the industry should be permitted to develop new marketing practices and self-regulation. We have just submitted a new concept for marketing mutual funds securities to the NASD. We believe our proposals will be highly beneficial to the customer, broker, salesman and underwriter. Because our plan will provide security and other benefits to the salesman and the broker-dealer, it will ultimately permit the reduction of the sales charge from 8.5% to 6.5%. This plan is non-exclusive and because of the benefits to all concerned, we believe it will ultimately be copied throughout the industry. I believe industry and the NA'SD should be free from legislative restrictions on price and cost schedules to implement new innovations within the industry when and if they become feasible. Thank you, Mr. Ohairman. This concludes my prepared remarks and I would be glad to answer any questions that you or the Committee members may wish to ask. RÉsuMÉ or Fx~n M. ALGEn Fred M. Algar, born Detroit, Michigan, 1934. Bachelor of Arts Degree, Yale University (June 1956), Master of Business Administration Degree, University of Michigan (June 1958). 1957 and 1958 Security Analyst at First of Michigan Corporation; 1958-1969 Security Analyst at Wells Fargo `Bank; 1960-1961 Security Analyst at North i~merican Securities Company; 1961-1964 Portfolio Manager at Winfield & Co., Inc.; 1964 Founder and President of Fred Alger & Company and Falco Associates. Fred Alger is on the Board of Fred Alger & Company, Inc., Falco Associates', Inc., W. A. Benjamin, Inc., Publishers, H. C. Bohack & Co., Inc., a New York Grocery Chain, and Security Investment Fund. Fred Alger & Company was retained as Research Consultant to Security Man- agement Company on January 1, 1965. At that time, Security Management Com- pany was the investment adviser to the Security Equity Fund, a growth Fund, with assets of $400 thousand, and Security Investment Fund, a balanced income fund of $8 million. Since that date Security Equity Fund has had the industry's best investment results recording a gain of 200%, ten times that of the Dow Jones Industrial Average, and has grown in size to over $60 million. The Security Investment Fund, during the same time period, has had the best cumu- lative investment record of balanced funds concentrating on income and has grown to $11.5 million. Mr. Alger's firms, Fred Alger & Company, Inc., and Falco Associates, Inc., also run the portfolios of several large clients, including a large segment of the FOP Proprietary Funds, Ltd., which is wholly owned by The Fund of Funds, Ltd. Mr. ALGER. First, mutual funds fall into three product categories: Growth funds, income funds, and balanced funds. A mutual fund share PAGENO="0086" 500 is a product that is offered to the public, with full disclosure for sale in a highly competitive industry. As a product, a mutual fund is one of the few products which can prove its excellence statistically. For ex- ample, I can prove that the security equity fund, which portfolio we run, has the best performance record in the industry during the 3 years we have managed it. This is not true of most products offered for sale. For example, can Chevy prove its excellence over Ford? The independent broker-dealer chooses which product he wishes to sell. The independent dealer is important because he rewards excellence by selling the best product the industry has to offer. At the other ex- treme, a captive sales force sells whatever its management company offers. For example, reading the testimony of Mr. Loeffier who preceded me, page 6, he says at the bottom talking about IDS's captive sales force, he says: However, the only products sold by IDS * * * are the shares of the IDiS- managed funds. Very simply, if the 5 percent load goes through, in order to main- tain his income, the independent dealer will be forced to affiliate with one of the few surviving larger mutual funds with `a captives sales force. Small funds, such as our own, will not be able to afford to distrib- ute product. The market will be abandoned to the multibillion dollar behemoths of `the industry. Second, H.R. 9510 proposes to amend section 203(b) `and 205(1) so' that any investment adviser to any investment company must register with the SEC-and by so doing, it cannot charge a fee based on per- formance. As I told you, we run the portfolios of two registered in- vestment companies. We also have about 10 clients whose private `portfolios we run. We charge a clients' fee of 1 percent of average assets or 10 percent of total appreciation, whichever is greater. We qualify for the performance fee if we beat the market by a certain percentage. We do not solicit accounts. We do not hold ourselves out to the public generally. Individuals or corporations who have noticed the fund's perforthance seek us out and ask us to manage money for ~them, despite the fact that our fee schedule is substantially above that charged by the funds we run. The SEC's rationale is to "insulate investment company share- holders from `arrangements that give investment managers `a direct pecuniary interest in pursuing high risk investment policies." What do you say to something which just is not true? On the one hand my firm's naine-our pride of craft-is intimately involved with the public record we show for the funds. On the other hand, individual clients are charged fees which relate directly to their performance in the market. A reputation of honesty and excellence cannot be bought. I have built m.y company on these contracts and on my name. I resent any meretricious implication which would cause legislation to put me out of business. Accordingly, I urge you to scrap the' relevant amendments in sections 203(b) and 205 (1). Third, I have noted in reading the accounts of these procedures that the committee is interested in receiving specific proposals from the industry. PAGENO="0087" 501 The principle of self-regulation has worked remarkably well, as the SEC point out. I believe the regulatory role of the NASD should be strengthened vis-a-vis the members. At the same time, however, Congress should make the NASD structurally more responsive to its membership by allowing immediate judicial review of administrative decisions before disciplinary action has been enforced. For instance, we have recently submitted to the NASID a new concept for marketing mutual funds. It will involve a cut in the load from 8.5 percent to 6.5 percent and, at the same time, strengthen the economics-and this is very important-for the independent dealer and his salesmen. This plan is nonexciusive and because of the benefits to all involved, we believe it will be copied throughout the industry. As you know, the NASD's administrative authority to approve or disapprove this plan is absolute and final. If it does not approve the plan, its judgment cannot be tested in court unless the NASID puts us out of business for doing it any way. It is a high price to pay to prove a point. At the present time, as only the very large funds or their closely affiliated dealers have the manpower and the money to afford the time to serve on the NASD's key committees, and specifically the in- vestment companies committee, I believe the decisions of the invest- ment companies committee and the NASD may reflect the interest of the very large mutual funds and not necessarily the best interests of the industry as a whole. I suggest to you that whatever problems the industry might have would be solved very simply by natural competitive forces if admin- isterative decisions by the NASID were immediately subject to some in- dependent, disinterested judgment. Thank you, Mr. Chairman and members of the subcommittee. Mr. Moss. Mr. Watkins? Mr. WATKINS. No questions. Mr. Moss. I find your statement on page 4, item 3, most interesting, because it acquaints me with a broad new authority in the hands of the NASD that I was not previously aware of, and I think one might be highly illuminating to the SEC because we have had some discus- sions as to whether or not we should turn this regulartory function over to the NASD. I think it was the subject of the exchange of letters between Senator Sparkman and the then chairman or president of NASD. Mr. ALGER. I think it is a very subtle thing. If you will, Mr. Chairman- Mr. Moss. I would like to have the subtlety made a little more apparent. Mr. AixiER. Well, we feel, I feel, that the NASD, as the SEC has pointed out, has done a very good job over the years. Practically speak- ing, the investment companies committee has a great deal to do with, in fact controls, the marketing structure of the mutual fund industry. It is represented only by members of large, gigantic funds and their interests. Our suggestion is that if the investment companies committee or rulings by the NASD could be made subject to judicial review with- Out having to go out of business-no one wants to do this to prove PAGENO="0088" 502 a point-but if they could pass down a decision, and then if the mein- her wanted, direct it to some independent judicial authority for re- view as with regard to their own standards or to the law which they interpret, then I think you would see unleashed vast new competkive forces. I mentioned this plan which we have. We can economically keep the independent broker-dealer in business and at the same time cut the load. Mr. Moss. We would be of course most interested, I assure you, in the proposal that you have to cut the load from eight and a half to six and a half, because that is one of the things that this series of hearings is about, but the authority that you ascribe to the NAS1) in this particular area of activity I do not think exists. Mr. ALGER. You are wrong, Mr. Chairman. Mr. Moss. My counsel advises me that I am not. Mr. ALGER. I think your counsel is wrong. Practically speaking, you have to go to the NASD first to make any change. I am not talking about just cutting the load. We are talking about an overall plan, a new way of compensation. Mr. Moss. I think that a new way of compensation would probably have to come here, would it not? Mr. ALGER. No, no. Mr. Moss. To the extent that you are discussing it in this context. Mr. KEITH. Mr. Chairman, the area in which I think the disagree- ment exists is as to the judicial review. The NASD could precribe a lower commission schedule, as long as it was within the scope of the- Mr. ALGER. Oh, now. We could, for instance, cut the load. I mean we could independently cut, instead of saying eight and a half, cut it down to six and a half or two or anything. We could do that. Mr. KEITH. Who is "we"? * Mr. ALGER. I am talking of the Security Management Co. Mr. KEITH. Your firm could do it. Mr. ALGER. Well, the Security Management Co. We advise them on how to run portfolios. Mr. Moss. Yes. Mr. ALGER. But the Security Management Co. could, or anybody could who is a member of the industry. You can cut the load. However, if it involves a restructuring of the meaning of discounts and conces- sions-I will tell you exactJy what we were going to do. We were going to set up-are you acquainted with pension funds? We were going to set up a pension fund for the salesmen of inde- pendent broker-dealers, which would .have full vesting after 5 years, no vesting before 5 years, but full vesting at the end of the fifth year. Fur- ther, we would do this v~a a closed-end mutual fund, which would have 400 shares or a per share value of $250. Now in return for a sustained commitment by the independent broker-dealer to sell our shares, we would agree that to the extent the performance of the fund fell below a certain performance level, we would contribute into the fund from the management company fees which his sales would represent, so basically we would be running a pension fund for his salesmen. Now this would all be fully disclosed in the prospectus. We were going to cut the load, and also we were going to spell out the details of PAGENO="0089" 503 this proposed pension fund as a part of the prospectus. Now to do this we have to go to the NASD to get their approval before we can put such a program into effect. And while we have not received formal- Mr. KEITH. Not so much because of its unique nature, although I as- sume that is one thing they are bound to look at critically? Mr. ALGER. It is just that they have control in this area. This is why you have had no change in the marketing structure of mutual funds in the last 25 years. Mr. KEITH. Just because they did not like your particular way? Mr. ALGER. Not just mine. Mr. KEITH. Of establishing the pension funds? Mr. ALGER. Not just mine. You would think in such a highly competitive industry, with over 100 managements actively competing for the investor's dollar, that someone would have come up with something different. Everyone has got very fertile minds, but their ideas have been nipped in the bud at the Investment Companies Committee of the NASD. Mr. KEITH. Mr. Chairman, I would like to ask some other questions. Mr. Moss. Certainly. Mr. KEITH. Are you one of the chief advisers to those in charge of the portfolio of Security Equity Fund? Mr. ALGER. Yes. We run the portfolio. Mr. KEITH. What is your relationship? You are the president of the firm that runs the portfolio? Mr. ALGER. That is correct. Mr. KEITH. Do you consider yourself a performance fund? Mr. ALGER. Fully managed. We are a performance fund, fully managed though. Mr. KEITH. What do you mean by "fully managed"? Mr. ALGER. Well, I think there is a difference. If I were talking in `the industry I would say performance. Outside the industry I would say fully managed, because, for instance, when the SEC is talking about "insulating investment company shaieholders," they mention words like "high risk" or "performance," and there is an implication here that it is a kind of rolling dice, and that is not necessarily `true. For instance, rolling dice would probably have implications relating to the sort of stock we would be investing in, an implication extending a little bit further that he would be investing in unseasoned stocks, small capitalizations or something along these lines. Just to give you an idea of what I mean `by fully managed as com- pared to this orientation. For instance, last year if we had been invest- ing in blue-chip stocks we probably would have done as badly as the market did, which was down 16 percent. In fact, every single one of our accounts was up. Mr. KEITH. By fully managed, do you perhaps mean that because it is a relatively small fund, you are right with it all the `time, `and you do not buy for the long trend; you buy what in your view is going to move in the right direction in the next few months as contrasted to buying the `true `blue chips? Is that what you mean `by fully managed? Mr. ALGER. Well, I mean our minute-by-minute management, trying to get a mix, a broad mix in the fund which performs well as compared. with other funds. Now, you cannot go hog wild on `this. PAGENO="0090" 504 For instance, there is a Treasury ruling, just to give you an idea- you were talking about a few months-there is a Treasury ruling which has been in effect that to stay an investment company and still retain the tax benefits, you cannot have more than 30 percent of your gross income coming from short-term profits; not net short-term profits but total short-term profits `within a 90-day period. So when we are talking about fully managed, we are not talking about really just staying in for a few weeks or a few months. You really have to stay in for 6 months or more. Mr. KEITH. How much turnover was there in your portfolio in the last fiscal year? Mr. ALGER. Substantial. It was certainly over 100 percent. Mr. KEITH. You have a portfolio currently in the vicinity of $60 million? Mr. ALGER. You see it has grown. The assets have grown so quickly. Mr. KEITH. I understand that. I would expect them to grow, par- ticularly with the kind of management that you have been stressing. Now what is the average length of time that you hold a stock in your portfolio? Mr. ALGER. As long as possible. Mr. KEITH. As long as you expect it to improve relatively well as contrasted with other improvements in the market? Mr. ALGER. That is right. Mr. KEITH. I-low long does that usually last? Mr. ALGER. There is no usual. There is no way of defining this. I am not trying to avoid you. Mr. KEITH. Let's do it mathematically. What was the total volume of sales last year in your fund? Mr. ALGER. Eleven million approximately. Mr. KEITH. Of a $60 million portfolio, you only sold- Mr. ALGER. We started out at $400,000, and then it moved up to $2 million at the end of the first year and then $11 million at the end of the second year in sales, and this year we have gotten $40 million approximately. Mr. KEITII. In sales? Mr. ALGER. Yes. Mr. KEITH. This year you have had $40 million in sales? Mr. ALGER. Thirty million. Mr. KEITH. That means new capital that has come in? Mr. ALGER. That is correct. Mr. KEITH. And how well have you done with that new capital? What would this book here say with reference to your success? Mr. ALGER. Is that Weisenberger? Mr. KEITH. Yes. Mr. ALGER. We are probably not in Weisenberger. We may very well be in it, I do not know but they have size limitations. We may very well be in it I think maybe we did qualify. We are up about 55 percent this year. We are running about tenth in the industry. The year before that we were second. The year before that we were first on performauce. Jt is awfully hard, I mean- Mr. KEITH. Were you here when we had the discussion concerning possible speculation in the market, not in the informed sense of the word but the rolling of dice to which you referred? J ____________________________________ PAGENO="0091" ~~O5 Mr. ALGER. You see this just does not exist. It exists somewhere. I mean it is something which seems to have caught on. For instance, I am just trying to point out, last year if we had owned the big companies, we would have lost a lot of money. We did not own them. We had cash at the right time and the companies we did own were growth stocks. This year growth stocks have been wonder- ful, but in the past 6 weeks we have been moving out of growth stocks into cash and into more traditional kinds of companies, companies which represent more nearly the economy. I think we just basically feel that growth stocks have had it. But when you talk about speculation, last year I would have been speculating badly to have owned General Motors and not speculating very much if I had owned say Polaroid or something like that. We are not putting labels on stocks. It is a question of whether they are going to make money for you or not, the texture of markets change. Mr. KEITH. What is the relationship of your board of directors with that of the mutual funds whose portfolio you advise? Mr. ALGER. Well, in the biography at the very back it has me on the board of Security Investment Fund. That is a misprint. Actually, I recently went on the board of Security Management Co. I am not on the board of Security Investment Fund, which is a balanced income fund we also run. Mr. KEITH. You said "we also run." You did not say "we also ad- vise." That gets to a point that I have been trying to make through- out these hearings, that to all intents and purposes the funds are run by the companies and not advised by them, and that is what you said just now. Mr. ALGER. Well, we run the portfolios, yes. There is no question about that. Mr. KEITH. I realize that you manage the portfolio, but you said "run the fund." Mr. ALGER. You know there is a problem in all of these discussions about arm's length or running the fund. For instance, if a mutual fund did not allow a vote to its share- holders at all, we probably would not be having these discussions at all. If it were just treated like a stock insurance policy which you were to own, and you could also buy the stock in the insurance company, there would be no problem. I mean it is a product. If we just did away with the vote for the shareholder, there really would be no problem. It is a product which we run, that is right. It is a very competitive one. The rewards are tremendous, because if we do well, as you can see, it will grow from $400,000 to $60 million. We do not have a captive sales force, but the independent broker- dealers will pick it up and sell it, because it is a good product and it is easy to sell, and we can prove it is a good product. Mr. KEITH. Do you believe that there is the usual relationship be- tween stockholder and management in mutual funds? Mr. ALGER. Sure. It is just like any other company. Stockholders do not run the management of any company in the United States of any size practically. Mr. KEITH. But the board of directors in the average corporation, when they are dealing with a service or a product which they are PAGENO="0092" 506 buying, and a member of the board of directors has an interest, he has to stand up pretty straight to disclose the nature of the transac- tion in which he is involved. Mr. ALGER. Well, of course in the same way, for instance, at our firm we have a last in, last out rule on investing in stocks. If everybody is completely in we can buy stock; all of our clients when I say every- body. And after everybody is out we can sell stock. Mr. KEITH. Let's put it this way. In the board of directors of a mutual fund there are 40 percent that are unaffihiated. Mr. ALGER. I think so. Mr. KEITH. Therefore, there are 60 percent, generally speaking, that are affiliated. These people owe their allegiance to the manage- ment company, and they are disqualified from voting on the manage- ment contract, but they are nevertheless present during the discussions and they are very much involved in the decisionmaking process in- directly, and that is their primary responsibility. Therefore, the con- tract that is entered into is, generally speaking, not as arm's length as would be the case in other corporate transactions, I would think. Mr. ALGER. Well, if we could- Mr. KErrn. It gets back to what you just said, "We run the fund." Mr. ALGER. We view it as a product which we are just trying to- Mr. KEITH. Yes. Mr. ALGER. I mean that is the way we view it. Mr. KEITH. The SEC does not think this is healthy. Mr. ALGER. Well, there is such tremendous competition. How can something be unhealthy which is so tremendously competitive? I mean that is of course the question, and in fact the SEC admits that if you view it as a product, the basis of the whole study does not exist. They admit this. And we say, "Well, gee, what else is it?" I mean you can oniy describe it in competitive terms. They talk about the vigorous sales competition. They also make references to the entrepreneurial risk. There is no clear-cut guarantee to success in this thing. In fact, I can tell you here we have had, and I will say the Security Management Co. has had the best product in the country, and once again here is a point which you can prove. You know, we can say we have had the best. We can prove it. And even so, just this year it broke even, and it has $70 million in total assets under management. Just this year it broke even and there was great rejoicing. I mean no one is making an awful lot of money. I have on my desk, for instance, in my office, an offer from a man who owns 40 percent of a company which is quite well known. They have about a half-billion dollars in assets under management which includes investment counseling accounts and some funds and they have a contractual program of $150 million in face and they have a captive sales force and they have been making money every year, and what do you suppose he wanted for his 40 percent interest? Would you have any idea offhand? Well, it was so depressingly little. He wanted $800,000 which he would accept in 6-percent notes if they were bankable. That was in parentheses, if they were bankable. Well, here is a man who has had, a tremendously successful company in a great growth industry, and for PAGENO="0093" 507 40 percent of it, all he gets is $800,000. Now, it is not a lot of money. I mean it really is not for the size which he has attained. I mean man- agement companies really are not very profitable. That is the fact of it. Mr. KEITH. No further questions, Mr. Chairman. Mr. Moss. I am not going to labor the point with you, but I can oniy say this: This statement that it will involve a cut in the load from 81/2 to 61/2 and at the same time strengthen the economics for the in- dependent dealer and his salesman, "This plan is nonexciusive and because of the benefits to all involved we believe it will be copied throughout the industry. "As you know, the NASD's administrative authority to approve or disapprove this plan is absolute and final." Now, you are saying that they could approve a plan that would take all of these funds down to a load charge of 61/2 percent? Is that what you are saying? Mr. ALGER. Yes. We specifically recommended it for our manage- ment company. Well, for instance, you have a member here in this room, Mr. Roland Robbins of First Investors, who is on the standing com- mittee. Mr. Moss. Let's stay to this question. Mr. ALGER. He could explain it to you better than I. Mr. Moss. Oh, I do not want anyone else to explain your statement to me. I want you to explain your statement to me. I have quite a nmnber of staff that I can have go over it and explain it. I want to understand quite clearly what you intend to convey to the committee. Mr. ALGER. The point I was making and trying to make is that I do feel that if the smaller funds, more robust funds had the right to innovate with marketing-you see there are certain problems with the marketing structure as it exists now. For instance, the big problem is if you want to cut the load how do you keep the independent broker- dealer in business. Mr. Moss. I know, but we have a very specific statement. You say that the "NASD's administrative authority to approve or disapprove is absolute and final." Mr. ALGER. That is correct. Mr. Moss. Is not the NASD action subject to review by the Securities and Exchange Commission? And does that not have the effect of staying an action? Mr. ALGER. According to my lawyers, it does not. Evidently, and it is just a thing that is in the act itself- Mr. Moss. Well, I can only say that you and your lawyers are either confused or I and my lawyers are confused. You could cut the load on your plans, the plans you advise, to 6½ without any NASD approval, could you not? Mr. ALGER. Yes, we could, but we could not come in with-for instance, as I say, we plan to use a portion of the management fee to contribute to a pension fund of salesmen through independent broker- dealers. Now, to do such a plan, even though it is fully revealed in the pro- spectus and spelled out, and is a part of the discounts and concessions which we would offer, because after all we are cutting the load, to do such a thing we would have to get approval of the NA SD. PAGENO="0094" 5O8 Mr. Moss. You could engage in the very common practice of giveups you receive from your brokerage in order to stimulate a sales force or to enrich the amount that the sales organization, could you not? Have you submitted a proposal to the SEC that they have rejected? Mr. ALGER. They sent it back to the NASD. Mr. Moss. For what, for comment? Mr. ALGER. No, for approval. Then they will look at it if the NASD approves it. Mr. Moss. But you said it is final and absolute. Mr. ALGER. That is correct. In other words, if the NASD disapproves it, then we have no right to go to the SEC with it. Mr. Moss. I have no further questions. Mr. Watkins? Mr. WATKINS. None. Mr. Moss. Thank you very much. The next witness will be Mr. Edward B. Allen, Jr., secretary- treasurer of Allen, Rogers & Co., Inc. You may proceed, sir. STATEMENT OP EDWARD B. ALLEN, JR., SEORETARY-TREASURER, ALLEN, ROGERS & CO., INC. Mr. ALLEN. Thank you. I would like to beg your indulgence and ask if you ~ ould move down in your thinking from the management fee, and the portfolio manage- ment, and the boards of directors of funds and so on, and come down with me if you will to the grassroots of this business, and talk more or less about the people end of it, that is those who are selling it. Mr. Moss. We are very pleased to do that. Mr. ALLEN. And those who are buying it. Mr. Moss. All right, sir, w~ will be pleased to hear from you on that. Mr. ALLEN. Perhaps I am the answer to Mr. Keith's question of a little while ago that it would be nice if we had a salesman here. I hope at least to some degree I qualify, Mr. Keith. Our company is a relatively small dealer specializing in mutual funds. We do some business over the counter, pretty much unsolicited. We do some listed business through a listed firm, but primarily we deal in the hiring, training, and supervising of sales representatives, registered represetantives who go out and contact the public and interest them in what mutual funds can do for them. Approximately 75 percent of our business is in contractual plans, and the rest of it is in outright cash purchases and so-called open accounts or dividend reinvestment programs. Various funds use dif- ferent terms. We have seven offices in New Jersey, eastern Pennsylvania, and Delaware at the present time, and about upwards of 200 salesmen, be- tween 200 and 250 registered represetntives right at this point. The firm started 6 years ago when my two partners and I were affiliated with another underwriting firm and sold funds for them before opening up our own shop. The initial reaction of our representatives, and ourselves to a great degree, when the SEC proposals were first rumored and then actually PAGENO="0095" 309 came out, was one of shock and dismay. We felt that it was incredible that these recommendations were being made, because, you see, the sales representatives in most organizations such as ours, I think I can speak pretty much for other firms of our size, are a pretty dedicated group of people who, in addition to the fact that they obviously are in business to receive monetary compensation, they also are, for the most part, extremely interested in being of service to their fellow man. I have been in the military as an enlisted man, as an officer, I was in the teaching profession, have a master's degree in education, taught for 10 years, coached athletics and so on, and believe me, there is no more dedicated a group of people than mutual fund salesmen, and they raised questions immediately when they heard of this report. I can give you no specific examples but general ideas such as what is the SEC trying to do, put us out of business? Or it sounds to me like someone is trying to undermine the free enterprise system. Or what do they think, we are getting rich in this business? And, of course, it did raise questions in our mind as to what could be the motives? The possibilities, of course, are political or personal gain or some such reason as this. Mr. Moss. I would prefer that you confine yourself to your state- ment on the subject you came here to discuss. As one of the sponsors, I assure you that I have neither political nor personal nor pecuniary gains in mind. Mr. ALLEN. I do not mean to imply that, sir. Mr. Moss. Well, you have succeeded quite admirably, so let's stay with the subject that we are here to discuss. Mr. ALLEN. My next statement was to be that obviously we drew no conclusions in that direction at all. The oniy conclusion we could come to was that at least from our standpoint down at the grassroots, work- ing with people out there every day, was that possibly the SEC did not fully understand the problems that we do have. Mr. WATKINS. Mr. Chairman, I think we ought to let him express his opinion. He can file his report if he wants to. Mr. Moss. Mr. Watkins, the gentleman did not ask to file his report and summarize it. Mr. WATKINS. Mr. Chairman, would you not permit him if he would request his statement be filed and then go on as he has? I think it is interesting. Mr. Moss. If the gentleman from Pennsylvania had been present, the chairman announced at the beginning of these hearings and well in advance that it would be necessary for every witness appearing to submit at least 24 hours in advance a statement of what his testimony would be. The gentleman is not now confining himself either to a sum- mary of his statement or to the statement which he has presented to this committee in accordance with the rules of the committee and the rules of the House. The gentleman will therefore confine himself to the statement he has presented here as his statement. He may summarize it if he wishes, but the rules of the House and the rules of the committee permit that type of requirement and that type of requirement will be imposed as long as I am chairman of this subcommittee. Mr. WATKINS. Now, Mr. Chairman, I do not mean to be disrespect- ful. I have a lot of respect for you and your ability and your knowledge PAGENO="0096" 510 of the law and all, but this gentleman does not. So can we not be a little lenient with a witness that comes up here- Mr. Moss. I have been most lenient. The gentleman has been here presenting a statement which is totally extemporaneous and totally irrelevant, and not related in any sense to the statement he prepared to submit to this committee as his statement. Mr. WATKINs. I will have to submit, of course, to the ruling of the Chair and I shall, but I would suggest to you in my behalf that you give me some of these grassroots opinions in writing. I would like to have them. Mr. ALLEN. Thank you very much. Mr. Moss. The gentleman is supposed to be here to give us grassroots opinion and he has carefully prepared them. Mr. WATKINs. The remarks he did not put in the report, let's put it that way. Mr. Moss. The gentleman can do that in his questioniiig. Mr. WATKINS. I do not believe in being the judge, court and jury in this thing. Mr. Moss. The Chair does not intend to pursue the discussion any further. The gentleman will proceed and proceed in order. Mr. WATKINS. I accept your decision. I think I told you that. You do not have to be so stern about it. Mr. ALLEN. I respectfully request that the statement be made a part of the record. Mr. Moss. The statement will, if there is no objection, be included at this point in its entirety. (The prepared statement follows:) STATEMENT OF EDWARD B. ALLEN, Jm, SECRETARY-TREASURER, ALLEN, ROGERS & Co., Ixo. A. MUTUAL FUNDS AND THE REGISTERED REPRESENTATIVE In the first twenty (20) years or so of the forty-six (46) years Mutual Funds have been in existence, the total assets of all Funds grew from zero (0) to approximately five hundred million dollars. In the last twenty-three years this figure has increased to approximately 45 billion dollars. The reasons for this rapid growth in these recent years may be attributed to the following: (1) Rising security prices reflecting the tremendous growth and earning power of American Industry. (2) The generally excellent Management, relative safety, and many con- veniences of Mutual Funds. (3) The growing affluence of our society. (4) The declining purchasing power of the dollar. (5) The excellent cooperation between our Government and our industry to set legal safeguards and high ethical and professional standards. (6) The efforts of Registered Representatives to bring the above factors into sharp focus and correlate them with the personal financial planning of people in all walks of life. We would not for a moment wish to minimize the importance of the flrsL five (5) reasons. However, the major influence, without a doubt, affecting the gratifying increase in the number of shareholders of both modest and wealthy circumstances, may be attributed largely to the efforts of Registered Represen- tatives. By the S.E.O.'s own admission in it's report, Mutual Funds have performed a very worthwhile and valuable service to the people of our country: "Mutual Funds are sold. They are not bought. Therefore, the Registered Rep- resentatives have been, are now, and, unless the S.E.C's recommendations are enacted into law, will continue to be, an indispensable part of this valuable service." PAGENO="0097" 511 B. A BREAKDOWN ON SALES CHAROES AND COMMISSIONS Although it seems reasonable to assume that Congress is hot interested in regulating prices, knowledge of how the clients' sales charge in Mutual Fuilds Is distributed should prove interesting. These charges apply generally to sales under $25,000 and are scaled down on larger sales. The Dealer-Representative commission ratio shown a~re our Company's. Other Dealers may vary their commission ratio somewhat. 1. Charge to investor-8% 2. Dealer receives-6% on most funds 3. Managers receive-5%, leaving 1% for the house 4. Sales Representatives receive 41/2%, 4%, or 3~/2% depending upon level of experience and accomplishment. The Managers receive, in override, the difference between these rates and 5%. This compensates them for hiring, training and supervising the representatives under them. If the S.E.C.'s economically impractical proposal of a 5% Sales Charge is enacted into law, one does not have to be a financial wizard to see that firms like ours would simply be legislated right out of business. The Dealer concession would be lower than we now pay our managers and top representatives and repre- sentatives could not afford to stay in the business at 1~% or 2% sales com- mission. Therefore, since they would no longer bring this vital service to the public, the S.E.C. folks would be doing a disservice to the very people they purport to protect. With all due respect for the S.E.C., personally, I strongly resent the implica- tion that for my 12 years in this business, I have been overpaid for my services. In actuality, every client in all those years who has carried out my recom- mendations has made money. No one has lost a dime. C. UNYAIE COMPARISONS If indeed the sales charge is too high, as alleged, it must be too high in rela- tion to the service rendered, or too high in relation to other services believed to be of a similar nature. These are matters of opinion to be settled in the free enter- price market place. It is interesting to note that the only complaints about Funds are from the S.E.C. and not from shareholders. The following is a comparison in costs between Funds and individual stocks based on $5000 in an individual stock. Funds: 8 percent to Buy No charge to sell. Stock: 1 percent to buy 1 percent to sell (approximately). Funds are purchased to keep, not to sell. Stocks are usally bought to sell at a future date. Let's assume that a buyer turns over his stock 3 times a year. That would result in a 6% total sales charge in a year or 60% in 10 years. The next example is $5000 in 50 stocks listed on the N.Y. stock exchange: Amount invested $5,000.00 Amount in each stock $100.00 Price per share .~ $50.00 Number of shares in each stock 2 Buying cost: Odd lot differential $12.50 Brokerage fee 300. 00 Selling cost: Odd lot differential 12.50 Brokerage fee 300. 00 State tax ~. 00 SEC fee .50 Total In and out fee 630.50 Percent of invested amount (percent) 12. 61 Mutual fund cost: $400 or 8 percent. 85-~592-68--pt. 2-7 PAGENO="0098" 512 Not only Is there a difference in charge but a more significant difference is that of method, purpose and planning involved. The average customer's man in a brokerage firm must make several trades a day usually over the telephone or with the client in his office watching the board, in order to make a decent income. On the other band, the Mutual Fund representative takes a different ap- proa~h, since he is interested in overall financial p}anning for his clients. He spends hours prospecting, personally interviewing to determine needs, abilities and long term goals, planning programs to meet such objectives as education of children, retirement plans, or current income needs from investments. If he is. progressive, as he ought to be, he also plans and coordinates life insurance pro- grams, works with attorneys on trusts, sets up corporate and personal tax- sheltered retirement plans. Instead of several sales a day, he is fortunate tG make two (2) sales a week and many times spends weeks on a single case. His job is to tailor a plan to individual, family or business needs. He believes that only after such things are taken care of should a person in- dulge in the moire precarious practice of playing the stock market. The Mutual Fund Industry is one which: 1. Sends thousands of young men and women to college. 2. Provides a dignified retirement for hundreds of thousands of older people. 3. Protects millions oif people from the ravages of inflation. 4. Gives people of all walks of life the best plan ever devised to provide a sound method of participating in the growth and earning power of American Industry. D. THS CONTRACTUAL PLAN Experienced persons in financial planning know that the vast majority of people, even though they live in the wealthiest country the world has ever known~ end up broke after a lifetime of work. The reason for most is that they never bad any plans to end up any other way. Since most people do not have $2,000, $5,000, $10,000, $50,000 or $100,000 to invest, their only salvation to achieve the above goals, is to save out of their income. This should be done on a planned systematic basis rather than on a bit or miss basis.. The only plan that makes. real sense is the Systematic Investment Plan or so-called Contractual Plan. The advantages of this plan far outweight the one disadvantage. The oni? disadvantage is that if the shareholder liquidates in the early years be would probably withstand a loss. It is the same disadvantage one fInds in a mortgage, life insurance policy, buying a car on time, etc. The client has this fully explained to his satisfaction before he embarks on a program. A plan for education Cif children or for retirement is extremely im-~ portant in financial planning. This plan provides a self~imposed semi-obligatory program to accumulate capital to take care of future inevitable financial needs.. It gives all the possible advantages and conveniences of an investment in Amer- ican Industry and reduces the risk to a minimum. See exhibit A-"Contractural Plan Results" which shows values of plans at various stages of accomplishment as well as salesmen's commissions earned. See es~hibit B-"Some Advantages of the Contractual Plan." E. HIRING AND TRAINING PEI5SONN~L Because of the high standards required for registration and licensing, it; takes about two (2) to three (3) months of study and training and examina- tions before an applicant is qualified to soilicit sales. Our firm has hired, trained and released about 500 people in 6 years to retain the present 250 representa- tives. Most firms operate on a straight commission basis. No draw or salary. Many representatives are part time. It is difficult to ascertain why all this is so if salesmen in this industry are paid such a high commission, as alleged by the S.E.C. Why do not more custoimer's men leave the individual stock business and sell Mutual Funds exclusively, if there is so much money in it? F. CONCLUSIONS 1. Well-informed citizens, who believe in the free enterprise system, are en- pable of judging the value of Mutual Fund purchases, i.e. costs vs results. PAGENO="0099" 513 2. The sales charge on fund shares purchases and contractual plans is com- pletely fair and fully justified in light of the service rendered. 3. The contractual plan is the finest and most sensible Investment vehicle ever devised for Investing regularly in American Industry. The many advantages and eonvenlences far outweigh the one disadvantage. 4. The Registered Representative is generally a hard working, conscientious, well-trained person who has his clients best interests at heart. His services usually extend far beyond the mere sale of Mutual Funds. fi. The sales charge in Mutual Funds cannot be equated with that of stocks per se. Exuinir A STATUS OF SELECTED CONTRACTUAL P LANS AS OF (~ CT. 2, 1967 - Name Monthly plan Face amount Number of investments 1 Amount invested Value Salesman's commission 2 1. 0. B $50 $9,000 6 $300 $151.74 $67.50 2. G. 0 100 18,000 15-8b 3, 500 1,247.64 292. 50 3. W.D 30 3,600 17-46b 510 714.12 87.75 4. iA 50 6,000 26-34b 1,300 1,428.24 146.25 5. 1. H 25 4, 500 28 700 730. 35 73. 19 6. C. F 30 3,600 38-20b 1,340 1,752.76 87.75 7. A. P 50 6,000 56 4,800 4,025. 04 146.25 8. C. C 75 9,000 63 4,725 8, 147.46 219. 57 9. P. B 60 7,200 66 3,960 6, 540.69 175. 50 10. F. I 100 12,000 69 6,900 11,588.22 292.50 11. A.G 25 3,000 72 1,800 3,035.01 73.19 12. P. T 500 60, 000 72 36, 000 66, 704. 70 744.00 13. H. R 100 12,000 83 8,300 13,389.75 292.50 14. E.S 50 6,000 96 4,800 9,040.11 146.25 15. J. S.3 25 3, 000 120 3, 000 4, 787. 85 73. 19 16. F. M.~ 100 12,000 120 12,000 15,370.00 492.50 Totals 1 370 174 900 947 89 735 148 653 72 - 3 210 39 Total amount invested 89, 735. 00 Unrealized gain 58,918.72 I 2nd number indicates number of payments behind. 5 Starting Salesman's Commission spread over 1st year. Completed Plans. Note: All above plans have been in existence for less than 6 years. Actual confirmations of the above records will be furnished upon request. ExHIBIT B SOME ADVANTAGES OF `IIIE CONTRACTUAL PLAN 1. Diversification. 2. Professional Management. (a~) Careful Selectien. (b) Constant Supervsion. 3. Distribution of Dividends Earned. 4. Distribution of Realized Profits. 5. Automatic Reinvestment at no cost. 6. Bank Custodian Services. 7. Certified Public Accounting. 8. Monthly Accounting and Reminder Notices. 9. Periodic Fund Reports. 10. Accelerate or De-celerate Monthly Investments without penalty. 11. Low Cost Completion Insurance. 12. 90% Withdrawal Privilege. 13. Redemption of Shares at no cost. 14. Transfer Privileges. 15. Systematic Withdrawal Plan. 16. Use as Collateral. 17. Tax advantages. 18. Designation of Beneficiary. PAGENO="0100" 514 19. Adaptable to Gifts and Trusts. (a) Revocable and Inrevocable. (b) Gifts to Minors. (c) Profit Sharing Plans. (d) Keogh Self-employed Retirement Plans. (e) Short-term Trust. 20. Year-end T~x Information. Mr. Moss. The gentleman may summarize the statement. Mr. ALLEN. I shall try, Mr. Chairman, to exercise as much restraint as Jean. The thing that we find out there in the field is that, generally speak- ing, most people do a rather poor job of personal financial planning, and I think all the statistics will bear out that after a lifetime of work in the wealthiest country that has ever been on the face of the earth, that many, many people end up quite broke. Those of us in the sales end of this business, I think, are in the forefront of an endeavor to try and bring into focus the needs of people and correlate them with their ability to set money aside and to correlate it also with the economic times in which we live, and offer plans and programs to that end. And what this. industry has done, and primarily through the sales representative, has been to send thousands of young men and women to college, has resulted in a dignified retirement for hundreds of thousands of older citizens, has protected millions of people against the ravages of inflation, and if we may be a little prejudicial, given people the best plan that has ever been devised to offer a participation in the growth and earning power of American industry. And I submit to you that mutual funds are a product or a service which is sold and not bought, very similar to life insurance. Very few people go down to Prudential or Metropolitan or John Hancock and walk in and say, "I would like to buy some life insurance." Mutual funds are pretty much the same. People do not generally seek out this service. It must be brought to them. And this requires sales- men who spend long hours prospecting, interviewing, planning, and if they are progressive in their thinking, probably correlating it with life insurance. They deal with attorneys in setting up trusts, work with self-employed retirement plans and with profit-sharing and pension plans in industry, and it is simply our contention that they should be paid for these services. it would seem that the SEC would want this compensation reduced and to decide just how much it should he. If I may, I should like to break down the sales charge on a lump- sum investment. The client generally pays about 8 percent. This is as- suming it is not a no-load fund. The dealer concession usually is about 6 percent. Mr. KEITH. You mean if somebody puts a lump sum down they pay 8 percent at that time? Mr. ALLEN. Yes. If a man invests $1,000, the sales charge is $80, the sales charge to the client. Mr. KEITH. At the time he puts it down, the total commission on a plan other than a lump sum, it works out to be about the same thing, if you see what I mean. Mr. ALLEN. No, I am sorry, I do not follow you. PAGENO="0101" 515 Mr. KEITH. If he is buying on the installment plan, he would be paying 8 percent over a period of years? Mr. AlLEN. Yes. Mr. KEITH. And if he bought a lump st~m of $1,000 each year, he would be paying $80 orB percent? Mr. ALLEN. That is correct, the difference being that on a contractual plan, of course, that the major portion of the sales charge comes out the first year, but in the end when the man completes the plan-. Mr. KEITH. He is paying everything in the first year if he only puts in the lump sum. He is paying the 8 percent. Mr. ALLEN. No. Let me give you an example if I may. Let's assume a man is just buying $1,000 worth of XYZ fund. Mr. KEITH. Yes. Mr. ALLEN. He buys $1,000 worth of shares, that is, minus 8 percent. He buys $920 worth of shares. The 8 percent is the sales charge to him. And then if I may, I would like to show you how this is divided. The dealer concession generally is 6 percent. We a~ dealers, have man- agers under us who receive 5 percent, leaving 1 percent for the house, so to speak, for us as the dealers. Now this breakdown of course will vary somewhat with other dealers. Although there is only so much one can work with, some firms will vary these percentages slightly. I am using our firm as an example here. Salesmen generally will receive 41/2, 4, or 31/2 percent, depending upon the level of accom- plishment, length of service, or whether they are working their way into management and so on. Now it is a little hard for us to understand that if the overall sales charge were reduced to 5 percent, how we could work out a system of compensation for our salesmen which would hold them, which would keep them with us as salesmen, and frankly, how we could stay in business. Mr. WATKINS. How could you sell if you did not have salesmen? People do not come to you like they would a doctor, do they? Mr. ALLEN. No, that is correct, very seldom. The longer one is in the business, the more this does happen, but it is an occasional thing. No, we just could not operate. Mr. WATKINS. In other words, what you are saying, if you cut it down to 5 percent you are out of business then? Mr. ALLEN. Absolutely. Mr. WATKINS. That is what I want to hear you say here. All this going around the bushes about some of this other I am not interested in. Mr. ALLEN. In our opinion this is exactly what would happen, be- cause we could not compensate salesmen to go out and sell this service. The only kind of dealership that we could have would be one where I suppose my partners and I would be alone in the business, and let's say the concession to the dealer was 31/2 percent. Proportionately I guess it would be something like that. So that we as principals would be the only ones selling and we would be receiving a 31/2-percent commission on what we personally would sell. Well, it is pretty obvious we would get out of this busi- ness and go into some other business. Mr. WATKINS. Mr. Allen, how many men did you say you employ in your firm of Allen, Rogers & Co.? PAGENO="0102" 516 Mr. ALLEN. About 240 or so I think at the moment. Mr. WATKINS. You are telling this committee now that those 240 people would be out of work? Mr. ALLEN. Yes, sir. I do not see anything else that could happen, because they are just not going to work for that little compensation. Mr. WATKINS. You could put them on relief. Mr. ALLEN. Well, maybe we can raise social security benefits. Mr. WATKINS. They can wind up on relief, do not do anything, get. paid, get a check sent to them once a month, We could do that. Go ahead, Mr. Allen. Mr. ALLEN. If I may go into this a little further, as regards the con- tractual plan. As far as we are concerned, and we may be prejudiced, the greatest single vehicle that has ever been made available for aver- age' Americans and people of modest means to secure an investment in American industry has been the contractual plan, because it ade- ~uately compensates the salesman for spending the time with this little guy, so that he can invest $25, $30, $40, $50 a month. There is only one disadvantage to the contractual plan, and that is, if the shareholder liquidates in the early stages, he will lose. This is always pointed out to him. I perhaps shouldn't say always. There may be some salesmen somewhere who don't, I don't know, but we certainly haven't had any complaints on it ourselves. The chief determinant, I think, as to what the sales charge should be, doesn't necessarily bear any relation to the performance of the product or anything of that nature. It bears a relationship to what it costs to do business, what it costs to get a salesman to go out and do the job. The markup on a diamond ring I suppose is 50 percent or something, I don't know; on a suit of clothes maybe 40 percent; an automobile, maybe 25 percent, and a can of beans two percent. The reason for the charge, I think, is related to the cost of doing business, and it is important to us what it costs us to do business and what we have to pay out in terms of overhead in order to stay in busi- ness. And as I said, the shareholders have not complained. It seems that the SEC are the only ones that have complained about the sales charge. If I may give an example of the difference between an open account and a contractual plan in terms of what the salesman earns, an open account simply being a level charge plan, where 8 percent is taken out each time an investment is made. If a man is going to invest $100 to begin with, and $50 a month as he would on a contractual plan, and if we set up an open account the same way-although, generally speaking, most of the funds don't do it that way-some funds have a minimum of perhaps $500, some $150, to open an account, and then the investor may add in $50 increments if, as and when the investor feels like it. On the open account, out of the first $100, the salesman would re- ceive 3~/2 percent, or $3.50 out of this $100. Picture now, he has called this person, made an appointment, perhaps called many persons be- fore he got the appointment with this prospect, and is spending his time going out to talk to this man. You see, many times this business is equated with the customer's man in a brokerage firm who makes most of his sales over the phone, PAGENO="0103" 517 *nnd does it in a relatively short time. In the mutual fund end of it, the salesman goes out and sits down with the client or brings him into the office and, as I said before, correlates this whole program for him and tries to set up a plan and a program to meet his needs, his thjectives, his hopes, his dreams for his children's education and his own future, and so on. So let's assume that a representative has 50 of these open accounts going. It means that he will get $1.75 every month if this client puts in $50. If he has 50 of these plans going let's say, this is $87.50 a month income to him. Assuming 20 percent attrition along the way, this is more like $60 a month income to the salesman, if all he sold was open accounts. On the contractual, on the other hand, a man puts in $100, the sales- man would make something like $22.50 out of the first $100 and $11.25 out of each $50 in the first year, and if the salesman, the representa- tive, had 50 of these plans going, this would be $562.50 monthly in- come to him, and again assuming that the same attrition involved here is 20 percent, which incidentally, our records prove would not be so because people carry out contractual plans and they don't carry out open accounts to anywhere near as high a degree. However, this would result in about $450 a month income to the salesman as com- pared with $60 a month in the case of the open accounts, or level charge plans. I think you will agree this is not a very high income, average or below average. So the registered representative would have to have many, many more than 50 plans going, and in the ease of the average representative, it will take him at least a year to institute 50 plans. Well, if we had to sell only the open account, as I said before, we would just be out of business. The only other alternative would be for the registered representative, and we ourselves as dealers, to deal only with wealthy people who could put in `thousands of dollars, and `thereby we could get an adequate commission and income for our- selves, or we could go into another business. Mr. Moss. Mr. Allen, do I understand you to say that this condition `would arise if you did not have the contractual plans, the front-end load plans? Mr. ALLEN. Yes, sir. Mr. Moss. How do you explain then the strange phenomenon of. my State of California, where with about 10 percent of the population of the Nation, we merchandise 23 percent of the mutual fund shares? `There isn't another State that equals it. Mr. ALLEN. I understand that. Mr. WATKINS. It is a large State. Mr. Moss. Does that give the selling forces more vigor, more initiative? Mr. ALLEN. I think that one interesting statistic to investigate would be what the average ~a1e is in California. Mr. Moss. We are going to do that. Mr. ALLEN. Because in order for a salesman representative to make a decent income in California or anywhere else, he would have to make relatively large sales, and it would seem to me that this might PAGENO="0104" 518 be discriminatory against the smaller man who can only invest $25 or $50 a month. Mr. Moss. With all kindness, `sir, I would suggest that you are lead- ing yourself down `a rose path that you shouldn't wander on, unless you have the statistical data to back it up, because you may find that the average sale there is no larger than it is out your way. Mr. ALLEN. It would b'e mighty interesting. Mr. Moss. You may find that the average investor is being encour- aged as much or more than out your way. Mr. ALLEN. Possibly. I `have never been to California, so I don't know. Mr. Moss. So I just would suggest `that it would not be the act of greatest wisdom to go ahead and commit yourself too far along that path that we are only selling to' the wealthy. I am not willing to con- cede that we have that mix of wealth in our population that would pro- duce that phenomenon. There are other State's I think with a higher income per capita tha~n~we have. Mr. ALLEN. Well, from where I sit, in looking at our problem. here, and what we would have to face, you ask me why this happens in Cali- fornia. My natural reaction would be that in order to make an ade- quate income, that a man would have to sell more. I don't `know, if he doesn't- Mr. Moss. They might be better salesmen, isn't that right? Mr. ALLEN. Possibly. I don't know, we haven't expanded as far as California, but we don't seem to find a great deal of difference between salesmen in say north Jersey `and Delaware or Lancaster and Mill- ville. Whether they are different in `California or not I really couldn't `say. Mr. WATKINS. Mr. M'oss can't tell you much about those places, can you, Mr. Moss? Mr. Moss. I have visited them, Mr. Watkins. Mr. WA~rxINs. We want you to come down, `too. We would like you to see more of them. Mr. Moss. I have enjoyed it too. Mr. ALLEN. Well, we do feel that the elimination of the contractual plan would drive representatives and firms like ours out of business. I think it would also deprive a lot of average people from the service which is now b'eing rendered to them, and in essence would ultimately hurt the very people that the SEC purports to protect. It would seem somewhat discriminatory against smaller firms like ours, `because whatever business, if we were to go out `of business, what- ever `business would be sold in mutual funds, it would seem to me would go through the larger, `wealthier firms who would perhaps sell it inci- dentally to their general brokerage business. Mr. WATKINS. Do you sell life insurance in your firm? MrAr~N. Yes, we do. We have, I guess, about a third o'f our repre- sentatives who are life insurance salesmen also. Thi's, o'f course, is one possibility that we have speculated on, and that is. if this bill were enacted into law that we would have to go, this is one avenue, we would have to go into the life insurance busine'ss. PAGENO="0105" 519 Mr. Moss. Are you a general agent at the pr~ent time? Mr. ALLF~N. Yes. Mr. Moss. For the life insurance business., Mr. ALLEN. Yes, we are. Mr. Moss. And you ~re a broker/dealer in addition. Mr. ALLEN. Correct. Mr. Moss. Do you specialize in any particular funds? Mr. ALLEN. Oh, no. Mr. Moss. You sell anything that is available. Mr. ALLEN. Any funds. Mr. Moss. With no concentration on any one of them. Mr. ALLEN. Oh, yes. I would say we concentrate on a particular group, although we do not tell our salesmen that they must sell this particular group, but various funds do give added concessions for a percentage of the business that a firm will do with them, and so we do a large portion of our business, I would say 80 percent, in one par- ticular group of funds. When we first went in the business 6 years ago, we looked into many of the funds, having `been with an underwriter `before, and were selling only one particular group of funds, and realizing- Mr. Moss. What is the nature of that added incentive? Mr. ALLEN. Oh, on the contractual plans in particular, I couldn't give you the exact figures, but there is an additional compensation in doing an additional amount of business per quarter. Mr. Moss. Do you have an idea what it is'? Mr. ALLEN. And we pass this in incidentally to the salesmen. Mr. Moss. You have an idea of what it is, don't you? Mr. ALLEN. A half million dollars a quarter I believe it the latest figure in face amount of plans. Mr. Moss. What is the added incentive that applies to this half mil- lion dollars a quarter? Mr. ALLEN. Well, there are so many different sized plans that I couldn't tell you right offhand just exactly. I could certainly get it for you. Mr. Moss. Will you supply it for the record? Mr. ALLEN. Surely. (The information referred to follows:) EXAMPLES OF VOLUME BONUS ARRANGEMENTS OF FUNDs WHICH HAVE CONTRACTUAL PLANS EXCERPT FRO1~f THE DREYFUS FUND INCORPORATED PROSPECTUS, DATED MARCH 21, 196~ The Programs are established under an Agreement between The Dreyfus Oor- porrtion and The Bai~k of New York, dated Thly 18, 1955, are governed by New York law, and cohstitut~ an investmclit company of the tfllit investment type under the Investment Company Act of 1940. They are registered with the Securi- ties and Exchange Commission under such statute, which does not imply super- vision of management or investment policies by the Commissioti or any ~ove~n- mental agency. Programs are available from authorized independent dealers. These dealers currently receive commissions from The Dreyfus Corporation ranging from 54% to 90% of the full 10-year or 15-year Sales and Creation Charge. Dealer com- missions on Fully Paid Programs ranged from 7.~% to .9% of the face amount of the Programs. Some dealers, because of their higher volume, receive additional PAGENO="0106" 520 commissions ranging from 3% to 11% of the standard commissiOns. A special arrangement has been entered into with one foreign dealer because of its addi- tional costs, unique pr~blems, and high volume; under this agreement that firm is paid a higher rate than other dealers. Also, some of the higher volume dealers receive 108% of the standard commissions allowed to dealers on second through tenth or fifteenth year payments. The commission rates may be revised from time to time by The Dreyfus Corporation. EXCERPT FROM THE OPPENHEIMER MANAGEMENT CORPORATION PROPECTUS DATED MAY 1, 1967 The General Distributor of OSCAP Plans is Oppenheimer Management Cor- poration (the "Management Corporation") 5 Hanover Square, New York, New York 10004. The Management Corporation is also General Distributor of ~the shares of Oppenheimer Fund as well as Investment Adviser to the Fund. As such General Distributor, the Management Corporation may be considered as the Underwriter of OSCAP Plans and the shares of Oppenheimer Fund as that term Is used under the Securities Act of 1933. As General Distributor, the Management Corporation receives compensation from the sales charges deducted by tho Cus- todian from payments by Planholders and on sales of shares of the Fund. A major portion of such sales charges is reallowed to dealers through whom Plans are sold. On Single Payment Plans dealer commissions currently vary from .90 of 1% to 7.98% of the offering price. On Systematic Capital Accumulation Plans, With or Without Insurance, commissions currently vary from 80% to 95% of the sales commissions deducted from the first year's monthly payments and from 35% to 70% of the sales commissions deducted from the remaining payments. Dealers may under certain circumstances receive in the calendar year in which they qualify: (A) Yearly Production Bonus equal to 5%-40% of the total OSCAP com- missions (Single Payment, first year and trail commissions) paid to them during the calendar year in which they qualify. (B) Yearly Service Bonus equal to 1/20th of 1% to 1/10th of 1% of the total net asset value of all shares credited to the OSCAP accounts of their clients as ~f the end of the calendar year in which such dealers qualify. * * * * * * During the year ended December 31, 1966, selling charges on the shares of the Fund's stock amounted to $941,358 on 1,689,035 shares. Of the foregoing Oppen- heimer & Co. received $174,289 including $57,318 as General Distributor and $116,. 971 as Dealer; $710,004 was reallowed to other dealers. Oppenheimer Manage- ment Corporation was appointed General Distributor June 28, 1966 and received $57,065. Oppenheimer & Co. as General Distributor for the Oppenheimer Syste- matic Capital Accumulation Program received $317,137 for its services and it also received $48,657 for services as dealer for said Plans. For the year ended December 31, 1966, the net investment advisory fee re- ceived by Oppenheimer Management Corporation was $703,340, after allowing against the fee of $761,219 a credit of $57,879 for certain salary and related expense paid directly by the Fund As of December 31 1966 there w'is a reseive for advisory fee of $606,735 the payment of which is contingent upon the reali- zation of investment gains. For the year ended December 31, 1966 total brokerage commissions paid amounted to $710,331 of which Oppenheimer & Co. received $421,925 at customary~ rates. Oppenheimer & Co. has a broker's blanket indemnity bond of $10,000,000 cover- ing partners and employees and the employees of the Fund and the Management Corporation. EXCERPT FROM FIDELITY CAPITAL FUND, INC., PRO5PEOTUS DATED APRIL 28, 1967 The Plans were organized under and are governed by the laws of the Common- wealth of Massachusetts. The Plans are considered to be a unit investment trust under the Investment Company Act of 1940 and are so registered with the Securities and Exchange Commission. Such rogistration does not imply super- vision of management or investment practices or policies by the Commission. PAGENO="0107" 521 CommissIons ranging from 64% to 89% of the total Creation and Sales Charge will be paid to authorized Investment brokers and mutual fund dealers who are members of the National Association of Securities Dealers, Inc. and who have executed a dealers agreement with the Sponsor. These dealers and invest- ment brokers are Independent contractors and nothing contained herein or contained in other literature and confirmations issued by the Sponsor or the Custodian, Including the words "representative" or "commission", shall con- stitute any dealer or investment broker a partner, employee or agent of the Sponsor or the Custodian. Neither the Sponsor nor the Custodian shall be liable for any acts or obligations of any such dealer or investment broker. Dealers who qualify by selling at least $60,000 face amount of Plans sponsored by the Sponsor in any calendar quarter will be given a bonus commission amounting to 71/2% of the first year Creation and Sales Charge. Dealers who qualify by selling at least $250,000 face amount of such Plans in any calendar quarter will be given a bonus commission amounting to 12.4% of the first year Creation and Advance Sales Charge. Dealers who qualify by selling at least $1,500,000, $2,250,000, or $3,000,000 total dollar face amount of Plans sponsored by the Sponsor in any calendar quarter, and such Plans constitute 60% of the dollar face amount of all Plans sold by the dealer during such calendar quarter, will be given a bonus amounting to 49%, 53%, and 56%, respectively, of the con- tinuing years' Creation and Sales Charge. Under specified conditions a foreign dealer who does not sell within the continental United States receives a com- mission of 105% of the first year's bonus commission paid to dealers. EXCERPT FROM THE TELEVISION-ELECTRONICS FUND, INC., PROSPECTUS DATEJI JUNE 22, 1967 The Programs are considered to be a unit investment trust under the Investment Company Act of 1940 and are so registered with the Securities and Exchange Commission. Such registration does not imply supervision by the Commission of management or investment policies or practices. Commission ranging from 64.5% to 77.6% of the total creation and sales charges in respect of Periodic Investment Programs calling for 120 monthly in- vestments, and from 54.6% to 63.4% In respect of Programs calling for 180 monthly investments and up to approximately 88% in respect to Single Invest- ment Programs, will be paid to authorized investment brokers and. mutual fund dealers who are members of the National Association of Securities Dealers, Inc., and who have exectited a selling group agreement with the Sponsor. In addi- tion, broker-dealers under certain cirôumstances, are entitled to receive a pro- duction bonus equal to no more than 15% of the regular first year commissions and 100% of the regular continuing years' commissions on Periodic Investment Programs. Mr. Kuipn. Is this additional compensation trips to Bermuda and things like that for your sales organization? Mr. ALLEN. Oh, no.. It is all published in the prospectuses of the various funds and fully disclosed. Mr. KmTH. What is the name of the fund that you sell most of? Mr. ALLEN. The Fidelity group of funds. There are a whole group of funds Obviously, in hiring and training salesmen, although dbviously we can't restrict them to selling a particular group and have no inten- tion of doing it, on the other hand, to try and train them to sell 300 odd funds and know everything about 300 odd funds is a monumental )ob The biggest thing that we are really selling in funds is the manage- ment, and this happens to be a group of funds which have done a very fine job in the past. Mr. WATKINS. Mr. Allen, didn't the State of Pennsylvania pass a law permitting you to do business with, your companies, mutual com- panies to do business with the municipalities and county govermnents, invest in your firms, that is taxpayers' money that would be. Mr. ALLEN. I am not certain of that, Mr. Watkins. PAGENO="0108" 522 Mr. WATKINS. I think that is correct, if my memory goes back that far. I think it is sound. I know ~nour bushue~s is sound. You ht~vea very sound and reliable firm; not ih m~ district either, Mr. Moss. Mr. Moss. I would say that is your loss, Mr. Watkins, Mr. ALLEN. Well, in conclusion, gentlemen, we feel that in the inter- ests of everyone concerned, the investor, the dealer, the industry itself, the salesmen, that thø SEC recommendations should i~ot be enacted into law. It is just about as simple as that. Mr. WATKINS. May I a~k a question off the record, Mr. Chairman? It does not pertain to this. Mr. Moss. Certainly, Mr. Watkins. (Off the record.) Mr. WATKINS. I have no questions, Mr. Chairman. I want to thank you for coming in here to testify before this committee. Mr. ALLEN. Thank you very much, Mr. Watkins. Mr. Moss. Mr. Keith. Mr. KEITH. No questions, Mr. Chairman. Mr. Moss. I want to join in thanking you also for your appearance, and if there are no further questions, the committee will stand ad- journed until 10 o'clock tomorrow morning. We will meet in this same room at that time. Mr. ALLEN. Thank you very much. (The following letter was received by the committee:) ALLEN, ROGERS & Co., INC., Bc~-Uy~iwyd, Pa., November10, 1967. Mr. JOHN E. Moss, Chairman, ~SuOcommittee on Commerce and Finance, Rayburn House Office Building, Washington, D.C. DEAR Sin: Enclosed find the answers to questions asked in your letter of October 26th, We hope they serve to give some insight Into the operation of firms such as ours in the Mutual Funds and Life Insurance business. In order to give a full year's picture, ~ve have used figures applying to the calendar year of 1966. 1. Number of Representatives in Mutual Funds-233 at present; 18 in 1966. 2. Number of Life Insurance Agents-95 at present; 78 in 1966 3. Number selling other securities-all Representatives are eligible to sell other securities. However, all sales of this type are unsolicited and handled only as a service to our clients. In our entire organization only 393 stock transactions were handled in 1966. About 75% of these sales were in listed securities on which we make no commission, since we are not a listed firm. We almost always charge N.Y.S.E. charges on over-the-counter securities. Consequently, we lose money on this regular stock business. We are not the least bit interested in this stock business. We are in the business of taking the necessary time to sit down and discuss personal financial planning with prospects and in recommending plans and programs to achieve their long term financial objectives. This is a vastly different business from that of the regular customer's man, who makes his living primarily by sitting on the phone all day taking buy and sell orders for stocks and bonds. 4. Number of full-time Representatives~-33 at present; 25 in 1966 5. Number of part-time Representatives-200 at present; 173 in 1966 6. Average annual income for full-time Representatives $9,708.00 7. Average annual income for part-time Representatives $1,000.00 (These are gross incomes before expenses of doing business such as auto- mobile, telephone, correspondence, etc., which the Representative himself must take care of. Also, the average age of Representatives Is probably in the 40's, or the prime earning time of their lives.) 8. Amount of Mutual Fund Business in 1966 (a) Cash $ 3,519,489.00 (b) Face Amount of Plans $13,960,550.00 PAGENO="0109" 523 9. Amount of Life Insurance Business in 1966 $7,00O~000.00 face amount (primarily term insurance) 10. Number of full-time men selling contractuals (All 198) 11. Number of part-time men selling contractuals (411 108) 12. Additional compensations to the firm from volume sales in contractuals. This is explained in the prospecti of the several funds which were forwarded to you several weeks ago. 13. Amount of this compensation passed on to Representatives (see attached commission schedules) 14. Amount of reciprocal brokerage business-$70,343.00 15. Amount of reciprocal earnings passed on tQ salesmen. It is our policy not to pass any of this directly to salesmen. However, it results in our being able to pay more generous commissions to salesmen. Also, this reciprocal business makes up the major portion of profit to our firm and is the primary source of funds for our employees profit-sharing plan into which we put $30,000.00 for the fiscal year of 1966. Also, such expenses as our annual convention, contest awards and the like come from this source. The rest goes to operating capital and dividends to stock holders. If the present proposals were enacted into law the resulting drastic cur- tailment of income would result in the following possibilities as we see them at this time: 1. We would be out of business entirely 2. Our business would be drastically changed as follows: (a) We would be forced to emphasize the insurance business and sell high cost, high commission insurance (which we do not now sell, be- cause we think it is usually not in the best interest of the client). (b) We would not solicit Mutual Funds sales and would sell them on'y as a strictly incidental part of the insurance business, or would accept only large sales which would result In an adequate commission for the time spent. (c) Our profit-sharing plan would be thrown out, which would make our employees very unhapply because it would adversely affect their retirement plans. We trust that this information will be helpful to the Committee and that their recommendations will be in the best interests of the public, the industry and dealers such as ourselves. Sincerely, E~WAED B. ALLEN, Jr. SCHEDULES FOR BEGINNING SALESMEN SCHEDULE A-COMMISSION IN FUNDS WHERE VOLUME SALES APPLY Monthly plan unit Double 1st payment Next 11 payments Total commission 25 $11.26 30 13.50 $5.63 $73.19 6.75 87.75 40 18.00 50 22.50 9.00 117.00 11.25 146.25 60 27. 00 13. 50 175. 50 75 33.78 16.89 219.57 100 45.00 22.50 292.50 125 56. 26 150 67. 50 28. 13 365. 69 33. 75 438. 75 SCHEDULE B-REGULAR SALESMANS COMMISSION IN FUNDS NOT ON VOLUME SALES Monthly plan unit Double first payment Next 11 payments Total 1st year $25 $10.10 30 11,60 $5.05 $65.65 5.80 75.40 40 15.70 7.85 102.50 50 20.00 10.00 130.00 60 25.00 12.50 162.50 75 32.00 16.00 208.00 90 38. 00 19. 00 247. 00 100 42.00 21.00 273.00 150 62.00 31.00 403.00 PAGENO="0110" 524 SCHEDULES FOR ADVANCED SALESMEN SCHEDULE A.-COMMISSION SCHEDULE ON VOLUME CONCESSION Monthly plan unit Double 1st Next 11 Total 1st 1 year 9 year 10 year payment payments year trail trail total $20 $10.00 $5.00 $65.00 $1.75 $15.75 $80.75 25 12.50 6.25 81.25 2.25 20.25 101.50 30 15.00 7.50 97.50 2.75 24.75 122.25 40 20.00 10.00 130.00 3.60 32.40 162.40 50 25.00 12.50 162.50 4.50 40,50 203.00 60 30.00 15.00 195.00 5.25 47.25 242.25 75 37.50 18.75 243.75 6. 50 58.50 302.25 100 50.00 25.00 325.00 9.00 81.00 406.00 125 62.50 31.25 406.25 11.00 99.00 505.25 150 75.00 37.50 487. 50 13.00 117.00 604.50 SCHEDULE B.-COMMISSION SCHEDULE OF FUNDS NOT ON VOLUME CONCESSION (Double) 1st Next 11 Total 1st 9 Year total Monthly plan unit payment payments year 2d through 10 year total 10th year $2500 $11.10 $5.55 $72.15 $20.00 $92.15 30.00 12.90 6.45 83. 85 24.00 107. 85 40.00 17.40 8.70 113.10 32.00 145.10 50.00 22.00 11.00 143.00 36.00 179.00 60.00 27.40 13. 70 178. 10 41.00 219.10 75.00 34.00 17.00 221.00 52.00 273.00 90.00 40.50 20.25 263.25 63.00 326.25 100.00 45.00 22. 50 292. 50 70.00 362.50 150.00 68.00 34. 00 442. 00 102. 00 544.00 (Whereupon at 5:35 p.m., the subcommittee adjourned, to recon- vene Tuesday, ctober 17, 1967, at 10 a.m.) PAGENO="0111" INVESTMENT COMPANY ACT AMENDMENTS OF 1967 TUESDAY, OCTOBER 17, 1967 HOUSE OF REPRESENTATIVES, SuBcoMMIrraE ON `COMMERCE AND FINANCE, COMMIrrEE ON INTERSTATE AND FOREIGN COMMERCE, Washington, D.C. The subcommittee met at 10 a.m., pursuant to notice, in room 2322, Rayburn House Office Building, Hon. John E. Moss (chairman of the subcommittee) presiding. Mr. Moss. The committee will be in order. We are pleased to welcome as our witnesses this morning Mr. Rob- ert W. Haack, president of the New York `Stock Exchange, Mr. Gus- tave L. Levy, chairman of the board of governors, and Mr. Donald L. Calvin, vice president, government relations. Would you gentlemen come forward and take your seats. STATEMENT OP ROBERT W. HAACK, PRESIDENT, NEW YORK STOCK EXCHANGE~ ACCOMPANIED' BY GUSTAVE L. LEVY, CHAIR- MAN, BOARD OP GOVERNORS, AND' DONALD L CALVIN, VICE PRESIDENT, GOVERNMENT RELATIONS Mr. HAAOK. Mr. `Chairman and gentlemen, I have with me a some- what modified, and, happily, abbreviated statement which varies only modestly from the one we filed last week. With your permission I should like to readit for the record. Mr. Moss. Without objection the entire statement will be received for the record and you may summarize it. (Mr. Haack's prepared statement follows:) STATEMENT OF ROBERT W. HAAOK, PRESIDENT, NEW YORK STOCK EXCHANGE The New York Stock Exchange believes that the regulatory framework that was established in the Investment Company Act of 1940 has worked welL The proposals in the bills before this Committee, if `adopted, may establish the regulatory pattern for investment companies for another generation of in- vestors. For this reason we urge the Committee to give the most careful con- sideration to the SEC's proposals. The Exchange's review of these bills raises a number of questions as to their potential impact on both the investing public and the securities in- dustry. More specifically, we are concerned with the thrust of the changes proposed for three very basic reasons: 1. No mechanism is provided for the self-regulatory processes wl~ich are well established in other segments of the securities industry. It is' our opinion that industry self-regulation should play an important and positive role in furthering the mutual fund industry's future growth. 2. New and, in some cases, novel proposals are made that are far- reaching and could prove detrimental to the interests of the investing public. (525) PAGENO="0112" THE IMPORTANCE OF SELF-REGULATION 5.26 3. Little justification is given for many of the proposals in either the SEO's report on investment companies or in its technical analysis of I-JR. 9510 and H.R. 0511. Those who are actively engaged in the securities busthess recognize that their future success depends on the confidence of the public investor. If con- fideuce is lost, so too may be their h~dttstry. Thus the industry regulates itself out of a self-interest which is consistent with the public interest. In many instances the requirements which the Exchange imposes on our member organizations and listed companies are more strict than are required by the Securities Acts or the Securities and Exchange Commission. Other self- regulatory agencies including the other stock exchanges and the National As- sociation of Securities Dealers, Inc. also impose regulatory requirements on their members. As a result investors using American markets have working for them three layers of protection for their interests. First, the conviction of men in the securities industry that the confidence of investors is their most valued asset. Secondly, strong self-regulatory agencies and exchanges withiui the industry which can be flexible and responsive to changing conditions. Third, Federal and state governmental agencies and a system of laws designed to provide both the disclosure of information and protectiomi of public interests. In our opinion it is in the public interest that all three layers of protection he continued and that this concept be embodied in the bills before this Committee. LIMITATIONS ON SALES CHARGES Abandoning the concept of self-regulation the Commission is seeking a statutory maximum on mutual fund sales charges of five percemut of the net asset value of shares purchased. Further, the SEC asks that it be granted the sole authority to increase or change the maximum. The Exchange opposes this proposal as not being in the public interest. We question the wisdom of asking Congress to turn its back on self-regulation in this area. The Commission makes no showing that the investment fund in- dustry is, in fact, a public utility and hence must have its: rates regulated by a governmental agency and nowhere in the commission report is there evi- dence that it has made a detailed analysis of the economic consequences of a five precent maximum. The Exchange Strongly endorses the approach of strengthening self-regulation in this area. We recognize that a number of problems remain to be resolved if the self-regulatory approach is to be followed. We believe, however, that self- regulation is vastly preferable to the approach suggested by the SEC. The NASD would seem to be the most appropriate organization to be given this self- regulatory responsiMhity. The NASD regulates profits and markups in a number of other areas. This would seem to be a logical extension of that responsibility. MANAGEMENT FEES Proposed Section 8 of the bill would establish an entirely new standard in the law to give the SEC indirect rate making authority over management fees. The bill suggests that new concepts be introduced in our securities laws, exist- ing law be repealed an numerous State court cases be overturned. The Exchange feels that these proposals would work to the detriment of mu- tual fund shareholders by stimulating burdensome and costly litigation and making it increasingly difficult for the industry to find men of stature and mdc- pendence to serve as directors. In our view the SEC proposals will not help funds to improve results for investors but may well hinder them in this effort. Further, there apears to be no basis for the implication that fund directors and shareholders ate not fully competent to determine what fees and salaries are reasonable for investment advice and that this decision must be made for them by the courts. We understand that the Investment Company Institute has indicated to the SEC its willingness to go beyond the present concept. As we understand that proposaL it contained three important points First, the number of independent directors would be increased from 40 percent to a majority. Second, the independ- PAGENO="0113" `~0 ent directors of the fund would be required to make a specific finding, in the exercise of business judgment, that a proposed management fee contract is reasonable. Third, and finally, a fund shareholder could commence an action in a Federal court to recover, on behalf of the mutual fund, any portion of a man- agement fee which the court found was unreasonable. In such an action, the court could upset a management fee contract upon the finding that the approval by the directors was an abuse of business judgment. We think that this proposal minimizes any risk there may be to the public interest in this area and ought to be adopted. CONTRACTUAL PLANS In another proposal, the Commission urges the abolition of contractual or frout~ end load mutual funds. In view of the growth of these funds in recent years it is evident that the public has found them useful. The Exchange, therefore, urges that it would be preferable to regulate any areas of real oi~ potential abuse rather than abolishing this investment media. MUTUAL FUND' HOLDING COMPANIES Proposed Section 7 of the bill would repeal present sections of the 140 Act which permit, within certain limits, the purchase of shares of an investment company by a registered investment company. It would prohibit in all instances the purchase by a registered investment company of shares of another investment company and would likewise prohibit the purchase by any investment company of shares of any registered investment company. It also would prohibit brokers or dealers in securities, registered investment companies or their principal underwriters from knowingly selling any share of a registered investment com- pany to any investment company. Here again, we would question whether the remedy suggested is not more drastic than is necessary. Section 7 goes too far in precluding ownership by in- vestment companies of shares of other investment companies. For example, it would prevent one registered closed end investment company from purchasing any shares in another closed end fund. It also seems to us to be an unfair and unenforceable burden to require brokers and dealers to be the instrument of enforcement with respect to the sale of regi~tered investment company shares to an investment company outside the jurisdiction of the SEC. The Exchange urges that restrictions on broker-dealers `be elim!nated and that a workable framework of regulation be established to prevent any specific abuses which may be created by one fund holding shares of other funds, rather than to abolish this particular form of investment media. AGENCY RULE-MAKING AND CONGRESSIONAL PREROGATIVES Finally, it is our feeling that many of the individual provisions in these bills give those in the securities business legitimate cause for concern. It is our impres- sion that many of the proposals give the SEC the broadest type of rule-making authority which, in effect, results in the delegation by Congress of its legislative functions to a Federal administration agency. It is our feeling that it is prefer able to draft such provisions along the lines of Section 16 of the Securities Exchange Act of 1934 and to set our specific requirements that must be met rather than to grant vague, broad, rule-making authorization to the SEC. CONCLUSION The New York Stock Exchange is not, and has not been opposed to regulation of the securities industry. We spend much of our time and energy in regulating the activities of our members and their employees. We have long recognized the wisdom of Congress in enacting the Federal securities acts and the benefits to the public that have resulted therefrom. But we do believe that additional legislation should not be adopted except to meet a clearly demonstrated need and that whatever legislation is adopted should be practicable and workable. The legislation before `this Committee promises to set down the legislative guidelines which will be controlling for many years. We agree wholeheartedly with the SEC that the investment companies have been useful and desirable for investors, but we feel that the documentation-and lack of it-in the Corn- 85-592-68--pt. 2-8 PAGENO="0114" 528 mission's position leaves much to be resolved. We are impressed, as always, by the careful consideration this Committee is giving as it moves to make its deter- mination of these matters. We respectfully urge that the changes made by the Ctmmittee in H.B. 9510 and H.R. 9511 be consistent with the reservations and recommendations suggested above. Mr. HAACK. My name is Robert W. Haack. I am president of the New York Stock Exchange. With me here today to present the views of the exchange on the proposed amendments to the Investment Com- pany Act of 1940 which are incorporated in H.R. 9510 and H.R. 9511 are Gustave L. Levy, chairman of the exchange's board of governors, and Donald L. Calvin, a vice president of the exchange. Our purpose in appearing before the subcommittee is to present the views of the exchange on the major proposals in this legislation. Mutual fund shares are not listed on our exchange and our board of governors has no self-regulatory responsibilities under the Invest- ment Company Act of 1940. Nevertheless, the exchange does have an interest in these proposals because mutual funds currently account for approximately 10 percent of all trading on the exchange and own an estimated 5 percent of all stocks listed thereon. Further, the exchange's member firms account for approximately 40 percent of all sales of mutual funds to the public and hence could be affected directly and substantially by the proposed legislation. We believe that the regulatory framework established by the Con- gress in the Investment Company Act of 1940 has worked well. This does not mean to say that changes cannot be made in the act to in- crease the protection of the investing public. The exchange's review of the bills before the subcommittee, however, raises a number of ques- tions as to the potential impact on both the investing public and the securities industry of the changes that are recommended in the exist- ing regulatory scheme. We are concerned with the thrust of some of the proposals for two very basic reasons: First, no mechanism is provided for the self-regulatory processes which are well established in the securities industry. It is our opinion that industry self-regulation should play an important and positive role in the industry. Second, little justification is given for many of the proposals in either the SEC's report on investment companies or in its testimony and supplemental analyses of the bills. The exchange's specific comments on the four major proposals in the bills are as follows: LIMITATION ON SALES CHARGES The exchange is of the view that maximum reliance should be placed on self-regulatory procedures in the area of sales charges. It is our experience that nowhere in the world is the investing public better served-and protected-than in this country. The self-regula- tory agencies and exchanges within the securities business have dem- onstrated that they can be flexible and responsive to changing conditions. It is in the public interest that self-regulation be continued, and that this concept be embodied in the bills before this subcommittee. PAGENO="0115" 529 The Commission's proposals relating to sales charges represent a tharp departure from the concept of self-regulation. Rather than seek- ing to strengthen self-regulation, the Commission asks for a statutory maximum on mutual fund sales charges of 5 percent of the net asset value of shares purchased. Further, the SEC asks that it be granted the sole authority to increase or change the maximum. The exchange suggests that this proposal be rejected for the follow~ ing three reasons: First, no meaningful justification has been given by the Commission as to why self-regulation cannot be made to work in this area. Why SEC ratemaking authority is preferable also is a wholly unsupported concept. Second, the Commission makes no showing that the investment fund industry is in fact a public utility and, hence, must have its rates regu- lated by a governmental agency. Third, nowhere in the Commission's report is there evidence that it made any detailed analysis of the economic consequences of a 5-percent maximum. The report provides no estimate of the effect of the lower revenues on sales, on the services which funds provide customers, on profitability, or on the number of firms that might become so unprofit- able as to be forced to leave the business. Certain industry studies mdi- ~cate that the unfavorable impact on the industry and its customers would be enormous. For these reasons, then, we oppose the SEC's proposal to set a 5-percent limit and strongly endorse the approach of strengthening self-regulation in the area of mutual fund sales charges. We recognize that a number of problems remain to be resolved if the self-regulatory approach is to be followed. The NASD would be the most appropriate organization to be given this self-regulatory re- sponsibility. We also support the NASD approach that the association initiate the necessary studies to develop effective guidelines for mutual fund sales charges. We are aware that problems exist with respect to the regulation of sales charges for broker-dealers that are not members of the NASID. While these problems are complex, we think that they can be resolved and that self-regulation can be made to work in this area. MANAGEMENT FEES Proposed section 8 of the bill would establish an entirely new stand- ard in the law to give the SEC indirect ratemaking authority over management fees. This authority would replace the basic corporate concepts of authority, responsibility, and accountability of directors, and ought to be rejected for the following four reasons: First, the bill suggests that new concepts be introduced in our se- curities laws, existing law be repealed, and numerous State court cases be overturned. It is appropriate to inquire, therefore, how this new concept will be superior to present law, and how it would improve the protection for fund investors. Second, proposed section 8 of the bill places the task of determin- ing whether a fee is, in fact, reasonable under the statutory standard on the courts. The adoption of the SEC approach coulc~ lead to a rash of legal suits against funds, investment advisers, and directors and PAGENO="0116" 530 officers, as it appears that this would be the only way under this section to determine whether the fee is reasonable. Third, the SEC approach of "ad hoc ratemaking by litigation" may well be regarded as a lawyer's delight. It could work to the detriment of mutual fund shareholders, however, by stimulating burdensome and costly litigation, and making it increasingly difficult for the in- dustry to find men of stature and independence to serve as directors. Fourth, there appears to be little basis for the implication that fund directors and shareholders are not fully competent to determine what fees and salaries are reasonable for investment advice and that this de- cision must be made for them by the courts. It seems evident, therefore, that the present statutory approach is far superior to the SEC proposal. Reliance in present law is placed in the judgment of directors of investment companies and their share- holders. This requires that the board of directors of the fund perform functions akin to those in any other business entity and to be held to the same standards of conduct. If changes are to be made in this area, the exchange would suggest that the role of the nonaffiliated director be strengthened. We think this approach minimizes any risk there may be to the pub- lic interest in this area and ought to be seriously considered in lieu of the proposal made in section 8. CONTRACTUAL PLANS In another proposal, the Commission urges the abolition of con- tractual or front-end load mutual funds. While the Commission asserts that the front-end load imposes an undue burden on investors, we would question whether it is necessary to abolish this investment media. The exchange takes the position that, rather than abolish contractual plans, any areas of real or potential abuse should be regulated and, possibly, a rebate policy should be in- stituted for certain early terminations involving hardship. MUTUAL FUND HOLDING COMPANIES Proposed section 7 of the bill would repeal present sections of the 1940 act which permit, within certain limits, the purchase of shares of an investment company by a registered investment company. It also would prohibit brokers or dealers in securities, registered investment companies or their `principal underwriters, from knowingly selling shares of a registered investment company to any investment company. It is the ex~hange's position that it is an unfair and possibly an impossible burden to require brokers and dealers to be the instrument of enforcement with respect to the sale of registered investment com- pany shares to an investment company outside the jurisdiction of the SEC. In the agreements which have been reached between the SEC and the Investment Company Institute, as outlined in the exhibit filed by the Chairman, of the SEC on October 10, there is, to be sure, some easing of the restrictions that would be imposed by section 7. Para- graph (1) (B) `still seems to create a problem since the language makes PAGENO="0117" ~53l it, among other things, unlawful for any registered broker or dealer "knowingly to sell . . . any security issued by" a~registered open-end investment company to any other investment company. This language might be construed as requiring a selling `broker or dealer to discover the identity of the buying broker or dealer's customer in order that the selling broker or dealer can be sure he is not violating the law. Any such condition would impose an impossible burden on the selling broker or dealer. Therefore, the exchange urges tha't the restrictions on broker- dealers be eliminated and that a workable regulatory framework be established to prevent any specific abuses which may be created by one fund holding the shares of other funds. CONCLUSION In the preceding comments we have discussed only four provisions of H.R. 9510 and H.R. 9511. In brief, we have urged the following alternatives to the Commission's proposals in these areas: 1. Sales charges. The exchange strongly endorses the approach of strengthening self-regulation in this area. 2. Management fees. The exchange opposes present section 8 of the bills and suggests that if changes are to be made that the role of the nonaffihiated director be strengthened. 3. Contractual plans. The exchange recommends that contractual plan or front-end load mutual funds not be abolished, but that any areas of real or potential abuse be regulated and possibly that a rebate policy should `be instituted for certain early terminations involving hardship. 4. Mutual fund holding companies. The exchange recommends that a workable framework of regulation be established to prevent any specific abuses which may be created by one fund holding stocks of other funds and that the proposed restrictions on brokers and dealers with respect to the sale of mutual fund shares to a fund holding com- pany be eliminated. The legislation `before this subcommittee promises to set down the legislative guidelines which will `be controlling for many years. It is the exchange's position that additional legislation should not be adopted except to meet a clearly demonstrated need and that what- ever legislation is adopted should be practicable and workable. The exchange agrees wholeheartedly with the SEC that the investment companies have been useful and desirable for investors, but we feel that the documentation-and lack of it-in the Commission's position leaves much tobe resolved. In conclusion, the exchange respectfully urges that the changes made by the subcommittee on H.R. 9510 and H.R. t~511 be consistent with the reservations and recommendations suggested above. Thank you. Mr. Moss. Thank you. Do either of you other gentlemen have a statement? Mr. LEvY. No, sir. Mr. CALVIN. No, we do not. Mr. Moss. `Thank you. PAGENO="0118" 532 Mr. Haack, is there any significance to the difference in phrasing in.~ the statement which was originally filed, and the statement which you have just given, as it relates to the recommendations contained under the subheading "Management Fees," beginning on page 4 of the state- ment you have just read, and also I believe on page 5 of the statement you have just read and 4 of the statement which you have previously submitted? The statement that you have previously submitted contains this phrasing: We understand that the Investment Company Institute has indicated to the S13~C its willingness to go beyond the present concept. As we understand that proposal, it contained three important points. First, the number of independent directors would be increased from 40 percent to a majority. Second, the inde- pendent directors of .the fund would be required to make a specific finding in the exercise of business judgment, that a proposed management fee contract is rca- sonable. Third and final, a fund shareholder could commence an action in a fed- eral court to recover on behalf of the mutual fund any portion of a management fee which the court found was unreasonable. In such an action, the court could upset a management fee contract upon the finding that the approval by the di- rectors was an abuse of business judgment. We think that this proposal minimizes any risk there may be to the public interest in this area and ought to be adopted. The language on page 5 which you have just read would appear to modify that substantantively. Is that the intent? Mr. }IAACK. No. Mr. Moss. It is not? Mr. HAACK. It is not. This is in our judgment a cut-down version, an abbreviated version. Mr. Moss. I just wanted to be quite clear. Mr. HAAOK. Yes, Mr. Moss, In the record. Mr. HAAC]t. Yes. Mr. Moss. Now, one of the matters which the SEC has criticized is that of the use of exchange brokerage or give-ups to the compensa- tion of dealers handling mutual fund shares. What is the position of the exchange on this issue? Mr. HAACK, This is a matter which is presently being discussed by our Cost and Revenue Committee, and the exchange has not come out with any official pronouncement on it. If I can give a personal opinion, it would seem to me that the sharing of commissions violates no good, sound business concept, that it results in no extra cost to the buying fund, and as a matter of fact you can make some very excellent reasons for justifying the concept of the lead broker in that it involves giving an order to only one fund instead of four or five or eight or 10 funds, eight or 10 brokers. As far as the bestowing of reciprocal business on brokers, it seems to me that this is not a reprehensible practice in this country. Reci- procity has been defined as doing business with those who do business with you. It seems to me there is no trouble in this area except in the possibility of abuse, where an incentive might be unduly large, so as to influence the judgment or the recommendation of the salesman. I think that this is subject to types and degrees of surveillance by the SEC and by the NASD which has the authority to regulate sales compensation. PAGENO="0119" 533 I think it in concept and in principle is perfectly all right and justi- fiable. The abuses, `as I say, can be controlled and corrected. Mr. Moss. In other words, your answer anticipates the following two questions: Oan the exchange handle the matter? Your answer would be yes, it can. Mr. HAACK. I think that the exchange in concert with the NASD could very well do this. As a matter of fact, I understand that my former associates at the NASD ~re presently addressing themselves to this very problem. Mr. Moss. And then does the SEC have the authority to direct regu- lation in this regard? Mr. HAACK. I would say yes, under 19(b) they certainly would have control. Mr. Moss. The answer, however, just given by you as to policy rep- resents an individual view and not at this moment the position of the * exchange. Mr. HAAOK, That is right. There are a number who would support me. Gus, do you want to speak to this? Mr. LEVY. I agree with Mr. Haack, Mr. Chairman, 100 percent. My personal position again is that the mere execution of an order is just one part of the commission. There is lots more that goes* into the earning of the commission than the execution. Therefore, I personally believe in the give-up system. I believe in reciprocity. Reciprocity is a part of the American way of life. Mr. Moss. But again we have-no official position. Mr. LEVY. Not as yet. Mr. Moss. By the exchange. Mr. }IAACK. Not as yet. Mr. Moss. Another matter which the SEC mutual fund report con- siders is that of the portfolio commissions paid by the various funds. It appears that there have been certain questions, and in some instances lawsuits, regardin~'tbe management securing its portfolio at the lowest possible cost. I believe this has led to suggestions either that the third market be used or that the stock exchange have lower rates-on larger blocs of shares. What is the exchange's view-point on this matter of commissions? Or has it'developed? Mr. HAACK. We are presently addressing ourselves to this problem. Instead of a commission based on the n-umber of shares involved, we are addressing ourselves to a study of a concept involving the amount of money involved. This would in effect give some kind of a volume discount to the larger buyer or seller. - One of the problems, however, is to make sure that the volume of brokerage commissions is not substantially damaged,, because if you reduce commissions- at the large end of the spectrum, the question is the possibility or advisability or feasibility of raising th-is in other areas which in turn might throw an unwarranted burden on the smaller investor. Mr. Moss. What authority does the SEC have in this? Mr. HAACJIL Similarly under 19(b) of the 1934 act, they could institute proceedings to accomplish their objective. Mr. Moss. In the letter which this committee received at the end of August from the then President Funston, it was indicated that a sub- PAGENO="0120" 534 stantial portion of the tremexilous market turndver this past spring and summer was attributable to the activities of institutions, including the investment companies. What is your position with respect to the influence on a free and open market of these transactions of investment companies. First, those companies whose policy it is to turn over their portfolio, and secondly, the other companies who have substantial blocks which either are held out of the supply of the market or from time to time are sold through the market? (The following correspondence referred to i~bove was submitted for the record by the committee :) HOUSE OF REPRESENTATIVES, COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE, Washington, D.C., August 3, 1967. Mr. `G. KEITH FUNSTON, President, New York Stock Eschange, New York, N.Y. Dii~n Mn. FUNSTON: One cannot but note that yesterday 13,510,000 shares were traded on the New York Stock Exchange following 12,290,000 on Tuesday, and 0,546,000 shares were traded on the American Stock Exchange following 6,108,000 on Tuesday, and also that the total volume of shares to date on `the New York Stock Exchange has been 1,476 million shares compared with 1,176 million in 1966 and 802 million in 1965 to the same date, and the total volume of sales to date on the American Stock Exchange is 620 million compared with 489 million in 1966 and 261 million in 1965 to date. In such connection, I am mindful of your testimony before our Subcommittee on Commerce and Finance on June 29, 1961 on H.J. Res. 438, a resolution di- recting the Securities and Exchange Commission to conduct a study of the ade- quacy, for the protection of investors, of the roles of national securities ex- changes and nationAl securities associations. At the time you expressed concern over `the activity In the markets which then existed. I am writing you In the thought that you might Indicate to me just wh'at is going on now in the stock markets which gives rise to this tremendous and in- creased volume of transactions and how the situation now may differ from that of sIx years ago. You may `also wish, In view of the pendency of the end `of your term as `head of the exchange, to i~tllize this opportunity to give some accounting of your steWardship by setting out the steps which have been `taken by the exchange during these past six years to strengthen the protection afforded to investors. With continuing good wishes to you in your new undertaking. Sincerely yours, HARLEY 0. STAGGERS, Clunrman. NEW YORK STOCK ExCHANGE, New York, N.Y., August 23, 1967. Hon. HARLEY 0. STAGGERS, Congress of the United States, Committee on Interstate and Foreign Commerce, Rayburn House Office Building, Washington,' D.C. DEAR CHAIRMAN STAGGERS: I am pleased to reply to your letter of August 3, itt which you ask my views on the reasons for today's heavy volume on~ the New York Stock Exchange and offer me the opportunity to discuss measures taken by the Exchange to provide increased protection for Investors during the past six years. I would like to discuss these two distinct and extensive subjects separately. SOURCES OF TODAY'S EXCHANGE VOLUME AND COMPARISONS WITH lOOt Average daily volume for the first seven months of `the year was 9.9 million shares compared with 4.1 millIon shares in 1961, a gain of over 100%. The Amen- PAGENO="0121" `535 can economy, of course, also grew substantially over the san~ie interval. Gross National Pirodust rose almost 50%-from $5~0 billion to Its present $775 billion; annual personal savings are 80% higher; corporate profits after taxes are up about 70%. The number of shareowners has risen by 42%-from an estimated 15.5 million in 1961 to the present 22 millIon. Financial institutions making broad use of the stock market, such as mutual funds and pension funds, have enjoyed j*rticularly strong gains. These factors plus the fact thOt the economy was able to move ahead without recession in unprecedented fashion `all have had their impact on Stock Exchange volume. All the major groups who use the stock market have increased their activity over the past six years. The table below shows the results of two Public Trans- action Studies which can be used to compare the volume attributable to public individuals, institutions and New York Stock Exchange members themselves in 1961 and 1966. MAJOR SOURCES OF NYSE VOLUME-SHARES BOUGHT AND SOLD IN ROUND LOTS AND ODD LOTS, 1961 AND 1966 1 EShares in millionsj . Shares 1961 -- Percent ` Shares 1966 ~- Percent Percent growth Public individuals Institutions and intermediaries NYSE members 3. 8 1.9 1.7 51. 4 26. 2 22. 4 6. 1 4.6 3.4 43. 2 32.5 24.3 60. 5 142. 1 100. 0 Total 7.4 100.0 14.1 - 100.0 - 90.5 1 "NYSE Public Transaction Studies," Sept. 13, 1961, and Oct. 19, 1966. The Public Transaction Studies Indicate that financial Institutions and intermediaries have led the way toward expanded volume on the Exchange. The data on large blocks, the SE'O's statistics on institutional transactions and analyses of th~e reports of institutions themselves confirm this finding. The latest Information released by the SEC, covering the first quarter of 1967, indicates that the four major groups of institutions bought and sold $10.4 billion of common stock in all markets, about three times the quarterly average in 1961. Even more dramatic Is the sharp climb in the turnover of institutional portfolios. In the first quarter of this year, the turnover ratio (transactions divided by holdings) reached almost 24%, in contrast to about 15% in recent years. Mutual funds have Increased their tprnover to 41%, against 19% as recently as 1964. Individual mutual funds-particularly the so-called performance funds-are thought to have even higher turnover rates. Judging from current figures on odd-lot trading and new account openings, non-professional market participants have not expanded their relative shftre of activity in the NYSE market during 1967, nor have they been purchasing on bal- arice. This is confirmed by reports from our member organizations, showing that the larger part of our volume attributable to individuals is now coming from the higher-income, better-educated, and more knowledgeable segment of the in- vesting public. This contrasts with conditions in 1961, when the Exchange felt required to caution the public on the unrealistic attitudes prevalent among some investors. While the share volume in 1967 has been at record levels, it is not unprece- dented in terms of the turnover in shares listed. This year's pace of 22% is about what it was in the post-war years of 1946 and 1950. In 1961 the turnover rate was 15%. From the turnover viewpoint, today's volume can be considered as catching up to the marked growth in the past six years in the number of securi- ties listed on the Exchange. At the beginning of 1961 there were 1,143 com- panies and 6.5 billion shares listed, compared with the current total of 1,277 com- panies and 11.3 billion shares. None of these influences in the market is really new. As emphasis has shifted among different groups of investors and different groups of securities, the Ex- change's continuing research and surveillance activities have enabled us to keep abreast of changing trends. PAGENO="0122" 536 For example, the Exchange's planning and development studies made over the past ten years did not indicate that present volume levels would be reached until the mid-1970's. The Exchange nonetheless pushed ahead with physical and operational improvements to handle much larger volume than was expected during any given year. Thus, we introduced the high-speed ticker in 1964, the computer center in late 1965, and have been continuing to work at automating the trading floor, odd-lot switching, certificate clearance, and back office proce- dures. These steps have enabled the Exchange itself to cope with the upsurge in activity without any serious problems in the marketplace. In summary, I think the increase in volume experienced over the pa~t year Is primarily attributable to institutional and other professional activity and does not at this time suggest a return of the conditions with which I was concerned in 1961. s~nrs TAKEN SINCE 1961 TO FURTHER INVESTOR PROTECTION The Exchange continually assesses its programs and procedures to insure that we are doing all we can to provide a climate of security for investors. I am finishing my tenure as President with the knowledge that the Exchange in these years has been highly responsive to the interests of investors in a great many small ways and some very large ones. It would be impracticable to enumerate all the steps taken during even the past six years and an attempt to do so would surely tax your reading patience. ~onsequently, may I remark on some of the major developments and offer examples of our more or less everyday progress. For convenience, I am dividing my review by the titles of the Exchange depart- ments which are primarily concerned with procedures designed to benefit investors. 1. Department of Member Firms This department administers most of the Exchange rules and policies affect- ing member brokerage firms, their principals and their employees among whom, of course, are the registered representatives who deal directly with the public. Obviously, any effective program must be centered on the organizations and personnel which advise the public, execute its orders, and handle its funds and securities. When I appeared before your Committee in 1961, we were in the process of revising our written registered representative examination program to maintain high standards of quality as the number of individuals entering the industry mushroomed. I think this program has proved successful. Since 1961 we have instituted new written examinations for branch office managers and supervisory security analysts. In addition, we ended a practice of over 100 years' standing by supplementing the oral interviews ol! new Exchange members and allied mem- bers with a comprehensive written examination. All these examinations are con- tinually being upgraded in an attempt to maintain high standards of perform- ance for member organization personnel. Shortly after I met with your Committee, we established a formal program whereby Exchange staff personnel spot-check the supervisory practices of some 3,700 branch and main sales offices at least every third year. This step was accom- panied by a program designed to encourage member firms to put increased em- phasis on the selection, training and supervision of sales personnel. This inten- sified attention to the performance of supervisory personnel and the training of registered representatives is, I believe, one of the most significant developments of the last six years for the protection of the investing public. We now utilize computers in our "stock watching program," which is designed to inform us daily of significant changes in price-volume and concentrations of ac- tivity in individual stocks. A review is made of each such security and of any other seciTrity which may warrant attention to learn why such activity has oc- curred. The object of this program is to permit the Exchange to satisfy itself that a fair and orderly market is being maintained. We work closely with the SEC in this program. In addition to administering rules and policies, the Exchange instructs mem- ber organizations in ethical standards of conduct towards customers and sponsors conferences throughout the country to spread this message as widely as possible among member organization personnel. I am enclosing a copy of our "Ethical Conduct Study Guide." PAGENO="0123" 537 The high level of financial responsibUity of our member organizations, which has been outstanding on a worldwide basis for many years, was expanded in 1964 by the establishment of a special trust fund program totaling $25 million. The Trustees of the special trust fund, with assets of over $10 million, may, in their discretion, assist customers of any member organization who may be threateiied with loss of their funds or securities because of the financial condition or in- solvency of the member organization. The establishment of this program followed the remarkable action of the Exchange community in providing $9.5 million to assist the customers of Ira Haupt & Co. following its failure. Another change aris- ing from this experience was a tightening in several ways of our barriers against the possible influence of commodities losses on securities customers. The Board of Governors in late 1960 deposited approximately $800,000 to assist the cus- tomers of du Pont, Homsey & Company when that firm went into receivership. In January 1961, the Exchange adopted an expanded mandatory fidelity in- surance program for member organizations. Probably the most significant aspect of this program is that it provides for coverage of general partners of member firms. Previously, fidelity insurance covering general partners had not been gen- erally available. In March 1961, the Exchange itself took out "excess" fidelity bonds totaling $10,000,000, which would come into play should the resources of a member organization and its general partners become exhausted as a result of a fraudulent or dishonest act. Also significant was the enactment of a rule requiring member organizations to send at least a quarterly statement to all customers who have any money or security balance in the custody of the firm during the preceding period. Most firms voluntarily sent monthly statements before the rule was enacted, but the rule ensured that all customers would be furnished this information. Previously, member organizations were required to send such a statement only at the time of an annual audit. Investors were further benefited recently when the Exchange permitted mem- bers brokers to offer life insurance on customers' debit balances in margin accounts. The Exchange just enacted a rule requiring member organizations to show on customers' statements the rates and amount of interest charged on debit balances. This voluntary step provides the type of disclosure which would be required under the "truth in lending" legislation presently before the Congress. There is one area, however, where progress has not been satisfactory, although we have tried to bring about reforms. I refer to the "unregulated lender" who can finance securities transactions unhampered by Regulations T and U of the Federal Reserve System. You will recall my testimony in 1961 indicated the concern with which we viewed the unhealthy effect on securities markets this un- regulated lending can have. Regrettably, little has been accomplished as the Board of Governors of the Federal Reserve System seems to think the unregulated lender is not as significant a part of the securities credit system as we do. You may have noted recent press comment on the unregulated lender or "factor," who ha's become more active ais current market l~vels attract persons desiring the high leverage this type of credit affords. As I am sure you know, the SEC Special Study also highlighted this practice, recommending that restraint l'e placed upon such lenders. As the enclosed circulars state, member organizations may not assist customers in arranging credit from these lenders contrary to Regu- lation T. However, this is an area where we believe further action at the Federal level is still required. 2. Advertising Department This department regulates Exchange standards for member organization com- munications with the public and formulates the Exchange's own national ad- vertising program. In September 1963, we significantly strengthened and expanded our already substantial rules governing advertising, sales literature, market letters, research reports, writing and speaking activities. A copy of these rules is enclosed. In particular we expanded the regulation of research activities, of promotion of past recommendations, of the use of testimonials, disclosure, identification of sources and portfolio analysis. A system of spot-checking our disclosure require- ments and the possibility of trading against recommendations was instituted. In 1962, for example, the Exchange staff reviewed 6,000 pages of member firm investment literature. In 1966, more than 25,000 pages of this material was reviewed. PAGENO="0124" 538 Over and above adding new rules, a great deal was done in ottr public pro- grams. We put greater emphasis on educating the public about investing and pointing out the risks as well as the rewards. From time to time, as conditions warranted., we warned the public about speculation and the need to follow sound investment practices. In our 1961 advertising campaign the Exchange stressed rules for the wise investor. I ~ enclosing a booklet which discusses the dif- ference between a broker and a tipster and the dangers that can result from heeding tips and rumors. A special campaign devoted to informing the public of Exchange regulations designed to protect investors was run in the Fall of 1962. This theme was continued in the Spring of 1963 in a new series of clear and factual ads. Part of our 1964 advertising was devotc~l to educating the public about the basic workings of the New York Stock Exchange. This was in addi- tion to cautionary statements which appear in virtually all Exchange ads, in one form or another. Sample copies are enclosed. 3. The Department of stock Li.~t Rules and procedures affecting companies listed on the l~xchange are admin- istered by this department. Many investors-~both individual and institutional- limit their holdings to companies listed on the New York Stock Exchange be- cause of the hallmark of quality implied in a listing. To maintain this confidence, the Exchange, among other steps, has increased its standards of eligibility for original listing and criteria for delisting three times since 1961. Applicants for listing must meet increased requirements for past annual earnings, share distribution, and related items. As the general level of the economy has risen, these requirements have been stiffened to ensure that a company applying for listing on the New York Stock Exchange has an exemplary operations record and sufficient distribution of its securities to pro- vide a market in depth. Our delisting criteria today are approximately 40% of our original listing requirements and are generally more stringent than the original listing standards of any other national securities exchange. To prevent rUmors and misinformation from influencing market activity, we have strengthened our policy requiring listed companies to disclose in a timely manner events which may affect investment decisions or securities values. This policy, spelled out in a 1960 letter from me to the presidents of all listed com- panies, has resulted in a more careful observance and regard for this objective. In the same vein, new methods of handling~ the public release of information by government agencies have been developed, to prevent individuals from capitaliz- lug on advance information regarding contract awards, important regulatory decisions and the like. Proper conduct by officers and directors of listed companies is important for the protection of investors. In November 1965 we published a booklet, "The Corporate Director and the Investing Public," outlining Exchange policies concerning outside directors, ethical conduct, conflict of interests and other problems which affect investors' security. Over 50,000 copies have been dis- tributed, and it has been widely acclaimed as an important contribution in the area of proper corporate conduct. I am enclosing a copy of this booklet. We have been successful in obtaining further investor safeguards through such means as requiring newly listed companies to report to stockholders on a quarterly basis, and to include a source and application of funds statement as well as comparative financial statements in their annual reports. We continually urge listed companies to include outside directors on their boards. Companies applying for a listing are urged to elect at least two outside directors to their boards within a reasonable time after listing. While precise figures are not available, a~ ~f 1961 we estimate that 60 companies did not then follow this practice, while today only about 15 companies have no outside directors. 4. The Floor Department The Floor Department Is responsible for the administration, Interpretation, surveillance and enforcement of the Exchange rules and policies relating to the overall operations on the Floor including the functioning of the auction market, the handling of orders and reports, and the publication of transactions. It also conducts the examination, registration, and surveillance of specialists, registered PAGENO="0125" 539 traders, odd-lot brokers, and processes all complaints, requests for information and general correspondence relating to any of these areas. The period since 1~61 has witnessed the introduction of the most modern automated data processing techniques and a nearly three-fold increase In The Floor Department's personnel devoted to its surveillance work. The procedures, policies and rules of The Floor Department have undergone certain signifiqant innovations and modifications in order to keep abreast' of expanding economic and market conditions. It is felt that the representative new procedures out- lined below, which have been enacted in accordance with our policy of con- tinually endeavoring to upgrade the quality of the market, have been of sub- stantial benefit to the investor and greatly strengthened the protection afforded to him. To ensure the financial responsibility of all specialist units in today's larger markets, each unit must now be able to assume a position of 2,000 shares in each specialty stock. Each unit's financial condition is checked regularly as well as after any significant market decline. Greater financial flexibility has been provided for in the event of unusual market situations. An emergency committee has been established and is authorized immediately to reallocate stocks should the necessity arise. In seeking to maintain, insofar as reasonably practicable, a fair and orderly, as well as the most liquid securities auction market, modifications have been made with respect to the general criteria for market maintenance by the spe- cialist. Specialists' dealings and stabilization rates have been subjected to higher standards. In addition, standards of depth and price continuity have been sub- stantially increased. New amendments to our rules now set forth more clearly that specialists' actions in establishing, increasing, liquidating oi~ reducing posi- tions must be consistent with their market making function. Moreover, a com- prehensive written examination is now required of all applicants for specialists' registration. One of our most significant advances made in the area of surveillance utilizes a computer to produce a monthly market study which flags for possible review a specialist's actual market performance in each 100 share unit common stock. Also. real-time automated price surveillance is now a fact, and price movements outside certain pre-set limits are automatically printed-out by the computer, thus alerting us to unusual situationis as they develop. Exchange automation has made possible the daily printing of a Transaction Journal, which now provides the time, tick and price variations of all transactions and quotations reported in the Market Data System. This provides quick, complete, and immediately acces- sible data for review and surveillance on an overnight basis. Through these surveillance and review pro'cedures. `w~ are able to note quickly abnormal price movements or possible rule infractions. In 1966, the odd-lot differential schedule was amended in favor of the "small investor" who places orders for less than 100 shares. The differential is now Vs of a point on issues selling up to $55 per share as compared with the previous "cut off" level which was $40 per share. A differential of ~4 of a point is appli- cable for Issues priced at $55 or above. Although investigative activities have always been conducted by the Floor Department, a formal Investigation Division has been created to enable the Exchange to provide complete and prompt investigation Into any questionable activities occurring on the Floor. In carrying out its self-regulatory role, any indication of a rule infraction-whether it is brought to our attention through our extensive surveillance proc~dures, by a Governor or member on the Floor, or through a public customer-is thoroughly investigated. When the facts disclose an actual violation, the case is carried to a conclusion under the applicable disciplinary procedures of the Exchange. If a public letter contains a complaint or inquiry, a complete answer Is given and an investigation conducted, if the facts so warrant. In 1968, our accountant-examiners began conducting annual surprise reviews of the back office records of specialists and registered traders. They also engage ii~ any special Investigative projects which may seeni appropriate in the light of overall surveillance objectives. Conotwsion I realize this letter is lengthy, and I ask your forbearance. However I am proud of our efforts to make certain that the public can invest in our market with PAGENO="0126" ~54O confidence and safety, and I appreciate the opportunity to summarize some of the measures we use. I would like to thank you for the courtesy you have shown me and members of the Exchange staff during the sixteen years of my presidency. I like to think that during these years the Exchange and those concerned with our securities ma~rkets in Congress have been effective partners in proposing programs designed to prohibit practices harmful to the investing public. I know my successor, Mr. Robert W. Haack, will continue this policy. Sincerely, G. Knirn Fuxsrox, Pre$ident. Mr. IIAAOK. This is a valid concern and one again which we are addressing. The advent of the institutional customer has been a phe- nomenon that has been developing over a number of years. It would appear roughly that institutional volume at our exchange at the mo- ment accounts for about 32 to 33 or 34 percent of our total volume. The indications are that this some time in the next decade might become as high as 50 percent. This raises some interesting philosophical and also practical ques- tions as to what effect this phenomenon has on the marketplace and the resilience of the exchange to adapt itself to this problem. We have made several studies to determine the impact pricewise of activities of institutional holders. We, in 1962, came up with the con- clusion that the funds on balance were a stabilizing force in the market- place. At this point, our most recent study was made the latter part of 1966, and again we have come to the conclusion that the effects, except for a long-term basis, are not of great consequence. The ability of the exchange to adapt itself to this phenomenon I think has been interesting. For example, in the third quarter of 1966 there were approximately 900 block transactions involving amounts of stock in excess of 10,000 shares. The third quarter of this year shows about a 100-percent increase in this, in that there were a~pproximately 1,735 block transactions involving transactions of more than 10,000 shares, and totaling some 42 million shares. Now, we tried to break this down, and we made a sample of 200 of those transactions. We found out that approximately one-half were affected at price fluctuations within a quarter of a point plus or minus of the preceding sale. We found out that two-thirds of these 200 sample transactions resulted in fluctuations of a half a point up or down from the prior sale. This I think speaks amazingly well of the specialist system, the financial ability, the willingness of these people to make markets and to accommodate the exchange to the increased activity of the institu- tional buyers and sellers. So far as the activity of these people is concerned, I would submit that our only control of them is through the broker-dealer, that we are not aible under any authority to question the motivation of these people; whether they are speculatively inclined or investment minded is something that we are concerned with but we do not have jurisdic- tion or control over their motivations. We try to make certain that the marketplace functions, that price discrepancies and variations are minimal. We have a stock watch system which addresses itself to that very problem, and there are occasions when we do go behind transactions as far as possible. PAGENO="0127" 541 Frankly, one of the amazing things to me is the resilience that the floor of the exchanges have shown to this fantastic development of the last several years. Mr. Moss. Thank you. Mr. Keith. Mr. KEITH. Thank you, Mr. Chairman. I think we, too, on this committee have been amazed at the ability of the market to handle these tremendous sales. You have just referred to this as a fantastic development. It makes me wonder whether or not further interest on the part of Congress to this fantastic develop- ment is necessary. Do you have sufficient authority in the exchange to expose to the light of day these activities that thus far you have been able to live with? Are you concerned about the continued spiraling or acceleration of the institutional buying to the extent that you feed that perhaps some kind of study should be made either by the SEC or by the industry, or by the institutions, or by all three? Mr. HAAOK. Well, I would say, first of all, that any additional information or light that is thrown on any problem area is most wel- come and, absent it, you and the SEC and the self regulators are operating in a vacuum. I don't feel that the need is particularly urgent at this time. So far as our concern of this spiral is involved, I think it imposes on us some obligations to make certain that our specialist system is well financed. As a matter of fact I have on my desk at the moment a proposal involving a credit bank for specialists, which would increase their already substantial financial abilities. One thing that does concern me, and this again is a personal point of view, is the increased reliance of the investment industry on in- stitutional activity for profitability. I remember some 25 years ago, when I started in the business, a lot of firms got the majority of their income from the relatively small investor. Now everybody is looking for the big ticket. You want to call on an insurance company or a mutual fund. The question in my mind is whether or not the funds are becoming so important to firms and to individual salesmen that there is a tendency to give shorter shrift to the individual in~ vestor, which I think works to the detriment of everything that we are striving for. The individual investor has been the bulwark of the auction market, and I again remember not so long ago when a specialist book would have many bids and offers up and down from the present marketplace. That is not always the case today. And absent that public investor, there is a greater burden put on the specialist, and this I think stems from the greater reliance for profitability on institutions. I think it ties in with the problem that any action taken in this legislation that would further curtail the economic incentive for broker-dealers to contact the individual investor undoubtedly re- dounds to the detriment of the whole system, and that is a personal point of view, but I would subscribe to it. Mr. STIJOKEY. Would the gentleman yield for a minute? Mr. KEITH. Yes. Mr. STUCKEY. Are you saying then that using the specialist system has not worked well? PAGENO="0128" 542 Mr. HAACK. Oh, to the contrary; it is working amazingly well. Mr. STUCKEY. With or without mutual funds or institutional investment? Mr. HAACK. I would say under either circumstance, but particularly well in light of the increased activity of funds. Mr. STUCKEY. So then you are saying that you feel that the spe- cialist has been effective in helping to control the market. Mr. HAACK. Very much so. Mr. LEVY. May I say what Mr. Haack meant to imply? In the old days there used to be a lot of orders up and down, buy and sell, in the book. Today the dealer has to be more of a specialist than ever before. Mr. STUCKEY. And he has handled this responsibility quite well. Mr. LEVY. Yes, sir. Mr. HAACK. But my point is that as it becomes increasingly attrac- tive economically for a salesman to focus on the larger customer, there is less time in his day to service the investnient needs of the smaller purchaser who has been the backbone of the entire stock- ownership program in this country. Mr. KEITH. I think it might be interesting for you to know the re- sults of some mail that I received on the subject of the proposals of the SEC. In particular I was impressed by men who had been broker- dealers calling on the small accounts that up until recently have been the lifeblood of the brokerage firms throughout the country. This fellow has his job done for him now. He can recommend a mutual fund. He doesn't have to do much research. And the buyer doesn't have to make a judgment between one stock and another. He makes it between one fund and another. Well, this is an unfortunate phenomenon, but it is what is happen- ing. Business is getting bigger and bigger, and buyers and sellers are getting bigger and bigger, and we are losing the individual initiative and imagination that has been ever present in the past. I have noted on two different instances recently people getting into the market as they were in the mid-1920's after reading about the fluctuations. These are the broker-dealers that are watching certain issues very closely and saying to individuals: "You saw what happened to such and such a stock last week." There are still this kind of salesman and this kind of speculator. There are, once again, a lot of people being sucked into the market- people with small incomes and large families, looking for a quick buck. Now it is the things that move this market that I am concerned about and about which I have raised questions here of other witnesses, specif- ically whether or not we should either have a separate resolution or, perhaps, as a title to this bill, giving some further authority to the SEC or to the Congress or to the private sector, or a combination of all three, to further explore these trends about which you have just spoken so knowledgeably. If you have any further comment as to that, in view of my observa- tions, I would appreciate it. Mr. HAACK. Let me say that I have with me several examples of some of the studies that our research department continues to put out relative to this very subject, so far as volume and activity of institu- PAGENO="0129" 543 tions, the participation, the effect on markets, and so forth, which I would be happy to leave with you, and I also have a copy of our study of institutional activity for the week of October 24 to 28 last year on this exchange, which I think breaks down some of these things very interestingly and may help you, Mr. Keith, to address yourself and focus on this very problem. Mr. KEITH. I hope it will. We will do the best that we can. Mr. HAAOK. So far as the wish for a study is concerned, I would say again that we always welcome information. I don't think that we would be in the vanguard of any group to push for it. We would not resist it. Mr. KEITH. These volume transactions by institutions, there must be a narrowing of the market activity between fewer and fewer firms and fewer and fewer broker-dealers. Some of them must be getting much more successful than others, relatively speaking. When 35 percent of the transactions are involving amounts in excess of 10,000 shares, that means that there is an awful lot of commissions being paid to particu- liar houses that do this business. Mr. LEVY. It is only 6!?~ percent. Mr. HAACK. I think you misinterpreted my statement. The total in- stitutional activity on the New York Stock Exchange is approxi- mately 32 to 35 percent. In the third quarter of this year there were 1,'T85 trades, whIch were nQt the total institutional orders, which ex- ceeded 10,000 shares. To answer your question directly, I would ~y that many firms have focused on the more profitable end of the business. One of the unhappy facts of life is tl~at it costs just as much to process a transaotiou in- volving 10 shares as it does 10,000, and some firms are more efficient, some firms are bç~tter maiiaged, some firms have better control of costs, and..you are absolutei~y right. Many firms are more successful than thei~r counterpail~ts. This, how~ver, is true of every business. Mr.' K~th'. What does it do to the regional exchanges? Does it en- courage themto be mQre orless active? Mr. UAACL I have enough problems speaking for my own members, Mr. Keith, to let alone speak for my friends at regional stock ex~ changes. The growth of regional stock exchanges has been inipre~sive. They are doing more and more business, just a~ we are doing more and more business. There are a number of factors that work to this. They, in some cases, have a different membership. In some cases there is the possible avoid- ance of a New York transfer tax which we are presently addressing oursel~ves to in another form. Mr. KEITH. I believe Massachusetts has a transfer tax, doesn't it? Mr. HAAOK. No. Mr. CALVIN. It has been repealed. Mr. KEITH. I am glad I brought the question up. Mr. HAACK. As a matter of fact the Boston Stock Exchange inserts ads in the Sunday newspapers as to the desirability of doing busi~ ness in Boston and saving the tax. Mr. KEITH. What other cost variances are there? Is the commis~ sion, generally speaking, about the same? 85-592--68--pt. 2-9 PAGENO="0130" 544 Mr. HAACK. The commission rate schedules are the same. Mr. KEITH. Is there some kind of, I won't say collusion, but is there some kind of an understanding that it shall be the same in all regions or is it just by chance? Mr. }IAACK. I would say that it is by chance. We address ourselves to the to the New York commission rate structure, which has been willingly adopted by other exchanges, with no duress or coercion on our part. Mr. KEITH. We heard Mr. Day, I believe it was yesterday, say that a company that wanted to do business in other States, more or less,. had to conform to the laws of New York State, that they had in effect preempted the field. If you want to do business in New York State, you had to have a certain commission on sales. Mr. LEVY. On insurance. Mr. KEITH. I understand that. Is there anything comparable here? Mr. LEVY. No. Mr. HAAOK. It is a free and open marketplace. Mr. LEVY. Mr. Keith, may I correct one figure? The block trans- actions comprise about 6.7 percent of the volume in the third quarter,~ not 35 percent. It was 6.7 percent I believe was the exact figure. Mr. KEITH. Where did I get the impression that it was 35 percent ~ Mr. HAACK. Our total volume from institutions is about 33 percent.. The block volume, transactions involving 10,000 shares or more- Mr. LEVY. In the third quarter. Mr. KEITH. I see. Mr. HAACK. Are only 7 percent. Mr. Ki~rm. The majority of theirs would be in blocks, but not blocks: in excess of 10,000. Mr. LEVY. Lots of them buy and sell on the dollar averaging basis up and down, and some do it on a daily basis. They buy so many shares a day or sell so many shares a day. Institutions operate all different ways. Mr. KEITH. Do you mean to say that there are some institutions that by reason of their management philosophy turn a certain portion of.' the portfolio over? Mr. LEVY. No, sir. Mr. KErrn. Periodically? Mr. LEvY. If they are on a buying program on a given stock they may buy on a scale down or a certain dollar amount every day or sell' on the same basis. That is what I meant to imply. Mr. KEITH. Thank you. On page 6 of your statement, with reference' to the contractual plans, you state that possibly a rebate policy should' be instituted for certain early terminations involving hardship. Now what do you have in mind there? Mr. HAACK. Well, I inserted that to eliminate the cancellation which' would be frivolous, which would be motivated `by, let's say, a market which has declined, for which there is no real sound reason except,, say, a weakness on the part of the purchaser. On the other hand, I can think of some cases where people observing all of the bona fides might through a prolonged illness, the loss of' PAGENO="0131" 545 employment, might be forced to terminate an otherwise sincere pro- gram. I think there could well be a differentiation between the two. Mr. KEITH. The investment companies have seen fit to tie in, to the life insurance business, in order to assure the completion of a plan in the event an investor dies enroute to his final goal, and in order to compete more effectively perhaps with the life insurance industry, would it not be similarly feasible for an investment company to make an arrangement with an insurance company so that if somebody be- came disabled their monthly payments could be continued? Mr. HAAOK. I am not an insurance expert, but I would think cer- tainly yes. As a matter of fact, we have a variation of that technique which has been embraced by some of our members recently, whereby they provide what is known as debit balance insurance in the case of a customer having a margin account. If the customer should die, the insurance comes into effect and picks up his debit balance, so I would say without complete knowledge that it would be a possibility. Mr. KEITH. When one considers the arguments that the SEC ad- vances to prohibit the front-end loads, and you counter with positive approaches, it would seem to me that the industry would be on a little sounder .ground. Mr. HAAOK. I would agree. Mr. KEITH. I would be happy to relinquish for the moment but I would like to come back later for a few minutes. Mr. Moss. Mr. Stuckey. Mr. STUCKEY. Thank you, Mr. Chairman. Mr. Haack, first let me ask you do you consider the mutual fund as a public utility? Mr. HAACK. Definitely no. Mr. STUOKEY. Then wouldn't the current bill which is proposed by the SEC, in which they propose to set themselves up as a ratemaking body, in effect make the mutual funds a public utility? Mr. HAAOK. It certainly would. Mr. STTJCKEY. Would you consider the bill before us constitutional or unconstitutional? Mr. HAACK. I am not an attorney, sir, and I would be reluctant to give an unqualified opinion. Mr. STUCKEY. Is there anyone that would like to answer that? Mr. LEvY. None of us. Well, Donald Calvin is an attorney. It is be- yond our competence, Mr. Stuckey. Mr. STUCKEY. I am not surprised. In your exchange with Senator Sparkman and also in your statement you say that the self-regulatory agencies and exchanges within the security business have demonstrated that they can be flexible and responsive to changing conditions. And you have also said that the National Association of Security Dealers would be willing to set themselves up as a governing body. I tend to favor this. I think any time that industry can self-govern themselves that we are this much better off, without Government interference. Would you like to explain a little bit or expound on that, because we have had a little conflict I think since the time that the letter was written to Senator Sparkman, when the hearings were being con- I PAGENO="0132" 546 ducted on the Senate side. I favor this type of proposal, and I would like to hear really a little bit more than what has been said about it, and do you think that there is a possibility of working this out? Mr. HAAOK. As you know, I have changed hats since I wrote that letter, but I haven't changed my convictions particularly. I think that the supervision or surveillance of sales charges is a natural and com- plementary function of self-regulation. The industry regulates itself in a number of ways. It regulates markups on principal transactions. It regulates and supervises underwriting compensation and spreads on new issues of stock. It supervises commissions in the over-the-counter market. It would seem to be almost evolutionary that it would also view this as a reasonable function, the surveillance of sales charges in mutual funds. I think that the industry has acted well and responsibly in this area, and I would see no reason why it couldn't do the same insofar as mu- tual funds are concerned. Mr. S~ruo~ii~. I agree with you. Now, your mutual funds are only a small aspect of your new hat now. I mean other individuals come in and out, and we discussed whether an individual trading on his own through a broker is better off than a person investing through mutual funds. Being as you have worn both hats, I would like to read a state- ment that was made by the Vice President of the United States speak- ing before the Investment Company Institute in 1965 and see if you would agree with his statement. This is a quotation from the Vice President's talk: I happen to believe that our great mutual funds represent a source of political stability and economic progress second to none in this nation. Mr. IIAAOK. I would agree. Mr. STUCKEY. So you are saying that the mutuals do have a good effect on the exchange. Mr. HAAOK. Unquestionably. Mr. STUCKEY. Another area that I would like to get into, arid we have discussed the wording if the NASD were to come in and to be self-regulatory, and that has been the use of the words "fair, gross, excessive or unfair." Now the NASD has adopted a rule to govern its members in the matter of mutual fund sales charges using the criteria "unfair." Can you tell us what procedural steps that the NA'SD might take to enforce its decision that a sales charge would be unfair, fair, or un- reasonable? Mr. HAACK. Again I can't speak for them, but I would imagine that a study could be made in which transactions would be analyzed by volume, by size, by type of customer, by geographical area, by amount and degree of effort and' salesmanship that goes into transactions, large, small, so forth and so on, and that out of this could evolve some kind of a policy. It might not be unlike the evolution, if you please, of what is known as the NASD markup policy as far as over-the-counter stocks is con- cerned, in which some 24 years ago a study was made of the over-the- counter market, and out of that came the markup policy which involved PAGENO="0133" 547 not inflexible standards but the possibility of invoking businessmen's judgment as to what constitutes fair and reasonableness, and I would think that the same approximate technique could be utilized here. Mr. STUCKEY. Then you think that if some agreement could be reached on the criteria of the wording, that the NASD and the SEC would be this much closer to letting the NASD be a self-governing, self- regulatory body? Mr. HAACK. Again I can't speak for them, but I would think, on principle, yes. Mr. STUCKEY. No further questions. Mr. Moss. On the same matter, with all due deference to my dis- tinguished friend from Georgia, if we were to provide by legislation as we would have to provide, that NASD assume the role of the regulator here, it would be within the limits prescribed by statute, would it not? Mr. HAACK. You mean with a statutory percentage? Mr. Moss. No; I don't mean that at all. 1 mean that the authority would have to be conferred by statute. Mr. HAACK. Yes. Mr. Moss. And therefore there would be a regulation by law. Mr. HAACK. Yes. Mr. Moss. Through a quasi-public agency, and this would not give to the industry the aspects of a utility. Mr. HAACK. That is right, sir. Mr. Moss. And we regulate both at State and Federal law fees paid to attorneys engaged in certain areas of practice. Sometimes the fees are not always regarded as being adequate, but nevertheless we do by law set those fees. This has not taken on the characteristics of a public utility. I merely wanted the record here to reflect the fact that in discussing the proposals of the Securities and Exchange Commis- sion, that it is not necessary that we undertake to change the basic character of the institutions with which we deal. Mr. HAACK. If I may add one other thing which you appreciate better than I, even with effective self-regulation, there is a substantial degree of oversight emanating from the Commission, and ~also from this committee, indirectly. Mr. Moss. That is correct. Mr. HAACK. Yes. Mr. Moss. Are there further questions? Mr. Stuckey. Mr. STUCKEY. There again I want to go back to your st~ttement that you did make, and it goes back to your self-~egulatory agencies within your various exchanges. Where this has been set up they have proven to be quite workable and, quoting from you, "to be quite flexible and responsive to changing conditions", and I think the SEC, in all fairness, would say too that this has proven to be an effective means of regulation. Mr. HAACK. They have, sir. Mr. STUCKEY. This is why I would like to see and would favor really some type of self-regulation by your dealers, because it has worked well here. It is proven. I think if there were some way where they could get together, it is not that I am saying we don't want the PAGENO="0134" 548 burden put on our backs. I just think this is a more effective means of doing it, and I certainly would encourage it. Mr. Moss. Well, I would not want the record to show that I have intended to imply that the self-regulation presently l:~emg exercised has been a failure. That is not my position. Mr. HAAOK. I understand. Mr. Moss. Mr. Keith? Mr. Kiirm. Thank you, Mr. Chairman. In the Senate hearings there is some reference to th.e Monthly In- vestment Plan. Mr. LEVY. Yes, sir. Mr. KEITI-I. And I believe it was representatives of the Association of Mutual Fund Plan Sponsors that pointed out that the cost to the individual investor getting in and out of the market in a monthly investment plan is somewhere between 13 and 141/2 percent. Is this roughly true? Mr. I[~~\cId. I dont. know the basis on which they come to that conclusion. Mr. KErrIr. Well, it is very well spelled out here on page 397, but let's assume that someone is investing $60 a month, and they are buying less than 100 shares. On the way in, it costs something in the vicinity of 7.35 percent and on the way out somewhere in the vicinity of 6.53 percent in the case of $50 stock. Mr. HAACK. My impression, my recollection is that the maximum, and this is subject to possible correction, but my impression is that the minimum amount that can be invested is $40 per quarter, and that if the minimum purchase were made, again my recollection is that the commission rate applicable would be 6 percent. Now, it so happens that many, many plans are started with, say, $500 or $1,000, and the subsequent purchases may be $40 or $50. When the plan is liquidated, of course, the larger dollar amount would ob- tain, and the percentage would go down. I don't think it is quite fair to analogize front-end loads with the MIP plan as sponsored by the stock exchange. First of all, the plan of the front-end load, it embodies or envisions a commitment to fulfill or to go to completion. TJrider the MTP plan, there is no such understanding~ obligation, or commitment, and it can be terminated at any time. I do have a figure here that the average MIP account payment is some $85, that the average commission is $4.81, which is 6 percent. The average plan is in operation about 2 to ~ years. The average value of a plan at liquidation is something between $12 and $1,500, and that the average commission between $12 and $1,500 is 1.3 percent. So I would say that. the cost. in and out is substantially less. Mr. KEITH. The average commission is 1 percent.? Mr. HAACK. It is 1.3 going out. Mr. KEITH. Going out. I thiiilc that is a valuable contribution, and I would invite your attention to the Senate hearings on page 397, and suggest that you might review the claims that are made there and respond to them more specifically, once again believing that full dis- PAGENO="0135" 549 closure is the primary purpose in all of these hearings. I would like it to be directed to the committee. Mr. HAACK. We will do that by letter. Mr. Moss. We will hold the record at this point to receive it. (The following letter was received by the committee:) NEW YOEK STOCK EXOHANOE, New York, N.Y.. November ~, 1967. Hon. JOHN E. Moss, Chairman, Snbeommittee on Commerce and Finance, Committee on Interstate and Foreign Commerce, U.s. Honse of Representatives, Ra,yburn Honse Office B'uikling, Washington, D.C. Dnan CoNGREssMAN Moss: During my recent appearance before the Sub- committee on Commerce and Finance, Congressman Keith requested that I re- view the data relating to sales charges for Monthly Investment Plan accounts that appears on Page 397 of the Senate Hearings on S. 1659 and that I comment on this data by letter for inclusion in the Record. I am pleased to offer the Ex- change's comments in the following paragraphs. In brief, it is our opinion that while the example appears to be arithmetically correct, given the underlying assumptions, it does not reflect the experience of investors with M.I.P. accounts in a meaningful way. This stems, In large part, from the fact that the example is based on a purchase of less than $100 and a subsequent sale of less than $100. Actually,, the number of cases where an in- dividual would open an M.I.P. account and later terminate it with total pur- chases of less than $100 would be very rare. Further, it is customary to regard the odd-lot differential as part of the price of the security rather than as part of the commission charge. The experience of our member firms has been that (1) the majority of M.I.P. accounts are started with an initial investment that is substantially greater than the subsequent monthly payments; (2) the typical plan lasts for 2 to 2% years with a total of 15 to 18 payments; and, (3) when a plan is terminated with a sale, the value of the stock sold is $1200-1500. The commission charges can be illustrated by the following example, using round figures for purposes of clarity. Cost Commission -~- Amount Percent Purchasea: Initial payment 10 monthly payments of $100 $500 1,000 $10 60 2.0 6.0 Total Sale: 1,500 70 4.7 Total amount realized Comnsissiép 1, 500 (1) I $20 or 1.3 percent. In this example, commissions amount to six percent of the combined pur- chases and sales. Other combinations of initial and monthly payments or inclu- sion of the odd-lot differential could Increase commission charges somewhat. It is extremely unlikely, however, In our opinion, that apy realistic combination of purchases and sales would result In a total commission charge approaching 13 percent. This would be so even if the maximum charge shown on Page 397 of the Senate hearings is assumed to apply to the initial purchase. The accumula- tion of monthly payments together with appreciation during the period of the plan could be expected to result in a substantially lower commission charge on the terminal sale. As shown in the example, while commissions represented 4.7 percent of total purchases, the Commission on the sale amounted to only 1.3 percent of the sum realized. PAGENO="0136" 550 I might also point out that termination of an M.I.P. account does not necessarily mean that the investor sells his accumulated shares. About two- thirds of the investors who terminate their M.I.P. accounts simply notify their brokers that they are discontinuing their monthly or quarterly payments and ask for delivery of the certificate. This is presumably added to the investor's long term holdings. Let me. again express my appreciation to yourself and to the Committee for your courtesy and interest during my appearance. Cordially, ROBERT W. HAACK, President. Mr. KEITH. I realize that it is not your bailiwick, necessarily, and you are not an attorney, but perhaps Mr. Calvin could comment. Do you feel that the mutual funds function as a fiduciary, in essence? Mr. CALVIN. The problem I have in answering that is that a fiduciary, the term "fiduciary," is a broad and often widely used term. Mr. KEITH. Well, in the generally accepted sense of the law in the State of Massachusetts. Mr. CALVIN. Well, I am not admitted to practice law in Massachu- setts. Mr. KEITH. Where did you go to law school? Mr. CALVIN. University of Illinois. Mr. KErm. All right, in the State of Illinois. Mr. CALVIN. In the State of fllinois- Mr. KErm. I understand that most States turn th Massacjrnsetts for its law as pertains to trusts. Mr. CALVIN. Well, in the case of a Massachusetts trust, I would say that my recollectimi, my law school recollection of law, is that under the Massachusetts trust I think the relationship is that of beneficiary fiduciary, but I wouldn't pose as an expert in that area. Mr. KEITH. Would that account, perhaps, for an internally managed fund having a smaller advisory fee? Mr. CALVIN. Again I would qualify the answer I am about to give is that I am really not an expert in this area, but it has been my un- derstanding that that would not be the reason. But again I certainly am not an expert in trust law in Massachusetts. Mr. KEITH. It has just been pointed out to me that we have, later on today, Mr. Milton H. Cohen, as a witness. He is representing Scudder, Stevens & Clark. I will ask him that question. Mr. CALVIN. I would much appreciate that. Mr. KEITH. I will reserve the other questions I had in mind for Mr. Ha.ack. Mr. Munr.HY. Some States, Mr. Chairman, turn to Massaôhusetts for even more than this advice, Mr. Keith. Mr. KEITH. I realize that. We have had ~a lot of presidents from Massachusetts. Mr. HAAOK. Mr. Ohairman, may I request that we be able to leave the folder that you have with you and that I might also leave a couple of other memorandums with you? Mr. Moss. Yes. Mr. HAACK. For your information and not particularly for the record. PAGENO="0137" :551 Mr. Moss. We would he very pleased to receive them for the files of the committee at this point. They may be included in the record after the committee has had an opportunity to study them. I want to thank you gentlemen for your appearance. You are now excused. (The following material was submitted by the New York Stock Exchange:) Nuw YoaK STOCK EXCHANGE MEMORANDUM SEPTEMBER 15, 1967. To: Prom: Stan West. Subject: Institutional Activity-Second Quarter 1967. HIGHLIGHTS Aggregate purchases and sales of common stock by four major types of In- stitutions (noninsured private pension funds, mutual funds, life insurance companies, and property and casualty companies) rose to an all-time high of $11.4 billion in the second quarter, up 10% from the previous quarter. Net purchases of common stock by these institutional investors were $2.2 billion, also a record high. Noninsured private pension funds alone accounted for $1.3'billion and mutual funds $0.6 billion. The turnover rates of noninsured private pension funds (16.4%) and life insurance companies (18.0%) rose to record highs in the second quarter. The mutual fund rate of 39.2% was only slightly lower than the previous quarter. PERCENT 40 - TURNOVER RATIOS OF COMMON STOCK BY U4STITUTIONS 30 OPEN- END INVESTMENT COMPAMES 20 i0 L~~E NSURANCE C0MPAE~~~- ~_*_~_._-~~ 000" PENSION FUNDS FRE a CAS~LVY / CO~ PAN Es 0 lb *~`62 `63 `64 ~`65 `66 QUARTERLY AT AN~JUI~L 1~A~1t Q .20 3Q 40 10 20 30 40 1966 1967 PAGENO="0138" 52 TABLE L-PURCHASES, SALES, AND NET ACQUISiTIONS OF COMMON STOCK I BY CERTAIN FINANCIAL INSTITUTIONS AND FOREIGNERS (In millions of dollarsj 2 Quarterly averages 1966 1967 1963 1964 1965 1966 April- July- October- January- April- June Septem- Decem- March June' ber ber Private noninsured pension funds: Purchases 940 1,095 1,395 1,655 1,825 1,505 1,700 2,120 2,510' Sales 390 525 640 750 830 605 680 975 1,170 Net purchases 550 570 755 905 995 900 .1,020 1,150 1,340 Open-end investment companies: Purchases 1, 000 1, 190 1,632 2, 585 2, 780 2, 315 2, 525 3, 525 3,630 Sales 810 970 1,290 2,325 2, 420 2, 575 2,200 2, 730 3,040 Net purchases 195 220 . 340 260 365 -260 325 800 590 Life insurance companies: Purchases 145 200 240 245 280 210 220 315 410 Sales 100 115 145 195 245 180 155 200 225 Net purchases 40 85 100 50 40 35 65 120 185 Property and casualty insurance com- panies: Purchases 180 190 190 220 230 205 260 275 265 Sales 150 165 175 150 130 100 125 210 175 Net purchases 30 25 15 70 100 105 135 65 90 Total (items 1-4, inclusive): Purchases 2, 265 2,675 3,460 4,710 5, 120 4,235 4,710 6, 240 6 815 Sales 1,450 1,775 2,250 3,425 3,625 3,460 3,165 4,110 4,610 Net purchases 815 900 1,210 1,285 1,495 775 1,545 2,130 2,205 Foreigners: 3 Purchases 680 770 910 1,175 1,445 1,000 1,035 1,550 1,89& Sales 630 855 1,035 1,255 1,520 1,025 1,215 1,585 1,755 Net purchases 50 -90 -125 -80 -75 -30 -180 -35 135 `Includes only cash transactions; figures do not reflect stock dividends or splits and exclude exchanges of one security for another. 2 Figures have been rounded to nearest $5,000,000 and may not add to totals. Reflects trading in domestic issues including preferred stock. Sources: Securities and Exchange Commission; investment Company.Institute; Institute of Life Insurance; Treasury Department. TABLE 2.-ANNUAL PURCHASE AND SALE RATES OF COMMON STOCKS [in percentj Noninsured Open.end Life Fire and private pen- invesilnent insurance casualty NYSE 4 sion funds 2 companies companies companies 3 1955 11.8 15.9 1L8 (5) 17 1956 11.8 18.8 115 (3) 14 1957 11.9 18.8 12.0 (5) 13 1958 12.0 2L7 13.0 (0) 14 1959 11.7 19.8 10.9 (0) 15 1960 11.1 17.6 9.9 (0) 12 1961 12. 1 20. 0 13.2 (0) 15 1962 9.7 17.3 9.5 7.1 13 1963 11.0 18.6 11.0 7.8 15 1964 30.8 18.7 12.2 7.4 13 1965 11.3 21.2 13.2 6.9 15 1966 ~1i6 33.5 14.5 7.2 19 1st quarter, 1967~ 615. 2 40. 8 6 16. 0 9. 2 23 2nd quarter, 19677 16.4 39. 2 18.0 7.6 23 1 Turnover rates are computed as the market value of quarterly purchases plus sales divided by twice the market value of average common stockholdings during the quarter. The result is then multiplied by 4 to obtain the annual rate. 2 Turnover rates prior to 1959 are for corporate noninsured pension funds only. Turnover rates are based on common stockholdings minus holdings of insurance companies, since most of the latter are intercorporate holdings. 4 Market value basis, not shares. o Not available. o Revised. Annual rate. PAGENO="0139" 553 TABLE 3-ANNUAL TURNOVER RATES OF COMMON STOCK OF NONINSURED PRIVATE PENSION FUNDS (In percenti Sale rate Purchase and sale rate Purchase rate Noninsured private pension funds: 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1st quarter, 1967 (annual rate) 2d quarter, 1967 (annual rate) I Revised. Note-Turnover rates prior to 1959 are for corporate noninsured pension funds only. TABLE 4.-ANNUAL TURNOVER RATES OF COMMON STOCK OF OPEN-END INVESTMENT COMPANIES [In percentj Purchase rate Sale rate Purchase and sale rate Open-end investment companies: 1955 19.1 12.7 15.9 1956 22.4 14.8 18.6 1957 23.7 13.9 18.8 1958 27. 2 16. 2 21. 7 1959 23.9 15.8 19.8 1960 20. 4 14.7 17. 6 1961 23.6 16.4 20.0 1962 19.9 14.7 17.3 1963 20.6 16.6 18.6 1964 20.6 16.8 18.7 1965 23.7 18.7 21.2 1966 35.2 31.7 33.5 1st quarter, 1967 (annual rate) 45. 6 35. 6 40. 8 2d quarter, 1967 (annual rate) 42. 8 36. 0 39. 2 TABLE 5.-ANNUAL TURNOVER RATES OF COMMON STOCK OF LIFE INSURANCE COMPANIES [In percentj Purchase rate Sale rate Purchase and sale rate Life insurance companies: 1955 13.4 10.2 11.8 1956 11.7 11.2 11.5 1957 13.4 10.7 12.0 1958 14.4 11.5 13.6 1959 13.1 8.7 10.9 1960 12.5 7.2 9.9 1961 16.3 10.0 13.2 1962 13.3 5.8 9.5 1963 12.9 9.1 11.0 1964 15.4 8.9 12.2 1965 16. 6 9. 8 13. 2 1966 16.2 12.8 14.5 1st quarter, 1967 (annual rate) 119. 6 1 12. 4 116. 0 2d quarter, 1967 (annual rate) 23. 6 12. 8 18. 0 1 Revised. 18.3 5.3 11.8 19.1 4.4 11.8 20.3 3.6 11.9 19.6 4.3 12.0 18.7 4.6 11.7 17.6 4.5 11.1 18.1 6.2 12.1 14.8 4.6 9.7 15.6 6.5 11.0 14.6 7.0 10.8 15.6 7.1 11.3 117.3 17.8 `12.6 `20.8 9.6 `15.2 22.4 10. 4 16.4 PAGENO="0140" 554 TABLE 6.-ANNUAL TURNOVER RATES OF COMMON STOCK OF FIRE AND CASUALTY INSURANCE COMPANiES [In percentj - Purchase rate Sale rate Purchase and sale rate Fire and casualty insurance companies: 1962 8.3 5.8 7.1 1963 8.5 7.2 7.8 1964 7.9 6.8 7.4 1965 7.2 6.6 6.9 1966 8.6 5.8 7.2 1st quarter, 1967 (annual rate) 2d quarter, 1967 (annual rate) 110. 4 9. 2 8. 0 6. 0 9. 2 7. 6 I Revised. Note-Turnover rates are based on common stockholdings minus holdings of insurance company issues since most of the latter involve intercorporate holdings. INSTITUTIONAL HOLDINGS OF NYSE-LISTED STOCK-i 966 lnsUtutionaZ HoZdings The attached table gives the latest estimates on institutional holdings of NYSE- listed stocks for 1949 and 1956-66. At the end of 1966, preliminary estimates show institutions holding $101.1 billion of NYSE-listed stock. This was 21.0% of the total list outstanding, up from a revised figure of 20.7% in 1965, 15.8% in 1956 and 12.7% in 1949. The reason for the proportionate increase in institutional holding in 1966 is that, despite the 1966 market decline, institutions continued to purchase stock on balance, while individuals were selling. For example, in the first three quarters of 1966, net purchases of all common stock (listed and unlisted) were $2.6 billion by non-insured pension funds, $0.7 billion by mutual funds, and $0.3 billion by insurance companies. Non-insured pension funds, the largest group of institutional stockholders, owned almost $35 billion, or 7.2%, of NYSE-listed stock at the end of 1966. Invest- ment companies, the second largest, held $28 billion, or 5.8% of listed stock. PersonaZ Trust Funds At the end of 1966, bank-administered personal trust funds (excluding common trust funds) held an estimated $56 billion of NYSE-listed stock. This compares with $65 billion in 1965 and $58 billion in 1964, with most of the changes due to price appreciation and depreciation. These estimated personal trust holdings are equal to about 12% of all NYSE- listed stocks outstanding. Thus, at year-end 1966, institutions and personal trust funds combined held an estimated $157billion of listed stock, or about one-third of the Exchange's total list. PAGENO="0141" 555 ESTIMATED HOLDINGS OF NYSE-LISTED STOCKS BY FINANCIAL INSTITUTIONS [Dollar amounts in billionsi Type of institution Yearend ~- 1949 1956 1957 1958 1959 1960 1961 - 1962 1963 1964 1965 1966 1 Insurance companies: Life Nonlife $1. 1 1.7 $2.3 4.5 $2. 2 4.1 $2. 7 5.4 $2.9 5.7 $3.2 6.0 $4. 0 7.7 $4. 1 7.1 $4.6 8.2 $5. 3 9.5 $6.4 10.1 $6. 0 8.9 Investment companies: Open end Closed end 1.4 1.6 7.1 4. 0 6,5 3. 5 10.2 4.4 11.6 5. 2 12.4 4. 2 17.2 5. 6 15.4 5.3 18.6 5. 7 21.8 6. 6 26.5 5. 6 24.1 4. 0 Noninsured pension funds: Corporate Other private State and local gov- ernment Nonprofit institutions: College and university endowments . 5 (2) (2) 1.1 5. 3 .4 .2 2.4 5. 6 .3 . 2 2.1 9. 4 .6 . 3 2.8 11. 8 .7 - 4 3.0 13. 5 .8 . 5 2.9 18. 7 1.1 . 7 3.7 17. 9 1.0 . 8 3.3 22. 6 1.3 1. 1 4.0 27. 5 1.6 1. 5 4.5 32. 5 1.9 1.9 5.1 30. 8 1.9 1. 9~ 4.4 Foundations 1. 1 4. 1 3. 4 5. 0 5. 4 5. 3 7.2 6. 7 8.3 9. 5 10. 1 8. 8 Other 1.0 3.1 2.8 4.0 4.4 4.4 5.6 5.0 5.9 6.8 7.7 6.9 Commontrustfunds Mutualsavingsbanks (2) .2 1.0 .2 1.0 .2 1.3 .3 1.4 .3 1.4 .2 1.9 .3 1.7 .4 2.2 .4 2.6 .4 3.2 .5 2.9 .5 Total 9.7 34. 6 31. 9 46. 4 52. 8 54. 8 73. 7 68. 7 82. 9 97. 6 111. 5 101. 1 Market value of all NYSE- listed stock 76. 3 219. 2 195.6 276. 7 307.7 307. 0 387. 8 345. 8 411. 3 474. 3 537. 5 482. 5 Estimated percent held by all institutions 12. 7 15. 8 ~L6. 3 16. 8 17. 2 17. 9 19 0 19. 9 20. 2 20. 6 20. 7 21. 0 1 Preliminary estimates. 2 Less than $50,000,000. NEw Yoni~ STocK EXCHANGE MEMORANDUM OcToBloit 9, 1967. To: From: Stan West Subject: NYSE Large Block Transactions (10,000 Shares or more)-Srd Quarter 1967 Block activity in the third quarter reached new highs in all respects-number of blocks, shares, and percent of reported volume: 1. Number-The 1,725 blocks in the third quarter were 5% above the sec* ond quarter total and almost double the 900 blocks in the third quarter 1960. 2. $Jutres-The 42 million shares traded compared with 40 mIllion In the second quarter and 20 million in the third quarter 1966. 3. Percent of Reported Volume-Block volume rose to a record 6.7% of NYSE reported volume, the seventh consecutive quarter in which this pro. portion increased. PAGENO="0142" 556 PAGENO="0143" 557 NYSE BLOCK TRANSACTIONS TABLE 1.-4TH QUARTER 1964-3D QUARTER 1967 Block volume Number Market Number of Percent of value of transactions Shares reported (in millions) issues volume 1964: 4th quarter 399 8,812,000 2.9 $297.8 250 1965: 1st quarter 538 12,405, 000 3. 6 469. 7 295 2d quarter 505 11,706,000 3.3 480.0 279 3d quarter 529 11,252,000 3.2 428.8 287 4th quarter 599 12,899,000 - 2.6 478.9 301 1965 total 2,171 48,262,000 3.1 1,857.4 1966: 1st quarter 841 19,685,000 3.6 723.1 384 2d quarter 922 20, 566, 000 4. 1 828. 9 415 3d quarter 900 20,364,000 5. 1 830. 0 407 4th quarter 979 24,683, 000 5. 4 921.2 434 1966 total 3,642 85,298, 000 4. 5 3,303. 2 1967: 1st quarter 1,385 33,917,000 5. 5 1,326. 5 508 2d quarter 1,650 39,694,000 6.4 1,588.0 570 3d quarter 1,725 41,970,767 6.7 1,658.9 582 Ave rage pe r transaction rage price Shares Value Ave 1964: 4th quarter 22,085 $746, 000 33~ 1965: lstquarter 2dquarter 3d quarter 4th quarter 23,058 23,180 21,170 21,534 873,000 950,000 811,000 799,000 377'~ 41 38~-~ 373/i 1965 total 22, 230 856, 000 383/b 1966: 1st quarter 2cl quarter 3d quarter 4th quarter 23,407 22,306 22,627 25,212 860,000 899,000 922,000 941,000 365% 405/s 403% 377/i 1966 total 23,421 907,000 383% 1967: 1st quarter 2dquarter 3d quarter 24,489 24,057 24,331 958,000 962,000 961,700 39~g 40 39~i'~ TABLE 2.-METHODS OF EXECUTING NYSE TRANSACTIONS OF 10,000 SHARES OR MORE DURING 3D QUARTER 1967 Transactions NYSE share volume Market value Type of procedure --- ____________________ Number Percent Shares Percent Amount Percent (thousands) (millions) Regular executions - 983 57 19,369 46 $719.9 44 Crossing of orders 1 729 42 22, 108 53 916. 3 55 Exchange distributions 13 1 494 1 22. 7 1 Total 1,725 100 41,971 100 1,658.9 100 - 1 For purposes of this study, a cross is defined as an execution where 1 member firm is involved at least partially on both the purchase and sale side of the transaction. PAGENO="0144" 558 TABLE 3.-AVERAGE SIZE OF TRANSACTIONS OF 10,000 SHARES OR MORE IN 3D QUARTER 1967 BY METHOD OF EXECUTI ON Type of procedure Average number of shares per trade Average value per trade Average price per share Regular executions Crossing of orders Exchange distributions 19, 704 30,326 38, 023 $732, 375 1,256,930 1,747, 878 37i'i 413~ 46 Total 24,331 - 961,710 393~ TABLE 4.-S1ZE OF NYSE TRANSACTiONS OF 10,000 SHARES OR MORE EXECUTED DUR1NG 3D QUARTER 1967 Transactions Number of Shares Number Percent Transactions Market value Number Percent 10,000 to 10,999 488 28 11 000 to 14,999 363 21 15 000 to 24,999 444 26 25,000 to 49,999 285 17 50,000 and over 145 - 8 Total 1,725 100 Less than $100,000 60 3 $100,000 to $499,999 615 36 $500,000 to $999,999 572 33 $1,000,000 to $4,999,999 447 26 $5,000,000 and over 31 2 Total 1,725 100 (The following correspondence with the American Stock Exchange was submitted for the record by the committee. The letter referred to below, addressed to Mr. Keith Funston, New York Stock Exchange, may be found on p. 534.) HOUSE OF REPRESENTATIVES, COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE, Washington, D.C., August 3, 1967. Mr. RALPH SAUL, President, American Stock Ewchange, New York, N.Y. DEAR Mn~ SAUL: Today I have written Mr. Keith Funston, President of the New York Stock Exchange, requesting his comments on the current activity in the stock markets, a copy of which I am enclosing you. It is my thought that you may also wish to address yourself to the same subject as it applies to your exchange. Sincerely yours, HARLEY 0. STAGGERS, Chairman. AMERICAN STOCK EXCHANGE, New York, N.Y., August 22, 1967. Hon. HARLEY 0. STAGGERS, Chairman, Interstate and Foreign Commerce Committee, Congress of the United States, House of Representatives, Washington, D.C. DEAR CHAIRMAN STAGGERS: I appreciate the opportunity afforded to us by your letter of August 3, 1967 to discuss the measures taken and planned by the Amer- ican Stock Exchange in light of current activity in the stock market. As you noted in your letter to Mr. Funston, the level of the activity on the ex- changes has Increased dramatically during the last year and current volume is at record levels. The American Stock Exchange has implemented a number of pro- grams to assure the efficient operation of the auction market and as volume has continued to grow, we have taken a number of other steps so that we may con- tinue to provide a fair and orderly marketplace responsive to public needs. To keep you and your Committee informed on developments at the Exchange, I should like to enumerate the measures we have taken and those we plan to take involving Exchange facilities and operations: PAGENO="0145" 559 Floor Procedures-During the Hearings before the Subcommittee on Commerce and Finance in early 1964, you expressed an interest in the procedures of the Ex- change for halting trading in emergency situations. Your interest in this matter arose as a result of market conditions following the assassination of President Kennedy. The Exchange subsequently adopted new procedures to permit f~rompt action to meet fast changing market situations and we believe these procedures have worked well. These procedures were adopted to deal with emergency situations but we have found that they can be applied in unusual market situations involving timely disclosure by listed companies of material corporate developments. Under the Exchange's listing agreement, a listed company is requIred to "make prompt pub- lic disclosure of any material developments in its affairs and operations, whether favorable or unfavorable, which might significantly affect the market for its securities or influence investment decisions." The Exchange is usually alerted to timely disclosure problems when its Surveillance Division detects unusual ftc- tivity in a stock, A call to the company may reveal that significant corporate information has not been released to the public. The policy of the Exchange is to halt trading whenever there are indications that news of significant corporate developments is available to some buyers and sellers but not to others. tinder our special floor procedures, floor officials have the authority to halt trading in an issue. Floor officials will continue a halt in trading until the com- pany has made public disclosure of the development and there has been a suffi- cient period after dissemin~ition to allow the public to evaluate and act on the news. The Exchange's ability to act promptly upon unusual market situations re- flects improved liaison between floor officials on the floor and the Exchange administration. Market Data ~ystems.-Last year a floor input system designed to speed the reporting of market information went into full operation. This system has virtu- ally eliminated the manual processing of sales and quotation slips before data is printed on the ticker, reducing the lapsed time between a transaction and its report on the tape from three minutes to less than 30 seconds. The Exchange's plans for conversion to a 900 character-per-minute (cp'm) ticker are reaching fruition. As of September 5, 1967, market information at the higher 900 cpm speed will be transmitted to desk unit devices and to the press. Conver- sion of the ticker installations is now underway and we expect that the entire ticket network should be converted by early 1968. The Exchange has an obliga- tion to the public to insure the dissemination of up-to-date market information and, consequently, we have made conversion of our market data systems a matter of highest priority. Automation of Ulearing.-An automated compared clearance program, in which reports of buyers and sellers are matched, is scheduled to go on line later this fall. This automated system should prove helpful to member firm operations, relieving back offices of `some of the paper processing problems which recently required shorter trading hours. Market Surveillance.-In December 1965, the Exchange amended its rules so that it could prescribe higher initial margin requirements in issues where spec- ulative activity appeared to exist. Recent Exchange studies indicate that the selective margin program has been a valuable tool in controlling speculative activity. Since May 1, 1967, the Exchange has imposed selective margin controls on 38 issues. In situations where unusual activity is noted, the Exchange is promptly con- tacting managing partners and officers of member organizations involved. While previously back office employees were contacted as part of our routine sur- veillance procedures, this new procedure is intended to emphasize the importance the Exchange attaches to such a referral. We have been using this technique on a selective basis where we believe it is necessary to emphasize our concern. To aid In this program, the Exchange is obtaining every half hour a print out of the 35 most active stocks including last sale and n~t change. Where the situation appears to warrant it, an immediate follow up is instituted. Specialists have also been urged to report promptly unusual market situations which will provide timely follow up by our Surveillance Division. The Exchange is now making available to each clearing member organization a summary weekly and monthly report of purchases and sales in all securities traded on the Exchange by security and its percentage of Exchange volume in each security. This has 85-492-68-pt. 2-l0 PAGENO="0146" 500 proved to be a helpful tool not only to the Exchange, but also to members in supervising the activities of their employees. Early this year, the Exchange began surveying a nationwide sampling of member organization branch offices on a periodic basis to assess the extent and quality of public participation in American Stock Exchange issues. These surveys provide the Exchange with an indication of the nature of high volume markets and help to identify the point at which the Exchange should consider taking cautionary or other action. During recent weeks, speculative trading activity has been a source of increased concern to member organizations and to the Exchange. On July 11, 1967, the Exchange recommended to its members that they give special attention to firm sales policies and procedures to determine their adequacy and effectiveness in light of current market conditions and investor attitudes. The Exchange empha- sized that members should step up their efforts to see that the implications of current activity are carefully weighed by all investors. Listing ~tand,as-ds.-S'trengthening of Exchange listing standards over the past five years is now bearing fruit in the listing of securities of quality companies. However, the Exchange must continue to assure itself that a security is suitable for auction market trading and that the issuer of the security is in a position to meet the obligations assumed by listing. We have previously indicated to the Committee that we are testing the adequacy of present listing and delisting criteria in light of past experience and changing market conditions. In this con- nection, last month we revised our listing requirements to obtain more detailed data on the distribution of shares of issuers applying for listing. The new require- ments will aid in evaluating an issue's suitability for auction market trading by enabling the Exchange to determine whether an issue has only local interest and the extent to which the public float includes substantial blocks owned by institutions and insiders. Future Program.s.-At our Annual Meeting in May, a major facilities program involving the trading floor and related member and public facilities was an- nounced. By modernizing our trading floor, we will be able to provide a public auction market, not only under today's high volunie conditions, but with oven greater volume expected in the future. We cannot precisely foresee, at this time, the eventual scope of the assistance that may `be offered by automation. We are presently surveying our overall auto- mation planning and we hope eventually to have an on-line stock watch system, a transaction journal and other means of rapidly ascertaining when unusual activity occurs and the source of such activity. I hope this letter is helpful in bringing you up to date on developments of the Exchange. If it appears that we can provide further information of possible use to you and your Oornmittee members, I hope you will be in touch with us. Sincerely, RALPH S. SAUL, President. Mr. Moss. Our next witness is Mr. James E. Di~y, president of the Midwest Stock Exchange. We must have order, in order that the time of the committee can be conserved. Mr. Day, you may proceed. STATEMENT OP JAMES E. DAY, PRESIDENT, MIDWEST STOCK EXCHANGE; ACCOMPANIED BY PRANK I. ROTHIN~, SENIOR VICE PRESIDENT; JO1~N G. WEITHERS, VICE PRESIDENT AND SECRE- TARY; AND JOSEPH N. MORENOY, JR., LEGAL COUNSEL Mr. DAY. Mr. Chairman, in an effort to conserve time, may I request your permission to enter our formal statement in the record? Mr. Moss. Without objection, the permission is granted. Mr. DAY. I will merely give excerpts of the major points, and hope- fully a clearer and somewhat expanded presentation in our summary. Mr. Moss. Thank you. You may proceed. Mr. DAY. Mr. Chairman, I am James E. Day, president of Midwest Stock Exchange, located in Chicago, Ill. With me today from our PAGENO="0147" 561 exchange are Frank J. Rothing, senior vice president, John G. Weithers, vice president and secretary, and Joseph N. Morency, Jr., legal counsel. We appreciate this opportunity to be heard on H.R. 9511 and 9510. Although this bill would make changes only in the Investment Company Act and the Investment Advisers Act, thereby altering the regulatory structure applicable to investment companies, invest- ment advisers and underwriters, our Exchange members realize they have an important stake in the end result. We are here in the interest of our members. Generally speaking, it is our view that, since the Securities and Exchange Commission has not provided sufficient facts and sup- porting evidence, in our judgment, to justify these concrete proposals, we must go on record in general opposition to H.R. 9511 and H.R. 9510. It is our conviction that the problems involved are extremely com- plex and need analysis in depth before proper legislation can be pro- posed. We believe that the bill was portrayed too simply by the Se- curities and Exchange Commission's Chairman when he said in effect: It is the purpose of the bill to give a fair shake to the more than four million Americans now owning mutual fund shares, and this can be done by reducing the sales load imposed on the acquisition of fund shares and by pro- viding a way in which unreasonably high management fees can be reduced. This is the sum and substance of the bill. Evaluation of this proposed legislation is complicated by the fact that it is based on an extensive document, prepared by the Securities and Exchange Commission and submitted to the Congress. This Se- curities and Exchange Commission report recommends substantial changes in stock exchange commission rate structure, reciprocity and other areas vitally important to the operations of the securities in- dustry which are far beyond the scope of this bill. We realize and respect the fact that this bill is mainly confined to lowering sales loads and management fees and prohibiting front-end loads. Nevertheless, we submit all of the Securities and Exchange Commission recom- mendations are interrelated. The Securities and Exchange Commission has pointed out the spec- tacular growth of mutual funds in recent years and the problems in- volved in the institutionalization of the marketplace. They further suggest the growing concentration of economic power over prices of individual stocks and corporations in the hands of a relatively small group of fund managers poses problems for investors, the investment industry and the orderly functioning of our capital-raising mecha- nisms. Obviously, these problems will not be solved by a simple reduc- tion in profits, sales loads, or advisers' fees. These com~p1ex areas give us genuine concern. We do not have answers for them. That is why we feel strongly that further economic analysis and study is urgently needed if changes are to be made. This bill, giving the Securities and Exchange Commission rate- making powers, is patently impractical and unreasonable. The various elements in the securities industry are in active and constant com- petition with each other for business. Securities firms are regulated, but they have no exclusive franchise as public utilities do. They also compete with insurance companies, banks, and other financial institu- tions for the savings dollars of the American people. Nonetheless, the PAGENO="0148" 562 plaiirthrust of ~he Securities and Exchange Commission's proposal to Congress is to reduce profits by giving them authority to reduce charges. Recent developments in the securities markets have convinced us that this proposed legislation cannot be evaluated properly until these major questions have been carefully considered: 1. What are the capital needs of our economy over the next 20 years? 2. Where will this money come from? 3. To what extent would these Securities and Exchange Commis~ sion proposals be harmful to the capital-raising structure of our country? We don't know. 4. Do the present methods and techniques of buying and selling by mutual funds cause erratic price swings in issues in which they have a substantial interest, or will they in the future? 5. Will the continuation of large block buying by all institutions change the whole concept of future financing and marketing of securities? 6. Will the funds, if they sustain their present rate of growth, dry up liquidity in the various marketplaces? The Securities and Exchange Commission raises the institution's impact on liquidity in their mutual fund study 1 and I quote: The growing importance of institutional investors in the stock markets has a significant impact on the securities markets. To the extent that irreguiar and relatively infrequent transactions in sizable blocks of securities by large insti- tutional investors become more significant and orders from small investors become less significant, the markets for individual securities become more susceptible to wide and erratic price fluctuations. Strangely, this Commission-sponsored legislative proposal makes. no attempt to deal with the recognized problems resulting from increased institutionalization. Liquidity in an auction market is provided by a continuous daily flow of 100 to 500-share orders in sufficient quantities to satisfy all normal pressures of supply and demand without leading to erratic price fluctuations. We would have to oppose, therefore, any pricing structure that would contain a volume discount that would make it attractive, in and of itself, for investors to bunch their orders through some institutional vehicle. This would have two undesirable effects: 1. Many smaller- and medium-size orders would be removed from the marketplace, thus reducing existing liquidity. 2. By routing orders through an institutional vehicle, they would become larger and exert extraordinary pressures on the market as clearly delineated by Chairman Cohen. Most importantly, any spectrum of pricing that provides a discount for larger orders, by its very definition, either directly or indirectly, places a more than proportionate burden of cost on the small indi- vidual investor. H.R. 9511 is a result of studies by the Securities and Exchange Commission, its staff and consultants, conducted pursuant to section 14(b) of the Investment Company Act of 1940. In that subsection, Congress authorizes the Commission to make a study and investiga- tion when and if it finds- 1 House Rept. Number 2~7 on public policy Implications of investment company growth, p. 26. PAGENO="0149" 563 any substantial further increase in size of investment companies creates any problem involving the protection of investors or the public interest * The very language used shows Congress was interested in the size of mutual funds and the resultant impact that increased size might have on investors or the public interest. These legislative proposals in ER. 9511 fail to meet problems resulting from the increased size of mutual funds and thus miss the target Congress invited the Securities and Exchange Commission to focus upon when section 14(b) was added to the Investment Company Act. CONCLUSION H.R. 9510 and 9511 has been urged upon you as a legislative solution to limited problem areas which actually have yet to be studied in depth. We have spelled out six major problem areas which we feel richly deserve thorough investigation and careful evaluation, but the bill deals with none of them. We are not opposed to the action in these areas but we are opposed to any legislative action before it is clearly understood what the re- suits will be. We do not know if the proposed reduction in charges for mutual funds would increase or lessen the sale of this form of in- vestment. The Securities and Exchange Commission has presented pre- vious testimony virtually admitting that they do not know either. The so-called institutionalization of the market is obviously the main thrust of the Securities and Exchange Commission. This i.s our concern, too, and as we have testified, the resultant impact on market liquidity. Chairman Cohen testified on the second day of your committee hearings, in answer to a question I believe by you, Mr. Chairman, that- Certainly we feel that the problem is growing and additional steps be re- quired. We are worried that some of these activities will produce a disorderly market, even if only in particular times. We assume from this that he is generally concerned about the liquidity in the marketplace, and we repeat we certainly are.. We do not appear before you to say there are no prc~blems in these areas treated by this bill, because we know they are there. We are trying to get across the blunt truth that what appears to be a relatively simple piece of legislation in the interests of the public will not necessarily bring those results. We are not surprised by the existence of the problems, but we are dismayed by the lack of overall planning relative to the definition and solution of the truly major problems that face the future of the public and our marketplaces. Therefore, Mr. Chairman, we recommend that Congress establish a joint industry-Commission study to consider these major problem areas in depth and then recommend to Congress a legislative program which is responsive to the conclusions resulting from such an appraisal. We believe such a study could be completed in a relatively short period of time, without the necessity of substantial appropriation. Further, to prevent any possible bias of either our industry or the Securities and Exchange Commission from slowing down such a study, or from limiting the potential, we would suggest that representatives of the Federal Reserve Board could be included along with members PAGENO="0150" 564 from your committee, Mr. Chairman, and members of the Senate committee. Thank you very much. Mr. Moss. Thank you~ Mr. Day. Mr. Keith. Mr. KEITH. Thank you, Mr. Chairman. Have you read the Wharton School report? Mr. DAY. I made a good attempt at it, Mr. Keith, but I would have to qualify my answer to say that there is a lot of it that I don't recall. Mr. KEITH. Do you know of anybody who has read it in total, per- sonally? Mr. DAY. No, sir; I couldn't vouch for that. Mr. KEITH. There is more to it than just this. Mr. Moss. That is the report. You are talking of the mimeographed volumes which look more impressive than they are. Mr. KEITH. I haven't read the report and I don't know anybody that has read it comprehensively except perhaps the man sitting back there, Mr. Cohen. What has happened to your exchange as the result of institutional buying in the last 6 or 7 years? Mr. DAY. Well, if you will permit me, Mr. Keith, I will say the Midwest Stock Exchange has been doing its best to compete with conglomerates in the stock exchange business, but as far as the institu- tional effect on our exchange is concerned, we find an increasing impact in this area. We have a growing amount of block orders coming in to us. They run about 17 to 19 percent of our volume now, and we use a 5,000 figure as a block, yes, about 17 to 19 percent of our business. Mr. KEITH. What has been the total volume increase on your exchange in the last 6 years? Mr. DAY. Perhaps I could best answer it this way from my limited memory. We ran 84 million shares last year for approximately 4 `billion billion in dollar volume 5 or 6 years ago. Mr. KEITH. What was it 6 years ago, roughly? Mr. DAY. I would say 50 as a guess. I would be glad to supply that figure to you later. Mr. KEITH. In dollar volume, 50. Mr. DAY. No, that would be share volume. I would say about one billion in dollar volume 5 or 6 years ago? Mr. KEITH. So as a percentage, what is your growth in 6 years? Mr. DAY. I would have to get that figure. Mr. KEITH. I would like to have those figures. (The following information was subsequently submitted:) MiDWEST STOCK E XCHANGE VOLUME Year Shares Dollars 1967 (9 months) 1967 (estimate) 1966 1965 1964 1963 1962 1961 1960 1959 1958 1957 79,292,912 106, 000, 000 84,747,740 69,605,096 50,584,823 43,773,297 39,738,398 42,990,970 31,432,388 33,692,787 28, 473, 135 25,901,100 $3,667,096,989 4, 800, 000, 000 3,886,892,250 3,085,807,767 2 286 202,056 1,755,658,882 1 511,814,969 1 761,745,757 1,235,159,894 1,390,505,923 1 046, 931, 658 864,754,046 PAGENO="0151" 565 Mr. DAY. I would say this. That since we formed this exchange, the Midwest Exchange, you know it was a consolidation some years ago, I think we might still have the greatest percentage gain in share and dollar volume of any exchange. Mr. KEITH. This sort of reinforces Mr. Moss' expressed philosophy that no matter what this committee does in the threat of the adverse impact, progress seems to continue. / Mr. DAY. I don't think there is any question that we have tremen- dous business now and substantial growth in our business since the long bull market. I know as the president I have been very grateful for a bull market. It makes you look good. Mr. KEITH. I have no further questions, Mr. Chairman. Mr. Moss. Mr. Murphy. Mr. MURPHY. Yes. Mr. Day, I want to congratulate you on your statement. Mr. DAY. Thank you. Mr. MURPHY. Through whom do most of the funds buy, through what form? Do they go through members of the exchanges? Mr. DAY. You mean the business that comes to us. Mr. MURPHY. Yes. They buy the stock, and after they have made their minds up just which blocks they are going to buy, who do they go through to buy it? Mr. DAY. Well, we find that they are either filled by the firm that they allocate the stock to directly, who have sold their shares, maybe half a dozen firms, or they use what is termed in our business as the "lead broker concept," where the fund may well want to give sub- stantial brokerage business in lieu of the fact that the firm has sold its shares, rather than splitting it up in small lots and handing it to individual firms, it gives it to what is called a lead broker who fills that order and then simply sends a check to these other dealer firms. Am I approaching your questian? Mr. MURPHY. Yes. Do they pay the same commissions as the in- dividual investor? Mr. DAY. Yes, sir. Mr. MURPHY. As a practice, do the funds from, say, Massachusetts, the funds from New York, the funds from Illinois buy through the exchanges in their particular areas? Mr. DAY. Not nec~ssarily. We would like to have a lot more business. They don't always try our marketplace, but this is iio criticism against the funds, because this is also true of dual members of the New York Stock Exchange. `Our position is that we would like our market tested by a fund or a member of New York or anyone. If our price is as good or better than New York. We think that we have a good marketplace, particu- larly from the sell side because, as we mentioned, there would be no tax. Mr. MURPHY. But you find that where the fund is located is where they buy? Mr. DAY. Not necessarily; no, sir. Mr. MURPHY. Is there any area disarrangement that you would think-I would think that probably the New York area would buy principally in New York and let's say the west coast market on the west coast. PAGENO="0152" 566 Mr. DAY. I don't know that that is necessarily true. Mr. MURPHY. Is there any marked imbalance? Mr. WEITHERS. Mr. Murphy, maybe to clarify it, I think that the tremendous change in communications and improvement in communi- cations give the funds, no matter where they are located, an opportu-~ nity to check the known marketplaces for the securities in which they deal almost instantaneously, so that there is a continuous check almost nationwide in all the recognized markets by the funds. Mr. Mmu'iiy. Thank you, Mr. Chairman. Mr. Moss. Thank you, gentlemen. I assure you that the statement you have made before this committee will be given very careful con~ sideration. I thank you for appearing. Mr. DAY. Thank you, Mr. Chairman. Mr. Moss. The next witnesses2 Mr. Ronald T. Lyman, Jr., Scudder, Stevens & Clark Co., accompanied by Mr. Harry Hagey of Stein, Roe & Farnham, and Mr. Milton H. Cohen, of Schiff, Hardin, Waite5 Dorsohel & Britton. Mr. MURPHY (presiding). Mr. Lyman, you can present your entire statement or summarize it, if you wish. STATEMENT OP RONALD T. LYMAN, JR., INVESTMENT COUNSEL SPONSORED NO-LOAD PUNDS; ACCOMPANIED BY HARRY H. HAGEY AND MILTON H. COHEN, COUNSEL Mr. LYMAN. Thank you very much, sir. Mr. Chairman, members of the subcommittee, Dr. Stevenson, my name is Ronald T. Lyman, Jr. I am appearing on behalf of a group of Investment Counsel Sponsored No-Load Funds, a list of the mem- bers of which has been handed up to members of the subcommittee. I am a general partner of the investment counsel firm of Scudder, Stevens & Clark and president of Scudder, Stevens & Clark Balanced Fund, and Scudder, Stevens & Clark Common Stock Fund, and I am a member of the board of governors of the Investment Company Institute. Here with me and also available to answer questions about one group's position are Mr. Harry H. Hagey, who is a partner of the counseling firm of Stein, Roe & Farnham of Chicago and president of its no-load funds, and Mr. Milton H. Cohen, counsel to our group. All of the investment companies in our group are open-end manage- ment companies and all are members of the Investment Company Institute. However, they differ from most open-end companies and most members of the ICI in that they are all "no-load" funds; that is to say, their shares are regularly offered at let asset value without a sales charge of any kind. In this and other respects specified in the law, they fall within a separate category of companies to which Con- gress gave special recognition in section 10(d) of the Investment Company Act of 1940. The investment counsel firms that act as advisers to the no-load funds within our group all have these characteristics: (1) They are registered as investment advisers under the Invest- ment Advisers Act of 1940. (2) They are principally in the business of rendering investment supervisory services as defined in that Act, and thus are entitled to call themselves "investment counsel" under section 208 (d) thereof. PAGENO="0153" 567 (3) They render investment counseling and supervisory services primarily to clients other than investment companies. The oldest no-load fund in the group was organized in 1928 and now has net assets of about $117 million. The youngest was organized as recently as 1965 and its net assets now amount to about $1,600,000. The largest fund in our group, organized in 1950, now has net assets of about $358 million. Typically, the counseling firms in our group had been in business for some years before creating their no-load funds. They had been per- forming counseling services for their various individual clients but had found it impractical to handle small accounts on an individual basis and had therefore found it necessary to specify a minimum fee for accounts they would accept. As a result, each of them had had the experience over the years of turning down requests to serve smaller accounts. Each of the firms decided that a good solution would be to create a no-load fund as a vehicle for combining investments of these people of smaller resources who could not be economically served as individual clients but who wanted unbiased, expert investment advice. Section 10(d) of the Investment Company Act takes the form of an exemption from the provisions of sections 10(a) and 10(b) (2) and permits an investment company meeting its special requirements to have its entire board, except for one director, consist of individuals who are affiliated with the investment adviser or officers or employees of the company itself. (Under the bill, the only change would be to substitute the concept of "interested" for "affiliated.") Among several requirements to qualify for the exemption, the critical ones are that no sales load may be charged and no sales or promotion expenses may be incurred by the investment company itself. Accordingly, there are no commissions paid to salesmen by any of the members of our group, and relatively little promotional effort. Essenti~dly, those who have become investors in these funds have done so on their own initiative, because they wanted to get expert and disinterested services of a par- ticular counseling firm through the medium of its sponsored fund. Our reason for appearing today is to be sure that the particular features of our situation are not lost sight of in the exploration of wider questions. Perhaps our group should be pleased and reassured by the fact that the SEC's long report discussing the mutual fund business devotes almost no space to us. On the other hand, although there has been no suggestion that the assumptions underlying section 10(d) have proved invalid in any way, certain of the amendments that the Commission is recommending, particularly those relating to fees for management services and independence of directors, would affect us along with the rest of the industry and as a practical matter would eliminate the distinctive treatment that Congress wrote into section 10(d) in 1940. Again, although we are members of the 101 and sub- scribe generally to the presentation made on behalf of all of its mem- bers, we felt that we ourselves needed to bring to your attention some special impacts of the proposed legislation on the no-load group. Obviously, we do not contend that the advisory or management fee charged to no-load funds should be other than "reasonable." The real question is how the fee and its reasonableness should be determined. Our basic position is that the fees paid by the no-load funds to their PAGENO="0154" 568 respective advisers, while varying within our group, are all well within the range of reasonableness, and that this result is brought about and assured by the peculiarly strong competitive situation of the no-load group, so that we believe the proposed legislative changes are unnec- essary. These changes, on the other hand, would upset the basic as- sumptions of section 10(d) and would subject the no-load counseling firms to new, unwarranted costs and risks, thereby discouraging the formation of the no-load type of fund. For all companies within our group the maximum advisory fee is 0.5 percent per annum, or half the statutory maximum of 1 percent, found in clause (6) of section 10(d). Tn the case of the largest fund in the group, the 0.5 percent is charged only on the first. $50 million of net assets, then 0.4 percent on the next. $100 million, then 0.35 per- cent on the balance. In other cases it is 0.5 percent. on the first $100 million or $125 million and either 0.4 percent or 0.375 percent on the balance. In still other cases no breakpoint for reduction below 0.5 percent has yet been found appropriate. Inasmuch as section 10(d) precludes the charging of a sales load or the. payment of promotion expenses by qualifying investment com- panies, the management or advisory fees received by tIie counseling firms from their respective no-ioa.d funds must absorb some kinds of expenses, including promotion expenses, that the rest of the industry can take care of as a fund expense or through the load. For this and other reasons, the aggregate expense ratio i.s much more significant tl.ian the fee rate alone in comparing and evaluating costs of invest- men / management. By the "aggregate expense ratio" I mean the man- `igcr ent fee plus all other operating expenses pai.d by the fund itself, expressed as a percentage of invested dollars. This ratio varies some- what from company to company, depending largely on size, but. is at a modest level for all members of our group, averaging about 0.6 percent annually or $60 per $10,000 of net asset value. We. suggest that management fees and total expenses are at these moderate levels today-while showing the variations they do-because competition works with special efficiency in the case of no-load funds. The investor pays nothing to become a stockholder of a no-load fund, except possibly the price of a postage stamp or a telephone call, so that he can freely change advisers by selling one no-load fund and buying another. From the investor's viewpoint these no-load funds are simply a means of obtaining counseling services of a particular firm by buying shares of its fund; thus, any dissatisfaction with services performed in relation to management fees paid, or vice versa, can be readily taken care of by switching no-load funds, and therefore advisers, without incurring any penalty. Competition works freely, limited only by legal restrictions on advertising. Stating this another way, it is of the essence of any mutual fund that its shares are freely redeemable by the stockholder. The no-load feature of our funds makes this unusual redemption feature a doubly powerful weapon in the hands of the investor, because it permits him to get the full benefit of competition by changing managements at his complete discretion. Congress recognized all this in 1940 when it enacted section 10(d) of the present act. For the investment company industry generally, PAGENO="0155" 569 section 10(a) required at least 40 percent of nonaffihiation between an investment company and its adviser, and to that extent, through sec- tion 15(c), fostered arm's-length bargaining in connection with ad- visory contracts. But in the case of no-load funds, as mentioned before, Congress said that a single outside director was enough-obviously because the need was seen to be quite different. Section 10(d) amounted to a recognition by Congress of three essential points: (1) That, contrary to what is often said about fund shares, no-load fund shares are "bought" by investors rather than "sold" to them; (2) That an investor is really selecting the advisory firm when he decides to buy shares of a particular no-load fund; and (3) That there would be no point in fostering arm's-length bar- gaining as to the terms of advisory contracts with no-load funds be- cause competition works freely and effectively: by hypothesis there is no deterrent to the investor's changing no-load funds if he is dis- satisfied with the adviser or its fee. We believe that Congress clearly intended, through section 10(d), to foster and encourage this type of fund. We believe, unhappily, that enactment of the present bill would inhibit and discourage them, not- withstanding that section 10(d) itself would remain virtually unchanged. One reason lies in the crucially different roles that the outside diree- toiss play under the present law and would be expected to play under the proposed law. Under present law and practice they serve the vahmble function, as in any corporation, of bringing an outside per- spective to all aspects of management's handling of corporate affairs. TI e keep the man agemeiit constantly "on its toes"; they raise ques- tions and express viewpoints that may not occur to members of man- agemeiit. But, while those with whom I am. personally a~quaiiited are men of high caliber and ability and perform their role seriously and conscientiously, these outside directors hardly conceive themselves as having a special, personal responsibility to negotiate the terms of an investment advisory contract at arm's length. Under the proposed bill, on the other hand, apart from the new requirement that an outside director be "disinterested" as distin- guished from "unaffiliated," there would be a drastic chaiige in his function and responsibility. He would have a large new burden of in- quiry and judgment before he could agree to an advi.sory fee as "rea- sonable." The law would set forth a very broad, yet we think rather nnbaiaiiced, list of "factors" or criteria to he considered, plus all others that might be "appropriate and material." As to all these criteria it would be the outside director's duty to request and evaluate ~ertineiit data and reach his conclusion as to reasonableness. In performing this complex task he would be entirely dependent on his own resources except for the adviser's furnishing data to him. In the case of a no-load fund the required number of outside directors-that is, only one-would not be changed, but for all pra6ti- cal purposes the distinction written into section 10(d) in 1940 would be wiped out, even though superficially left there. I say this because it seems very doubtful that any ou'tsider would be willing, all alone, to take responsibility for carrying out the new and burdensome func- tions imposed by section 15, and hence the no-load funds would be forced to ask several outsiders to share the responsibility. PAGENO="0156" 570 Moreover, the new role of the outside director or directors would be a quite anomalous one, because the suggested section 15 contains provisions that look in quite opposite directions. On the one hand, it contemplates a greatly enlarged burden on outside directors to make diligent inquiry and apply appropriate criteria to determine the "reasonable" fee level. But on the other hand, this procedure is to be largely ignored in the ultimately significant determination of reason- ableness by a court. Nor could an outside director take comfort in the happy thought that he would not be exposed to personal liability. Although the SEC has said that it intends no personal liability, the bill as drafted would not, in our counsel's view, accomplish this result. It seems likely that many individuals who might have been will- ing to serve as outside directors in the past would be unwilling- even if they would pass muster under the new "disinterested" re- quirement-to take on the sharply increased responsibility and risk of directorships under the new law. Those who would be willing would probably expect, and be entitled to, more substantial compen- sation for the much greater burdens involved. Moreover, for reasons already indicated, it would almost inevitably be necessary to have more than the minimum number. The combined effect would be that all funds would be hard put to find enough willing and qualified per- sons to serve, and small funds (several of which are among the mem- bers of our group) would have a new and significant expense burden. In my prepared statement as filed with the subcommittee, on pages 13 and 14, there is some mention of two respects in which the new definition of "interested person" is regarded as unduly broad and burdensome to our type of fund. My understanding is that the agree- ment between the SEC and the ICT, on the various so-called second- ary points in the law, would take care of these particular difficulties, so that I will omit this material from my present testimony. In closing, what I would like to emphasize is that the bill would amount to a repudiation of the basic concept of no-load funds that had existed for many years before 1940 and that Congress accepted and fostered in the 1940 act-without any showing that no-load funds have not lived up to the 1940 expectation or that the concept was in- valid in any way. In 1940 Congress did not emphasize-it deemphasized-the role of `the outside director of a no-load fund, because it regarded such a fund as being essentially a vehicle for investors to obtain invest- ment advisory services that could not practically be made available on an individual basis. Likewise, no need was `seen in 1940 to emphasize any distinction between the no-load fund and the counseling firm or to subject the management fee to special judicial scrutiny. The con- cept was that an investor could move freely among competing no-load funds or to other sources of investment advice, depending on his own estimate of relative benefits and costs. Today, with no showing that this concept is not as valid as ever, it is proposed to change all this. Although nominally the basic unity of fund and adviser would still be recognized, actually there would be substituted, by enlarging and emphasizing the role of the independ- ent director, a new concept of separateness and independence between fund and adviser. But beyond this, and even more serious, there would PAGENO="0157" 571 be an encouragement of litigation rather than competition as the main sanction to assure reasonableness of fees. The counseling firms traditionally have looked at their sponsored funds as a means of extending their counseling business to smaller in- vestors, not as separate entities toward which they were in the posi- tion of independent contractors. As a matter of basic policy they make it cost-free for investors to become shareholders of the funds and cost- free to redeem and go elsewhere (except for a minor redemption charge-retained by the fund and not the adviser-in one or two in- stances). The firms in our group are quite happy to live in a com- petitive environment. They do not want stockholder-clients to join or stay on unless they are satisfied on the basis of performance and costs. By the same token, they know they must satisf,y these stockholder- clients, not outside directors or any other outsider, as to the fairness of their fees in relation to services performed if they are to stay in busi- ness and grow. It is expensive to start any mutual fund, even apart from the cost of creating an advisory staff. In the case of a no-load fund particu- larly, the sponsor cannot expect to achieve a profitable operation ex- cept over a very extended period of time, because there is no selling load to absorb any of the startup or promotional cost and, with no salesmen, growth is typically very slow. The sponsor depends on slow but steady growth in the number of fund stockholders who are satis- fied to pay the established fee for what they receive. The whole idea would be very much less attractive to a sponsor if it were expected to deal at arm's length with outsiders and still could be second-guessed and exposed to liability and expense through the kind of stockholder litigation that would be encouraged by the bill. For these reasons we believe there is a strong likelihood that the proposed amendments would seriously discourage the formation of new no-load funds-a result that we are sure this committee would not favor. We appreciate very much having the opportunity to be heard by you. Mr. MURPHY. Thank you, Mr. Lyman, for a very fine statement. I note that you have with you a Cohen,.. Milton H. Cohen, who was counsel to the Commission on its special study, and of course, made a number of suggestions regarding the improvement of the shareholder's position in mutual funds as well as in the market generally. Mr. Cohen, one of the things disturbing this cQmmittee is the tre- mendous growth of the investment company industry, and of institu- tions as a whole and the resulting effect upon free markets as we have known them. Do we have free markets on the exchanges? Mr. COHEN. We commented in the special study at great length on the growing role of institutions in the securities markets. We devoted part of our chapter VIII as I recall, to the phenomenon of increased purchases by the large institutions, and we talked about their activity as bearing on market mechanisms and the suitability of existing mech- anisms to handle all that. I think we exposed for the first time some problems that needed to be talked about and further studied, and we recommended that they be the subject of continuing studies, and I think those subjects have been. receiving more attention in the last 5 years than they had received at the SEC or elsewhere in the preceding period. PAGENO="0158" 572 Now when you ask whether the markets are free, we again coin- iuent.ed on the concept of a f ice market in the special study in relation to the concept, for example, of an orderly market, and we saul tha.t aiiytlimg you (10 to be assured of orderliness may on the Other side of the COil be considered as affecting freedom of the market. For example, the specialist system, winch is the stock exchanges' main mechanism for assuring orderimess, can be consjdered as to some extent liinitiiig pure freedom, if the latter term means ]etting a mar- ket operate in accordance with the random flow of public buy and sell orders without any interveiition by anyone to keep that market orderly. So, to the extent you deliberately concern yourself with and do soinethnig about ordeili ness, depending on semantics I suppose, you cati say that that is affecting freedom of the market. Mr. Muiuin-. Can the specialist survive in the exchange today, let's say under present circunist.ances? Mr. CoLIEN. We found that tlie specialist's iole had changed tre- mendoiisly between 1934 when the Exchange Act was adopted, and. 1962 wiieii we made our study. I think this was brought out by soii ie basic testnnoiiy by presidents of the New York Stock Exchange at two different times, one of whom defiuiecl a special ist a.s someone who han- dles orders for others-that was an early definition-and Mr. Fun- ston's much more recent 1961 definition that a specialist is someoiie who acts as a dealer in the market. rphlus the 51)eciahiSt role had greatly changed as the flow of public orders changed, and as blocks purchased and sold by institutions were not being handled through the ordinary niechani sms. Now since 1962, there seems to be a further trend in that direction. I haven't had occasion to make further studies since the special study and I have no peisoiial knowledge of t.]iis, but from what I read, it appeals that the trend is more Hi that direction, and I would say that the specialist system has to keep adapting itself to the new uses of the market. I read a ear or so ago of a specialist himself coinmg in to l)e the ma in puichiaser 0 t' a $17 million block that went over the stock ex- change. Now that certaiiily isn't the traditional function of a specialist., so you can say that the specialist concept has been chaiigmg and pie- sumably will coiitiiuie to change as the needs of the niarket change. Mr. MuRPhY. Mi. Cohen, we have a series of questions that we would like to submit to you and hold the. record opeii at this time for V0U1 1eSJ)OllSe to them. They will be lengthy an(l we are probably going to be crowded lor time ~n 1ust a little while, and I have some otlli~1.~ questions foi Mr. Lyman. Mr. COILEN. I will domybest,sii. (The followi iig letter was received by the committee:) Scm~'r, HARDIN, WAITE, Donsc:rwL & BRITTON, Chicago, Ill., October 31, 1967. Hon. JoHN E. Moss, Chairman, ~a)committee on Commerce and Finance, Committee on Interstate and Foreign Commerce, Rayburn~ House Office Building, Washington, D.C. DEAR MR. Moss: This is in reply to your letter of October 18, 1967 in which you posed the following questions: "Do we have free markets? Can we have them? What is the influence of tremen- dous blocks being bought and sold by the institutions? What is the influence of large blocks being held off the market by institutions? Are some issues held in PAGENO="0159" 573 large enough quantities by institutions that the issues should be delisted? Do you think that the exchanges or sales by an investment company or an institution for that matter, actually can run up or run down the price of a security? Can the specialist function amid these big block transactions?" As you know, I answered certain of these questions orally, at pages 635-637 of the typewritten transcript, when I appeared before the Subcommittee as counsel for the group of Investment Counsel Sponsored No-Load Funds. Of course, my remarks at that time as well as the following ones are made in my personal capacity and not on behalf of such group of No-Load Funds or any other group or person. The 1063 Report of the Special Study of Securities Markets, for which I bad senior responsibility as Director, had a good deal to say, directly or indirectly, on the topics covered in your questions. I would respectfully call your attention especially to the following portions of the Report: Part 2, pages 13-18, dealing with the concept of a "free" market in relation to a "fair" and "orderly" one, and also the concept of "depth." Part 2, pages 128-33, 136-42, and 164-65, discussing specialists in relation to the handling of block (institutional) transactions and In relation to "freedom" of the market. Part 2, pages 167-21, containing our conclusions and recommendations concern- ing specialists, of which several are somewhat pertinent to your questions, especialiy the following: "9. The NYSE and Amex should undertake studies, in conjunction with the Commission, as to methods or plans by which the capacity of specialists to acquire larger blocks of stock within the framework of the auction market could be otherwise strengthened. Among other possibilities, consideration should be given to (a) the establishment of an exchange-administered capital fund from which specialists could borrow under appropriate limits and safeguards; (b) the estab- lishment of a capital fund, through contributions from the brokerage income of all specialists, that would be administered by specialists' representatives and! or the Exchange itself and would be available for taking positions beyond the financial capacity of an individual specialist; or (c) establishment of a system of limited self-Insurance by specialists as a group. Reference is made to recom- mendation 4 above with respect to increasing specialist capital requirement and the recommendation in part F of this chapter concerning the possibility of creating a category of `auxiliary specialists.'" Part 2, pages 828-31, discussing the importance of, and factors affecting, "depth" of an auction market, including the factor of increased institution- alization. Part 2, pages 838-70, dealing with institutional participation and block transac- tions, especially the summary and conclusions appearing at 806-70, including the following recommendation: "1. Institutional participation has become increasingly important in the total business of securities markets and, since the institutions tend to deal in larger blocks and for other reasons, such participation presents sj~ecia1 problems from the point of view of the exchanges and in relation to the public interest and protection of investors. In view of the growing importance of institutional trans- actions and the probability that needs and problems associated with them will not remain static, it is particularly important that there be an adequate body of information about them on a continuous basis for the use of the Commission, the self-regulatory bodies and the Investing public. The Commission should institute programs to obtain, and to publish on appropriately aggregated bases, more con- tinuous data concerning institutional participation in the securities markets, including securities held, amounts of gross and net purchases over periods of time, and turnover rates. From time to time the Commission should hold conferences with, or otherwise invite the views and suggestions of, institutional investors, the principal exchanges and representatives of the securities business with regard to changing impacts of institutional transactions on securities markets, related needs of institutional investors, and questions of public policy involved." Part 2, pages 952-61, relating to "currents of change" in the securities markets and the need for continuing study, including the following finding: "2. Institutions have become greater participants in trading markets, par- ticularly in respect of NYSE-listed securities, and the relatively large size of their transactions has tended to aggravate the problem of temporary disparities in supply and demand in a continuous auction market. For this reason and because PAGENO="0160" 574 of generally `thinner' markets, demands on the specialist ssytem have become greater than in prior times, and greater for some securities than others." And the following recommendations: "1. It is essential for the Commission to improve its facilities and programs for continuous accumulation of data with respect to fundamental, but often ob- scure, changes in the components, uses and needs of the total pattern of trading markets; i.e., the separate markets when considered in relation to each other. This need, together with others discussed in chapters VI, VII, and VIII, calls for both a reappraisal of present reporting systems, with full regard to the burden of supplying particular information in relation to its utility in the public interest, and a considerably wider perspective as to potential uses of data processing equip. ment irs discharging the Commission's regulatory responsibilities. "2. The Commission should establish a separate, permanent policy and plan- ning unit within its staff, having the responsibility of accumulating and analyz- ing Jfertinent data bearing on market patterns and practices generally, making special studies as the need may be indicated, and reviewing policies and regula- tions in light of changing circumstances." Part 4~ pages 844-47, dealing with institutional activity in the May 1962 market break. What we said in the passages referred to above and elsewhere In the Special Study Report was based on voluminous statistical and other data compiled and analyzed over a period of time by a 65-man study group. On the other hand, as I mentioned at page 637 of the typewritten transcript, I personally have had neither the occasion nor the facilities to gather any similar data covering the period since 1962. Accordingly, I have no real basis to express any further views at this time on the questions posed in your letter, other than to say that it is my general impression that (i) the conclusions and recommendations that we expressed in 1963 have generally been supported and confirmed by subsequent experience, (ii) inevitably, because of implementation of Special Study rec- ommendations or for other reasons, important changes of various kinds have taken place in the securities markets since completion of the Special Study, and (iii), of particular relevance to your inquiries, the mutual funds' and `other institutions' share of ownership and activity in corporate equity securities has grown very significantly. I would also point out in the latter connection that the 1963 Report itself, having emphasized the already evident trend toward institutionalization of the securities markets and the dynamic and changing character of such markets gen- erally, went on to stress the need to gather relevant data on a continuous basis and to re-examine from time to time the adequacy of market mechanisms and regulatory measures in light of observed changes; see, in addition to certain of the passages quoted above, the following passage from the Special Study's first transmittal letter dated April 3, 1963 (reprinted in Part 1, page xiv, and Part 5, page 22): "A corollary of prime importance is that broad-gaged studies of the kind under- taken by the Special Study cannot be once-in-a-generation affairs but should be a major part of the Commission's regular and continuous activities. To be able to see the forest instead ~f just the trees, to be able to evaluate current trends and future potentials as well as past results, the Commission should have a permanent staff group, small but expertly manned, that is free from routine administration and assigned the responsibility of observing and measuring im- portant trends, identifying and evaluating new developments, and from time to time making special studies of particular subjects. . . To the extent that the Commission has not heretofore implemented these recommendations for continuous compilation and study of relevant data (not limited to institutionalization but covering other important trends as well) I would strongly urge that it be encouraged and enabled to do so, as I believe that the kinds of questions posed in your letter do need re-examination from time to time in the public interest but are too important and too complex to be answered even by an expert body except on the basis of adequate current data. Such data might also be useful in determining whether, and, if so, in what manner, certain recommendations of the Special Study not yet implemented should be put into effect, and what additional or substitute measures may be indicated from time to time. For example, it appears from Mr. Haack's testimony on October 17 (page 590 of the typewritten transcript) that the New York Stock Exchange presently has under consideration a measure resembling one of the PAGENO="0161" 575 alternative measures mentioned in our recommendation No. 9 on specialists, quoted at pages 2 and 3 above. Your letter also asks for my comments on the problems outlined in the Special Study Report regarding the mutual fund industry, particularly the question of sales load and management fee. The Special Study did. not really deal with the subject of management fees, its examination of the investment company area (Chapter XI, pages 89-255 of Part 4) having been limited es- sentially to a few topics closely related to studies undertaken by the Special Study in other areas: selling practices (including front-end loads), reciprocal business, and insider trasactions in portfolio securities. On these subjects my personal views have not changed since the 1963 Report, but I should again say that I have not had the occasion or the means to examine more recent data that might be pertinent to present judgments. Respectfully yours, MILTON H. COHEN. Mr. MURPHY. Mr. Lyman, as I understand your position, you are concerned oniy that you have to have one or two additional independent directors, and that your advisory fees which you now say are reasonable might be subject to some independent consideration. Of course, the question of additional nonaffihiated directors is one which will come up for consideration by the committee, but it is not clear yet that you advance this suggestion very seriously. On the other hand, you do seem to be concerned about the manage- ment fee, even though as you state, your fees are reasonable, and you cannot argue against a test of reasonableness. On page 16 of your statement you speak about the kind of stock- holder's litigation that might be encouraged by the bill. I wonder if you would discuss this a little more at length, and whether you have a suggestion of how a court test of the reasonableness of fees can be secured without a great deal of litigation. Mr. LYMAN. Well, I think that the only way that a court test can be achieved without any degree of litigation is for the company to give in. This is what has been going on in some cases. We think that it is a matter of degree here on the independent director. We wouldn't feel that under the present concept of the 10(d) companies the independent director had a necessarily special mission to agitate on the subject of the management fee, because the investor has come in without paying any entrance fee or initiation fee, if you like, and he is completely free to come and go as he chooses. Therefore, he is deemed to be capable of judging the reasonableness of the fee that he is buying. I won't say that our independent directors are not concerned with the fee. Of course they are. As good businessmen they a:re bound to be. If our fees are unreasonable I am absolutely certain that we would hear about it from them. But I think under the concept of the 10(d) company there is not that special assignment, whereas there would be under the proposed law. Mr. HAGEY. Could I comment just briefly, and perhaps add some- thing to that? Mr. MURPHY. Please. Mr. HAGEY. I think all of us who have now quite well established no- load funds would recognize that if you went ahead and passed this legislation, we would live with it one way or another. We think that you would be doing some things to us, perhaps inadvertently, in at- tempting to deal with an overall problem which we think would be harmful. 85-592-68--pt. 2-11 PAGENO="0162" 576 But in terms of what I understand ybur question to be directed to~ I would suggest that you might feel, as we know that the SBO and others feel, that there is something about investment-'counsel-spon~ sored no-load funds that represents a pretty outstanding and `different kind of a vehicle for the investor, and they would like to see more like us. What we are saying really to you here is that if you do some of these' t'hings that would `be included in this bill, require additional outside directors, require them to `accept greater responsibility with a whole list of criteria spelled out against which their must test the manage.~ ment fee, subject them to much greater chance `of litigation, in case a shareholder, whether justified or not, chooses to `bring suit-and bear~ ing in mind that no-load funds are started by an investment counsel firm from scratch, and they lose money for years, and that the only reason you start them, other than trying to oblige clients who want a place to put smaller amounts of money, is that you hope maybe some~ clay this will be a profitable thing for you-we are saying to you that,, if the rules of the game are changed~ we think you discourage the formation of future no-load funds, and we doubt that this is in the public interest. Mr. MURPHY. Do you think there would `be any way, Mr. Lyman, to find out the reasonableness without going through a stockholder suit? Mr. LYMAN. Well, I think there is the present method, which, in our opinion, is a satisfactory one and an effective one. Nobody has proved what is reasonable and what isn't reasonable, necessarily, but I think that the fact that you can attract investors with no sales force over a period of years, and have your funds consistently gro'w, is an indica- tion that this is not considered an unreasonable fee to pay. This is the working of the people associated with the adviser and the inde- pendent directors, all as a complete group. If there was `anything un- reasonable about the management fee, I think we would hear about it from our independent `directors, even though we only have to have one. Mr. MURPHY. Have you had any complaints with the fees? Mr. LYMAN. I would say, basically, no. Mr. MURPHY. Have you had any suits? Mr. LYMAN. You realize, of course, that our funds in terms of the industry are very small, and in practically every case there is already a sliding fee in existence. Mr. MURPHY. Have there `been any suits brought as far as fees are' concerned? Mr. LYMAN. Not that I know of in the no-load funds. Mr. MURPHY. Thank you very much, Mr. Lyman. Mr. Cohen, I will' submit those questions to you. Mr. Keith. Mr. KEITH. Thank you, Mr. Chairman. Mr. Cohen, it is nice to see you again, and Mr. Lyman. I `believe you had something to do with the SEC's "special study." Mr. COHEN. I had something to do with the special study, yes, sir. Mr. KEITH. I am just now reviewing the recommendations that were contained in the special study with reference to mutual funds,, and you say in the concluding paragraph: PAGENO="0163" 577 In conjunction with its comprehensive program of study of the investment company industry, the Commission should recommend to the Congress legisla- tion amendi~ig the present provisions of the Investment Company Act of 1940 which relate to contractual plans. Consideration should be given to the aboli- tion of any future front-end load. If It should be concluded that such abolition is not called for, such legislation should both substantially limit the amount and method of application of any such load and prohibit the offering of front-end load contractual plans by any mutual fund sales organization without the simultaneous offering of a level-load voluntary plan for shares of the same fund and (except for prepayment of selling charges) on substantially the same basis. (Off the record.) Mr. KEITg. Back on the record. When the SEC came out with its recommendations based in pa~rt upon a study in which you had been intimately involved, did you express yourself publicly about these recommendations? Mr. COHEN. No, sir. I was not consulted in any manner or degree after I completed the special study in 1963. Mr. KEITH. And did you make any voluntary observations from the public point of view? Mr. COHEN. Not in any area involved in the present bills. Mr. KEITH. Mr. Lyman, it is my understanding that Loomis-Sayles is one of your group. Mr. LYMAN. That is correct. Mr. KEITH. Is not Loomis-Sayles the one that is going to try to get into the retail business through Reader's Digest? Mr. LYMAN. I understand that is correct. I simply saw a newspaper article on the subject. Mr. COHEN. I understand that is true, in respect of an operation abroad. Mr. LYMAN. It is not true domestically. Mr. COHEN. It is not a domestic operation at all. Mr. KEITH, Mr. Cohen, do you generally concur in the testimony offered by Mr. Lyman? Mr. COHEN. Yes, sir. Mr. KEITH. Isn't his testimony in direct opposition to some of the special study's proposals, about which I was asking you? Mr. COHEN. I don't believe there is anything in M~r. Lyman's testi- mony that is in the slightest degree inconsistent with anything in the special study. What we focused on mostly in the special study regarding mutual funds was selling practices, and of course the group I now represent, the no-load group, does not have salesmen and doesn't engage in selling in the sense that was being talked about. In the Special Study we also commented particularly on the front- end load, but the group I represent here is about as far away on the spectrum from the front-end load as you can get, so I don't believe there is anything that we are now saying that is at all inconsistent. Mr. MURPHY. Excuse me, Mr. Cohen. Mr. Keith, those are the second bells, and I am afraid we are going to have to go to the floor. Would you like to submit some questions in writing to Mr. Cohen? Mr. KEITH. It is your intention to stop thehearing now? Mr. MURPHY. That is right. We are going to adjourn until tomor- row morning at 10 o'clock in room 2123. PAGENO="0164" 578 Mr. KEITH. Well, if I have any further questions I will submit them. I don't want to leave Mr. Cohen or the hearing with the impression that there is a difference of opinion. I am just seeking the facts here, and I certainly thought that the front-end load was mentioned in your testimony? Mr. HAGEr. There is no reference to it. Mr. LYMAN. In my testimony? Mr. KEITH. Yes. Mr. LYMAN. None. Mr. KEITH. Is not a front-end load contemplated in the Reader's Digest operation? Mr. LYMAN. My understanding is that there is a load but it is in a European operation. It isn't a front-end load, Mr. Keith. As I say, my only information is the newspaper. Mr. KEITH. It is not a front-end load? Mr. LYMAN. No. It is a load. Mr. KEITH. It is a contractual plan, is it not? Mr. LYMAN. That I don't know. I just thought they were selling shares with a load abroad. We can find out. We have a representative from Loomis-Sayles here. Mr. HAGEY. Sir, I am advised by a nod from a representative of Loomis-Sayles that it is not contractual. Mr. LYMAN. It is not a contractual plan. It has a load but not a front-end load. Mr. COHEN. In any event, that aspect of Loomis-Sayles business is simply not involved in the presentation today of a group of no-load funds sponsored by investment counsel firms. Mr. KEITH. And the recommendations contained in the Special Study are, insofar as mutual funds are concerned, consistent with those that you are supporting here today. Mr. COHEN. I am confident there is no inconsistency whatsoever. Mr. KErrH. Thank you, Mr. Chairman. (The following letter was received by the committee:) SOUnDER, STEVENS & CLARK, Bo$ton, Mass., Noven~ber 3, 1967. Hon. hAsTINGs KEITH, House of Representatives, Washington, D.C. DEAR MR. KEITH: This is in reply to your letter of October 27, 1967, addressed to our group of Investment Counsel Sponsored No-Load Funds, among others. Question 11, the only one. addressed to our group, reads as follows: "What changes in the proposed legislation may be necessary to accommodate and encourage no-load funds?" The changes that we consider necessary for this purpose (apart from the changes in so-called "secondary" proposals that have been agreed to by the Securities and I~xchange Commission and the Investment Company Institute) are as follows: 1. All of the members of our group are within the category of companies for which Congress made special provision in section 10(d) of the Investment Com- pany Act of 1940. We are not in a position to speak for or comment about the rest of the industry, but we strongly feel that, as applied to companies qualify- ing under section 10(d), no need has been shown for amending section 15 in the manner proposed in H.R. 5910. In particular, proposed new subsection (c) of section 15 would amount to abandoning the concept of no-load funds embodied in section 10(d) and, for reasons summarized in my testimony on behalf of our group, would be the single most important obstacle to our type of no-load in~ PAGENO="0165" 579 vestment company. Therefore, our primary suggestion is that, if section 15 is amended in anything like the fashion proposed, there should be an express ex- emption for section 10(d) companies, at ieast from the propoised new subsection (c). 2. The list of criteria of reasonableness set forth in proposed paragraph (2) of subsectionS (d) of section 15 of the Act seems to us to be very one-sided and unbalanced. For example, although the Commission had suggested in its Report on Public Policy Implications (at page 145) that reasonableness should not be measured merely by "the cost of comparable services to individual investors" or "the fees charged to other externally managed investment companies," it failed to list either of these two important factors in proposed paragraph (2). We believe that if anything like the proposed section 15(d) is adopted and made applicable to section 10(d) companies, paragraph (2) should be omitted entirely. 3. The new requirement in proposed subsection (a) of section 15 that com- pensation for investment advisory services and for all other services be stated "separately" would also present particular difficulties for section 10(d) com- panies, in light of the circumstances that (i) the counseling firms that render advisory services to them are primarily in the business of rendering counseling services to other clients, so that unusual allocation problems are presented, and (ii), by reason of restrictions contained in section 10(d) itself, the manage- ment fees paid by the no-load funds must absorb some kinds of expenses that the rest of the industry can take care of as a fund expense or through the load. Since the Commission's Technical Statement indicates (at pages 4-5) that this new treatment in subsection (a) is essentially in aid of provisions of para- graph (2) of subsection (d) that we suggest be deleted in any event, we be- lieve that the proposed requirement to state compensation "separately," if adopted for other investment companies, should not apply to section 10(d) companies. 4. While the subject is not directly involved in the proposed legislation, we believe that a further measure to accommodate and encourage no-load funds would be to liberalize somewhat the present "tombstone ad" requirements. It is not apparent to us why further relaxation could not be accomplished within the existing statutes, but if the Commission feels that its present rule 134 goes as far as possible without statutory amendment, either a broatlening of present section 2(10) (b) of the Securities Act of 1933 or a special provision in the Investment Company Act as to advertisements of investment companies might be needed. Respectfully yours, RONALD T. LYMAN, Jr. (For the group of Investment Counsel Sponsored No-Load Funds). Mr. MUTRPHY. The committee will be adjourned until 10 a.m. tomor- row in room 2123. (Whereupon, at 12:30 p.m., the subcommittee adjourned, to recon- vene Wednesday, October 18, 1967, at 10 a.m.) PAGENO="0166" PAGENO="0167" INVESTMENT COMPANY ACT AMENDMENTS OF 1967 WEDNESDAY, OCTOBER 18, 1967 HousE OF REPRESENTATIVES, SUBCOMMITrEE ON COMMERcE AND FINANCE, COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE, Wa8Mngton, D.C. The subcommittee met at 10 a.m., pursuant to notice, in room 2128 Bayburn House Office Building, Hon. John E. Moss (chairman o~ the subcommittee) presiding. Mr. Moss. The committee will be in order. We are very pleased to introduce our first witness this morning, who appears at the request of the committee, Prof. Henry C. Wallich, professor of economics, Yale University. Professor Wallich. STATEMENT OP HENRY C. WALLICH, PROFESSOR OP ECONOMICS, YALE UNIVERSITY Mr. WALLICH. Mr. Chairman, I understand it is agreeable to you if I summarize my statement. Mr. Moss. Certainly it is. We will receive your statement for the record, and you may summarize it. (Mr. Wallich's prepared statement follows:) STATEMENT OF HENRY C. WALLICH, PROFESSOR OF ECONOMICS, YALE UNIVERSITY CAN THE MUTUAL FUND BUSINESS BE IMPROVED ?-THE INVESTMENT COMPANY AMENDMENTS OF 1967 The economics of mutual funds reach far. Judgments must take into account distant ramifications and allow for exceptions if they are to avoid being contra- dicted by particular instances. it is safe to say, however, that the growth of mutual funds has on the whole been beneficial to their holders and to the economy. The issue before your Committee, as I see it, is improvement, not reform. Holders have benefited, for the most part, by a good rate of return. In times when inflation falsifies the true return on fixed dollar claims, mutual funds have made it easier for the small investor to hold common stocks and have given him shelter against this form of loss. Mutual funds protected him against some of the risks of stock ownership by offering a degree of diversification that he could not have easily and cheaply attained on his own. The economy has benefited by an increased demand for equities. While, the stock market does little in the way of providing capital for business, it does indirectly encourage business investment if it lowers the cost of capital. A high price-earnings ratio for common stocks is the analogue of a low interest rate on bonds. It enables businessmen who are alive to their cost of capital to reach out farther for investment opportunities than they could at a higher cost of capital, even if they do no new stock financing. With price-earnings multiples almost doubling compared with the late forties, this cheapening of investment funds must have stimulated business investment In plant and equipment, even though bond rates and mortgage rates are probably higher because money has (581) PAGENO="0168" 582 gone into stocks. In promoting this trend toward a lower cost of capital for business, the growth of mutual funds can claim a share. The zpread of stock ownership through mutual funds has improved the distribution of income and of wealth. It has strengthened the foundations of our private enterprise system, even though we are still far from a true People's Capitalism. These are important achievements. Mutual funds bav4~ been good also to the securities industry. This, too, is grounds for satisfaction .Tbe industry is a valuable part of the American econ- omy. Its welfare is important, as is the personal welfare of the individuals that draw their living from jobs in the industry. Nevertheless, a reader of some of the literature that is building up around these hearings is bound to feel some concern over the role that consideration of welfare of the securities industry may play in any new legislation. It is in the nature of things that a large part of the literature should be coming from the industry. They must defend their interests, and they are doing so very ably. But this should not obscure the fact that the chief objective is welfare of the mutual fund investor and of the entire economy. Without implying criticism, it is pertinent to recall what the role of Govern- nient has 1~een whenever it has concerned itself with competition in an industry tb~t is not perfectly competitive. It has started out to protect competition, and ended by protecting competitors. Some such danger seems to loom in the present case. Hopefully, and quite probably, the securities industry will ultimately benefit from an improvement In mutual funds legislation through broadened public acceptance, greater sta- bility, enhanced competitiveness. But the Issues cannot be discussed principally from the point of view of how they would affect the industry. Areas for improvement If ownership of mutual funds is predominantly good, it is pertinent to ask why changes should be proposed. At least temporarily, these changes could in some cases lead to persons not buying shares they would otherwise have bought. One answer is that investors may believe themselves to be buying something that in fact they are not buying, such as superior market performance. This applies particularly to the advisory fee. A second is that even very desirable results may be bought at too high a price. This applies, I believe, particularly to the sales load or sales charge, and to the front end load. Finally, a desirable activity may produce side effects, that are not desirable. This applies to the heavy trading activity, to the resulting speculative climate accompanied by potential market instability, and possibly the excessive absorption of human and material resources into stock market activity. I shall take up these matters in the foregoing order. Advisory fee The Securities and Exchange Commission believes that the advisory fee paid by mutual funds to their investment advisers is in many cases too high, and recommends that it be subjected to standards of reasonableness. The Commis- sion bases its case partly on comparisons with the cost of other ways of investing in comon stocks, and partly upon the failure of economies of scale to be reflected in many of the fees. The industry, through various spokesmen, has replied that the fees actually charged are lower than the Commission thinks, do .not compare unfavorably with completing media, and do reflect economies of scale. The difference here is partly one of presentation of statistics, partly of proper choice of comparisons, partly even of semantics. In my view, *the Commission's way of summarizing the complex facts is substantially right in terms of what it is proper to compare and what data to use. Neither side, however, seems to have considered the conclusion that seems to emerge from the studies of technicians that the true value of investment advice is on average virtually zero. This follows from the "random walk hypothesis" that has become familiar through numerous academic writings of recent date, The random walk hypothesis,1 strictly speaking, has been discussed and em- pirically tested principally with respect to the influence of past movements of the stock market upon subsequent movements, i.e., with the effect that chartists believe themselves to be exploiting. The evidence strongly suggests that there is 1See Paul H. Cootner, editor, The Random Character of $tock Market Prices, MIT Press, 1964. PAGENO="0169" 583 no such influence of past movements. The random walk hypothesis can be ex- tended to all past events on somewhat restrictive assumptions that in practice are likely to be met only in part. The theory is supported, however, by frequent find- ings that randomly selected portfolios on average tend to do as well as or better than the average of mutual funds.2 The random walk hypothesis says that, in a perfect market, all past events that could possibly influence the price of a stock have already been discounted by the market and that the next move is therefore entirely unpredictable. The chances of an upward or downward move, to be sure, need not be equal. If there is a long run upward trend, as there appears to be in the stock market, the upside chances are always a little better. But, according to this theory of complete discounting of all that is known, and subject to the re- spective probabilities, neither research into the company, nor the industry, nor the whole economy, nor chart reading, would enable one to predict the next move, or any thereafter, better than a random guess. Implied in this hypothesis is that the market responds instantaneously to news. Only then will those who have the news not be able to buy a stock before the news becomes discounted. Implied also is that such forecasts as are made are not self- fulfilling, i.e., that a fundamentally unfounded belief that a stock will go up does not lead to a large amount of buying that does put it pp. Neither condition is fully verified by today's markets. News does not travel instantaneously, and in- vestors, especially fund managers seem to watch and follow each other in a way that makes some professional's forecasts self-fulfilling. Furthermore, although I have no statistical basis for saying so, it is my belief, based on some 30 years acquaintance with the stock market, that there are a few superior individuals who do see farther than the rest. They therefore can discern and act on factors that the rest of the market has not yet `seen and discounted. They can then turn in a consistently superior performance. Occasional superior performance, it hardly needs adding, is `commonplace. Somebody must always be holding the stocks that are going up. Only consisten'cy can be accepted as evi- dence of possession of really superior powers. But even of those rare individuals of this caliber whom I have been privileged to know, one of whom wrote what was long the leading textbook in stock market analysis, I fear I cannot say that they permanently escaped the law of the market. The market learned their methods, and used them until stocks again by and large tended to sell for what the best judgment thought they were worth. When discounting has been pushed to that point, the best judgment can do no better. When large numbers of investors are seeking out stocks undervalued by some standard, there will cease to be undervalued stocks. When everybody is buying growth st'ocks, these will sell at a price that makes them no more attractive than other stocks. This mechanism appears to be what prevents mutual funds from doing better than random choice. Studies I have seen by Irwin Friend and Douglas Vickers, by William Sharpe, and recently a Ph.D. dissertation by George Douglas at Yale have all shown that `mutual funds on average do not do better and usually do worse than random selection. This proposition, which for academic purposes would have to be stated subject to certain technical qualifications, cannot be refuted by comparing the rise of particular funds with each other, or with that of any of the averages. Aside from the fact already mentioned that we are speak- ing of average performance, proper measurement requires that rjsk be taken into account. Different funds deliberately seek different degrees of risk. They are thus not comparable in terms of their capital gains and current income alone. Risk is usually measured by the variability of a portfolio, i.e. by the dispersion or range of its rate of return, taking capital gains and current income together. When risk is so measured, it turns out that indeed the mutual funds that accept higher risk have on average a higher rate of return. But it is also shown that an average of randomly selected portfolios will usually have a higher rate of return for a given risk, or a lower risk for a given rate of return, than mutual funds. George Douglas' dissertation showed something else. There is available a tech- nique, worked out originally by Harry Markowitz, which enables a portfolio manager to reduce his risk for a given rate of return, or achieve a higher return 2For econometric studies of mutual fund performance, see Irwin Friend and Douglas Vickers, "Portfolio Selection and Investment Performance," Journal of Finance, September 1965, pp. 391-415; William F. Sharpe, "Mutual Fund Performance," Journal of Business, January 1966, pp. 119-138; George W. Douglas, Risk in the Equity of Markets: An Empiri- cal Appraisal of Market Efficiency, Yale Ph. D. dissertation, 1967, especIally pp. 45-53. PAGENO="0170" 584 without having to accept a higher risk. The technique consists in isolating securi- ties that move independently of, or even counter to, the market. It rests on the fact that a portfolio in which all stocks move in the same way is no better diversi- fied than any single one of these stocks. If this seemingly simple principle were widely practiced, its usefulness, like that of all other stock market techniques, would of course disappear. Independently moving stocks would be pushed to high prices at which they could cease to have special attraction. But Douglas was able to show that the market does not avail itself of this technique, although some superior investors may do so. `This finding, aside from Its technical interest, further helps to dispel belief in the superiority of most professional management. Those who find it difficult to believe that there should be no pay-off to the vast mass of research that Wall Street pours into the securities market may want to consider also some specific disabilities under which the mutual funds labor. One of them is that their big cash inflow comes when the market is booming. `They therefore tend to buy more securities when the market is high than when it is low. This is inverse dollar averaging. It leads to paying a higher than average price In the course of a marekt fluctuation. (One of the few good techniques that are open to an investor with a stable cash flow is real dollar averaging_investing the same amount periodically and thus buying more shares when they are cheap than when they are dear. This technique, too, would of course be neutralized if enough investors had the means to follow it.) A second disability of the larger funds' Is that they can obtain worthwhile posi- tions only in the stocks of larger companies, and tend to put prices up against themselves when they buy aggressively. Another side of this is the apparently deliberate use, in some cases, of such buying power to run up prices. A third is the desirability, for purposes of salesmanship, to show a good posi- tion in the most lately popular stocksL Otie must hope that there is no truth to the story of the salesman who complains to his manager that prospects won't buy the fund because it has no XYZ stock, whereupon the manager a few days before statement days buys himself a position in XYZ at top prices. But one cannot be sure. If evidence is desired of what some market professionals think of the value of some professional management, there are the closed end investment funds. Their shares are selling in the ~market like any other stock at a freely fluctuating price. They provide the same kind of managment-sometimes ~by the same in~ dividuals-as mutual funds. With few exceptions the closed end funds sell at substantial discounts from the market value of their portfolio, of the order often of 20-30 percent and even more. This cannot be explained on the grounds that their purchaser buys some un- realized appreciation in which he has not participated but on which he must pay the tax when the gains are realized. The asset value of these funds would have to consist entirely of unrealized appreciation to justify a discount of at most 25 percent at present tax rates. Moreover, there is the prospective reduction in capital gains tax liability that results from the lower price of the stock when It goes ex its capital gains dividend. The fact is that, where there is no sales pressure, the market puts a negative valuation upon investment manage- ment. The unexploited availability of investment management at a discount naturally raises a question regarding the justification of a substantial advisory fee for mutual funds. Needless to say, a fund will always have expenses' connected with its opera- tions. For these it must charge. The SEC data show that the nonadvisory ex- penses have varied widely, with a median of .09 percent. In some eases operating expenses appear to be covered out of advisory fees. What has been said so far applies logically to all investment advice, not just that paid for by mutual funds. On average its result are unlikely to be better than random choice, its value therefore very low or zero. This does not mean that the individuals engaged in investment analysis are not in general very able people, doing a competent job. But by the nature of their work they all-except- ing possibly a very few superior people-tend to neutralize each other. It is much less meaningful, therefore, to compare the level of mutual fund advisory fees with other fees, than to raise the question how far any of these fees are econom- ically justified. In any event it seems clear that whatever can be done without undue interference with the market to bring down mutual fund advisory fees,. as the Ootnthission proposes, will be a step in the right direction. PAGENO="0171" 585 On the manner of implementing this proposal I would like to limit myself to the following observations. The best method of correcting a price that for somo reason seems unjustified is always to get the market itself to go to work. In the present case, one would suppose that the market would do the job if enough buyers of investment advice came to realize that they are trying to buy some. thing that in the nature of things is ordinarily not to be had. But this realization is unlikely to come from abstract reasoning. It is much more likely to result from repeated. demonstrations that carefully selected portfolios are no better than randomly selected ones. That this suspicion is dawning now on a lot of in- vestors is evident from the growing~dem.and for periodic evaluation of investment performance, something almost unheard of in former times. But these evalua- tions, even when correctly done, taking into account risk, which is rarely the case, have an unfortunate consequence. The advisory and investment manage- ment organizations feel impelled to improve their performance by more frequent switthing. While this is unlikely to improve their results, it does lead to very heavy trading, instability of particular stocks, and potential instability of the whole market. Thus the normal means of bringing about the correction of a disequilibrium price seems to be attended in this instance by high social costs. It may, moreover, take a long time before Investors, who inevitably look at In- dividual, non-average cases, convince themselves of how poor are their chances of finding one of the rare superior individuals to advise them and thus having better than average prospects. Thus in the case of mutual funds, it seems desirable to follow the line of ap- proach that the Commission is proposing. The sale$ load The Commission proposes to put a ceiling of 5 percent on the sales charge (expressed as a percentage of net value invested), equal to a sales load of about 4.76 percent (expressed as a percentage of gross amount paid). For the numer- ous funds now quoting a sales charge of 9.3 percent or sales load of 8.5 percent, this would involve a substantial reduction. The industry has replied that this involves a form of public utility type regu- lation that is unwarranted in a competitive Industry. If enacted, the arbitrary reduction in sales load would cut the margin available for the underwriter, the distributing retail dealer, and the salesman. Many distributing firms would be seriously hurt, some would go out of business, fewer salesmen would sell funds, the investor would end up owing fewer shares, mutual funds would cease to grow rapidly. Of these possible consequences the weightiest appears to me the prospective reduction in the number of shares reaching the Investor. It is plausible that at least in the short run this would be a consequence of a lower sales load. It seems generally recognized that mutual funds are sold, not bought-else why should closed end shares go begging in the open market at a discount? A lower volume of sales would hurt the investor and the economy, although it is impossible to say how much. No one knows whether investors ceasing to buy mutual funds would cease to save altogether, or save in fixed dollar claim form, or perhaps even buy stocks in some other way. A survey of buyers of front end load funds indicated that about 75 percent would not buy common stock in any other form. These buyers, however, are subject reportedly to particularly vigorous salesmanship. The possible injury to the industry likewise deserves attention, although it does not strike me as the primary consideration. These effects have been analyzed In some depth by the industry and by the Commission staff. Since the analysis deals with the effect of all the Commission's recommendations, their discussion will here be postponed. Though a sales load of 8.5 percent sounds high, there would be no basis for public intervention in the pricing process, provided the industry were com- petitive and buyers had adequate information. On both scores, however, the industry falls short of perfection: it relies on government enforced price main- tenance at the retail level, under Section 22(d) of the Investment Company Act, and the product it sells contains a good admixture of hope along with informa- tion. There is opportunity for competition at the top: underwriters are free to set, and do set, any sales load they choose. Some choose zero. The industry seems strongly opposed, however, to introducing competition at the retail level, which otherwise would seem to be the obvious answer to the problem of possibly exces- sive sales loads. The Commission supports the Industry in this regard. PAGENO="0172" 586 It Is important to examine the competitive situation at the top, because this may give a clue as to what would happen at the retail level if price maintenance were removed. The existence of what appears to be a very high sales load sug- gests that competition is not very active. The industry claims that the load has been coming down, not by reduction of the maximum rate charged, but by such devices as cumulated purchases becoming eligible for volume discounts and load-free reinvestments of dividends. The SEC thinks that the trend of the sales load is more correctly described as upwards. Industry representatives argue that many transactions at the top load rate are so small that the under- writer loses money, unless they are followed by repeat orders of larger size. Indeed some underwriters lose money on their overall underwriting operations. They may recoup, however, on advisory fees and, directly or indirectly, on brokerage commissions. The fact seems to be that sales effort tends to be pushed to the point where the marginal transaction leaves no profit, no matter how high the sales load. There is then no strong reason why the sales load should change in response to competition, no matter what its level. The same conditions might prevail if the load were 10.5 percent, or 12.5 percent, except that the total volume of sales would be enlarged by an even greater number of even smaller transactions. If this interpretation is approximately correct, it would follow that competi- tion may exist at the wholesale level, even though it does not lead to a decline in the sales load. It is a competition to attract salesmen more than to attract investor~s. It tends to push up the reward paid to salesmen, so that the sales load does not come down or may even tend to rise. If there is some tendency toward competition at the wholesale level, there is no reason to assume that it could not exist at the retail level. At present, how- ever, competition at the retail level is prohibited under retail price maintenance. Thus it seems likely that retail price maintenance is not an empty gesture, but is effective in preventing a competition that would otherwise exist. The conclusion that retail price maintenance is important is confirmed by two additional considerations. One is that the offer of an identical product at'a lower sales load is more likely to make the buyer switch salesmen than would the offer of product that is merely similar. To be able to buy fund A at ~a 4.5 percent load instead of 8.5 percent is a strong competitive argument, whereas Fund B at 4.5 percent instead of Fund A at 8.5 percent may not be. A second consideration harks back to the pre-1940 history of the mutual fund industry. Intensive competition then apparently prevailed, which led to the establishment of price maintenance through the Investment Company Act of 1940. Terminating retail price maintenance and allowing competition instead of regulation to determine the sales load may involve unforeseeable consequences. On the other hand, if price maintenance is continued, a good case exists for regu- lation of an industry that in one important phase of its operation is. not com- petitive. Before the grave step toward regulation is taken, however, it is well to examine in more depth whether the termination of price maintenance would really lead to the chaotic conditions some membOrs of the industry predict. It is claimed that a "bootleg", i.e. free, market would then arise in which investors wishing to redeem could sell their shares at slightly more than the current market value which the fund itself offers. T'heshares would then be resold for loss than what the fund would charge (including sales load). Such a market which would be perfectly legitimate, `would obviously be beneficial both to investors who redeem and Who purchase. The fund would lose the sales load on the shares turning over in the market instead of being reissued by it. The industry appears to believe that net sales also would suffer, presumably because the availability of shares in the market would drive down the sales load and reduce the interest of distributors and salesmen in pushing new sales. In that event, it is argued, funds might at times face an excess of redemptions over sales. While this would mean a shrinkage of the funds' assets, it would by no means mean a major crisis, since the funds' assets have a ready market. While funds as a group apparently have rarely if ever in recent years been net sellers of stocks for any length of time, such a condition ought to be no calamity. It would tend to depress the stock market, but orderly selling should be capable of being absorbed. Industry sources also seem to believe that ending price maintenance would give a competitive edge to those funds that maintain their own sales organizations currently representing some 40 percent of the industry's `assets. These funds would be able to prevent their salesmen frOm etitting the load, i.e. could exert PAGENO="0173" 587 internal price maintenance. While this `night imply a major competitive read- justment, it is not clear that the gains to investors would not make it worthwhile. It is claimed further that reduction of the sales load would encourage investors to switch among funds. This could of course happen whether the load was reduced by removal of price maintenance or by regulation. Funds with unfavorable investment results would suffer net redemptions. They would be impelled to im- prove their performance by more active trading with the attendant greater in- stability of markets. While these results are possible, the magnitude and gravity of the consequences seem to add only very moderately to the case against ending price maintenance. The issues in the area of sales load may be summarized as follows: 1. The mutual fund industry now enjoys a partial shelter from competition, i.e. at the retail level, through price maintenance. This creates, a prima fade case for regulation of the sales load, although the case must be buttressed by evidence that profits of the underwriter, adviser and broker, often the same party, are excessive, or that costs are unreasonable compared with the cost of other means of buying securities, and interms of the service rendered by the seller. 2. Removal of price maintenance would end the case for regulation. This solution would be far preferable to regulation, if it does not produce excessively harmful repercussions. 3. Both regulation of the sales load `and termination of price maintenance may reduce the volume of mutual fund sales, although the extent is' very un- certain and would depend, in case of regulation, on the maximum sales load fixed. If the reduction is large, the injury to investors who no longer receive the attention of `salesmen and cease to buy mutual funds would have' to be counted up against the gain to those who continue to `buy. If the reduction should be so large as to materially influence the level of stock prices, this broader implication for the welfare of `stockholders and the economy would also have to be considered. In my personal judgment, an alternative approach that would be worth exam- ining is to remove retail price maintenance. If this is judged too severe, or too fraught with uncertainties, the `level of retail price maintenance might be cut to, say five percent. Flexibility might be allowed for subsequent further re- ductions. Front end load The Commission's recommendation that the front end load be abolished raises the same issues `discussed in connection with the regular sales load, but in a much intensified form. The basic issue again is whether a whole group `of `potential buyers of a useful service or product `should in effect be deprived of the oppor- tunity to acquire it because a minority of this group is subject to exorbitant selling costs and possibly to more serious abuses. The front end load is a means of selling mutual funds to "investors" on so small a `scale as to justify the salesman's time only if periodic subsequent pur- chases are made without further selling effort. Since the salesman's work is done at the beginning, he must be paid at that time~ Potentially the payment could be financed by the salesman's employer. This, however, would require working capital which some employers do not have, who would then have to drop the business. Alternatively, the salesman's compensation can be taken out of the early installments. In that case the cost becomes wholly disproportionate to what the investor buys during this period. A similar situation exists in life insurance. To many persons, however, the value of insurance is likely to be higher than the advantages of mutual fund ownership. A certain analogy can be seen also with respect to small loans, where very high interest charges have been made legal in many states. Again, however, the benefits o'f these loans in many instances will he greater than fund owner- ship. The purchase of a contract may induce individuals to save who otherwise would not do so. This seems broadly desirable. The front end load, by imposing a penalty on discontinuance, strengthens the incentive. The `high lapse and re- demption ratios presented by the Commission nevertheless indica'te that these inducements have only limited power. There are other ways, moreover, in which an individual can impose upon himself an even more powerful discipline to in- duce saving, such as insurance or savings bond payroll deduction. Given the modest circumstances of most buyers of front end load plans there Is a question ho~ many of them ought to be stock owners in any event. Insurance and some fixed dollar savings come befo're stock ownership. PAGENO="0174" 588 The high combitied lapse and redemption ratios indicate that many buyers are sold who should not have been sold. Not all lapses and redemptions mean losses, however. But all lapses and redemptions point to the high cost of what is bought ranging from a sum equal to the amount of savings actually invested (at 50 per- cent load) to at a minimum about 10 percent if the full plan is adhered to. Losses imply an excess of payments over liquidated value. Data from a sample of four funds presented by the industry show that the percentage of plans ter- minated with a definite loss ranges from 3.5 percent to about 33 percent for these four funds. However, the data understate because the plans listed as still active probably contain some number of plans that eventually will end with a loss. The loss per account is modest, of an order of magnitude of $100, according to in- dustry statements. Aggregate losses are small, while aggregate realized and un- realized gains are very large. The overwhelming predominance of aggregate gains over losses reflects to some extent the rise in the stock market, a factor that can- not be counted upon with assurance. The basic question is how far the gainers would be injured by measures d& signed to protect the losers. It should be noted that in the front end load area, the Government has already enmeshed itself in regulation, since the Investment Company Act limits the first year load to 50% and the overall load to 9 percent. The issue therefore is not one of favoring regulation in principle or objecting to it. It should also be noted that the industry apparently is satisfied with this regulation and does not in gen- eral seem to argue that free unregulated competition could be trusted to take care ~of this particular problem. Enough evidence has been presented by the Commission to make plausible that some changes are desirable in the front end load area. Two possible solutions might be explored as alternatives to, or modifications of, the rigorous approach chosen by the Commission. 1. A reduction of the permissible front end load to 20 percent. This would make the first year's load little more than twice the usual 8.5 percent load. If the dealer puts up another 10 or 20 percent, which he would recover from future installments, the compensation to the salesman would not' be much less than at present. The range of prospects who would be given an opportunity to buy mutual funds would be reduced only moderately. 2. Leaving the present load unchanged but requiring some compensation to be made to holders who redeem at a loss. The cost of this could be charged partly to the salesman, which would encourage him to be more selective. The rest would have to be borne by the dealer and perhaps the underwriter, again encouraging a more conservative selling approach. Concluding remarks It may be helpful to the present legislative effort to view the stock market and the mutual fund industry in terms of the broader evolution of our financial system. One of the principal trends in this evolution has been the advance of institu- tionalisation. This has meant the growth of intermediaries that convert the pri- mary obligations of particular borrowers into assets more convenient to hold for particular investors. In the market for corporate bonds, it has made possible the raising of capital with a minimum need for appeal to individuals. The bond market in this way has become a mass production operation functioning with low turnover, low costs, and yet indirectly providing high liquidity to Individual savers through depositary institutions. Mutual funds have initiated a similar development in the stock market. The stock market is still predominantly the domain of individual investors, as the bond market once was. The amounts of new money that it raises are minute compared to those raised by the bond market-in 196g, $2.5 billion of stock against $15.6 billion of corporate bonds alone. The gross income that the securi- ties business draws from commission business and other activities related to stock transactions probably exceeds the amount of money raised for industry via new stock issues. As a money raiser the stock market is extremely inefficient. Most of its operating cost must be allocated to the provision of liquidity, if indeed it can be said to have a productive function. Mutual funds in the course of time probably will make the stock market more like the bond market. Perhaps the amounts of new capital raised in it will never be very large, since industrial equity money comes largely from profit re- tention. But mutual funds can provide liquidity to individual investors much as commercial and savings banks do, without need to turn over primary securities. PAGENO="0175" 589 This evolution can be viewed as desirable and also as probable because it fol- lows a pattern that has been tired and that is economical. The special character of common stocks, with their speculative attraction, will probably impede a fully parallel development. But the general direction may turn out to be thesame. Prob- lems of voting control would have to be solved, perhaps by limiting the percentage of the total votes that may be represented by mutual fund votes. This could be made to enSure any desired degree of noninstitutional stockholders' control. At the present time, however, while already acting as important intermediar- ies, mutual funds are far from performing the function of reducing the turnover of primary securities. They are adding to this turnover, and are probably making the stock market less rather than more stable. This is not the pattern of the bond market. It is a very expensive way of meeting the very limited pur- poses it serves. In trying to create a legislative framework within which the mutual fund industry can freely evolve, thought should be given to ways in which the pattern traced successfully by the bond market can be transposed, with appropriate modifications, to the stock market. Mr. WALLICH. I would like to say that it is a great honor to appear before this committee. I have had a practical interest as a security analyst in the stock market for something like 30 years, and from that vantage point I have the firm conviction that mutual funds are a good thing for the American people. If they didn't exist, they would have to be invented; particularly in an age of inflation, here is a way in which relatively low-income people can participate in growth, and can protect themselves against inflation. If what I am going to say may sound critical in some respects of the funds it is simply selecting some negative aspects. It does not mean that I am critical of the whole institution of mutual funds. The areas for improvement that have been picked out by the Com- mission are the advisory fee, the sales load, and the front-end load. I would have a few more to add to these; for instance, the problem of whether the funds are creating an unnecessarily speculative climate. On the advisory fee, the Commission argues that it is too high. They present data to support this. These data are controverted by the in- dustry. As always, it is a matter of how to read statistics and what statistics to read. My judgment is that on balance the interpretation put upon the data by the Commission is much more nearly right than the interpretation put upon them by the industry, able as their pres- entation has been. I think the Commission is right in asserting that charges are too high. But one can go one step further. If the charge were related to per- formance rather than to the mere fact that a mutual fund with diver- sified risk is being offered, then one ought to measure performance and see if mutual funds really do better than random selection. A good deal of evidence has accumulated lately that that is not the case. In other words, throwing darts at the stock market page on average over a period of time gives about the same results. Now this has to be understood in a very precise way. One has to com- pare portfolios of the same degree of risk. It is no use comparing a portfolio of relatively stable stocks with a portfolio of high flyers. ~In the `comparable case, the evidence seems to show, on the basis of a pretty exhaustive econometric tests, that on average in the long run mutual funds for the same risk have no better return, and for the same return have no less and often more risk, than randomly chosen portfolios., This means that it is no use comparing mutual funds with the Dow- Jones average or any other average, because that leaves out of account PAGENO="0176" 590 the risk factor. The risk factor can best be measured by the spread over which the securities fluctuate. The wider the fluctuation, the wider the risk. It appears that the rapidly moving stocks are the wide risk, wide fluctuation stocks. It is therefore quite possible to put together a fast moving portfolio. If the risks do not have the consequences they might, this portfolio will do better than a lower risk portfolio. That is the simple consequence of the fact that investors dislike risk. They put a premium on safe stocks and they put a discount on high risk stocks. If one is willing to accept risks, one can buy fast growth high return stocks, and do well so long as nothing ha.ppens. Mr. Moss. Professor Wailich, would you prefer to complete your summary in advance of questioning or would you like to discuss as you move along? Mr. WALLICH. I would be perfectly happy to do the latter, assuming that after we have taken say one-third of the time on this topic, if that is your pleasure, we could go on to the next, because I have basically three broad topics to talk about. Mr. Moss. You may proceed. Mr. WALLIdH. It wasn't stated on the recoi~d. Mr. Moss. Also in introducing Profesor Wallich I wanted to say I believe you were a member of the Council of Economic Advisers to former President Eisenhower. Mr. WALLIcu. That is right, Mr. Chairman. Mr. Moss. Thank you. Mr. WALLIOH. Congressman Keith, do you wish to pause at this point? Mr. Moss. You proceed with your summary. Mr. WALLICH. Very good. The upshot from these considerations is the following: The statistical evidence shows that by and large random portfolios, blindly picked portfolios, do as well as expertly picked. There are some exceptions which do not prove or disprove the rule. The overall evidence still stands. The conclusion is that on av- erage and in general investment advisory fees are unjustified, be- cause investment advice is worth zero. Now that doesn't mean that particular funds haven't done well, haven't done better than the average, or that particular funds haven't done well in particular years. I am speaking of a long-term broad average, the kind of experience that an investor would have if he invested over 20 or 30 years. He would on average be as well off throw- ing darts as he would be attaching himself to the fortunes of a fund. If that is true, then clearly the function of the funds is not to pro- vide superior performance. It is simply to provide diversification of risk. That they can do with one man and a secretary. There is no need for an elaborate research staff. If next I may turn to the subject of the sales load, there are two as- pects to be considered. One is the ordinary load of 8.5 if expressed as a load, and 9.3 if expressed as a sales charge, and the front-end load. It is necessary first of all to point out that this is not a competitive industry. It is a monopolistic industry with the Government prevent- ing competition at the retail level. A salesman cannot come to me and say "My normal charge is 8.5 percent butT will let you have it for 2." He would be acting illegally~ PAGENO="0177" 591 Once this kind of Government regulation enters; the arguments for a free market and for nonregulation fall by the wayside. Once a monop- oly has been created, there is a strong case for regulation. In this country we have always regulated natural monopolies. Mutual funds have a Government-created monopoly at the retail level. There is a case for regulating it. My preference would be to abolish retail price maintenance; that is, eliminate section 22(d). I do not believe that the consequences would be disastrous. I do not believe that this would lead to heavy net sales of funds, and if it did, I think the market could probably absorb them. I suspect that the problem between the captive sales forces and the salesmen of the other funds could be ironed out also. I do think that at least temporarily it might lead to a lower volume of sales. Here one has to make a value judgment. Mutual funds are a good thing. Even a good thing can be brought at too high a price. We would all agree if the sales charge were 50 or 100 percent, that would be very high. Whether 8.5 is right or 5 is right or 15 can become a matter of difference among reasonable men. It is said that this proposed regulation would affect the fortunes of the industry. If we went to 5-percent sales load, it is said it would lead to a lot of' losses of jobs. I would argue this way. If we raised the charge to 15 percent, we could employ still a lot more people in the industry. We are thus implicitly depriving potential people of a potential job by having the present charge. The fact that some people would lose their job has to be seen in that perspective. These salespeople are on the whole, one can say, not very well paid. I think $7,000 is the median average income. This is something that a halfway competent salesman can make in a lot of other lines. It is not at all clear that a great favor is done to these salesmen by keeping them in marginal positions selling funds, unless a strong case can be made that these funds ought to be sold because the buyers ought to have access to funds. On that question I agree a reasonable case can be made. Mutual funds are a desirable thing to have. They are worth paying for. They are worth paying `a substantial sales load. But considering the ways in which people can be sold without the sales charge, I think 8.5 percent is too high. Today people can be sold through newspapers, they are sold through radio, and there are ways of getting to low-income people by word of mouth. All that suggests that once the ice `has been broken-and surely the ice on mutual funds was broken long ago-we can go to a lower charge. Turning next to the front-end load funds, if I may refer to a per- sonal experience, I started analyzing this issue with the preconception usual among economists that `a 50-percent front-end load is a very bad thing. I partly unsold myself on this as I looked at the evidence. It seems clear that front-end load sales go to a different type of buyer, one who otherwise really wouldn't have a chance to buy, and who probably is not a reader o'f the financial pages of the Times an.d the Wall Street Journal and similar newspapers. He has no access to funds. He would never buy. He would never get the benefits. Therefore, I think a case can be made for a front-end load. 85-~592-68-pt. 2-12 PAGENO="0178" 592 The present technique I think is perhaps excessively burdensome. There may be ways of improving it. This could be done through re- funds, for instance, to people whose contracts lapse. It could be done by lowering the overall commission somewhat, say to 20 percent from 50, and having the underwriter make up to the salesman the risk. It is clear that the salesman needs something like 50 percent to come to my door and spend an hour with me selling me $500 worth of mutual funds.He can't afford to spend that time for less. He has got to be paid. He can't wait to be paid either until I have fulfilled the contract. But perhaps this payment to the salesman could be made up from other sources, principally, of course from the principal underwriter. This leaves me with my last subject, which is speculative activity. Mr. KEITH. You mean you are not going to get into the question of fiduciary relationship. Mr. WAi~LIoH. Congressman Keith, this is a difficult one for an economist. I have no legal background, and I think I might be stray- ing out of my area of competence, if I have one. The problem of speculative activity: In the last few years we have had the appearance of the performance funds. They have unques- tionably done better than the average. Even if we look at the variance of the stocks, they may for a given risk have done better. Further- more, in declines they have not, like some of the stocks they held, gone down very far. For the most part, they have performed pretty well on declines too. There is, therefore, the question whether the performance funds really are in accordance with the theory I have propounded before, that on average one cannot do better than the averages, allowing for risk, because all that is known has already been discounted by the exist- ing price of the stock. I would say this. The theory behind the statement that it is diffi- cult to do better than the market is buttressed by a great deal of his- torical experience. It is buttressed also by some very obvious a priori thinking. If the performance funds defeat- Mr. KEITH. What kind of thinking did you say? Mr. WALLICH. A priori, in other words, theoretical reasoning. Mr. KErril. It sounds like a legalistic term. Mr. WALLICH. It is. Mr. KErni. I didn't think you had the competency. Mr. WALLICEEI. I stand corrected. Mr. KEITH. What does it mean? Mr. WALLICH. It means preceding from something prior; that is, in advance of evidence, or reasoning from prior general principles. However, in this particular case the evidence supports the a priori reasoning. And the evidence is heavy. It is not casual, of the kind that the industry has produced. That is what one would call casual evidence. If one believes the evidence and the theoretical re~sonin.g, one arrives at the conclusion that the performance funds are generating their own successes. That is to say, they influence the market, and that is why they do better. I have not really studied the detailed evidence on this, but two facts may be cited: (1) activity in the market has greatly stepped up since the performance funds made their mass experience; (2) high-priced stocks have begun to jump about in a PAGENO="0179" 593 manner that they did not use to do. Five percent, 10 percent, 15 per- cent per day has become commonplace. There are simple ways of generating one's own success without in the least conspiring. I don't assume that fund managers conspire with each other to bull a certain stock. But, as Chairman Martin of the Federal Reserve has pointed out, there are nevertheless similarities to the pooi operations of the 1920's. One simple way of making a spectacular impact on the market is to place a large order 10 minutes before closing, good for the day. Then the broker knows that he is going to lose that order unless he finds the stock right away. Then watch the stock take off and go. On the quo- tation sheet it will show X-Y-Z corporation up five points, 10 points, 15 points. The next day there is a great big pile of buy orders on the desk of the manager of a brokerage firm. The fact that funds very often go back into a stock after recently selling it also suggests that kind of activity. It doesn't suggest a well considered, long-run approach, such as looking at a stock on funda- mental grounds and saying "We want it at this price or we don't." People that go in and out quickly are speculative. Operating in great volume, they are likely to influence prices. These are my comments on speculative activity. I am not against speculation as such. Speculation performs a useful function. When speculation becomes destabilizing, however, it is bad. When specula- tion takes over and sucks in the public, it becomes dangerous. When smart speculators unload on less smart speculators, a real social prob- lem is posed. In other areas we do not allow amateurs to compete with profes- sionals. We do not allow a professional fighter to box an amateur be- cause the amateur would be slaughtered. In the stock market we seem to think it is all right to let the professionals loose on the amateurs. One justification for this open approach would be that by and large the pro- fessionals do no better than the amateurs. So let them fight it out. But if I believed that professionals can and normally do slaughter amateurs, I would consider this a real problem that would have to be dealt with. Thank you very much, Mr. Chairman. Mr. Moss. Thank you. Mr. Keith. Mr. KEITH. Thank you, Mr. Chairman. As I have listened to the earlier portion of your testimony, which I found really quite inter- esting and in a way reassuring and reasoned so far as the present posture of the industry is concerned, you mentioned that an individual could do just as well if he would sit down with a secretary and spend a little time thinking about it, and at that point I made a notation. Lots of us don't have secretaries. Others don't have the time, and there- fore we don't make those judgments, and we want to be reasonably sure, and so we buy a mutual fund because we want this spread, and we want reasonably good management. If we want to be speculative we buy a, performance fund. But at the same time there is an additional factor as to why we don't have that secretary. We have only got $20 a month, believe it or not. So I was reassured when later on in your statement you justified the front-end load in order to get the small buyer and the seller together. PAGENO="0180" 594 You talked later on about the loosening up of the regulations on advertising. I bedieve the law is quite specific with reference to no-load funds. It would seem to me that a very natural development would be one that I suggested yesterday allow advertising by no-loads similar to that used by savings banks to sell their life insurance. They are allowed to spend only fund resources, in this case I guess it would be the man- agement company's resources. The no-load investment companies re- sources could be used for promotional material of that sort, if you loosened up the legislation as it pertains to no-load funds' advertising~ I would like to have your observation on this, and if you care to on the earlier remarks which I made which were an interpretation of what you said. Mr. WALLICH. I quite agree with your interpretation, Congressman Keith. We buy mutual funds because we don't want to take the risk of buying a single stock, and we don't have the time and the money to study it. Buying mutual funds in principle is a good idea for many investors. The fellow with the secretary I envisioned to be the mutual fund manager. He should have a secretary and not a research staff of people drawing sometimes tens and perhaps hundreds of thousands of dollars. Mr. KEITH. I see. Do you think there already is a little of that in these management companies? Mr. WALLICH. I think that these people by and large work very hard to no avail. These are able and intelligent people. They work very hard. There is no featherbedding in the sense of loafing on the job. But since a thousand other able and intelligent people have already brought their best judgment to hear on the price of a stock, one can pretty well assume that a stock is selling for what the best human judgment thinks it is worth. To have the same job done over again by another group of able and hardworking people is just a waste of time. If they don't agree with the price that has been produced by the others, they are as likely to be wrong as right in their different ap- praisal. That is why I think one can buy a stock without analysis, pro- vided one looks at the risk. The price is likely to be right. The risk may not be suitable for the particular buyer. Now as to easing the limitations on no-load fund advertising, I think no-load funds are the logical answer to my various strictures. There is still the fact that they charge an advisory fee. I think they should be no-load, no-advisory fee beyond .operating expenses. The secretary needs to be paid. There is a mailing problem, a safekeeping problem, and so forth, That I believe is something of the order of 0.1 percent of the value of the portfolio on average, and that is really all the expenses that is justified. If there is to be advertising, again a somewhat higher either advisory fee or a positive load charge would be needed. I think advertising is entirely appropriate for a no-load fund. One can do one step better. One can go into the market and find one's self a fund that is closed-end as the term is, and is usually selling at a discount. That discount incidentally says what the market place when it is uninfluenced by salesmanship really thinks of the value of profes- sional management. When you leave it to the market to determine what PAGENO="0181" 595 the management of these great closed-end funds is worth, they say on average it is minus 10 percent, minus 20 percent, something of that order. There are some slight qualifications because unrealized capital gains enter into the situation in these funds, but that is a minor fact. Well, in sum I very much agree. Whatever can be done to strengthen the position of no-load funds is a step in the right direction. Mr. KEITH. Would you agree that the brokers are sort of spoiled, and maybe even get a little bit lazy because instead of doing a lot of homework and coming up with issues that are better than the aver- nge, inviting the attention of their clients to these issues, that they take ndvantage of a client who is also a little bit lazy, perhaps doesn't want to do much thinking or research and he is perfectly willirLg to buy a good mutual fund, and get a good appreciation, rather than buying ~ particular stock and getting perhaps a better buy for himself and his family? Mr. WALLICH. Well, sir, when- Mr. KEITH. And is this healthy? Mr. WALLICH. When I was in the brokerage business, we worked -very hard I thought. My broker friends I still think are hard work- ing people. There's a problem, however, of preference of buyers in favor of mutual funds because if a broker sells a client a listed stock, he makes one percent commission. If he sells him a mutual fund, he gets some cut in a much larger commission, 8.5 percent. 1-b does not get it all. There may be a salesmnan~s share involved. Something may go to the principal underwriter. But the bias is in the direction that you say. Mr. KEITH. Well, for the very small buyer, the man who runs the gas station, who teaches school or has a limited amount of money with which he can get into the market, even on the installment plan, it would seem to me that front-end loads and the mutual plan sales- man serve a useful purpose. But when a man can afford to buy mutual funds in the amounts of $5,000 to $10,000, he is usually brighter than average, more investment conscious than average, and if he doesn't like the way his mutual funds are working, reading in the press about throwing darts at the paper and things of that sort, he can move into individual issues under the present scheme of things very easily. Maybe he is lazy and content with the average appreciation that is coming his way. Mr. WAr~TcH. Yes; I think he would be no better off on average going into individual issues than going into funds, except that he would save the advisory fee. If he buys himself a rounded portfolio his chances are that he will do the same as the average for equal risk stocks, and that is just how his fund is likely to do. I very much agree that a man can acquire this habit of dealing with his stocks. The problem is to break the ice, get him acquainted with the stock exchange, get him to a broker. Once he has bought securities and knows that he can do it on the telephone, he can shop for himself much more cheaply than he can in mutual funds. Moreover he can get diversification even at present by buying closed-end funds and buying them at a good discount. Mr. KEITH. This may not be your field, but would you say that economies can be achieved by funds becoming internally managed, PAGENO="0182" 596 and that perhaps legislation should be enacted that would encourage the establishment of internally managed funds as contrasted to those with management companies? Mr. WALLICH. I think that internal management makes a lot of sense. It is in keeping with the way other businesses are run, and it is likely to make for better terms for the investor, because then the inter- est of the management is in doing something for the fund rather than doing something for the management company. Mr. KErril. Going to the si~bject of speculation, you mentioned per- formance funds. We have had considerable discussion here with ref- erence to these funds. Do you have any evidence that in anticipation of declines in the market that they get into a much more liquid position in a hurry? Mr. WALLICH. I haven't examined this evidence, but I believe it must be so, because the performance funds have not declined much during periods of decline, when some of the stocks that they typically held, like Xerox and IBM were virtually cut in half. So they must have somehow succeeded in getting out. That is a compliment to their ability, but the reason why some stocks went down so much is, of course, in part that selling by funds occurred. Mr. KEITH. Have you taken any steps, as one who is knowledgeable in this area, to encourage either the exchanges or the mutual fund' industry or the Congress other than your appearance here, to study the possible existence of activities that are adverse to the market's and to the buyers' interests, such as the point you just mentioned about waiting to place an order in the last 10 minutes of the day? Are there' other techniques where full disclosure would perhaps inhibit and per- haps help the exchange in the regulation of its own operations? Mr. WALLICH. I `have not studied this sufficiently to feel very sure. These are preliminary impressions, and I feel quite hesitant about suggesting that anything should be prohibited. It may be that the' placing o~'heavy orders at the end of the dayhas already had a damper' put on it. But speculation as such is not a bad thing when it does not become destabilizing. I would go slow on controlling speculation. I would hate to think of controls being employed as they are in the com- modity markets, with maximum price movements during a day, for' instance, or suspension of trading in some particular issue. `These are interferences with the free market that one goes to as a last resort, to combat very great evils. Very often they have side effects, such as creation of black markets, th~t frustrate the intention. If I had any suggestion in this area what to look at, without recom- mending it firmly, it would be to do something via the tax route. For' quick in-and-out tradin'g funds would be deprived of the conduit privi- lege. It is not a very great privilege that they ha:ve, of not paying' income tax on their dividend receipts if they pay out 90 percent. If you withdrew that privilege, the so-called conduit arrangement, then `funds would only pay tax on 15 percent of intracorporate dividends. This would not be a very heavy burden anyway. A tax on their capital gains would be something else. Another approach `that would not directly interfere with the market would be to put some limitation on turnover and impose perhaps PAGENO="0183" `597 higher taxes if the turnover exceeded a certain percentage of portfolio. I feel quite hesitant about that kind of thing. I would want to know more facts first before coming out flatly for it. Mr. KEITH. Would you think it advisable that the legislation we are considering have perhaps a title or a section authorizing a study of speculation? Is that important? Mr. WALLICII. A study would be a good thing. I think it should not interfere with going ahead on the other points. But if the study was simply part of the legislation being passed, then assuming this study is competently done, it would be a useful one. Mr. KEITH. I have no further questions at this time, Mr. Chairman. I would like perhaps to ask one more later on in the discussion. Mr. Moss. Mr. Watkins? Mr. WATKINS. Mr. Chairman. Mr. Wallich, you stated that you OK mutual funds. You think that mutual funds are proper. Mr. WALLICH. Yes, sir. Mr. WATKINS. You say the mutual funds are proper. You approve the method. I note too that you are a professor at Yale University. Mr. WALLICH. Yes; that is right, sir. Mr. WATKINS. And that your approval goes so far that you are bringing in three mutual men, men that are employed in mutual funds to decide your investments. Mr. WALLICH. Yes. Mr. WATKINS. Now I am not interested, Mr. Wallich, in the big fellow, how he spends his money. He has plenty of advice, attorneys and professors, and a board of directors. I am interested in the small man who has the opportunity to purchase mutual funds. You made a statement, if I understand you correctly, that 8.5, 9.3, or 5 percent-the way I understood you to say, that you could use any figure and get the balance that you would need from some other place. What do you mean by that? How are you in business if you only have a certain percentage to pay your salesmen and your cost of opera- tion, your management and the various other costs of setting up this enterprise, this business? What other ways can you get it? You have got to operate at a profit. Mr. WALLICH. In this complex of earnings that a management or advisory company has and the broker has, there are really three sources of earnings. One is the sales load, the second is the advisory fee, the third is the commissions that the broker gets. To the extent that there is some personal relationship between the advisory group and the broker and the principal underwriter, and very often that is the case, although by no means always, this money in a sense all goes into the same pot, althought not legally. That means- Mr. WATKINS. You say not legally? Mr. WALLICH. Not legally because the profits of the advisory com- pany go into the corporate income, the profits of the brokerage firpi whose partners may be officers and stockholders of the advisory coth- pany go to them directly and are taxed to them directly. When I said not legally, I didn't mean illegally, but that there is a different cor- porate setup. PAGENO="0184" 598 Mr. WATKINS. How in your opinion do you think that 5 percent is a fair rate? I have heard a lot of testimony here saying, "Do you agree with this?" Many of these firms would `have to go out of business. One firm has 240 employees, operating in the State of Pennsylvania, New Jersey, and Delaware that are giving a real service to the small pur- chaser of their funds, of their stocks that they sell. They say that they cannot operate on 5 percent. Now that is the meat of what I would like to know. The technical business is being handled by my friend here. I want to get into that position. That is the biggest complaint against this bill, objection to a 5-percent levy by the SEC. Mr. WALLICH. Yes, sir. Mr. WATKINS. Will that ruin a business or won't it? With this 5- percent fee, with these other methods that you say they might have- Mr. WALLICH. There are always marginal businesses', and some busi- nesses may have to shift to some other line and some salesmen may have to start selling something else if we go to a 5-percent charge. Mr. WATKINS. Do you think that is proper, that we have the right to rule a man's business out? In other words, a business is operating successfully and not imposing any loss to the public. I understand from testimony it is about 2 percent. What right do we have in your opinion, I am asking you, sir, to do a thing like that? Mr. WALLICH. The right I think derives from the fact that this is a monopoly. We have ii~etail price maintenance. If you were prepared to institute free competition at the retail level, and let these 240 sales- men go out and really compete, that is to say cut- Mr. WATKINS. Well, they do compete, don't they? Mr. WALEICH. They do not, sir. I am sorry, sir. Mr. WATKINS. They compete with other companies. There isn't just one mutual company. Do you know how many mutual companies there are that do this business in the United States? Mr. WALLICH. With due respect, they engage in rivalry and they may work very hard. I am not accusing these people of- Mr. WATKINS. Do you know how. many there are? Do you know how many firms there are in this business? Mr. WALLICH. Yes. I don't know the number. I know it goes into the hundreds. This is not relevant to the proper concept of competi- tion. As Professor Samuelson has said once before, there is a kind of monopoly that a small organization, of which there are hundreds, may have under certain conditions. For instance, a single bank in a small town, or a drugstore where there is no other drugstore within 20 blocks. In the mutual funds field the nature of monopoly is a little different. It is that the law requires the SEC to engage in retail price maintenance. If two salesmen of dif- ferent funds meet, and they both charge 8.5, none are allowed to cut. Mr. WATKINS. Let's stop at the 8.5. I want to take exception. You say that it is a monopoly, and you say it is not competitive. I say it is a competitive business, at least I think so. You can perhaps enlighten me, I will have a change of heart perhaps, but I think it is a competi- tive business for this reason. Will you agree that if John Smith comes to me from one mutual company and he sells me the idea to purchase various stocks through his firm, perhaps he has got a better in, perhaps PAGENO="0185" 599 he knows a little more, and perhaps he is a better adviser to me as a little fellow who has no knowledge of stocks. Now along comes another firm that offers me other suggestions; You say that isn't' competitive? Mr. WALLICH. These people don't engage in price competition, Congressman. Mr. WATKINS. They don't engage in price but they engage in ad- vice. They engage in advice and that becomes competitive. Maybe one fellow's advice is better than the other's. Mr. WALLICH. But in my judgment the advice of both is equally good and neither is worth anything. Mr. WATKINS. In other words, I wonder how much advice it is. Somebody can boost on the stock market, too. They can get a rumor going around to buy Smith & Jones, you name the company, it is going to do so and so and the first thing you know the board starts to move, doesn't it? Mr. WALLICH. If I may, let me try to define the nature of the dif- ference, and why you view this as competitive and I do not. To me competition basically means price competition, not quality competi- tion, although that is an important aspect. If I go and buy a car in an automobile dealer's showroom, I haggle over the price. I go to the next showroom, the dealer quotes me a different price and we haggle again. With these two mutual fund salesmen I can not haggle. That is what I mean by saying they are not competitive. They may be competitive in other ways. Mr. WATKINS. I still think they are competitive. You haven't con~ vinced me that it isn't. The business is certainly competitive. Now getting back to this 5 percent, do you think that they can oper- ate on 5 percent and stay in business? That is what I would like to know. I am very interested in a lot of other testimony here on which you have enlightened me so much, but I want to know about this 5 percent. Do you think if this restriction is put on by the Federal Gov- ernment here, that they can operate on 5 percent? Mr. WALLICH. I think the great majority can, and a lot of those who think they can't probably can too. Mr. WATKINS. Do you have any statistics or figures to prove that they can? Mr. WAU4ICii. I have a- Mr. WATKINS. Other than thinking. In other words, do you have facts and figures that you can show me that these people can operate on 5 percent? I would like to have it. Mr. WALLICII. I have considerable experience with industry state- ments that say that they would be ruined by- Mr. WATKINS. I am not interested in experience, I am interested in facts. Do you have the facts? Can you show me a concrete scale that will show me that they can operate on5 percent? Mr. WALLICH. I will be very glad to supply you with one which shows that some, and a great many of them., can. There will be some marginal companies that cannot. I do not deny that. Mr. WATKINS. Why should we put the marginal companies out? If one large company has a greater volume, a bigger amount of busi- ness, he can ~stay in and the little fellow goes. Is that what we are going to do? PAGENO="0186" 600 Mr. WALLICH. Because we are imposing retail price maintenance on the public, and I think the public has a right to be protected. Mr. WATKINS. Is the public being hurt? Do you have any evidence to show that the public is being hurt? I haven't seen any of it here. Mr. WALLICH. Well, the public paying 8.5 percent certainly is worse off than paying 5 percent. Mr. WAI~EINS. Well, certainly 8.5 is higher than 5, but I happen to be-it doesn't have anything to do with this and I shouldn't use the time of the committee. I am in the transportation business, the Wat- kins System, 30 States in this country. I pay my salesman 10 percent. They hold the 10 percent for the entirety if they can, as long as they ~are with the firm. So why argue about 8.5 or 10 or 6.5? I am talkin about 5. This bill here wants to reduce the payment to 5 percent an that will be it, and that is the meat of this thing. I want to know if you can give me any evidence that says that they can operate on 5 percent or that they can't. Mr. WALLICH. I would first say that the public first deserves pro- tection before the industry deserves protection. Second, I think that the majority can operate on 5, and those that cannot will be dollarwise certainly a minority, but we can argue over figures and prospects. Mr. WATKINs. I don't want; to argue. I want to become enlightened through testimony, and I ask you to do this for me. Give me proof that they can operate for 5 percent. Second, I would like to have you explain to me how the little man will be approached, as my good friend mentioned here, the grocery man, the gasoline station man, the truck operator, too. I want some- one to talk to me. How is the little fellow going to operate if someone ~doesn't come around and try to tell him what is good and what is bad, even though he only makes $7,000 a year. That is better than being on welfare. Mr. WALLICII. This is a very real point. Mr. WATKINS. Exactly. That is the point. Mr. WALLICH. As I said, you can legitimately even consider a 50- percent-front-end load and a 9-percent-contract-sales load payment, ~provided the buyer follows through. The front-end load fund does reach a different class of investor. I think this class deserves to be reached. I do think that as the ice gets broken- Mr. WATKINS. I know that we are pressed for time and I sometimes feel sorry for my chairman the way I use the time up, but frankly, let's get to one point and forget this other aspect. Frankly, do you think the SEC has any right to set a rate of 5 percent on these people? Mr. WALLICH. As long as it administers section 22(d), yes, because that is what we do with all other regulated industries or natural monopolies. We regulate the price. Mr. WATKINS. I question your monopoly. I say it is competitive. Mr. Moss. Will the gentleman yield? Mr. WATKINS. Yes; Twill, Mr. Chairman. Mr. Moss. I think the gentleman is overlooking the fact that Pro- fessor Wallich is making that there are a variety of types of monop- olies. The point here is that there is monopoly of price. That sales- PAGENO="0187" 601 man A for company A cannot go out and offer the same share at a lesser figure than salesman B from company B. That on price itself? where normally there is some competition, in this industry competition is absent. I think another point that has not been touched upon, and must be considered as relevant here, is the effect of the giveup or giveaway to the sales organization to encourage it perhaps to push one fund over another, not becaues it is a superior performer for the public, but per- haps a superior producer for the dealer. These are elements of com~ petition which this committee must consider. I thank the gentleman for yielding. Mr. WATKINS. I would like for you to just come down in plain words and let's get down to it. You say you believe in mutual funds but yet you have other ideas that would wreck them. Mr. WALLICH. I dont' think what the Commission proposes would wreck the mutual funds in the least, Congressman. It would possibly reduce their sales and possibly only in the short run. In the long run, as people realized that they were not paying an exorbitant charge, there might be more interest in them rather than less. But in the short run I would think that there might be a few sales- men that would then sell life insurance or would sell st~el or whatever. Mr. WATKINS. Why should you switch him from life insurance if he is doing something that is good? What right does this Federal Government have to reach in and tell people what they are going to do? Is this a free country or isn't it? Let's get down to principles, not the bill. Mr. WALLICH. If it is a free country then why aren't they allowed to compete and cut the sales load? If you will let them cut the sales load- Mr. WATKINS. Can you tell me how they are going to operate on 5 percent and tell me how many companies will be eliminated? Just don't say some. If you are going to make remarks that are going to be ~nfiuential on every Congressman here who reads your remarks, then I want to. see facts. I don't want to see theories. Mr. Moss. The Chair is going to state that the gentleman may de- mand facts, but the statement that has been presented here represents the considered opinion of a qualified witness. It is as valid as the con- tentions of those who have appeared and repeatedly said that a re- duction to 5 percent would destroy, without submitting any meaning- ful or relevant statistical material to back up their conclusions. Now to the extent that the gentleman is able to produce relevant material in response to the question of the gentleman from Pennsyl- vania- Mr. WATKINS. That is all I want. Mr. Moss. The record will be held to receive it. But the Chair does not expect nor would he instruct the witness to produce the impossible. Mr. WATKINS. Mr. Chairman, I don't consider it impossible. A man who comes in here with theories must have facts. You don't build theories up unless you have some- Mr. Moss. With all charity I would say to my colleague that his theory is not backed by fact. PAGENO="0188" 602 Mr. WALLICH. May I' add~ Mr. Chairman, that I base my statement on experience, and experience is noz~mally regarded ~s part of facts. The experience Is that when an industry says that it is going to be ruined, that it is well worthwhile tO be skeptical and to take a very detailed look at that position. Mr. WATIUIcs. Your college up there employs mutual men to handle their funds. And you say what is the end result, zero. I don't think it is zero. I think life is a chance. When people buy stock, you have a chance. If you buy a mutual fund you have a chance, too. But I would appreciate it if you would giv~ me the inforn~iation. I have had the opportunity to read part of your testimony before the Senate and I shall certainly read it more carefully, but I would like to have the plain facts to tell me how they can operate at 5 percent, and the ones that you know that can operate and the ones that can't. Mr. WALLICH. I will be glad to. (See letter to Chairman Moss dated October 27, 1967, on p. 03.) Mr. WATKINS. Thank you. Mr. Moss. Mr. Murphy, do you have any questiofls? Mr. MURPHY. No questions. Mr. Moss. Mr. Keith. Mr. KEITH. I don't really want to go into further question's. I would like to visit with you about this personally to satisfy myself as to some points that you have made. I would say that it seems clear that if you lower the charge from 81/2 percent or 9 percent to 5 percent, you would still have that same retail price maintenance that you are concerned with, and I would say that we then have two problems. We have the smaller buyer, and you say you are not worried about the front-end load so that salesmen can get to the little man. I believe your testimony indicates that.. Mr. WALLICH. Yes. Mr. KEITH. I would say that the man who can afford to buy with the larger amounts of money, he can make the necessary research to find out what kind of fund, what kind of portfolio he wants and what kind of price he wants to pay, and that the evidence does indi- cate that there are variations in this downward `from 8 or 9 percent to 1.8 percent or 2.8 percent. Mr. WALLICH. Yes. Mr. Moss. Professor Wallich, I want to express my appreeiation and the appreciation of my colleagues on the committee for your testimony. I think it is a very thoughtful and thought provoking statement. I will have several questions to be sent to you at a later date, and I would appreciate your responding to them. I want to, again, thank you for appearing and taking time away from the very busy schedule in order to accommodate the committee. Mr. WALLICH. Thank you very much, Mr. Chairman. Mr. WATKINS. I, too, Mr. Chairman, would like to join in thank- inp~ you. Mr. WALLICH. Thank you, Congressman. (The following letter was received by the committee:) PAGENO="0189" 603 DEPARThtDNT OF ECONOMICS, YALE UNIvERsITY, New Haven, Coun., October 27, 1967. Hon. JOHN E. Moss, Chairman, ~ubcoinmittee on Commerce and Finance, Committee on Interstate and Foreign Commerce, 2125 Rayburn House Office Building, Washington, D.C. DEAR Mn. CHAIRMAN: In response to the question stated in your letter of Octo- ber 18th and in fulfillment of the commitment made to Mr. Watkins during the hearings, I am submitting the following comments and data. Question 1. The disabilities under which mutual funds labor (pages 8 and 9 of the statement). The first disability cited in the statement is the tendency for cash inflow to be highest when the market is booming, causing funds to `buy more securities when the market is high than when it is low. The data cited in the report of the SEC "Public Policy Implications of Investment Company Growth", and pages 287-289 lend support to this contention. The report cites the Wharton study to the effect that "net acquisitions h~r mutual funds were greatest `in the first quarter of 1954 when the price rise was gathering momen- tum, in the fourth quarter when the price rise was at its sharpest, and in the first quarter of 1955 when stock prices were at their sixteen-month peak'". Table VII-6, page 288, shows that in more recent years net acquisition by investment companies were highest in 1961, the year preceding the great break of 1962. The behavior of mutual funds during the third quarter of 1962 and the third quarter of 1966~ cited on page 289, also suggests that the funds were heavy sellers fol- lowing suh~tantial `break~. According to the SEC report, Lhis was due more to the discretionary investment decisions of fund managers than to the pressures of shareholders' redemptions. The concentration of sales following substantial breaks suggests that preceding these breaks, purohases were relatively heavy. A second disability cited in the testimony is that the larger funds can obtain worthwhile positions only in the stocks of larger companies and tend to put prices up against themselves when the buy aggressively. Three variables are involved here: 1) the size of the fund and the resulting minimum position that it finds worthwhile, 2) the size of the company whose stock is bought, which limits broadly the amount of stock that could be available, and 3) the breadth of the market for the stock, which sometimes may be small even for a large company if the floating supply of stock is small. The net implication is that large funds cannot buy the stocks of very small companies or even of larger companies with a limited floating supply. Since many large companies have done extremely well, this does not necessarily preclude the large funds from making excellent investments. But the most spectacular investment results probably have been achieved by investors "getting in on the ground floor", i.e. buying stock in a `small corporation that subsequently enjoyed great growth. This type of investment is difficult for large funds to make. The third disability refers to the possibility of window dressing. Information to that effect must necessarily rely on hearsay from trade sources. I am prepared to assume that reputable funds seek to avoid operations that could be interpreted in this light. I hope that the testimony presented the "story", which personally I have no reason to question, in a sufficiently qualified form. Question 2. The testimony qualifies the suggestion to terminate section 22(d) by proposing the action only if it does not produce "ea~cessively harmful reper- cussions." I regard retail price maintenance as undesirable in principle, what- ever the industry so protected. In the case of mutual funds, I can see no obvious consequence flowing from the ending of 22(d) that could clearly be expected to produce "excessively harmful repercussions". The principal effect, in my view, would be to reduce the income of underwriters, retailers, and sales- men. The sales charge then would apply only to net sales of fund shares, not to gross sales, assuming that all redemptions would cease and be replaced by sales in a free market on the part of fund `shareholders. PAGENO="0190" 604 The industry, however, seems to believe that termination of 22(d) would have severe consequences. I believe that their ease is entitled to a close examination. If this examination, as I would expect, fails to validate the industry's claim, the expectation of excessively harmful repercussions could be disregarded and 22 (d> should then in my judgment be terminated. The qualification introduced in the testimony thus amounts to no more than that the industry's contention be studied before action on 22(d) is taken. Question 3. The testimony suggests, as one of two alternatives of dealing with the front-end load, that the present load be left unchanged but some compensation be made to holders who redeem at a loss. Several possibilities suggest themselves. (1) Some grace period could be allowed within which a buyer could cancel the entire transaction and get his money back. This might take care of flagrant case's of "overselling" and would protect buyers who discovered early that they had. made the wrong decision. The grace period would have to be relatively short,. say a month or two. Else buyers who bad no reason to regret their decision in principle might nevertheless claim a refund if the market turned against them.. This approach does not, however, take care of buyers who lapse or redeem later on. (2) Compensation could be made to ali buyers who redeem, or only to those who redeem at a `loss. The best procedure would seem to be that compensation to the buyer be limited to the excess of the front-end load over the normal sales load, allowing any loss from stock market movements to be borne by ~the buyer. (3) Compensation could also be made to `buyers who allow their contract to lapse without redeeming. This approach would remove the temptation, inherent in (2) above, to redeem shares after a contract had lapsed, instead of keeping them in the expectation that payments would `be resumed at a later date. Administra- tively, however, this procedure might be very diffiéult. It would mean that the fund would have to make restitution of part of the load to all buyers who lapsed even temporarily. When they resumed, the original charge would have to be re- instituted. This could happen several times during the life of a contract. It would establish an undesirable motivation on the part of the buyer. A more detailed study would have to be made to decide among these alter- natives. The grace period proposal gives a minimum of protection and should involve no great difficulties. If alternatives (2) and (3) turn out not feasible or not advisable, I would regard the proposal made in the testimony to reduce the front-end :load as preferable to the alternative of a grace period. Question 4. In commenting on measures that might be taken to limit speculative activity of mutual funds, I~did not have specifically in mind disclosure require- ments for sales. This approach seems a possibility nevertheless. However, simple disclosure of the fact of a sale prthably would not suffice, since funds now publish their their portfolios quarterly anyway. Requirement to disclose the reasons for sale, on the otherhand, probably could be circumvented, since sales can always be claimed to have been made in order to raise money for purchase of other stocks. It would he difficult to prove that a fund selling a block of stock had information not available to the rest of the market, and in most cases the fund probably would not have such information. To give adverse tax treatment to short term gains would resemble, in a sense, the present treatment of short term gains by insiders. While this solution is not within the legislative scope of `the Committee, it would deserve consideration by the appropriate Committees if speculative activity of the funds continues to increase. QUnSPIONS BY MR. WATKINS In the course of my verbal testimony, I promised to supply certain data in re- sponse to questions by Representative Watkins. I hope it will be agreeable to you and Mr. Watkins if I make these data a part of this letter. The question raised by Mr. Watkins was how mutual funds could operate under a 5 percent sales charge, and what parts of the industry would and would not be able to operate under such a charge. A study was prepared in 1966 by Booz, Allen and Hamilton, Inc., for the National Association of Securities Dealers, Inc., entitled "Over the Counter - PAGENO="0191" 605 Markets Study." Table 1, Appendix D, and Exhibit IV (page 13) of that study were employed by the SBC to produce Tables 1 and 2 attached. Table 1 shows the share that firms of different size have in various sources of gross income,, including from retailing mutual fund shares. Table 2 shows the projected loss of gross income for the same firms under the Mutual Fund Report Recommen- dations. Relevant to the present discussion is only the projected los of income from mutual fund sales resulting from a cut in the sales charge from 9.3 percent to 5 percent, a reduction of 46 percent. Table 2 also shows the projected loss. from elimination of give-ups with which my testimony has not been concerned. Table 2 shows that the heaviest loss of income would occur in the two lowest size groups, firms with less than $20,000 gross income, and with $20-35,0004 gross income. The "less than $20,000 group" would lose 25 percent of its income,, the $20-35,000 group would lose 21.4 percent of its income. There are 707 firms in the lower and 232 firms in the higher income group, out of a total of 2,483 firms.. For firms above these two size categories, the projected loss ranges from a maxi- mum of 15.9 to a minimum of 0.9 percent of average gross income. Losses of thin magnitude are not essentially different from income losses tha1~ occur in the course of business fluctuations. In a time when activity in the securities markets has stepped up considerably, the projected loss would for most firms. probably repre- sent no more than a slowing in the rate of growth of their income. The losses in the two lowest categories, of 21.4 and 25.0 percent respectfully, are of a higher order. They nevertheless present a distorted and misleading picture of the true facts. The 707 firms in the "less than $20,000 group" have an average gross income of $8,000. Obviously these are securities firms only in a nominal sense. Very probably they are in good part part-time operations of single individuals. `It is hard to see how, on $8,000 gross income, an office could be rented or an office staff kept. The 232 firms in the $20-35,000 group have an average income of $28,000. These too are operations of minimal size. Together, these two groups represent- trig one-third of the total number of firms have 0.5 percent of total gross income. Their share in the total income from retailing of mutual fund shares amounts to. 5.8 percent. It is by no means to be assumed that even a loss of 25 percent of gross income would drive many of these securities firms out of business at a `time when other parts of the securities business are expandin.g rapidly. But in any event, to continue a 9.3 percent sales charge in lieu of a 5 percent charge, means to charge the buyers of mutual funds an added 4.3 percent. This 4.3 percent charge yields an ad~1ed income of about $47 million to `the 2,483 firms, of which the 939 firms in the two lowest size classes get approximately $2.8 million. The total income of these 939 firms is only $12.2 million. In other words, in order to keep firms with a gross income of $12.2 million in business, which quite possibly might continue in business in any event, fund buyers would pay an additional charge of $47 million of which these firms get $2.8 million. The larger part of this charge, approximately $44 million, accrues to the bigger firm's which, as pointed out above, would not feel Its loss very heavily. Mutual fund buyers could pension the 939 small firms off at `one-quarter of the cost. The conclusions which in my judgment follow the data are these. 1) There is no evidence that even the smallest firms cannot survive a cut in the sales load' from 9.3 to 5 percent, particularly at a time of expanding securities markets, even though some of these firms may have dIfficulties. 2) The cost of mutual fund buyers of keeping these firm's in business, on the unlikely assumption that otherwise' `they would mostly go out of business, exceeds the t'otal income of these firms by a multiple of about four. It exceeds the loss that these firms would suffer from `the drop in the sales charge by a multiple of almost 17. ] can see no justification, either social or economic, for such a policy. I appreciate the opportunity to submit this additional material. Sincerely yours, HENRY 0. WALLICH,,, PAGENO="0192" TABLE l.-RELATIVE PARTICIPATION OF 2,483 NASD FIRMS IN SOURCES OF GROSS INCOME ACCORDING TO SIZE OF FIRM [Gross income for size group as percent of all groupsi Percent Over $40,000 $15,000 to $40,000 $6,200 to $15,500 $3 300 to $6,200 $2 500 to $3,300 $2 000 to $2,500 $1,440 to $2,000 $955 to $1,440 $535 to $955 $225 to $535 $200 to $225 $f85 to $200 - $170 to $185 - $150 to $170 $135 to $150 $120 to $135 $105 to $120 $9Oto $105 $75 to $90 $6Oto $75 $50 to $60 $35 to $50 $2Oto $35 Less than $20 __________ __________ __________ __________ __________ Size of firm 1 (in thousands) Number of firms Total gross Corporate Stock Reciprocal OTC activi- OTC activi- Retailing Sponsorship income underwrit- exchange and give-up ties in corpo- ties in bands mutual fund of mutual All other ings commissions commissions rate stocks shares2 funds 7 21.6 10.3 29.7 12.3 14.6 7.7 10.1 0 22.0 19 22. 1 33.7 21.2 15. 0 14.4 23.6 28.6 2.4 25.5 36 14.4 17.7 15.0 11.4 10.9 14.8 5.8 16.1 15.9 64 12.7 11.9 12.1 13.7 11.9 15.0 7.8 37.4 12.1 34 4.4 5.2 4.6 6.5 3.8 4.1 1.8 7.5 4.2 41 4.2 4.0 3.7 5.7 6.3 5.4 3.7 9.7 3.2 53 4.1 4.0 3.6 3.8 5.0 5.8 3.7 5.1 4.4 74 3.9 3.9 3.3 8.5 5.6 4.0 4.9 6.9 3.3 137 4.3 4.1 3.3 7.4 7.6 6.9 6.4 7.0 3.2 C~ 261 4.1 3.3 2.2 7.4 8.7 7.0 6.6 4.4 3.7 ~ 40 .4 .3 .2 .8 .9 .4 .9 1.0 .2 C~ 37 .3 .2 .1 1.1 .8 .3 1.0 0 .4 39 .3 .1 .1 .7 .8 .5 .6 .8 .2 39 .3 .1 .1 .4 .7 .5 1.0 0 .2 47 .3 .1 .1 .7 .9 .9 .9 .1 .2 47 .3 .1 .1 .3 .7 .4 1.2 .3 .2 56 .3 .2 .1 .7 .9 .3 1.1 .2 .1 70 .3 .1 .1 .8 .9 .5 1.2 .1 .2 76 .3 .2 .1 .8 .8 .5 1.4 .2 .2 99 .3 .1 .1 .5 .9 .3 1.6 .2 .2 116 .3 .1 .1 .3 .9 .4 1.6 .1 .1 152 .3 .1 .1 .4 .8 .3 2.3 .3 .1 232 .3 .1 (3) .5 .7 .2 2.8 .1 .1 707 .2 .1 (3) .3 .5 .2 3.0 .1 .1 Total, all reporting firms 2,483 100.0 100. 0 100. 0 100.0 100. 0 100. 0 100. 0 100. 0 100. 0 1 Size of firm based on 1964 total gross income. percent as large if income from mutual fund sales of non-NASD firms were included. 2 It should be noted that NASD firms account for only about 60 percent of all mutual fund retail Less than 0.05%. sales. Therefore, the percentages shown for each of the NASD groups in the table would be only 60 PAGENO="0193" 0 E E E E 0~ c~ 00 0~ 0~ p 2 0~ 607 ~ ~t)C0)Lg)u)~ ~ ~ C~4 ~ 000~0)~ ~ 00 ~ 00 00N.C~4~ Lt)C~ ~ - r~oo oo~ ~ ~C~J ~ c~j ~N. C'.~0) C~4 ~ 00 0000t~Ø~~j a~ - c C~4 ~ 00~0 ~ c~0Q ~ ~ r-~ c'j ~0C)~ ~r) C~ r~. - - C0C0j C~) C?)Lt~ ~ ~ C~J ~ ~ - 0) ~ 4_,_,_ ~) 00 ~-c~j Oor~ LCC~j ~ (~J - - - 0 0 2 2 0 0 0 -J I- 2 ~,) -0 ~.&_ 0 - 0~ o = ~t~_ 0 2 0 C,) C,) 0 0 C,) C') 0 0 0 0~ 2 00 E 00~ 00 0) E ~ Eco ~ 8 0 8 C,) 85-~92-68-pt. 2-13 8 1= 00 a PAGENO="0194" 608 Mr. Moss. Our second witness this morning is Judge ilenry J. Friendly, of the United States Court of Appeals for the Second Cir- cuit. Prior to his appointment to the bench in 1959, Judge Friendly was for 30 years engaged in private practice of law. He has had a distinguished career as scholar, lawyer, jurist, and author. Judge Friendly has examined the administrative process, with particular emphasis on the regulation of business by the Federal regulatory agencies. While in private practice, especially during the years he was gen- eral counsel to one of the large companies, Judge Friendly had an extensive administrative law practice. As an appellate judge in the circuit which includes a major business and financial center, he has participated in many decisions involving the statutes administered by the Federal regulatory agencies, including the Securities and Exchange Commission. Judge Friendly wrote the opinion in two important cases involving the Investment Company Act of 1940, Brown, Bullock & ~VVliilhelni vs. Merchison. As an author, Judge Friendly has contributed many articles to legal journals on the administrative process and other topics, as well as a much heralded book entitled "The Federal Administrative Agencies, The Need For Better Definition of Standards." Judge Friendly's breadth of experience makes him particularly qualified to comment upon certain of the matters which are before this subcommittee, and it was for that reason that I invited Judge Friendly to appear here, and I am very, pleased, sir, that you were able to respond to the committee. I want to thank you especially in view of the fact that I understand the air transportation broke down this morning and you had to leave at a very early hour from New York in order to reach us. STATEMENT OP JUDGE HENRY J. FRIENDLY, U.S. COURT OP APPEALS, SECOND CIRCUIT, NEW YORK, N.Y. Judge FRIENDLY. Thank you, Mr. Chairman, I think I should apol- ogize to the committee for not having been here at 10 o'clock. Per- haps it was my previous experience as general counsel for an airline that gave me more faith in that medium of transportation than proved to be justified this morning. A~ the chairman has stated, I have been a judge of the U.S. Court of Appeals for the Second Circuit for some 8 years. We sit in New York City, and because of its position as the country's largest financial aid investment center, we have had rather more than our share of pro- ceedings relating to the statutes administered by the SEC, including the Investment Company Act. I was asked last spring by Senator Sparkman and have been asked by Chairman Moss tO express my views as to the feasibility of the i~roposa1 in the bills which you have before you, that there be added a new subsection 15(d), which requires that all compensation for serv- ices to a registered investment company by an investment adviser or other specified persons shall be reasonable, with that requirement to he enforceable in an action by the Commission or by an interested party. PAGENO="0195" g309 I should like to make entirely clear that in complying with that re~ quest, as I felt bound to do, I am limiting myself to that precise in- quiry. While I have read the relevant parts of the report of the SEC that gave rise to this bill, and some of the material that it has pro- voked, I would not want as a judge to express any opinion whether the reasonableness of the fees of advisers of investment companies is a problem requiring legislation, or if so, whether section 15(d) is the best possible solution. On the other hand, I am glad to give the subcommittee such help as I can on the limited question whether Congress should hesitate to enact a requirement like section 15(d) for fear that the courts could not administer it properly. I think I can sum up my position by saying that while the courts are not looking for any more business, bcc~iuse we have plenty, and Congress keeps us well occupied with new lines of business, I perceive no reason why the courts could not effectively administer section 15(d) if Congress should decide that it wants us to do so. The question whether charges or other business practices are rea- sonable is not a new question for courts at all. Long before the Inter- state Commerce Commission, the first Federal regulatory commission, was created in 1887, courts were deciding about overcharges by rail~ roads and other carriers, a,nd in many states they continued to do that as to intra-State rail rates and other utility rates for many y~ars there- after, until in the first and second decades of this century public service comniissions came to be created. I think it is peculiarly appropriate to recall that work of the courts before a committee whose landmark report preceding enactment of the Securities Exchange Act of 1934 declared in some &mous words that also have their application to mutual funds: The great exchanges of this country, upon which miuions of dollars of securi- ties are sold, are effected with a public interest in the same degree as any other great utility. In addition to that jurisdiction over public utility rates, courts frequently have to pass on questions of business reasonableness when a corporate acquisition or merger is attacked as unfair to one party or the other. Still another instance where courts have to deal with the question of reasonable value comes from the Constitution itself. I refer, of course, to the provisions of the fifth amendment that private property shall not be taken for public use without just compensation. And the problems that we sometimes encounter in fixing a fair price for a large condemnation, particularly where the property is not of the kind that is freely bought and sold, seem to me at l7east as hard as the task that is here proposed~ Another very well known area where courts pass on the reasonable- ness of business practices without aid of any previous administrative determination is in suits by the United State~ or by private plaintiffs relating to acts that are alleged to constitute unreasonable restraints of trade. Examples like that, and one could give many others, seem to me sufficient to answer the objection that was made by a witness in the Senate hearings when he ~aid that the question that was posed by section 15(d) is not a legal question but an economic question. I don't PAGENO="0196" 610 dispute that, but a very large part of the work of the courts consists not in evolving new rules of law but in applying well-known and con- ceded legal standards to the many complexities of life, whether those be determinations of the fair value of property or the reasonableness of a restraint of trade or what constitutes due care in driving an auto- mobile or in navigating a tanker. Ooming closer to the problem at hand, there are many instances in which courts now have to decide, and for a long time have had to de- cide, what constitutes reasonable compensation for personal services. One instance is their role in passing on the fairness of arrangements between a fiduciary and his beneficiaries, a standard of fairness that might well apply to this very problem but for the effect that has been given to the ratification of management contracts by stockholders or unaffiliated directors. Another instance is where a contract for personal services cannot be carried out according to its terms, either because it lacked required formalization, or for failure on some other account, and the court then has to step in and determine the fair value of what has been done. Still another instance is where no price for the service ever was fixed, as often occurs, for example, in relations between lawyer and client. The standards that courts have used in fixing the value of legal work, the nature and extent of the servicesaperformed, the cost to the lawyer of performing them, the novelty of the problem, the amount involved, the results achieved, his professional standing, the contin- gent or uncontingent character of the reward, the customary charge for comparable services, are quite reminiscènt of the standards of sec- tion 15(d) (~) of the bill that is before you. A further area, perhaps even closer to that with which you are here concerned, is the work of the courts in fixing fees of attorneys and others in derivative suits, in decedents' estates, and in bankruptcy and reorganization. Such fees can sometimes be very large, often running into six or seven figures, and the criteria `that the courts have applied in fixing those fees are quite similar to those that are here proposed. I ~hould also point out what may be most relevant of all, namely, that the courts already have responsibilities as to `the size of the fees of investment advisers. There is a common law liability of directors for waste, arid while a plaintiff who seeks to prevail on that score may have to show that the fee is not merely unreasonable but unreasonably unreasonable, a court still has the job of comparing what has been done with what has been received, just `as it would have under section 15(d). I might add that the existing situation here affords great possibilities of lack of uniformity, in view of the differences among the States as to just how `much a plaintiff has to prove in cases of that sort. In addi'tion to these tasks arising out of the common law, the Invest- ment Company Act itself imposes various liabilities in the determina- tion of which the reasonableness of fees of investment advisers may have to be considered. Our court held 6 years ago in Brown against Bullock, a case which, as the chairman was kind enough to mention, I was privileged to write the opinion for the court sitting en banc, that :a Federal claim against directors existed under section 87 of the act for willful conversion, which could be accomplished by the payment of a PAGENO="0197" 611 grossly excessive fee to an investment adviser, and under section 15 of the act in its existing form, for failure to exercise proper case with respect `to the continuance of a contract with. an adviser. Then there is section 36 empowering the Commission to bring suit for gross miscon- duct or gross abuse of trust. When directors are claimed to have vio- lated those sections in the payment of `fees, the court is obliged to make some judgment on the size of the fee, although in order to impose ha- bility, it would have to find `the fee not merely excessive but perhaps excessively excessive. One objection that I understand has been made to judicial enforce- ment of a standard of reaso'nahleness of the charges of investment advisers is the likelihood of their reaching divergent results, with con- sequent unfairness to advisers in some cases `a~nd to investors in others, although as I have said, that possibility exists in a very marked degree under existing law. It can be said that the need for uniformity is a reason and surely it is an important reason why once an administrative agency has been given power over a particular subject, the courts should require resort to it in the first instance. But the point in answer to that is that the primary-jurisdiction doctrine applies only when there already is juris- diction in an administrative agency. It does not rest upon a concept of inherent capacity of the courts to deal with the problem, but as a leading scholar has said, upon recognition of the need for orderly and sensible coordination of the work of the agencies and the courts. Still I would have to agree that if uniformity in standards as to the fees of advisers of investment companies was the controlling considera- tion, that would be better accom~li~hed by requiring any complaint to be presented to the SEC for action, subject only to the usual limited judicial review. However, Congress could well decide that the need for uniformity in this area of the fees of investment advisers was less compelling than as to railroad or other utility rates, and that, accordingly, the court should have a larger and the agency a smaller role. Congress has a considerable variety of choices available to it. Exclusive resort to the SEC would lie at one end of the spectrum. Next would come a direction that except perhaps in cases where the lack of merit of the claim was apparent, there should be an initial reference to the SEC for deter- mination by it, even though ultimate decision would rest in the courts. Further along would be the possiblity of a report by the agency, which was merely advisory, and which the court was free to disregard, such as the report the SEC commonly makes as to allowances in reorganiza- tion proceedings under chapter 10 of the Bankruptcy Act. And still further along would be a plan like that of the pending bill, where the agency, in addition to having the right to sue on its own, may but need not intervene in private suits, and the decision rests with the courts. It is for Congress to decide in each case just what mix of administra- tive and judicial participation is best adapted to the problem at hand. One end of the spectrum gives more in administrative expertise and unformity; the other more in those qualities of restraint, freedom from supposed bureaucratic rigidity, open mindedness and good sense that judges at least like to believe are attributes of courts. PAGENO="0198" 612 I think it is rather heartening to see, an administrative agency dis- playing such willingness to leave the decision to others. For my own part I would return the compliment by suggesting an amendment which would provide that in actions under section 15(d), the court either may or must call on the SEC for ~an advisory report. I would be quite content with the permissive form, since I am confident that at least in the early days of the statute, it would always be used. On the other hand, I would have no objection to a mandatory requirement. With such reports available, I would suppose that the courts would develop intelligible guidelines within a relatively short time. That result would be aided by the fact that since actions to recover unrea- sonable fees are equitable in nature, they would be tried to judges and not to juries. Under the' rule that prevails in our circuit and in most others, the conclusion of the trial judge would be freely `review- able on appeal, thereby insuring uniformity within each circuit and providing the possibility of `ultimate reconciliation in the Supreme Court if, as I do not in fact anticipate, the ,circuits were to develop serious conflicts. Since the claim would be Federal in character, actions could always be brought by plaintiffs in Federal courts or removed by defendants to them, regardless of the citizenship of the parties. However, as the bill stands, Federal jurisdiction would not be exclusive, and there would be nothing to prevent suits re~iaining in State courts, includ- ing continuation of' the practice whereby identical suits have often been brought in both sets of courts, with the Federal court utilized for its generally more liberal procedures for discovery and the State court for its generally less rigorous investigation of settlements. At present, Federal jurisdiction under the Securities Exchange Act of 1934 is ex- clusive, whereas under, the Securities Act of 1933 and `the Investment Company Act, it i~ concurrent with the courts of the States. Altl~iough I am generally no friend of exclusive Federal jurisdiction, I would think Congress might wish to consider whether in this particular in- `stance it might. not be well to confine litigation to the Federal courts, as is done, for example, with respect to suits under the antitrust laws. This would be a step in the direction of uniformity, and the very fact that an action under section 15(d) substitutes for what might have been made an exclusive remedy before ,the Securities and Exchange Commission would be a sufficient justification. What remains is `the claim that section 15(d) would be a litigation breeder. To my mind, it is not a valid objection that a statute may lead to the bringing of lawsuits. What would matter would be if it lead to the bringing of unjustified lawsuits. While some derivative actions are brought simply for harassment, we have become increasingly aware over the years that others serve a useful purpose in policing directors and officers of companies who otherwise would be laws unto them- selves. Indeed, we have the very highest authority for that proposition in the Supreme Court's statement in J. I. Case Company against Borak, dealing with the SEC's proxy rules, where the Court said that "Actions by stockholders provide the necessary supplement to Com- mission action, in view of the limited resources of time and money available to the Commission," and has analogized this to the role of the private treble damage suit in the enforcement of the antitrust laws. PAGENO="0199" 613 I think there are a good many safeguards against unjustified suits under section 15(d). First of all, the funds are given a year to bring their houses into what they conceive to be order, and they would be well advised in my view to reduce advisory fees at least to the level that have been marked out by settlements in the suits brought under existing law. Funds that had not done that, particularly the large ones, would he the prime targets for private action. Mr. KEITH. Mr. Chairman. Mr. Moss. Mr. Keith. Mr. KEITH. I wish that you would go back to the start of that para- graph that you are now reading. Judge FRIENDLY. About the safeguards? Mr. KEITH. Yes. Would you read that again? Judge FRIENDLY. Yes, I will be glad to. Of course, again I don't mean by saying this to say that Congress ought to do one thing or the other. It does seem to me, however, that some fears have been voiced which, while I wouldn't say they were wholly without substance, I think have been considerably exaggerated. What I was saying was that I think that there are a good many safeguards against the bring- ing of unjustified suits under section 15 (d). Mr. KEITH. I thought I heard you say "It seems to me that would be reasonable for the Congress to enact some legislation that would require them to be more reasonable in their fees, more closely parallel- ing those of comparable situations in this area." Did I not hear you say something to that effect? Judge FRIENDLY. No. I would put it rather that I don't think Con- gress should be deterred from doing it by fear of litigation, if it thinks it is a good idea generally. Now whother the problem calls for action is something I don't want to speak to. Mr. Moss. Would the gentleman yield? Mr. KEITH. Yes. Mr. Moss. I believe the reference to the statement on page 13, I have been following it rather closely, would provide this language which was read by Judge Friendly: First of all, the funds are given a year to bring their houses into what they conceive to be order-section 28. They would be well advised to reduce advisory fees at least to the level marked out by settlement in the suits brought under existing law. Funds that had not done this- and at that point the interjection of the question. Judge FRIENDLY. Al] I really meant by that remark was that if I were advising one of these funds, I would certainly tell them to get down that low, which isn't of course very low, but I should think a fund that continued to keep its fees above the level that had been marked out by settlements wou]d be asking for a place as a defendant. That doesn't mean necessarily it would lose the case, but I should think it would be signaling itself out as a target. Mr. KEITH. Judge, I was not following as closely as was the Chair- man, and I missed the word "suits" as it pertains to this particular discussion, and I was thinking of suits in connection with the settle- ment of estates rather than suits in the cases before courts in this isolated area. PAGENO="0200" 614 Judge FRIENDLY. I see. Well, I was saying I think that funds that had not brought their fees down to that modest extent, especially large ones, could probably expect to be defendants. While I think suits might also be brought against some of the smaller funds, my guess would be that the plaintiffs would generally be content to let those await the settlement or judgment in the suits against the larger and more vulnerable ones. Once a half dozen actions had progressed to settlement or judgment,~ I should think most funds would bring themselves into a position where they would no longer be attractive objects for suit. I put it just that way because the economies of the situation are such that private actions will not be prosecuted unless there is a strong possibil- ity of success. Plaintiff's lawyers will not wish to spend years litigating against well financed defendants unless there are real prospects of financial reward, and I think we can also be confident that the SEC will not bring unjustified actions. So to summarize, while I am expressing no views on the question' whether there is need to regulate fees of advisers, I do believe that regulation of the sort embodied in proposed section 15(d) will not impose on the courts a task which they cannot satisfactorily perform. I do think that two amendments would be advisable, one allowing the courts to call on the SEC for an advisory report in any case, and another giving the Federal courts exclusive jurisdiction of suits under' this section. Thank you. Mr. Moss. Thank you, sir. Mr. Keith. Mr. KEITH. Thank you, Mr. Chairman. I am handicapped by the fact that I am not an attorney and am not able to follow all of the legal questions that are involved. But in the settling of these suits, do you feel that management companies settle these because they have concluded that there was a good chance that the decision might go adverse to their interests? Is that a proper question to ask from' this bench to that bench Judge FRIENDLY. Well, I will give you my opinion. I think the set- tlements have been so modest that the companies were exceedingly well advised to take them even if the plaintiffs' chances of success were exceedingly small. It seems to me that they were buying a cheap insurance policy. Mr. KEITH. In other words, the attorney for the one bringing suit must have felt that he didn't have a good enough chance that he should hold out for a court decision. Judge FRIENDLY. Well, I think, Congressman, one has to look at the' practicalities of these suits. They are brought typically by counsel for people having a very small financial stake in the mutual fund. They don't differ in that respect from other derivative suits, and when I say that, I am not casting any aspersions whatever on the attorneys. Quite the contrary, as I have said, I think they have performed a most' useful function. But the fact of the matter is that the suit is really brought for the benefit of the attorney more than it is for that of the plaintiff, and' when the settlement gets up to a certain figure, the attorney is likely to feel that good business judgment on his part dictates accepting it,, PAGENO="0201" 615 because a bird in the hand is considerably more valuable than one in the bush, and there is also a law of diminishing returns. A judgment that would be worth $10 or $15 million won't produce two or three times as much fees as a settlement of five, and I think it is just as sim- ple as that. I don't mean the- Mr. KEITH. I have been amazed at the protestations of these at- torneys who have brought these suits. One in particular has bragged about the fact that he got a half million dollars for a certain suit that he won, and there is no thought in his mind but what that was a rea- sonable fee for him to charge for the few hours of work that he spent before the bench or even the many hours of work. Judge FRIENDLY. Many I would say. Mr. KEITH. In the large amount of these decisions do you feel that the judges were of the opinion that management companies were fiduciaries in the Massachusetts legal sense of the word? Judge FRIENDLY. Well, I get the impression they did, but they as- cribed great significance to the stockholder ratification. Also of course they ascribed a great deal of significance to the general level of charges in the industry. It is very hard to say that defendants were doing something outrageous when they were doing what everybody else was doing. Mr. KEITH. For example, in the case of Dreyfus Management Co., they are still charging one-half of 1 percent fee, and the stockholders ~f that management company are entitled to a return; I believe the stock is valued at something like $44 million. They have paid that price for it. In the scheme of things today, in the free enterprise economy, many of these management companies feeling that they are the ones who set up the mutual funds as a vehicle for bringing more funds on which they could get additional advisory fees, it seems to me the whole climate historically has favored the creation of mutual funds as a means for getting additional funds over which the management com- panies could exercise their judgment and receive their just reward, and if we get them into a strictly fiduciary position, the mutual funds will by custom and common law and statutory law too then be bound to bargain for the best and cheapest that they could, and exercise a truly independent judgment. Judge FRIENDLY. I think the theory of the existing law was that they would do that, but it hasn't worked out that way, for under- standable reasons. Mr. KEITH. I don't think that the theory of existing law is that way. I think that the law developed to govern the conglomerates that grew in order to successfully operate this industry. Judge FRIENDLY. What I was referring to were all the elaborate provisions about the length of the contract and the need of annual review and votes of the unaffiliated directors. I think those `showed an intention by Congress that these matters should really be looked at. My impression is that that hasn't worked out as intended, and that because it hasn't, this proposal has been made. Mr. KEITH. Our question of course is what is in the best interest in the long run for our constituents and our country, as to whether or not curtailment of the present legal fabric would diminish interest in the establishment of mutual funds which some of us feel `contribute greatly to the economy in the way of providing capital, and an oppor- PAGENO="0202" 616 tunity for inve~tment. for the féllbw who \vants to get in on this ~od thing, that is the gio'wth of~ industry and the development or the subsequent improveme~rt in equity. Judge FRIENDLY. That I think is the subshtntive question which I think I ougl'it not speak to, but which you h~tve. Mr. KEITH. Well, we are looking for all `th~ advice tha~t we can get. I would only entertain any further cpthment that ~rou wanted to make philosophically or ecoi~omicálly on the subject. I am rather sorry that you haven't felt free to (do that. `. ~Tudge FRIENDLY. Well, I would go this far. It ,~eem~ ~o' me very hard for anyone to sa~ that there is anything~ `~vrong in a requirement that fees should be. reasonable. In fact, asI understand it, the iudhstry doesn't challenge that ,~t all, WITIaIt they are fearful of is that courts will in fact produce fees that are unreasonable, ui~rea~onably lo~ and that they will be subject tO a great deal Of `hai~a'ssment, and I can perfectly well understand why th~y feel' that way. In my judgment, their fears are exaggerated, but perhaps if I were sitting where they do, I would.feel the. ,~ame way as they ~do and prefer to have things remain as they are. You will have to decide who is right. Mr. KEITH. Do you feel that the usual pattern of stockholder pro- tection exists in this industry as in other industries? Judge FRIENDLY. I don't think it exists in this industry. It might be an interesting philosOphical speculation as to how far it really exists in some others, but I don't think it exists in this from what I have seen of it. Mr. KEITH. Have State courts shed any light on this subject do you know? Judge FRIENDLY. All of the decisions have, I think, been in State courts, nearly all certainly, and they haven't shed vei~ much light, because they have felt that this matter of stockholder ratification has taken this situation out of the ordinary rule that where a director is on both sides of the situation he must sustain the fairness of the arrangement, and have put it into the area where the plaintiff has to prove waste, which is a much heavier burden. Mr. KEITH. How would the stockholders in the management com- panies be protected in this legislation? Judge FRIENDLY. You mean the companies that have gone public, where the adviser has `sold stock to the public? Mr. KEITH. Yes. Judge FRIENDLY. Well, I think they are going to have a real prob- lem if it should turn out that the results would be a downward revision of fees. Of course, I am not saying that they would or wouldn't. If they did, undoubtedly those `companies would be somewhat less profit- able than they now are. On the other hand, these people bought stock in those `companies, knowing that these management contracts were of short duration, were subject to revision, or to cancellation, and they also knew that the Congress of the TJnited States was still sitting and could `change the law when it saw fit. Mr. KEITH. If you were a trustee of an estate, the portfolio of which was $10 million, would you feel that a `fee of one-half of 1 percent `for the management of that portfolio was unreasonable? Judge FRIENDLY. Well, I certainly would, in view of the existing scale. PAGENO="0203" 617 Mr. KEITH. You say you would? Judge FRIENDLY. I would feel it was unreasonable in view of the fact that I could buy it so much cheaper,. unless the man had some unique ability. Mr. KEITH. Well, the particular fund that I have in mmd is Drey- fus Fund, and in relation to what has happened to that portfolio contrasted to we will say a bank in a small city charging one-half of 1 percent for a $5 million estate, the portfolio over a pei~iod of years seldom would show the return or the appreciation that the Di~eyfus Fund shareholders show. . Judge FRIENDLY. That fund has certa~inly done remarkably, no one can challenge that. . . . . Mr. KEITH. Once iii awhile I get this book out to look at, and if you look at Dreyfus Funds, it has gone through the roof. You look at the others with lesser fees oftentimes, and improvements have been most modest by comparison. Judge FRIENDLY. Yes. One just wonders whether there is any cas- ual relation. I think there are also other funds that have the same fee as the Dreyfus Fund, with supposedly very competent people run- ning them, which haven~t shown anything like that appreciation. Mr. KEITH. Here we are finding people- Judge FRIENDLY, I think, of course, a court would take that into account, obviously, if their advisory fee came before a court. Surely a court would take that performance into account. Mr. KEITH. What troubles me philosophically I suppose is in growing up, going to college, taking business law and learning about caveat emptor. A salesman comes around and there it is fully dis- closed, and they may have in hand the reports contained in Trust and Estates and it shows the various fees and all these various funds. Take your choice. "We think you ought to buy this one. Sure we get a good cut out of it, but look what we have done over the years. If you want to buy it," and there is a full disclosure, aiid the man is in a position to spend $10,000 or invest $10,000, therefore he has shown some business judgment in accumulating that money, it would seem to me that in the scheme of things full disclosure having been present, and a meet- ing of the minds, that he has a right to enter into that contract and that these people have a right to offer those kinds of funds to the public. Judge FRIENDLY. Well, they certainly have in the past, there is no question about that. The point I suppose is that in addition to this well informed and well heeled investor, we have a great many other small people who don't know anything about it, and as was brought out before, there isn't any really substantial price competition. I can imagine, coming back to your case, the $10 million estate, if I had such confidence in a particular man, and felt so sure that he was going to do well for me, I might consider it entirely reasonable to pay him five or 10 times the going rate. But at least the submission of the Com- mission is that that isn't what happens here. That these things are taken rather sight unseen. Now whether the whole matter is important enough to warrant Congress in acting is a very real question. Mr. KEITH. The fact that so many cases have been brought and PAGENO="0204" 618 most of them settled, getting into court and then settling would mdi. cate that the law is working reasonably well in its present form? Judge FRIENDLY. No; I wouldn't draw that conclusion, because I think the courts have laid down such a heavy burden as to discour age the bringing of these suits, the burden of proof on the plaintiff. Mr. KEITH. Thank you, Mr. Chairman. Mr. Moss. Mr. Murphy? Mr. MURPHY. No questions. Mr. Moss. Mr. Watkins? Mr. WATKINS. Mr. Chairman. Judge, I wonder if you would clarify my conception. I feel as though freedom of contract is a rule under the Federal Constitution. The exception would be the right of Con- gress to abridge it can be justified only by the existence of special circumstances such as war, depression, a public utility with monoply power, or a fraud, waste, or similar matters. Now it seems to me that-do you agree with that? Judge FRIENDLY. Well, I would agree there has to be special circumstances. Mr. WATKINS. I am certainly in no position to argue with the dis- tinguished gentleman. Judge FRIENDLY. No; I agree there has to be a special justification for it. Certainly I agree with that. Mr. WATKINS. It seems to me as though the SEC has put these mutual people in the same category perhaps with the stockyards, in which there were cases-290 U.S. 420- Judge FRIENDLY. Perhaps the industry would rather be analogized to- Mr. WATKINS. Do you agree that it seems as though that is what has happened? Judge FRIENDLY. Yes; I think it might be a more pleasant com- parison `to say perhaps it `h'as put them in the same place as the insur- ance companies. That is a little more attractive analogy. Mr. WATKINS. I feel as though this is an infringement upon the people's rights, and it seems to me that a Big Brother, which `is our Federal agency in this case, why should they substitute their judgment for that of an investor? `There doesn't seem to be any quarrel in this country about the investors. I haven't received any. Perhaps there is. I have never received any complaint. Do you think it is legal-do you think it is right that the Federal Government should step in as Big Brother and take my place as an investor, if I want to buy the stock? I should be the one to bring the complaint. Judge FRIENDLY. Well, I think it is legally defensible for the Gov- ernment t'o do this, if you gentlemen find that the conditions are such as have led to Government intervention in other areas, commencing with the railroads in 1887. If you find that, in effect, there is no com- petition, and that because of `the nature of `the industry, the buyer really is defenseless- Mr. WATKINS. Your Honor, when you talk about the railroads you are talking `about monopoly. Judge FRIENDLY. What did you say, sir? Mr. WATKINS. Railroads are governed by the Interstate Commerce Commission. PAGENO="0205" 619 Judge FRIENDLY. Yes. Mr. WATKINS. By the Public Utility Commission, whether it is intrastate or interstate. May I ask another question? I don't want to take up too much time. I promised `the chairman I wouldn't, and I am in no position to argue with you. Would you answer this, Judge. The SEC proposes that the courts shall determine reasonableness of mutual fund management fees. Now do you know of any other industry other than those which operate under a Government fran- chise or a public utility or a monopoly in which courts are directed to determine the reasonableness of fees charged in the industry for the service rendered? Judge FRIENDLY. Normally, you give that job to the administrative commissions. Mr. WATKINS. That is what I thought. Judge FRIENDLY. Subject to review by the courts. Take the insur- ance companies as an analogy. There certainly is a great deal of com- petition in all phases of the insurance business. But all their premiums are regulated by State commissions, subject to judicial review. As I said, that would be a perfectly possible thing for Congress to do here, to give this to the SEC, subject to judicial review. I have a feeling the industry would dislike that even more than it dislikes this, but that is a solution. What I have tried to suggest is that there is no real reason why the task couldn't be given to the courts in the first instance. It seems to me it is probably less painful to the industry than doing it the other way, although I would see no objection to giving the job to the SEC. Mr. WATKINS. Do you feel as though the States have properly regulated, or do you think they have done a poor job of it? Don't you think it is an infringement again on States rights? I know in the State of Pennsylvania that we have protected the public in every way, but we haven't gone to the point of setting rates. Don't you think this is going to be an infringement of States rights? Judge FRIENDLY. I wouldn't know whether they have done a poor job or not. I just haven't familiarized myself with it. I doubt if there would be any great outcry from the States if Congress were to broaden the Investment Company Act or any of the other Federal securities laws. My impression in talking to State judges is that this is a job they are very glad to let us handle. Mr. WATKINS. I think you will get a lot of jobs if this goes through. I have had 12 years experience in the State of Pennsylvania and am very much interested in insurance, in our securities commission. I feel as though we are moving in this way that this is an infringement. Do you think it is or do you not? Judge FRIENDLY. Well, it is obviously within the power of the Fed- eral Government, because it is limited to companies that are operating in interstate commerce and using the mails, and so forth. It is always a question of judgment for Congress whether it wants to use the power. Mr. Moss. Will the gentleman yield? Mr. WATKINS. Yes, in a minute. Don't you think, Your Honor, that if this bill were passed, that we might just as well close up the State, if they are going to name rates ?~ PAGENO="0206" 620 We might as well let them do everything, just get out of business and stop spending the money in protecting `the public. Judge FRIENDLY. I would think there were still quite a few fields in the prevention of securities frauds that are open to the States. I wouldn't `be worried about that. Mr. WATKINS. Go ahead. I yield to the' chairman. Mr. Moss. I point out `that the security markets have been regulated for ap~ro~imately 34 years by the Federal Government. We are not propo~rng here to embark upon any new or novel path, nor to take away from the `States any significant authority. Mr. WATKINS. We are doing it in my opinion. Mr. Moss. `Well, `the gentleman, of course, is entitled to his opinion, but I suggest that he might be voicing a more convincing opinion if he should support it more conclusively `than he has to this point. Mr. WATKINS. Mr. Chairman', will you yield? Mr. Moss. Of course, I will `yield to the gentleman. Mr. WATKINS. I just `wanted to get information from the judge. I respect his `testimony, even' tho'ugh I didn't have the opportunity to have hi~ full testimony in front of me, but I will `be able to read it later inthe record. Mr. Moss. If the gentleman h'ad informed the `Chair or any member o'f the staff that he did not have the testimony in front of him, it would have been supplied to him immediately. Mr. WATKINS. Well, I listened very well and I have no argument `with his testimony. I will certainly have to review it. Mr. Moss. Will the staff see that the gentleman is given a copy of the testimony so that he may have the opportunity of reviewing it. Mr. WATKINS. Will t'he chairman be so kind as to see that I get a copy of it so I don't have to'wait for the official record? Mr. Moss. The Chair thought that the gentleman was getting a copy in advance as all of the members have, and he will certainly reinforce his instructions to the staff. Mr. WATKINS. Thank you, and I want to thank the witness for answering my questions. Judge FRIENDLY. I am very pleased to have had the opportunity. Mr. MosS. Judge, I want to express my very real appreciation for your appearance here. I know it has been at a considerable personal inconvenience, but it has been most informative to the committee. Judge FRIEr~TDLY. Thank you. Mr. Moss. The committee will now stand adjourned until 10 o'clock on Monday morning next. We regret that we must ask the witnesses to return at `that time. The committee, will not meet tomorrow or Friday. The committee is now adjourned. (Whereupon, at 12:15 p.m., the subcommittee adjourned, to re- conveneMonday, October 23, 1967, at 10 a.m.) PAGENO="0207" INVESTMENT COMPANY ACT AMENDMENTS OF 1967 MONDAY, OCTOBER 23, 1967 HousE oi~' REPRESENTATIVES, SUBCOMMITTEE ON COMMERCE AND FINANCE, COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE, Washington, D.C. The subcommittee met at 10 a.m., pursuant to notice, in room 2123, Rayburn House Office Building, Hon. John E. Moss (chairman of the subcommittee) presiding. Mr. Moss. The committee will come to order. This morning the committee resumes its hearings with Mr. James W. Davant, chairmah of 1~he board, Association of Stock Exchange Firms. Would you introduce to the committee the gentlemen who are accompanying you? STATEMENT OP JAMES W. DAVANT, CHAIRMAN OP THE BOARD, ASSOCIATION OP STOCK EXCHANGE FIRMS; ACCOMPANIED BY LEON T. KENDALL, PRESIDENT; AND WALTER B. LEVERING, CHAIRMAN, LEGISLATION COMMITTEE Mr. DAVANT. On my right is Mr. Walter Levering, chairman of our legislative committee, and on my left Mr. Leon Kendall, president of our association. Mr. Moss. Will you gentlemen be seated. Mr. DAVANT. Mr. Chairman, in compliance with Mr. Painter's for- mal notice and rules of the Hou~ie we have filed a preliminary text of the statement with the subcommittee 5 days in advance of our appear- ance this morning. In the interim my associates and I have condensed and refined the text, and with your permission I would like to proceed with the shorter version at this time. Mr. Moss. Is it your desire to have the full text of the original version put in the record? Mr. DAVANT. Yes, sir. Mr. Moss. Without objection that will be done. You may proceed with the condensed version. (Mr. Davant's prepared statement follows:) STATEMExT OF JAMES W. DAVANT, CHAIRMAN OF THE BOARD, AssOcIATIoN OF STOCK EXCHANGE FIRMS Mr. Chairman, I am James W. Davant, Chairman of the Association of Stock Exchange Firms and managing partner of Paine, Webber, Jackson & Curtis. With me today from our Association are Leon P. Kendall, President, and Walter B. Levering, Chairman of our Legislation Committee. We appreciate this oppor- tunity to be heard on HR 9510 and 9511. (621) PAGENO="0208" 622 The Association of Stock Exchange Firms Is a 54 year old organization of member firms of the New York Stock Exchange. Our 510 member organizations offer a complete array of investment services to all classes and sizes of investors- individual and institutional. And they account, according to New York Stock Exchange research estimates, for at least 40% of all mutual fund sales to the investing public. Many of our member firms are also members of the American, Midwest and other leading securities and commodity exchanges as well as active in over-the-- counter markets and investment banking. We wish to add to the record our thoughts on how the securities industry can best meet its commitment to the consumer-investor, the publicly-owned corpora- tion and the general public. We will suggest specific criteria for a soundly functioning securities business and evaluate the proposals presently before Congress against these standards. For financial institutions to function in the public interest, they must: (1) Provide facilities which are adequate to the growing needs and changing requirements of a constantly expanding economy. (2) Be able to withstand shock and be able to sustain losses. (3) Attract and retain efficient and competent management. (4) Contribute to economic growth free of inflation and economic instability. Applying these principles to the' securities and mutual funds Industries, they require that such organizations have the resources and capital to: (A) Provide highly-trained and qualified sales personnel who are properly motivated to serve the public by educating, advising and protecting the investor. Provide "plant an'd equipment"-offices, and the proper tools for handling a sub~ stantial volume of transactions-so that investors in smaller communities as well as big cities may have ready access to financial markets' and receive a full range of investment service. (B) Reinforce consumer-protection by having the sales force supervised by' highly-trained compliance specialists as well as by the partners or management- level officers. The investor must be shielded from, possible over-selling abuses from which no industry is immune. (C) Provide quality investment vehicles and professional services aimed at an ever-broadening range of consumer needs. Consumers save in a variety of ways with varying means and `objectives. Thus, to encourage `maximum savings and investment flows, a diversification of investment media has to `be developed- media which have to be constantly supervised, revised and supplemented by new ideas. It is against the broad background of these consumer-interest criteria that ASEF moves into its evaluation of the proposal before this Committee. SALES CHARGES The recommendation for a 5% ceiling on, mutual fund sales charges is a seem- ingly magic figure, requiring no economic justification as to what it will do to or' for the investor in mutual funds or the securities industry. In our view, the SEC ha's offered no meaningful evidence that the consumer-investor has been harmed by present selling charges. On the contrary, the sales charges do not appear to be inconsistent with the incentive required by sales personnel to bring this savings medium and its benefits to potential investors. The `contention that `lower price is the most important-and virtually exclu- sive-measure o'f the public interest, that something "cheaper" must be "better'~ is at best half truth and false economy. The investor, no less' than any other thoughtful consumer-purchaser, must weigh `carefully the relative merits of lower cost against his needs in te'rms of both product and service. Looking ahead, the reduction of sales charges to 5% would place obstacles in the way of expanding the ownership of equity instruments to `broader groups, and thus, limit rather than enlarge the savings services made available to the public. Fund sales personnel would be discouraged from catering to smaller' investors who' buy in lower dollar units and to investor outside urban centers. Our `smaller regional firms tend to secure' a relatively greater share of their revenues from mutual fund sales `than `larger firms, so the burden would fall particularly hard en them. Mutual fund investors are also being edueate4 contin- ually as to investaient securities and the expanding svailability of funds having differing investment objectives, and regularly `supplied with market `information, from which they can make their own investment decisions. PAGENO="0209" 623 In view of the paucity of information and economic justification behind the SEC's proposal, and the considerations noted above, it is our firm conviction that more comprehensive and detailed studies of the subject should precede any legislative action in this area. It is determined that tile services of an industry- government study group would be an appropriate vehicle for this effort, the ASEF-as in the past-stands ready to participate. MANAGEMENT TEES As ASEF sees it, it is clearly in our customers' and our own best interests to do everything possible, as distributors of mutual funds, to assure the continued maintenance of high standards of service and performance on the part of fund managements. The reservoir of individuals with outstanding managerial talent is never excessive in a growing economy, and such executives must be compen- sated according to the values they create. Here, again, there is incomplete documentation. What little analysis there is relates fees only to the cost of producing services-a rerun of the cheaper-must- be-better theme. There is no recognition of the fact that in mosp service busi- nesses (and particularly in the business of money management), an~ true measure of fees charged must also consider the va'ue of services rendered. In fact, deter- mining the appropriateness of fees and commissions by relating them only to costs, could very quickly destroy the ability of the industry to deliver value to public investors. The present approach, whereby directors of investment companies and their shareholders, using their best judgment, pass on the reasonableness of manage- ment fees, is far superior to the SEC's approach of regulatory and judicial deter- mination. An increase in the ratio of independent directors from 40% to a major- ity, would be consistent with the public interest. To have these directors make a specific finding regarding any management fee contract may also be in order. Such steps, we feel, would tend to minimize any, risk that the public and share- holders' interests may be jeopardized by excessive costs for management. INDUSTRY RESPONSIBILITY TO ITS CUSTOMERS The consumer-investor is better protected in the United States than anywhere else in the world. In buying securities, he is afforded three levels of protection: By those in the individual securities firms striving to earn and retain his con- tidence; by strong self-regulatory agencies; and by federal and state govern- mental agencies functioning under laws designed to protect the public interest. The securities industry has been striving diligently to achieve higher standards of professionalism and service through more thorough training of salesmen and the introduction of modern data processing equipment and high-speed cOmmu- nications systems. In cooperation with the SEC, and acting under its self- regulatory authority, the industry also is committed to meticulous compliance with a mounting multiplicity of laws, rules and reporting requirements. These efforts, voluntarily instituted as often within the industry itself as in response to outside pressures, have unquestionably benefited the investing public. Of course, these measures have resulted in higher costs of doing business. The New York Stock Exchange has taken a formal look ahead, to try to deter- mine the size and scope of the needs of a growing investing public in an ex- panding American economy over the next decade. This review led to some startling conclusions. By 1975, shares listed on the NYSE alone can exceed 20 billion- double what they are today. The number of potential shareowners is expected to increase by at least 10 million, and shares traded will rise accordingly. The Exchange community alone will have to add 50,000 more persons to its payrolls, including 25,000 more qualified and trained sales representatives. This is eight more people for every ten employed today (and many more than that number will have to be recruited and `trained to produce a net addition of 25,000). As many as 1,500 additional offices-four more for every ten now in operation-will have to be planned, located and staffed. The Exchange research indicated our iPdustry must attract an additional $85 for every $100 of capital now employed in the business. To attract an additional $1 billion in needed capital funds, we will have to maintain a level of profitability sufficient to induce such new capital to flow to it. The present proposals do not accord sufficient weight to the economic conse- quences of the recommendations on the ability of the securities industry to meet S5-592-68-pt. 2-14 PAGENO="0210" 624 its commitments to its presefit and prospective customers and to a growing na- tional economy. To pare down profit margins, while causing costs of investor services to rise may well change the investment industry in ways that will be adverse to the public interest. CONCLUSION On the basis of the criteria set forth in this statement, the key proposals in EER 5910 and 5911, if adopted, would, in our view, result in less rather than more protection and in poorer rather than, better service to, the investor. The evidence at hand is inadequate for the establishment of guidelines which may well prevail for the next generation and have a serious impact upon an Industry as dynamic and important to the national welfare as the mutual fund industry. We submit that the implementation of these proposals will: Result in the deterioration of service to the investor. Some firms may discourage mutual fund business. Fewer neW and specialized funds will be developed. Motives for innovation will be less compelling and services will be retrenched. Result in less protection for investors, because it will curtail the industry's financial capacity for raising its standards and introducing new safeguards. Discourage competent individuals from entering the securities business by reducing compensation and the availability of financial incentives. Finally, the legislation before this Oommittee promises to set down legislative guidelines which could be controlling for many years. In our view, the case presented for changes of so fundamental a nature has not been sufficiently documented through essential basic research. Mr. DAVANT. Thank you, sir. The Association of Stock Exchange Firms is a 54-year-old organization of member firms of the New York Stock Exchange. Our 510 member organizations offer a complete array of investment services to all classes and sizes of investors-individual and institutional. Phey account, according to New York Stock Exchange research estimates, for at least 40 percent of all mutual fund sales to the investing public. Many of our member firms are also members of the American, Midwest, and other leading security and commodity exchanges as well as active in over-the-counter markets and in investment banking. We wish to add to the record our thoughts on how the securities industry can best meet its commitment to the consumer-investor, the public owned corporation, and the general public. We will suggest specific criteria for a soundly functioning securities business and evaluate the proposals presently before Congress against these standards. For financial institutions to function in the public interest, they must- (1) Provide facilities which are adequate to the growing needs and changing requirements of a constantly expanding economy. (2) Be able to withstand shock and be able to sustain losses. (3) Attract and retain efficient and competent management. (4) Contribute to economic growth by attracting savings for investment. Applying these principles to the securities and mutual fund in- dustries, they require that such organizations have tht~ resources and capital to- (A) Provide highly trained and qualified sales personnel who are properly motivated to serve the public by educating, advising, and protecting the investor. Provide "plant and equipment"-offices and the proper tools for handling a substantial volume of transactions- so that investors in smaller communities as well as big cities may have PAGENO="0211" 625 ready access to financial markets and receive a full range of investment service. (B) Reinforce consumer protection by having the sales force su- pervised by highly trained compliance specialists as well as by the partners or management-level officers. (C) Provide investments and financial services to meet consumer needs. Consumers save in a variety of ways with varying means and objectives. Thus, to encourage maximum savings and investment flows, a diversification of investment media has to be developed. With this as background, let us examine the proposals. SAL~S ChARGES The recommendation for a 5-percent ceiling on mutual fund s~1es charges. is a seemingly magic figure, requiring no economic justifica- tion as to what it will do to or for the investor in mutual funds or the securities industry. In our view, the SEC has offered no mëan~ngful evidence that the investor has been harmed by present selling charges. On the contrary, the sales charges do not appear to be inconsistent with the incentive required by sales personnel to bring mutual funds to potential investors. The contention that lower price is the most important-and vir- tually exclusive-measure of the public interest, that something "cheaper" must be "better" is at best false economy. In our view, the reduction of sales charges to 5 percent would place obstacles in the way of expanding the ownership of equities to broader groups, and thus limit rather than enlarge the savings services made available to the public. Fund sales personnel would be discouraged from catering to smaller investors who buy in lower dollar units and to investors outside urban centers. Our smaller region~l firms tend to secure a relatively greater share of their revenues from mutual fund sales than do larger firms, so the burden would fall particularly hard on them. Mutual fund investors using ASEF firms are also being exposed continually to other investment opportunities, and are regularly supplied with market information from which they can make their own investment decisions. In view of the paucity of information and economic justification behind the SEC's proposal~ and the considerations noted above, it is our firm conviction that more comprehensive and detailed studies of the subject should precede any legislative action in this area. If it is determined that the services of an industry-government study group would be an appropriate vehicle for this effort, the ASEF-as in the past-stands ready to participate. MANAGEMENT FEES As we see it, it is clearly in our customers' and our own best inter- ests to do everything possible, as distributors of mutual funds, to assure the continued maintenance of high standards of service and performance on the part of fund managements. The reservoir of indi- viduals with outstanding managerial talent is never excessjve in a growing economy, and such executives must be compensated accord- ing to the values they create. PAGENO="0212" 626 Here, again, there is incomplete documentation. The available anal- ysis relates fees only to the cost of producing services. There is no recognition in the SEC proposal of the fact that in most service busi- nesses (and particularly in the business of money management), any true measure of fees charged must also consider the value of services rendered. In fact, determaning the appropriateness of fees and cOm- missions by relating them only to costs, could very quickly destroy the ability of the industry to serve public investors and particularly the smaller investors. The present approach, whereby directors of investment companies and their shareholders, using their best judgment, pass on the reason- ableness of management fees, is far superior to the SEC's approach of regulatory and judicial determination. An increase in the ratio of independent directors from 40 percent to a majority would be con- sistent with the public interest. To have these directors make a specific finding regarding any management fee contract may also be in order. Such steps, we feel, would tend to minimize any risk that the public and shareholders' interests may be jeopardized by excessive costs for management. INDUSTRY RESPONSIBILITY TO ITS CUSTOMERS The investor is better protected in the United States than anywhere else in the world. In buying securities, he is afforded three levels of protection: By those in the individual securities firms striving to earn and retain his confidence; by strong self-regulatory agencies; and by Federal and State governmental agencies functioning under laws de- signed to protect the public interest. The securities industry has been striving diligently to achieve higher standards of professionalism and service through more thorough training' of salesmen and the introduction of modern data processing equipment and high-speed communications systems. In cooperation with the SEC, and acting under its self-regulatory authority, the in- dustry also is committed to meticulous compliance with a mounting multiplicity of laws, rules and reporting requirements. These efforts, voluntarily instituted as often within the industry itself as in response to outside pressures, have unquestionably benefited the investing pub- lic. Of course, these measures have resulted in higher costs of doing business. The New York Stock Exchange has taken a formal look ahead, to try to determine the size and scope of the needs of a growing invest- ing public in an expanding American economy over the next decade. This review led to some startling conclusions. By 1975, shares listed on the NYSE alone can exceed 20 billion-double what they are today. The number of potential shareowners is expected to increase by at least 10 million, and shares traded will rise accordingly. The exchange community alone will have to add 50,000 more persons to its payrolls, including 25,000 more qualified and trained sales' representatives. This is eight more people for every 10 employed today-and many more than that number will have to be recruited and trained to produce a net addition of 25,000. As many as 1,500 additional offices-four for every 10 now in operatioii-will have to be planned, located, and staffed. PAGENO="0213" 627 The exchange research indicated our industry must attract an addi- tional $85 for every $100 of capital now employed in the business. To attract an additional $1 billion in needed capital funds, we will have to maintain a level of profitability sufficient to induce such new capital to flow to it. The present proposals do not accord sufficient weight to the eco- nomic consequences of the recommendations on the ability of the secu- rities industry to meet its commitments to its present and prospective customers and to a growing national economy. To pare down profit margins, while causing costs of investor services to rise may well change the investment industry in ways that will be adverse to the public interest. CONCLUSION On the basis of the criteria set forth in this statement, the key pro- posals in H.R. 9510 and 9511, if adopted, would, in our view, result in less rather than more protection and in poorer rather than better service to the investor. The evidence at hand is inadequate for the establishment of guidelines which may well prevail for the next gen- eration and have a serious impact upon an industry as dynamic and important to the national welfare as the mutual fund industry. In summary, reduction in the profitability of investment firms could well result in: 1. A deterioration of services to the public, many of which are pro- vided without charge; 2. Hampering the industry's ability to compete for qualified per- sormel and to train and supervise them adequately, in the interest of serving the public to best advantage; 3. Impairing the ability of firms to meet the increasing regulatory requirements designed to protect the investing public; 4. Inhibiting the flow of new capital into the business at a time of accelerating demand for additional investment services; 5. The inevitable consequences of making large firms larger and forcing smaller firms out of the business, thereby limiting the choice investors have in securing investment services. I thank you, sir. Mr. Moss. Thank you. Mr. Watkins. Mr. WATKINS. Thank you, Mr. Chairman. Mr. Davant, would you consider mutual funds a monopoly, or would you consider it a competitive business. Mr. DAVANT. I consider it a very competitive business. There is a choice of buying any number of investment media, any number of mutual funds, either no load, load, closed end, open end. This is an area where there is complete disclosure of information. The investor has complete ability to move from one investment to another. Mr. WATKINS. I thank the gentlemen. I have no further questions, Mr. Chairman. The statement speaks for itself and I think it is a very fine statement. Mr. DAvANT. Thank you, sir. Mr. WATKINS. I appreciate having the opportunity of listening. Mr. DAVANT. Thank you, sir. Mr. Moss. Mr. Murphy. PAGENO="0214" 628 Mr. MURPHY. No, questions. Mr. Moss. Mr. Keith. Mr. KEITH. Thank you, Mr. Chairman. With reference to m~qiagernent fees, you say on page 3, "The reser- voir of individuals with outstanding managerial talent is never, exces- sive in a growing economy, and such execl4tives mitst be compensated aocording to the values they create." The portfolios of these funds in rriany respects are sithi1a~' and cer- tainly the research which pays o~ for or~e stock of one company con- sidered for the portfolio of one fund pays off to the othe~ `funds. They are well compensated for the work that they do. The evidence that we have seen here would indicate that, particu- larly when you contrast the ~uccess of their portfolios with others. But that is an observation, not a uestion. When you go on in the third paragraph on that same page ~nd say, "To ~bave these directors make a specific finding regarding any man- agement fee contract may also be in order." Don't you argue that they in effect do t~iat now, these particular directors? Mr. DAVANT. I can~t answer in the specific instances. I. think it is quite usual in boards for outside directors to perform this function. I think it would be desirable to have them do so. Mr. KEITH. Actually, it seems to me what it does is invite attention to the fact that `these unaffihiated directors have to stand up for the fund shareholders. Mr. Chairman, I have some questions that are not specifically for this witness. It is my understanding that we may ask these questions of any witness by correspondence and that the time will not expire today. Mr. Moss. That is correct. Yoi~i have 2 weeks following the close of these hearings to direct written inquiries to any of the witnesses who have appeared before us. Mr. KEITH. ~&nd then they would have 2 weeks in which to respond. Mr. Moss, A maximum of 2 weeks. Mr. KEITH. I would be perfectly satisfied if you gave us less so a& to shorten the total span. If you wanted to, the period might be 5 days for committee members to ask questions and 2 weeks for response. Mr. Moss. Is there unanimous consent? Mr. WkTKTN5. No, I object to that. I don't see any reason for rush- ing this. Mr. Moss. Counsel advises me that the record shows that the origi- nal unanimous-consent request was the period of time would be a total of 2 weeks after the witness made his appea~anc; so that will acconunodate the gentleman from Massachusetts. Mr. KEITH. In other words, if I expect them to do an adequate job I should get my questions in fairly soon. Mr. Moss. Yes. Mr. KEITH. I have no further questions, Mr. Chairman. Mr. Moss. Mr. Davant~, I note that in reference to the mutual fund industry you state the management sales role and management fee should he retained in order to have a sound functioning and profitable securities business. It is my recollection that several years ago the PAGENO="0215" 629 rule of thumb was that the securities business was profitable with 2 million shares on the New York Stock Exchange and that that figure was set more recently at somewhere around 3 million shares a day with the concurrent trading of the American Stock Exchange. Now, we have been witnessing trading days of up to 10 million shares a day. What is it that is unsound about the securities industry in view of this volume already achieved? Mr. DAVANT. The volume, sir, has a way of coming and going, particularly in this business. Our break-even point now is a good deal higher than the 3 million shares per day. In 1965, it was 4.8. million. The most recent break-even point I have seen is approximately 7 mil- lion shares per day. Mr. Moss. Would you supply the committee with that data and the source of it. (The following information was received by the committee:)~ BREAK-EVEN PoINTs ON SECURITY CoMMIssIoN BUSINE5S-4961-1966 According to reports prepared by the New York Stock Exchange on the income and~ expenses of member organizations, the break-even points on security com- mission business between 1961 and 1966 are as follows: Year Break-even point (shares) Average daily NYSE reported volume (shares) 1961 1962 1963 1964 1965 1966 3,100,000 3,700,000 3,900,000 4,100,000 4, 800, 000 5,900,000 4,100,000 3,800,000 4,600,000 4,900,000 6, 200, 000 7,538,000 During 1967, the break-even point has risen further, to approximately the 7 million share level and perhaps above that level. The staff members of the Ex- change responsible for assembling and analyzing these data have corroborated my judgment here. The Exchange defines the break-even point as the minimum average daily NYSE reported volume needed by member organizations doing business with the public to cover expenses on their security commission business. Among the special factors at work recently tending to push the break-even point higher have been the increased costs of plant and equipment-especially data processing machinery, the cost of overtime to handle present workloads, the recruiting, breaking-in and training of new and lesser skilled employees, the second shift operations to handle volume, and the special costs generated by the log jam of paperwork that has hampered efficient operations in many back-offices. Mr. DAVANT. Yes, sir. Mr. Moss. Is that on the stock exchange alone? Mr. KENDALL. Sir, these data are from the New York Stock Ex- change 1967 Fact Book. They report here the figures through 1965, based on the New York Stock Exchange Income and Expense Report, which is an official report made by member organizations to the exchange. The 1966 figure should now be available. I do not have it here, but we would be pleased to make it available to you. Mr. DAVANT. Mr. Chairman, the cost of doing business has risen substantially in this business as I suppose in most businesses. For instance, when I started some 22 years ago, I was told to go out and sell. Here is a book. We now train our sales representatives over a pe- PAGENO="0216" 630 nod of 6 to 8 months, speaking from my own firm's experience, and we estimate our cost at about $15,000 per man, before he is permitted to deal with the public. Mr. Moss. But you have reached about the 2 billion point trading volume this year, with the average of course at 10 million a day, which appears to still be a relatively profitable area. As I recall a recent study indicates that the commissions paid' last year were in excess of 1.4 billion, or about one-half of 1 percent of the gross na- tional product, whh~h suggests a rather significant volume `of in- come from the exchanges. Is that correct? Are you having difficulty h~aring? Mr. DAVANT. Yes, sir; I am. Mr. Moss. That is a niost unusual experience for me to have people who have difficulty hearing me. Mr. DAvANT. I am sorry, sir. Now I can hear you. Mr. KENDALL. Sir, if I may, I think truthfully what has happened to us is that in the last 2 to 21/2 years the volume of activity on ex- changes had doubled. In order to accommodate to this, we have had an increase in overtime~ an increase in costs of operations that have been of an almost, I don't want to use the word, "crash"- Mr. Moss. Isn't that precisely what it is? You have had an unan- ticipated growth. Mr. KENDALL. That is right, sir. Mr. Moss. And it has been riding for some time at a very large level which was also unanticipated. Mr. KENDALL. That is correct. Mr. Moss. And as a result you have found yourself faced (1) with a lack of trained personnel, (2) with a ]~ack of automation sufficient to handle the volume, and (3) you have been required to engage in the uneconomic practice of excessive use of oyertime. Mr. KENDALL. Correct. Mr. Moss. You tend `to shy away from overtime. You reach a point where physical resources don't match perhaps the appetite for dollars. Mr. KENDALL. T'hat is correct, sir, and for example, to go further on this point, as the new president of the association, the first assignment the board gave me was to add to our staff a director of personnel devel- opment who has the specific assignment of attracting, recruiting into Wall Street and training up to 10,000 new employees for the opera- tions area, not the sales area but the operations area, within the next ~ to 9 months. Mr. Moss. That gets me on to my next question. On page 4 of the revised statement you discuss the growth and the need for a greatly expanded sales force, projecting I think through the year 1975. But if the present trend for institutional buying or institutionalization con- tinues, does it follow that there ~will be the same requirement for in- creased sales representatives by members of the exchange to sell issues on the exchange? Isn't it more likely that the recruiting problem will be to recruit the sales force to sell mutual funds rather than the exchange shares themselves? Mr. DAVANT. Mr. Chairman, I speak in reference again to my own firm. Approximately 6 percent of our income is derived from the sale PAGENO="0217" 631 of mutual funds. This is part of our business, but in effect we are a de- partment store of investing, and a mutual fund is not the answer for all investors. We must provide services throughout the country for investors to make their own choices as to which types of investments they would like to make. Mr. Moss. Let's reverse it and put it the other way. Is the anticipated growth in individual investor participation exepected to keep pace with the institutionalization of the market. Mr. DAVANT. Yes, sjr. Mr. Moss. Do you have any studies to back up that statement? Mr. KENDALL. Sir, I was the author, the project director is a more appropriate term, of a study looking into 1975 for the exchange community. This was done in 1965. At that time, based on information and studies by the National Industrial Conference Board, a fine re- search organization in New York, we determined that the number of Americans earning $10,000 or more a year would likely double between that year and 1975. These households have a potential of discretionary purchasing power which makes them possible investors for the first time. We also know that it is not unusual for a mutual fund shareholder to also own common stocks. The Investment Co. Institute Fact Book, which I have before me now, indicates that the composite shareowner owns 2.7 common stocks directly and 1.4 mutual funds. Mr. Moss. Mr. Kendall, my question went to the nature of the study and the availability of it for this committee, the study, at least the conclusion that the growth of individual buyers of shares will keep pace with the growth of the institutionalization of the market as a result of the growth of the number of mutual funds and mutual fund shares. Mr. KENDALL. I would say that the potentials that we see in the evolution of the American household are such that if these potentials are developed by sales techniques, by branch networks, by services amenable to them, that, yes, sir, this would continue. Mr. Moss. That isn't what I asked. I said is there a study? You indicated that you were the author of a study. Mr. KENDALL. Yes, sir. Mr. Moss. I asked if that study is available to this committee. Mr. KENDALL. I can make this study available to the committee quite readily, sir. Mr. Moss. All right. Then we ask that the study be made available so that we can have the opportunity to more reflectively consider it. Mr. DAVANT. Mr. Chairman, may I point out the study is dated December 1965. (The study referred to may be found in the committee files.) Mr. Moss. It represents a judgment. Mr. DAVANT. Yes, sir. . Mr. Moss. Which is being utilized here today as the basis for testi- mony. Therefore, it becomes very relevant to the inquiry of the subcommittee. Mr. LEVERING. And relevant too, sir, to the possible thought that additional studies of this type ought to be made available to your committee. PAGENO="0218" 632 Mr. Moss. We are interested in receiving all the studies we can get. Just in passing here, the question of monopoly. Would you say that the mutual fund industry has all the characteristics of a completely free and competitive product? Mr. DAVANT. My own firm, for instance, sells variously 123 different funds. The freedom of choice is quite wide. Mr. Moss. I am not talking of freedom of choice. I am talking of the characteristics of a fully competitive product. Can you cut the price? Mr. DAVANT. No, sir. Mr. Moss. You cannot. And then when we get into the management, how much competition is there in this field of management? How many instances in your experience have you known one group of managers to outbid or underbid another group of managers in taking account of that? This is characteristic of a large part of American industry. I think in the advertising industry it isn't at all unusual to see sudden changes maccounts, but here in the mutual fund industry do you have any experience, any significant factor of competition between manage- ment groups seeking to garner accounts from each other? Mr. DAVANT. I have none. Mr. Moss. And then you also agree that there is price maintenance. There is not competition in price on item A. There might be on item B or C which you can offer, but when you offer them, you offer them at the same price as all of your competition does. Mr. DAVANT. Yes, sir; like any other fair-traded item. Mr. Moss. Well is it like a fair-traded item? Can you cite for me a fair-traded item anywhere else that is as universally fair traded, as completely or as uniformly traded as a share in a mutual fund? This is ~ill 50 States as I recall that you have this fair traded. Mr. LEVERING. Sir, that is a question that would be ~very difficult for us to answer, but to get back to your- Mr. Moss. Don't you sell retail? Mr. LEVERING. Yes, but I am talking about other areas, not the securities business. Mr. Moss. I didn't raise the questions- Mr. LEVERING. I couldn't answer it in other areas. Mr. Moss. I didn't ask you to answer. Mr. Davant is the one who objç~cted to the question and said "Like any other fair-traded item." Those are his words, not mine. Therefore, I just assumed that he had reasonable acquaintanceship with fair-traded items. Now if he hasn't- Mr. DAVANT. I cannot answer that for other States, sir. Mr. Moss. You don't really know whether it has the characteristics of other fair-traded items. Mr. DAVANT. I think that is correct. Mr. Moss. Thank you. Are there any further questions. Mr. KEITH. I have one that I would like to get some comments on as to the wide experience of the chairman of the board of the Associa- tion of Stock Exchange Firms. That has to do with speculate. Since these hearings started there has been a lot of comment in the press about developing a need for some way to keep track of the buying and selling which might be of a speculative nature, particularly by selling PAGENO="0219" 633 in a narrow market that might cause a price movement. The fact that a large volume may be disposed of at the end of the day or bought at the end of `the day. I would like to know if you think there are sufficient devices available to keep track of this large volume transactions, if there is sufficient exposure to the public of these transactions, and if there is a need for any further light to be shed on them through, per- haps, regulatory path that might be followed but which hasn't yet been taken advantage of. Mr. DAVANT. Mr. Keith, I believe that the SEC and the regulatory bodies have sufficient `authority to carry this out. There `is always a problem of speculative excesses. Speculation itself isn't bad, provided it is knowledgeable, and conducted under proper regulation. `There has been a substantial amount of activity that has appeaied to be speculative in nature recently. I think the stock exchange itself is `doing a very fine job of monitoring it. It doesn't `do a job that is 100- :percent effective because things do slip by, but I think it is doing a very excellent job of monitoring this type of activity. Mr. KEITH. Do you read Sylvia Porter? Mr. DAVANT. Sometimes. Mr. KEITH. She `had a very wide readership. Mr. DAVANT. Yes, sir. Mr. KEITH. I think very recently she had a column dealing with `this, and pointed out that there were a lot of goings-on that were not ~wholesome in their effect upon the market. But you do not concur, I gather. Mr. DAVANT. I think the market must constantly be kept under sur- veillance. In times of great activity there is always the possibility ~of excesses. Mr. KEITH. I have no further questions. Mr. Moss. Are there any further questions? If not I want to thank you gentlemen for your appearance. Thank you. Mr. DAVANT. Mr. Chairman and gentlemen, thank you very much, sir. Mr. Moss. The next witness is Mr. Richard W. Jennings, prQfessor of law, University of California at Berkeley. Mr. J~nnings. STATEMENT OF RICHARD W. J~ENNINGS, PROFESSOR OF LAW, UNIVERSITY OF CALIFORNIA, BERKELEY Mr. JENNINGS. Mr. Chairman and members of the committee, I am ~appearing here today at the invitation of the chairman of the sub- *~ommittee to express my views on }]I.R. 9510 and H.R. 9511, the legi~- lation of public concern falling in the field of my professional com- petence. I have been professor of law at the University of California School ~of Law, Berkeley, for 20 years, specializing in corporation and se- curities regulation. Be-fore that I was an attorney engaged in private practice in San Francisco. I wish to make clear that I speak in an individual capacity and not in my official capacity as a member of the law faculty of my university. I have prepared and have submitted a statement regarding several items in the proposed legislation. This is not `a long statement. I wonder PAGENO="0220" 634 whether it is the wish of the committee that I read the statement or whether I should just file it and present myself for possible questions ~ Mr. Moss. I leave that entirely to your choice, whichever means you feel will most effectively indicate the views you have. Mr. JENNINGS. I would like to then take up the matter of manage- ment fees. I have restricted myself mainly here to legal problems involved in connection with the mutual fund structure. I will first deal with the problem of the proposed amendments to section 15 of the act relating to management fees. The mutual fund structure is quite unique in that unlike most American corporations and financial institutions which employ their own staff to manage their affairs, the mutual fund typically receives its investment advice and management services from a separate organi- zation which is owned and controlled by the sponsors of the fund or their successors. The fund usually has a board of directors who nego- tiate the advisory contract with the investment adviser. Traditionally, the fee in an investment advisqry contract was one-half of 1 percent of the average assets of the fund during the year. In the early years of a fund, such a fee may in fact be inadequate. As the fund grows, how- ever, the fee becomes more and more attractive. For example, if a fund has average assets of $100 million at one-half of 1 percent, the fee would amount to $500,000. If the average assets grow to $600 million, the fee computed at the same rate rises to $3 million. And if the fund climbs to a billion dollars of assets, the fee of $5 million becomes enormous. It may be an oversimplification to say that "it costs no more in research effort to buy 100 shares of stock than 100 shares", as Judge Moore suggested in Brown v. Bullock, 294 Fed. 2d 415 (2d Cir. 1961), but surely this is an area where the economies of scale clearly would be expected to operate. The Investment Company Act recognizes the inherent conflict of interest between the investment adviser and the fund by requiring (a) that at least 40 percent of the board of directors be "independent" of the adviser, that is not affiliated with it; and (b) that these unaffihiated directors annually approve the contract. Thus, the act supports the illusion that the unaffiliated directors will negotiate the advisory contract on behalf of the fund shareholders. It is also customary to have the advisory contract ratified or approved by a majority of the shareholders. In reality, however, when the shareholders are asked to ratify the contract, they cannot negotiate for the fund. They are limited to rejecting or accepting the contract formulated by the fund directors. Furthermore, with the proxy machinery supposedly in the hands of management, there is no difficulty in obtaining shareholder approval of the advisory contract. Mr. KEITH. I have a question. You changed your testimony and I wonder the reason for it. You said on page 2 with reference to Brown v. Bullock "Surely this is an area where the economies of scale clearly operate." I think you changed that in your oral statement. Mr. JENNINGS. What I really mean is that it should be cheaper proportionately to operate a $1 billion fund than a $100 million fund. Whether the economies of scale are passed on is another question. PAGENO="0221" 635 Mr. KEITH. You indicate that they clearly operate with this method. Mr. JENNINGS. Yes. Mr. KEITH. One wonders if they really do pass on the economies of scale. Mr. JENNINGS. I think the economies of scale are there. The question is whether they are passed on to the fund shareholders. Mr. KEITH. That is the intent that I thought you had, but it didn't read that way. Then you have just changed your testimony on three further: "With the proxy machinery in the hands of management, there is no difficulty in obtaining shareholder approval." You put in the word "supposedly," I believe in there some place. Mr. JENNINGS. I wonder if that could be read back. Mr. KEITH. The word "supposedly" could be read back. Mr. JENNINGS. At what point, sir? Mr. KEITH. Twill reread that sentence. Mr. JENNINGS. "Furthermore, with the proxy machinery in the hands of management, there is no difficulty in obtaining shareholder approval of the advisory contracts." Mr. KEITH. I thought you said the word "supposedly" in your oral testimony. Mr. JENNINGS. I don't recall at what point, sir. Mr. KEITH. That is all right. I won't belabor it. The record will show it. Mr. JENNINGS. I think I may well have said-did I say "With the proxy machinery supposedly in the hands of management"; was that the point? Mr. KEITH. It is my recollection that you said word~ to that effect. Mr. JENNINGS. Well, I think, as a matter of fact, clearly the proxy machinery is in the hands of management since they solicit the proxies, so I will ask that the record be corrected to strike out the word "sup- posedly", which I did add. May I then continue? Mr. Moss. Yes. Mr. JENNINGS. How are the so-called independent directors selected? Again to quote Judge Moore in Brown v. Bullock, "they are usually selected by and known to management; they are not self-appointed strangers." Indeed, they are invariably so selected. There is, of course, nothing illegal abqut this practice, but the reality is that while the present Investment Company Act assumes an "independence" on the part of the unaffiliatecl directors, it is difficult, if not impossible, for the unaffiliated directors to represent and negotiate for the fund share- holders~ Indeed, within the mutual fund industry, the view is widely held that the mutual fund corporation is merely ~ shell, and that the advisory contract is actually negotiated between the investment ad- viser and the fund shareholders when the fund shares are purchased. Under the shell theory it is argued that the Investment Company Act "recognizes and permits the organization of the externally managed fund, and * * * the stock has been sold to the public on that basis." It is contended, therefore, that the fairness of the advisers fee is not a question for the directors. As a leading attorney specializing in the field has put it: "That is the way it was sold, and even assuming that with a $1 billion or $2 billion fund you could get a cheaper internal organiza- PAGENO="0222" 636 tion, that i~ri't what the stockholders bought, and I don't see that there' is any requirement on the directors to consider changing the setup." Mr. Alfred Jaretzki, Jr., University of Pennsylvania Law School Conference on Mutual Funds (115 U. Pa. L. Rev. 699, 747 (1967)). It should be added, however, that since 1959, partly as a result of litigation involving over 20 of the Nation's largest arid best known funds, the fees of a number of funds have been scaled down as the assets have grown *in size. There are also indications that the un- affiliated directors. of some funds periodically review the advisory contract and renegotiate the contract so as to reduce the management fee to reflect economies of scale, the quality of performance, and the like. See Statement of Mr. Robert M. Loeffier, Conference on Mutual Funds (115 U.,Pa. L. Rev. 659,736-37 (1966)). Despite these exceptions, however, the facts are that the funds have' had an enormous growth in the last few years; that management fees" ro~se to staggering proportions; and that in many instances the econo- mies `that go with `size have not been passed on to the fund share- holders. It was inevitable that the enormous profits from management fees would make the advisory companies literally gold mines. Accordingly,. there have been numerous sales of controlling stock interests ~n invest- mént advisers, io which the sellers cashed in their chips at an enormous. profit and at capital gain rates. A number of advisory companies have made a public offering of the Common stock so that the company hits become publicly owned. In one case, the selling shareholders reaped a h~tru-est' of over $40 million, after deducting underwriting costs, still retaining an interest of about 12 percent, in the management com- pany. I might say, parenthetically, that you have the curiouS feature of" a fund having an advisory contract with an adviser organization~ which in a sense has control of the fund, and then which itself goes public, so that public shareholders invest in the adviser, rather than' having internalization, and it really is a most curious type of financial structure. AlthQugh the Investment Company Act as originally enacted at- tempted to cope with the problem, with the enormous growth of' funds, the act pro~vide'd a built-in protection to the fee contract, rather than furnishing a corrective. Section 36 authorizes the SEC to bring' an action to remove any director, or investment adviser or underwriter,.. for `~grCss misconduct or gross `abuse of trus:t in respec'~ of any reg- istered investment compa~ny." In Bro~k v. Manage~1 ?wnd$, Inc., 286" F. 2d 901 (8th Cir. 1961), the court; questioned whether by virtue of' section 36 a private right of action existed which could be enforced' by shareholders, either `derivatively, or by a class action, to recover' ~xeessive fees paid. See, however, Brown v. Bullock, 294 F. 2d 415 (2d Cir. 1961), where the court indicated the possibility of an action under' the Investment Company Act. H `a private right ef action exists, section 44 vests concurrent jur- isdiction in the State and Federal courts. The question is open as to what standard the court would apply in determining the propriety of the fees `charged. Under State law, the courts have been inclined to accept the fund- management company format and refuse to intervene unless the fees.' PAGENO="0223" 637 are regarded as unconscionable or shockingly excessive. Thus, in the leadino~ case of Saxe v. Brady, 184 A. 2d 602 (Del. Ch. 1962), the Dela- ware chancery Couft held that, even assuming that an independent board did not in fact exist, when the shareholders approved the con- tract, the management company is relieved of the normal burden of a fiduciary to establish the fairness of the contract; the burden then falls upon the shareholder-plaintiffs "to convince the court that no person of ordinary sound business judgment would be expected to entertain the view that the consideration was a fair exchange for the value given" (p. 610). In that case the advis~r's fee was the flat one-half of 1 per- cent rate. Defendants showed that almost 60 percent of the funds in 1961 were charging that rate while almost 30 percent were even higher. Plaintiffs then claimed that the dollar amounts paid under the ar- rangement were excessive. While some other comparable funds with a sliding scale schedule paid lower fees, the court felt that this did not establish an outer limit. Nor was the sharp rise in profits as a result of an enormous growth in the fund determinative. As the court put it: "[T]he very nature of the compensation arrangement (percentage of asset value) lends itself to the payment of sums having no neces- sarily reasonable relationship to the `value' of such services if tested by compensation standards usually applied in the business commu- nity." The court stated, however, that under the flat fee arrangement "at some point the relationship between admittedly reasonable ex- penses and net profit can become so disproportionate as to be shocking by any pertinent standard." The court felt, however, that a fee of $3 million to administer a fund of $600 million did not indicate waste~ in view of the practice in the industry. As the court put it, "if the fund- management company format is to be legally questioned, such inquiry must come from some other place." It would appear that the court felt that that inquiry should be made at the congressional level, because the mutual fund structure as pro- vided in the Investment Company Act really fosters this kind of a re- suit at the judicial level. Without in any way questioning the quality of the performances of investment advisers, it is believed that any fair appraisal shows that a serious situation of conflict of interest exists that needs legislative correction. See also Allegliany Corp. v. Kirby 333 Fed, 327 (2d Cii', 1964). What does the bill propose to correct the situation: A. The definition of a person affiliated with the investment adviser is sharpened so as to exclude persons having strOng ties with the adviser. B. It repudiates the shell theory by imposing upon the unaffihiated directors the duty to request information and evaluate the reasonable- ness of the advisory fee; and imposes upon the investment adviser the correlative duty to furnish the information reasonably necessary for the directors to determine the reasonableness of the fee. 0. It supplants the standard permitting excessive fees unless they are regarded by a court tp be shocking or unconscionable with a stand- ard that the fees be reasonable. Some of the factors to be weighed in de- termining the reasonableness of advisers fees are: (a) the nature and extent of the services, including separate evaluations of advisory serv- ices and other services; (b) the quality of the service; and (c) the ex- tent to which the fee schedule takes account of economies of scale. PAGENO="0224" 638 Various safeguards are provided: (a) Funds are given 1 year to review their contracts and, if necessary, put their houses in order; (b) the burden of proof that the advisers fee is unreasonable is upon the person attacking the fee; (a) liability for damages is restricted to those persons receiving the compensation; and their liability is limited to any excess received beyond a reasonable fee as found by a court; (d) there is no recovery for compensation paid more than 2 years before the dates on which an action is filed. The SEC's finding that the management and advisory costs of the externally managed funds are, as a general rule, appreciably higher than the corresponding costs of internally managed funds of com- parable size is not surprising. It can be argued that there is no more reason for a mutual fund to contract out various management serv- ices than for General Motors Corp. to make contracts with various managerial groups to perform management services, sales services, and the like for fixed fees unrelated to performance or expense ratios. Parenthetically, I think it would be a curious thing to have an ordi- nary business corporation operated in that fashion. The SEC does not challenge the fund structure, however. The modest proposal contained in section 8 that judicial review of such fees as to reasonableness be spelled out is long overdue. Again, in view of the conflict of interest, it would not be unreasonable to impose upon the adviser the burden of establishing the reasonableness of the fee. This, incidentally, is a normal rule as to fiduciaries, that the bur- den where there is a conflict of interest is upon the fiduciary to estab- lish the fairness and reasonableness of the transaction with the bene- ficiary. However, the Commission has made the more moderate proposal of placing the burden of providing unreasonableness upon the person attacking the adviser's fee. Surely if the person can carry this bur- den, he should be permitted a judicial remedy against unreasonable adviser's fees. A transfer of control of the investment adviser is related to the problem of fees. If fees are excessive, the price received by the sellers of a controlling block may represent a capitalization of the excessive profits being taken from the fund, and therefore, may be in equity an asset of the fund. The bill proposes to amend section 15(g) to meet this problem. It is made unlawful to transfer control of an investment adviser of a fund, if the terms are likely to impose additional bur- dens on the fund, limit its freedom of action, or be otherwise in- equitable to the fund. 2. Amendment to $ection 36-enjoining breach of fiduciary duties.- Section 36 now authorizes the SEC to bring an action in the Federal court to enjoin any officer, director, investment adviser, and certain other affiliated persons from performing his respective role if such person has been guilty of gross misconduct or gross abuse of trust. The amendment would authorize an injunction against such persons engaged in actions which involve a breach of fiduciary duty to the fund. The fiduciary standard is one the courts understand; it does not carry the taint of gross misconduct or gross abuse of trust, thereby giving the court greater flexibility; and the standard is that now im- posed upon broker-dealers ana investment advisers under other acts PAGENO="0225" 639 administered by the Commission. Indeed, this is the common law standard with which all fiduciaries are required to comply. 3. Front-end load.-I favor the elimination of front-end load plans as provided in section 16 of the bill. The Commission's analysis of the justification of this proposal is quite convincing. At the present time four leading commercial States prohibit the sale of contradtual plans: California, my own State; Illinois, Ohio, and Wisconsin. And I am sure that the committee has the evidence that California has 22 percent of the sales of mutual funds in the United States, and it is my recollection that it is the largest purchaser of mutual funds, which indicates that funds may be sold without having a contractual plan, and very successfully. These States have adopted the policy now proposed in the amend- ment to the Investment `C~mpany Act because they feel that the con- tractual plans by and large are unfair to `the small investor. In California this is by an administrative ruling of the California corporate securities commissioner, which was adopted many, many years ago on the ground that a contractual plan was not fair, just, and equitable to the security holders, and while there were some efforts on part of the industry to get a change in that respect, neither the execu- tive nor the legislature have yielded to this, and this is just not, you know, a question of debate in California today. It is regarded as settled. I refer the subcommittee to pages 15-16 of the SEC analysis of the bill. That was a reference to their report to the Senate, and similarly to the House subcommittee. I have not in my statement said anything about sales commissions. I feel that the question of sales commissions is an economic question, and not a legal question, but I have reviewed the evidence that was presented before the Senate Banking and Currency Committee, and particularly the testimony of Prof. Paul Samuelson and Professor Wal- lich, who `are eminent economists. I agree particularly with Professor Samuelson that we have in `this industry, as the chairman indicated by some of the questions to one of the earlier witnesses, a case of im- perfect competition where there is no competition at the retail sales level, because of congressional legislation in section 22(d) of the In- vestment Company Act; and that the most appropriate solution to restore the competitive situation in the industry would be to repeal that section. Now the SEC takes a more modest proposal here, and that is that the sales commissions be cut from around 9 percent back t~ 5 percent. Professor Samuelson's testimony and other testimony indicates that the stock exchange commissions fixed by the stock exchange under supervision of the SEC is about 1 percent, and on an in-and-out trans- action would be about 2 percent, so that the cost of selling mutual funds is nine times the cost of direct stock investment. As Professor Samuel- son points out, it is quite obvious why a broker-dealer, when given the option of earning nine times or perhaps more than that, if it is just a purchase of direct stock, all other things being equal, and where the customer doesn't have a strong preference, would be inclined to recom- mend a mutual fund. I think this has generated the enormous growth of mutual funds, and it is very unhealthy from a competitive point of view. It really puts the broker-dealer in a difficult position, and in a position of conflict of interest. 85-592--68--~pt. 2-15 PAGENO="0226" 640 Now Professor Samuelson suggests that particularly the stock ex~ change commission rate structure, with the give-up practice, which I am sure you are familiar with, where up to 60 percent of the commis- sions on portfolio transactions of the primary brokers are again fun- neled back to the stock exchange firm, which sells the mutual fund, which adds to the 9 percent or the 8 percent, or 8½ percent another 4 percent, which really brings it to about 121/2 percent on selling mutual funds is quite unhealthy. So that I would favor repeal of section 22(d),~ or if not, the adoption of the 5-percent figure, which I believe that the' industry would be able to live with. I would just like to add that in 1961 and 1962, when the question of abolishing floor trading came up on the New York Stock Exchange,~ we heard the argument that this `would result in a lack of liquidity in the markets, and dire consequences were indicated, and then we have today 10-million-share days, so that one can't always envisage what the impact of a particular bit of regulation will have upon the industry. This is a very dynamic industry, and I ventured in my testimony before the Senate to say that after 10 years, if this legislation were adopted, the probabilities would be as in other legis~1ative efforts of the Congress in the securities industry, that the industry would look back on it as being beneficial legislation, whereas at the time they may feel that it would have dire consequences on them. Professor Samuelson predicts the probabilities of a steady growth of mutual funds in the next decade, but it seems to me that there are great difficulties in the commission rate structure of the stock exchange, and the full commission as it relates to the sales commission on mutual fund shares that is unfavorable toward direct investment `as against institutionalization. I think that the Congress itself has favored the institutionalization of investment by adopting section 22(d), and should realize that this is the impact of that legislation. I will pass on with that to the problem of holding `companies. 4. Holding oompanies.-I support section 7 of the bill w'hich is de- signed to prevent the creation and operation of fund-holding com- panies and the further enlargement of existing structures of this type. The introduction of the holding company device into the mutual fund field is particularly unwarranted. It would permit those persons who control the holding company to use leverage in other funds so `as to exercise an influence over the fund and its managers in ways that are detrimental to outside `shareholders. Furthermore, use of the hold- ing company device introduces an `additional layer of management charges and administrative costs. Congress has recognized the dangers of the use of the holding company in the public utility field. The mutual fund structure itself provides an additional layer between investor and corporate enterprise. The fund mechanism is justifiable in t'hat it enables investors to pool their investment adviQe as well as achieve diversification. The mutual fund structure is presently sufficiently complex without adding the complexities of the holding company. Accordingly, I strongly recommend adoption of this provision of the bill. In conclusion, I support the goal sought to be achieved by the In- vestment Company Amendments of 1967. Thank you very much. PAGENO="0227" 641 Mr. Moss. Thank you, sir. Mr. Keith. Mr. KErni. Thank you, Mr. Chairman. I think that th~ professor has ~sort of polarized the point of view of the SEC in this matter. We on this committee have to make our judgment as to whether or not you are right and that the industry and the capitalist system and the individual benefit as the result of this legislation as suggested or, as is anticipated by those who are 1800 from you, that the legislation will adversely affect our system and the individual who shares in its bounty. Have you any private practice at the moment, Professor? Mr. JENNINGs. No. I am presently special counsel to the attorney general of the State of California, in a case now before the courts, but other than that, I am a law professor. I occasionally serve as a con- sultant both to government and to private parties; that is, attorneys, in a case that is related to my field. I should have added that I am appearing here not as a representa- tive of any private clients, but on the invitation of the committee, as I indicated. I was a consultant for the Securities and Exchange Commis- sion for 1 month during the special study, and I am coauthor of the leading casebook in securities regulation, and in that capacity I am interested in regulation, and I have regular contact with the Securi- ties and Exchange Commission, and I am not hostile to regulation. But I am not, other than that I am not in any way connected with the Commission. I may say that, as a matter of principle, 1 have tried to maintain a position of public interest rather than developing a consulting prac- tice on the side that might make it difficult for me to appear before a committee like this in the way that I would like to do, and I feel that I have been able to maintain that. But if I do have a bias, I may say that as a professor I am interested in seeing an improvement of the security markets and a fostering of free competition in the United States, and I am a strong believer in our free enterprise system. I think we have a great securities industry. The New York Stock Exchange is the finest auction market in all the world for securities, and I would like to see us foster and preserve that. Mr. KEmI. I certainly sense that attitude on your part, but I did want the record to show if there was a background which might indi- cate a bias. As you have described what has happened in this industry, it seems to me that as it has been outlined by myself and others here earlier, that money managers in seeking ways to get more money to manage, dreamed up the mutual fund approach, and it has been lucrative, and other entrepreneurs have seen the good thing and gotten in on it. It is about as simple as that, both at the management level and at the sales level. If we adopt the suggestions and recommendations that you and the SEC have, it is going to be a less lucrative field. There will cer- tainly still be management companies but there won't be the incentive to start funds that there has been. In my view thus far it seems to me that the public has benefited by this incentive to get in because of the profits that could be made. I think that the statute with which we are dealing here is wide open to profit- able relationships between the fund and the investment company. PAGENO="0228" 642 That doesn't mean that it is necessarily wrong, if we do get more peo- pie into this business. If they get out and display their wares in a forthright fashion, and don't misrepresent, I think that the effects of the 1940 act are beneficial. Maybe it didn't go as far as it should, but nevertheless we have a pretty good economy as a result of the capitalist system. I am scanning your testimony as I comment on it. If you would care to correct me to any degree. Mr. JENNINGS. Well, I would just say that we have here, I think it has to be admitted that the investment adviser is in a fiduciary rela- tionship, but we have in this industry conflicts of interest that no other industry that I know matches. You have the brokers, the port- folio brokerage. Mr. KEITh. Are they legally in a fiduciary relationship? Mr. JENNINGS. What? Mr. KEITH. Are they legally in a fiduciary relationship? Mr. JENNINGS. In my view, without any question they are in a fiduciary relationship. Mr. KEITH. I said legally. Mr. JENNINGS. Yes, I believe so, yes. Mr. KEITH. Have the courts so held? hasn't a case been brought `trying to prove that point in the State of `California? Mr. JENNINGS. You mean the 1.8.1. case? Mr. KEITH. Yes. Mr. JENNINGS. No; the 1.8.1. case was a case involving the sale of control by the shareholders. Mr. KEITH. Didn't the SEC argue that- Mr. JENNINGS. The SEC argued `that that was a gross abuse of trust under the Investment Company Ac't, and the court held to the con~ trary on that. This is a question of sale of control. Mr. KEITH. Wasn't `the pitch made that `that trust was of a fiduciary nature? Mr. JENNINGS. I happen `to have written in this field myself, and I don't really place much weight on the 1.8.1. case. I feel that if that case were properly presented, say `to the second circuit, you might get a little different result. I would say that in my view that the investment advisers under a management contract-in the first place certainly the directors of the funds are fiduciaries and the directors of the fund have the duty. to get the best executions and to get the best advice at the most reasonable prices for the fund, and the point I made was tha't they do not exercise that, they cannot under the structure, and I think inherently this is very bad, and the courts have not gone into the situation, as I tried to explain, because they fall back upon the structure that is established in the Investment Company Act. Mr. KEITH. Did the Congress in its report in the last treatment of this subject indicate that this was a fiduciary relationship? Mr. JENNINGS. You mean `the special study? Mr. KEITH. No; the `Congress in its reoprt. You just said in your view under the act which we are now operating there was a fiduciary relationship, andI am asking-I am not an attorney. Mr. JENNINGS. Yes. Mr. KEITIL We have been told that there is great store in decision- making, in `the committee report and the legislative debate. Was there PAGENO="0229" 643 any indication in the committee report or in the legislative debate on this matter? Mr. JENNINGS. I haven't reviewed that, Congressman Keith. Mr. KEITH. That would be in connection with your studies on the SEC position. You say here on page 5, your comment was that "This is a most curious type of financial structure." Mr. JENNINGS. That is right. Mr. KEITH. If, as I understand it, it has been patt~rned ever since 1940 for this kind of operation, it is well understood by buyers of mutual funds, not the unsophisticated but the more sophisticated buyer, certainly there has been a lot of stress given to this unique nature. Mr. JENNINOS. You understand why I made that statement. Mr. KEITH. This is unique to this industry but I would not say it is a most curious type of financial structure. I think it is one that has found great acceptance here and elsewhere. Mr. JENNINGS. Well, you do find in industry occasionally a com- pany being organized and then a management company contracting to perform the services at a flat fee. That generally has been prevented now by regulation, but the management fee of course is a very nice way of getting away from internalization, but generally in. American industry you do not have externally managed companies. You have it only in this particular aspect of financial institutions actually. Mr. KErm. But this is the accepted way. Mr. JENNINGS. Oh, yes. Mr. KEITH. Now would you maintain that that the internally man- aged mutual fund executive group are reasonably paid? Mr. JENNINGS. Yes. I think that the figures I have seen, for instance, take the Massachusetts Investors Trust, where the five trustees get $450,000 a year. I think that compares rather favorably with other types of financial management, and as I understand it, the operating expense ratio and the adviser costs there are about one-third of the cost of an externally managed- Mr. KEITH. Yes; but the cost to the individual shareholder is rela- tively inconsequential. What the SEC is trying to get at is `the reason- ableness of the remuneration to the entrepreneur, and in one case you have an internally managed company where they are making a lot more money than some of the externally managed companies with smaller portfolios, and you are arguing now that they are worth what they are getting because of the size of the portfolio. Mr. JENNINGS. No. All I am saying is that when you have-~-this is a form of corporate operation or a business organization, and it seems to me to be really anomalous that, say, a billion dollar fund can't hire directly its management, but has to get an externally managed adviser to do that operation. This must seem curious even to you. It is so common, however, that sometimes you know we get to the point where what is really anomalous we take for granted, and I think that is the only thing- Mr. KEITH. I agree that we oftentimes find some things that we have taken for granted yet in retrospect, we wonder how we ever hap- pened to go along with that as long as we did. But if you understand the history of these funds, you realize that the law permitted and encouraged this kind of activity and these people took advantage of it. PAGENO="0230" 644 Mr. JENNINGS. I only wish to add that since the law permitted it that way, that is why we need this corrective regulation. Mr. KEITH. I understand. I went to that conference up at the Wharton School. Mr. JENNINGS. I beg your pardon? Mr. KEITH. They had a conference at the Wharton School. Mr. JENNINGS. Yes. Mr. KEITH. Back in February, 1 think it was, put on by the bankers and lawyers, if I recall correctly, and there was an attorney up there who bragged about the fact that he received a $500,000 fee in connec- tion with some case that he had presented. Mr. JENNINGS. Mr. Pomerantz? Mr. KEITH. Yes. I just wondered if the fee that he got really didn't belong to the fund rather than to the attorney, under your philosophy. Mr. JENNINGS. Well, you know that- Mr. KEITH. I mean certainly that would seem to me to be extraor- dinary compensation to get, if you followed your philosophy; based upon the research and the amount of work that he had to do, couldn't it beheld that that fee really belongedto the fund? Mr. JENNINGS. Well, in connection with fees- Mr. KEITH. Do, you believe a court would have held that fee was reasonable? Mr. JENNINGS. Well, not only that. The court passed upon that fee. Mr. KEITH. It did really? Mr. JENNINGS. In all derivative suit litigation, the court has to approve the reasonableness of the fee, based upon the recovery and based upon the services, and I am sure that Mr. Pomerantz had to file a very extensive bill, and you may know that he had a little difficulty up in Boston in connection with one or two cases there, and the first circuit had to reverse Judge Wyzanski because of certain hostility in that connection. But I would say that I am perfectly consistent here, that all attor- neys' fees in this ~kind of litigation have to be approved by the court as to reasonableness. Mr. KEITH. There have been references by other witnesses concern- ing the proximity of Boston to my constituency and for your informa- tion and, for the record, the mutual `fund men in my district have not bothered to acquaint me with the ramifications of this so far as Mr. Pomerantz or any of the other details are concerned. Mr. JENNINGS. I didn't mean to- Mr. KEITH. Oh, you didn't. About all that I know of this whole affair is what I have gotten from reading the Senate hearings and from being here when we passed the amendments to the act in 1964; and as a result of these studies from previous years on the committee. With reference to the front-end load, you made some observations about California in particular. In the case of California, is not that sales force helped by the investment company in one way or another? Isn't that more like an internally managed operation? Don't the sales- men in those cases make something like an average of $15,000 or more ayear? Mr. JENNINGS. Are you talking about 1ST? Mr. KEITH. Yes. PAGENO="0231" 645 Mr. JENNINGS. Well, 1ST, I don't think is responsible for the front- end load problem, but I think it is true. I never made a study of 151, but it is my understanding that the biggest profit in 1ST is on the sales side of the business. You know funds start from three sources: Brokers who want portfolio business may start a fund; investment advisers who are skilled in advising may form a fund; or an organi- zation that has salesmen or wants to develop a sales force may form a fund, and I think- Mr. KEITH. And a combination of all three. Mr. JENNINGS. And combinations. And it is true as I understand it, though this is a matter that could be checked, that 1ST depends more on sales commissions than otherwise. They have been very suc- cessful in one aspect. They developed a sales force of retired business- men who had been rather successful themselves. Mr. KEITH. What I would like to know for the record is whether or not these salesmen for a fund operating in the fashion 1ST does have there extra compensation made available to them by reason of the relationship between the investment company and the fund itself? Do you know of any? Why the extraordinarily high income for the salesmen and why the success in California? Is there any knowledge that the committee might have that would enable us to look with favor on the techniques used in California as contrasted to the rest of the country? Mr. Moss. Will the gentleman yield? Mr. KEITH. Surely. Mr. Moss. I stated earlier in the hearings that I intended to develop all pertinent facts on the selling of fund shares in California, and have those available for the committee. I am undertaking to do this study. Mr. KEITH. I have no further questions, Mr. Chairman. Mr. Moss. Mr. Murphy. Mr. MURPHY. Professor, I certainly enjoyed your testimony. Mr. JENNINGS. Thank you, sir. Mr. MURPHY. You stated that there was sufficient evidence in the Senate hearings to justify a cutback in sales charges from 9.3 percent down to 5 percent. Was there statistical evidence submitted or was this opinion evidence of the two professors that you had mentioned? Mr. JENNINGS. Well, neither one presented statistical evi~lence. It was economic analysis of what might likely occur under this kind of a change in that you have imperfect competition today. They both felt that if there was competition introduced at the retail level, it would be a healthy situation, that probably we have too many part-time sales- men in this industry. You know one of the characteristics of this industry is that salesmen are recruited and they first sell their rela- tives and their friends, and they go on from there. Many of them drc~p out at that stage, and I only have a brief sampling myself, but from my own experience it is just curious the number of people who buy mutual funds because someone's brother that they know is selling mutual funds, And I think that mutual funds could be marketed in a much more efficient way. Mr. KEITH. Cold canvass is a cold business. Mr. JENNINGS. Yes. PAGENO="0232" 646 Mr. MURPHY. Professor, it doesn't seem that there has been any indication on the part of the industry to compromise the difference in those figures, 5 to 9.3 Mr. JENNINGs. I gather that from newspapers. They have got sec- tion 22(d) and a very big spread here, and I don't think one would expect, as Professor Samuelson indicated, it is not to be anticipated that they would like to give that up. But I think it would be healthy from two points of view. I would like to see more direct investment myself. I would like to see the broker-dealer have a little more ~ption to put people into direct investment instead of mutual funds. I think it would be healthy for the economy. Mr. MITRPHY. Do you think the funds have arrived at the point where they will be bought rather than sold by the investor, and there- fore the salesman is not as necessary as he might have been in the earlier development stage of the fund? Mr. JENNINGS. I really can't answer that. I hesitate to get into these economic questions, because I am just a layman like everyone else, just trying to observe the situation and make some judgments, but I don't have any expertise in that field. Mr. MURPHY. Thank you very much, Professor. I have no other questions, Mr. Chairman. Mr. Moss. Mr. Watkins. Mr. WATKINS. Thank you, Mr. Chairman. Professor Jennings, are you in favor of contract sales of funds? Mr. JENNINGS. Do you mean by that where the person forfeits something if he doesn't make his installments? Mr. WATKINS. I mean contract sales where a person pays as he goes along, the little fellow who purchases insurance, purchases policies, and he- Mr. JENNINGS. I think the question is what he loses if he doesn't continue his payments. That is the question. Mr. WATKINS. Are you opposed to contract sale, yes or no? Mr. JENNINGS. I am opposed to the front-end load as it is now operated under the investment-as now permitted under the Invest- ment Company Act, which permits 50 percent to go to the salesman, and the statistics show there is a very great forfeiture, and it develops a hard,sell and I think it is a very unhealthy thing, and I think we proved in California and in a few other States that it is completely unnecessary. Mr. WATKINS. You said it is unhealthy and unnecessary. What experience have you had in that? Do you know of losses that investors have had or what? Where do you get this information from, or is this just a personal view? Mr. JENNINGS. I will give you one example. Mr. WATKINS. I would like that. Mr. JENNINGS. Talking to my barber who told me about his brother who had signed up on a $15,000 contract, and he had forfeited out and lost a substantial amount, and I said, "Well, that couldn't possibly have happened. They don't have a front-end load in California." He said, "That is right, but this was in Oregon." And I think that there is quite a bit of statistical evidence that has been presented and studies made as to the impact of the front-end load. PAGENO="0233" 647 And for that reason, you know at least 30 years ago in California the Commissioner of Corporations decided it was not fair, just, and equitable and simply prohibited it, and the industry has grown enor- mously as a result of that. Mr. WATKINS. You talk about the industry growing enormously in California, which I think it has. California is a big State and it is cer- tainly still a growing country. The State of Pennsylvania hasn't had that experience. It has been a growing industry there. Mr. JENNINGs. I beg your pardon. Mr. WATKINS. What is that? Mr. JENNINGS. What has happened in Pennsylvania? Mr. WATKINS. I am saying it has been a growing industry. It has been accepted and approved by the State laws, by the Securities Com- mission. We don't have any trouble there. I would like to know myself what the investors say about this. You have explained the law in California very nicely and I appreciate it, but I don't agree with a lot of your statements and a great many of your thoughts on it. I think this is good and I am just wondering if you can answer this question. I think this is a very good one. Do you think that the SEC should propose a 5-percent rate on this industry? Do you think that is proper? Mr. JENNINGs. I think that since you have in this industry resale price maintenance by Government action, if that is continued, then it is necessary to have some control of the reasonableness of the sales commissions just as the Government maintains control of the reason- ableness of stock exchange commission rates. Stock exchange commission rates are fixed by the stock exchange, the New York Stock Exchange, subject to oversight by the SEC. Mr. WATKINS. That is true. Mr. JENNINGS. In this case it is left to the courts to determine. Mr. WATKINS. Let me ask you this question. Do you know of any other industry other than those operating under Government fran- chise, a public utility, that- Mr. JENNINGS. Well, this is a regulated industry. Mr. WATKINS. I understood you to say, too, that you considered this not a competitive industry. Mr. JENNINGS. Not competitive at the retail sales level, that is cor- rect, and I think this was admitted by the industry representatives this morning. Now, when it is a question of whether you have freedom of entry into the industry, there is freedom of entry into the industry, probably more than in most, and a wide range of products of different character offered. That is not the issue. But the question is whether, for instance, if I want to sell my mutual fund shares, I have to sell those back to the company or if I want to buy, I can't buy them on the open market. If you repeal 22(d), there would develop a market by buyers and sellers of mutual fund shares which would cut that cost. Mr. MURPHY. Would the gentleman yield? Mr. WATKINS. Yes. Mr. MURPHY. Professor, you said you didn't feel that there was retail competition in the sale of mutual funds. Mr. JENNINGS. On price. PAGENO="0234" 648 Mr. MURPHY. How about for the selling of one fund versus another? Mr. JENNINGS. Oh, certainly, but as to price, its retail price is maintained. Mr. MtTRPHY. The individual would be subject to subscription by several salesmen, say one salesman representing one fund. Mr. JENNINGS. Oh, yes; or by a broker/dealer who sells, say 5& funds. Mr. M1TYRPRY. Thank you. Mr. WATKINS. Do you know of any other industry where the Gov- ernment has a- Mr. JENNINGS. I just want to point out again that this is a regulated industry where you have a structure in effect which is approved by the Congress. Mr. WATKINS. You are not answering my question. Do you know of any other industry that the SEC puts a fee on? Mr. JENNINGS. That the SEC is putting a fee on? Mr. WATKINS. Yes, or setting a fee. Mr. JENNINGS. Well, so far as Commission rates are concerned, and also so far as Commission rates at the over-the-counter level. They are self -regulated subject to SEC supervision. Now, this bill does not pro- pose that as a solution. This bill proposed that this be left to a court to determine the reasonableness, not of fixed fees, but, you know, a question of whether it is reasonable under the circumstances for the particular company, which is a more flexible- Mr. WATKINs. it is my understanding, if I am correct, that they would set a fee of 5 percent subject to court. Mr. JENNINGS. No, on the sales commission you are quite right. I was on the advisers fee. You are quite right; yes, sir. Mr. WATKINS. I am concerned very much with the little fellow. I think that is the fellow we have to worry about. How can a little man, how can he know about the markets, how would he know what stocks to buy? Don't you think that these mutual funds give a real service to~ the little fellow? Mr. JENNINGS. Yes, I think that mutual funds perform a real serv- ice, surely. I haven't argued to the- Mr. WATKINS. Do you know of any crookedness where an investor has been hurt? Mr. JENNINGS. Well, yes, the managed fund case. It has been, I think, a clean industry, but you asked me do I know of any. Mr. WATKINS. In other words, what percentage would you say have been hurt, where they have found bad cases-i percent, 2 percent? Mr. JENNINGS. No, I think it is a well-managed industry. Mr. WATKINS. In other words, it is the same as any other industry. Mr. JENNINGS. No, the securities industry, I think, is probably cleaner than most. Mr. WATKINS. We know of lawyers who go bad, don't we? Mr. JENNINGS. Yes. Mr. WATKINS. What would happen to the small mutual funds? For instance, I know of a gentleman who testified here that he has 24Q em- ployees, and he said if this fund is reduced to 5 percent, that they could never pay the salesmen, the management fees, the office fees, the' various costs of running this fund. These people would have to be laid PAGENO="0235" 649 off. Do you agree with that, that a 5-percent fee would put them out of business? Do you know of any firms that would? Not the big fellow now-I am talking about thc~ small fellows. They have a right in this country to earn a living. I am sure you feel the same as I do. Mr. JENNINGS, May I answer? Mr. WATKINS. Please. Mr. JENNINGS. I am opposed generaJly to resale price maintenance. I believe in the competitive system, and I think that in the competitve world the consumer will be better off and the business will prosper. Now what you have here is a noncompetitive situation by Government action. Mr. WATKINS. We have a line of disagreement on that, but go on. Mr. JENNINGS. Well, I think I have answered the question. Mr. WATKINS. You didn't answer. I asked you what would happen with a 5-percent fee. Do you think that small firms can operate under it? We have had testimony that they couldn't. Now you are an expert in this. I want to know your opinion. Mr. Moss. Just a moment. The gentleman has not represented him- self as an expert and in fact specifically disclaimed expertise. He stated quite clear and unequivocally that he was appearing here pri- marily on the questions of law involved in the proposed legislation, and it was only as an aside that he departed from his prepared text to make a comment on the load charge, but he clearly said that it was on the legal question, so the record reflects the fact that he is not appearing here as an economic expert. Mr. WATKINS. Mr. Chairman, am I correct, if I heard the genfieman testify and I made a note here that he thought rates of 8 percent, 9 percent, he even ran it up to 121/2 percent. Mr. Moss. The gentleman is very correct. Mr. WATKINS. Did he make that stateemnt? Mr. Moss. The gentleman is correct in everything except his state- ment that the gentleman represented himself as an expert in that field. He did not. He gave an opinion. He did not represent it as an expert opinion. Mr. WATKINS. I will reword it. In your opinion do you think they could operate on a 5-percent rate? Mr. JENNINGS. Well, I don't have any information on that, and what I tried to make clear was that I hesitated, I didn't put anything in my statement on the question of sales commissions, but in reviewing the testimony, particularly of people that I regarded as experts in this field, Professor Samuelson and Professor Wallich, who made an eco- nomic analysis of the question of sales commissions, I came to the conclusion that they were very convincing. Now as to whether the figure-I think there is an obvious disparity between the commission rates on direct investment in the stock exchange of a half of 1 percent and 9 percent, and with the give-ups up to say 12 percent in the case 6f mutual funds. Now my own personal judgment, without any economic data, is that that looks quite out of line. The economic data ought to be developed, but I think it is very much like the chainstore situation, where the chainstore comes in and performs a very im- portant function, but it certainly cuts costs of retailing. Mr. WATKINS. SEC doesn't regulate chainstores. PAGENO="0236" 650 Mr. JENNINGS. No, but I point out again that the mutual fund in- dustry operates under really special legislation. Mr. WATKINS. That as you know, Professor Jennings, you know that-regardless of whether you do or not in this bill, there is the matter of this fee. The SEC is setting this fee. I haven't received too much complaint about this bill, very little in fact other than on this one section. - Mr. JENNINGs. Not the advisers fee so much. Mr. WATKINS. No. Mr. JENNINGS. Well, I am sure that- Mr. WATKINS. The biggest complaint is that we are going to put t~ lot of pople out of business if we put this 5-percent fee on under which they say they can't operate. And another thing, the SEC has the power to do it. I think some- body is certainly going to take that to court. Why do they pick this one industry to pick on? Why do they jump on them and let every- body else go? Now just as to my own thinking, you buy an insurance policy and you pay a year's premium on it, and with a life insur- ance policy what do you get back if you are not able to pay it off the second year? What happens to the first payment you make? Mr. Moss. The gentleman knows that the SEC- Mr. WATKINS. I am just asking the question. Why don't you let me go on, Mr. Chairman? It is only going to be a second. This is a com- parison here. Mr. Moss. The insurance industry is not subject to any regulatory action by the- MrG WATKINS. That is just what I am trying to get to, Mr. Chair- man, and I want him to tell me- Mr. Moss. The question you asked is why does the SEC pick out this industry. Mr. WATKINS. Right. Mr. Môgs. It picks out the industry because it is charged by law with regi~ulating this industry. Mr. WATKINS. What happens to me, I will ask you if you don't want him to answer it, what happens to me if I purchase an insurance policy, a straight life policy, and I pay $300 the first year? Mr. Moss. lEt depend on the laws of your State. Mr. WATKINS. What happens in California? Mr. Moss. Well, I am not going to undertake to respond to that. This is not a committee on insurance. Mr~ WATKINS. I have had experiences that I know, not personally but I know of people who have paid the $00 and if you didn't pay the second year he lost the fee. Mr. Moss. For the gentleman's information I have quite a number of letters up in my office which I shall be pleased to put in the record from buyers of mutual funds or shares complaining bitterly about sales charges and of the losses they have sustained not only when they have cashed out early, but as a result of the failure of the funds to perform as indicated. Now if the gentleman wants that material in the record, I. will be most pleased to put it in. Mr. WATKINS. Mr. Chairman, I would be delighted to have it in the record, because I don't have any such complaints. PAGENO="0237" 651 Mr. Moss. I will be very happy to hold the record at this point and respond to the gentleman's inquiry by placing those letters in the record. (The letters referred to follow:) CONGRESS OF THE UNITED STATES, Housn OF REPRESENTATIVES, Washington, D.C., November 6, 1967. ED WILLIAMSON, Clerk, Committee on Interstate and Foreign Commerce, House of Representatives, Washington, D.C. DEAR ED: During the proceedings of the hearings on HR 9510 and HR 9511, I assured my colleague from Pennsylvania that I would submit, for the record, letters which I have received from individuals across the nation concerning the subject under consideration by the Subcommittee. I would appreciate it if you would include the attached letters in the official transcript of the hearings. Sincerely, JoHN E. Moss, Member of Congress. ALEXANDRIA, VA., October 4, 1967. Representative JOHN E. Moss, Cha'irmctn. DEAR Mn. Moss: It is my hope that your committee will take some positive action to reduce the fees, and more important the commissions I pay on mutual fund purchases. I am buying shares in Manhattan Fund, with a plan to use them for Retire- ment about 10 years away. Each month, some salesman gets (8%) of my sav- ings from now on, even though he no longer does anything to serve me. I send my checks to the bank, and they send me a receipt after sending him 8% for nothing! Doesn't seem quite fair for so many years to come. Seems to me that 3% or 4% would be plenty for his Small original effort. Thank you. H. T. MAULDING. OCTOBER 19, 1967. DI~R REPRESENTATIVE Moss: Mr. Haack (Pres. NYSE) is plunking for hands off the racket. If the funds would police themselves, obviously you wouldn't be having your hearings. Do the crooks police themselves? The distortions and dangers, the Funds are causing in our securities markets, may yet lead to serious trouble. Besides, with their constant accumulation of money, they are pricing American shares out of reach of the public, who should be able to invest at reasonable prices. These stocks are not poker chips-they represent the ownership of our companies and if the people can't buy them, we have lost a freedom. The NYSE will sponsor anything that makes money for their members, but show little concern for the public. Inside & advance info-kickbacks & payoffs for info not available to legitimate stockholders & much more I know nothing of, but is obviously there-pool opera- tion-collusion between Funds-you name it-it is happening every day & the SEC is reluctant to interfere. Maybe they are being carried in some swinging stocks. You should put the NYSE under some meaningful control, as they are adver- tising for public participation. They are an unconscionable monopoly & should be controlled like AT&T or the utilities or railroads. Sincerely, F. SANDERS. P.S. I am writing this because the little fellow seems to have no voice with you people. These Funds buy on advance info & dump, leaving the little guy stuck. Where are the marrying, partying Johnson's sacrifices? What is it with you guys? PAGENO="0238" 652 War on & boys dying, yet you- 1. Let Wall St. & the NYSE go on a gambling binge that may wreck the coun- try & surely helps cause inflation. 2. Refuse to make large companies that benefit from war orders bear their share of the burden. 3. Refuse to close tax gimmicks for the rich & their foundations. 4. Refuse, for the 1st time in war, to have wage & price controls. 5. Refuse to pass plain decent conduct laws for Congress but pass salary & travel boosts at such a time. Mister, I've seen crumbs & bums but my leaders win. Why don't you let the Swiss run our gov't? They take over when we don't talk to someone. And they don't steal. FLUSHING, N.Y., October 14, 1967. DEAR REPRESENTATIVE Moss: I am writing to you as one small Mutual Fund investor, out of the 31/2 million banking on you as "Representative" of the people to wage the good fight against the powerful vested interests of the Mutual Fund Industry. For example dividends are a natural accretion of investment and risk. Why does my very profitable Putnam Growth Fund charge me 8'/2% for my dividends? This is simplest bookkeeping item with no salesman ever involved! Actually as a well read individual I did my own research and wanted to buy directly from Mutual offers because I wanted and needed NO salesman. Yet I was referred to brokerage house and had to pay a substantial load for Dreyfus, Fidelity Trend and Manhattan regardless. Why? Again the relative range of operating expenses and costs among the over 300 Mutual Funds are astounding and shocking. Why should Revere have expenses of 95.7% of income whereas Mass. mv. Trust has only 5.9% of income. My own personal Tn Continental has about 2.% and are of lowest in industry. Size may be a factor but certainly legislation seems in order. Both my I)reyfus & Putnam Gr., as well as many others have identical men both as trustees of Fund proper, and also as directors of separate financial management of same Fund. Most are honest, but human nature being what it is-a serious conflict of interests could well arise. It would, I feel, always be decided in favor of directors not the small investor. Compare the huge salaries and bonuses paid to managers of Funds to your own salary. Why this outlandish disparity? Why shouldn't there be a fair salary ceiling with the rest to small investors who also partake in risk. Why should average sales load of Mutual Funds be. 9.3% of net-so much higher than all other media of investment? We ask you to support S-1659 the Investment Co. Amendments Act of 1967 as representative of the people. Cordially, SAMUEL G. GILBURT. PITTsBURGH, PA., October 17, 1967. Hon. JOHN E. Moss, U.S. House of Representatives, Washington, D.C. Da~&a CONGRESSMAN Moss: Thank you for challenging the rOle of salesmen in the sale of mutual funds. Just a few months ago I invested in four funds after considerable research. All the brokerage did was sign the application blank and continue to collect fees. A very good friend of mine did precisely the same thing and so do other serious investors. Our judgments after examining prospecti are as good as theirs. Very truly yours, ARTHUR W. AmES. WEsTwooD, N.T., October 14, 1967. M~ DEAR MB. Moss: I think that you are doing a fine job investigating the mutual funds. If you get into it deeply you will find plenty of Hanky Panky In what they do. Who is to protect the small person who invests his life savings in these funds, and then is disappointed when he finds out the bitter truth. PAGENO="0239" 653 Please continue your good work and see that the laws are tightened up on the entire securities industry. Sincerely, IRVING LEIBOWITZ. Dovnn, DEL., October 21, 1967. Hon. JOHN E. Moss, House of' Representatives, Washington, D.C. Sm: My husband and I have followed with great interest the SEC recOm- mendations on mutual funds and more recently, the I-louse Commerce sub- committee investigation. A recent New York Times report (10/14/67) dealt primarily with the sales commission charged by the majority of funds. The NASD and the mutual funds argue a reduction to 5% would seriously reduce their sales force and stress the services rendered by the salesman. The average investor has no lobby to speak for him and to protect his interests. We feel compelled to write of our experience, which is undoubtedly a common one in hopes that it will give you the "other side of the picture"-~the investors'. In June of 1960, we heard of a reputable mutual fund salesman through my husband's co-workers. We asked the gentleman to contact us, and he did. On an appointed evening, be came to our home and gave us an excellent indoctrina- tion into mutual funds, their differences, and past performances. (This last was a large reference volume with all available funds included.) He left us with the prospectus for three funds, and appropriate application blanks. We chose to begin investing in Massachusetts Investors Growth Fund and have continued regular periodic investments (completely voluntary) ever since. We also re- invest all dividends and capital gains. Over the 7-year period we have been satisfied with the growth of our investment and the management of the advisory board. Our one dissatisfaction is with the sales charge. We never saw our salesman again after the first evening-there was no need as the investments are made by mail. He has never rendered any services of any kind. Our only contact is a Christmas card from him once a year. Our cash investments have totaled $6,700 and our dividends $463+. At the present 8~/2% sales charge, we have paid $608+ for one evening's counseling-and shall continue to pay with all subsequent investments. This is an absurdity and all out of proportion. We suggest that the mutual funds, if they are good enough, do not need to continue to "sell" the regular investor. Let them pay their salesmen a regular salary, or a commission on new investors, but after a period of two years or so, the long-time investor should not be penalized with the exorbitant sales charge for no sales services rendered. No one sells us; we sell ourselves. With hopes for an equitable solution to these problems, I remain. Yours truly, CHARLENE S. TROCHTA. Mrs. Joseph F. Trochta. ARLINGTON, VA., October 26, 1967. DEAR Mn. CHAIRMAN: I strongly support your bill to abolish front load mutual funds and reduce the cost of mutual funds from nine to five percent. Small time investors should be encouraged to invest in the securities market and a cost reduction is one way to attract such people and at the same time add vitality and strength to the securities market. Presently I have two separate plans for the fractional purchase of shares with the Quinby Company of Rochester, New York. The Company's Quinby plan is both a front load plan and its cost is about nine percent. Please advise me whether the Quinby Plan offered by the Quinby & Co. Inc. of Rochester, New York will fall under the jurisdiction of your bill as the company is set up for the fractional purchase of shares and not a mutual fund. The attention of your subcommittee or the Secuirties Exchange Commission to this matter will be appreciated. Sincerely, BOUDAN WENGLOWSKYJ. PAGENO="0240" 654 TENAFLY, N.J., October 27, 1967. Representative JOHN E. Moss, House of Representatives, Washingtoa, D.C. fluAn Mn. Moss: As an owner and continuing buyer of mutual funds, I applaud your handling of the hearings on mutual funds. I think a 5% load charge is more than adequate. I also believe that manage- ment fees are in some cases much too high. Some ceiling should be placed on them. Yours very truly, CHAELES P. O'KANF.. Mr. WATKINS. That is exactly what I know. I want to know what the purchaser is saying. I appreciate that the distinguished gentle- man is here to testify and you have done well, it is wonderful. Cer- tainly you are enlightened in the law. You `are a very smart man. Your testimony shows that. I haven't regretted anything that he has to say. It is his feeling. But I do have a feeling about this bill, and I don't think this 5-per- cent fee is right. I don't think the SEC has any right to put it on, and if they put it on these people I want to see them get into other categories. Mr. Moss. The gentleman is eminently correct. The SEC has no right to put it on and that is why they have suggested to this com- mittee that we consider the advisability. It is finally our responsibility and our determination not the SEC's, and they haven't proposed to usurp the authority of the Congress or of any other interests. That is not the question pending before this committee. Mr. WATKINS. May I say to the gentleman that I thank you, even though the chairman wouldn't let you answer my question. He finally did it but E think we have a friendly understanding. I certainly ap- preciate what I have read here. If I understand it, the chairman might like to write to you in the period of a week and ask you questions about some of your testimony, is that correct? Mr. Moss. That is correct. Mr. WATKINGS. Thank you very much, and thank you. Mr. JENNINGs. Thank you. Mr. Moss. And thank you very much. Mr. JENNINGS. Thank you very much, Mr. Chairman. Mr. Moss. I appreciate your taking the time to travel here to Wash- ington to respond to the interests of the committee. Mr. JENNINGS. It was a pleasure. Mr. Moss. The next witness will be Mr. J. A. Livingston, financial editor of the Philadelphia Evening Bulletin. Mr. Livingston. Mr. WATKINS. Mr. Chairman, may I be excused? Mr. Moss. You may be, sir. Mr. WATKINS. I would like to hear Mr. Livingston but I have to leave. STATEMENT OP J. A. LIVmTaSTON, FINANCIAL EDITOR, PHILADELPHIA BULLETIN Mr. LIVINGsTON. Mr. Chairman, most mutual fund salesmen are hon- est and serious in their effort to assist investors in using savings wisely. But they are subject to a double pull-their self-interest against PAGENO="0241" 655 the interest of the investor, often a person unskilled in finance or economics. This conflict is inherent in the stock and bond business. Wall Street manufactures securities for sale. A securities salesman has the job of persuading investors to buy the merchandise which is for sale. Yet, at the same time, he tries to advise investors on what is best for them. Thus, he wears two hats-the hat of the salesman, anxious to earn a commission and the hat of the investment counselor, or adviser, duty- bound to help his client or customer. When the showdown comes, whom does he serve-his wife and kiddies, or the investor's wife and kiddies? It is argued that full disclosure protects investors buying mutual funds. But what does full disclosure provide? It tells how much a particular fund charges. It does not mention alternative investments. It does not indicate that the investor can buy mutual funds without a sales load-with no commission whatever. It does not mention closed- end funds selling at a discount. And if a salesman is asked about a no-load fund, he tends to parry the question, by saying: "Well, you know you get what you pay for in this world"; or, "Often no-load funds have a redemption fee instead of a sales fee"; or, "No-load funds have higher management fees and they have to be paid year after year." These are not even half-truths. So there is not full disclosure orally. It is also argued that competition protects investors. But competi- tion has worked the wrong way. Sales commissions have tended to increase over the years toward the highest level. Sales organizations early discovered that they fared best by raising commissions. The evidence on this is on page 208 of the SEC report to this committee, dated December 2, 1966. This is human nature. The customer's man in a brokerage office or the independent salesman tends to push the stock or bond which yields him, the seller, the greatest return. The recent sale of dual-purpose funds in Wall Street suggests this. The commission was about the same as that on mutual funds. Many of these funds were oversubscribed- because of the intensive sales efforts. But now the capital share of six out of seven of these funds are selling at discounts from their net asset value. In terms of real worth--- getting assets for one's money-each is a better buy than a mutual fund. But Wall Street has lost interest in selling them. Salesmen have gone back to the greater return-mutual funds. I think this was a point that Professor Jennings tried to indicate. The SEC proposals have been described as utility-type regulation. There is validity in this statement. The mutual fund industry, as it is constructed, is like a public utility. The prices are fixed. The fund is protected against price cutting. rfhere are no discount houses in mutual funds. If the funds are pro- tected against unfair competition then the investors should be pro- tected against overcharging. To support these comments, I am including four recent articles I have written but which I won't read. As I see it, the buyers of mutual funds, for the most part, are unsophisticated investors with limited savings. They turn to mutual funds because they want a diversified holding of securities, super- 85-592-68---pt. 2-16 PAGENO="0242" 656 vised-managed-by experts. As small investors they need more pro- tection than the salesman who contacts them. Mutual fund sales charges are far out of line with the cost of pur- chasing most securities. The salesman takes no risk whatsoever. Neither does the broker nor sales organization. On most normal transactions, 5 percent is considered a maximum reasonable brokerage or sales fee. The standard sales load on most mutual funds today is far above that. As has already been indicated, it is about 9 percent. As for the front-end load contractual commission, it is so high as to approach the unconscionable. There is no justification whatever for charging a sales fee on an investment that is to be made in the future. I might add in response to some of the last questioning that I don't think it is the duty of the SEC and Congress to protect salesmen in this industry. The responsibility is to protect the investor who is putting up his savings and doesn't know in all cases exactly what he is buying and is dependent upon what the salesman tells him. Mr. Moss. Mr. Livingston, wouldyou like to have these four columns included as part of your testimony? Mr. LIvINGSToN. I think that would be very nice if you would be so kind. Mr. Moss. Without objection, then, this will be done. (The articles referred to follow:) THE BUSINESS OUTLOOK-AUNT NELLIES STIMULATED No-LOAD MUTUAL FUNDS (By .1. A. Livingston) False ideas about mutual funds abound-particularly about no-load funds, those that don't charge a sales commission. My recent series on load versus no- load funds brought questions from hundreds of readers. Here, synthesized, are the questions most asked-with answers: Q. About two months ago I purchased two well-known mutual funds. Then I read your articles pointing out that ia a no-load fund all the money invested goes to work, whereas in a load fund the comm,ission is taken out first. Should I sell my load fund and switch the money into a no-load? A. No. You have already paid the sales commission. You don't gain anything by disposing of the shares you already own and shifting to a no-load. Additionally, you'd have tax complications: Capital gain or loss? HARD TO SuLL? Q. I attended a meeting of investors and. someone raised the question of no- load mutual funds. The Apeaker said we'd have a hard time buying them and an even harder time selling them because no broker would touch them. Is that true? A. It is true that brokers rarely deal in no-load funds. There's no money- commission-in them. Therefore, such shares have to be bought by writing directly to the funds. It is totally untrue that a shareholder in a no-load fund will have a hard time cashing in his shares. No-load funds, like load funds, are required to redeem shares at a net asset value. This can be done by tendering shares to the fund- in writing. Q. How does a no-load mutual fund defray its sales costs? A. In theory, there are no sales costs. In theory, no-load funds are sold "over the transom," or by word ~f mouth. One person tells another. The origin of no- loan funds is pertinent. Many no-load funds are operated by investment counsel firms. These firms supervise accounts of $100,000 or up for well-to-do clients. Such clients often have Aunt Nellies who need lots of Investment help for small amounts of money-$5,000 or less. PAGENO="0243" 657 HOW THEY ARE SOLD Investment counsel can't give personal attention to sums so small. At the same time, they can't say "No" to Mr. Well-to-do. Decision: Put all the Aunt-Nellie money into a common pot-a no-load mutual fund. New money comes into such funds through clients with Aunt Nellies or from satisfied Aunt Nellies or recom- mendations of Aunt Nellies rather than door-to-door selling. Some no-load funds advertise. They earn fees on assets-the money that goes into the mutual fund. As the fund grows, the greater the management income. Such advertising, however, is not paid for out of dividends or interest earned by no-load funds any more than the advertising of load funds comes out of earnings. The underwriters, or sponsors, of the funds pay for the advertising. Q. How can I determine which are the load and which the no-load funds in quotations in the newspapers? A. The no-load and the load funds are readily differentiated. Most newspapers publish bid and asked prices on fund shares. The hid price is how much the fund will pay investors for its shares. The asked quotation is the price at which the shares are sold to the investor. THERE'S THAT SPREAD In a load fund, there is a difference-a spread-between the bid and asked prices. Dreyfus Fund was recently quoted at $15.13 bid and $16.51 asked. The difference, $1.38, is the sales commission or load. Wellington Fund was $13.63 bid and $14.80 asked. The load here is $1.17 a share. In the case of no-load funds, there is no spread between bid and asked prices. Thus, Loomis Sayles Mutual Fund was recently quoted as $13.23 bid and $13.23 asked; and Stein, Roe & Farnham Balanced Fund was $22.04 bid and $22.04 asked. The Bulletin separates the load and the no-load funds in its tabulations. This is not the general custom. (This is the first of three Q. and A. columns on mutual funds. The second will appear tomorrow.) 1i~eprinted From the Evening Bulletin, sept ember 5, 1967 Tim BUSINEs$ OUTLOOK-MUTUAL FUND PROMISES SHOULD BE IN WRITING (By 3. A. Livingston) More questions and answers on mutual funds: Q. It has been suggested that no-load funds are parasites, that people would not know abont them if salesmen for the load funds did not eceplain the possibili- ties of mutual funds as long-term investments. A. There is justice in that. Mutual fund salesmen have done an important job in selling Americans on common stpcks. Many persons, who bought mutual funds ten, 15 and 20 years ago have reason to be grateful that a salesman rang the doorbell. Some of this selling spilled over to the no-load funds-naturally. The salesman sold a no-load fund-unintentionally and without reward. That happens in every business. The salesman who persuades a customer that she needs a vacuum cleaner may discover later that she has bought another make. C'est la vie. Q. Why do you think that it is necessary for Congress to reduce the sales com- mission on mutual funds? The mutual fund industry is highly competitive. It's not a monopoly. There are hundreds of funds, including no-load funds. Investors, therefore, have a wide choice. The prospectuses a're ecoplicit on the amount of the sales charge. Does the investor need more? COMMISSION SEEMS HIGH A. To me, the usual sales commission, which amounts to 9.3% on the money which goes to work for the investor, seems high. I grant that a Salesman who spends time explaining the merits of a mutual fund is entitled to remuneration. But, no-load funds are available and the Nationa~L Association of Securities Deal- ers has usually regarded 5% as an adequate maximum reward for selling over- the-counter securities. PAGENO="0244" 658 The broker or dealer handling mutual funds takes no underwriting risk. The shares are "created" after the sale. The fact that the prospectus is explicit on the sales charge is not relevant. Most mutual fund buyers are inexpert-and not comparison shoppers. They rarely read prospectuses. They rely on the oral statements of salesmen, which are not cleared by the SEC. ABSOLUTEL~ INCORRECT Q. Is it correct that the management fees of no~load funds are invariably higher than those of the load funds and that is how the no-load funds make up for the absence of a sales commission? A. Absolutely incorrect! The management fees and sales charges are distinct from one another. The sales commission goes to the salesman and the organization be represents. The usual charge is about $85 per $1,000. After the commission is taken out, the management fee, or percentage, is levied on the $915 that the mana- gers of the fund handle. On the purchase of the same amount of no-load shares, the management percentage applies to the full $1,000. Some very large load funds have extremely low costs. Among these are Massa- chusetts Investors Trust and National Investors with expense ratios of 0.19%. This includes all costs of operating the fund, as well as the fee for management. RELIABLE ASsURANCE? The expense ratios of the larger funds-load and no-load-range from about 0.4% to 0.6%. The average expense ratio for all no-load funds with assets of one- million dollars or more amounted to 0.82% last year; of all load funds 0.76%. Clearly then, expenses of load funds are not decisively lower per dollar at work than those of no-load funds. Q. I have been assured that if I put my savings in a mutual fund my money will grow faster than if I kept in in a bank or in savings bonds. Can I rely on this? A. Get whoever said that to put it in writing! Rarely does the income from a mutual fund's investments exceed 3%. This is less than the interest on savings deposits or on savings bonds. Moreover, mutual fund shares represent risk investment-mostly comnion stocks. These sometimes decline in price. Money is safer and income surer in the bank or in savings bonds. Only during periods of long prosperity can an invest- ment in a mutual fund be counted on to outearn compound interest. The slow, steady tortoise sometimes beats the bare. (This is the second of three Q. and A. columns on mutual funds. The third will appear tomorrow.) Ileprinted From the Evening Bulletin, September 6, 1967 THE BUSINESS OUTLooK-No-LoAn MUTUAL FUNDS: BROKERS SKIRT QUEsTIoN (By J. A. Livingston) This is the third and last column on questions frequently asked about mutual funds. Q. Is it true that if I buy a mutual fund which doesn't charge a sales corn- mission, I'd have to pay a getting~out charge? A. A few no-load mutual funds-less than one out of four-may charge redemp- tion fees. Rarely do these amount to more than 1%. This is small compared to the usual 9.3% getting-in fee on a load fund. The redemption charge is designed not to make money but to deter in-and-out trading. The prospectus or sales literature will indicate if there is a redemption charge. Q. I told a mutual fund salesmen recently that I was interested in a no-load fund. He applauded, saying I was wise to buy a mutual fund for long-term invest- ment. Then he instilled doubt. He asked: Have you considered the greater invest- ment fle~vibility of load funds over no-load fnnds-especially in a weak stock market? Because salesmen are actively selling, he said, a load fund has a steady inflow of new money. This means it can reduce its proportionate holdings of common stocks merely by holding on to incoming cash. He said, however, that a no-load PAGENO="0245" 659 fund does not receive a large cash flow from sales. Therefore, it would have to sell some of its holdings, possibly at a loss, to reduce its common-stock risk. Is that correct? SIZE VERSUS FLEXIBILITY A. Hardly. Most load funds are larger than no-load funds. Consequently, the cash inflow through selling would be larger than to no-load funds. But pro- portionate to size, there is no great difference. This is borne out by two separate statistical studies, one covering all funds by the Investment Company Institute, a trade association consisting largely of load funds, the other based on the sales of the ten largest load and the ten largest no-load funds. Conclusion: No-load funds have as great a flexibility in declining markets as load funds. Indeed, it can be argued that they have greater flexibility. They are smaller. Therefore, they are not laden with large blocks of shares which might be hard to dispose of during a decline. And though they don't have salesmen pushing their shares, satisfied investors often become "salesmen." Q. I have been accumulating shares in a mutual fund under a front-end load contractual plan. The salesman eeplained that half of my fIrst year's payments would be sales commission. But I didn't know of the eccistence of no-load funds until I read your column. lihould I discontinue my plan now, considering that I've already paid a substantial part of the commission? DOVETAILED INSURANCE A. This is a matter of arithmetic and judgment. If the fund you purchased has an excellent record, you may want to keep on with the plan even though you continue to pay commissions. After the first year, the commission generally amounts to 3% to 4% on each payment. On large amounts, it's less. If a no-load appealed to you, you could make a contract with yourself to buy it periodically. Then by dropping the contractual plan, you'd save commissions. Contractual plans often offer ah option-group term life insurance which declines automatically as the investor's payments cumulate. This adds to the cost but is a feature many persons like. It assures completion of payments in case of death. You, yourself, can buy term insurance but the amount would not dovetail exactly into your investment plan. Q. Where can I get a list of no-load funds? I've asked customers' men several times but they seem not to hear or they change the subject. NO-LOAD LIST AVAILABLE A. This is understandable. Brokers make no money on no-load funds. I can provide names and addresses. Send a self-addressed, stamped envelope, marked "No-Load List" to J. A. Livingston, The Bulletin, Philadelphia, Pa. 19101. Q. Do you consider mutual funds a good investment for the average investor? A. Yes. For the person who prefers to let someone else manage his money, the mutual fund is an excellent way to purchase a diversified stake in American industry. But a word of caution is in order. Common stocks entail risk. The United States has enjoyed unparalleled prosperity since the end of World War II. Common stocks have appreciated 500%. There is no assurance that this will continue or be repeated. In selecting a mutual fund, load or no-load, the buyer must carefully consider which type of fund he wants-a go-go-go speculative venture or a balanced invest- ment in long-term American progress. (Last of three articles.) Reprinted From the Evening Bulletin, september 7, 1967 [From the Evening Bulletin, Oct. 19, 1967] THE BusINEss OUTLOOK-ARE MUTUAL-FUND BUYERS LIKE UTILITY CusToMERS? (By J. A. Livingston) William Van R. Oadmus, head of a Livingston, N.J. firm handling mutual funds and various types of insurance, feels that I "have done a great injustice" to mutual funds. He writes: PAGENO="0246" 660 "For some 20 years, I have sold mutual funds to clients who wanted a sound investment medium. I have always picked the top performing funds and although we know that the past is no indication of the future, a good fund will usually continue to do well. "A retired school teacher put $1G,000 in a fund a little over 10 years ago. She started to withdraw $100 a month at that time. She recently called me to state that she was 75 years old and despite the withdrawal of 71/2% a year, her fund was worth $21,000. She is now withdrawing $125 a month and I doubt that you~ could convince her that a mutual fund was not a good investment. "I have had clients telephone as a result of your articles to ask if they should withdraw their money from mutual funds and put it in a savings account or a `no-load' fund. It would be very difficult to find any 10-year period going back over the past 20 years in which a good mutfial fund did not show better results in income and growth than a bank account with compound interest." NO POINT IN SELLING OUT I agree with Mr. Cadmus. Many persons, who bought mutual funds ten, 15 and 20 years ago have reason to be grateful that a salesman rang the doorbell. But this doesn't mean that history will repeat. Since 1947, stocks have increased 500%; since 1957,130%. Will that happen anew? And I can understand Mr. Cadmus' perturbation when clients-suddenly learning of the existence of no-load funds-want to get out of load funds. The same question has been put to me and I have answered: "You have already paid sales commission. You don't gain anything by dis- posing of shares you already own and shifting to a no-load fund." NO PRICE CUTTING ALLOWED But these answers-these agreements with Mr. Cadmus-beg the funda- mental question: Are sales commissions on mutual funds too high? Should the Securities and Exchange Commission have power to reduce them from the customary 9.3% to 5% as proposed in legislation before Congress? H. Lawrence Bogert, president of the Investment Bankers Association and a partner in the influential investment firm of Eastman Dillon, Union Securities Co., is emphatic in saying: No. In testimony before the House Subcommittee on Commerce and Finance, he likened the SEC's proposal to "utility-type regula- tion of charges and profits." There's validity in this-and justification. Each fund has a monopoly over ita own price. The law prohibits securities dealers from trading with the public in mutual funds by cutting the sales fee. These are price-fixed securities. WHY THERE'S REGULATION Mr. Bogert notes that many companies and many salesmen offer mutual funds. So there is competition among funds for sales-for volume. But competition has not pulled sales charges down. It has tended to drive them up. Why? Because salesmen tend to push merchandise that yields them the greatest reward. Most Investors in mutual funds are not experts in finance, investment analysis or bookkeeping. They rarely read prospectuses or shop for value. They put their trust implicitly in the salesman. To assure that this trust is not abused is a responsibility of Congress and the SEC. This is in accord with the spirit of the securities laws. Naive and trusting investors are much like householders who purchase electric power, telephone service, or gas from a franchised utility. That's why we have utility regulation. That's why we have SEC regulation. Mr. Moss. Mr. Keith. Mr. KEITH. Thank you, Mr. Chairman. Mr. Livingston, I have read your articles ever since I have been on the Washington scene, and I think they are helpful to us in the Con- gress in comprehending what is going on in the financial world. Mr. LIVINGSTON. Thank you very much. Mr. KEITH. Before coming to Congress I was a salesman for the Equitable Life Assurance Society, and it is one of these regulated in- PAGENO="0247" 661 dustries, where there is at least some of the same kind of price fixing as has been pointed out here. It is, however, very competitive. I would like to say in defense of the salesman, you have stressed or implied when the showdown comes-"Whom does he serve, his wife and kiddies or the investor's wife and kiddies ?" He serves his own wife and kiddies best and himself best to the de- gree that he can win, hold, and deserve the confidence of the customer on whom he is calling, and I do commend toyour attention the book "A Fortune To Share," by Vash Young. As I said earlier, in these hearings, this was given to me when I graduated from prep school in 1934 by the master of the academy. Ad- mittedly a lot of salesmen start off selling to their friends, but they are not going to do a job on their friends, and if they did I would say that this is not the successful man in the long run. Mr. LIvINGsToN. May I comment on that? Mr. KEITH. Certainly. Mr. LIVINGSTON. There is no doubt that the successful salesman in any business serves his clients, but in many businesses, particularly when you are young, you have got a very strong pull to earn commis- sions, and in the insurance business an analogy that has been used by Mr. Day and by other persons doesn't seem to me entirely appropriate. First, it is very hard to buy insurance without paying a commission~ It is possible to buy funds, mutual funds, which do just exactly the same jobs of these load funds that charge a commission of 81/2 to 9 to 9.3 percent without paying a commission. So there exists competition~ In New York and in Massachusetts people can buy insurance without paying a comwission, in one other State- Mr. KEITH. Connecticut. Mr. LIVINGSTON. Connecticut, so therefore there isn't the same situ- ation. The investor in mutual funds has alternatives. Furthermore, the salesman in the securities business does have a semifiduciary rela- tionship to the investor, the person he is meeting, and that is why the SEC has introduced the rule of suitability. You have got to pick investments which are suitable to the financial and economic and social status of the individual, and the salesman could very well offer a no-load mutual fund or he could offer a closed- end fund selling at a discount, but because the commissions are so much higher on mutual funds, the temptation is terribly great to sell the mutual vis-a-vis these alternative investments. I am sorry to make such a long speech. Mr. KEITH. That is all right. Mr. LIVINGSTON. But on insurance it is said that the front-end load is 50 percent. But if you read Mr. Day's testimony carefully, you will notice that he says that the cost of writing the insurance the first year is frequently not enough to pay the salesman, and therefore the com- pany has to take some of this money out of its surplus to do so. So it isn't the purchaser of the policy that pays the full commission in ther first period. But when you buy a mutual fund on the contractual plan, and you pay 50 percent in the first year, it is the investor who is paying all of the money, and his investment, his money, is not going to work. Why should a person pay in advance for an investment he hasn't made? I am sorry, I didn't mean to ask you a question. PAGENO="0248" 662 Mr. KEITH. I guess we could really explore this at some depth and I would like to, but I think it would be a rather long procedure, because we have several areas in which we have differences of opinion. Mr. LIVINGSTON. Mr. Congressman, may I add this. On annuities in an insurance plan, if I am correct, which is much more comparable to a mutual fund contractual plan, the sales commission in the first year is only 15 to 20 percent, or 10 to 15 percent, according to a book by Dan M. McGill, "Life Insurance." Mr. KEITH. Well, we have heard here about books pro and con. Figure lie and liars figure. Mr. LIVINGSTON. Well, I am trying not to lie. Mr. KEITH. I know. And I don't mean Mr. McGill has done that, but the compensation for selling an annuity is not as great as for selling life insurance, and there are probably adequate sales and social reasons for that. But let me just say this, to get specific here, and I am not agreeing with all that you have said. We can pursue it perhaps at a later date when I get the record straight between us. On these no-load funds, the law, it seems is quite specific. It prohibits them spending any money on sales if they conform in other respects to the basic law. I would think that if we loosen up that section to permit no-load funds to advertise in the way savings banks do in Massa- chusetts, that the public would have these facts which you now are afraid they don't have. Mr. LIVINGSTON. They advertise. Mr. KEITH. They don't advertise except institutional ads. They don't really try to motivate people to come in. They don't say "Buy a no-load fund and save the agent's commission." They don't say "flo it yourself and save money." They just advertise the fact that they are a no-load fund, as I recall the advertisements. I am talking about more motivating sales literature mailed out to the prospects, and through the financial sections of the newspapers and magazines. They might loosen up a bit and get somewhat away from the no-sales load to some sales load to cut out the agents to some extent. Now I in taking your advice bought a no-load fund, and it was one of these where you buy it at a discount. I guess that is the term used~ Mr. LIVINGSTON. Well, that would be a closed-end fund. Mr. KEITH. it was a closed-end fund. And I sold at a discount. Mr. LIVINGSTON. That is right. Mr. KEITH. That brought a factor into play that I didn't really count on, but I wasn't an authority in this field. I didn't buy, as I hoped to simply a cross section of a diversified portfolio. I had that dis- count on the way in and on the way out. So these no-load funds are of two sorts. You have the closed end and the open end, and those that are sold at a discount you don'~t neces- sarily get what you think you are getting, because of the introduction of this fluctuation in the market at the time; is that not correct? Mr. LIvINGsToN. Well, it is correct within the limits of the state- ment. When you buy a closed-end fund that is selling at a discount-- let's take, for example, `Tn-Continental Corp. which was selling at a discount- Mr. KEITH. Were you looking over my shoulder? PAGENO="0249" 663 Mr. LIVINGSTON. No, I was not, and if you bought Tn-Continental you did very well, if you held it long enough, because `about 3 or 4 months ago it was selling around 22 or 23. Mr. KEITH. I held it until my daughter's tuition came around again. Mr. LIVINGSTON. Well, one should never buy stocks for tuition. But if you had purchased it 4 or 5 months ago, you would have bought it at a discount of 30 percent. The price of the stock would have been about 22 or 23. The market has not gone up very much in the mean- time. Tn-Continental is now selling around 29, `and the discount has fallen to 20 percent. So actually, people have begun, at least so far as Tn-Continental is concern, to think that this is a good security. Now, what you get when you buy a closed-end mutual fund is not a guarantee that you will be able to sell the stock at the net asset value of the stocks and bonds and cash behind the shares. What you do get, however, is a bundle of assets 20 to 30 percent more than you are pay- ing for, and these go to work for you. If you bought `Tn-Continental today, you would get about $130 of assets for every hundred you put up. Mr. KEITH. But aren't you in a sense really speculating as to what the demand will be? Mr. LIVINGSTON. No, sir, I am not. Hear me out, please. What I am saying is that if you have $130 working for you, and the fund earns 3 percent on its money, it means that you are getting 30 percent more at 3 percent than if you had brought a no-load mutual fund where you would buy only $100 of assets for your money, and you are getting a good deal more than if you bought a load mutual fund where instead of getting $100 for every hundred you put up, you only get $91 of assets working for you. So what I am saying is that you are getting a tangible extra by pur- chasing this, and I am also saying that if Wall Street brokers did not have these two hats, and were not interested in commissions, they would be selling these closed-end mutual funds, and there would be no discounts. And I can give you a specific example on this case if you want me to. Mr. KEITH. Well, it is a bit difficult for me to follow all of what you have said. Mr. LIVINGSTON. Can I reexplain it? Mr. KEITH. I think it isn't really serving our purpose. I would like to have you do so but not at this time because the record need not be developed on that score. But I would like to understand it better and, perhaps I will take some of your advice as a result of my further education. Now, it seems to me that you are pretty hard on the industry and the salesman in your concluding statement, where you have striken the word "scant" and have said "There is no justification whatever for charging a sales fee on an investment that is to be made in the future." Mr. LIvINGsTON. That is right, I mean it. I deliberately changed the word. I didn't want to hedge. I don't believe in a contractual front-end load plan; no, sir. Mr. KEITH. But they charge a sales fee on other than a front-end load. Mr. LIVINGSTON. I am only talking about a front-end load contractual. PAGENO="0250" 664 Mr. KEITH. Taken out of context, one would-r---- Mr. LIVINGSTON. I didn't mean it that way. Mr. KEITH. Well, you know how the press is at taking politician's statements out of context. Mr. LIVINGSTON. Well, I think it is the front-end load only. That is the only case in which you have a sales fee on a security to be pur- chased in the future. Mr. KEITH. I said that with a smile. You were reading your notes there. Mr. LIVINGSTON. Oh, I am sorry. I know we embellish statements. Mr. KEITH. I did read all of your columns and I had read them when they originally appeared. I guess in summary you would con- clude that we don't need this industry to the extent that we should en- courage people to get out and sell it as hard as they have. That it doesn't really bring sufficient capital into our market to either serve the capital requirements of the Nation or the need of the little fellow to get a share in the equities of our great society. That is in essence your point of view, I trust. Mr. LIVINGSTON. Well, I think I would modify that, sir. I would say that the mutual fund industry today has 4 million shareholders. It is very well known. As the result of my articles I received something like 12,000 to 14,- 000 letters. Many of the letters said, "I never knew there was `such `a thing as a no-load mutual fund. Thank you for telling me. Thank you for your courage in writing this," and so forth. Well, now, it seems to me that the industry is be'coming widely known. You don't need to have the very high sales fee any longer to `encourage salesmen to spread the mutual fund gospel. There is money to be made at 5 percent in this industry. It is a very, very adequate reward for selling securities. On the New York Stock Exchange the commissions are much less. What I think might happen would be that the marginal salesman might be put out, but there is also money to be made in the manage- ment end of the business. Mr. K1~ITu. Thank you very much. Mr. LIVINGSTON. Thank you. Mr. Moss. We look at this sales `fee and I have been interested in noting that it not an unusual phenomenon that whenever we hear legislation we talk about the small fund, the small salesman with the small selling margin. The fear ~was expressed earlier today by our first witness in his item No. 4 that inevitably the followup to any change in existing law would be to create ever larger funds and sales organizations. Well, if we look back retrospectively at almost any business, that is the inevitable course of any successful operation, isn't it? They tend to concentrate and grow and the smaller ones fall by the wayside. They use many devices in an effort to prevent that happening, but it has hap- pened in virtually every type of `business one can think of today, `hasn't it? Mr. LIVINGSTON. I think so. Mr. Moss. Now, selling is a very interesting endeavor. I was a sales- `man before I was a politician. PAGENO="0251" 665 Mr. LIvINGsToN. I sold books when I was in college. Mr. Moss. I sold many things. And I was also a real estate broker. And so I have a very healthy respect for the role that the commission plays in selling, and I think that you have basically in any sales or~a- nization two groups, particularly if you have an attractive commission structure and a hard market. You have the highly professional sales- man and he is really going to be successful regardless of anyone or anything. He is going to succeed. And then you have those that are attracted like flies to honey, by the size of the commission, the potential. They don't stay in long but they do come in, and there is always a new supply of them to back up the group. This is the group of sales personnel, not the professional, and the one that is probably more concerned with the immediate short-range interest of his family than the long-range wisdom of giving the best advice and building a solid basis for repeat business and for the relations between friends that sends business to a store; isn't that right? Mr. LIVINGSTON. I think that is right. Mr. Moss. .~nd if a sales commission is too high, we have had noth- ing in this record that indicates that 9.3 is any more justified than 5, or for that matter than 3. We have had many expressions of opinion but we have had nothing in the record that I can see, and I have watched it very carefully, that shows that there is a greater justifica- tion for one or the other, except as you pointed out, and I think very properly, if we are only concerned with the sales organization. The interest of this committee, the reason for the creation of the Securities and Exchange Commission, the very conditions which brought it about in the early 1930's was because the previous system did not adequately recognize the public or the investing public's interest, isn't that correct? Mr. LIVINGSTON. I think that is right. I might add, Mr. Chairman, that there is something ot suggest that the 9.3-percent Fales load is high, and that is that so many of these no-load mutual funds are growing and prospering. The T. Rowe Price Co. of Baltimore xe- cently announced that they were no longer going to take any new shareholders in New Horizons Fund because it had reached the size that they felt was completely adequate to their responsibilities. If you look at the prospectus of Dreyfus Fund, which has been a very r'~pidly growing fund, and an extremely successful fund, it indicates that the sale of the fund had become so great that management had to consider changing their investment policy, because you can't operate with a billion dollars the way you could operate with $200 or $300 or $400 million. And I sometimes wonder if the sales effort hasn't begun to wag the dog in this industry. There was a time, when this industry first began, that funds would discnss what was the optimum size, $300, $400, or $500 million. But now, as far as the load funds are concerned, this is out the window- bigger and bigger. Mr. Moss. That of course gets to the point that Congressman Keith stressed, the need to study the problem of institutionalization of the markets. But the one point I wanted to bring into focus is that while ~we certainly are not expecting to act in a manner to the complete dis- PAGENO="0252" 666 advantage or in utter disregard of the interests of the seller, salesmen, or the selling organization, our underlying responsibility is to the over- all investing public, and if he is encouraged to continue investing, it follows inevitably that the business itself will be- Mr. LIVINGSTON. I think that is right. Mr. MOSS. I want to thank you very much. Oh, Mr. Keith has a couple more questions. Mr. KEITH. Have you by chance done a column on the monthly in- vestment plan? Have you done a colunm on that? Mr. LIVINGSTON. I don't believe I have. Mr. KEITH. Would you care to comment as to this? Mr. LIVINGSTON. Well, it has always seemed to me a cumbersome plan. When it first came out I thought it was cumbersome, and if I were an investor and I had a choice, I would certainly buy a no-load mutual fund and get a diversified group of stocks rather than to try to pick up a part of a share of U.S. Steel or A.T. & T. or one or two shares every 2 or 3 months. Mr. KEITH. I am sure you have done many columns on speculation. Mr. LIVINGSTON. You mean on the go-go funds and this new attitude toward investing? Mr. KEITH. Not necessarily the go-go funds, but the institutionaliza- tion of the market and the tendency where there is a narrow market for institutional investors-by the way, I think I saw where commercial banks in a study by the New York Stock Exchange did more trading of a speculative nature than did mutual funds. I believe that the net position at the end of the period indicated that commercial banks had been more active in this kind of activity than others. Mr. LIVINGSTON. Well, yes, I have written about this, but not with any firm conviction as to its impact upon the market, because there are no quantitative figures. I know that the U.S. Trust Co., which is one of the most venerated and staid institutions, has now announced a policy of "Best by Test." You have to show performance in order to keep your customers and get new customers. And there seems to be a tendency to emphasize short-run returns from investing rather than what you ex- pect to get 2, 3, or 5 years from now. And I suspect that this is all part of the environment in which we live, in which people are trading iii securities for dollars and dollars and dollars, and this is what John Maynard Keynes talked about in his chapter on "Long-Term Expecta- tion in the `General Theory.'" Mr. KEITH. On this question of commercial banks and institutions and their activities in the market, the average charter of a commercial bank indicates I believe that its purpose is to serve the community in its efforts to finance corporate activities. Is that about correct? Mr. LIVINGSTON. Yes, sir. Mr. KEITH. Now do you think there is any tendency for commercial banks now to move their surplus and perhaps their reserves in the market in a way to make more money for their bank and its share- holders in an activity which has been thus far secondary? Mr. LIVINGSTON. Well, I think we are talking about two different things, sir. Mr. KEITH. We are talking about institutional- PAGENO="0253" 667 Mr. LIVINGSTON. I was talking about the trust department of the bank. Mr. KEITH. Yes. Mr. LIVINGSTON. Handling the funds of clients. Mr. KEITH. And my question goes beyond that. Mr. LIVINGSTON. I don't think the banks are permitted to invest any of their own money to any large extent in stocks, so that to that extent- Mr. KEITH. Do you think that these investments I have referred to in the New York Stock Exchange report on this subject with com- mercial banks are listed as being big buyers and sellers, do you think that those were the trust accounts? Mr. LIVINGSTON. Oh, sure, I think they were pension funds. Oh, yes, pension funds that the banks handle, and individual trust ac- counts. Oh, I don't think, oh, no, they weren't the banks' funds. I think the banks would like to get into it, but they are forbidden by law to do so. Mr. KEITH. Well, the banks there are fiduciaries, this is what you point out, in the literal sense of the word. Mr. LIVINGSTON. Yes, but they have a carte blanche in most fidu- ciary accounts to invest as they please, and they have to render service to the person who is the investor, or the account may be shifted to somewhere else. Mr. KEITH. Do you think that there is any real threat of increases in institutional activities that is of such speculative nature as to ad- versely affect the public interest? Mr. LIVINGSTON. Well, I do indeed. I think that the fear of what is going to happen to the dollar, the concern about inflation is such that insurance companies and pension funds and even large individual investors who would normally put their money in bonds are putting it in common stocks. This is creating a notion that you can make money in the stock market. I know from the letters I have received and the desire of people to get into funds that are going to perform well. It is always a desire to protect themselves against deterioration in the dollar, or to speculate to get something for nothing. Mr. KEITH. Well, they expect to get their share in the equities of the corporate assets of this country, but I am not talking about an in- formed trustee or pension fund manager considering the long-range interests, as a trustee. I am just wondering, you mentioned the go-go funds, the performance funds, I just say that that is a part of the whole thing. That banks, insurance companies, and private investors move into the market in a big way where it is a narrow market, and by that move affect the price of the stock, and then move out in a way that allows them to make a profit on that transaction, and perhaps leaves others stranded. Do you follow me? Mr. LIVINGSTON. Yes, I do. Mr. KEITH. Do you think that there is any need for investigation by the SEC or the Congress or both into this kind of activity? Do you think it requires our serious attention? Mr. LIVINGSTON. I wouldn't know. I think only an investigation would reveal whether it is a powerful enough influence on the market. PAGENO="0254" 668 Obviously there is great temptation. In the 1920's the pools wou]d buy stocks and push them up, and then sell them out. They were fre- quently at the mercy of the market itself, because they didn't have unlimited funds. Now you get the large investment companies that decide to pur- chase a particular stock, and they begin accumulating it. They push it up, push it up and up. And then they figure. that the price is about right and it is ripe for selling and then they sell. They walk away from. it; they sell it out. I don't know whether there is anything wrong in that. Now if you find that there is a deliberate manipulation, somebody says there is a short supply in this and I am going to push it up and then get out, fine. I don't know, I would hesitate to suggest that it is as calculated as that, that it happens. You see, the U.S. Trust Co. has a policy on this. They have graded. investments as A, B, and C. I have forgotten just what the categoriza- tion is. But they would say A is a stock which is low, let's buy it at such and such a price. B is a stock that. we want to own, but it is above a proper price and maybe we had better not buy it now. And C is a stock which we would like to have in our long-term portfolio, but it is too high, we won't buy it. Well, now they are constantly moving.stocks fom A to B to C, dc- pending upon the price. Well, suppose you buy a stock at A, which is. a stock it wants in its portfolio for long-term holding. And so they begin putting it into the accounts that they have, and it begins moving up. When it reaches B, they will continue to hold it in the accounts that have it, but they won't buy it for future accounts. Then when it gets up to C, they decide to sell it, because it is no longer attractive in terms of price. Well, could a~lybody suggest that that is speculation, deliberately~~ pushing up stock? Now if this becomes uniform policy within Wall Street, if this is a practice of many trust companies and many insti- tutions and various funds, then you are going to get the problem that they will all be grading many of these stocks in the same way, and one of these days they are going to put them all or a; great many of them in the C category and they will just try to walk away from them and there will be no market. This is what happened in 1929. This is al- ways what happens in pool operations. It is one of the great problems where people are always anticipating what other people will anticipate prices ought to be. I suggest you read `this chapter in Keynes, on long-term expectations. Mr. KEITH. I would like to but my constituents `have more pressing~~ needs that keep me from it, but I may have to get to it. One last question. Many witnesses have been talking about the economies of size. Mr. LIVINGSTON. Of scale; yes. Mr. KEITH. That is a phrase that has come up. Do you feel that a large bank like U.S. Trust should on behalf of its accounts turn to the third market rather than buying on the exchanges, to give them the advantages of economics of size? PAGENO="0255" 669 Mr. LIVINGSTON. I think a large bank has a responsibility, a fiduciary responsibility of getting the stock at the best price for its clients, a~nd I think if it can get it in the third market it is its responsibility so to do. Mr. KEITH. I have no more questions, Mr. Chairman. Mr. Moss. I want to thank you. Regretfully, the second bell has just rung and it is necessary that we go to the floor. The committee will adjourn until tomorrow morning at 10 o'clock. (Whereupon, at 12:45 p.m., the subcommittee adjourned, to recon~ irene Tuesday, October 24, 1967, at 10 a.m.) PAGENO="0256" PAGENO="0257" INVESTMENT COMPANY ACT AMENDMENTS OF 1967 TUESDAY, OCTOBER 24, 1967 HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON COMMERCE AND FINANCE, COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE, Washington, D.C. The subcommittee met at 10 a.m., pursuant to notice, in room 2123, Rayburn House Office Building, Hon. John E. Moss (chairman of the subcommittee) presiding. Mr. Moss. The committee will be in order. Before hearing our firet witness, I would like to ask ~unanimoiis consent that the record be held open for the balance of this week to receive statements from those who desire to submit them to the sub- committee. Hearing no' objection, that will be the order of the committee. Our witness this morning is the Honorable Manuel F. Cohen, Chair- man of the Securities and Exchange Commission, who is returning for the purposes of summarizing the views of the Commission after some `2 weeks of testimony before this subcommittee by representatives of all segments of tb.e industry. Mr. Cohen. STATEMENT OP HON. MANUEL P. COHEN, CHAIRMAN, SECURI- TIES AND EXCHANGE COMMISSION; ACCOMPANIED BY PHILI? LOOMIS, GENERAL COUNSEL-Resumed Mr. COHEN. Good morning, Mr. Chairman, and Mr. Watkins. Mr. WATKINS. Good morning. Mr. COHEN. I guess I should at the outset repeat what the reporter asked me this morning. He said, "Mr. Cohen, will you read your 44- page statement or summarize it in 80 pages?" I am afraid I am going to do the latter. But seriously, I will try to be as brief as possible, so that I can take as many of your questions as your time permits. I am available at any time. As I say, I am very pleased to be here to answer some of the ob- jections that have been made and to clear up certain of the miscon- ceptions that may have been created by testimony of certain repre- sentatives of the industry. At the outset I should emphasize that when I was here about 2 weeks `ago I told you that the purpose of this bill was a rather simple one, and that was to provide a fair shake to the millions of Am~ricans who have invested in mutual funds and other types of investment com- panies, and for the uncounted additional millions who will invest in this medium in the future. (671) 55-592--OS-pt. 2-17 PAGENO="0258" 672 I do want to emphasize, reemphasize, that that is the basic purpose and the sole purpose of this statute. However, whefi I say sole pur- pose~ I do want to indicate that it has a corollary effect, and it is an effect that may be found in all of the statutes administered by the Com- mission. Those statutes I think were deliberately designed and have had the effect of protecting the securities industry itself from the con- sequences o.f the overreaching by some who have been engaged in that business. I cannot recall a single advance made in the securit1es laws which has not been met with the argument that it would have the effect of making business less profitable or even impossible for some segment of the industry or for some people. I need not repeat, I am sure all of you recall, that the first of the statutes, all of which have their genesis in this committee and are monuments to the wisdom of the members of this committee through the years, was the Securities Act of 1933, and that was greeted with the argument that grass would grow in Wall Street. And every improvement in the statutes and every improvement in the rules has always been met with a similar argu- ment, that any such change would upset the market, would create prob- lems for those engaged in the market and for the people that they serve. But I think the facts of the matter are that after all of these improve- ments, we have a securities business that is bigger, that is stronger, healthier and more prosperous than it has ever been before in the history of this country, and indeed in the history of the world, and as I will show later, this is especially true for those engaged in the business of organizing, managing, and selling the shares of mutual funds. Now it is true that the securities industry is a closely regulated in- dustry, and it has been closely regulated by the Feder:al Government and by the self-regulatory organizations created by statutes passed by the Oongress for more than a third of a century, and I cannot over- emphasize that the legislation before you really breaks no new grounds. it is not a tampering with the free enterprise system. It is merely a few relatively minor, although some would think otherwise, adjustments in an existing regulatory pattern that was carefully hammered out be- fore this committe and the Congress. The reasons for the changes grow from the great affluence that has affected this industry in the 27 years since the 1940 act was passed. I should say that Congress' concern with investment companies precedes that time by a substantial period. The 1933 act, as you will recall, requires disclosure in connection with any offering of securities `by an issuer, or on its behalf. But in 193~, the Congress felt that disclosure was not adequate to meet the problems that existed in what was then a fledgling and infant industry, and in the statute passed in that year directed the Commission to conduct a comprehensive study of the industry This led to a substan tial number o~f reports to the Congress and finally in 1940 the Congress passed the Investment Company Act and, I should make clear, without a single dissenting vote in the Congress. The report of this committee makes clear, it states unequivocally, that disclosure is an inadequate method for dealing with the problems that arise in this industry, prob- lems which arise in some measure because of the extraordinary struc- ture of this industry. PAGENO="0259" 673 Now a great deal has been said in the last couple of weeks about competition in this business. I think the plain fact of the matter is that, the business does have a substantial number of units, but very little competition in the sense in which that term is ordinarily used. This may sound like a paradox but it isn't. There are a great many of these separate units, but they are severely restricted by law, Federal law, from competing with one another by offering better prices for the securities of a particular fund. There is no effort-and I introduced in evidence, when I appeared here before, a document which indicates that the trend is continuing- there is no effort to offer a better deal to the investor by providing a lesser charge. The competition, to the extent that it exists, is to seek the favor of the salesman, and his employer, the dealer, and that is achieved and is still in progress by offering greater financial rewards to those who engage in the sale of shares. Now, this type of competition bears little relationship, if any, to free enterprise, the classical free enterprise system as we know it, and the type of competition that we discuss. It is for this reason that I have earlier referred to this as a perverse form of competition. It is the kind of competition which has Government protection and encouragement for charging the highest charges that the traffic will bear. It is a system under which the Federal Government authorizes the industry to operate outside the controls of the antitrust law, outside the controls normally provided by disclosure of compensation for man- agement services, and outside the controls provided normally by com- petitive free enterprise. In fact, the statute provides a shield against those forces from operating within this industry. It is for this reason, I believe, that the Federal Government and the industry share respon- sibility for the excessive charges now being made to the American public for investment in mutual funds, and it is for this reason that I think the Federal Government has, and I would hope that the indus'- try would join in meeting, the responsibility to give adequate weight to the interests of the public, and thus assuring the continued health and development of the securities markets, and more particularly of these mutual funds. I wish to emphasize that this bill is not directed against mutual funds. In our view this bill will not affect mutual funds. It is designed to make mutual funds a more attractive vehicle for investors, many of whom perhaps were deflected from taking advantage of this vehicle, because of the high acquisition and maintenance costs. Now, perhaps I should deal with advisory fees. In this area, in my view, industry witnesses have completely misconstrued what our pro- posal is, why we advanced it, and how it would operate. Industry wit- nesses conceded (1) that they were fiduciaries, (9) that investment ad- visory fees should be reasonable, and (3) just to quote their words, "the investment adviser has a definite responsibility to see to it that the fees are reasonable." Although they were at times, some of them anyway, rather coy about admitting this fiduciary responsibility, after some searching questions put by the subcommittee, the record is indubitably clear on this subject. Mr. WATKINS. Mr. Chairman. Mr. COHEN. Yes, sir. PAGENO="0260" 674 Mr. WATKINS. Mr. Cohen, do you mind giving me the page you are on? Mr. COHEN. I am reading from some notes- Mr. WATKINS, I thought so. Mr. COHEN (continuing). That I prepared, Mr. Watkins. As I said,. I was going to- Mr. WATKINS. All right, you go ahead. If you get back to your script let me know. Are you going toread your script? Mr. COHEN. No, sir. I offer the script for the record, but when I have completed this I would be more than happy, subject to the chair- man's wishes, to take any questions you may wish to put to me. Mr. WATKINS. But you are not using your record now. Y9u are speaking off the cuff. Mr. COHEN. I am using some notes. It is intended to summarize the situation, perhaps to highlight some of the more important issues as I see them. Mr. WATKINS. You go right ahead. I was just lost here. I couldn't find it in the script. Mr. COHEN. I am sorry, sir. They also made the point that the investment adviser creates the fund, and operates it in effect as a business. Many of them stated that "It is our fund, we run it, we manage it, we control it," and I don't think there is anything wrong in them saying it. They were just ad- mitting what is a fact of life. The investment adviser does control the fund. But nowhere have they been willing to mention, even under the rather penetrating ques- tions put by the subcommittee, what is a necessary consequence of the situation that they concede as well as an important fact of life in this business, and that is that the investment adviser in effect sets the fee, and he does so in a situation in which he has a very definite conflict of interest. In fact, this point was emphasized by a number of witnesses, some of whom referred to the fact that the investment advisory organi- zation was a corporation which had shareholders, and that obviously, though perhaps they didn't put it exactly this way, their shareholders are interested in maximizing the profits that they may gain from the service that they provide to the investment company. I can't think of a more classic case of a conflict of interest, and a stronger case of two groups pulling in opposite directions, and yet the person who sits in that position sits at the head of the table and he sits at the foot of the table, and he sits all around the table. In this connection I think I should reemphasize that, with one exception that I recall, no one suggested that the directors are really in a position to negotiate, as that term is normally understood, in the fixing of fees. In fact, there were some witnesses, including some who sit on the boards of investment companies, who suggested that that was not the purpose for which they were chosen. One, who I believe is a practicing lawyer as well as a member of the board, suggested it would be inconsistent with his obligation as a director to attempt, in any way, to upset the relationship between the adviser and the fund in any such bargaining arrangement. Now, unless, of course, there is the possibility that the board might change the arrangement, I have great difficulty in seeing how any type of effective or even ineffective bargaining can take place. PAGENO="0261" 675 But it is by a studious disregard of this situation that the industry is able to misconstrue our proposal as involving ratemaking or profit regulation. It is nothing of the sort. However, since- Mr. Moss. Mr. Chairman, Mr. Keith has a question. Mr. COHEN. Yes, sir. Mr. KEITH. You seem to be reading from a prepared statement. Mr. COHEN. I am reading from some notes of mine of various types and kinds. Mr. KEITII. I am somewhat handicapped. We had hoped to have your rebuttal statement yesterday so that we could review it and have a chance to comment on it. I am trying to read what you have prepared here and listen to what you are saying there, and it is difficult to follow. But I would like to have you restate if you could what you have said in the last couple of minutes. You seem to be saying that this iS a strange phenomenon that exists on the part of the companies with the usual corporate structure and operation, what you might call corporate democracy. I wish you would restate what you have said. Mr. COHEN. Some of the things are not included in the paper I have bef ore me but I will try. Mr. KEITH. Perhaps if the reporter would go back 2 or 3 minutes and read to us what you have got there in your~notes, please. Mr. COHEN. I would prefer to restate it, Mr. Keith, because I will make it stronger this time, but I will be glad to take your suggestion. Mr. KEITH. You might pinpoint what I think is after all the main difference of opinion in one of the two areas involved. Mr. COHEN. I don't think that so far as the things I have just said that there is any difference of opinion. I have heard no witness deny the fact that he is really a fiduciary. I have heard no witness say that the fee should not be reasonable. I have heard no witness say that he does not have an obligation to see that the fee is reasonable. I have only heard one witness suggest that there is truly effective argument, I am leaving the word "bargaining" out deliberately, with respect to fees. I don't think there is any great dispute here. Mr. KEITH. I am talking about the corporate entity involved here, the way in which it differs from the usual corporate structure. Mr. COHEN. I didn't testify to that, but I will be glad to right now. Mr. KEITH. It seemed to me that you were speaking to this, even though it may not have surfaced, and you recall in your first statement you talked about how, as I recall it, the management companies formed the mutual funds, and then in a later application or further delinea~ tion of the activities of the mutual funds, you mentioned that they entered into a contract with the management group, and indicated that the tail thus was wagging the dQg. Now is it not a fact that by and large these investment companies have chosen a mutual fund vehicle to sell their product, and that there is a corporate purpose being served by this close relationship, and that it is simply the vehicle which is used to merchandise mutual funds to~ the mutual benefit of the person who buysit and the management corn- pany who advises? Mr. COHEN. No, sir. Mr. KEITH. You don't feel that this is the historical and in effect present modus operandi? PAGENO="0262" 676 Mr. COHEN. Well, you have two questions in that, two points you make in that question. It is true, as I stated before, that a number of funds were created by investment counselors in order to take care of persons who did not have the amount of cash available that they thought appropriate for handling that person's problems or plans on an individual basis. They therefore set about to create a corporation in which the individual's wishes would not have to be dealt with, but they created an institution whereby some person could come in and obtain a participation in the institution, without any .choice on his part, once he is in there, as to the nature of the securities, as to the management activities of the company. But while this is true of cer- tain investment counselors- Mr. KEITH. Pardon me. I just want to keep it straight as you go along here. At the time that he entered into this èon'tract to acquire the shares in the mutual fund, the management company portfolio, he was advised as to what the financial objectives were, the investment policy. I mean if there was none stated, then it was carte blanche, but generally speaking it would give some indication in the prospectus to comply with customer rules and procedures in this area. Mr. COHEN. Mr. Keith, I must disagree with that about 1,000 percent. First, I want to complete the answer to your question. While there were a number of investment counselors who set up funds for this purpose, I did indicate when I was here last that a great many other funds were created by broker-dealers, in order to have a vehicle that would be available and also perhaps to partake of the brokerage. It is interesting to note that a great many of these investment counselors who did set up these organizations set up an organization which would provide its shares to the general public at no load, no charge, and I think you heard from representatives of that group. In addition to that, mutual funds were set up by business people, some of whom had no experience whatsoever in this field at all, because this as I indicated has provided for those who have created these things, sold them, managed them, something in the nature of a money tree, and this is found to be the fact today. There is a rubber company, at least one, that owns a management firm; I.T. & T. owns one. There is a brewery company. It is just good business. In fact, many of them are so incapable of running the fund that they subcontract it out, and I introduced as an exhibit tables which showed that where that existed and where there was arm's length bargaining for the provision of the services, the charges made to `the investment adviser, who is receiving the typical charge, were very very substantially less than that. I think I have an extra copy of that exhibit here today, and I can illustrate that at some length. But now coming `back to your question as to the structure, it seems to me that at various times the industry goes one way and says, "Why, this is a corporation, and if we are to be tested in what we do, we must rely on the traditional corporate waste doctrine to protect us from everything." At another time they say, "Well, that is just in the way somehow, and this is really a shell, and it is a direct relationship." Well, it isn't a direct relationship. It is a corporation. It is deliber- ately chosen as such, and the Congress recognized that in 1940, and because it is a corporation and because it is an institution, you get institutionalized services I think it should be viewed that way PAGENO="0263" 677 Now this was created to provide a mutual organization. That is not the technical term. But it is far from a mutual organization; there has been no fair sharing of the growth of these mutual organizations. And I will show you later, only because the industry introduced some figures which I think are completely misleading, what the actual facts are with respect to these mutual organizations. But I think it is important to emphasize- Mr. KEITH. Are you implying that it is a mutual organization? Mr. COHEN. I am saying that it is sold as a mutual fund. Mr. KEITH. Yes. Mr. COHEN. And they have tried to argue that it is a mutual organization. Mr. KEITH. Who is trying to argue that? Mr. COHEN. Well, if you- Mr. KEITH. I raise that question because they were very careful it seemed to me not to claim that they were mutual. Mr. COHEN. Because they are on the horns of a dilemma. On the one hand they want to say this is a personal service. Mr. KEITH. Who argued that it was a mutual in the legal or income tax sense which is a significant factor? They were very careful it seemed to me to compare their operations with that of a stock life insurance company. Mr. COHEN. I want to deal with that and I brought some figures along to deal with that. Mr. KEITH. My second question to you, I am not quite happy with your first answer- Mr. COHEN. I know, but if you will let me answer them one at a time, Mr. Keith, as I forget them. Mr. KEITH. Will you respond to that point? Mr. COHEN. Yes, sir. So far as this mutualization that we are talking about, these are referred to as mutual funds. That is the common parlance. The statute refers to them largely as open end companies. Now what I mean is that there is a continual argument "Look what this fellow is getting. He is getting this great service and it costs him $22 a year," as if that is- Mr. KEITH. My question was who has argued that they were mutual in the legal or income tax point of view. Mr. COHEN. I don't know about the income tax thing. I have not heard any arguments about that. Mr. KEITH. Or the legal. Mr. COHEN. What I am saying, Mr. Keith, I am trying to answer your question- Mr. KEITH. My question is, the one that I want you to answer is, who has argued that they were mutual in fact as well as in name? Mr. COHEN. They don't argue it that way, but by arguing to you that this is really a relationship between the investment adviser and the individual shareholder, who may be just a name that is somewhere in a computer, they are arguing that this is that type of an arrange- ment, and that is the type of discussion that goes on. Mr KEITH They are arguing that it is a corporate arrangement as contrasted to a mutual arrangement. Mr. COHEN. It is a corporate arrangement when their actions are asked to be put into account Then they like to rely on the corporate waste doctrine. PAGENO="0264" 678 Mr. STUCKEY. Will the gentleman yield? Mr. CohEN. Whereas if this was direct relationship of someone providing the service, I mean it would be very difficult for them not to concede that they weren't in fact trustees, but they are not prepared to accept that, although they do admit they are fiduciaries. Mr. KEITH. Mr. Stuckey has a question. I yield. Mr. S~rurcici~y. We are talking about corporate structure and we talked about the investment advisory fees. If it is in fact a corporate structure~ then if the majority voted agaihst renewing the contract then it would not be renewed; is that right? Mr. ComiN. It has never happened, sir. Mr. S~rtrcKEY. But in fact they could vote not to renew it, is that correct? Mr. COHEN. That is right, Mr. Stuckey, it could happen; yes, sir. May I finish the answer though? Mr. &ruoKEY. I think you just did. Mr. CO~tEN. I don't think I have. Mr. STLJOKEY. You ~just said that they could vote not to renew it. Mr. COHEN. Theoretically, yes, sir. Mr. STUOKEY. So then it would be in a sense a corporate structure~ Now what would be the difference between that say that I owned 51 percent of a company and I could vote all the directors that I wanted to own there. Would that be a conflict of interest? Mr. COHEN. Would you have a conflict of interest? If you engaged in a transaction with your company there would be a conflict of interest and the law might hold you to account. Mr. S~rcrcKEY. In other words, if I had a contract with the corpo- ration. Mr. COHEN. That is exactly right. Mr. Sptrci~r. There would be a conflict of interest. Mr. COHEN. There would be a conflict of interest and the courts and the law have recognized this situation for many years. And if someon& wanted to question the reasonableness, the fairness of that transaction,. he could do so. Mr. S'rtTOKEY. Sure, that is right, a minority stockholder could ques- tion it. So they could also do the same thing through the courts. Mr. COHEN. No, they can't, sir. Mr. S~rucKEr. If a majority voted in favor of renewal which is dis- closed in the proxy statement then there is full disclosure. If they wanted to vote not to renew it then they could also do that. Mr. COHEN. Let me answer that. I think you had the testimony of a~ prominent judge here, who indicated that were it not for these pro- visions in the statute, which the Congress put in in 1940 as a protection to investors, that is to say stockholder ratification and unaffiliated director approval, that these things could be put into account. But be-- cause of those facts, the courts have construed the situation as not making it possible for them to test the arrangement, the contract, on the basis of reasonableness, but to use his language, the plaintiff ha~ to prove that it is excessively excessive or unreasonably unreasonab1e Now that is the difference between the ordinary corporate structure and this one. Mr. Moss. The Chairman has correctly used the statement of the judge, excessively excessive would be the burden of proof which would~ be put on anyone in this connection. PAGENO="0265" 679 Mr. STUOKEY. Is this the way the law reads? Mr. COHEN. This is what~ the courts have said. Mr. Moss. The judge said it as a means of emphasizing the very ~different nature of proof which would be undertaken. Mr. STUOKEY~ Now let's go back to the conflict of interest because this concerns me and let's go back to saying that I own 51 percent of a corporation. Then the corporation gave me a contract as president and chairman of the board. This would be a conflict of interest. Mr. COHEN. Would that be a conflict? Mr. STUOKEY. Yes. Mr. COHEN. Yes, indeed. Mr. STUCKEY. We have got a lot to- Mr. COHEN. There are a few cases in recent years, Mr. Stuckey, that never reached the courts. One of the very largest oil companies in America entered into a contract with a director and with his firm. When that was disclosed, he resigned as a director. There was another situation where the president of a very large insurance company, who was a director of a prominent company engaged in a transaction with his company, and I am not altogether sure there was anything wrong with the situation, but when that was disclosed, he resigned as presi- dent of the insurance company. There was another situation where a gentleman was the president of a large automobile company, and I am just talking about a few cases that have been in the newspapers in the last several years, where his company, his automobile company entered into contracts with certain supplier companies in which he had an interest. When that was dis- closed, he was compelled to resign. I am not speaking only to basic business morality, forgetting the law. So far as the law is concerned, it is absolutely clear that where there is this situation, and I referred to the Geddes v. Anaconda case when I was h~ere last, where that type of transaction is put in issue the defendant whether he owns 51 or 91 percent has the burden of estab- lishing the fairness of it. In our proposal we don't go quite that far. Mr. STUOKEY. But simply because he owns 51, percent and does hold the contract does not make him in violation of the law. Mr. COHEN. No, but you asked me whether he was in a conflict of interest and I have to say the answer is right. But once being in the conflict of interest, that transaction, even though entered into by the board, is subject to some examinaiton by an independent body. Mr. STUOKEY. Sure, this is the way that our system works. But you are saying that this is a conflict of interest. How many corporations would you say in this country, just venturing a guess, where a person owns 51 percent or more and is in fact president of the corporation or chairman of the board? Mr. COHEN. Well, I think there are probably a great many of them, but I don't know that they all engage- Mr. STUCKEY. Aren't they in violation of the law? Mr. COHEN. No, sir; I didn't say that the ownership of the stocic was a violation of law nor did I say engaging in a transaction was a violation of law. The only point I am making is that when they do in fact engage in a transaction of that kind, they are in the position of conflict of interest, and under the laws of the Tjnited States and of the States, this may be brought into question. PAGENO="0266" 680 Mr. STUCKEY. That is right, but they still are not actually in violation of the law. Mr. COHEN. I didn't say they were, sir. If I suggested that, then perhaps I overstated it. Mr. ST1TOKEY. All right. So if this is true in a regular corporate structure then the same thing would be true in- Mr.~ COHEN. No, sir. I think the judge explained it much better than I, in fact he sat on a couple of cases that dealt with this sub- ject. The courts have a rule which they apply in this case. Where you have, as required by statute, and as put in by the Congress to protect the investors, two things, shareholder ratification and ap- proval by the directors, both or singly, the courts say that the ordinary test of whether or not there has been overreaching or just unreason- ableness has to be put aside, and the plaintiff has the burden of proving corporate waste, which the judge described as being excessively exces-~ sive or unreasonably unreasonable. Now it is surprising to me that these people, who admit that they are fiduciaries, who do not deny that they are in a conflict of interest,. a~nd they don't deny this at all nor do they deny, in fact some of them say as a matter of course, that they run these funds, they are their funds, it is almost as if they have a proprietary interest, would urge before this committee that they should not be subject to any independent review by any independent body. It is an extraordinary situation. Mr. STUCKEY. The point that I was trying to make here, because even though an investment adviser does sit on the board and he is a stockholder, this in itself does not constitute a conflict of interest. Mr. COHEN. The investment adviser is rarely a stockholder. In fact~ I know of very few situations if any where the investment adviser is a stockholder of the fund. Normally he is not. Mr. STUCKEY. I can think of corporations where members of the board sit on the board and are not necessarily a stockholder. Mr. COHEN. This is true, but I was trying to answer your question factually. They do~have this contract. There is no denying the factual situation. Mr. STUCKEY. The point I am trying to get across is whether it i~ a corporation, and the mutual funds as I understand it are a corpora- tion. I do not see the difference between the mutuals and the regular corporation because if a majority votes against renewal then you sim- ply do not renew the contract, and I still maintain that this is legally so, that this can be done, and you yourself agree. Mr. COHEN. Let me try this another way, Mr. Stuckey. I think you asked me, and I think Mr. Keith asked me whether or not all of these things weren't disclosed. Well, the fact of the matter is that these companies were operating in 1933 and before 1933, and in 1933 the act was passed requiring diselosure. So immediately in 1933 all of these things had to be disclosed. But the Congress determined in 1935 that that was not enough, and it directed the Commission to conduct a comprehensive study, which resulted in I think five or s~x volumes of reports, and ultimately in 1940 at the request of the industry as well as that of the Commission, a statute was nassed, and this committee I said in its report to the Congress that disclosure cannot deal with the problem. And insofar as the problem we are talking about is con- PAGENO="0267" 681 cerned, it was urged to this committee that these were small companies, they would never grow very large. The Congress therefore felt that certain elementary safeguards should be put into the statute, and these were to provide in certain situations that a minority of the board would be unaffihiated and in others a majority, and that the unaffiliated directors would have the job of approving the contract. They also provided for shareholder ratification. What I am trying to say is that if you didn't have these require- ments, the courts might have been able to deal with these problems under the same rules against overreaching that apply with respect to ordinary corporations But because of those things, the courts have said that those rules shall not apply. The plaintiff must prove cor- porate waste, and that is the end of the world, so to speak. Mr. STIICKEY. So he can do this. Mr. COHEN, Sorry? Mr. STUCKEY. So he can do this. So an average stockholder can do this, right, through the vote. Mr. COHEN. IEEe has to carry the burden of proof, and no stockholdei~ has been able to do that. Mr. STUCKEY. And this iS what I- Mr. COHEN. Even though in 50 cases this was brought in issue. Mr. STUOKEY. All of these people that we refer to, and I will be quite honest with you, I have heard no public dutcry from them. You haven't seen that many cases, and I am sure if this was this much of a gross excess, of excessively excessive wrong with it, we would have heard this public outcry because people simply do not like to be taken advantage of, Personnally I agree with what you said up to and including the 1940 act. I think it has worked quite well. It does give them legal means if they have a group or if they are being mistreated. Mr. COHEN. I don't know if you are agreeing with what I said, but I understand your point, Mr. Stuckey. Now so far as the public outcry is concerned, there are a number of answers to that. I don't know about your mail, but mine has beem very substantial. And I think that there have been other things that have been in the public print which deal with this particular problem. But I don't think you measure this by the numbers of people, some of them small, modest people who have jobs, that go about their own business, by counting the letters that they write. Even if you did that, I have got a lot of letters. That is not the point. The basic point is that the Congress created a structure here. The Federal Govern- ment is responsible for it. It has produced the result which the Com- mission, after studying this matter very, very carefully over a long period of time, has found to be unfair to the shareholders, and all we are suggesting here is not any radical change of the laws, not any new radical statute, but a minor, a relatively minor, adjustment of the existing statute to take care of a problem which it was urged on the Congress would not arise in 1940. It has now arisen. Mr. STUCKEY. How can you say that it would not put them out of the business in this situation? Mr. COHEN. We wouldn't put any mutual fund out of a business and I don't know how you arrive at the conclusion that you would put half of the businesses out of business. I just don't get it. PAGENO="0268" 682 Mr. Moss. The Chair notes the desires of the members and he shares the desire to have the utmost discussion, but in view of the statement when the witness has concluded, if we are ever going to bring these hearings to a conclusion, we will hold to a 5-minute rule. With the utmost regret, we have now taken 40 minutes to discuss two relatively unimportant items in a statement which runs to approximately 40 pages. Mr. KEITH. Mr. Chairman. Mr. Moss. Mr. Keith. Mr. KEITH. I have no objections to your ruling, but I would not like to let the record stand that this is relatively an unimportant item. Mr. Moss. The Chair of course in making that statement merely voices his own opinion, and does not attempt to have the record bear the burden of conveying the idea that it is a consensus of the com- mittee. Mr. KEITH. Thank you. Mr. COHEN. Mr. Ohairman, I don't want to violate your ruling: I appreciate it very much. But if I may, I would like to say one further thing in answer to the questions that Mr. Stuckey has put to me, and implicit in some of the other questions put to me. When the industry was here, they introduced, I think in connection with the testimony of Mr. Welch, certain tables which were designed to show the percentage of net earnings as compared with the assets in three categories: banks, insurance companies, and mutual funds. They had a list of 25 of the largest stock life insurance companies, 25 of the largest banks, and a list of mutuni fund assets and earnings of management companies in 1966, in which they attempted to show that comparing assets under management, the mutual fund managers' net earnings were relatively modest. Now we did not raise this issue about profits. We think, however, that since they brought it in we owe it to the committee to present the situation as it exists, and as the facts demonstrate. It is an unusual situation to indicate their profitability in relationship to assets of the funds. I think the normal way people consider this is by considering the relationship of earnings to stockholders' equity or to gross revenues, and I have some tables here which I wish to submit to the committee, and I will make them available for anybody at the head of the table, which takes the same banks, the same insurance companies and the same group of management companies, those as to which we have information-these management companies are companies which do nothing but manage investment companies-to show the difference in the situation. Now, whereas, in the case of the management companies, the group we have selected shows earnings as a percentage of stockholders' equity running say from approximately 34 to 72 percent, in the case of stock life insurance companies there is only one situation, three situa- tions, I am sorry, that exceed 15 percent, and in the case of the 25 largest banks, there isn't one situation that reaches as much as 14 percent. Now we also have a table which shows the profit margin before taxes in relation to total income of these management companies. With one exception, which is Channing Financial Corp., whose ex- PAGENO="0269" c~ C' -4 -4 >< C C,) C,) C -4 C) C C,) -4 C C) = Ci) ,0 C -4 -< 0 -4 C C,, -4 C C,, C Ci) 00 Ni~)0*) 04 ~0 C~400U1 C4~D00 C-~Ci)~ ~ C) ~(O ~ ~ ~C)-'C) 0OC).~ Cc,oo~ ~C))CC ~)CQCC)C~-~ CCC NCCCCC-~ CN CC C)~C0 V'T')OO P4~00~ C) 0 >< -a C,, C/) 0~ -I~~ C ~ C 0) -r a- C ~ ~ 00-4 C ~,, 00 ø~ C -4 C C 00 C C C,) C 00 ~-J-4O0C~-)~ C0C~)Ci0 to ~-t, ~` I4~. CCN)C-000N0000 C')-44~ ~)00~C) PAGENO="0270" 684 AFTER.TAX EARNINGS AS A PERCENTAGE OF STOCKHOLDERS EQU1TY OF THE 25 LARGEST STOCK LIFE 1NSURANCE COMPAN1 ES-1966 Stockholders equity (thousands) Dec. 31, 1966 After tax earnings (thousands) 1966 Earnings as a percent of stock- holders equity Aetna Life Insurance Co Travelers Insurance Co Connecticut General Life Insurance Co Lincoln National Life Insurance Co Teachers Insurance and Annuity National Life & Accident Co Continental Assurance Co Occidental Life Insurance Co American National Insurance Co Franklin Life Insurance Co Jefferson Standard Life Insurance Co Southwestern Life Insurance Co Equitable Life Insurance Co. of Iowa Life Insurance Co. of Virginia Liberty National Life Insurance Co United Benefit Life Insurance Co Northwestern National Life Insurance Co -- Kansas City Life Insurance Co State Farm Life Insurance Co Washington National Insurance Co Life Casualty Insurance Co Provident Life & Accident Insurance Co__ Southland Life Insurance Co Paul Revere Life Insurance Co California-Western States Life Insurance_.~. $432, 061 471, 010 290, 039 405, 479 61, 096 279, 078 158, 518 209, 364 245,222 149,522 161, 592 93, 504 61, 567 94, 765 99,028 89, 411 60, 043 62,206 64, 845 109,290 79,702 58, 100 30,056 91,408 58,528 $40,647 48, 201 25, 788 39, 573 11, 461 28, 741 14, 840 19, 554 20,124 19,855 14, 898 7,794 4, 299 9,071 13, 851 5,924 6,444 6,153 10, 484 12,221 9,675 7, 182 5, 560 8,487 5, 297 9.6 10. 2 8.9 9.8 18. 8 10. 3 9. 4 9.3 8.2 13.3 9.2 8.3 7. 0 9.6 14. 0 6.6 10.7 9.9 36.2 11.2 12.1 12.4 18. 5 9.3 9. 1 AFTER-TAX EARNI NGS AS A PERCENTAGE OF STOCKHOLDERS EQUITY OF CERTAI N MANAGEMENT COMPAN I ES, 1966 Stockholders equity (thousands) Dec. 31, 1966 After tax earnings (thousands) 1966 Earnings as a percent of stockholders equity Anchor Corp Dreyfus Corp Insurance Securities, Inc Keystone Custodian Funds National Securities & Research Corp Putnam Management Co Supervised investors Services VanceSanders&Co Waddell & Reed WellingtonManagement $4, 449 7, 650 6, 534 4, 882 2,976 2,505 883 3,058 14, 269 2,956 $2, 162 3,233 4,703 2, 118 1, 113 936 307 1,171 5, 027 1, 861 48. 6 42. 3 72.0 43. 4 37. 4 37.4 34.8 38.3 35. 2 63. 0 Note: Distributors Group, Hamilton Management Corp., Investors Diversified services, and Van Strume and Towne, Inc., have not been included, because it was not possible to secure comparable data for stockholders equity and.aftertaxearnings. Mr. COH~IN. Now Mr. Chairman, I would like to take advantage of your offer and go back to my opening remarks. Incidentally, for the benefit of any who were not here when I testified last, I referred to this effort on the part of the sellers of funds, those who manage them, to seek the favor of investors. I introduced at the last time an adver- tisement put out by the Winfield Underwriters, Inc. in a recent pub- lication. Thait organization is associated with a fund that had one of the best experiences in recent years and yet they have increased the dealer concession. In other words, they have decided to take less for themselves out of the overall sales load. They have not attempted to reduce the charge to investors. This is the type of competition to which I have referred that exists in that area. But going back to the advisory fee area, I do want to emphasize, even at the expense of repeating I think the last statement I made, that the industry can only come to where it is by a studious disregard of the situation as it exists. They argue that our proposal is ratemak- ing or profit regulation, and it is nothing of the sort. It is simply PAGENO="0271" 685 a means for the enforcement of a fidueiary~s obligations in a conflict- of-interest situation, and it is the traditional means for such enforce- ment, independent scrutiny by a court of equity, not by the SEC. I understand, and I am frank to say that I did not have a chance to read his testimony carefully, but I understand that the judge who testified suggested that perhaps in the best of all possible worlds, that scrutiny should in the first place be done by the SEC. We considered that. We abandoned it. We did not wish anyone to have any notion that the Commission was reaching for additional power, and we wished to make as clear as we possibly could that this issue, when it arose, would be in the hands of an independent body in the traditional American way, in the courts of law. Now while the industry insists that its fees should be reasonable, that they are reasonable, that they always have been and always will be reasonable, even in this conflict-of-interest situation, they are singularly reluctant to submit this question to any sort of independ- ent and impartial review. Although, as I intend to point out in more detail later, we by no means suggest that all investment advisory fees are unreasonable, or even that most of them are, it would be singular indeed, given the situation which prevailed, if all fees have always been and always will be reasonable. No such suggestion finds any sup- port in the record. The dollar amount of fees has grown tremendously as the funds have grown, and this notwithstanding the fact, which the industry admits, that the costs of investment management do not rise very rapidly if at all as the fund grows, and I have just introduced some statistics which cover 1966, which the industry argued was a trou- bled year, and yet it reflects the fact that they did very well. They did a greait deal better than any of the other financial institutions to which they have referred. I might say they did a great deal better than practically anybody else in the securities business. Now fees and expense ratios of the large funds vary all over the place, and I must emphasize that our points have been directed to the large funds, because as the funds grow larger, the economies of size become apparent. Actually, this is the vehicle they created. They wanted a corporation. They wanted people to come in. This is where the word mutual may have an effect, Mr. Keith. By joining together, and as you grow you get the benefits of economy that a large insti- tution provides. These people have been significantly reluctant to share in any fair way those economies with the people whose money they manage and who have made possible this unparalleled prosperity which they enjoy. We are not against prosperity. We think that they should have profits. They should be reasonable profits. But we think the investor deserves some recognition too. Now one large fund will pay $6 million and another about the same size will pay $3 million to be advised, and of course internally managed funds pay far less. In this connection, we also have a situa- tion of a group of funds which have their own service organization, a service organization which takes care of the needs of the various funds at cost, allocated in proportion to the size of the funds, and it is very interesting, and if I may I would like to introduce the figures as they relate to that situation. I brought copies along for all mem- bers of the committee and anyone else having an interest in the matter. PAGENO="0272" 686 Mr. Moss. Is there objection to having this included in the record at this point ~ Hearing none, that will be done. (The information referred to follows:) THE BROAD STREET GROUP: A CASE STUDY OF ECONOMIES OF ScArs IN MUTUAL FUND MANAGEMENT The Broad Street Group is a complex of investment companies affiliated with and sponsored by a New Yor~ Stock Exchange member firm, J. & W. Seligman and Company. At 1966 year end, total assets of the groups's investment com- panies were $1,460 million. The members of the Broad Street Group include: (1) Tn-Continental Corporation, a closed end Investment company formed in 1929 with 1966 year end net assets of $508 million. (2) Broad Street Investing Corporation, an open end investment com- pany which became affiliated with The Board Street Group in 1932, with 1966 year end net assets of $858 million. (3) National Investors Corporation, an open end investment company which became affiliated with the Broad Street Group in 1942, with 1966 year end net assets of $555 million. (4) Whitehall Fund, an open end investment company organized in 1947 with 194343 year end net assets of $15 million. (5) Tri-C~ntinental Financial Corporation, a wholly owned subsidiary of Tn-Continental, acting as a special situation investment company. (6) Broad Street Sales Corp., a wholly owned subsidiary of Tn-Con- tinental Financial Corporation, which acts as wholetale distributor of the three open end funds. (7) Union Service Corporation, which acts as investment adviser tO all the above investment companies. Union Service provides investment research, econoniic analysis, and srtper'ctison of the execution of purchases and sales of securities at cost. In 1963 It employed 92 persons of whom about half were economists or financial analysts. Pursuant to an arrangement made in 1931, all of the above funds conduct most of their brokerage business thru the New York Stock Exchange firm of ~T. & W. Seligman. The principals of J. & W. Selignian and all of the above named companies (with the exception of Broad Street Sales) are, with some exceptions, the same ~iersons. The major remuneration to these men comes from J. & W. Seligman and not from the investment companies listed above. The nature of the organizational structure of the Broad Street Group in which management services are performed at cost affords an excellent oppor- tunity to study the true cost of managing a mutual fund. The shareholders of the Broad Street Group are able to enjoy a low, and decreasing expense ratio, as shown in Table I. TABLE I. -EXPENSES OF BR OAD STREET GROUP Management fees as a Average net assets of Broad Street (thousa~ds) Management expenses percent of average net ~ Total expenses (thousands) Expense ratio (4)÷(1) (1) (2) (3) (4) (5) 1966 1965 1964 1963 1962 1961 1960 1959 1958 1957 1956 1955 1954 1953 $1,460,807 1,411,438 1,254,184 1,085,623 1,029,330 939,492 770,980 681,008 552, 144 474,047 451,979 388,590 301,144 253,357 $1,602 1,543 1,432 1,378 1,302 1,208 1,182 (1) (1) (1) (1) (1) (1) (1) 0.11 .11 .11 .13 .13 .13 .15 (1) (1) (1) (1) (1) (1) (1) $2 564 2'358 2'263 2'261 2'092 1948 1'856 1633 1' 497 1'415 1'207 1'085 997 912 017 17 `18 21 20 21 74 24 27 30 27 28 33 :38 1 Not available. Note-While data is available from 1940 to 1953, Union Service Corp. managed other portfolios in addition to the Broad `Street Group prior to 1953 and the data is therefore not comparable. PAGENO="0273" 687 Mr. COHEN. This group of companies is called the Broad Street Group and this is a little memorandum prepared some time ago, not in connection with this testimony, but having read the testimony given by the others, I thought it important to bring this to the attention of the committee. As the memorandum indicates, the Broad Street Group is a complex of investment companies affiliated with and sponsored by a New York Stock Exchange member firm, J. & W. Seligman & Co. I should say that while the partners of that firm do receive salaries from `the group of investment companies, and there are seven includ- ing the service company in the group, their principal remuneration is from the brokerage. But if you look at table I, without fussing with the rest, I think you can see what the management fee rates are, have been since 1960, the earliest date that we have figures for on manage- ment fee rates as a percentage of net assets, and what `they are in 1966. But we have figures going back to 195~ with' respect to total ex- penses. The expense ratio, which includes not only the management fee but all other expenses, has been declining from 0.38 to 0.17. We are not talking about new or strange things. We are not talking about things that some funds have not already done. Other large funds have undertaken other steps which have had the effect, even though they haven't changed their schedule of charges, but have had the effect of reducing the charges to the investor, and ha~ve brought them down to levels far lower than that which exists in a great many other com- parable situations. Of course, there may be some differences between them, but I think it is a reasonable question why the range should be that wide, and why companies of comparable size should be subjected to such greatly varying charges. And obviously, it also points to the fact that perhaps the unaffiliated directors are not able, as I have suggested, to do a gerat deal about this situation. Now these unaffiliated-well, before I get to that, I should say that it may well be, I want to be perfectly comprehensive if I can, that some of these fees are unreasonably high, and maybe others `are un- reasonably low. We are not suggesting that everybody's fees be brought down to the lowest level. We are not suggesting that anyone is too high or anyone is too low. All we are suggesting is that if someone wants to put in issue, whether it is the SEC or a shareholder, the question whether the fee charged in his situation is fair, he should have an opportunity to do so without being hamstrung by doctrines which come about unintention- ally because of certain provisions put into the act in 1940 by the Con- gress to help rather than to hurt the investor. I think there is enough evidence before you in all the tables that have been submitted to you to indicate that these unaffihiated directors, even when they can concern themselves about the size of the fee, really do not have any alternatives. There is no real bargaining power. But their presence in a sense provides an umbrella for the invest- ment adviser. This is the point. Perhaps that is an inappropriate way of stating it, but that is the fact. As the judge pointed out, the doctrine of corporate waste prevents effective judicial review. It is also somewhat anomalous that people who concede that they are fiduciaries, that the fees should be reasonable, are unwilling as a prac- tical matter, no matter what they say, to have any independent body, 85-592-68--pt. 2-18 PAGENO="0274" 688 a court of law, review their situations except on a staiidard of corpo- rate waste, which as every lawyer knows is at best the most. difficult standard in the world, and at worst provides no remedy at alL Now not ouiy does the industry misconstrue the nature and the pur- pose of our proposal. They also misconstrue how it would operate in practice, and they do exercise their ingenuity, and by golly, they have a lot of it, in conjuring up imaginary or exaggerated difficulties rather than trying to devise workable means to avoid these difficulties while still protecting investment company shareholders and at the same time protecting themselves. In the first place, they misconstrue the Commission's attitude and purpose. I am quite prepared to state that we do not regard all invest- ment advisory fees as unreasonable, nor would we propose to embark on any campaign to cut the general level of fees way back to that of thB lowest. I wish to restate that one of the important conclusions under- lying our recommendation was that the economies of scale attributable to that growth and attainable as the funds grow, have not been ade- quately shared with the funds' shareholders. It is to this situation that our principal concern is directed. I must point out, and the figures are before you, that a number of the people in the industry, and unfortunately there are not too many, did recognize the situation. Some of them recognized this many years ago, long before there was a Wharton School report, long before such a report was initiated, and they took steps to share these economies of scale with their shareholders. It really hasn't hurt them. They have sold as well as any. In fact, they have sold better. And the investment managers have done exceedingly well. Now an argument could be made that these people who admit they are fiduciaries and are providing services to this corporation, to this institution that they create, should only be entitled for compensation for their services. But they say-and we are not for the purposes of this legislation taking issue with the suggestion-that they should also be entitled to some entrepreneurial profit. As I say, a reasonable argument could be made against it. We `are not making it. We are accepting the fact that they should have some entrepreneurial profit, for those who have been successful in starting and building an invest- ment vehicle. We recognize, `and it is the reason we came to this conclusion, that the creation and the building of a fund does involve certain risks, and that those who are successful are entitled to some reward. But that reward must be within reason, `and at some point in time and growth, the reward will have `been reaped. Now the courts, as the judge pointed out, have traditionally been able to deal with these problems, and certainly the courts will con- tinue to deal with them in the context of the particular situations. I might say in this connection that `another distinction between the mutual fund advisory organization and banks `and insurance com- panies is that in an insurance company the owners of it, the share- holders, whether they be many or few, have to provide capital to quarantee the promises to the man who wants to buy a life insurance policy, `and that is strictly enforced by the States. So also in the case of the banks. Their capital is at risk to take care of the obligations and PAGENO="0275" 689 the promises of the bank. There is nothing at risk here so far as these investment advisory organizations are concerned, nothing at all. They don't guarantee any particular success or lack of failure or any level of asset value. Now, turning to another point, we are accused of proposing to substi- tute our judgment for the judgment of the fund directors. This is wrong on at least two counts. In the first place, and I must emphasize it, any judgment as to the reasonableness of a particular fee would be made by the court, not by the SEC. In the second place, if the directors really exercise a business judg- ment, if they do more than act as rubber stamps, if some of them change their views as to their responsibilities and do more than go through the rituals and feel that they do have an obligation to inquire and to seek justification, and they make a conscientious effort to arrive at a reasonable fee, taking into account all relevant factors, not only the ones we have mentioned but all relevant factors, and not merely rely on what the fellow down the street has been charging last year, I am certain, as I know all of you who have had any experience with the courts, whether as lawyers or as clients, must be, that the court would give appropriate weight to their judgment. And as I mentioned, I believe T mentioned and if I haven't I should now, it would be appropriate for the legislative history so to indicate. Now I come to another point that is somewhat related. It is a little imore troublesome to me. It is in effect contended that we will engage in a sort of raternaking by blackmail. I hope you will understand that TI rather resent the suggestion. There is a suggestion made explicitly or sometimes implicitly that we will do something that we will of course not do. We will not require our opinions or the opinions of our staff about fees to be set forth in registration statements or pro- spectuses. We will not, we never have and we have been regulators and policemen for some 30-odd years now. We will not threaten suits unless we conclude that a suit is necessary to accomplish a statutory purpose, and that we have a case which we reasonably believe will persuade a Federal judge. Now this raises an issue I want to repeat. We would, of course, conduct ourselves in all areas of our work by starting a lawsuit and asking qustions later. The suggestion has been made somewhere that this is a coercive authority. Now obviously whenever you have some authority and responsibility to enforce the law, it is coercive in that sense. But we would think that where a reasonable question arose, that we would want to bring it to the attention of the parties involved, and discuss it with them, just as we do in many other areas, and frequently they persuade us that we have been misguided, that we haven't been fully informed, and that our point of view should not be as was first suggested. This could happen. But we would not, and again I must reemphasize, this Commission has never, and never will in my opinion, engage in this sort of blackmail which has been suggested. Now in addition to being worried about the Commission, the industry is also worried about the small investor suing. We don't think that the ~courthouse door should be closed to him or that bars such as the stand- :ards of corporate waste should be erected in his path. In fact, the sum PAGENO="0276" 690 and substance of their argument is they don't want anybody reviewing the situation. There are, however, ways-if this is a problem-of avoiding un- warranted litigation and I am informed that in his testimony on Wednesday Judge Friendly pointed out some of them, and his sug- gestions certainly merit the most serious consideration by the industry and by us. And I am sure they will receive the consideration of the committee. But there may be additional steps which could be taken which we could develop if the subcommittee so wishes, although we have some reserva.tions whether some of them go too far in protecting the managers at the expense of the shareholders of the fund. Now in summary, industry witnesses have misrepresented this entire~ proposal. We do not urge ratemaking. We are not against profits. We do not wish to injure the investment advisory industry, and cer- tainly none of our proposals would hurt the mutual fund industry, or even drastically alter the existing level of management compensation,. generous as it may be. Indeed, we are not even suggesting a change in the structure of the industry, which in a large sense gives rise to the problems which we are discussing here today. We have, however, a situation where the investment advisers can,~ and as I indicated in some instances have, enriched themselves at the expense of those to whom they stand in a fiduciary relationship free of any effective control or independent or impartial scrutiny. ~I want to make it perfectly clear that this is not true of all of them. Many of them have made an effort to share the economies of scale with their shareholders and have done so for many years. And they have not suffered in terms of sales, profits, or what have you. Our purpose here is to restore to this area the traditional check on overreaching by fiduciaries, and that is impartial review in the courts of the United States. Mr. Chairman, there were a few other questions that were suggested to which I might address myself. I will be glad to do that now or take your advice as to how to proceed. There were a few questions raised by some of the witnesses that I understood the subcommittee was interested in having some reaction from the Commission on. I can deal with those right now. Perhaps I should make that clear. The subcommittee did receive a number of suggestions from other witnesses which relate to the mat- ters I have just discussed, and it has been suggested that it would be helpful to the subcommittee for me to address myself to those matters. I don't think they will take a great deal of time, but I am at your suggestion. Mr. KEITH. Could you ask, Mr. Chairman, as to the nature of those questions? Mr. COHEN. Yes. Mr. Moss. Those questions were raised by the witnesses? Mr. COHEN. Right. Mr. Moss. And for which answers on the part of the Commission would be supplied? Mr. KErm. I would suggest that we go ahead and try to comment on the statement he has made and then if time permits have further comments. Mr. Moss. All right, you may proceed at your pleasure. PAGENO="0277" 691 (The statement referred to follows:) SUPPLEMENTARY STATEMENT OF HON. MANUEL F. COHEN, CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION Mr. Chairman and members of the subcommittee, I deeply appreciate your :affording me the opportunity to come before this Subcommittee for a second time to answer some of the objections that have been made to H.R. 9510 and 9511 and to clear up some of the misconceptions that may have arisen in the light of the testimony of certain representatives of the industry. Over the past two weeks, I have carefully read the statements submitted to you by representatives of the securities business, as well as the transcripts of your questions and their answers on the points that have concerned' you. I must confess that I found it a rather depressing experience because the industry has been so negative and unconstructive. When I appeared before you two weeks ago, I told you that the purpose of these bills was a simple one-it was to provide a fair shake for the millions of Americans who have invested in mutual funds and other types of investment companies and for the additional millions who will invest in these media in the future. I want to reemphasize that basic purpose, because I think it is' something `we must not lose sight of. The industry, however, insists that even if Congress should take the most mod- est steps to attain this goal, the health of the industry would be severely im- paired. This is a familiar refrain heard iii each of the hearings preceding the securities laws enacted by the Congress. In fact, these laws have served only to protect the securities industry itself from the consequences of overreaching by some engaged in that business. There has not been a single advance in the regulation concerning securities ~whicb it was claimed would not have the effect of making business less profita- ble-or even impossible-for some segment of the industry. Some of you may re- call the forecast that, if the Securities Act of 1933 were enacted, "grass would ~grow in Wall Street." Every improvement in the disclosure requirements has been made over the argument that it would make it impossible for some class of issuers to tap the public securities market. Every improvement in business stand- ~ards has been made over the objection that it would be impossible for ordinary business men to operate under a crushing burden of government regulation. And ~after all these improvements, over all these objections, the securities business is bigger, stronger, healthier and more prosperous than it has ever been before. The securities industry is a regulated industry. It has been regulated by the Federal government for more than a third of a century. The legislation before you is not an instance of government tampering with a free enterprise system. It is an adjustment of an existing regulatory statute to meet problems which were not present or even foreseen when that statute was enacted 27 years ago. In many respects, these problems are attributaible to the unforeseen conse~ ~quences of Federal regulation. A great deal has been said in the last two weeks about competition in the securities business. The plain fact of the matter is that this business has a large number of competitors and very little competition. This may sound like a paradox but it is not. There are a great many separate units in `the securities business, but they are severely restricted from competing with each other by the unique Industry structure tolerated by and the anti-competitive protections afforded by Federal law. In fact, the mutual fund industry does not compete on the basis of price for ipvestor favor. There is little effort to offer a better price to the investor. The primary effort is to offer a b~tter deal to the dealer and the salesman, so that they will push the shares ~f a particular fund to investors who have no effective *ay of evaluating different funds or of determining whether mutual funds are `an appropriate investment for them at all. This type of competition bears no relation to the classical free enterprise sys- `tern. It is `a "perverse" or "upside down" competition, which can exist only because the present scheme of Federal regulation of this industry makes it pos- sible. It is a system of competition which brings enormous benefits to the indus- try, but not price benefits to the investor. It is a system under which the Federal government authorizes the industry to operate outside of the controls of the anti-trust laws, o~utside the controls provided by disclosure of compensation for management services, and outside the controls provided by a competitive free PAGENO="0278" 692 enterprise system. The Federal government, together with the industry, shares responsibility for the excessive charges now being made to the American public for investment in mutual funds. Unfortunately, the industry has not seen fit to meet this responsibility. The arguments that have been advanced before this Subcommittee opposing H.R. 9510 ignore both the undisputed facts and the realities of 27 years of experience under the Investment Company Act. The Federal government must meet that responsibility by restoriug a proper balance between the interests of the public and the interests of the industry. I should like to turn now to a discussion of the particular issues involved and deal with the major contentions advanced by the industry. 1. THE BILL REFLEOTS MODERATE OHOICES AMON~ THE ALTERNATIVES AVAILABLE TO DEAL WITH THE PROBLEMS OF nxcnssivn ADVISORT FEES AND SALES LOADS Despite the industry charge that provisions of the Bill with respect to advisory fees and sales loads are "drastic", 1 they represent a moderate and conservative approach towards resolution of the serious problems in these areas. The problem of excessive advisory fees, for example, results from the conflicts of interest. built into the external management structure of the mutual fund industry, a structure alien to the American way of doing business. The simplest way to deal with these conflicts of interest would be to eliminate them. This could be done by requiring the mutual funds be internally managed by their own officers and directors in the same way that most other companies, including financial institu- tions such as banks and insurance companies, are managed. Managers of invest- ment companies, like those of other corporations, would then receive compensa- tion for their services primarily in the form of salaries and other readily disclosed remuneration subject to conventional limitations instead of receiving gross man- agement fees in a manner which obscures the excessive nature of these fees. The Commission, however, has rejected this approach as being too drastic at this time and instead has chosen to recommend only that the conflicts of in- terest inherent in the present industry structure be subjected to meaningful con-~ trols in the form of an express, readily enforceable standard of reasonableness.. We know of no other means which on the one hand would deal adequately with the problem of excessive fees and on the other hand would disturb less the estab- lished structure of and ways of doing business in the mutual fund industry. The need for controls over sales loads arises from the anticompetitive effects of Section 22(d) of the Investment Company Act, which interferes with the freedom of dealers to compete for customers. by offering mutual fund shares at a. price lower than that fixed by the principal underwriters of the funds. The industry claims that the present level of sales charges is reasonable and required by competitive conditions in the industry. However, when repeal of Section. 22(d) was suggested to persons within the industry, they reacted with expres~ sions of deep, and indeed almost violent, concern that the mutual fund industry could not survive the test of meaningful price competition. The Commission was not necessarily persuaded as to the basis for this concern. Nevertheless, it determined to adopt an approach which would deal fairly with the situation and which the industry would regard as a more moderate and conservative posi- tion. It determined not to recommend that existing restraints on competition in the sale of mutua' fond shares be elimir~ated. It urged that investors be protected by a statutory ceiling on sales loads which would be subject to upward revision by the Commission when the public and investor interests seem to require such action. With respect to front-end loads in the sale of contractual plans the Commis- sion has recommended the abolition of this method of investing in mutual fund shares which for many purchasers has proved to be extraordinarily costly. It took this step, however, only because of the failure of the industry to develop meaningful alternatives which would protect adequately the substantial number of invcst~rs who, in fact, do not complete the payments on their plans. Many of these investors pay sales charges amounting to more than one dollar for every dollar invested in fund shares. Many of them, because of these unconscionable sales charges, have lost money on their mutual fund investments despite the rapidly rising securities market of recent years. Even so, the Commission did not 1 See e.g., Statement of the Investment Company InstItute, pp. 17-32. (HereInafter re~ ferred to as "Id Statement, -"). PAGENO="0279" 693 recommend abolishment of the contractual plan itself, which, in addition to the sales load, involves the imposition of an extra custodial fee to cover the adminis- trative expenses of handling the periodic payments of contractual plan purchasers. 2. MUTUAL FUND ADVISORY FEES ARE EXCESSIVE The industry does not seriously dispute the basic facts uncovered by the exten- sive studies that have led to the introduction of these bills. These facts are: (a) There are substantial economies of scale in the management o investment companies. It should not cost 100 times as much to manage a $10& million dollar fund as it costs to manage a million dollar fund and surely it should not cost a thousand times as much to manage a billion dollar fund.. (b) Despite widespread recognition of this fact within the industry and. despite the pressures generated by the Wharton School Report and by exten- sive shareholder litigation attacking the fees as excessive, the economies of scale have not been shared equitably with fund shareholders. In 1966 over one-half of the externally-managed funds with assets exceeding $100 million paid advisory fees of .48 percent of net assets or more, only 2 percent lower than the traditional .50 percent rate that is customarily paid by the small funds in the industry. (c) The advisory fee rates of the larger external-managed funds on the average are double the average management cost rates of the larger inter- nally-managed funds. There is no difference in the nature or extent of the services required in the management of these two types of investment eoinpanies. (d) Mutual fund advisory fees for funds with assets of $100 million or more are on the average at least 8 times higher than the rates charged by leading banks for investment advisory and other services to pension and profit-sharing plans with $100 million in assets. (e) The same advisers who supply services to mutual funds can and do change substantially lower fees for management of the much smaller port- folios of private clients who, unlike fund shareholders, are in a position to, and in fact do, bargain effectively for lower costs. (f) Advisers to mutual funds who contract out the investment advisory function to another advisory organization are able to do so for fees that are a fra~etion of the fees they charge the mutual funds under their management for these services. (g) In many cases, the advisory fees paid by the larger funds bear no~ relation to either size or investment performance of the funds. Managers who serve larger funds often receive higher fee rates for comparable serv- ices than are managers of smaller funds whose efforts have resulted in superior investment performance. For example, the investment performance of Hamilton Funds, Inc., a fund with 1966 year-end assets of $490 million,. which pays advisory fees at the rate of .50 percent per annum may be com- pared with the superior investment performance of Chemical Fund, Inc., a. fund with year-end 1966 assets of $411 million, which pays advisory fees at the rate of .30 percent per annum. Nevertheless, the industry persists in its contention that there is no need for a statutory standard of reasonableness with respect to advisory fees because the fees "are reasonable." 1 This is a barren claim wholly unsupported by the evidence. 8. THE INDUSTRY'S ATTEMPT TO JUSTIFY THE FEES AS "BARGAIN BASEMENT COST'~ TO THE INDIVIDUAL INVESTOR IGNORES THE BASIC CONCEPT OF A MUTUAL FUND The industry has attempted to justify its failure to provide mutual fund in- vestors with an equitable share of the economies of size by suggesting that an advisory fee of one-half of one percent is "bargain basement cost" for the pro-~ fessional management and diversification of investment risk which a mutual fund gives to its investors.2 Of course, such an assertion ignores the total cost of a mutual fund investment. The combination of sales charges, advisory fees and brokerage commissions which an investor must pay in connection with his mutual fund investment represents the most expensive way ever devised by the securities~ 1 ~ Statement, 23. 2Testimony of the Investment Company Institute, Record, p. 196. (HereInafter referred to as ICI testimony, R -). PAGENO="0280" 694 industry for mass participat1oi~ in the securities market. Mutual funds costs are no more "bargain basement" than the quality of their product. Although mutual funds offer a security of high quality, the high cost of a mutual fund investment places investors at a substantial disadvantage in the achievement of their financial goals. Iustification of advisory fees in terms of the cost to the individual investor is inconsistent with the basic concept of a mutual fund. Mutual funds are created and sold to the public as a "mutual" investment median through the pooling of individual savings for investment in equity securities just as mutual savings banks offer a way to pool savings for investment in home mortgages and other debt securities and mutual insurance companies offer a way to pool premiums and thus, reduce costs of family protection. Our proposal that mutual fund advisory fees be governed by a standard of reasonableness would require that the economies of size be shared with ftind ~harebolders. It would make the operation `of mutual funds more consistent with the put~poses for which they are created and the basis on which they are sOld. While the industry has created the funds and sold their shares with all the trappings and attractions of "mutual" savings institutions, its representatives attempted to suggest to this Subcommittee that the externally-managed fund is not a mutual savings institution at all, but more comparable to a stock insurance company.1 But neither stock insurance companies nor a major segment of any `other industry are characterized by the externally-managed structure, which compensates i'ts managers not on the value of their services, but on the vaitte of the company's assets. Such a method of compensation, which expresses the com- pensation as a fraction of one percent of the fund only obscures the many millions of dollars in managerial emoluments that flow from control of a mutual fund. The industry cannot have it both ways, selling shares in a mutual savings institution while abandoning any attempt to operate the institution for the mutual benefit of its investors. Indeed, even in the ordinary corporate situation, where no attempt is made to create a corporate entity with the trappings of ~nutuality, the propriety of self-dealing transactions) such as management compensation, is not measured in terms of the cost per shareholder or cost per customer. When a director of a manufacturing company cause~s his company to deal with a supplier in which he has a financial interest and the supplier over-charges the company, the transac- tion has never thought to be justified on the grounds that it cost each shareholder only a few cents. Such a transaction is condemned as a breach of fiduciary duty because it contravenes the norms of the business community and the basic tradition of the law. 4. THE INDUSTRY'S ATTEMPT TO SHOW THAT ADVISORY FEE RATES ARE DECLINING IS EASED ON A MEANINGLESS STATISTICAL EXERCISE Although at times industry representatives have suggested to this Sub-Com- mittee that there is no duty on the part of fund managers to share the economies of size wih fund shareholders, at other times they have claimed that advisory fees are declining and the economies of size are being shared with shareholders. They support this claim by statistics which purport to show that since 1946 -average advisory fee rates for all mutual funds have declined by 19 percent- from .46 percent of net assets in 1946 to .37 percent of net assets in 1966-and that total operating expenses during this period have declined by 28 percent.2 Advisory fees are almost always paid to the persons in effective control of the fund and constitute by far the major part of the operating expense's of a mutual fund. On the other band, expenses other than advisory fees, which usually are paid to banks, lawyers, accountants and printers who are un- affiliated with the fund's management, constitute only a small portion of a fund's operating expenses. The industry's own statistics show that any reduc- tions in advisory fees that might have taken place have failed by a wide margin to keep pace with the reduction in the other operating expenses of mutual funds, expenses which usually reflect payments to non-affiliated per- -sons who stand in arm's length relationships with the funds and their manage- ments. Thus, even the industry's own figures raIse a serious question as to the adequacy of the sharing of the economies that they allege has taken place. 1 ICI Testimony, R 218-2a5. 2 ICI Testimony, R. 198; ICI Statement, Exhibit 8. PAGENO="0281" 695 Moreover, exhibit 8 to the Investment Company Institute's testimony, on which the claim of the 19 percent reduction is based, showa a strange andi confusing picture. According to this exhibit, mutual fund advisory fees amounted to .37 percent of assets in 1966. This same chart shows, however, that advisory fees in 1958, when the in- dustry was only a fraction of its present size, amounted to .38 percent of assets-only 1 percentage point higher than the "average" of the 1966 fees. It also shows that in 1949 advisory fees averaged .40 percent of assets, only 3 percentage points more than the "average" 1966 fee rate. In 1949 the Industry's assets were less than $3 billion. According to the industry's statistics, therefore, the economies of size were shared with fund stockholders,. long be- fore the funds had grown to the point where they had economies of size to share. These contradictions in the industry's own data suggest that its claim of substantial reductions in advisory fees is based on an invalid statistical exer- cisc. In fact, it is meaningless as a measure of the regulatory problems be- fore this Congress because it is based on a weighted industry average which gives great weight to the relatively low fees paid by a few very large funds.. The funds, including the internally-managed funds, which, as we have noted, pay substantially less for investment advisory services than the externally- managed funds. The plain fact, which the industry does not dispute, is that over one half of the largest funds-those with assets of $100 million or more- paid advisory fees at the rate of .48 percent or more in 1966. The fact that there has been little deviation from the traditional .50 percent advisory fee rate, which was characteristic of the much smaller investment company in- dustry of the 1940's and 1950's, demonstrates the seriousness of the excessive' fee problem. 5. THE INDUSTRY'S ATTEMPT TO DEMONSTRATE THE "MODESTY" OF ITS PROFITS ia BASED ON INVALID COMPARISONS The industry has attempted to show that the pofits of mutual fund manage- ment organizations are "modest" by calculating the profits of 14 such companies not as a percent of revenues or shareholder equity but as a percent of the capital: of the funds they manage.' The industry then compares these profit figures with the profits of the twenty-five largest insurance companies and banks as a percent of the public capital held by these institutions. This is an absurd basis for com- parison. It is like determining profitability of a real estate management firm as a percent of the aggregate value of the property it manages or the profitability of a consulting engineering firm as a percentage of the construction costs of the proj- ects it works on. It is the investment adviser, no't the fund which receives advisory' fees and makes profits. In many cases the pre~tax income of the adviser is very handsome, ranging up to 65 percent or more of their advisory fee revenues. If a comparison is to be made of the profitability of mutual fund management organizations on the basis of capital, a more appropriate comparison would be profits as a percent of shareholder equity. On the basis of shareholder equity the' profits of publicly-held mutual fund management organizations are, indeed, im- pressive. They show an annual return of 30, 40 and even close to 70 percent. In contrast, the median profit of the twenty-five largest insurance companies and banks selected for comparison by the Investment Company Institute amounts to a 9.8 percent and an 11.1 percent return on shareholder equ'ity. The Commission believes that the question of whether mutual fund advisory fees are excessive should not be decided solely on the basis of the adviser's. profits no matter h'ow computed. It is clear, however, that profits of mutual fund management organizations are hardly more "modest" than are the fees they charge their mutual fund clients. The industry should not be heard to justify its excessive charges by a fallacious statistical presentation as to the "modesty" of their profits. 6. THE INDUSTRY CLAIM THAT ADVISORY FEE RATES ARE EFFECTIVELY CONTROLLED BY COMPETITION, DISCLOSURE, UNAFFILIATED DIRECTORS AND SHAREHOLDER APPROVAL IGNORES REALITY Despite `the unbending rigidity of the advisory fee structure in the rapidly growing mutual fund industry, the industry claims that competition, disclosure, `ICI Statement, ~9-3O; ICI Testimony, R. 202-203. PAGENO="0282" 696 tinaffihiated directors and shareholder voting are effective controls over the fees.' The facts are, as the industry well knows and twenty-seven years of experience amply demonstrates, that there simply is no competition in the advisory fee area, that unaffihiated directors have not been effective in keeping advisory fees reasonable and that shareholder voting has no effect on such fees. (a) Advisory fees are not subject to competition The industry apparently concedes that investment advisers do not compete for the privilege of serving mutual funds and that mutual funds have no real op~- portunity to shop around and seek the best terms they can get. If th:at were other- wise, surely there would be instances where the independent directors have successfully dislodged an adviser who was willing and able to continue. In fact, with one possible minor exception, there have been no such instances in the history of the industry. No proxy contest has ever been waged against, much less has one succeeded in displacing, an incumbent adviser to a mutual fund. Indeed, many independent directors suggested that it might be considered a breach of fiduciary duty to attempt to dislodge the adviser. It appears from the industry testimony that the type of competition referred to is the competition among funds to sell their shares to investors; at the same time they attempt to establish that the invesment advisory fee is insignificant insofar as the average small investor is concerned. The two positions can hardly be reconciled. The best indication of the role competition in sale of fund shares plays in keeping advisory fees reasonable is bow those who sell mutual funds treat the fees in their selling literature. The fact is that even those funds with relatively low fees seldom emphasize that fact. Take, for example, the prospectus of Massa- chusetts Investors Trust. This fund, which is internally managed, pays its five trustees salaries which under any standard of executive compensation is quite handsome; yet their management cost rate of .12 percent of assets is less than one-fourth the traditional .50 percent rate. Its prospectus, however, makes no mention of these facts and indeed makes no mention of its relatively low operat- ing expenses beyond that legally required by Commission rules, If the fees charged are important competitive factors, it is strange that those funds enjoying the lowest fees do not vigorously advertise that fact. There is one group of internally-managed funds with relatively low manage- ment costs that does emphasize this fact in its selling literature. An official of this fund, however, has himself questioned its effectiveness as a sales induce- ment, except, perhaps, in extremely large transactions. Although the amount of the advisory fee, which is a recruiting charge, is important to investors, their lack of awareness as to the fees is understandable. In addition to the fact that the amount of the fee when expressed as a small percent of the fund's assets tends to be obscured, it is hardly likely that the relatively small differences among the fees paid by most funds would be a `determining factor in his selection of a fund. Nor is it likely that salesmen would invite the attention of the investor to any differences that may exist. They would also be inviting attention to the sales charge, which though paid only once, is more than eighteen times the .50' percent advisory fee. (b) The Indisstry Claim that Unaf/Uiated Directors are Effective in Keeping Advisory Fees Reasonable is a Myth We do not disagree that the unaffihiated directors can make valuable contributions by providing fresh ideas concerning particular industries or securities, trends in the economy and the general operation of the business. We believe, however, based upon the available facts from extensive studies, that the industry is perpetuating a myth when it persists in its contention that the unaffi- hated directors represent an important additional factor in the "competitive" process affecting advisory fees. In the fee area, unaffihiated directors have not been effective and, in the nature of things, it is unrealistic to expect otherwise. As we have said, competition among investment advisers for advisory contracts with mutual funds is' generally unknown to the industry. Thus, the unaffihiated `directors have no practical alternative but to accept the proposals of the adviser, and, at least in the past, they have tended to regard a renewal of `the investment advisory contract as merely a matter of corporate routine, something like `approving the minutes of the last meeting. Indeed, there have been a number of `1~CI Te~timoiiy, 198. PAGENO="0283" 697 embarrassing instances where an investment advisory contract of a mutual fund was not renewed as required by the Investment Company Act simply because everybody concerned forgot about it. While such carelessness is uncommon, it is a symptom of the significance assigned to the ritual of approval. As one industry spokesman acknowledged, at most, the unaffihiated director's role is limited to "moral suasion." Apparently, in most such situations the advisers' fees have not suffered as a result of any suasion-~Inoral or otherwise-emanating from the unaffiliated directors. The attorney who prosecuted most of the shareholders suits involving advisory fees testified: 1 "I said before I know one man-he happens to be associated with a man who is sitting near the door-who operates one of America's largest if not the largest investment company-who to my knowledge really stood up as an unaffihi- ated director, and when I tried to settle my lawsut he fought with me because he thought my proposed settlement wasn't adequate. "And this I must say came with the same kind of shock to me as it did to you. "But aside from that one man, in the 14 cases I have run into, involving, as an estimate, something like a hunded or more unaffihiated directors, I have not seen the counterpart of that in any case. "These men, by and large, go along and rubberstamp. "The proof of the pudding is that when these funds were growing from $100 million to $2 billion and they were getting a flat one-half of 1 percent advisory fee, wouldn't you imagine that somewhere, sometime, somebody among the unaffiliated directors would say, `Now, look, fellows, this is getting a little out of hand. A $500,000 fee is not a $10 million fee. Wouldn't it be nice if we were to sit around the table to talk about reducing it from half a percent to three- eighths percent or some scale-down?' "That never happened. "Senator BENNETT. You're sure it never happened? "Mr. POMERANTZ. It never happened. "Senator BENNETT. You're sure? "Mr. POMER.ANTZ. It pever happened at the instigation of an unaffiliated director." This is not cited as an indictment of the unaffihiated directors. Persons invited to join boards of directors do not normally do so to oppose the management or to bargain at arms length with their fellow directors who are affiliated with management. This is normally not considered their function. When It is neces- ~ary to nominate someone to serve as an tmaffihiated director, all parties un- doubtedly look forward to a harmonious relationship, and the unaffiliated director not unreasonably accepts the position upon that assumption. If an unaffihiated director were to suggest to his fellow affiliated directors that the fund has been charged an unreasonable advisory fee which should be reduced, the bar- *mony of the board would in all probability be ~eriously disrupted. Tjnaffihiated directors, of course, know this and it is probably a factor which accounts in con- siderable measure for their inactivity in the fee area. (c) Over three decades of e~vperience contradict the industry claim that stockholder voting is effective in keeping advisory rates reasonable The industry also suggests that existing requirements of shareholder approval constitutes an effective control over advisory fees, despite the well-accepted fact that, in most situations, the great majority of shareholders simply send in their proxies when the management requests them to. Shareholders acquiescence is hardly surprising. There is little else they can do. If shareholders should by any chance vote down an investment advisory contract they would leave the company without management and jeopardize their investment. But this pos'- sibility is purely hypothetical. It is commonly accepted, and many years of ex- perience with proxy regulation in all areas of corporate life support the con- clusion, that in the absence of organized opposition to a proposal, most share- holders either do not return their proxies or mark them in favor of management proposals. In the case of mutual funds the possibility of organized opposition is particularly unrealistic. Advisers do not compete for advisory contracts with funds by organizing proxy contests. And the possibility of a shareholder-initiated contest is also remote. See hearings before the Senate Committee on Banking and Currency on S. 1659, 90th Cong., 1st Seas. (1967), p. 696. PAGENO="0284" 698 This Is not to say that proxies and the proxy statements are not meaningfuL~ They are very useful as a disclosure device; but they do not and cannot control mutual fund management fees. Indeed, requirements of shareholder approval. have only impaired existing controls. In the absence of such action courts will inquire into the reasonableness of advisory fees. But, as industry representatives have conceded, ratification by stockholders or approval by independent directors has caused some courts to require any shareholder who challenges a manage~ m'ent fee in court to prove not merely that the fee is unreasonable, but as Judge Friendly has put it, that the fee is "excessively excessive" so as to constitute a waste of corporate assets.' This has heretofore proven to be an insuperable' burden in management fee eases and has seemed to defeat the very purposes of the Congress in 1940 in providing the "few elementary safeguards" to deal with a problem that had not yet developed but now looms large on the horison. 7. THE INDUSTRY WANTS TO REMAIN AS THE SOLE ~TUDGE OF THE REASONABLENESS OF ITS OWN FEES The industry's own testimony indicates that it does not believe its protesta- tions that competition, disclosure, unaffihiated directors and shareholders approval. are "important" factors in reducing advisory fees. The statement of the Invest- ment Company Institute asserts that "most of these management companies which have achieved their entrepreneurial goals have progressively reduced the' rate of their fees over the years." 2 The question might well be asked, who determines whether a management company has achieved its entrepreneurial goal from the fees paid by the funds it manages? Certainly not the unaffihiated directors of the funds.! Time after time unaffihiated directors have stated that the profits of the investment adviser was no concern of theirs in evaluating the reasonableness of the fee and that it would be improper to suggest that the adviser disclose to them their profits from the management of the fund. Nor are the shareholders in a position to determine whether the management of their fund have "achieved their entrepreneurial goals." Indeed, the industry han Strongly protested on, each occasion where the Commission has suggested that the profits of investment advisers should be disclosed to shareholders as information material to evaluation of the reason- ableness of the fees. What the industry is therefore saying is that reductions in advisory fees should depend on whether an adviser has made enough money from the management of' the fund it controls and the determination of that question should rest solely in the discretion of the investment adviser. Mutual fund shareholders should not' rely upon adherence to the basic fiduciary standards of fairness in dealing with. their advisers but must depend on the largess of the adviser. We do not think that such baronial self-determination is a substitute for a readily enforceable statutory standard of reasonableness where the trusteeship of people's money is involved. 8. THE INDUSTRY ADMITS ITS "VERY DEFINITE" RESPONSIBILITY TO SEE TO IT THAT' TIlE FEES ARE "REASONABLE" BUT OPPOSES EFFECTIVE ENFORCEMENT OF THIS~ RESPONSIBILITY The industry has conceded in testimony before this Committee that an invest- ment adviser has a "very definite responsibility to see to it that the fees it charges are reasonable". Nevertheless, it complains that enactment of an express standard of reasonableness would "drastically" change existing law. Such at view is based on a misconception of the purpose of the `bill. As Judge Friendly has pointed out and the industry apparently concedes, the courts traditionally have held that those who manage or control a corporation have a fiduciary obligation to deal fairly with it.2 Courts normally will inquire' into self-dealing transactions between a corporation and its insiders and will upset such transactions unless the insiders can sustain the burden of proving' fairness. Mutual fund advisory contracts with affiliated persons are a classic example of `a self~deahing transaction. In the shareholder litigation involving advisory fees, `tTestimony of Judge Henry S. Friemllyt, R. 690. 2 ICI Statement. 25. 8Testimony of Judge Henry S. Friendly, It. 689, 704. PAGENO="0285" 699 however, the courts have held that because of the Act's requirements for ap- proval of advisory contracts by shareholders and unaffihiated directors, the courts will not inquire into the fairness of advisory fees unless the plaintiffs can prove that fees are so excessive as to constitute a waste of the fund's assets. Proof of waste as we have noted, requires a showing that the fees are not only excessive, ~but "excessively excessive." Thus, the Act's requirements of shareholder and unaffihiated director approval, which Congress intended as a protection for shareholders, has actually insulated the fees from judicial scrutiny. The purpose of the Bill is not to change existing law but to enforce it effectively by removing the unwarranted and unintended fetters to judicial scrutiny of the fairness of management compensation in the mutual fund industry. `It may be true, as the industry emphasized, that in applying the corporate waste doctrine to advisory fees, the courts have acted no differently than they might have with respect to self-dealing transactions involving ordinary commer- cial corporations. But as the industry also emphasized, the structure of the mutual fund industry is unique and its managers usually are not compensated like managers of ordinary commercial corporations. For this reason, the application of ;the waste doctrine is singularly inappropriate. It strips mutual fund shareholders of the only protection available to them against the overreaching that results -where uninhibited conflicts of interests prevail. If, like ordinary corporations, mutual funds were managed by their own offi- cers, subject to the supervision of their own directors, then the stockholders -would have the protection of the unbiased business judgment of the directors as well as meaningful disclosure of and conventional limitations on executive corn- ~pensation. On the other band, if mutual funds obtained management services from unaffihiated management organizations, then as sometimes occurs in the case of hotels and some other operations, then fund shareholders would have the protection of arms-length bargaining between the management company and their own directors assisted by officers `having no personal interest in the transactions and owing loyalty only to the fund. The problem with the externally-managed mutual funds in that neither of :these protections exists. There is no arms4ength bargaining as to fees and even ±he unaffihiated directors have no opportunity to exercise real business judgment, which implies the selection among available alternatives of that course of action which seems best for the business. In this situation independent review by a -court, applying the standard of reasonableness which usually prevails' where fiduciaries are in a position to fix their own compensation, is required to protect -the interests of fund shareholders. 9. THE CHARGE OF "RATE REGULATION" IS WHOLLY UNJUSTIFIED There has been a persistent effort on the part of industry spokesmen to char- acterize the Commission's recommendation, that investment advisory fees should be reasonable, as rate regulation, and then to say that this is not appropriate because mutual funds are not public utilities.' While the very argument is a semantic one, conjuring labels, rather than providing analysis, we recognize that investment companies are not public utilities and for that and other reasons we -do not suggest rate regulation. But it must also be recognized that insofar as supplying investment advice to the funds they control mutual fund advisers have an effective monopoly. For this reason we propose that the well-established standard, that fiduciary compensation must be reasonable, be applied to invest- ment advisory fees and that where there is a question whether that standard has `been lived up to, the determination be made, as It traditionally has been, by courts of equity. The courts, under the proposed standard of reasonableness, would not fix a schedule of rates for the Industry, or for a particular fund; they would rather decide whether a particular fee submitted to them was within the `range of reasonableness under all the circumstances. This, as Judge Friendly has noted, is a traditional function of the courts and is not unduly difficult to -administer. If the industry Is satisfied, as it asserts, that the independent directors and -other controls have kept fees at reasonable levels, they have nothing to fear from court review. The statutory proposal, which in a number of respects is less 1 ICI TestImony, 206, 220; Testimony of the Investment Bankers Association, R. 2tS-~51. PAGENO="0286" 700 demanding than the common law rules as they apply to fiduciaries, would im- pose on the plaintiff the burden of proving unreasonableness; there would be no personal libility attaching to the directors; only the adviser woi~ld be liable and then only for the portion of any fees paid within two years of the com~ inencement of a suit found to be excessive. 10. THE INDUSTRY'S CHARGE THAT THE COMMISSION WILL BE IN A POSITION TO CONTROL ADVISORY FEES DEFIES THE PLAIN LANGUAGE OF THE BILL The plain fact is that under the provisions of the Bill, the courts, not the OQmlnission, would determine whether fees are reasonable. Nevertheless, it is charged that the Bill would give the Commission the power to "control" the fees.~ Such a charge only reflects the industry's posture of seeking to avoid aiiy kind of independent scrutiny of the reasonableness of their fees. When actions by stockholders are suggested as a means of enforcing the standard of reason-~ ableness the industry Complained that this will produce "strike suits" and a multiplicity of litigation. If Commission action is suggested as a means of' avoiding shareholder litigation, it is argued that the Commission may "coerce" the advisory firms. If the industry is satisfied, as it asserts, that the independent directors and other controls have kept fees at reasonable levels, they have nothing to fear' from court review. The statutory proposal, which in a number of respects is less demanding than the common law rules as they apply to fiduciaries, would impose on the plaintiff the burden of proving unreasonableness; there would be no~ personal liability attaching to the directors; only the adviser would be liable and then only for the portion of any fees paid within two years of the com- mencement of a suit found to be excessive. Even though the courts, not the Commission, would determine whether feesz are reasonable, it is suggested that, without recourse to the `courts, the Com- mission will blackmail the adviser by requiring it to state in a proxy statement, or a prospectus, the opinion of the Commission or that of the staff, that the fee may be unreasonable although no litigation has been commenced, or is even con- templated. This implication of misconduct on the part `of the Commission is- totally unwarranted. If litigation with respect to a fee has been instituted, Commission rules' require disclosure of the existence of such litigation to the' extent that it is material. Those rules do not-and we would not-require dis~ closure with respect to the opinions of anyone associated with the Commission concerning the reasonableness of a fee at any other time. It would seem to be to the advantage of the fund advisers to discuss any substantial questions~ which may arise with the Commission before suit is instituted. It may be assumed that the industry does not want the Commission to sue first and ask questions. later, yet they turn even this opportunity into one of coercive portent. This is. nonsense. Any possibility of litigation is, of course, in a sense coercive. En that sense a minority stockholder, whether or not our proposal is enacted, could "coerce" a mutual fund management by telling them the fee was too large and if they did~ not reduce it, he would file suit. In other areas, `under existing legislation, the Commission has the power to initiate, and in many situations has initiated,. litigation designed to halt violations of law. All such actions are also, of course,, coercive in a sense. The industry position on this question comes down to the argument that no agency should be empowered to enforce the law because it might "coerce" people by telling them that it thought they were violating the law' and if they didn't stop, It would be forced to take action. This possibility, which is inherent in the very existence of law enforcement agencies is not an adequate- basis for declining to permit enforcement of the well-established fiduciary stand- ard of reasonableness as to investment advisory fees. II. THE INDUSTRY HAS PRODUGED NO MI~ANINGFUL ALTERNATIVES Since publication of the Commission's Report in 1\fiay, 1966, both the Commis- sion and members of Congress have repeatedly asked industry representatives; to come forth with Workable alternatives to the proposals that have been set forth in `the Bill. It has been made clear to all that careful consideration would. 1 ICI Statement, 31. PAGENO="0287" 701 be given to any proposals submitted by the industry. Thus far, the industry has presented nothing except proposals that would serve to further insulate the advisory fees from judicial scrutiny. While it complains, for example, about the vagueness of the standards that we have recommended as appropriate for determining reasonableness of fees, it has made no suggestion as to changes in the standards made which would assist it `in this apparent quest for greater certainty. The industry appears to be interested only in the kind of certainty that would flow from the absolute control over the level of the fees that it now has. It fails to recognize that mutual funds are affected with an important public interest which requires at the very least effective enforcement of the usual standards of fiduciary duty. Here corporate managers are dealing with the entities they control under conditions which involve serious conflicts of interest and marked differences in bargaining power between amateur investors and professional advisers who control billions of dollars of public capital in a few hands. We submIt that the public interest requires this legislation. II. WHAT OF THE EFFECT OF SALE'S LOADS REDUCTION ON SELLERS OF MUTUAL FUND SHARE? During the hearings, much has been said about the adverse effect that the sales load provisions of HR. 9510 and 9511 would have on those who sell mutual funds. The extent of this adverse effect has, we believe, been exaggerated. A decrease in gross revenue, if it occurs, may lower the income of at least some of the people who sell the item in question. Of course, this is based on the assumption that lower sales charges will not make fund shares more attractive and thereby stimulate sales. Upon this assumption, enactment of the bill would lower the earning~ of many mutual fund sellers and may cause some of them to leave the business. Now it is never pleasant to recommend a course of action that will make life for some people less comfortable. Nevertheless' the Commission, after years of careful consideration, unanimously concluded that, if the price maintenance scheme in the statute-which has had the effect of raIsing costs~-4s to be continued, substantial reductions in mutual fund sales charges would be In the public interest and that legislative action to achieve that objective is needed. If the mutual fund sales charges that now prevail were free market prices determined by the normal interaction of supply and demand, it might not be necessary to recommend the imposition of a statutory ceiling. But mutual fund sales charges are not free market prices. They are prices fixed and maintained by the fund managers under an exemption from the antitrust laws. That exemp- tion-Section 22(d) of the Investment Company Act-permits the funds' prin- cipal underwriters to fix prices to which every retail dealer that sells these shares must adhere. No dealer anywhere (not even a dealer who has no contract or contact with the principal underwriter and who obtains shares from other sources, including investors) can deviate from the price that the principal underwriter has set. Since each principal underwriter seeks to induce dealers and salesmen both to sell mutual fund shares rather than other securities and to sell the shares of its fund or funds in preference to those marketed `by competing principal under- writers, there is a constant upward pressure on sales loads. The strenuous op- position of almost every segment of the securities industry to the very thought of free retail price competition in the mutual fund business is based upon the as- sumption that the prices now paid by mutual fund buyers are far higher than the prices that would prevail in a free, competitive market. It seems strange to some that, by and large, these high purchase costs to buyers have not resulted in high incomes for retail sellers. There is, however, a fairly simple explanation. Selllng mutual funds is an easy occupation to enter. Almost anyone not found guilty of a serious crime can become a mutual fund salesman. And since fund salesmen are, with rare exceptions, compensated on a pure commission basis, another salesman adds little to the employer's costs. Any sales that the new sales- man makes (no matter how few or small) produce income for the employer. It is a case of the more, the merrier. There is a typical pattern. Each new salesman makes-or tries to make-sales to his friends and relatives. Carrying his selling efforts beyond that Is more difficult. Prospects aren't that numerous because the ratio of salesmen to prospective investors is so high. In this connection, I might point out that Mr. Cornelius Roach of Waddell & Reed, Inc., estimated before PAGENO="0288" 702 this Committee that there are abou 90,000 people selling mutual funds. Since there are approximately 4,000,000 mutual fund shareholders, there is, by Mr. Roach's estimate, a mutual fund salesman for every 44 existing mutual fund shareholders. Even if one were to estimate that there are only 50,000 mutual fund salesmen, there would be a mutual fund salesman for every 80 mutual fund in- vestors. So it is inevitable that many full-time salesmen find it very hard to earn a good livelihood solely from the sale of fund shares. When a salesman does manage to unearth somebody who could invest in a mutual fund, he often finds that one of the army of part-time salesmen or a full-time salesman from a large New York Stock Exchange firm has already made the sale. Hence the turnover rate among saelsmenis very high. In few other areas of the American economy does the labor force rotate at a ~comparable rate. New recruits who believe-or who are led to believe-that selling mutual funds is an open road to riches, or at least a dignified way in which to add a meaningful supplement to an income primarily derived from some other source, are offset by equal numbers of dropouts who have found that it isn't quite as easy to make money selling mutual funds as the recruiter said it was. Just as it is relatively easy to become a mutual fund salesman, it is not diffi- -cult to become a mutual fund dealer. All it takes is $2,500 which can be bor- rowed. Man~i salesmen, who tire of sharing what they produce with their em- ployers, venture into business for themselves. But the same obstacles that the proprietors of these new mutual fund retailing firms faced as salesmen still con- -front them and their sales recruits. Hence the high entry rate among mutual fund dealers is counterbalanced by a high departure rate. The essential question thus becomes whether federal law should continue to insulate mutual fund Sales organizations, which have probably grown oversized and inefficient in terms of production, from both price competition and price regulation. The Commission is not insensitive to the legitimate needs of the mutual fund salesman and of the small mutual fund dealer for compensation. Indeed, as I have pointed out, the present system provides the seed for such failure. How- ~ever, we must also consider-indeed, we must give priority to-the interests of some 4 million investors, most of whom are far from affluent themselves. All of us are interested in minimizing unemployment. But Investors should not have to combat unemployment by paying artificially high prices-prices pro- tected by law, not produced by market forces-for mutual fund shares. It may be that, as one member of this Committee has suggested, there is a mutual fund salesman here or there who just couldn't possibly make a living anywhere else and who would have to resort to public assistance if sales loads were reduced. I would doubt that. But there are also a number of very large and very pros- perous New York Stock Exchange firms whose reputations, whose contacts with hosts of investors, and whose extensive networks of branch offices enable them to sell large quantities of mutual fund shares. These member firms-roughly 10% -of the broker-dealer community- account for 40% of all fund sales. The high mutual fund sales loads of today 1~nable these firms (remember that they are the firms who get the lion's share of the very generous brokerage commissions the funds pay out when they buy and sell securities) to do very well indeed. And this stems from Section 22 of the Act which frees them from the price competition and from S.E.C. oversight responsibility that exists in other areas of the securities business. High sales loads may be of some help to the weak in the securities industry. But the general public pays a tremendous price for that help. And most of that price goes into the pockets of the largest and the most affluent securities firms who are well able to fend for themselves. The most invidious of the arguments put forward, however, is that these rewards for selling mutual fund shares are necessary to keep in business small ~and medium sized funds who underwrite small issues, make local markets, and so on. No proof has been offered to support this. There is no reason why under- writing and market making should not be profitable. But even if we assume it to be correct, it amounts to a claim that the unsophisticated investor-so they describe him-must continue to pay these high charges else the firms will dis- ~continne all activity. In other words, the unsophisticated investor must subsidize 4he most sophisticated and more affluent investor who buys new issues or invests ~directly. This is, indeed, a strange argument. PAGENO="0289" 7o~ What I. have thus far said. sugge~ts~ I know, that ~eetk~n 22~U)shou1c~ b~ ~e- pealed and that mutual fund sales charges shQuld be, determined~ b~r~ market forces. just as other prices are. There is much to be said for that suggestion, as Professor Wallich pointed out to this Committee. If. we had to choose between things as they are and deleting Section 22 (d) , which would produce greater price competi- tion than now exists, the Commission would seribu~1~ ~ohsider that ~ a~ a sthp to deal with the present situati~it Free eomiiètitlbn Woi~ld be ~ iM~toVeffiO~t over what we now have. And there are ways of equaliz1i~ the situation of th~ independent dealer distributed' fflnds w~it1~ thOsewhO ethp1o~caj~ti~v~ ~ fOrces. But that is not the only choice. Thei~e Is anothOr j~ossibllit~ Which we~ificiuded in the memorandum of alternatives provided to you Which ma~ be, froth tbe~i1iL1 dustry's point of view, less drastic and which We, On balance, deem preferabie~ to an all-out competitive regithe. That alternativO i~ tO a~fnefid Sectldn~ 22~d) to permit price maititenance up to, but only up to, 5%. We conSiderOd all of thesO, and while we were not perstiaded that the induStry's fears Were ws~ratited, ~e recommended the approach fotind in section 15 of the bill. tTtidP~ the bill resale price maintenance would be preserved and the lndtistry would ~datlntie tb b~ sheltered from competitive pressures at the retail lOVel, but mutual ftYd~slt1eS charges would be subject to a 5% ceiling With~d1ScretlOti5ry DOWer lfl~th~ Cbrti-~ mi~sion to permit sales charges of more than~-5% hi apprOptth~e eaSe~. We thitik this approach somewhat preferable to pric~ ~oth~pctltionfOr~ a thhi~' bar ot reasonS. OnO Is based ott the vieW of Some that independent brok~-dealms and their salesmen wottltl in all probability fai~aJMthr uiidar a ~ eeihuig th~aii~ they would under all-out competition. Those who hold thiS~ ~Vew tirge thätdeietilng Section 22(d) would produce:real competition which might .givecaØtlve StileS~ organizations an advantage over independent dealers. It does seOm a bit titi~ realistic to expect retail price competitiOn to do much to! bring doWn -the ~rice of those mutual fund shares Which are sold only by a single exeittslve retail dis- tributor, at least immediately. Although thiS captive problem cotild be dealtwith- for example, the law could require every prinripal underwriter to thake the shares of its funds available to every registered broker-dealer who wanted to sell them-the Commission decided not to recomhietid any step that might teird to give large, captive selling organizations eVen a temporaty advantage Over thOir smaller, independent competitors. Also, it Is impoSsible to predict just how much downward pressure retail price* competition wOtild put on mtitMl ftu~d sale~ charges. While I am not persuaded that such wOuld be the case, the indtistry hAS told us that market forces thight drive the normal sales load far beloW 5%. if this occurred, competition would have a far more marked imptct On tha small retail dealer and on that dealer's salesmen than the Commission's present pto- posals could possibly produce. In passing, I might observe that these coiisiderations~ to which the Commis- sion gave much weight In itS deliberatiotis, ought to demonstrate that the S.E.C. is coneerned about the small man In the securities businOss. Moreover, there is, as the CommiSsion has noted in its report on the PtlbIic Policy Implications of Investment Company Growth and Its previous statements to this Committee, a second reason for the regulatory-as distingished from the purely competitive-approach. Competition will undoubtedly do a tot for the knowledgotble, sophistIcated, price-conscious Investor. But what Would it do ~or the WidoW WhO has never beard of the WO~Z street Jo~-nal? Mast peOple, not jttst widoWs, are not highly sophisticated in securities matters. They rely on the recommendations of sectiH- tIes salesmen who bold themselves out to have ~ spee~al knowledge and wisciQin in this complicated and risk-exposed business of equity iCvestthent. Comparison shopping is difficult for per~ons without all the tools of analysis at their command. Hence free price competition in the sale of mutual funds might well not achieve the desired result. - So at least it seems to us. But :~ l~ave nevpr denied that the question of.com- petition versus regulation is an exceedingly close one. Perhaps it would be better to permit sales charges to be set in a free market than to set them by law. Our considerations led us to recommend a limited degree of reguiatbrn. Indeed, there may be other and more desirable forms of regulation. (One suggestion has been that the appropriate self-regulatory institution should ~tttempt to deal with the problem in the first instance with adequate review and residual authority in the Commission. In this latter cqnneetion, I sent you a copy of an opinion of the Department of ~Tustice which.. was provided at therequesto1~ Ser~ator Ben- &5-~592-68-pt. 2~-~---19 PAGENO="0290" `704 nett.) But clearly it should be one or the other, and not the present state of neither competition nor regulation. 12. FRONT-END LOADING OF MUTUAL VUND SHARES What has been said of the problem of sales loads on lump-sum purchases of mutual fund shares is applicable to a far more aggravated extent in the case of front-end load plans for the purchase of mutual fund shares. The contractual plan is a device whereby shares of a mutual fund normally sold for an 8.5 percent sales load are sold on a front-end load basis to persons who wish to invest periodically. Under the contractual plan, the investor is expected to make payments, usually over 8, 10 or 121/2 year periods. It Is a long term program for the investor, but not for the seller. The 50 percent front-end load deductions from the first year's payments amount to from 1/2 to over ~ of the total sales load to be collected from all the payments to be made over the life of the plan. The investor prepays a sales load on installments which h~ may never make. We have already seen from the statistics provided by the industry that this too often is the case. After the front-end load is collected, the salesman Is much more intersted In making fresh sales and in collecting new front-end loads than in promoting persistency among those who have already been sold and whose continued payments give the sellers a relatively minor fraction of what they can earn fr new sales. A visit to an inactive planholder may produce one $50 payment at trail commission rates. But the Special Study of Securities Markets found that on the average six installments are initially paid on a new contractual plan sale. Thus the sellers will immediately collect half of $800 on the new sale, The contractual plan has been likened to the constitution of a certain impor- tant world power. On paper, it is a surprisingly high-principled document. In practice, those subjected to it do not reach the promised goals. The representa- tives of the contractual plan sponsors have not denied that their own statistics show that contractual plans have failed to achieve the advertised goal-the pro~ motion of systematic and consistent investing `by plan, purchasers over a sub- stantial number of years. The plan sponsors' statistics show that substantially less than half of contractual'plan investors complete their plans and that, as a result, large numbers of investors (25 to 43 percent of their customers) end up~ 10 and 12 years after their initial purchase, having paid sales loads of 20 percent to 50 percent-two and one-half to six times as much as is paid by those w~o purchase fund shares, on a lump.sum or voluntary, level load plan basis. There is no such thing as a salesman who sells contractual plans exclusively. He is a mutual fund salesman. Contractual plans are merely part of his line. Any knowledgeable customer who wishes to invest in the same mutual fund by purchasing its shares, on a lump-sum basis or periodically through a voluntary plan can and will obtain them at the normal sales load. And, be can obtain them from the very same salesman who sells front-end load plans in shares of that very same fund. It.is only the unsophisticated who pay the inordinately expensive front-end load. ~8. Is MUTUAL FUND INVESTING BY PERSONS WHO HAVR BEEN UNABLE TO ACCUMU- LATE SAVINGS FOR INVESTMENT ~`URPOSES SO DESIRABLE THAT A 50 PERCENT FRONT- END LOAD SHOULD CONTINUE TO BE PERMITTE~ UNDER THE INVESTMENT' COMpANY ACT? Even if we assume the desirability for some investors of this inefficient way of selling, i.e., of going to the homes of proSpective customers, is the front-end load equitable when there is a good likelihood that a large, proportion of those to whom salesmen are motivated to sell will not make `future investments for which the front-end load is largely a prepayment? Congress must. decide whether it is good to have a type of selling which, according to its own proponents, depends for its very existence on the extraordi- nary subsidization of sellers of mutual funds by the mai~y persons M~o pay the front-end load but cannot, or who for other compelling reasons, do hot complete the plans. It has been said that the front-end load brings the, advantages of equity in- vestment to many persons Who otherwise Wou~d. not invest. But according to a survey of mutual fund shareholders submitted by the Association of lVtutgal Fund Plan Sponsors, 47 percent of contractual plan holders do own common stocks. Sellers of those common stocks were able to reach these persons although the applicable sales charges were far less than those paid on contractual plans. PAGENO="0291" 705 14. IS THE FRONT-END LOAD JUSTIFIED BECAUSE MOST OF THOSE WHO HAVE INVESTED IN CONTRACTUAL PLANS HAVE MADE OR COULD REALIZE A PROFIT DESPITE THE FRONT-END LOAD DEDUCTIONS? Despite the generally rising levels of the stock markets during the past 15 or 20 years, 10 and 12 years after purchasing contractual plans, 25 percent and 33 percent of the investors in two of the four contractual plans which have sub- mitted data had lost money. Nor have the plan sponsor~ denied that most of those who lost money' did so because of the front-end load deductions. In view of the generally rising market levels, very few would have bad a loss had the usual sales load deduction been applicable rather than the front-end load. Even more important, perhaps, is the fact the the risks created by this form of selling are borne solely by the planholders. The sale of a security does not create a profit-sharing arrangement between the broker-dealer and his customer. Yet the sellers take one-half of the first year's payments and only half (or less) of the investor's payments for that period go to work for him. 15. WHAT REMEDIES DO THE PLAN SPONSORS PROPOSE? The plan sponsors have admitted that this area deserves attention and that these problems were "actually called to our attention primarily by the SEC." The remedies they offer are, however, woefully inadequate One such suggestion is to extend the 30-day refund privilege, presently offered by plan sponsors that account for 70 percent of the contractual plan business, to all contractual plans. However, experience shows that this privilege does not reduce the high redemption and, lapse rates on contractual pltrns. The Special Study's survey of contractual plans sold in February 1959 found that 3~ years later the combined figure (36.6%) for redemptions and lapses on contractual plans sold with the 30-day refund privilege was higher than the comparable figure (32.9%) for contractual plans sold without that privilege.2 Another suggestion made by the plan sponsors is that they be given a fair chance to demonstrate that they can improve planholder persistency. Over four years have elapsed since these problems were discussed in the Report of the Special Study of Securities Markets. Yet we have been told that one sponsor has initiated a series of follow-up letters to customers who cease making pay- ments. The Commission doe's not know the pertinent facts of that experiment. We do know that the Special Study found that a substantial portion of reacti- vated accounts subsequently became inactive once again. For four years the Commission has eagerly awaited evidence of self-regulatory procedures that have substantially improved the front-end load situation. We are still waiting. 16. WRY IS DISCLOSURE A PARTICULARLY INADEQUATE PROTEOTION FOR T~IE CON- TRACTUAL PLAN INVESTOR? Some members of this Committee have questioned, why, given the present regulatory limits on front-end loads, disclosure is not adequate to protect in- vestors. In a similar vein, some have wondered why disclosure of the front-end load coupled with an offer of the 30-day refund privilege is not adequate to protect investors against "overpersuasiveness" by salesmen. These ard reasonable questions. But the hard fact Is that the front-end load deduction, in effect, commits a purchaser to invest in shares of a particular mutual fund usually over ten years on the basis of information supplied to him at the time he begins the plan. At the time he is sold the plan, and, indeed, for years thereafter, be may be satisfied that be will be able and willing to complete his payments. But how can he know what his financial future will be? Adverse personal cir- cumstances long after the sale may render him financially unable to continue his pnrchases-and I do not suggest, as the plan sponsors have, that those circum- stances are limited to his being unemployed or `suffering an Illness' which results in his being unable `to continue in his employment. He may have an unexpected `Testimony of Association of Mutual Fund Plan Sponsors, me., H. 441. 2 See Report of Spdctal Study of Securities Meerkets, 88th Cong., 1st Sess., House Doe.. No. 95, Pt. 4, p. 268, Table XI-11. PAGENO="0292" 7o~ need to support relatl~res unable to care for themseIve~. He ma~r have tinfore- seen expen~ês in providing for his family. His income may not keep pa~e with increases in the cost of living. Moreover, disclçsure is helpful primarily in eva1u~iting the prescnt merit Qf an Investment. In the case of the contractual plan, we deal with long periods cluri~ig which there, may be significant changes in the investor's personal situatipn, in the general economy, and in the performance of the under1yir~g frjnd. The plai~- holder's investment goals may change. If he bought a plan in a balanced fund, he may later decide that it is more desirable that his investment henc~rt~ zhould be in a growth fund. Or an investor may decide that, the managemeqt of the fund he has been investing in has not lived up t~ hjs~ ~xpectations and that he wishes to ~1locate his futu~ savings to apother fund with different invest- ment goals. Other mutual fund investors can aiid do make such decisions. The contractual plan invest9r is penalized to a uniquely heavy extent if he decides to invest elsewhere in the futi~re. The disclosures and the re~uud privi~ legè offered him at the time of his purchase have no bearing on these future contingencies. Mr. KEITH. Mr. Chairman, you have givefi oUr committee and the Congress and the, cpwiti~y much food for thought, consideration, arid action, I suspect. But when you say. none of your proposals would hurt the mutual fund industry,: you attempt, it seems `to me, to d~s-~ credit the entire pi~esentation of' the ,c~se by those s~ekiñg to defend themselycs. I think `it is this committee's responsibility to ~~ke that, judgment~ I certainly am not going to buy that conclusion. 1 don't think you have proven that point as yet. You have given us cause for thought. ` ` ` ` ` Mr. COHE~.Mr. J~eith, so that I can understand what you are' point- ing to, when you say the mutuaJ fund- `Mr. KEITH. I am not pointing at anything. I am just pointing out, and I took it down as well as `I could, a sentence in your concluding commentary to the e~ct tbat "certainly none of ~ur proposals would hurt the mutua~E fund industry." Mr. COHEN. I am talking about the mutual funds. I am not talking about the s~l1ers and I am not talking about the mailagers. Obviously, our proposals will have some irnpact on them. Mr. KEITH. So you are saying it wouldn't hurt the mutual funds. Mr. COHEN. That is what I said, and as to the latter point, if you wish to put it to me, I would be glad to expand my answer in those areas, but I want to make it perfectly clear I am talking about the mutual `fund a~ an investment vehicle. Mr. KEITH. I `see. Mr. COHEN., Our purpose here is not to hurt them, b~ut to thiprove them, to make theim more attractive, to make them easier to sell. Mr. KEITH. I' am quite certain that your purpose is that I don't question your purpose. I~ may be a matter of ~emantics th to where one leaves off and the'othei~ begins, but a~t any rate you are now poifiting out that the word "industry" was not intended or perhaps not in fact present in that quote that I made. Mr. COHEN. Wé~ll, if I misled you I am sorry, Mr. Keith. Mr. KEITH. No,~tha~ is ~ll' right. Mr. COHEN. I meantl to emphasize that none of our propçsals are directed at mutual funds as such, their viability, continued viability, growth, and usefulness. Our concern is with respect to the charges which are levied `upon investors in acquisition of nn investment in such a fund, and the maintenance of such an investment. PAGENO="0293" 707 Mr. KEITH. I am glad I pointed it out, .1 think that your explanation is appropriate. As we draw nearer to ce;nclusion of these; hearings, you have ~n~de a rather dr~m~ti*c portrayal of the profits of these manage- ment companies, and it seems to me that we should be seeking ways to open this business up so that supply and demand can have an impact on this problem. More people should get into it, and i~t the law of supply and demand become effective. This is the problem that we have had, and I don't see- Mr COHEN This was the first question to which I was going to ad dress myself, Mr. Keith. Mr. KEITH. Go ahead. Mr. COHEN. I understaiid that ProfessOr Wallich suggested, and some others have, that our recommendation in the `area, of sales load doesn't go far enough, or that there is an: alternate approach which might be better, and that is to i~epeal section 22(d), which `would eliminate this federally enforced price maintenan~e provision and ex- emption from `the antitrust laws, a result which e;onceivably wOuld meet `the objective you have just stated, by opening up to many more people than is now possible a willingness, ~or an' ~op~ortunit~ and a willingness, to invest in these funds bec~use acquisition cOsts might be more moderate than they are tod'ay. This is the proposal Professor Wallich `made. To the extent that the Commission has been criticized in the p~ibiie print, `and we have had very little criticism editorially, but when we have been criticized, it has only been in this particular area, that we have&t `gone; far enough, that we should not abide this situation, which, perhaps might have been appropri~te at a time when this was an infant industry, but rather rely on free competition. Now I think this is a legitimate ue5tion, and the Commission considered it very carefully. I can't tell yOu how many hours we spent on this. And, as I indicated in my testimony when I appeared here before,,6 or 9 months before, we issued our report I called in the leader's of the industry, and I said that this was a proposal which had been put forward for our consideration, and that before the Commission acted on it, it would be most helpful to the Commission to have the benefit of the views of everybody concerned. Universally they objected to it. They raised all of the questions and objections which have been raised here before you when the question has been put. So far as the Commission is concerned, I would have been and the Commission would have been in a more appealing positiOn than had we wrapped ourselves in that mantle of free competition. I think the statement I used, which was perhaps a little gaudier last time, was that I might ride down Pennsylvania Avenue on a white horse with the shiniest armor possible. Nevertheless, no matter `how attractive that seemed to be, we decided against it, and there were several rea- sons why we did. In the first place, there issome uncertainty as to the consequences of repeal of section 22(d). I must emphasize, if I can digress for just a second, because Mr. Watkins wasn't here when I `attempted earlier to explain, that this is not like a fair trade law in a State, and there are PAGENO="0294" 708 some States that have them, where the manufacturer or the distribu- tor enforces the law by bringing action against somebody who does not keep to the fair trade price. This is a federally enforced thing. Everybody must comply, and if a dealer wants to cut the price, and if he does it more than once so he is being deliberate about it, the Com- mission may have to consider whether or not we want to refer him for criminal prosecution. At the very least we might have to take action by way of injunction. The Federal Government enforces this, and I know of no other situation like it. Now the industry- Mr. KEITH. You are going to speak to the unique reasons. Mr. CoHEN. Yes, sir; I am coming to this. Mr. KEITH. As to why this should be enacted by Congress. Mr. WATKINS. Mr. Chairman, will you yield? Mr. Moss. Mr. Watkins. Mr. WATKINS. Why do you direct that to me so much? I read your testimony. Mr. COHEN. I am sorry, I am just turning this way and that. I don't think I have been paying you enough attention until now, Mr. Watkins, and I want to give you an equal amount of attention. Mr. WATKINS. I have been sitting here listening and I have been quiet today. I don't know if you have had the benefit in this rebuttal, you are accorded the privilege of coming in here after reading the testimony of every witness and knowing everything that has been said here, and with a very capable staff, that is certainly available to you at your wishes to compile a record which I have been sitting here and listening to, and which I appreciate. I like to listen though I don't always agree with what I hear. But- Mr. COHEN. This is. a disease that all of us have on one occasion or another. Mr. WATKINS. You talk about the various States and all. ~ou get into that. In compiling your facts and all, have you ever called on the State of Pennsylvania Securities Commission? Mr. COHEN. Have we what, sir? Mr. WATKINS. Have you ever called in the State of Pennsylvania, the Securities Commission? Mr. COHEN. On this issue, no. Mr. WATKINS. To get their views on what is happening. We are regulating there. Mr. COHEN. Mr. Watkins, we meet fairly regularly with all of the State commissioners. We attend their annual meetings. We have liai- son meetings with them, in many areas including the area concerning which we are now speaking, and I can say to you, I don't remember particularly now the action of the Pennsylvania commissioner, but a great many "blue sky" commissioners-and I believe in conventions- they passed a resolution adopting, enforcing and encouraging the recommendations we have made to this Congress. I am talking now about the cOnvention of all the State administrators. Mr. WATKINS. Endorsed your recommendations? Mr. COHEN. Yes, sir. Mr. WATKINS. They did? Endorsed the 5-percent ceiling? PAGENO="0295" 709 Mr. COHEN. They endorsed them all, sir. Mr. WATKINS. I would like to see that. Mr. COHEN. Yes, sir, we will provide it for the record. It is a res~ olution of the North American Securities Administrators, which consists of all the State administrators, all 50 of them, the admin- istrators in the Canadi~in Provinces and the administrator in Mexico. (The following letter was received by the committee:) SECURITIES AND EXCHANGE COMMISSION, Washington, D.C., October 24, 1961. Hon. HARLEY 0. STAGGIm5, 4'Jha'irman, Con~mittee on Interstate and Foreign Commerce, Honse 0]' Representatives, Washington, D.C. DEAR MR. CHAIRMAN: In my testimony this morning, I mistakenly stated that the state securities administrators had adopted a resolution supporting the Com- mission's recommendations for amendment of the Investment Company Act. In fact, as I have been informed today by the President of the North American Securities Administrators, that Association has not taken any position on th~ proposed legislation. The expression of support to which I should have referred was an editorial In the "Blue Sky News" for December 1966 by John K. Kyle, the then secre- tary of the NASA and for many years the distinguished securities administra- tor of the State of Wisconsin. The "Blue Sky News" is issued monthly by the NASA. I enclose for your information a copy of his editorial, entitled "Support the SEC Mutual Fund Recommendations." I wish to express my apologies to the subcommittee for this misstatement. Sincerely, MANUEL F. COHEN, Chairman. SUPPORT THR SEC MUTUAL FUxu RECOMMENDATIONS (An editorial by John K. Kyle, editor, Blue Sky News) The comprehensive report and recommendations of the Securities and 1Th~change Commission for changes in mutual fund regulation have been sent to each ad- ministrator, in both summary and complete form. They have been covered exten- sively in the financial press. For this reason, we are not taking space in your own publication to repeat the information. We are, therefore, devoting what space is available this month for comments thereon. ?~orth Americ~in Securities Administrators, as an organization, has had no opportunity to act as a body. There will be no such opportunity to act until the September meeting, except through committees or possible referenda. The views expressed in this editorial are necessarily those of the editor as an individual. Any contrary views, criticisms, or comments by administrators are invited, and will be given equal space in forthcoming issues of your publication. I have indicated to the Securities and Exchange Commission that I am in accord with each of the recommendationsL We, in Wisconsin, were especially pleased to note the propo~al for legislation to do away with the so-called "front end" load, o~ to use an industry-coined term, "contractual plan." While only four or five states are currently without the "front end" type of sales commissions, we know that many administrators have had serious misgivings about them. They have been accepted in many states only because of an unrelenting campaign for them by those who prosper from their sales. There is no issue which has com~ before the Wisconsin department, during my term, which has generated more pressure, ranging from charming persuasion `to blustering near threats. These plans are unfair and inequitable, both to those unfortunates who find ~t necessary to discontinue investments `before completing their programs, and to those who do continue making `their payments until the end. The former lose up to half of the money they invest. The latter suffer from having only half of their money going into their investipents, "in shares of American industry" during the early years'. That lack of early investment of a substantial portion of their investments continues to handicap the results sought to be obtained from these programs. Reports in the Wall Street Journal, in the first issue following publication of the report indicate that various industry groups had already moved to PAGENO="0296" present a "united front" with conferences beiween the various gro~ips ali~eady being scheduled. There will be, of çourse~ a i~at~iira1 reactien to any regulatory plap çlesigi~ed ~o give mutual ~upd inyestoi's more of the returns fron~ their pooi~d funds, broBgbt about by ábolhihing the precent "~oub1e cOthinis~1ons" ~hd~iilgbe.ie rated than are charged else~there h~ the ihvesti~ent industry. ~Ii~b~ ~lear obligatidli ot administrators, both state and ~edeta~, Is in the di~ rectiou :of, pi~otecting 1~be investor. This ~-epprt ~s tIxe third, of a series, maçle by independent and impartial study groups. All have reached the conclusion that there has been overreaching for compensation, which needs legislative and a4rninistrat~v~e correctiou. We, in Wisconsin, are giving consideration to the possibility of public. 1~e~ipgs' on some of the proposals, giving industry and organized and unorganized investors a chance to. be beard on the ~ncrits of these plans. We son~etin~es tbink too lnapy..~ecuritie~ regulation',patterns are developed in "chambers". . "POOp AUNT JA~Ff~ There has `already been an Indication of the type of argtiment which will he used b~' i?~du~stry In an `~ttethjjt to detent the~ ~EC recommendations; Keith ~un~toh, Pre~ideht of the Ne'wYork Sthek~ Exchange, reccntly~ made a speech ~betore the American *Manbgement"A~sociation. lie apparently `knew of~ thu concern of administrators over the "give-aways" of about half of the coin- inlsstuns charged' `mutual `funds and other'~lnstitutional `in~irestors for the han- dling of large portfolio `ti~annacti~hs Twice in~ th~ ~peec~ and twice in. the `highlight sttmmary, Funston ecied that "to give a big institutional customer a prefi~rential `break over Aunt Jane would offen~d the puhilcinterest." No one' baa proposed changingth~ commission ~ate charged the mythical Aunt Jane in those cases where the transaction is small~ and `there ~nus:t be a minithum `charge so the dealer `will hot `lose nioney on' the deal; This is a recognized business practice similar to the charge made when' Aunt Jane, with `her limited resources' `and appetite, buys a quarter of a pound of butter at the store instead of a full pound. Mr. Funsten's argument Ignores the `thousand~ of Aunt Janes and Uncle Liewellyns, who have pooled their investment funds in mutual funds. Ac- cording to advertising of the sponsors, they have' been joined by ivy-walled colleges, trust funds, and other good folks who are looking for dependable and honest money mapagers t~ invest for them. What has been happening? When Aunt Jane and Upcl'e Lew pool their money this way, the amohnts Involved are so large `that dealers handling portfolio' `transactions' have been saying: We don't need the full commissions to be properly paid for our work, and can't we find somebody to whom to give about half of it. But poor Aunt Jane and Uncle Lew, whose collective money generated these commissions, don't get the benefits. The portfolio dealer and the fund managers and underwriters look aMund `for someone else to share In the largess. Much of the time they discover other dealers, who have already been paid 7 to 9 percent for `selling shares in the fund to' a new group of Aunt Janes' and Uncle Lews, And they give away, what properly belongs to. Aunt Jane `and Uncle Lew, to these salesmen, in the form of `a kind of bonus. It is plain that in' the forthcoming `debate it will be up to those charged with protecting the public Interest, to unmask these arguments and to see that the right concern i~ expressed for not only the good old aunts and uncles, the "widder" Bro'wns, and the young parents planning for their children's college education, for retirement, etc.,' etc. Mr. WATKINS. Personally, I feel as though no one wants to ken this thing going at-I think perhaps your study has been very goo but as I said, I think we have to go much further. I think you have infringement upon State rights and on the cost, and you want to regu~ late this one industry with a fee. Mr. CoHEN. There is no infringement on State rights, sir. Mr. WATKINS.' That is questionable. Mr. COHEN. The statute makes it clear that there isn't. It so pro'- vides. Mr. WATKINS. I wonder yet with all the testimony you haven't said just why you are so interesting in putting this 5 percent level on, sub- ject to court approval, of course. PAGENO="0297" 711 Mr. CoHEN. Well, if I can complete my answer to the question put that I was just dealing with, I may deal with some of the matters you have raised, Mr. Watkins, and if I haven't I will be glad to expand it in any way that you wish me to. Mr. WATKINS. I am sure that the Commissioner has the exceptions I have taken. You have read those exceptions I judge, haven't you? Mr. COHEN. I have read most of the transcripts, yes, sir, and I think there may be a little disagreement of opinion, but perhaps I can persuade you today. Mr. WATKINS. If I am not correct, will you correct me on this. I un- derstand the State of California, which State our distinguished chair- man is from, I take no exceptions with this, that for many years there. has been the opinion that the sales load was at about 10 percent, and I find that other States run anywhere from 9 to 15 percent. Mr. COHEN. Mr. Watkins, those States dcin't direct that fee. They permit the payment of that fee. Mr. WATKINS. That is right. Now you say you are not infringing upon State rights. Mr. `COHEN. No, sir, I ~1m not. Mr. WATKINS. You ai~e setting down a rule that it will be five per- cent in every State of the Union, wouldn't it? Mr. COHEN. There is no State in the Union that ~equires the pay- ment of any fee because many no-load funds are sold in those States. Mr. WATKINS. That is true. Mr. COHEN. Now if the Congress believes that this is a national problem, and it decided this a long time ago, ~7 years ago, and deter- mines to adjust the statute now to meet current needS and obligations, this is no infringement at all. It is perfectly conSisteiit with States rights and State provisions. Mr. WATKINS. I think you don't need to pursue it any further. I think it is an infringement, with all respect to you. I ath certainly of the opinion that it is a competitFve business. Are you? Mr. `COHEN. It is a com~etitive business in the manner i1~i which I have described it. It is a business which- Mr. WATKINS. You say it is a competitive business. Mr. COHEN. In the manner in which I have described it, Mr. Watkins. Mr. WATKINS. Why with a competitive business, why should your Commission or why should I in the Government become the mother and go into competitive business where it i~ a free enterprise and has the right to operate. Mr. COHEN. Because the Congress already did that in 1940 by putting `this price fixing scheme in the statute. That is not competitive business. This is what I was trying to speak to at this particular time. The statute now, and since 194b, inter1~eres with competitive business in this area. Mr. WATKINS. Not to the extent that you are proposing. Mr. COHEN. I am sorry, sir. The statute is unequivdcal. No person, no matter. where he gets it, from the issper, froth another dealer, or even from a private person, no broker-dealer may sell a share of a particular fund at a price less than that fixed by the issuer. Mr. WATKINS. True. PAGENO="0298" 712 Mr. `COHEN. That is not competition as you and 1 normally expect it, sir. Mr. WATKINS. Well, the price of the shares are geuerally unifprm anyway. Mr. COhEN. No, sir; I don't think that is so. Mr. WATKINS. Do you consider the industry to be a monopoly? Do you think they have a monopoly on it? Mr. COHEN. No, the industry is not a monopoly in the sense that you use it, sir. There is competition as among funds. This is. true. Mr. WATKINS. You bet there is competition. Mr. COHEN. But if I may answer your question, sir, the competition is `an unusual one. It is a competition not for the customer, not for the investor's dollar. It is a competition for the favor of the salesman, by offering him more `and more remuneration, which `the investor has to pay. That is the kind of competition it is. The normal competition you and I know is `to try to get the business away from somebody else `by offering him a better service at `a cheaper price and in a more timely manner. That `doesn't exist here. Mr. WATKINS. There is nothing wrong with that. I think it does exist. In other words, the larger company that operates in a more progressive manner, they have had research and they have better investment advice- Mr. COHEN. They all have research. Mr. WATKINS. They can give a better price perhaps than a smaller firm that wasn't available to them perhaps. Mr. COHEN. As a matter of fact- Mr. WATKINS. It is competitive, then the smaller firm would have to meet the price of the larger firm, wouldn't it? Mr. COHEN. It doesn't work that way. But as `to a particular fund,. the `shares of A, B, C `fund, whether y9u `are a big firm or a small one or' a medium, yon cannot change the price. Mr. Moss. You have exceeded your 5 minutes'. Mr. WATKINS. You mean you are shutting me up, Mr. Chairman, with just 5 minutes? I might just. as well go over to the House of Representatives and start; to' do a little work. Is that all I. am going to have here or can I have many 5 minutes?'' Mr. Moss. I don't think the Chair has to apologize nor would ~th~ Chair apologize to any member of this committee for protecting th~ir rights in permitting them the widest of latitude. The Chair~ has~a responsibility to the committee to conclude these hearin~s, and the Chair intends to discharge that responsibility. The question pending directed to you by Mr. Keith is relevant tp the question of section 22(d).. Will you address yourself to that? Mr. COHEN. Yes, sir. I think I was a~ the point of saying- Mr WATKINs A parliamentary inquiry, Mr Chairman Mr. Moss. Mr. Watkins, the Chair h'a's given you more time than the rules require. He has attempted to afford you the widest latitude,, and ~1l that we have as a result of it is a philosophical discussion which has added nothing to the meat of these hearings. Mr. WATKINS. I don't mind being ruled out but I- Mr Moss I ruled out Mr Stnckey and I have ruled out Mr Keith and I intend to rule out any other member at this point. PAGENO="0299" 713 Mr. WATKINS. I will accept your ruling under protest. Mr. Moss. You must accept my ruling. Mr. WATKINS. I don't have to accept it. I accept it under protest. Mr. Moss. The gentleman will suspend any turth~r interruptions. Mr. WATKINS. I will be happy to retire. Mr. Moss. That is a matter for the gentleman's choice. Mr. WATKINS. If you desire I will be happy to retire. Mr. Moss. I do not desire the gentleman to make a further spectacle of himself. Mr. Cohen, you will address yourself to the question propounded on section 22(d). Mr. COHEN. Yes, Mr. Chairman, if I may I would like to assure Mr. Watkins that I would be glad to supply any additional information now, later, at any time, because I do want him to be satisfied that the problems he has are met. But I want to go back to the point I was making. I did call the industry in. We did discuss this problem. They felt that the lifting of section 22(d) would be disastrous for the funds and those who sell them. They said that the dealers who wanted to sell mutual funds would stop buying them from principal underwriters and purchase them at cut prices in the market, and that mutual fund sales charges would thereby be driven down to a point where most dealers would stop selling them at all. In other words, they said the force of competition would reduce the charge. They said that as a consequence the existing system of distribution would break down, the underwriters would be unable to make enough sales to offset redemptions, and the funds. would be thrown into a net redemption status, and ultimately wither away. Now we believed then and we still believe that many of these fears are very much exaggerated. In fact, there are funds from. time to time, and there are funds right now, that are in a net redemption status, and it hasn't been a disastrous situation for the industry. Nevertheless, in reviewing the situation, the Commission was persuaded that the industry was seriously concerned. On the other hand, there is another school of thought that believes that the repeal of section 22(d) would not really accomplish the full- scale competition that its proponents suggest, because they say that even if they were free, mutual fund dealers would not cut prices. The `absence of competition hasgotten to be a way of life in the mutual fund industry. And I am talking about competition in the sale of the shares of particular funds. Of course, insofar as you are dealing with the integi ated organi- zations-and a representative of one of them proudly stated, and I am not quarreling with that, that his group accounts for 15 percent of the industry-they sell only through their own representatives, and obviously there is no competition there. And it was urged that repeal of section 22(d) might also favor those fund managers who deal through the so-called integrated or captive sales organizations rather than through dealers. Section 22(d) does not really have much effect on these organiza- tions, because as. I have indicated, there cannot be any real retail com- petition where there is only one retailer. There was apprehension that if PAGENO="0300" 7j~4 22(d) were repealed, and the general level of loads received by dealers declinedsomewhat, the captive organizt~tions would have an advantage over independent dealers in recruiting salesmen. Now there are ways in which this advantage could be offset to some degree, for example, by requiriug those funds to make their shares available to independent dealers at the same price, that is asset value, that is asset value plus distribution charge, on which their own sales force operates, and authorizing the Commission as well to make ap- propriate rules to be sure that the charges levied by these integrated or captive sales organizations would be in line with those that prevail generally in a situation where: independent dealers are `making mar- kets in a regime of free competition. Both of these steps it should be noted would of course involve some regulation of sales load, at least for a segment of the industry. It was also felt that repeal of section 22(d) probably would not benefit or might not benefit, maybe the word "probably" is too' strong, the small unsophisticated investors to whom sales are made on a door-to-door basis, since such sales are made in an atmosphere in which price competitidn is avoided whenever possible. Thus, perhaps the. very people most in need of protection would not get it from a repeal of section 22 (d)~, which would primarily benefit the more knowledgeable and sophisl~icated investor who might be in a position or be advised to shop around., We accordingly, propqsed regulation rather than repeal of section 22(d), because' of the `uneven effects that such repeal probably would have had. Mr. KEITH. Mr. Chairman. Mr. Moss, Mr. Keith" would like to query you further in order to clarify the' response you are making to this question on section 22(4). Mr. COHEN. Yes, sir. Mr. KEITH. I do not believe that thei~e has been much argument be- fore this committee in cOnnection with any recommendation to the effect that we seriously consider amendment of section ~2'(d). I under- stand as a matter of election you and the industry did reach agree- ment in this rOspect, Mr. COHEN. No,, sir. Mr. KEITH. No ~ Mr. COHEN. Not on this 22(d) issue. I,an~ not sure that I under- stand your point But I must say this, Mr Keith It was suggested to me the question should be answered. A member of the committee asked that I deal with this particular problem just a~ you did a little while ago, so that there is considerable interest, and I understand that Professor Wallich, if no one else, raised this issue. I understand further that this issue has been raised by other people, ~nd :1 assume that it is before the committee. Indeed, in the memorandum which is dated May 1, 1967, which I sent to each member of the committee, together with our technical statement on the bill, I listed' among the possible alternatives which we had considered, or which had come to our attention, the possible repeal of section 22(d). Now I have tried'in a few minutes to explain the reaction of the industry as we understand it, and the reasotis which led the C~mmis- PAGENO="0301" 715 sion to depart from what I think in many other respects seems to be a most attractive way of dealing with this problem. In other words, we took on a real burden by recommending 5 percent so everybody could say we are price cutting and so forth and so on and price fixing, and so on, rather than taking the easier route and saying let's lilt 22(d) and let's allow free competition to~ play, or at least to ht~ve a chance. We undertook the more difilcult task, and we still feel that that is the appropriate route. Mr. KEITH. If I may in an effort to give further discussion on alter- native methods of achieving a better buyer's market, more choice, more economy of scale in the field of management, there are it seems to me at least three or maybe more ways in which people can buy mutual funds. We have the no-load funds and we have internally managed funds, and we have relatively new develo~iments, at least new to this com- mittee, of those individuals who want to buy into a particular stock, such as the "Quimby Plan." Of course, the law permits that' kind of choice to the individual, and in order to open up that market, that may b~ somewhat, under a cloud by reason of statute, isn't it possible to encour~ge variation in load by permitting no-load funds to advertise other than by "tomb- stone" ads? Mr. COHEN. No-load funds have substai~tial and. in many respects greater liberty in the area of advertising than dc~ other corporations selling securities to the public. In 1954-- Mr. KEITh. In selling mutual funds to the public? Mr. COHEN. Yes, sir. You are talking about no-load funds now. Maybe I misunderstood your question. Mr. KEITH. I am talking about no-load funds. Mr. COHEN. I will try `to answer yc~ur question this way. In 1933, and we are now talking about th~ Securities Act of 1933, the Congress decided that the pro'tection that the investing `public needed was to have presented to it, in convenient form, a document which we call a prospectus, which contains the information deem~ed rele~rant and material `to an informed judgment. The Congress determined, based on hard experience, and many, many examples, some of which I have locked up in a curio, case, to do away with the type of advertising that o~curred in the 1920's and in `the early 1930's. So the, Congress decided that the only advertising that should be permitted in the newspaper, subject to the reprinting of the full prospectus, or as we allowed later on, a newspaper prospectus, which is a kind of a summary of it, that they be permitted to have a very simple advertisement, which ,has gotten to be called a "tombstone" advertisement. Mr. KEITH. Excuse me. We have got just a' few miuutes left today. Mr. COHEN. Yes, sir. ` , ,. ` Mr. KEITH. And maybe you can jn~t disabuse tue `of my logic by accounting for `section 10. ` ` `~` `. Mr. COHEN. Section. 2(10)? ` . ` ` ` ` Mr. KEITIIT. Section 10(d), the ifs, "If such an investm~iit cc~tnpany, open end company," and so forth, no sales low charg~d on securitie~- PAGENO="0302" 716 Mr. COHEN. That is another issue, sir. I thought you were talking about tombstone advertising. Mr. KEITH. I am talking about ways to open up the market. It goes on to say "No sales promotion incurred by such company"- Mr. COHEN. Let me deal with that. First I will finish the other very shortly by saying that in 1954 the matter of advertising- Mr. KEITH. But there is nothing in the statute under which they operate today that inhibits their more aggressive selling of load funds. They can today if they want to finance sales or promotion expenses. I am talking about the 1940 act, is that not pertinent today? Mr. COHEN. Is that not pertinent today? Mr. KEITH. Yes. Mr. COHEN. I am not sure. Pertinent to- Mr. KEITH. Is it not pertinent to this discussion? Mr. COHEN. I am not sure that that is pertinent to the discussion on this bill, but I think it is a pertinent question. Mr. KEITH. My question was how can we open up this thing to get the competitive forces at work to give the buyer more choice? Mr. COHEN. Well, I think the industry has indicated that, that they have to pay salesmen increasing amounts in order to- Mr. KEITH. I realize that. Mr. COHEN. I understand that. Mr. Moss. I think that what Mr. Keith is asking, Mr. Cohen, is the only device available to increase the attractiveness of the sales field itself to the salesmen, or is there available a legal method for more aggressively advertising these funds, bringing them directly to the attention of the prospective buyers? Mr. COHEN. There is a basic issue. I am sorry, I misunderstood the question. I think the Congress was concerned very seriously with dilu- tion of the interests of people who are in a fund. Now for this reason section 10(d), and I am now aware of a par- ticular provision to which you refer, provides that there shall be no promotion expenses incurred by the registered company, because to the extent that they became more aggressive and they used the assets of the fund, this would be a fee paid by existing shareholders, who have very little interest or concern with whether or not other people come into the fund. This is the reason for that provision. Now normally to the extent that there is promotion, and there is considerable promotion by some in the no-load area, it is paid for by the investment adviser out of the fees that he gets for managin.g the fund, and there is a very simple business reason for it. The larger the fund, the larger the fee. So it is a business expense which he is pre- pared to assume. But if you should impose that charge on the fund itself, you may be asking people who bought 10 years ago, 5 years ago, 3 years ago, to pay the part of the promotion for the benefit of the investment adviser to bring other people into the fund. Mr. KEITH. I suppose what it leads to is internal management of mutual funds. * What we are trying to do on this committee is allocate economies of scale through the present scheme of things, the free enterprise system, lull disclosure, true competition, and not to set up, if possible, a pater- PAGENO="0303" 717 nalistic agency to aócomplish the same objective, if our corporate struc- ture in its present capability can do the job, and what Mr. Watkins was trying to do was to find out whether or not the States couldn't do the job. You don't feel that they can. Later on we are going to discuss whether or not the NASD could regulate this thing. Apparently you have- Mr. COHEN. Mr. Keith- `Mr. Ki~rm. You can answer those comments later on. You have al- ready to some extent. Mr. COHEN. I haven't, sir. Mr. KEITH. You have given us an awful lot to chew on. Let me give you a little hit. Mr. COHEN. I will be glad to, but I am trying to be helpful, Mr. Keith. The only way I know how is by speaking to these points. Mr. KEITH. Well, getting to the alternative method of internal man- agement, if your proposal became law, these management companies, their profits as a result of that decision would immediately be subject to, I would suspect, a reduction to 10 percent instead of an average of 40 percent return on stockholders' equity. Internally managed funds wouldn't have to live with that law. You say they would. How would they do `so? Would they go internal? Mr. `COHEN. There were a lot of questions there, Mr. Keith, and I hope you will bear with me. I will try to deal with them. First of all, to correct a misimpression, `we never proposed that the NASD be elected to undertake this job. That came about as a result of a question put to the NASD by the chairman of the Senate Banking and Currency Committee, in which they replied that they would be willing to undertake it under certain conditions specified in the letter they submitted to him. It is n~y impression that the bulk of the m.utual fund industry does `not want the NASD in the picture. The~y don't want the NASD to fix sales charges. They don't want the SEC to be involved. They don't want the courts to be involved. They don't want the Congress to do an~$hing about it. But they want the price-fixing arrangement. Now coming back to your question about internalization and things `of that sort, our recommendations are rather mild. In the area of management fees we are only asking that they he subject to a standard of reasonableness, and certainly a person who is, asking cfther people `to give him their money to manage should be subject to a test of reason- ableness, not by the Commission but `by the courts, and that we remove from the statute the protections put into the statute by the Congress, to the extent that they have really become a shield for the manager rath~r than a protection for the investor. That is what it is. Now there are many ways in `which this could be achieved. Internalization- Mr. KEITH. The shield for the manager existing ,until the `Congress put that in the statute to provide a little bit more protection for the shareholder. Mr. COHEN. That shield did not exist before, no, sir. If I `understand what the law is, because of this requirement for unaffihiated director approval and sharehol'der approval of these contracts, instead of a test of reasonableness, the test is corporate `waste; that is, it must be excessively excessive or unreasonably unreasonable. Normally, the PAGENO="0304" 718 shareholders do not pass on the contracts that a commercial corpora- tion makes with anyone, nà matter how big it is, that is not normal corporate pra~tice, but the courts said this is unusual, this is unique. You have got situations here that do not exist in the normal corporate setup. We are trying to restore the statute to what the Congress in- tended to achieve in 1940. Mr. KEITH. My point was that in 1940 the shareholders did not have that protection because of this built-in conflict. We thought that there should be unaffiliated directors. Mr. COnEN. Precisely. Mr. KEITH. You waintain it hasn't worked as well? Mr. COHEN. You put it very well, Mr. Keith. Because of those pro- visions the Congress put in to protect the investor, it has worked out in away to his detriment. Mr. KEITH. Oi~.'ba1ance, I am ~iot sure I agree with you. On balance the funds have been weU managed-they have done well-and people have chosen this vehicle as an investment. Mr. COHEN. Mr. Keith, they have done well. There is no question about that. Very few people have not done well in these rising markets, and you have had testimony before you by very prominent econOmists who raise some serious questions as to the value of the investment management.. We are not questioning that. We are saying they: are entitled to a fee. The only thing we are' saying is, it should be a rea- sonable fee. Let'm~ answer your question, though. Mr. KEITH. All. right, if y~u would. The question I really want to ask is this,: Is there any epd result that would accrue by reason of the enactment of your rec~mmendatidns* that would cause these funds to move to an internally: managed oper~tipn, getting the apparent bene- fits of size, that, for example, Massachusetts Investment Trust gets? Mr. COH~N. Mr. Keith, I am glad you put' ~t tha~t way. There is nothing in the bill to prevent it, ai~d when I was here before I made a special point fo urge upon the oothmittee that in tharking up a bill, it not do aflything which `would pre~ent that ~ossibi1ity~ that possible thutualization, that possible internalization, so. that they wo~i1d operate in the way, a normal corporation is operated, or by means of a service `corporation owned by the funds. I agree with that ~00 percent, and I think we all must be sure that that would not happen. I think Mr. LOomis has so~nething to add to that.. Mr. LooMIs. I agree with all that, but I wouldn't want the record to appear that our bill is going to require them to internalize-be- cause I don't think it `will-that will be a choice that they will have to make. ` Mr. COH~N. `As a matter of. fact, *e, abandoned that choice even though it was an .~ttraotiv~ one, and settled oa what I considered to be the most conservative, the most modest prOposal possible. Mr. Moss,. Mr. Stuckey, you have some questiOns noi~v? Mr. STUOKEY. Thank you, Mr. Ohairman. ,,JI~et'~ go back to management. You "stated in yoi4r memorandum that the dollar cost ~to `the individual for management fees is relatively small and has little impact: upon, his investment decision. If this is so, why. does he n~ed protection ag~inst e~cessive management fee~? And what do you mean by "relativ~ly small"? That is, relatIve to what? PAGENO="0305" 719 Mr. COHEN. Mr. Stuckey, he is a stockholder in a corporation. He has joined with many other stockholders. He is not seeking individual advice and he doesn't get it, and all the services that attend it. He is in a company that grows. Now, any normal corporation that has big buying power has the ability to obtain its supplies, its services, or what-have-you, on a basis which takes into account its size. All we are saying here is that in this area those common, everyday rules ought to apply to an equal measure. Mr. STU0KEY. Then you back up your statement that the dollar cost to the individual for his management fees is relatively small. Mr. COHEN. The amount to the individual investor, depending on his investment, may be small, but I don't know what you mean by "relatively." Mr. S~rucKEY. You said in your memorandum that it was. Mr. COHEN. Yes; yes. What I am saying is it varies in a particular case. But it is small to him. But that is like saying "What difference does it make if we pay the president of the corporation $10 million when there are 10 million shares outstanding? It is only a dollar a share." Mr. STTJCKEY. If he is worth it, I don't see why you shouldn't. I think you should. I don't think there is anythizig wrong with that. Mr. COHEN. If he is worth it; I am sure the court will take that into account in determining whether or not the fee is reasonable or unreasonable. Mr. STUCKEY. All right. Now, has the Commission found any mal- practices in the field of management fees? Mr. COHEN. Our whole purpose here, Mr. Stuckey, is that we believe by looking at every other situation that we think at all comparable, that there are malpractices. The charges here are excessive. Mr. STUCKEy. iI~Iave you found any malpractices in the field. of management fees? Mr. COHEN. They are excessive, and to tliiat extent it is a malpractice. Mr~ STUOKEY. They are all? Mr. COHEN. Sir, I didn't say they all are. I said that there are fees here that are excessive. I think if you look at the exhibits introduced into the record by the industry, and look at the range of fees charged for management of similar size funds, I think there is a rettsonable ques- tion raised whether one at one end is unreasonably high, whether the other one is unreasonably low. They both may be all right, depending on the facts of that particular case. Mr. STUCKEY. So you stated, as I understand it, that there are mal- practices in the field of management fees now? Mr. COHEN. In the sense I use it, we do believe that the fees are excessive in a number of areas; yes, sir. Mr~ SrUCKEY. So why haszi't some court action been taken? Mr. COX1E~t. Because of the standard whicl~ Judge Friendly pointed out. Now, so far as the Commission is concerned, we have to deal with section 36, and if you will forgive me, I want to explain that. Section 36, in its origir~al form, was a criminal statute. The industry objected to that in 1940, and almost at the last minute-I don't remem- ber whether that is precisely correct-the statute *~s changed to make it a civil statute. But they used the words, "guilty of gross abuse of S5-592--e8-~pt. 2--20 PAGENO="0306" 720 trust," not. "abuse of trust," which is the standard any court goes by, not "abuse of fiduciary obligation;" but "gross abuse of trust." This industry says they don't want to be viewed in any other light except in a gross abuse of trust, a very strange position. Mr. SPUOKEY. So, isn't this right? You have found no maipractices in the management field? Mr. COHEN. We have not brought any actions under, section 36 attacking the fees. Mr. STUCKEY. All right. Now, do yott, think that a prominent dis- closure `of management fees-let's take for example, say, on the cover page of a prospectus, would this adequately inform the pros~pective investor? Mr. COHEN. It might. It probably does adequately inform him. But the Congress decided that that was not enough in this, area. If dis- closure wa's enough, there was no need for the 1940 act to begin with, but let me point to one thing, Mr. Stuckey. In every other area of inside dealing, if a director wants, to sell 10 shares of stock, any stock, to the fund, it is forbidden, even though it may only amount to $1,000, or $100. It is forbidden, and he has to apply to the Commission. The Commission has to find that it is fair and reasonable; that it involves no overreaching, and that it is con- sistent with the policies of the company and the purposes of the act. But here, you have the `same conflict, much more insidious, far more far reaching, and there is no standard for review. Mr. STUCKEY. So you are saying that. a prominent disclosure of the management fee on the cover of a prospectus would not adequately inform the prospective investor? Mr. COHEN. Yes, sir; we are saying that, obviously. We, wouldn't be here otherwise. Mr. STUCKEY. So, in effect, you are saying that an individual `in- vesting in a mutual requires more protection against paying excessive `charges than an individual, say, purchasing, say, `a kitchen stove on the installment plan? Mr. COHEN. Yes, sir; and that was the Congress decision in 1940. Mr. STUCKEY. ,So you are saying he is ignorant-, Mr. COHEN. I didn't say he is ignorant, sir. I said' he needs more protection. Mr. STUCKEY. I don't see this. , Mr. COHEN. Well, the point is, in the 1933 act, there are `all kinds of provisions for giving information, but the Congress decided in 1940 that it needed more,, that it needed regulation of this industry, because of the built-in conflict, because these people sit astride, these funds, and run them, and they sit on both sides of the table. It isn't a situation of an ordinary, corporation where you are held ~ccount- able to your own shareholders, and you don't have any other i.nterest. When you have another interest, then you are, accountable in a court. Mr. STUCKEY. We are getting off in another area. Now, do the mutual fund shareholders have any way of knowing what the profits of the management company are? , `, Mr. COHEN. They don't have it now, except indirectly in those situation's where the management company is a publicly owned com- pany and the information may be found in the. public files somewhere. PAGENO="0307" 721 Let me answer that fully. Some years ago, the Commission thought that this might be a way of dealing with th~ problem. And it made a proposal. Now, you fellows have heard some explosions here, but they don't compare with the explosion that occurred at that time. Mr. Sptrojcj~y. Do you think if they disclosed this in a prospectus- whateffect do you think it would have? Mr. ColiuN. It wouldn't change our views. Mr. S~uci~r. No, or the person purchasing the mutual fund. Mr. CohEN. I don't know that it would. Mr. STtTCKEY. Would this be a material disclosure? Mr. OOHEN. I don't know that it would, because if someone is sold these funds face to face, however he buys them, because he wants to buy this vehicle, and this is the charge that the traffic will bear, he doesn't have many alternatives. Mr. STUCKEY. I want to ask one last question, because I know time is running out. The answer can be submitted later if there is no objec- don, to save some time. But I have not seen where this is different from an ordinary corporation. I have seen where the disclosure is there. I don't see that it is different from any other business but we come back to the 5 percent, which as you said is the great burden in setting the 5 percent. I have yet to see in writing or in any testimony how you arrived at 5 percent. This is something I would like to see. How did you come up with 5 percent? Why not 5.32, or why not 6.8? Mr. COHEN. I will answer that as I did when I appeared here before. We examined into the charges made elsewhere in the industry. And, by the way, under the 1934 act, as it relates to transactions on the stock exchange, the test is reasonableness. In the 1934 act, as it relates to transactions in the over-the-counter market, except for mutual funds, the test is reasonableness. And they even have a rule in the NASD that these charges should be fair. But in the context of sections 22 (b) and (c), and 27, no one has felt that there was sufficient authority to deal with this problem. In looking at all of those situations2 we found that the charges for mutual funds were very substantially higher than the charges for the acquisi- tion of securities in many other areas. That was an important consideration. But we also looked at the fact that that is not the end of the expense that the investor bears. He is in the fund. Every time they change a security, he has to pay the brokerage. He has to pay a management fee, and we thought that in our recommendation we were arriving at a figure which was generous in relation to other situations. We examined the cost involved in distributions, where the under- writers assume a market risk on a security of comparable quality, so to speak, and we found that that was lOwer than 5 percent. So we arrived at 5 percent. Mr. STUCKEY. So you have stated, and your figure is different from 8.5, but you say the prevailing sales charge is 9.3 percent, and you wish to see it cut to 5 percent. Mr~ COHEN. Yes, sir. Mr. STUCKEY. Presumably, you think then that 5 percent is a reason- ~able sales charge. PAGENO="0308" 722 Mr. COHEN. We do. Mr. SI~JOKEY. I assume, then, if 5 percent is considered reasonable, why not 9.3 being considered grossly excessive? Mr. Com~N. I would like to explain that because that question is one that I have troubl~d myself about for Inally, many years. In section 27, which relates to contractual plans, the Congress fixed the maximum sales load at 9 percent. Now, I might also mention that was the first time, under the 1940 act, the Congress undertook to fix a maximum price in the Federal securities laws. I think 22 (b) and (c) read in terms of unconscionable and grossly excessive charges, with some residual authority in the Commission. The NASD has felt, and through the years the Commission has felt, that in the context of that statutory situation which I have explained, it would not be possible to establish that that standard of unconscion- able or grossly excessive could be applied to the run-of-the-mill charge which approximated the figure whjch the Congress itself fixed in section 27. Mr. STuc1~1~1~. This is the point of our whole question; 9.3 is just about double the 5 percent which you say is reasonable, a complete doubling or close to it, which to me would constitute excessively ex- cessive, and yet this has never been proven. The courts have ruled that it was not. Mr. Col-JEN. No, sir; it has never been before the courts. Mr. STUOKEY. I thought there were three cases. Mr. COHEN. No, sir. Mr. Moss. I think that the point that the chairman was attempting to make, in saying that the fee on the front end load, the Congress set it at 9 percent, and because of that action by the Congress, it was felt that they could not sustain t1~e burden of pioving that that fee applied to the noi~-ftont-end load was excessively excessive or unreasonably unreasonable. Mr. STtTCKEY. But the point that I still maintain is that the courts themselves do have the right to determine whether it is excessively excessive. Mr. Moss. Dr. Jennings yesterday and Judge Friendly both pointed out the virtual impossibility of proving that. They felt it was of little value to protect the investor. Mr. COHEN. Mr. Stuckey, there have been no cases that I am aware of where that issue has been before the courts. The cases involved man- agement fees. Now the only way the Commission could attack it, subject to this 22 (b) and (c) thing, as I have explained, is by bringing an action under section 36 charging these people with being guilty of a gross abuse of trust, and t1~e Commission has felt in the context of the statutory situation that it was not authorized to bring that type of action. Mr. STUCKEY. There have been no actions? Mr. COHEN. There have been none; no, sir. We have initiated none. Mr. STtJCKEY. Thank you. Mr. Moss. Mr. Chairman, on page 5 of your statement you said, "The simplest way to deal with conflicts of interest would be to eliminate them." PAGENO="0309" 723~ You said, "This can be done by requiring the mutual funds to be internally managed." But then you say, "The Commission rejected this approach as being too drastic." However, on pages 27 and 29 of your statement, yoti point out that mutual fund advisory fees are excessive: "The unaffihated director does not work to reduce fees," and that "Internally managed funds have lower costs of advice." On the basis of the argument which yu yourself made, I cannot see your statement that the abolition of the outside advisory service is too drastic. In other words, I think that your reasoning would lead to the conclusion that such a proposal would not be too drastic, as you set forth in your statement. Mr. COHEN. It would be very difficult to argue against it. I will try to explain the situation. Mr. Moss. Is this not exactly what Congress did in 1935 ? Mr. COHEN. Yes, sir. Mr. Moss. In connection with public utility holding companies? Mr. COHEN. Yes, indeed. Mr. Moss. Why haven't yoU made that r~commendation here, then? If you would like to reflect upon that op.e very carefully, it is not intended to entrap you, you can prepare a written r~sponse and I will supply you with the question. Mr. COHEN. I will be glad to do so; yes, sir. Mr Moss In fact, I have a number of questions which will be proposed to you in writing, and 1 will restate now the situation as we close this phase of the hearings. The members of the committee have the right to propound questions to any of the witnesses in writing. ~he witnesses are to respond within 2 weeks. That means 2 weeks from today, the questions which are received should be answered and the answers back in the hands of the committee for inclusion in the record. Mr. COHEN. We appreciate the opportunity very mu~h. (The following letter was received by the cominittee:) Sncurn~tns A*n lcxcriAxals COMMISSION, Washiñ~cton, D.C., NoDeø1~ber 7,1967. Hon. JOHN E. Moss, Chairman, ~ubconun'ittee On ConvinercO and Finance, House of Representatives, Washtagton, D.C. DEAR Ma. Moss: I ath pleased 1o enc~osO the Commission's ré~1ies to the 8 questions which you submitted to us under cover of your letter of October 24. Please do not hesitate to call on me if you wish any further information in connection with this legislation. Sincerely, MANUEL P. COHISN, Chairman. tEnclosuresi 1. It is~ of course, true that the simplest and the most effective way of dealing with a conflict of Interest problem is to eliminate the conflict by re~noving its fundamental causes. For this reason, one might conclude that the external ad~ visory system ought to be abolished and that investment companies should be precluded from contracting out the most essential parts of their work to separate entities controlled by the same people who are in practical control of the invest~ mOnt companies. It may be useful, therefore, to outline the countervailing con~ siderations which led the Commission to conclude that It would be desirable to recommend the more conservative approach taken in ER. 9510. PAGENO="0310" 724 ~nterna1izaf4on might not benefit the shareho1der~ of newly created funds. These investors sometimes benefit from the external system b~ause an advi~er to Such a fund often is willing to invest his time and energy to:bnild the ~und and therefore may spend more to rim the fund then he receives from it ~fl ad- visory income in the first years. He does so in the hope that as the fupd grows it will provide an advisory income that will be adequate enough to compensate for the deficits incurred when the fund was small and to provide an opportunity for capital gain. Since the prospect of the entrepreneurial profits that can be earned under the external system once a fund reaches a certain size is a principal, incen- tive for the formation of new funds, there is some reason to believe that forced internalization might inhibit the formation of new funds. Consideration should also be given to the fact that many mutual fund manage- ment companies are now publicly held. Since most of those companies derive substantially all of their Income from their profitable advisory relationships with the investment compai'nes that they serve, compulsory internalization would have a greater impact than our recommendation on the interests of the many tbousands of public investors who hold stock In mutual fund management companies. It should be pointed out, however, that management company shareholders are a much smaller and a more sophisticated group than mutual fund shareholders.1 The prospectuses covering public offerings of shares in mutual fund management companies have made it very clear that under the Investment Company Act the relationship between an invOstment adviser and its investment company ctient is always terminable at the investment company's election. The Commission believes that It Is important to achieve a fair balance of all the interests affected and that every effort should be made to find an ap- proach which would deal effectively with problems of mutual fund investors in a manner that would have the least possible adverse effect on the mutual fund management business. We think that section 8 of H.R. 9510 and 9511 embodies such an approach. The Public Utility Holding Company Act of 1935 prohibits registered hQlding companies from supplying goods or services to the operating companies in their systems. It permits holding company subsidiaries or "mutual service com- panies", to furnish such services, but only under contracts to be "performed * * * at cost fairly and equitably allocated * * s." ~ shonid `be noted in this connection that there are today, large, successful funds and fund' complexes which are operated either by their own staffs or by service `subsidiaries owned by the funds themselves. While there arO similarities between the role of the service company in the utility business of the pre-Holding Company Act era and the role o'f the man- agement company in the mutual fund business of today, tb~ two situatioi~s are not precisely *paral1~el. In the mutual fund case, the advisory business is generally the central function and main source of profit of the management company, *hich usually has no'substantial stock interest in~ the funds which it advises. To compel internalization ~by law `would be to wipe out the value of management company securities, substantial quantities of which are held by public investors. In the utility situation, on the Qther band, the service function was only a part of the holding companies business Their principal assets were the securi ties of the operating companies, and their principal source, of, income was gen- erally the return on those securities Their dissolution resulted in the distribu tion to the holding company sliareholdei~ of operating company securities which very often had a market value higher than that of the surrendered holding com- pany securities. Moreover, while the conflict~ of interest engendered by external management in the mutual fund industry `directly affect the interests of four million mutual fund shareholders, the conflicts of interest endemic to the public utility holding company structures of the pre-1935 era inflicted direct injury on almost every consumer of gas or electricity In the United states. The artificially inflated costs of production that `the service company device inflicted on `the operating com- panies affected the customers as well as the security hctd'ers of those companies. State and local regulatory bodies were unable to prOtect consumers because they I the end of 19~6 the publicly held management companies `had about 67;000 share- holder accounts, less than 1% `of the approximately 7,000,000 shareholder accounts that the mutual funds had at that same tinle. PAGENO="0311" 725 usually lacked jurisdiction over the service companies. Drastic action was imperative to protect consumers and to promote maximum utilization of the technical advances in th~ transmission of electricity. Of course, nothing in the bill precludes the voluntary internalization of invest- ment company management through the acquisition of the management com- panies by the investment companies they manage on a basis fair to all interests concerned. With respeet to compulsory internalization, however, the Commission believes the view expressed at page 149 of Public Policy Implications of Invest- ment Company Growth is still valid: "The Commission believes that an alternative to the more drastic solution of compulsory internalization of managements should be given a fair trial. That alternative lies in applying to management compensation the standard of reason- ablenéss that the Act applies to other transactions between investment com- panies and their affiliated persona The Commission believes that this regulatory approach also can resolve the problems that exist in the area of investment com- pany management compensation. If it does not, then more sweeping steps might deserve to be considered." 2. The Commission clearly has the power to require comparative disclosure of the relative management costs of different investment media. tinder the Securi- ties Act of 1933 the Commission can insist on the disclosure of all material facts. 4dternative investment media and a comparison between theif costs and those of the particular investment medium offered are plainly materiaL Thus the question is not one of power but of the wisdom of exercising It. Although the Commission has on previous occasions considered the possi- bilities, it has concluded that the advantages of comparative disclosure in investment company prospectuses were not clear and, in any event, there were doubts that the benefits would offset the administrative difficulties this type of disclosure would entail. To begin with, the advantages would be limited. Management costs are sig- nificant. But even to the most cost-conscious investors they are by no means the most significant cost of mutual fund investment. From the small investor's point of view the sales load is by far the principal cost of a mutual fund investment. Most mutual fund investors are small investors, and the 8.5 percent sales load that they normally pay is almost 19 times an advisory fee rate of one-half of 1 percent, Thus, comparative disclosure in the management cost area would have to be complemented by comparative disclosure in the sales charge area. Disclosure of comparative cost ~vould also require that disclosure of manage- ment and acquisititon charges be supplemented at least by reference to relative benefits, for example, investment performance. The performance of a fund Is undoubtedly as material to an informed investment decision as are operating costs and sales charges. This would present additional~ diMculties. There would be a question whether the comparison should deal with all alternative investment media, oi~ all mutual funds, or to funds of a particular type, or whether it should refer to some stock i~aarket average. There would also be the problem of assigning a particular fund to a particular categQry, since the dividing lines among the various cate- gories of funds are not aiwayselear. It has been argued that there is a risk that adequate disclosure in this area would be self-defeating because It would requIre mutual fund prospectuses to become, in effect, treatises on investment in general. Bncyclopedic prospectuses would .of course be useful in certain situations but they might become totally unreadable to the average investor. Prior attempts by the Commission to add oifly a portion of such disclosure to proxy statements and prospectuses have been met with these and other arguments. After 34~ years of experience there are still many problems in trying to deter- mine what is needed in order to give a fair portrayal of a particular security, To determine what constitutes a fair presentation in relation to the attributes of all other competing investment media would present infinitely greater and more difficult problems. However, as noted at the hearings, we are not satisfied that the range and value of present disclosure is adequate. Our staff has been reviewing these requirements to determine whether and the extent to which improvements can be made which will assist investors without imposing unnecessary or impossible PAGENO="0312" 726~ burdens on issuers~ This effort will `be expedited as much as possible within the limitations of our resources. 3. Prior to the hitroduction of HR. 9510 on May 1, 1907, the Investment Com- pany Institute made two proposals to the Commission as alternatives to the provisions of the Bill relating to advisory fees~ The Institute's first alternative would have increased the number of independent directors required to be on an investment company board of directors from 40 J~ercent to a majOrity of the board. This requirement, for the most part, reflects the existin~ industry prac- tice. In addition, the Institute suggested an elaboration Of a relatively minor part of our own legislative proposals, which would merely tighten the standard for the independence of unaMliated directors by requiring them to be "disin- terested" persons. Although we believe that enactment of thi~ proposal Would be helpful in certain other areas of investment company affairs, unafilliated directors cannot effectively deal with problems in the advisory fee area. As we have previously pointed out, the problem is not the unwillingness of the un- affiliated directors tO deal with the questions, it is `their inability to do so. After the Commission rejected this proposal as wholly inadequate, the Institute submitted a second "alternative" to the Commission's propo~al, This alternative would have required that a majority of the independent directors of an investment company, before approving an advisory contract, find In the exercise of their busi- ness judgment that the compensation payable to the adviser is reasonable, Under this proposal the Commission would be precluded from taking any enforcement action. Only th~ tnvestment eomp~ny or a fund shareholder would be able to insti- tute~ a suit alleging that the directors had "abused their business judgment." However, a court could not render judgkn~nt fOr the plaintiff on the ground that the fee was unreasonable, even if it found that the evidence supported that con- clusion, unless the plaintiff proved by "clear `and Convincing evidence" that the director's approval of the advisqry contract, was a "clear abuse of business judg- ment." This proposal may have the virtue of recognizing the elementary princi~ile that the fiduciary's fees must be reasonable and that it is,a proler function of the courts to enforce this ~bli~atjon, But it would, in fact, hamstring the courts in the exercise of this traditional role by preventing them from acting unless the evi- dence was "clear and convincing" that the approval of directors was "a clear abuse of business judgment." This proposal would have the effect of putting the directors, partlcula~ly the unafflhiated directors, on tria~, rather than the fees. It would neither be fair to~ the' directors nor lead to an effective enforcement. As a praCtical matter, it would provide an eyen greater degree of ihsnlatlon froip judicial scrutiily than now exists as long as the defendants could show thafl the directç~rs had gone through the ritual prescribed by careful counsel to wrap the fees in the protective cloak of "business judgment." V'or these reasons the Commission did not an~ does not now believe that the proposals of the Institute constitute a viable alternative tO the proylsions of I1.It. 9510 with respect to advisory fees. We do not believe that Mr. Robert Haack, inhis statement to the Subcommittee on behalf of the New York Stock Exchange intende4 to r~c~ prol~sals ~dlf- ferent from those that had been advanee~I by the InStitute ax~d rejected by the Commission. Mr. Haack did, however, describe the Institute's proposal as per- mitting the courts to enforce a standard of reasonableness If it found an "abuse of business judgment." Such a proposal, like the Institute's proposal, would still put the directors, rather than the fees, on trial. It also implies that the directors are in a position to make a "business judgment" in approving an advisory contract when in fact they have no realistic alternative but to accept the `contract offered by the adviser. But the Institute's proposal did not go even that far. It would preclude enforcement of the standard of reasonableness unless the court could find "clear and convincing evidence", which showed a "clear abuse of business judgment." 4. In his letter of October 18, 1967, Deputy Attorney General Warren Chris- topher, comments principally on the Commission's recommendations for a 5 percent limitation on the basic sales charge for mutual fund shares and for a standard of "reasonableness" to be applied to advisory fees. With respect to sales loads, the Department of Justice notes that the proposed ~3 percent limitation is not inconsistent with the basic concept of the Investment PAGENO="0313" 727 Company Act of 1940,. under which the investment company Industry is already subject to a substantial degree of regulation. The Department suggests, however, that in addition tO the proposed limitation on sales loads, the Congress consider modifying the resale price maintenance provisions of Section 22(d) of the Act, either by repealing that section altogether or by amending it to provide that no sales coUld be made "at a price higher than the current public offering price." The Department nOtes th~tt the principal objections that have been made to the proposals for repeal of Section 22(d) are that it would enable knowledgeable investors to purchase mutual fund shares at lower prices than unsophisticated investors, and that it might give "captive sales forces" an undue advantage over independent dealers in selling fund shares. These objections, of course, were fully exposed before your Subcommittee In our statep~ent, and were among the reasons why the Commission recommended the 5 percent limitation rather than the repeal of Section 22(d). We believe, of course, that retail price competition can result in great benefits *to consumers in the mutual fund area, as it has in So many other areas. While we have not recommended the repeal or substantial modification of Section 22(d), therefore, we cOncur in, the suggestion of th~ Department of Justice that the Congress give careful consideration to this proposal in conjunction with our proposal for a 5 percent limitation, in view of the very different situation which exists in the industry today as compared with the situation which existed when the Investment Company Act was adopted in 1940. With respect to advisory fees, the Department of Justice suggests that the Congress consider vesting in the Commission, rather than the courti, the au- thority to determine the reasonableness of management fees, or in the alterna- tive requiringthe Commission to report to the courts on the merits Of ahy private lawsuit instituted under the standard of reasonableness. Our suggestion to vest this authority in the courts, rather than in the Com- mission, reflected our confidence in the ability of the courts to adjudicate this type of question, which Judge Friendly made clear in hi~ testimony before your Subcommittee. We also wished to make clear that the Commission was not `seeking any kind of "rate-making authority" in this area. The suggestions of the Department of Justice are designed to assure con- sistency of regulation and to avoid proliferation of court action. We recognized the importance of both of these objectives in our stateteent and in our legislative proposal, which specified certain factors to be taken Into account in determining whether a particular fee is reasonable, and which proVides for Commission Intervention as a matter of right in private suits to enforce the standard of reasonableness. A~s Judge Friendly noted in his statement, there is a specirtim of alternative techniques for achieving these objectives, including those sug- gested by the Department o'f Justice. While we have not ~ought authority for the Commission to determine the reasonableness of advisory fees or a require- ment that the Commission submit a report t'o the court in all cases, we would of courSe' undertake"the `respensibility if the Congress decided that either of these modifications in our proposal is' desirable. 5. Mr. Ronald Lyman testified regarding the difficulties he would have under the bill in getting non~affiiiated directors. This argument was n'ot advanced by Loomis~Sayles Mutual Fund, Incorporation ("Loomis-Sayles") in the apiplica- ti'~n It filed fo'r a Commission order enabling it to continue operating with ~ Board of Directors more th'an 60 percentum of whose members are affiliated `with its investment adviser. As a no-load fund, Loomis Sayles has not been required to have such a Board of Directors and the company felt it should not change its Board simply because it proposed to sell its shares at a sales load overseas. Mr. Lyman testified that no-load mutual funds would be hard put to ~find enough willing and qualified persons ~to serve as non-athliated or disinterested directors because of the sharply increased responsibility and risk imposed on them by the bill. He stated that it is likely that many individuals who might now be willing `to serve as non-affiliated or disinterested directors would be unwilling to do so under the new law. In contrast, th'e appl'ieation filed by Loonils-Sayles did not refer to this matter. Loomis-Sayles stated that unless It received an exemption under the Investment Company Act, it would be necessary to either increase the size of PAGENO="0314" 728 its Board of Directors or to obtain the resignations of certain of the affiliated directors or a combination of the~e two alternatives. Loonlis.Sayies represented that, because the board consisted of 14 directors, it did not believe that it would be in the best interest of its shareholders to increase the size of Its Board of Directors. Furthermore, Loom:is~Sayies represented that it did not believe that it would be in the best interests of its shareholders to remOve from the board persons who had been selected on the basis of their i~bi]iity and experience. The Commission granted Looniis~Sayles the order requested on October 25, 1~967. It should be noted however, that the sole effect of the Oommi~sion's order is to permit Loomis~Sayles to avoid changing the make up of Its Boarct of Directors while offering and selling its sha~es in (lerniiany at a 71/2 percéntum sales load. 6. The Securities and Exchange Commission is studying the impact of invest- inent companies and other financial institutions on the securities markets. We are now attempting to expand our knowledge in this area by requesting more frequent reports from investment companies and by inaugurating a pro- gram to collect similar data for other institutions. The data presently available on institutional trading in individual securities are for the most part quarterly data on net changes in investment company portfolios. As part of its surveillance activities the Commission on certain occasions has made specific inquiries into investment compitny trading in particular securities. CONCLUSIONS As to the impact of mutual funds on the markets for particular securities, the Commission's Report on Public Policy Implications of Investment Company ~Growth noted their tendency to concentrate their portfolio holdings in relatively few securities. Indeed, in recent years many of the largest funds have reduced the number of different stocks in their portfolios. Such concentration increases the power of fund managers to affect the market in particular securities by their investment decisions. Further, as the irregular and relatively infrequent trans- actions of institutions in sizable blocks of securities become Increasingly signifi- cant and the relative importance of individuals' 100- and 200-share orders declines, the auction markets find it increasingly difficult to maintain the high liquidity, depth and continuity which they traditionally have sought to achieve. Oorrespondingly, particular issues which mutual funds trade becomes more susceptible to sharp, sudden and erratic price, fluctuations. Our study of the quarterly data shows that there is some apparent relatisn~ ship between changes in the balance of investment company holdings and the direction of price movements for individual stocks. Investment company impact appears greater on t1~ese stocks most heavily purchased on balance than on the stocks most heavily sold ~n balance. One might logically infer that trading by investment companies causes this relationship. Others might argue, h~wever,~ that Investment companies have, a tendency to buy stocks that are rising in price and sell stock~ that are declining in price. On the basis of the quarterly data available it is impossible to reach any definitive answer. The relationship of investment company transtactions to stock illarket prices is strongly influenced by the behavior of the market as a whole. When the market goes down sharply (e.g., the second and third quarters of 1960-) both the nw~t heavily purchased and the most heavily sold stocks perforrn more poorly than when the market goes up (e.g., the fourth quarter of 1966 and the first quarter of 1967). The Commission's case studies of trading in individual securities over short periods of time show that in some cases professional managers tend to have the same pertinent information and a similar ability to analyze it. Accord- ingly, their investment decisions tended to be homogeneous. A. fund manager that is determined to sell a large. block quickly may not be able to find institutional purchasers willing to buy the block at something close to the last price. If the block cannot be sold near that price to the public through a secondary distribution, there is a strong possibility that the stock's price will decline sharply. This in turn may cause other fund managers to dispose of or lighten their holdings of the stock, causing the ~~stock's price to `plummet downward. PAGENO="0315" 729 TABLE 1.-NUMBER OF COMMON STOCKS HELD AND AVERAGE MARKET VALUE PtR HOLDING AMONG THE LARGES1 MUTUAL FUNDS,1 DEC. 31, 1963, TO DEC. 31, 1966 Name of mutual fund Number of common stocks held Average market value per holding Percent 1963 1966 Percent 1963 1966 increase (decrease) (in thousands) (in thousands) increase (decrease) 1. Investors Mutual, Inc.2.~._ 2. Massachusetts Invest- 134 111 ~ (17.2) $10,010 $12,997 29.8 ment Trust 3. Wellington Fund, lnc.L._ 4. Dreyfus Fund, Inc 5. United Accumulative Fund 6. Affiliated Fund, Inc.4 7. Fundamental Investors, Inc 8. Insurance Securities Trust 100 106 133 140 155 117 103 133 157 71 154 87 3. 0 25. 5 18.0 (49.3) (.6) (25.6) 18,381 9,285 3,716 ~ 3,986 5,273 6,305 19,204 8,802 8,778 10,980 7,264 11,582 4, 5 (5.2) 136.2 175.5 37.8 83.7 Fund 9. FidelityTrend Fund, Inc_ 10. Investment Co. of 95 77 138 113 45.3 46.8 12,154 1,200 7,637 6,715 (37.2) 459.5 America 11. National Investors Corp... 12. Hamilton Funds, Inc.°_.... 13. Television-Electronics 114 133 106 125 129 81 9.6 (3.0) (23.6) 2,360 2,780 2,844 4,051 4, 141 4,776 71.6 48.9 67.9 Fund, Inc.° 14. Chemical Fund, Inc 15. George Putman Fund of Boston 16. Dividend Shares, Inc.°..... 17. State Street Investment Corp 18. American Mutual Fund Inc.4 19. Boston Fund, Inc.6 20. Financial Industrial Fund, Inc.8 107 53 107 99 105 76 107 110 94 55 87 99 122 96 87 83 (12. 1) 3. 8 (18.7) 16.2 26.3 (18.7) (24. 5) 3,062 5, 585 ~ 2,085 3,238 1,901 2,232 2,044 2, 169 3,786 7, 117 2,881 3,307 2,550 2,929 2, 163 3,553 23.6 27. 4 38.2 2.1 34. 1 31.2 5.8 63.8 1 Includes the 20 largest funds managed by different investment advisers. 2 As of Sept. 30, 1963, and 1966. As of Nov. 30, 1963, and 1966. 4 As of Oct. 31, 1963, and 1966. 5 As of Oct. 31, 1963. 6 As of Jan. 31, 1964, and 1967. INCREASE IN CONCENTRATION Table I, infrs~, compares, for 20 of the largest funds, the number of common stockhoidings and their average market value at the end of 1963 and 1966. Between 1963 and 1966 ten of these funds Increased the number of common stocks in their portfolios, while nine decreased the number, and in one case the number remained unchanged. During this period of fund growth 18 of the 20 funds increased the average value of each holding. In part these Increases are due to rising markets. In most instances, however, funds are placing more money in individual stocks than they ha~re done in the past. For instance, Fidelity Trend Fund, whose assets increased from $106.1 million in 1963 to $983.1 million in 1943t~, increased the number of common stocks in its portfolio from 77 to 113, an increase of almost 47 percent. In 1963, however, the average amount held of each stock was only $1.2 million and in 1966 this had increased more than 41/2 fold to $6.7 million. The largest mutual fund, Investors Mutual Inc., during this period decreased the number of common stocks in its portfolio 17 percent and increased its average holding about 30 percent. STUDY OF QUARTERLY DATA Table II. shows that in the second quarter of 1966 the NYSE Composite Index decreased 5.09 percent. The price of all ten of the most heavily purchased stocks fared better than this index, and the prices of seven out of ten of the most heavily sold stocks fared worse than this index. The median of the most heavily purchased stocks increased 10.0 percent, while the median of the most heavily sold stocks decreased 6.7 percent. PAGENO="0316" 7~Q e; ~±`~` ~` ~ ~ ø~ r~ç4 ~ 00 d,-~-~~i -c4co 00tfl0000~~~ *OQ odC4 0000 co ~-o~ 00 ~ ~ ~ ~ r-~4~4~ ~ ~ 00 C, C, LU (0 C, LU ci) C., C, I- C') C, 0 C.) 0 C,) LU -J C', C, Cc) LU C') = 0~ >~ 0- 0 C.) z LU I- -t LU -j 2 0- PAGENO="0317" 731 CO ~ DC~4 N~ ++!j!+++ I ~ c.~ ~ ~ ~ -7~a~r c~~r 0)CO~ CO~~ Co r- ~ Co C)~ ~ `~r `~ `~r~ CO Co ~ N~N~ CO Co 0)1'-. (0(0 °~ 1 1'4~ Co - C"( 0)~0),-4 -J QI C- CC 0 0~ ~ 0 ~ Co z I -~ Co Co Co C- Co 1'-, CC CC 0' C.) 0 I- Co 0 0 C-) U- 0 Co 1-u C,, Co 0) 0~ >- C- 8 1- I- > 00 Co~1'~C'J C1~Cv)t()-4 Co Co C~J ) Co c~OO >- > Co 0)1') (0 C) * CC 0) Co >- Co CoC)O) ~ c~ (0(t) CoCo C) Co~ ~1'-. 04 0) 04 Co 04,-~C)~U(0CO QO~C) ~OOC)OO (0(t) CoCo~Co ~ PAGENO="0318" 732 ~00C4C~4 ~ ~ o*r~ -r~-~ .~ ~ ~ -~ CDC~U~ 0DN~ CO~ (0L~)~~ ~ C(~4~C'~ C)Lt~ ~ oo~ o-~ = ~00 C~ ~*~(t) C~)t~ (000 ~fl t~r- (0c~ ! ~ `L~~C'JC.J ©r-~C(J-~ ~ r~*~ 00 *~v,> 0~ S (0tt)~J ~ *-~CO~ (0(C)00 0~ C0C~ 0)tfl ~ 0~ I ~~iu ! III ©r~ C0)~ ~c~CJ ~ (0J~Cfl'-~ ~ 0) ~C\1 (`J < *5 *~ c~r-~ ~ ~ C#) o~ - 0D(OC~4~ - e'~~ ~ ~o~oo~ c~ (0~)00 00 N DC C4 C,, ~ 5 C-) 00 0~ ~ 0) ! ~0 ~ II~~ ** >- >0) - PAGENO="0319" - C~) CC 0)0) C0U) -~ 0)0000 r-. 000) U) 00 00 00 C) 0000 ~U) ~ 000) b~ C~J - OU - - ~ 0)0)0- C- 00 ..~0000 0)0-04 ~ 000-U) U) 0--~ ~ 00. 0-~ ~CC) 0-U) 001-0) ~ 0400 ~ C-) 0D~ C-) 0- ~00 ~C-) 00 00 0)0-000-0- ~ 733 04 r~-~o 000)0-0- -~ 0)0) 00(~ ~- 00 +~+~++ I~i+ 0000 000)00 C) ~ IOU) 0000 ~ U) .-~C C~00U)0- C) ~ 0-0-00 000C~ 0)000-0- 0-0)04 ~00 ~ 0Q~ C) 00~-~-o ~C0)~.o U)U) ~ U) ~ U) 00..o CCC) U) C) 000) U) IO~U) 00 U)C)IO4.-C,-o00 -J -J CC 0 .2 -a) ~ ~ 2 C C.g C 2 2 00 U) U) C 00 2: 0 2 00 0' U) 0 U) 0 0 C~) 0 C,, -4 U) 0 U) U) C.) 00 0~ >. 0): 0~ 0 C.) U) > > 00 I- 0-1) 00C~) 00 ~ CCC) r-U)U) U) 0- ~ ~ C-IOU) 00 ~ U) 00000)0-C) 0- ~ 0) 0)o~ (o~0- 000) r~ 0-U) 0 C)0 o- 00 ~ ~ 00 C) )~ 0-U) U) 0-C) ~ - U)C) 00 000000-U) 0- ~ 0C~ c') ~oU) 0CC) 00 2 ~ 0. >- 00 .2 o~ CC 2 wE >_0) E~ 0)> C?) PAGENO="0320" 734 As shown In Table III in the third quarter of 1006 the NYSE Composite Index decreased 10.0 percent. The prices of nine out of ten of the møst heavily pur- chased stocks had above average appreciation, while seven out of ten of the most heavily sold stocks declined more than this index. The median of the most heavily purchased stocks increased 3.2 percent, and the median of the most heavily sold stocks decreased 17.7 percent. In the fourth quarter of 1906, as shown in Table IV, at page 8, the NYSE Com- posite Index increased 5.09 percent. Price increases for eight out of ten of. the most heavily purchased stocks were greater than~the rise in the index; six out of ten of the most heavily sold stocks showed price declines greater than the index. The median price increase of the most heavily purchased stocks was 71.2 percent; the median of the most heavily sold stocks decreased 11.8 percent. In the first quarter of 1907, as shown in Table V, the NYSE Composite Index in- creased 13.2 percent. Nine out of ten of the most heavily bought stocks had price increases which exceeded this figure, seven out of ten of the most heavily sold stocks fell short of it. The median price of the most heavily purchased stocks increased 29.9 percent; the median price of the most heavily sold stocks increased only 4.7 percent. There is a tendency for different stocks to be in the top ten stocks purchased or sold on balance in each quarter. Among the stocks purchased, 32 hfferent stocks appeared with only seven of them appearing in more than one quarter. One of these appeared in three quarters. Of the stocks sold on balance in each of the four quarters, there were 31 different stocks, three of which appeared in two quar- ters, one in three quarters and one in all four quarters. Within these four quar- ters, five stocks appeared among the most heavily purchased in one ~uartor and among the most heavily sold in another quarter. In two of these cases the stocks appeared among the stocks most heai~ily purchased or sold more than once. This seems to indicate that institutional favor, and disfavor shifts rapidly from stock to stock. The greater the percent of volume which is accounted for by investment com- panies, the greater is the relationship to the change in the price of the stock. This is shown by Table VI which presents an analysis of the price movement of the 50 stocks most widely held by investment companies shown in Table VII. As can be seen from Table VI, the greater the percent of volume accounted for by the balance of investment company trading the greater the likelihood that the stock's price change, relative to the index, will be in the same direction as the PAGENO="0321" 735 balance of investment company trading. Considering all 50 stocks, 30 out of the 50, or 60 percent. did better or worse than the averages according to the balance of investment company trading. Of the 34 stocks where the net purchase or sales balance exceeded 10 percent of volume, 23 stocks, or 68 percent, did better or worse than the averages according to the balance of investment company trading. How- ever, when only those 14 stocks in which the balance of investment company trading exceeded 20 percent of total volume are considered, 12 out of the 14 stocks, or 86 percent, showed such an impact. TABLE VI.-EFFECTS OF INVESTMENT COMPANY TRADING ON 50 STOCKS MOST HEAVILY HELD BY INVESTMENT COMPANIES QUARTER, ENDED MARCH 31, 1967 1 ALL 50 STOCKS 22 stocks in which investment company purchases 28 stocks in which investment company sales exceed investment company sales exceed investment company purchases 12 stocks did better than 10 stocks did worse than 10 stocks did better than 18 stocks did worse than market averages market averages market averages market averages 34 STOCKS IN WHICH BALANCE OF INVESTMENT COMPANY VOLUME EXCEEDED 10 PERCENT OF TOTAL VOLUME 15 stocks in which investment company purchases 19 stocks in which investment company sales exceed investment company sales exceed investment company purchases 9 stocks did better than 6 stocks did worse than 5 stocks did better than 14 stocks did worse than market averages market averages market averages market averages 14 STOCKS IN WHICH BALANCE OF INVESTMENT COMPANY VOLUME EXCEEDED 20 PERCENT OF TOTAL VOLUME 5 stocks in which investment company purchases 9 stocks in which investment company sales exceed investment company sales exceed investment company purchases 4 stocks did better than 1 stock did worse than 1 stock did better than 8 stocks did worse than market averages market averages market averages market averages I Market average used is the NYSE composite index which increased 13.27 percent. &5-592---6S-pt. 2--~1 PAGENO="0322" 0 CO CO LU 0~ I- CO > U- 0 CO C, 0 -J 0 C-, 0 CO 0 0 C-, CO C, OE: -J LU = > LU -J 00 736 -J -J 0~ = 0 ~ to r-00 COC~ - )C)C'4 N-tO- 4,-)~0 ~ ~ ~ ~ ~ \~ \~\~ ~ r-.U5 00 C, IC) NJ C, N-~ 000 Ø)C, ~ a)I- a) (0(C) 0)N4 (0IC) to) r- r-w o~ r-oo (000 ~ 00(0 a) dN4o~ .--~r a)'-,- ~-- ~ a)-t ~ (0 a)~ ~ 00(0) ~ 0)10) 00 a)~ 0) ~-n4) 00L0 cOlt) at- r-~ 0000 N-C, 0)10) CON. (0 (0) * 000 ~ N-U~-(0 (0N-N4~-0IC) 00N-r-~Lt)00 00(0 Ott) cON- cO~ 0)(0)LC) -o a)r-~-NJ~ c~0O ~ 000(0 (0c000~ r-~OO ~ a)LC)~CJ a) a)NJ a) (00000(0 a) a)~ a) (C) (`.1 NJ 0000(0)04 a) (0 a)a)t0)~NJ O0) a)0)LC)Lt)00L0004C,L0)00-° N- N-IC) C, N- a)~ 000)10)000400(000004 a) (0(000 CO PAGENO="0323" 737 C\I C')-~ f4U) .-c 0000) 00CC C)) a)r-. cor---' or f-.1 ~ 00 c.Or-.~\t) 0) .-Ocf ~- C-) oc C')c)) CC) ~ 00CC)- c-.j 0) 00cr) ~ 0) (0~ CO.-o Cc) 00 cOC-.J Cc) o%J0)(r)N- N-(0u) ~ c~ -cf--CO C) c-cr-) C) C') 00 (C)OOC) c-C 0)u)0,c- N- fC) 0N- c-.-~ f- 00 ~2CC)0O ~ 000) 00 f)) ~- CC) (.0 N-CON. NJ 0Oc~ N- N- L~~N-cC ~-C ~ - N- c-c ~ N- ~N-COC) Wr~. (00)CO~ N- N-N- ~~J) ~ N-CO~ N- N- N-LC-~ C') ~ ~- -.. ~ 0000CC) N- ~ 1) N- C) CON- N- 0)00(0 (.O~ 0) o')?-~ N-Nor N-N-N-N-~N-~~(.)N-~-C N-c-cc- N-C ~ 000))'- (0(0 N. (.0CC-N- C')).C) N. CC) (0(0(0 N- C-O) ~ 0)00) N-)) oN- (C) ~ ~; 0. E -C- .~ E ~ >-~ (.0' PAGENO="0324" 738 CASE STUDIES On one day in November 1966, well over a half a million shares of one so-called glamour stock were traded on the New York Stock Exchange. Trading in the issue opened at 126%, the high for the day. From that 126% figure the stock skidded down to 105. It closed that day at 10G~/4, for a net loss of 19~/~, a drop of approximately 17 percent during that single day. Mutual funds bought 1,500 shares (about 1/4 of 1 percent of the day's trading) during that day. But mutual funds sold almost a quarter of a million shares (43.5 percent of the day's trading volume) on that day. Among these sales by the funds was one block of 25 thousand shares sold at 1151/4, another block of 32 thousand shares sold at 114, and a third block of 137 thousand shares sold at 109%. In August 1966, one stock opened at 218. By the end of the next day, it had fallen to 200%, for a loss of 171/2 points in two days. During that two-day decline mutual funds sold about 135 thousand shares of the stock, approximately 45 percent of the trading volume in the issue during the period. Some funds bought some shares as its price was skidding. But those fund purchases amounted in the aggregate to only 50 thousand shares, just about 17 percent of the volume. In four trading days in early June of 1966 the price of one corporation's shares fell from 85% to 75l/~. During these days mutual funds sold shares equal to about 27 percent of New York Stock Exchange trading volume in the issue during the period. Mutual fund purchases during this period totaled only about 6 percent of the volume. During the ensuing two-week period the funds, as a group, switched to the buy side of the market. Mutual funds bought a total of over 100 thousand shares, more than 23 percent of the volume during the period. Mutual fund sales, on the other hand, amounted tO only 65 thousand shares. Bolstered by this buying support from the funds, the price rose 12% points to 87%. Later that month, there was a very sharp reversal of the upward movement. On that day the price dropped 8% points on the New York Stock Exchange and an addi- tional 1% on the Pacific Coast Stock Exchange so that all the gains of the previous two weeks were almost entirely erased in that one day of trading. Sales by mutual funds that day accounted for 53 percent of total volume compared to mutual fund purchases of less than one-fifth the amount. During the next two weeks The price skidded another 141/4 points to 64%. During that two weeks of sharp declines three funds that had purchased over 100 thousand shares earlier in the month became heavy sellers. From June 24 to July 8, those three funds sold a total of over 170 thousand shares. During one week and one-half period in September 1966, the price of the stock of one corporation declined 32% points from 151% to 119, a decline of more than 20 percent in little more than a week. During this decline aggregate mutual fund sales of over 70 thousand sh~ires accounted for 45 percent of the total trading volume. Mutual funds did some buying during this period. They bought 3 thousand shares, less than 2 percent of the total trading volume. 7. Professor Ernest L. Polk III, Professor of Law at the University of North Carolina, has submitted a statement to the Subcommittee strongly supporting the provisions of H.R. 9510 which would require that advisory fees be reason- able. Professor Folk expressed doubt over the provision of the Bill which would place the burden of proving unreasonableness on the party objecting to the fee. He noted that state corporation law often recognizes that a fiduciary is in a bet- ter posturC to prove the reasonableness or fairness of his action than the chal- lenger to establish the contrary and suggested that the Bill be changed to place the burden of proving reasonableness upon the defendants. The Commission recognizes that H.R. 9510 would not go as far as many courts have gone in enforcing the fiduciary obligations of those who manage other people's money and it would not ob~iect to a change in the Bill to imple- ment Professor Folk's suggestion. The Commission believes that the Bill, as presently drafted, provides for effective ellforcement by shareholders. As Pro- fessor Folk pointed out, liberal pre-trial discovery procedures provided for in the Federal Rules of Civil Procedure and eompar~thle procedures in many state courts ease the task of a plaintiff in obtaining the information which l5 within the knowledge and possession of the defendants. In addition, even where a plain- tiff has the burden of proving the allegations of his complahfl, many courts place the burden on the defendants of moving forward with evidence which is within their exclusive knowledge or control. For these reasons, we do not believe that placing the burden of proof on the plaintiff would create undue obstacles to prosecution of an action to enforce the standard of reasonableness. PAGENO="0325" 739 Professor Folk also states that if the Congress is not disposed to place the burden of proving reasonableness on the defendant, the Bill should provide that the burden of proof would not shift to the plaintiff as a result of shareholder ratification but only if the contract is approved by a majority of the disinter- ested directors who are not interested persons of the investment adviser. We believe that the provisions of the Bill in conjunction with existing requirembnts of the Investment Company Act achieve substantially the same result. Under the provisions of the Bill the plaintiff would have the burden of proving unrea- sonableness only if the compensation is paid pursuant to a contract or other arrangement approved or authorized in accordance with the requirements of the Act. The Act now requires that a contract be initially approved by shareholders and thereafter renewed either by shareholder vote or by vote of a majority of the unaftlliated directors. While it is theoretically possible to avoid a vote of ap- proval by directors by submitting for shareholder vote, as a practical matter, the submission to shareholders is accompanied by recommendations of the directors. In this connection, the Bill places a duty on directors of an investment company to request and evaluate the information material to the reasonableness of advisory fees. 8. This proposal would permit the continued existence of mutual fund-holding companies which do not acquire more than 3 per cent of the total outstanding stock of any other registered investment company and which sell their shares at a public offering price which includes a sales load of no more than 11/2 per cent. The proposal contains other restrictions, apparently designed to meet the problems of a mutual fund-holding company. The restrictions would permit any registered investment company, the shares of which are held by such a fund- holding company, to refuse to accept for redemption from such a conipany in excess of 1 per cent of its shares in any 30-day period. The restrictions would also require the fund-holding company to either pass through to its stockholders the right to vote securities held in its portfolio or to vote such securities in the same proportion for and against as all other holders of such securities vote. The proposal also suggests a "grandfather" clause to permit only the opera- tion of the two fund-holding companies now in existence. This is an unacceptable alternative since, if the restrictions suggested by the proposal are adequate, there would be no need for such a "grandfather" clause. If, on the other hand, the restrictions are not adequate, the public interest would not be served by legis- lation designed to permit the continued existence of even just a limited number of fund-holding companies. In other words, if the concept is good, there would be no reason to prohibit it at all, and if it is bad, any prohibition should apply across the board. Upon analysis it is clear that the proposal falls short of solving the problems inherent in a fund-holding company operation. It would not protect against the layering of advisory fees mior would it protect against the layering of administra- tive expenses. Furthermore, the limitation of a 11/2 per cent sales load masks the problem of cumulative sales load that would exist upon the turnover of port- folio securities by the fund-holding company. The proposal also fails to answer problems inherent in a fund-holding company operation such as the fact that restrictions in its investment policy could easily be avoided by investments in mutual funds with contrary investment policies. The restrictions on redemption and voting suggested in the proposed amend- ment would themselves create new problems and require special comment. The restriction on redemption is a recognition of the danger inherent in the threat of potential redemption which would be available to a fund-holding company. A restriction such as that proposed-maximum assured redemption of 1 per cent of a portfolio fund's outstanding securities during any 30-day period- would appear to protect a registered mutual fund ~yhose securities are owned by a fund-holding company from this threat. At the same time, however, it would expose the investors in the registered fund-holding company to undue risk. Assuming, for example, a registered fund-holding company with its assets fully invested in 3 per cent of the outstanding stock of several registered mutual funds, if each of those portfolio funds are obligated to redeem only 1 per cent of their outstanding securities within any 30-day period, only 1/~ of the total assets of the registered fund-holding company would be liquid and available within a period of no more than 30 days, to meet the redemption needs of it~ own investorS. The proposed restriction with respect to voting rights is also unsatisfactory. The restriction contemplates two alternatives-the registered fund-holding coal- PAGENO="0326" 740 pany would either seek instructions from its own securities holders or vote its portfolio holdings in the same proportion as all other stockholders of portfolio funds vote. The first alternative-involving a pass-through-is not desirable be- cause of the expense and impracticality of repeated proxy solicitations by the fund-holding company. Each time a portfolio fund would solicit its stockholders, the fund-holding company would be required to do the same. A vote in the same proportion, on the other hand, would mean that investors in the fund-holding company would be deprived of an opportunity to exercise their own individual judgment on matters of importance to the stockholders of the mutual funds whose securities are held in the portfolio of the fund-holding company. Mr. Moss. Mr. Keith~ Mr. Keith. I wonder if we could have Mr. Cohen back to develop this matter ~ If there are to be no further public discussions with him, I have had a chance to look over institutional activity for the week of October 24-28, 1966, by the stock exchange, and I wonder if we shouldn't give Mr. Cohen a chance to comment on what further reflections he may have made with reference to the need for some action by this Committee and the Congress in this field. Mr. Moss. I would, before having you respond, I think it would be very helpful, I would like to ask unanimous consent to include in the record at this point a speech by Commissioner Hugh F. Owens be- fore the Mississippi Valley group of the Investment Bankers Asso- ciation of America, of Hot Springs, Ark., October, 1967. Without objection that will be included at this point in the record. (The speech referred to follows:) A REGULATOR'S LOOK AT QUICK PROFIT FEvEE-SOME DISQUIETING REACTIONS (Address by Hugh F. Owens, Commissioner, Securities and Exchange Commis~ sion, Washington, D.C., before Mississippi Valley Group, Investment Bankers Association of America, Hot Springs, Ark., October 20, 1967) In 1961, the high level of investor interest In new stock issues led Keith runston, who was the President of the New York Stock Exchange, to observe that "some would~be investors are attempting to purchase shares of companies whose names they cannot identify, whose products are unknown to them, and whose future is at best highly uncertain." Both before and since the hot issue market of 1961, there have been investors who have pursued what has been called the "bigger fool" theory of investing. There comes a time, of course, when the latest fool places his sell order only to find that buyers are unwilling to take `the stock off his hands at anything ap- proaching the price he recently paid for It. We have little sympathy for the speculator caught in the shakeout. We are concerned, however, for the unwary who are victimized by those who persuade them that the securities markets are a place to make a quick buck. There are some disturbing signs that we may be on the threshold of another hot Issue market. While it has been said that history does not repeat Itself, there is once again some evidence that issuers whose names end in the syllables "-tronics" or "-sonics," and other sounds which seem to suggest waves of the future, are being grabbed up by the public at substantial premiums over their offering prices. In a recent Instance, a registration statement which became effec- tive on September 5, 1967 contained an Income Statement showing that for the six-month period ending May 31, 1967, the issuer had earnings for the first time In its history. Within 10 days of the effective date of the registration statement, the underwriter and issuer decided to withdraw the offering, cancel all transac- tions, and bring to the Commission's attention facts that had not previously been disclosed-that the company had operated at a loss in June and July of 1967. By the time this action was taken, the entire offering had been sold out at the offering price of $22.50 per share and active trading was in progress at prh~es up to $49.00 per share. As a result of the concellation, no securities were delivered and no transactions were consummated. PAGENO="0327" 741 This case primarily illustrates the adverse consequence that can result from the failure to amend a registration statement in a timely fashion. But it also is an example of the extent to which the public, when prone to speculate, will disre- gard the considered judgment of both the issued and underwriter as to the approx- . imate worth of the securities. These matters are all too reminiscent of the experience of six years ago. They suggest that perhaps the only thing we learn from history is that nobody learns anything from history. This audience, however, need not be reminded that the aftermath of hot issue markets can be disastrous for those in the investment banking business as well as for investors. In most cases, severe losses were sustained by those who invested in and, as of May 8, 1962, still held those hot issues. Following the: May 1962 market break, the over-the-counter market went into doldrums from which it is only now-some five years later-beginning to emerge. And in that aftermath, the market for common stock ummderwritings also suffered for a long time. I am confident that time investment banking community will Put its best foot forward in attempting not to encourage another major hot issues market with its inevi- table aftermath. I should make clear that, absent fraudulent and manipulative practices, specu- lation in the securities markets has never been viewed as unethical or oppro- brious. In enacting the Securities Act of 1933 and the Exchange Act of 1934, the Co:ugress recognized, however, that excessiv~e speculation accompanied by considerable price gyrations can be detrimental to the national interest. The Exchange Act established certain controls over securities speculation. In Section 7 it vested in the Board of Governors of the Federal Reserve System power to regulate the amount of credit that may be initially extended on any security registered on a national securities exchange. By adjusting the mnount of bank credit available for securities transactions, the `Fed" can attempt to moderate the tempo of price fluctuations in securities markets. Moreover, the Commis- sion is authorized by Section 10(a) of the Exchange Act to prohibit or limit short sales of securities or the use of stop-loss orders. By all counts, these governmental powers and other regulatory authority contained in the Federal securities laws have been used judiciously to maintain public confidence in the securities markets. Our aim over the years has been to exercise the minimum amount of regulation of the securities markets consistent with the public interest and the interest of investors. Speculation in the securities markets has long attracted the attention of the Securities and Exchange Commission. Until recently, our activities in this respect have primarily been directed toward uncovering situations in which fraud and manipulation are present or in which the absence of adequate information would provide the take-off point for such activity. Most recently, however, we have viewed with great concern certain new development.s in the securities markets. One of t:hese developments is short-term trading by a number of professional in- vestment managers. Illustratively, financial institutions effected $11.4 billion of common stock purchases and sales in the second quarter of 1967, a new record. This compares with a quarterly rate of $8.1 billion in 1966 and only $3.1 billion in 1962. In our Report of Public Policy Implications of Investment Company Growth we called attention to the following facts. I will not belabor you with more statistics, hut in sum the facts are these: 1. The percentage of all corporate stock held in institutional portfolios has risen at a rapid rate. 2. Among institutions, increases in the stoekho]dings of investment companies and, most recently, of non-insured pension funds have been striking. 3. Institutions and institutional intermediaries account for a much larger pro- portion o~ trading volume in securities than their holdings alone would indicate. 4. Public individuals' share of trading volume has been declining while the institutions' share has been rising. 5. Mutual funds have, by far, the highest portfolio turnover rates of all institu- tional investors. The latest data indicate that mutual funds as a group are turning over their assets at an annual rate of 35%. Some, including large funds, have a far higher turnover rate. Mutual funds also tend to engage in larger size transactions than other institutional investors and account for a large por~ tion of secondary distributions and other types of block distributions of securities. Our Report noted further that despite the fact that the a ssets of mutual funds *have grown at a rapid rate in recent years, many of the large funds which have PAGENO="0328" 742 shared in this growth have reduced the number of different stocks in their port- folios. This concentration increases the power of a few fund managers to affect by their investment decisions the market in particular securities. Further, as the irregular and relatively infrequent transactions of institutions `in sizable blocks of securities become increasingly significant and the relative importance of individuals' 100- and 200-share orders declines, the auction markets find it increasingly difficult `to maintain the high liquidity, depth and continuity which they traditionally have sought to achieve. Correspondingly, particular issues which mutual funds trade become more su'sce~tible to sharp, sudden and erratic price fluctuations. The growth of the funds and other institutions has resulted in substituting the investment decisions of a few professional managers regarding large blocks of securities for the decisions of large numbers of individual investors. Individuals' investment decisions tend `to be heterogeneous since there are wide differences in their knowledge of pertinent information, ability `to analyze the facts a't hand, and in their personal motivations to buy or sell at any particular time. Their buy and sell orders at `any one `time tend to be in rough balance and their im- balances generally can be handled by the market activity of professionals- specialists and others. Price fluctuations from order-to-order tend `to be very close to the previous price. Professional managers, however, tend to have the same pertinent information and similar ability to analyze it. Accordingly, their investment decisions tend to be homogeneous. A fund `manager that is determined to sell a large block quickly may not he able to find institutional purchasers willing to buy the block at something close to the last price. If the block cannot be sold near that price to the public through a secondary distribti±ion, the chances are that the stock's price will decline sharply. This in turn may cause:other fund managers `to dispose of or lighten their holdings of the stock, causing the s~iock's price to plummet downward. Here are some examples. Case 1.-On a single day in the Fall of 1966, well over 500,000 shares of the stock of one of the so-called glamour stocks were traded on the New York Stock Exchange. Trading in the issue opened a't `the high for the day and then skidded 16%, closing that day down 19~/~ points. Now what did the funds have `to do with that? Mutual funds bought 1,500 shares (about 1/4 of 1% of the day's trading) of that company during that day. But mutual funds sold nearly a quarter of a million shares (43.5% of the day's trading volume on that day. Among `these sales `by `the funds were one block of 25,000 shares sold at 1151/4, another block of 32,000 shares sold at 114, and a third block of 137,000 shares sold at 109%. Case 2.-In the Summer of 1966, another of the glamour stocks declined 8% or 17% points in `two days. During that two-day decline, mutual funds sold over 130,000 shares of this company, approximately 44.7% of the `two-day trading volume in the issue. True, some fund's bought `the stock as its price was skidding. But `those fund purchases amounted in the `aggregate to only about 50,000 shares, just about 37% of `the massive volume of fund selling. Case 3.-During seven trading days in `the Fall of 1966, another common stock declined 32% points from 1511/2 to 119 so that the market value of the stock fell by more than 20% iii little more than a week. During `this decline aggregate mutual fund sales of about 70,000 `shares accounted for 45.15% of the `total trading volume. Mutual funds did some buying during `this period. They bought 3,000 shares, just about 4% of the number of shares that `they had sold. While these examples are not commonplace, they are no longer unusual. More could be cited. During `the first two decades following the enactment of the Investment Coin- pany Act of 1fl40, investment by the funds for long-term appreciation of capital and income was the name of the game. In recent years, however, many rela- tively new funds' have pursued investment policies which favor rapid turnover of portfolio securities in the light of short-term market movements. Some of these funds have been successful in a considerable number of their longer-established competitors-but by no means all of them-has placed increased emphasis' on taking short-term profits and losses. The reverse side of this short-term trading activity occurs when fund man- agers decide a stock is a good buy at or about its current price. So they begin to accumulate the stock. This does not mean `they purposely act in concert; but as noted, thOir behavior patterns often tend to be homogeneous and show a strik- ing degree of similarity. As some funds buy this stock-and often the process of PAGENO="0329" 743 accumulation is slower than that of liquidation-the price of the stock rises on heavy volume. Strong tape action may atract many individual investors and, when the funds stop buying and their purchases are disclosed and publicized, still other investors will buy, reasoning that fund managers' judgement is supe- rior. By this time the fund managers may decide that the stock has no more potential for near-term appreciation and that other stocks are more promising. They sell. If other institutions agree that the stock is overpriced, the funds may dump the stock or a substantial part of it. Now the stock's price may be down to where it was when the funds began to accumulate it. But many individuals will have bought the stock and have losses because of the short-term trading activi- ties of the funds. The fund managers, moreover, may again repeat the process in the same stock or different stocks. Whether or not such increased trading activity by the funds is properly labeled "speculative," the impact of their increased emphasis on short-term movements has had, as previously noted, and may increasingly have an unsettling impact on the continuity, liquidity and orderliness of the markets in particular stocks. Since some medium-size and a few large funds are engaging in this type of trad- ing, and since they may hold a substantial portion of the floating supply of even the popular and widely held securities, the market impact of this type of trading can be even greater than that of the clearly speculative activities of a small number of unregistered hedge funds and of a few registered funds, whose assets are relatively small, whose disclosed investment methods emphasize speculation. Hedge funds generally are partnerships of affluent persons which (i) claim an exemption from registration under Section 3(c) (1) of the Investment Com- pany Act based upon the contention that they have no more than 100 securities holders and make no public offerings of their securities, and (ii) use speculative devices such as buying securities on margin, using put and call options, utilizing debt obligations, and short selling. Numerous reports have been published in the news media of the concern of many in the securities industry, including leaders of its investment company sector, and of others about the impact of short-term trading and speculative activities by certain institutions and, particularly, by investment companies.. Some, including the American Institute of Management and Chairman William McChesney Mai~tin, Jr., of the Board of Governors of the Federal Reserve System, have compared such activities and the effects of such activities to the pool operations of the 1920s. Mr. Martin in a recent speech found "disquieting" the trend of certain mutual fund apd other institutional managers to measure their success in ternis of relatively short-term market performance. He stated: "Given the large buying power of their institutions, there is an obvious risk that speculative in-and-out trading of this type may virtually corner the market in individual stocks. And in any event, activity of this kind tends to create undesirably volatile price fluctuations." Mr. Martin concluded: "The specific responsibilities of the securities industry to those who use its market place may be covered rather well by what used to be called the pursuit of long-run, enlightened self-interest. Customers * * * must not suffer as a result of inside trading or massive institutional speculation * * ~`. It is the responsibility of the Exchanges and other market organizations to have proper `rules and requirements and to' see that these standards are scrupulously observed." If I seem to have zeroed in on investment company managers, let me assure you that we are aware of quickened interest of other institutional managers in the profits to' be realized from short-term trading. The new wrinkle is that today's speculation and short-term trading is being done by professionals-the managers of the so-called "Go-Go" funds and of other institutions. The manager of one of the newer' "Go-Go" funds has explained this approach by stating that investment managers are much more technically oriented and that news moves faster. "What used to take two or three years to happen can now take place in a matter of months * * `~. [M]arket develop~ ments have become so tremendously compressed in time * * `~. The values are the same, but the realization of them is much more rapid. This is a much higher risk game than it was two years ago and there is a greater premium on being right." 1 To me, this appears to mean that such professional managers are most A. Theodore Lyman, Jr., Senior Vice President of Putnam Management Company, the adviser to Putnam Equities Fund, quoted in Financial World, September 27, 1967, p. 25. PAGENO="0330" 744 concerned with trends, not basic values. And I, for one, find it difficult to dis- tinguish this from speculation. Many of you have been aware of the facts and the problems that I have just related. I am sure, therefore, that your question is what, if anything, has the S.FIC. been doing on this front? The answer falls into two categories. First, to protect those who invest in mutual funds that engage in short-term trading, the Commission staff has reviewed fund prospectuses. The purpose of this review has been to assure ourselves that those who invest their savings in such funds will have adequate information toward the end that they will not unwittingly risk their money in speculative endeavors. Secondly, toward the end of helping maintain the general investing public's confidence in the securities markets, we have initiated a fact~gathering program. We must know in greater detail than we now do of the nature, extent and impact of short-term trading activities by institutions. We have sought and received the cooperation of the Investment Company Institute in obtaining on a monthly basis information showing a breakdown of most of their members' assets by type and the total value of portfolio securities purchased and sold by each member fund. We have proposed the adoption of a~new reporting Form N-1Q for registered management investment companies which would make available on a calendar quarter basis information on the gross transactions of such companies in individual portfolio securities: and on their securities holdings at the end of each quarter. Among other matters, we are studying the frequency, nature and impact of mutual funds' trading reversals, i.e., buying and selling or selling and then buying, in individual securities within 20 days:. We also are studying the~ activities of the hedge funds to learn of the type and volatility of securities. they trade and the relative short interest of hedge funds in those securities. The studies made thus far demonstrate the complexity of questions presented by the growing role of institutions in the markets and by the increased emphasis some of them are placing on short-term trading. Our studies emphasize the need for still more detailed information in these and other areas if we are to obtain reliable answers to questions of market impact. There is a need for data which will provide, on a regular basis, a current and continuing picture of the participation of institutions In the markets. This type of information is indispensable if we are to evaluate the adequacy~ of exchange markets and other markets for such trading, and if we are to be informed of the effects of such institutional market activity on noninstitutional shareholders and on portfolio company managements. Without such knowledge, it will be difficult for us to know whether changes are necessary in exchange- rules and in Institutional disclosure requirements or whether legislation in this area is needed. In addition to information from the exchanges, the Investment Company Institute and the Association of Closed-End Investment Companies, the Cons. mission has been receiving some help in data gathering by institutions over which we do not have regulatory jurisdiction. Among these are the managers of 70 per cent of the total assets of non-insured pension funds, of 82 per cent of the total assets of life Insurance companies, and of 60 per cent of the total assets of property and casualty insurance companies. Analysis of the impact on the markets of institutional trading generally,. and in particular short-term institutional trading, will require continuing and additional information from securities industry associations and institutional managers. I believe that these institutions will respond to Chairman William McOhesney Martin's call for enlightened self-interest. I am hopeful that they will use their resources to supplement those of the Commission, and other governmental bodies that have an interest in these problems, in the compilation, analysis and evaluation of the information necessary to: a better understanding of the impact of the changing nature of institutional trading activity in the securities markets. Mr. MOSS. Now would you respond to: Mr. Keith? Mr. CoilnN. I understand that my letter to you, Mr. Chairman, and the letter to Chairman Staggers, in which you raised these issues some time back, are in the record, and I won't try to repeat all of that. PAGENO="0331" 745 We are continuing our studies, our investigations We ar~ con- cerned, and one of our sister agencies has recently taken some actiona in this general area I think the question, if I heard it correctly, was as to the general desirability of initiating a study I think it would be desirable to have a study, to collect and collate the various bits of information I should say that we do have considerable information, but we don't have as much information as we would like to have Even more important perhaps than such a study, which should be a thorough one, I think it is desirable to establish as best we can a con- tinutng flow of information, because the institutionalization of the market is continuing apace, and in my opinion will continue at a great pace So that the idea oif a study is a good one, if only it would make clear that the Commission has authority to seek information from all types of institutional investors, and to provide for a continuing flow of information. I should say on a more mundane note that our staff is not so situated as to be able to conduct such a study, and a suggestion that there be a study I hope would be coupled with a very strong suggestion to, and an acceptance by, the Appropriations Committee of the need for addi- tional resources In the meantime, I should point out that we are not waiting for that, that we have been exploring within the Government-and I have been having conversations with mdustry leaders outside the Government- ways and means of perhaps coordmating our several resources to this end, but the idea of a study, and the idea of directing the Commission to conduct one in my opinion would be a desirable one, provided we were able to carry it out and to continue the flow of information on a regul ir and continuing basis Mr Moss And you are now in the process of preparing an estimate of what your requirements are? Mr COHEN I have already made those inquiries and, subject only to a more careful review of the figures, I can give you the tentative figures as I have them now We estimate that over a 2 year period we would need something be- tween three quarters of a million dollars and $1 million Perhaps we could do it with a little less, particularly if we got a good deal of co- operation from outside organizations. On r continuing basis we have estimated that it would cost between $200,000 and a quarter of a million dollars a year to have the staff to gather, to collate and to study, digest and produce the necessary infor matron for the benefit not only of the Commission but of the entire industry and all the persons concerned I should say that this is not a matter of concern solely to the Corn mission This is a matter of concern to anyone interested in our economy, and particularly in our capital markets There is an interest in this in other departments and agencies of the Government, in the self regulatory institutions and in the very institutional investors themselves There are also other problems that go beyond mere market impact that would necessarily be involved in any such study Mr. Moss. Mr. Keith. Mr KEITH I would like to have you comment if you would by way of building the record to support the suggestion that you have just PAGENO="0332" 746 made. On this institutional activity in the New York Stock Exchange report, they show the average number of blocks per month, blocks being 10,000 shares or more. You are certainly familiar with this document. Mr. COHEN. I have seen it; yes, sir. Mr. KEITH. They show, for example, that in 1965 there were a total of 181 block per month. In 1966 there were 304 blocks per month. In 1967, the first quarter, 462 block per month as an average. That is a 50-percent increase over the previous year in blocks per month and it is three times what it was in 1965. Do you have any comment to make? Mr. COHEN. Yes. Mr. KEITH. What has happened in successive quarters? Is that still accelerating? Mr. C0ITEN. So far as I know that is still accelerating, and I should say that other activities are accelerating. I don't want to use this as a sounding board for my problems, but let me give you some indication of the situation with repect to new issues and trading volume. Since July 1, the beginning of our fiscal year, we have received I think almost twice as many registration statements as we did in the corresponding period last year, and the volume of trading on the exchanges has been at an average level of around 10 million shares a day, and there doesn't seem to be any sign that this is going to let up. My own feeling is that it will increase. Now I would like to tie this together, and as you have invited me, to make a record. There is an aspect of the testimony given, particularly by the IBA, that I thought particularly interesting, and I hope you will indulge me a minute or two. They `talk about people's capitalism and about the necessity for liqiuidity of the markets and a few other things. They said liquidity meant having more shareholders, and there is an increasing number of shareholders all the time. Yet they insist on providing these great rewards to sellers who might otherwise invite their customers to buy listed securities, over-the-counter securities, thus increasing the liquid- ity, but because of these great rewards, these salesmen keep putting people into institutional investment media, and these institutions are growing at a great rate. Now apart from the inconsistency of it, you can understand why I think these institutions will continue to grow, even if the Congress adopts every jot and tittle of our recommendations. There is another argument they made in this field of sales charges which I think is terribly interesting and which is related to this point. They say that there are many small- and medium-sized firms that make local markets, that engage in distribution of small issues, that sell over- the-counter securities, and if you cut the sales charges for mutual funds, they will go out of business. First, I don't believe it. If, however, it is true, consider what it means. It means that they are levying a heavy charge on the unsophisticated investor, by their own admission, in order to subsidize these other areas. Now maybe they are not making enough in the other areas, but that is no way to make up for it, by charging the unsophisticated in- vestor with a high sales load. That is what they say. "If we don't get this high sales load, we are out of business." That is a very, very unusual position to take before this committee. PAGENO="0333" 747 Mr. KEITH. This study goes on to point out that commercial banks are the largest net buyers. My question here is, and I got an answer yes- terday and I just want to be reassured by you, that when a commercial bank buys, generally speaking, is it for the accounts for which they are trustee or is it occasionally the investment of a reserve or surplus? Mr. COHEN. I would think generally speaking it is for the account of others, pension funds that they manage, for the account of commin- gled funds that they have created, common trust funds, or trusts in which they act as trustee, either solely or jointly. In addition there may be some other activities of the banks in this area. Now this is one of the reasons why I answered your question by suggesting that a study would he helpful, because we would be able to improve our knowledge in this area. We would be able to improve our continuing understanding of the changing patterns that are going on in this field. Mr. Loomis would like to add a word. Mr. LooMIs. It is my understanding that the banking laws generally prevent commercial banks from dealing in ordinary corporate securi- ties for their own account. They have to be acting here for others. Mr. KEITH. One last question if I may, Mr. Chairman. It points out where we talk about the number of block trades per month, the total volume from the New York Stock Exchange is re- assuring in that it is only 5.5 percent. My question is how broad a market do we really have when you think of the things that have triggered stock market recessions in years past. It may be to a large extent caused by a large movement in a narrow market. Mr. COHEN. Well, there are a number of answers to that question, some of which I don't have. But let me try a few which may be personal reactions. First of all, if we are speaking about mutual funds, and this is not necessarily true of pension funds, because of the redeemability fea- ture, they want to be in a position to be as liquid as possible as quickly as possible, and it is required by law, except as there may be an emergency. This has generally limited the mutual funds to the largest companies with the largest number of shares outstanding. Now if the company is large enough, for example, American Tele- phone & Telegraph, then perhaps the effect of an institution, or more than one institution, purchasing and selling the security may have a little effect on it. But if it is a smaller, albeit a large company, but a smaller one, and where the floating supply may be more limited, it seems to me quite reasonable to conclude that the activities of the funds may have a very, very important effect on the market action of that security, and we have sufficient information to support that as a matter of fact. Indeed the speech which Chairman Moss introduced in the record refers to three cases, without identifying the companies, which per- haps illustrate the point that I have just made. Those three cases are just three of the cases which are part of our continuing study of this whole area, to which I referred in my letter to Chairman Moss in August, but you have made a point which I think is very significant. These block sales have been increasing. As I indicated earlier, when I appeared here last, these are transactions effected off the exchange. PAGENO="0334" 748 They are brought to the exchange and crossed on the tape This is not the usual auction market with great depth and liquidity If the market itself could absorb them, they would go on the market instead of being arranged outside But while the New York Stock Ex change has devised a number of procedures to deal with this problem, and I understand Mr Jllaack said that at the moment it is fairly well under control, while Mr Day, I understand perhaps suggested other- wise, I don't know, but I am convinced that this is a growing phenomenon The pension funds are still growing, and the mutual funds are grow ing, and they will continue to grow, and the insurance companies are getting into this activity in a very big way, and the banks propose to get into this activity in a very big way So it is inevitable that this problem will increase in size, and it would be very happy and very fortuitious and consistent with the traditions of this committee to initiate a study now before things are out of hand Mr Moss Thank you, Mr Cohen, The bells have rung for the mem bers to answer a quorum on the floor So with regret I have to now dis- continue these hearings You will receive written questions, and your prompt attention to them will be appreciated Thank you for your appearance Your statement, as submitted, will be included in the record of these hearings The committee will now stand adjourned Mr COHEN Thank you and the other members of the subcommittee (The following letter was received by the committee ) SEcuiiITIEs AND EXCHANGE COMMISSION Washington D C November 7 1967 Hon HASTINGS KEITH House of Representatwes Washington D C DEAR Mn Knirn I am pleased to enclose the Commission s replies to the 12 questions which you submitted to us under cover of your letter of October 27 If there is any further information you desire in connection with this legisla tion please do not hesitate to call on me Sincerely MANUEL F COHEN Chairman Enclosures 1 In the over 50 stockholder suits referred to at p 132 of the S E 0 Report, Public Policy Implications of Investment Company Growth a How many fund shares were owned by each of the individual plaintiffs initiating the litigation? Neither the individual complaints nor the reported court opinions in the stockholder suits attacking mutual fund advisory fees as excessive indicates with one exception how many fund shares were owned by the individual plain tiffs instituting the litigation Therefore, we do not have this information with respect to each of the shareholder suits The one exception is the litigation in volving the management fees paid by Axe Houghton Fund B The court s opinion approving the settlement indicates that the plaintiff in that suit held 607 shares of the fund on March 21 1962 the date suit was instituted See Kerner v Cross man 211 F 2d 397 b What was the value of each such plaintiff s shares on the day suit was brought? The per share net asset value of one share of Axe Houghton B was $916 on March 23 1962 The 607 shares held by the plaintiff in the Kerner case were there fore valued at $555912 on that date Since we do not know how many fund shares were owned by the individual plaintiffs in the other suits we cannot compute for each suit the value of their shares on the day suit was brought PAGENO="0335" 749 c. What would the maximum dollar recovery to each such individual plaintiff have been in each such suit? Neither the complaints nor reported opinions in the individual cases indicated the maximum dollar amount of the recovery sought by the plaintiffs and we are unable to estimate the maximum potential recovery. In Kerner v. Grossman, the courts finally approved a settlement of the lawsuit which resulted in estimated savings to the fund of $291,462 per year based on the fund's size in 1962. We esti- mate that this resulted in savings of $8.73 per year for the 607 shares held by the ptaintiff in that case. In our view, the reasonableness of advisory fees cannot be justified in terms of the cost per shareholder. Our recommendations that mutual fund advisory fees be governed by a standard of reasonableness reflects our basic view that these managers of mutual funds, having created the funds and sold their shares with all the trappings and attractions of "mutual savings institutions", must be held to the same standards of fiduciary duty and self-restraint required of the managers of other types of "mutual savings institutions." Indeed, even in the ordinary corporate situation, the fairness of executive salaries or self-dealing contracts such as involved in advisory fees are not measured in terms of cost per shareholder. When the director of a manufacturing firm causes his com- pany to deal with the supplier in which he has a financial interest and the sup- plier overcharges the manufacturing company, the business community does not attem:pt to justify the transaction on the ground that it costs only a few cents extra per shareholder. We know of no reason why self-dealing transactions such as involved in mutual fund advisory fees should be judged on a different basis. 2. Please list all the stockholder suits challenging mutual fund management fees which have been commenced in the past ten years and give the date each suit was initiated and its present status. Attached hereto are tables listing separately all the shareholder suits chal- lenging mutual fund managewent fees, which to our knowledge, have been com- menced in the past 10 years. Table I lists the suits initiated prior to the pub- lication of the Commission's Report. In many cases several complaints were' flied attacking advisory fees of a single fund as excessive. Since Table I does not list the names of duplicate suits, the list consist of 22 cases rather than the 50 suits which actually were brought. Table II lists the shareholder suits which have been brought after publication of the Commission's Report on December 2, 1966. Unlike the suits instituted prior to publication of the Commission's Report, the later suits are concerned mainly with questions of portfolio execution and brokerage allocation, rather than the advisory fees. However, since the reasonableness of advisory fees have been placed into issue by the allegations of the complaints, the names of these cases a:re furnished in answer to your inquiry. TABLE L--SHAREIIOLDER SUITS INVOLVING MUTUAL FUND ADVISORY FEES INSTITUTED PRIOR TO PUBLICATION OF COMMISSION REPORT Fund involved Name of suit Date brought Disposition 1. Affiliated Fund, Inc Kellmer v. Prankard Aug. 26, 1960_.~_ Settled. 2. Axe-Houghton Fund A SaXe v. Axe April 1960 Do. 3. Axe-Houghton Fund B Kerner v. Grossman Mar. 21 9061 Do. 4. Capital Shares, Inc Nadel v. Curtin March 1963 Do. 5. Chemical Fund, Inc Mieselman v. Eberstadt 1960 Do. 6. Diversilied Growth Stock Fund Greene v. Sheperd February 1963.~_ Do. 7. Dividend Shares, Inc Brown v. Bullock Aug. 5, 1960 Do. 8. Dreyfus Fund Adler v. Dreyfus Dec. 31, 1963 Do. 9. Fidelity Capita Fund, Inc~ Levitt v. Johnson August 1963 Do. 10. Fidelity Fund, Inc Lefkof v. Johnson July 10, 1961 Do. 11. Financial Industrial Fund, Inc Acampora v; Birkiand February, 196L__ Do. 12. Fundamental Investors, Inc Saxe v. Brady Jan. 29, 1960 Do. 13. Group Securities Kirman, v. Anderson April 1963 Do. 14. Investors Mutual, Inc Ackert v. Ausman July 28, 1960 Do. 15 Investors Stock Fund, Inc Glicken v. Bradford Mar. 31, 1961___ Do. 16 . Keystone Custodian Funds Saminsky v. Abbott August 1960 Do. 17. Lazard Fund, Inc. (The) Saminsky v. Hettinger Aug. 1, 1960 Do. 18. National Securities Series Chabot v. Empire Trust Co July 1960 Do. 19. One William Street Fund, Inc Rosenfeld v. Richardson July 1960~. Do. 20. Television Electronics Fund, Inc Simonson v. Cooley Feb. 6, 1962 Do. 21. United Funds, Inc Ruskay v. Reed Aug. 1960 - Do. 22. Wellington Fund, Inc Rome v. Archer July 12, 1960 Do. PAGENO="0336" 750 TABLE Il-SHAREHOLDER SUITS INVOLVING MUTUAL FUND ADVISORY FEES INSTITUTED SINCE PUBLICATION OF COMMISSION REPORT Fund involved Name of suit Date brought Disposition 1. Manhattan Fund, Inc 2. Oreyfus Fund, Inc 3. Keystone Custodian Funds, Series S-3 4. American Investors Fund 5. United Funds, Inc White et al. v. Auerbach et aL.. Schlusselbergv.Weissmanetal Schlusselberg v. lnyestors Over- seas Services Ltd. et al. Fogel, et al. v. óhestnutt, et aL liorenstein v. Waddell and Reed, Inc. Jan. 10, 1967 do do Jan. 6, 1967 Oct. 26, 1967 Pending. Do. Do. Do. Do. 6. Fidelity Capital Fund, Inc 7. Affiliated Fund White v. Johnson White v. Driscoll Jan. 10, 1967 Jan. 19, 1967 Do. Do. 3. Why are the expenses of interiiially managed funds apparently lower than those of externally managed funds? Internally managed funds are operated by their own officers and employees who, like most corporate executives, are compensated directly by their company through salaries and other readily disclosed forms of remuneration. For this reason, the management costs of the internally managed funds are subject to the restraints imposed by disclosure and conventional limitations on executive salaries that govern executive compensation in most areas of the economy. These restraints are not present in the case of externally managed mutual funds, which usually pay for most management services by means of a fee based on a percent of the fund's assets, rather than by salaries and other common forms of executive remuneration. Appraisal by shareholders or directors of the fairness of these fees is far more complex than the appraisal of the reasonableness of the compensation paid to individual executives. Even in the case of internally managed investment companies, the restraints of disclosure of and conventional limitations on executive salaries may have been weakened by the pattern of fees paid by externally managed companies. For example, the five trustee-directors of Massachusetts Investors Trust and Massachusetts Investors Growth Fund, Inc., received combined compensation in 1966 for their personal services to the funds in the amount of $2.2 million, an average of $450,000 per year for each of the five managers. Although this com- pensation is quite handsome by any standard, one of the two funds, MIT, has the lowest management expense ratio of any fund in the industry. As noted in the Commission's Report, a national magazine has reported that in 1951 when the funds managed by the MIT trustee-directors were much smaller and their compensation much less than today, the MIT trustees voluntarily imposed a limitation on their own salaries, because: "They decided that they were, or soon might be, making an embarrassingly good living from the trust." In 1952 this limitation was dropped and the compensation of the MI~P trustees has since increased in amounts that are closely proportionate to the growth of the funds under their management. The shareholders of Massachusetts Investors Trust, however, have been able to enjoy some of the economies available from the growth of their fund because management and other operating costs except those relating to trustee's compensation have not risen proportionately to the growth of the fund. MIT's management cost ratio in 1966 amounted to .12 percent of average net assets. In contrast, the shareholders of externally-managed funds in many cases, have not received a fair share of the economies of size available from the growth of their funds. Over one-half of the externally-managed funds with assets of $100 million or more in 1966 paid advisory fees amounting to .48 percent or more of average net assets. 4. Section 22(d) of the Ir&vestnvent Company Act of 1940 precludes price com- petition between two salesmen selling the same fund. It does not preclude price competition between these salesmen and the salesmen of another fund which may have a lower load or no load. How can this e~uisting competition be made more effective? Given the present requirement for retail price maintenance in Section 22(d), we know of no way of significantly enhancing the effectiveness of price competi- tion between funds. As your question recognizes, most mutual fund transactions are initiated by salesmen. Accordingly, the only mutual fund prospectuses that the ordinary PAGENO="0337" 751 investor ever gets to see are those that the salesman wants him to see. The ordinary small investor does not know of no load funds and consequently does not ask for such information. Indeed, he tends to rely on the recommendations of the salesman who he presumes is knowledgeable about the available alterna- tives. And it is quite natural for the salesman to want to sell that which is most remunerative for him. If the salesman works for an integrated distributor that sells directly to the consumer through a so-called "captive sales force"-and a great many mutual fund salesmen work on this basis-he has only one group of funds to sell. All of the salesmen sell the shares of those funds at the same sales load. We know of no instance where a distributor which operates a "captive sales force" has attempted to obtain a competitive advantage by reducing its sales load to less than 8 percent. A distributor which reduced its sales load substantially might well be at a substantial disadvantage in competing for salesmen with those distributors which had a higher sales load and could therefore offer a higher rate of commission to the salesman. Indeed, in recent years, the largest captive sales organization raised its sales load from 7.5 to 8 percent. In the case of funds distributed by independent broker-dealers, the customer again will generally see only those prospectuses that the salesman wants him to see. It is true that there are scores-indeed, hundreds-~of funds that an inde- pendent broker-dealer can sell. But the ones that he actually does sell are likely to be the ones that he finds most remunerative. Unless his firm is sponsoring a no-load fund, which would be unusual, he is not likely to show a no-load fund prospectus. He would receive either no compensation for doing so or remunera- tion substantially less than the normal commission for selling load fund shares. Nor is he likely to direct his customer's attention to closed-end investment com- panies, which offer the very same type of diversification and the very same type of professional management that mutual funds do. When a salesman sells a closed-end security, he earns only a normal stock exchange commission. He earns a great deal more than that commission when he sells load fund shares. Hence the only investment companies that most broker-dealers and their sales- men are likely to discuss are load funds. As noted below, in answer to Question 5, there are virtually no low load funds generaly available to the public. And since the general range of sales loads is between 7.5 and 8.5 percent, salesmen are unlikely to stress this small difference because of the likelihood of stimulating the customer to consider no-load funds or closed-end companies. The salesman feels no obligation to the customer, in choosing among comparable investment companies, to recommend the one which carries the lowest sales charge. 5. The committee has heard conflicting testimopy whether a lower load will cause higher or lower sales of fund shares. What is the sales structure and experience of the seven funds which presently have sales charges ranging from 3 to 55%? How does the sales structure and experience of these funds compare with the sales structure and experience of funds charging an 8.5% load?. In our judgment, the sales experience of a low-load fund is of questionable relevance in determining whether a reduction in the generally prevailing level of sales loads will cause higher or lower sales of fund shares. Under present day conditions, large numbers of mutual funds available to dealers offer two or three times the de_aler discount that a low-load fund can offer. It, therefore, cannot be expected that low-load funds would be aggressively sold. Moreover, as Indi- cated in the mateials below, the low-load funds referred to in the question largely represent special situations. For this additional reason, their sales experience is not particularly helpful in attempting to answer the question presented. Of the seven registered funds, listed below, whose reported sales charges in 1966 would come within the range of 3 to 51/2%, the first has now raised.its charge to 71/2%, the second is available only to insurance companies, the third is avail- able only to members of a teachers association, and the fourth is a high-grade bond fund which does not invest in equity securities. Thus, of the seven, there are only three fund's in this sales load range which would be' generally comparable to the standard load funds. Two of the remaining three funds are sold to the public directly by the distributor and have net assets of about $1 million and $7 million, respectively; the remaining fund has $62 million in assets and its shares are available through securities dealers, but only about 16 per cent of its shares are publicly held' 85-592-68-pt. 2-22 PAGENO="0338" 752 A. SUMMARY OF THE SALES STRUCTURE AND EXPERiENCE OF THE FUNDS INDICATED TO HAVE SALES CHARGES RANGING FROM 3 TO 5.5 PERCENT Name of fund Percent maximum sales charge Fiscal yearend net assets 1. Equity Fund 2. Insurors Mutual Fund 3. Teachers Association Mutual Fund of California 4. Keystone, B-i Fund 5. Hampden Fund 6. Horace Mann Fund 7. lstel Fund 1 7. 5 3.0 4. 0 4. 15 4.0 4.0 3.0 $39, 115, 822 (2) 5, 034, 517 9, 341, 858 1, 128,249 6,786,248 62,062,313 On Nov. 30 1966 United Pacific Corp., the parent of Pacific Northwest Co. merged with Van Waters & Rogers, Inc. As a result, United Pacific Corp. the principal underwriter became the wholly owned subsidiary of VWR United Corp. The sales load on shares of this fund was raised from 3 percent in 1966 to the present rate of 7.5 percent. 2 Shares are not distributed to the general public. Shares are made available solely for the common investment of surplus funds and reserves held by certain town mutual instfrance companies located in the State of Wisconsin. 1. EQUITY FUND Sales are now made through dealers under sales agreements allowing up to 6% dealers concession depending upon the amount invested. The fund is a diversified, open-end company whose objective is "to seek growth of capital and income." Shares are available to the general public. SALES EXPERiENCE 1966 1965 1964 Proceeds from sale of new shares Redemptions as a percent of new shares issued $5, 713, 104 29. 6 $6,436, 470 23. 2 $5, 655, 971 22. 1 2. INSURORS MUTUAL FUND While this company is categorized as a mutual fund, it is not in the same category as the normal mutual fund. The shares of this company are available solely for the common investment of surplus funds and reserves held by certain town mutual insurance companies located in the State of Wisconsin. The town mutuals are insurance companies organized pursuant to Wisconsin law during the period from 1860-1927 in order to provide fire insurance coverage to persons within a limited rural vicinity. Thus, while IMF is a registered investment company, its shares are not available to the general public. 8. TEACHERS ASSOCIATION MUTUAL FUND OF CALIFORNIA Sales of the fund shares are made directly by the principal underwriter. No sales are made through other brokers or dealers. The fund is an open-end, diversi- fled investment company whose objectives are "long-term growth of capital and increasing income for the future." Shares of the fund are offered exclusively to members and employees of the California Teachers Association and their families rather than to the general public. The principal underwriter of the fund is the wholly-owned subsidiary of the California Teachers Association-Southern Section. SALES EXPERIENCE 1966 1965 1964 Proceeds from sale of new shares $908, 407 $678, 904 $566, 175 Redemptions as a percent of new shares issued 26. 3 45. 0 58. 9 PAGENO="0339" 753 4. KEYSTONE CUSTODIAN FUND, SERIES B-i Sales of shares of the fund are made through dealers who receive concessions ranging to 3%. This fund is one of nine separate funds in the Keystone group which encompasses combined assets of more than $1 billion The Keystone Series B-i Fund is an open end diversified company whose primary objective is to se curi' the relative price stability of the High Grade Bond Class with as liberal yield as can be obtained `Shares of this fund are made available to the general public SALES EXPERIENCE 1966 1965 1964 Procec ds from sale of new shares $24 849 454 $13 644 134 1 $885 279 Redemptions as a percent of new shares issued 95. 1 79. 2 93.3 ill-month period. 5. HAMPDEN FUND Sales of fund shares are made directly by the distributor. There is no arrange- ment for dealers discount. The fund is an open-end, diversified company whose objective is "to provide long-term growth income and principal." Shares are avail- able to the general public. SALES EXPERIENCE 1966 1966 1965 1964 Proceeds from sale of new shares $83, 614 $88, 681 $260, 909 Redemptions as a percent of new shares issued 108. 3 84. 0 35. 7 6. HORACE MANN FUND Sales of shares are made directly upon application to the underwriter who retains the entire sales load. The fund is a diversified, open-end company whose objective is "capital growth and appreciation." Shares are available to the general public through salesmen employed by the principal underwriter. SALES EXPERIENCE 1966 1965 1964 Proceeds from sale of new shares $1, 106,245 $1,279,707 $875,724 Redemptions as a percent of new shares issued 38. 3 31.9 49.4 7. I5TEL FUND (TOTAL NUMBER OF SIIABEHOfLDERS-820) Shares are sold both directly by the principal underwriter and through dealers. On sales through dealers, the principal underwriter reallows the entire amount of sales load to the dealer. The fund is an open-end, diversified company whose objective is "to maintain a carefuiry selected and diversified investment port- folio which includes Securities chosen for stability and their prospect of apprecia- tion." Shares are available to the general public; however, most of fund's stock is owned by a small group in the following percentages: Percent Officers and Directors 3. 3 ~luracao Securities Corp 01. 1 Savings corp., N.V 7.2 de Neuflize, Schlurnberger, Mallet & Cie 12.2 Total 83.8 PAGENO="0340" 754 SALES EXPERIENCE 1966 1965 1964 Proceeds from sale of new shares 1 Redemptions as a percent of new shares issued 2 $7, 490,785 23. 2 $3, 432, 052 30.6 $8, 401, 165 21. 4 1 The group indicated above has maintained approximately the same percentage of ownership throughout this period. Thus, it can be assumed that a substantial portion of the proceeds from the sale of new shares came from this group rather than from sales to the general public. 2 On Dec. 7, 1966, the fund acquired the assets of Pallas Corp. in exchange for 1,157,653 shares of Istel. Not included in this figure is the $20,000,028 representing this acquisition. B. MUTUAL FUND INDUSTRY IN GENERAL The standard load funds are sold in one of two ways-either through dealer agreements which allow a dealer concession of a substantial portion of the sales charge or through the "captive" sales force. Sales Ea~perience (Source: Invest- ment Company Institute) 1966 1965 1964 Total net assets $34, 829, 400, 000 $35, 220,200,000 $29, 116, 300, 000 Proceeds from sale of new shares $6, 422, 100, 000 $5, 196,600, 000 $4, 016,200, 000 Redemptions as percent of new shares issued 31. 2 37. 8 46. 7 6. Would a relaxation of "tombstone ad" requirements for mutual funds help to reach prospective purchasers at less expense than is presently incurred? If mutual fund advertisements were only required to emphasize a few factors, such as management and sales expenses, would that result in more effective competition in the area emphasized? The Securities Act of 1933 generally provides that advertisements for se- curities which are the subject of a registration statement filed with the Commis- sion under that Act other than summary or full prospectuses, must be limited to identifying material with respect to the securities being offered. These restrictions apply to all securities subject to registration under the Securities Act and not only mutual fund shares. They reflect the Congressional determination that public offerings of securities should be made primarily through prospectuses con- taining adequate information material to informed investment decisions and not through advertisements. In 1954 Congress again considered this question with particular reference to advertising of mutual funds and amended the Securities Act to give Commis- sion rule-making power to permit some variation in the advertising restrictions of the Act for different types of securities. This amendment, however, was not intended to permit the Commission to adopt rules which go beyond the basic restriction of the Act against the sales of registered securities through advertise- ments which do not contain the basic information necessary to informed invest- ment decisions. Nevertheless, the Commission, through adoption of Rule 134 in 1955 and subsequent interpretations has considerably liberalized restrictions on advertising. In recent years mutual funds have made greater use of advertis- ing media in the sale of their shares. The question of whether relaxation of tombstone advertisement require~ merits wouid enable mutual funds to reach investors more economiOally involves the question of whether such relaxation would result in a change in the existing competitive practice of the industry-substituting to some extent price competi- tion for the favor of investors instead of the existing competition for the favor of dealers through sales compensation. Given the existing structure and sales methods of the industry, we doubt if a mere relaxation of requirements with respect to tombstone ads would bring about such a fundamental change in com- petitive practices. This is particularly true if one assumes that the restrictions on retail price competition imposed by Section 22(d) of the Investment Company Act would remain in effect. At present there are certain funds which advertise quite extensively even within the existing limitations. Indeed, some funds use radio advertisements exten- sively while other funds have had their prospectuses printed as a supplement to PAGENO="0341" 755 the Sunday edition of the Hew York Times and widely distributed. We have ob- served no correlation between the extent of advertising by various load funds and the sales load charged. Those which advertise widely in general have no lower sales loads than those which do not. This affords some support for the conclusions we have expressed. The second part of the question is whether more emphasis in mutual fun~ advertisements on sales charges and management costs would result in more effective competition in the areas emphasized. We assume that this question does not refer to the prospectus where these matters are already required to be given considerable emphasis. The present tombstone rule permits the sales charge to be stated and no-load funds usually emphasize in their tombstone advertise- ments that there is no sales charge. Management expenses are presently not permitted to be included in such advertisements. This could be changed, but as we have pointed out in prior testimony and in the answers to other questions, meaningful disclosure with respect to management compensation for externally managed mutual funds presents complex and difficult problems and we doubt if this could effectively be done within the confines of a radio, television, or newspaper ad. While the Commission has authority to modify the requirements concerning the tombstone ads, in exercising this authority we feel obligated to bear in mind the fact that in enacting the Securities Act of 1933 Congress did not intend tombstone advertisements to serve the function of sales literature as distinct from identifying securities proposed to be offered. We believe it was contemplated that the prospectus and literature supplementing the prospectus, rather than tombstone ads, would be utilized as sales literature. 7. `What should therole of the S.E.C. be in any self-regulatory pattern of sales charge limitation? The Commission should have adequate and effective oversight powers over the actions of self-regulatory organizations. The NASD, is responding to Senator Sparkman's suggestion that self-regulatory organizations might assume a re- sponsibility over sales load, stated in its letter of June 16, 1967, that it would prefer to substitute Commission oversight of this kind provided in Section 15A. (k) (2) of the Securities Exchange Act for the more extensive direct Commis- siori rule-making power in this area now provided for in Section 22(c) of the investment Company Act. The NASD's suggestion was as fOllows: Section 22(c) of the 1940 Act now provides for SEC authority as to sales loads, which authority, if exercised, would supersede any previously exercised A~sociation authority. We believe that duplicate authority should be eliminated in this area and that commission oversight can be accomplished, as in the ease as to other Association rules, by an appropriate amendment to Section 15A (k) (2) of the 1934 Act. We believe the Section 15A(k) (2) oversight as suggested by the NASD would be adequate for the protection of investors. The Commission has had similar oversight powers since 1934 over stock ex- change commission rates pursuant to Section 19(b) of the Securities Exchange Act. In his testimony before the Senate Committee, Mr. Keith Funston, then president of the New York Stock Exchange, suggested that a 19(b) type procedure might be utilized in connection with NASD supervision of maximum sales loads and suggested that this procedure "seems to be working in our area." The subject of self-regulation and the nature and function of Commission oversight was considered in some detail in Chapter IV of the Report of the Special Study of Securities Markets, particularly pages 693 through 728. The essential conclusions are stated on page 723 as follows: Although governmental oversight of self-regulation is essential, the workability of self-regulation depends also on restraint in the Commission's exercise of its reserve power. The relationship between the Commission and ~the self-regulatory organizations has at times been referred to as a "partnership" or "cooperative regulation." Under either expression the roles of the Commission and the self- regulatory agencies are essentially complementary, and the self-regulatory agen- cies must enjoy such autonomy as will enable them to act as responsible, dynamic partners in a cooperative enterprise. It is in this spirit that we would endeavor to work with the NASD in the area of determining maximum sales loads for mutual funds. It has been our consistent policy in matters of this type not simply to substitute our judgment for that of the self-regulatory bodies but to attempt to resolve any differences of view in a mu- tually satisfactory result. In the administration of Section 19(b), dealing with stock exchange commission rates, the Commission has only once in past 33 years PAGENO="0342" 756 found it necessary to hold a formal proceeding and to require the Exchange to modify one of its requirements. 8. A specific objection to the front-end load is that people hove been forced to redeem in the early years of their plan at a loss to pay unavoidable hardship cc,- penses arising from illness, unemployment, or death. What percentage of plan- holders ha've been forced to liquidate for hardship reasons? How many of these hove liquidated at a loss? What is the aggregate loss sustained by such persons in a typical twelve month period? It might be observed at the outset that the Commission has not basically ob- jected to the front-end load on the grounds stated in the "specific objections." Our chief objection is that at the time on investor purchases a front-end load plan certificate, he cannot know what his financial future will be nor whether through the next ten years he will be willing to invest in the same mutual fund. Changes in financial condition result- (i) not only from death, but also from the birth of additional children; (ii) not only from unemployment, but also from tho failure of an employed or self-employed person's income to keep pace with increases in the cost of living; (iii) not only from illness, but also from an unexpectant need for a healthy investor to support aging relatives who are healthy yet unable to provide for themselves; (iv) not only because of hardship expenses, but also because of unforesee- able expenses in providing for the well-being of his family; and (v) not only because he has unavoidable expenses, but because he be- lieves it would be morally undesirable to avoid them. Similarly, when the investor begins his contractual plan he cannot know whether the fund's performance in future years will be such that he will wish to~ continue to purchase its shares, or that his investment objectives will remain the same as the fund's. Other mutual fund investors can and do decide to invest new money in different mutual funds. The 101 Shareholder Survey indicates that over half of mutual fund lump sum purchases own shares of two or more mutual funds. But the front-end load penalizes the contractual plan investor to a uniquely heavy extent if he decides to make his future investments in another fund. The disclosures and the 30- or 60-day refund privilege, which for many years have been offered him at the time of his purchase, have no bearing on these future contingencies. It might also be observed that the front-end load does not merely penalize those who redeem at a loss in the early years of the plan. It penalizes all who' fail to complete their payments, including the many who lapse but do not redeem their certificates. Our answers to the specific questions asked follow: (a) What percentage of planholders hove been forced to liquidate for hardship reasons? We have two sources of information. One is the survey conducted for the Special Study by the Securities Research Unit of the Wharton School of Finance and Commerce of the University of Pennsylvania. Part of that survey was con- cerned with those who redeemed contractual plans. Eighty-six percent stated that they redeemed their certificate to use the profits for a specific purpose. The specific purposes stated by such persons were as follows: payment of medical or hospital bills (9%) ; payment of other types of debt (34%) ; purchase of durable consumer goods such as automobiles, furniture, etc. (9%); vacation (2%); education expenses (7%); other household or personal expenditures (19%); purchase of home (9%); investment in a business (5%); purchase of shares in another mutual fund (5%); purchase of common stock other than fund shares (3%) ; purchase of other types of securities (8%); open or increase savings accounts (7%); and, some other purpose (3%) .~ The above responses indicate that those who redeemed did so for a great variety of reasons. Among those who did so to pay debts, medical or hospital bills ac- counted for 9%, but payment of other types of debt accounted for a far larger' percentage. The other known source of information is a survey conducted on behalf of the Association of Mutual Fund `Plan Sponsors which was referred to in `the testi- ~ of Special Stuay of Securities Markets, House Doe. No. 95, Pt, 4, 88th Cong., 1st Sess., p. 872. The figures add up to more than 100% because some respondents oaerecl more than one specific reason. PAGENO="0343" 757 mony before the Subcommittee of Mr. John H. Khs'tmayer. The questionnaire consisted of two questions, as follows: 1. When you liquidated a mutual fund investment plan in 19~, did you do so because you chose to put this money to some other use, or because circumstances required you to raise cash? { ,] Chose to { ]`Oircumutances required 2. Did you have `any other financial resources which you could have used instead of liquidating your investment plan? Yes, `had other resources [ J No, did NOT have other resources Among the respondents, 55% said that `circumstances required them to redeem. Of these, 45% said they had no other resources. Th'e fact that the remaining 10% had other resources `does not mean, as the plan sponsors' suggest, that `as a practi- cal matter these investors did not have to redeem. When required by circum- stances to raise cash, a person who has only a small amount of emergency funds may properly feel that he cannot liquidate them in order to maintain his con- tractual plan investment whic'h is `subject t'o the risks of the market. Similarly, many `of the 44% who stated `that t'hey "chose" to redeem may have inferred from the wording of the question that they had `had a real choice in determining whether to liquidate their emergency funds or to redeem their certificate. We doubt that even the plan sponsors believe th'at that is `a realistic choice. Yet their questionnaire did not take this factor into consideration. Thus it appears th'at a large majority of those who redeem uncompleted con- tractual plans at a loss are forced to do so' by reason of changed financial circumstances. (b) How ma'iw o'f these have liquidated at a loss? `Other sta'tistics `of the plan sponsors indic'ate that 17% (or about one out of six) `of their investors ~redeem uncompleted contractual plans at a loss. This is an average. Investors in some contractual plans fare better than others because of differences in their fund's performance. As pointed out in the Commission's Report, 33% of the investors in one contractual pl'an redeemed at a loss a's did 25% of th'e invest'ors in another contractual plan. `Most of those investors would have' a `profit if the normal sales load rather than the front-end load were de- ducted from their payments. `It is highly significant th'at the questi'onnaire was put to tho'se ~tho redeemed a plan starting anywh'ere from several `months t'o over five years after their initial purchase. Yet the Plan Sponsors Association has offered a hardship refund limited to a period `o'f only one year `after the purchase of `a contractual plan. (`c) What is the aggregate loss sustained by such persons in a typical twelve- month period? The `Commission `does not have the necessary data to ans'wer this question. 9. How can prospective purchasers of mutual fund plans be made effectively aware of the ecoistence of level load voluntary plans so that they can compare the relative merits of contractual abid voluntary plans? The prospectüses of most contractual plans already indicate on their front page that the investor may invest in the underlying mutual fund shares on a lump sum or a level-load plan basis at normal rather than front-end load sales charges. However, given the great disparity which exists between the immediate compensa- tion a salesman can earn from selling a contractual rather than a voluntary plan, it would be difficult to assume that his oral sales presentation would refer to the level-load voluntary plan, or, if it did, that such oral presentations would result in a fair comparison of the relative merits of contractual and voluntary plans in the same fund. Given the six times greater sales compensation from the first year's payments for the sale of a contractual plan, there Is much doubt as to whether prospective purchasers can be made effectively aware of the exist- ence of level-load plans and of their relative merits. This is not to suggest th'at disclosures in the prospectus could not be improved. However, we do not believe that improved prospectus disclosure will be adequate to meet the problem. 10. What is the median loss sustained by contractual planholders who liquidate at a loss? What would the median ecoperience of this group have been if they had invested in voluntary plans? We do not have data showing the median loss. However, statistics of the plan sponsors showing the 10- and 12-year experience of investors in four contractual plans indicates that the average loss was about $67 per account among those which were redeemed up to 10 or 12 years after being opened and before com- pletion of 36 payments. PAGENO="0344" 758 Nor do we know what would have been the median experience of this grouj~ of investors in four plans if they had instead invested in voluntary plans. How- ever, an indication of the impact of the front-end load on investor profits and losses is available for one of these four contractual plans. It is presented in Chart E on page 96 of the* October 10, 1967 Statement of the Securities and Ex- change Commission before the Subcommittee on Securities of the House Com- mittee on Interstate and Foreign Commerce on HR. 9510 and 9511. Chart E compares profits or losses at the end of each year between 1955 and 1964 on investments made in a particular balanced fund through both the contractual and voluntary plan. Assuming investments of $100 per month, at the end of the first year, the voluntary plan would have been worth $8 less than the $1,200 paid in, but the contractual plan would have been worth $565 less than the $1,200 paid in. At the end of the fourth year of systematic monthly payments, the profit on the voluntary plan would. have been $748, but the profit on the contractual plan would have been $169. (The differences likely would have been greater had the experience of a growth fund rather than a balanced fund been considered.) In the typical situation, at the end of the first twelve payments, a contractual plan investor has about 47% less invested than does a voluntary plan investor. His profits will be proportionately less than those of the voluntary plan investor. If he redeems at a loss, it too will be substantially greater for the contractual plan investor than for the voluntary plan investor. And the contractual plan investor who has as many as 24 payments will have about 23% less invested than under a voluntary plan. After having made 36 payments, at which point his effective sales load is about 19%, he will have about 14% less invested than under a voluntary plan. During the three years there will have been, on the average, more than a 14% difference between the amount invested under the contractual as opposed to the voluntary plan. 11. What changes in the proposed legislation may be necessary to accommodate and encourage no-load funds? In our judgment, no changes in the proposed legislation are necessary to accommodate and encourage no-load funds. Aside from proposals with respect to sales charges which do not apply to the no-load funds, we do not believe that the legislative proposals affect no-load funds in a manner differently from load funds or would be burdensome to the no-load funds. Mr. Ronald T. Lyman, Jr., spokesman for the no-load funds, testified before the Subcommittee to the effect that the legislation would place a particular burden upon the disinterested director of a no-load fund in those instances where, as permitted by law, a no-load fund has only one such director. We do not believe that this is necessarily the case. The legislation would require the investment adviser to supply to all of the directors information with respect to the reasonableness of the investment advisory compensation and it would be the duty of all of the directors to consider and evaluate this information. This responsibility is not imposed solely on the disinterested director. We think that such a requirement of consideration and evaluation is implicit in the requirement of existing law that all the directors, including the disinterested director or directors, must approve the investment advisory contract. At the hearings industry witnesses and others differed in their views as to the seriousness with which the directors have in the past viewed this responsibility, but we believe all agreed that such a responsibility does exist and the furnishing of information would assist the directors in discharging that responsibiilty as well as directing their attention to the matter. It also seemed to be generally agreed at the hearings that investment ad- visory fees should be reasonable. While the evaluation of the fee in the case of a no-load fund may involve somewhat different factors than are present in the case of a load fund, we would see no basis for exempting no-load funds from any requirement that fees be reasonable. 12. What has the experience of NYSE Monthly Investment Plan investors 1 been in the following areas: As of March 31, 1967, there were 217,263 MIP accounts In force through New York Stock Exchange member firms. Of these, 187,000 are handled through Merrill Lynch, Pierce, Penner & Smith, Inc. (Merrill Lynch). About one half are individual regular MIP accounts and the rest are payroll deduction plans. The latter are not pertinent to the present dis- cussion since the individual purchaser (employee) does not pay any commission; the employer pays a lump sum commission. The above discussion pertains only to the handling of individual MIP accounts. The Commission has not made an independent study of MIP. All of the information has been provided either by Merrill Lynch or the New York Stock Exchange. PAGENO="0345" 759 _~J a. How many have liquidated at a loss? To our knowledge neither the Exchange, the odd-lot firms, nor the Commis- sion houses have any data which could show how many MIP's have been liquidated at a loss. In fact, on termination not all accounts are liquidated- some customers ask for possession of their certificates so there is no way of telling when or at what price they eventually sell them. b. What is the lapse ratio on M.I.P.? Inasmuch as the Monthly Investment Plan is for no stated fixed term, it is not wholly appropriate to speak of them as ~lapsing." In this framework, we are advised that the life span of the average MIP is about 3 years. Mer- rill Lynch's experienceS has been that over this three year period an aver- age of about one year's payments are made, but the average payment is about twice the amount of the minimum installment called for by the plans. Thus the average MIP investor pays in an amount equivalent to the mini- mum periodic installments for the first two years of his plan. At the time of termination only about 1/~ of the investors ask that their MIP accounts be liquidated-the rest either ask to have their certificates sent to them, leave the account dormant or go into another security. This is one of the reasons why it is difficult to determine if a customer has sustained a loss at the termi- nation of the plan. c. What is the average percentage sales charge paid by M.I.P. Investors? The Exchange and Merrill Lynch estimate that the "sales charge" paid by the average MIP investor is approximately 8%, considering his cost in and out and taking into account the odd-lot differential. The maximum commission charge is 6% of money invested for transactions of $100 or less. Since the average payment is a little over $100, the commission is slightly under 6% At termination the average account has a value of $1500 and the commission upon liquidation is $20 or 1.3 percent. The remainder consists of the odd-lot differential. d. What sales material and other disclosures does the purchaser receive? The investor receives a booklet called "Investing on a Budget" which includes an order blank, together with any financial or research reports he asks for. e. How is the suitability of the investment for the investor determined? The suitability of the security selected by the customer is determined for the most part on the basis of the same factors used in determining suitability for other customers. The Exchange's rule on "Know your customer" is equally relevant for MIP accounts. Overall, the MIP is intended to appeal to the long range investor who has only limited funds available for investment and seeks the advantages of dollar-cost-averaging. An indication of the type of securities chosen is reflected by the 10 most popular securities in MIP accounts as of mid-May, 1967: 1. American Tel & Tel 2. General Motors 3. Radio Corp of America 4. General Tel & Electronics Corp. 5. Int'l Business Machines Corp. 6. Sears, Roebuck 7. General Electric Co. 8. Eastman Kodak Co. 9. Tn-Continental Corp., (a closed-end investment company) 10. Standard Oil of New Jersey More than 50% of the total MIP accounts are in these securities. f. What advice and service does the purchaser receive? The primary advantage provided by the Monthly Investment Plan is the opportunity to purchase fractional shares of stocks on a budget, and the option of having his dividends automatically reinvested. The MIP customer is given the same general advice and service that is given to regular customers of the broker/dealer. For instance, the member firm holds his securities without charging a custodial fee. In addition, MIP customers of Merrill Lynch receive at least three times a year a publication called Market Hight'ights which gives a concise summary of general economic trends together with a succinct report concerning the customer's security among others. This service is available only to MI]? customers of Merrill Lynch. PAGENO="0346" 760 (The following letter and material was received by the committee:) SECURITm5 AND EXCHANGE COMMISSION, Washington, D.C., November 6, 1967. flon. JOHN E. Moss, *~Chairman, Subcommittee on Commerce and Finance, Committee on Interstate and Foreign Commerce, House of Representatives, Washington, D.C. DEAR Mn. Moss: Enclosed are the responses to your requests of October 26, 1967. They include: 1. A table showing net assets, total expenses and advisory fees, and fee rates and expense ratios for all active mutual funds which had reported a full year's * ~operations on June 30, 1967; 2. A table showing the basic management fee rate, and each level at which that rate is reduced, for mutual funds registered with the Commission; 3. The Commission's June 30, 194E~7 index of active registered investment ad- visers, principal underwriters, sponsors and underlying companies (may be found in committee's files) 4. A table showing the income, expenses and profits of 13 publicly held advisory organizations; 5. A table showing the sales loads, and breakpoints for quantity purchases, of mutual fund shares; 6. Two tables showing sales and redemptions of mutual fund shares by size of fund for the sixteen months ended September 30, 1967. With respect to item 3, I would like to point out that additional data for earlier years may be found in tables 111-8 and 111-9, at pages 122 and 124 of our Report. These tables are limited to organizations which are required to publish reports under the 1934 Act because they are publicly held. Attempts by the Commission to obtain such data on a regular basis from other advisory organiza- tions have been opposed by the industry. The tables referred to in item 6 show that of 158 funds reporting data, 110 were in a net sales status for the 16 months ended September 30, 1967. Of the 48 that were in a net redemption status, 12 were not offering shares, and 28 of the remaining 36 had average net assets of under $100 million during this period. The 36 funds offering ~hares that were in a net redemption status accounted for a total of $165 million in net outflow, with about 27 percent of that figure eoming from one large fund. The 110 funds in a net sales status had about $4 billion in net sales, with over $3 billion coming from the 65 funds in which sales were more than double redemptions. I hope we have been responsive to your requests. Sincerely, Enclosure. ITEM 1 MANUEL P. COHEN, Chairman. 1. Investors Mutual, Inc 2. United Funds, Inc 3. Massachusetts Investors Trust 4. Wellington Fund, Inc 5. Investors Stock Fund, inc 6. Dreyfus Fund inc 7. Affiliated Fund, inc 8. Fundamental Investors, Inc 9. insurance Securities Trust Fund, as sponsored by insurance Securities, Inc 10. Fidelity Trend Fund, Inc 11. Massachusetts Investors Growth Stock Fund, Inc. 12. National Securities Series 13. Fidelity Fund, Inc 14. Investors Variable Payment Fund, Inc 15. Investment Co. of America 16. National investors Corp 17. Television-Electronics Fund, Inc 18. Hamilton Funds, Inc 19. Puritan Fund, Inc 20. Fidelity Capital Fund, Inc 21. Chemical Fund, Inc $2, 660,836. 5 $9, 743.9 $9, 743.9 0.34 0.34 2,433,744.6 9,047.7 8,529.4 .39 .38 1,967,048.8 3,933.6 2 749.0 .19 .14 1,849,140. 1 7,286.7 4,838.2 .38 .26 1,692,047.6 6,337. 1 6,337.1 .36 .36 1,634,845.5 8,870.0 7,497.7 .59 .50 1,227,065. 2 4,160. 1 3,027.8 . 33 - 24 1,086,646.2 5,752.2 4,717.9 .51 .42 1,083,099.6 6,345. 5 6,345. 5 . 58 . 58 983, 109.6 4,780.6 3,814. 1 . 54 .43 890,853.5 3,137.1 1,778.1 .35 .20 757,636.3 4,492.2 3,213.4 .78 .56 605,037.0 3,079. 3 2,444.8 . 50 .40 576,215.2 1,673.5 1,673.5 .34 .34 561,591.4 2,809.6 1,846.5 .52 .34 554, 563.7 1,035.9 528. 0 . 19 . 10 545,671. 0 2,990. 1 2,097. 5 .62 .43 489,971.7 3,180.1 2,521.3 .66 .50 478,315.8 2,232. 1 1,753.6 .49 .38 425,176.9 2,276.5 1,786.0 .59 .46 411,280.6 1,626.4 1,268.6 .38 .30 Net assets Name of fund as of June 30, 1967 (thousands) Total expenses (thou- sands) Advisory fee (thou- sands) Expense ratios (percent) Advisory fee rate (percent) PAGENO="0347" - ~. C) a: : : : : : $ $$$$$$$ ~ CC) ~9 ~c~z I ~ ~ 4cC0 ~ ~ ~ C~C~00 ~C) Jm~CD tD~ ~CO ~Ø~O) Q~Oi~ -`.~ ~ C~~-J C. ~oo -J ~J~- ~D C~©0) DC C~ 00 CD~ CCC-J N~ 0) COD) Q1~J ~CD~-4 000)000))') a -&`~- ~ :42 ~ 4~ (fl$J)C~ ~C)Th) )`)0) 0)Q$~) 0)CC)$-'0)$- QC'~4 0)-C ~ ~CD ~ ~ $J)$D )J)$~) $~C)0) Co D)~ 0) ~ C) CO ~`J CO~- ~ D)~') )-$~$) ~-~J ~`)CD)') $JCC~ CO ~ 0)~ OCD~J -)0)00)J100$D ~O) CD-'0OC~ C0~4 ~J0) )`~-~C) `4.~ c~ 0)D).~ c,)al COD) ~ (n C)1CD r').~ COW ~W 0) W D~ 00)O~D WOO Q0)~CD )`) C~1N 0)0)N.)C0 - CJ1W0)D)$-~ 0)COW 00-' ~flWC00~ 0000$\00) 0) 0)VW CJW 0)0) 0) ~W CD)') .~(0 C) COD) 0)0)00 OO~ c~~W c~ `-J COD)W ~.J~'4 .~cD CflC0~C0- C~ D)0)~o-t~'-J COD) D~CO0)CD D)-.JCO CO WWD)CD 0) `.4w )`)C) W p~O) CD ~ u)aCCD)-~W ~j NDW ~ ~C~JCDt')W C$t~~.4 ~C~D) - o ~.OC CD 3 - .. .~ PAGENO="0348" -n C) 0) C) -~ C~ 00(00)0000 0)~-) C~)Q) (00)- 0)0O(~ C00 (C) (0r0(0 ~)0)00 ~ (-C C-) (0 000000(0 ~ 00 00 ~J 00000000 ~4C) ~4 -3 -J (C1~ ~ (-COO N) (-)C~C (-C 00(J) ~0) (C) N) ~ N) CC)0000(0 ~ 00 *-4 ~ 00 (-COO N) N) 0) 0)000)00 C) 0 - - 0~ PAGENO="0349" C, B PAGENO="0350" 3 ~: ~: I ~C)C~C~C~ J00000000(OcO ~ C~3c~ ~-~-~J~a ~OC' 4c~OC N~ c~o ~(~Ø(~ C~)t~CJ1C~%JO)CO O)(~C.~~ U~OO ~~a~-J ~ ~ ~ Jc~cji~~ c~c~icoa -.~r~c ~, C., ~ ~o~c'- ~ r.~c~N' --o~ ~,, - PAGENO="0351" 765 0)C~J 00C) N- C) N- C)C) C) C) ~ - C) 00 N) U) U) ~C) N) 0) ~ C) C) ~U)C) C) :00U)00N~N-00a~~N) ~C)N-00~U)~N) N- - N) C) C) N- U)U) C) C) O)N- C) C) U) U) U) C) 0000 C) C) C) C) 0) ~ ~ 00 C)U)U) N-N-U)U) U) ~ N-N-0)C)N)U)~U)C)N)N-~N)N-N- ~ :~; ~ N-~ 2 c~C)~2 N- C) C) C) C) C)C) C) C) C) C) C) C) C) C) C) C) ~U) C) C) C) U) C) U)C) C) C) C) C) C) C) CDC) C) C) C) C) C) C) C) U) C) C) U) C) C) U) C) CD U) C) N-C) U) U) N- C) N-U) C)U) C) C) .-U) U)U) C) U) U) U) N-U) U) N-U) U) ~ U) - N-U, N)U)N- N- ~-~-CN-U) N- U) ~ U) N)N- N- N- 2 2 2 N) 2 2 ~ U) is C) C)C) C) CD C)C) C) U) C) C) U) C) C) U) 00 ~N2~) N- U) N-N-N-~ ~N-i.000~tN)N)~ C) N- N- N- N) N) N)~ ~U)U) ~ U) COC) C) C) C)C) U) U) C) C) C)U)U) U)U) U) C)U)U)C) C)C) C) C) C) C) C) C) C) C) C) C) U) C) C) C) C) C) C)C) C)U) C) C) C)C)C) C) C) C)C) C) C) U) C) C) 5 C) C) U) U) ~ C) ~ C) N- C) ~ C) U) U)U) U) C) N-C) C) C) C)U) 0)C) C)C) C) N- N- C) C) N- N- C)N-N-N-N-C)U) C) ~~U)C) U) N- N- 0)N- N) N)U) C)U) C) N- 0)U) U)U) U) ; I: ~ ;~p;~ ~ ~ ~ ~ ~o., ~ ~- ~2 ~-` E C) p PAGENO="0352" 766 :~ ~ :~ ~` ~ ~roo~~ ø,~ cao-..-~--ø ~ (0 ~ 0~ H::: ~ 9a)a~ ~ ~ ~:: :::::: a, ,~ C..) aa - a a, a) ~ ~ ~ :g~ : ~ : :~ ~ I :~`~"~ I I : Q ~ (0~ ~ ~ ~ :~ ~` ~ ~ "` `~` ~ ~ ~- ~ .. ~ ~ ~ ~ ~, ~, a,- * **-: ~ U. ) a)) PAGENO="0353" 767 ~ ~ ;~ ~ 00 C~ ~ 0'4 (~) ~ 0) ~ c~) LO) C)) ))4 SC) (~) (~) :~~g ~ :~ ~ ~ ~))4C)4C'4 ~ 4C)4~4C)4C'4C~4C)~~-)C)) ``~C'J~ C))00 000)050) s0)sC)c))c'40450) cC)00~ (N (N ON (N ON ON (NON (N ```~`~55 C%J(N SC) ~ COO COC) 00000 5''((~ COO CO ) CO ~D C) CO COO 0000)0 C) ~ SC)CO 0 CO SC) SC) C) CO CO CO CO COCO C) CO 5' N- CO CO ON - CO `SC) SC) SC) 50)50)50)50) SO)SC) ``````~ COO 0 SC) CO C) CO CO CO C) ~ ~ ~ ~ ~ :~ :~ :~ ~ :~ :~ :~ ~ ~ ~ ON ON o~ : ~ ~ ~ ~ 0)) 0)50) 50) 50) 0)SC)50) 00)50)50) 00) I ~ ~ ~ ~ ~ ~ ~ ~ (DC) CO 50)50)5)) 50)50) COO CO COO) CO CO CO COO COO C) ~ CO~ CO CO ~ C) CO CO CO 85-592-68-Pt. 2-23 PAGENO="0354" 768 3. ~ U- t~a1~ ~ ~ -~-~ G) ~ ~ E :~!cDc~J ~ - 4, - ~~~WWW `-, ~H'' ~ ~~~HWHH~\W\I C4 ~ ~ ~ PAGENO="0355" O)C~4 `-~OOQ~OO ~ r-. ~a)~ oN.~or-. r-~OO~DOON~ Lt) ~ 769 . a-.. PAGENO="0356" 770 *~ ~ C.) ~ .; c~J r-. ~ C~)CO Lt) r-. - C') CrCoo - r- ~n r-. 0) 0~C 0) .-~r, C')O0 - ~ c' ~ ~ c c ~ 0) (0 C'.~ 0) 00 C'~ ~ (0 (CC E PAGENO="0357" 771, ~ ~ .3 PAGENO="0358" - `-~ : ~ ~ C~4CO~' 8oor~ cY) C~) 772 a, ~ C., ~ Ui 0 .~ . C-)- PAGENO="0359" . *~*~d C~J C~4 N.~ - - - ~ ~ 00 C~JLt~ ~C~4 C'J CO~ U) (~4 C~)L() 773 * : 02 0? 02 PAGENO="0360" E .E ~ Cl) .774 00 - C0~ 00 ~ ~4 Ø~ ~ ~00 ~ ~C) ~ ~C) 00 :~ E PAGENO="0361" C) C) C,) C,) C C,) _n ~ C ~ m -~ -n C,) - >C) -~ 3 PAGENO="0362" = C,, U- 0 C,, 0 C-, z 0 0 - C~ ~ - o 0 o~ ~ o2 ° -_J - 00 ~ Ow C,, ~ C,)< = CO~ ~ =~ E ~- _JUJ CO CO = ~ 00 ~ C,, C~) - 0~ = >- C) ~)LflC Cr)LCCLCCCC CC 000000 000 CC 00 ~O 0000 000CC 00CC Lt) 00000 000CC) CC) Ct)LtCCC)CC) CC) CC) CC) ~ H~~N1 ~C~JC~C%JCC4NICC4 ~88~8 :~~8~88S ~`~" ~ CC) c~co CC) CC)CO)CC.J NJ NJ C~ :~ ~ 776 ~ I C, .00 N. ~ .00 ob 0 ~ ~ a o.~.2 ~- O_ a ~ CC) ~ - C!~~ 00 CC E CC) U) U) CC) c~ o o o cCCCCC 000000 LC)CC) N. CdCdLC~C N. CC)~ ~ LC)CC)U)Ct) CoLt) N. N. NJ U)N.N. N. N. LOU) 0~ CoLt) CC 000000Cc) LC)U)OQ CC) CC) CC) U) CC) U) U) CC) CC) Ct) ~o U) ~)0C) U)U)u~ LOU) CC) ~ U)U)CC)U) U)U)Ct) C)0000N.N.N.CtC N-CO 000000 N.N.0000000000 00000000000000000000 C,, 0 PAGENO="0363" .~ 777 I PAGENO="0364" 778 ITEM 6 TABLE A--FREQUENCY DISTRIBUT1ON OF THE NUMBER OF FUNDS BY SIZE AND SALES/REDEMPTION RATIO (JUNE 1966-SEPTEMBER 1967) [Sales/redemption ratio in percent[ Average net asset size (in millions of dollars) 1 0 Net redem ption status Net sales status Total 0 to 50 50 to 100 100 to 200 200 and over OtolO 3 3 4 7 11 28 lOts 50 6 7 7 10 16 46 50 to 100 3 3 4 6 11 27 lOOto 500 - 0 3 4 14 15 36 500and over 0 0 1 8 12 21 Total 12 16 20 45 65 158 I Funds which had either no sales, or neither sales or redemptions in the 16-month per od. TABLE B-AGGREGATE DOLLAR VALUE (IN THOUSANDS) OF 16 MONTHS' NET SALES, DISTRIBUTED BY SIZE AND SALES/REDEMPTION RATIO (JUNE 1966-SEPTEMBER 1967) [Sales redemption in percenti Average net asset size (in millions of dollars) 1 0 Net redem ption status - Net sale --- 100 to 200 s status --- Total 200 and over 0 to 50 50 to 100 0 to lO 2 (418) (2, 140) (165) 2, 066 33, 369 32, 739 lOtoSO (14,265) (17,265) (9,973) 9,866 206,303 174,561 5Oto 100 (18,298) (16,774) (15,044) 50,916 188,515 189,315 lOOto 500 0 (30,079) (29,096) 110,212 641,983 693,020 500 and over 0 0 (44,539) 806,552 1,948,651 2,710,664 Total (32,981) (66,363) (98, 817) 979,612 - 3, 018, 848 3, 800, 299 1 Funds which had either no sales, or neither sales or redemptions in the 16-month period. 2 Excess of redemptions over sales. (The following material was submitted for the record:) STATEMENT or HAROLD L. BACHE, BACHE & Co., INC., NEW YORK Many, years ago Bache & Co. Incorporated decided that a mutual fund meets the need of many Americans who want to buy common stocks for this purpose but do not have the time `and financial skill to make wise choices among the thousands of available stocks, or the capital required to buy the relative protection of an adequately diversified portfolio. The share of personal savings in this country that has gone into mutual funds over the past decade or two has been influenced by the growing public need for experienced investment help. People with savThgs to invest have had to seek protection against inflation. Historically, common stocks have provided a hedge against inflation, since they represent participation in the growth and develop- ment of the economy. One major fear that exists duty to the severity of the proposed legislation (S. 1~59) is that the number of security dealers able to offer mutual funds may be sharply reduced. In the light of investment success and service to the client, I find it difficult to believe that the need exists for the changes being proposed. A discussion of the most important proposals follows. SALES CHARGES The law of supply and demand in the world of personnel and employment demands that highly qualified people receive commensurate remuneration. Regis- tered representatives, as well trained, intelligent and conscientious individuals, are entitled to make an adequate living in the Securities field. For the most part, Bache & Co. Incorporated receives 80% of the sales commissions involved in the purchase of a mutual fund with the remainder going to .the distributing company PAGENO="0365" 779 Since this 8Q% share, on average commissions, amounts to only 5% of the dollar amount invested, we do not hesitate to state that this figure is economically and morally justified and that the registered representative is fully deserving of his approximate 50% share of this figure. Small orders, involving as little as $100, requiring the same individual handling by Bache & Co. as is given to large orders. constitutes a large percentage of all our mutual fund transactions. These orders involve a substantial amount of time and effort on the part of the registered representatives and service personnel of Bache & Co., in consideration of the commission generated. If these commissions were to be reduced, it would definitely increase the competition that presently exists in the registered representative's business day, necessarily resulting in fewer small mutual fund sales. If sale's charges are excessive as the SEC states, I think our practical experi- ence in our own internal mutual fund sales development program would be quite different. The list of figures `below gives the net yearly commissions earned by the average Bache & Co., Incorporated registered representative from total mutual fund sales for the last five years. Year: Amount 1963 $790 1964 607 `1965 1, 018 1966 1, 253 1967 1, 711 5-year average per registered representative 1, 0Th During this period of time, Bache & Co., Incorporated had an average of about 1,500 registered representatives. If the mutual fund sales of the 25 most success- ful registered representatives were not included, the figures quoted above would dip drastically. These average figures indicate that registered representatives in the Bac'he & Co., Incorporated organization do not share the SEC's contention of the lucrativeness of mutual fund sales. Perhaps the most uninformed argument made against costs is that mutual fund shares involve higher acquisition charges than other types of securities. We feel that there is justification for such higher costs. `Shares in mutual funds are unlike any other security and are `bpught and sold differently. A mutual fund share is a participation in a long-term investment plan. The principal char- acteristics of mutual funds are broad diversification of investments and con- tinuous professional management. Open-end mutual funds provide the only medium through which millions `of investors with limited capital can own shares in diversified portfolios of 50 `to 100 or more carefully selected securities under professional investment management with immediate redeemability of their shares at net asset value. Therefore, you can see why it i's an extreme oversimpli- fication, albeit true, to say it costs eight or nine times as much to invest $4,000 in a mutual fund as to buy 100 shares of a $40 listed stock. Using the same $4,000 investment, if `the investor buys an odd lot or an Over-The~Counter stock, he pays a much higher acquisition cost either in the way of mark ups, or higher sales charges. In addition, he also pays commission for liquidations. The services provided a inutuaf fund shareholder also point `out clearly the difference hetween a mutual fund share and a stock. Holders of individual stocks receive no services other than those supplied by the brokerage house through which he makes his purchase. Mutual fund shareholders, on the other hand, have such services as automatic reinvestment of income and capital gain's distributions, tax information, plans for periodic withdrawals of cash and the built-in con- venienée of handling an `ownership interest in many stocks through one security. The investor has a wide range of choice in the price he pays to acquire mutual fund shares. The sales charge depends upon the schedule of charges of the fund and the size of the purchase. All sales charges do not start a't 8% or 8%%. One of the largest funds charge's 7½% for purchases up to $5,000 and then dips to 6% % for purchases over $5,000, and as is true for most funds, they do not charge a redemption fee. There are very few services or products that can be brought to the public with mark ups as low as these. We think it is important to point out that there are over 50 no-load funds avail- able to the public without any sales c'harge. With such competition, it is inappro- priate to seek lower sales charges for funds where sales charges exist. A study conducted by the NASD in April, 1967, dealing with the impact of the proposed sales charge limitations revealed some startling information. This PAGENO="0366" 780 study concluded that if the proposed sales charge limitations had been in effect in 1966 it would have decreased the profits after taxes of small broker-dealers (gress income under $100,000) by 179%-of those in the $100,000-$200,000 category by 222%-those under $2.5 million sales by 28%-and those over $2.5 million by 20%. As a result, the smallest firms which represent 64% of all broker-dealers would be forced from a profit to a loss position. 1 am sure this is not the SEC's purpose but it could still be the result. MANAGEMENT FEES We believe it is the prerogative of each management company to set the fees it feels are proper for the services being rendered. Notwithstanding the SEC's contentions to the contrary, the mutual fund management business is an ex- tremely competitive one. In the face of this obvious certainty, it would be totally opposed to the American concept of business to have a federal regulation of prices or charges outside of the utility or subsidized industries. The SEC's contention that the mutual fund management groups only compete for the dealer's favor and not for the investor's favor misses an important point. Management groups to try to impress upon dealers the merits of their particular funds in the same way that all service industries try to impress the individual dealers handling their product. However, since the funds do not sell directly to the public, but only through dealers they must maintain a close association with these dealers to keep them informed on charges occurring within the funds. In 1966 the average management tee paid by all mutual funds with assets of $100 million or more (accounting for 80% of the industry's total assets) was 0.37% or $3.70 per $1,000. However, if the investor should so desire, he can select the fund with the lowest management fee. This information is readily available from a variety of publications located in public libraries as well as brokerage offices. However, it is hard to conclude from all the publicity involved in the legislative recommendations that mutual funds with very low management fees are widely available: The underlying reason for the belief that mutual fund management fees are too high is the argument that since most major banks charge management fees in the area of .06 or .07 of 1% to their trust accounts over $100 million in size, mutual funds should therefore do the ~same thing. Unfortunately, this reasoning does not take into consideration the fact that a bank, potentially, has many additional sources of income from each trust in addition to the management fee, while a mutual fund has the management fee as its only source of income. Another item worth noting here is the recent mutual fund started by First National City Bank of New York. It has a minimum investment figure of $10,000 and a 1/2 of 1% management fee. So, you see, not everyone with investment money being managed by a bank is getting this low .06-07 of 1% charge as the SF10 would lead you to believe. CONTRACTUAL PLANS The contractual concept was first pioneered by the life insurance industry and was exceptiOnally successful in achieving mass distribution of a desirable product-life insurance (it is solely because of the front-end sales charge that an insurance salesman can take time to sit down and sell an individual a $10,000 whole life policy; in most cases, 50%-75% of the total first year's pre- mium goes to the salesman, and approximately 7% of the premium for the next 7-10 years reverts to the salesman as commission). Such is also true of the present contractual mutual fund. Cursory examination reveals that a publicly acceptable precedent exists and is the basis of the contractual concept. For anyone not interested in either of these systems, other possibilities exist: The insurance purchaser can buy term insurance or cheaper bank life insurance where the savings element would still be present but with a lower sales charge; the mutual fund buyer can buy a voluntary plan or no-load fund. I strongly suggest that as long as voluntary plans and no-load funds exist and are widely advertised and publicized, the SEC's idea of rising to the protection of the average Investor by complete elimination of contractuals is a disservice that will take its toll by severing all hope of equity invOstment by a majority of the American population. While it may be true that the contractual fund buyer would have been better off to have invested in a voluntary plan for the same period of time, the real PAGENO="0367" 781 question is would he have started his program at all if someone hadn't sat down in his home and convinced him of the merits of the idea? And, if a sales- man takes the tiñie and patience and has the investment knowledge and sales ability to sit down and start a family on a regular fund purchase program, does he not deserve some sort of accelerated financial compensation? I feel it is im- portant to realize that as a rule the contractual plan buyer is not a sophisticated equity investor. Margin, leverage, portfolio turnover rate, etc. are not important to him. Rather, he is interested in educating his children or supplementing his social security payments and benefits from the discipline encouraged under the contractual program. It seems ironical that at a point in time when contractual spending and bor- rowing is urged upon the consumer from all sides that contractual investing should be so severely criticized. Credit card buying, loan agency borrowing and easy term car financing urge the average American to abandon personal economic and financial restraint. This is all considered part of our way of life. Is a contractual plan any more of a disadvantage to a person who discontinues It in the second or third year, thus losing a percentage of his money invested, than is a whole life policy which is discontinued in the second or third year before any cash value has accumulated, or the repossession of an expensive autothobile after the first year? In each case, a product was purchased with long term inten- tions but later disposed of after a short period of time, resulting in a financial loss. It is to be hoped that better selling will hold these eases to a minimum in the future. Since the contractual type program seems to be the only economically feasible way of initiating and servicing small mutual fund accounts, where salesmen visits to the home are required, it is to be hoped that some modification of their first year 50% sales charge-say by spreading this charge over the first three years as one fund is now doing-will be evolved thus resulting in a still better investment vehicle. In closing, I think it is well to mention that for many years l3ache & Co. incor- porated has tried diligently to insure that all mutual funds were properly sold and that all mutual fund liquidations were held to a minimum. Each liquidation requires a questionnaire to be completed by the registered representative involved to insure that such course of action was decided upon by the investor after care- ful consideration and not solicited by our representative. BACHE & Co., INC., New York, November 2, 1967. Congressman HAsTINGS KISITH, House Office Buiiding, Washingtoii, D.C. DEAR CONGRESSMAN Kniru: Thank you for your letter ofOctober 20 in response to my views on the proposed mutual fund legislation. The matter of no4oad funds is a very misunderstood one. As you well know, the management companies sponsoring no-load funds do so for profit. The only difference between load and no-load funds is the manner of distribution; i.e., the former through salesmen (requiring commission), the latter directly from the sponsor. Bache & Co. Incorporated does not have sales agreements with the sponsors of no-load funds. Let me emphasize at this point that this does not mean we question their integrity or investment acumen. It is just an economic fact of life that we cannoit handle a product in which there is no chance of a possible commission or profit. If a customer asked one of our R.R.s about investing in no-load funds, our salesman would attempt to interest the customer in an appropriate load fund if he felt the customer should be investing in funds in the first place. Failing in this, he would probably supply the customer with the address of one or more no-load funds with information to the effect that these funds can only be purchased di- rectly from the sponsoring organization. Our R.R. could supply the growth record, expense ratio and other readily avail- able statistical information on a particular no-load fund but he would not go into other factors such as depth of management, investment philosophy, etc., since we, as a firm, do not maintain close liaison with these funds and are not prepared to give and maintain information of this nature. When a customer becomes a PAGENO="0368" 782 client by purchasing a mutual fund (or any other security for that matter), we feel it is our responsibility to stay well informed on the fund and management company so that at any time in the future we would be able to give an accurate recommendation to that particular client on the advisability of maintaining, de- creasing or increasing his investment in that fund. In effect, we are put on retainer as financial advisors whenever anyone buys a mutual fund through us. This would be an impossible responsibility to fulfill with regard to no-loads since we do not keep in close touch with them for the reason stated above. Therefore, to answer your last question,, our salesmen could not be compen- sated for any effort expended on their part to help a customer purchase a no-load fund. Generally speaking, no mutual fund should be purchased on the merits of its performance alone. However, for the most part, this is exactly what happens when an investor buys a no-load fund. He has very little understanding of the investment philosophy underlying portfolio changes, recent management changes that could possibly effect future investment results and, particularly for the large investor, of general stock market and economic conditions which should be the underlying factors upon which all investment decisions are bssed. In reality, it take~ a sophisticated individual to examine the prospectus and literature of dif- ferent no-load funds to choose the one best suited to his objectives. We think the salesman plays a very important role in helping people select the proper investments-including the choice of the appropriate mutual fund. It is a generally accepted tenet of business life that you should not accept legal or medical advice through the mail. We have found this to be a wise philosophy in the investment field also: If you should desire clarification on any of my comments or if you think there are any other areas in which I may be helpful, please do not hesitate to let me know. Sincerely, HAROLD L. BAcu~, Chairman of the Board. STATEMENT øF FINANCIAL SERVICE CORPORATION OF AMERICA SUMMARY While we realize that our industry, like any other industry, can be improved, we are convinced that the proposed S.E.C. legislation is drastic in nature and would have very serious consequences on our business and on the investing public. 1. The elimination of contractual plans designed to compensate a salesman for selling relatively small monthly plans would: A. Drive many salesmen out the business and attract virtually none to the business. B. Remove one of the soundest methods of accumulating money now available to the American public. 2. The reduction of the maximum s~tles charge on cash mutual fund sales from 9% to 5% would: A. Force some investment dealers out of business. B. Force other investment dealers to merger into bigger companies. C. Force many remaining investment dealers to concentrate on trading accounts-getting customers interested in buying and selling stock fre- quently-rather than on selling mutual funds to their customers. We believe that for many investors this would not be to their advantage. DISCUSSION OF FINANCIAL SERVICE CORPORATION OF AMERICA'S PO5ITION ON SE.C. LEGISLATIVE PROPOSALS We have observed in working with several thousand individuals over the past 81/2 years that most of them are not good investors. We have also ebserved that the temptation to spend money-rather than save and invest it-is great. So great, in fact, that many people never accumulate over a few thousand dollars. This is frequently true, not only of those with moderate incomes but also those with high incomes. Somehow as the income rises the outgo rises to match it, PAGENO="0369" 783 Because of the above we believe that mutual funds-to help the individual manage his money--and the mutual fund salesman-to convince him of the desirability of saving and investing-are a desirable part of the American economy. Mutual funds offer the investor an opportunity, at reasonable cost, to have full-time professional investment men selecting his stocks for him. The results achieved by most of the funds have been excellent. There has been a net flow of money into mutual funds in each of the past 8 years. At the same time, there has been a net flow of money out of common ~tocks by individuals. This seems to indicate that the investing public more and more recognizes the value of pro- fessional investment help as offered by mutual funds. We believe that the legislative proposals of the S.E.C. would have a very dam- aging effect on this industry that seems to be accomplishing so much for the American investor. Here are the three primary recommendations of the S.E.C. apd the position of Financial Service Corporation on each: 1. Reduce the ma aimuin sales charge from 9% to ~% The S.E.C. compares the cost of buying mutual funds with the cost of buying individual stocks on the New York Stock Exchange. They say that even 5% is substantially more than the N.Y.S.E. commission. This is true. However, in- dividual stocks are bought and sold with great frequency by many investors, Mutual funds-by their very nature of providing a dynamic management of money are bought with the idea of holding many years. Because there is usually no need for the investor to change his investment in his funds, there is not the repeat business on the same money in mutual funds as there is in individual stocks. The retail dealer in mutual funds has costs of operations similar to distribu- tors of other products. Large office staffs must be maintained. A sales staff must be maintained: These are necessary to provide the investor the service that he needs and deserves. Even if the retail dealer received the full 9% that could be charged-this is not a very big mark-up on a product. How many businesses are there who mark up their product only by that amount? The furniture business marks its product up 100%. Mark-ups of 40% and 50% are common to cover the cost of distribution in America. As a practical matter the maximum sales charge made by the funds varies from 71/2% to 81/2%. The retail dealer receives only about 75% to 80% of this- or about 6%. Also the mutual funds offer discounts for larger purchases. For example, a typical breakdown of cost to the investor and % to retail dealer would be: Amount invested Percent of sales charge Percent to retail dealer lJpto $24,999 $25,000 to $49,999 $50,000 to $99,999 $100,000 to $249,999 $250,000 to $499,999 $500,000to $999,999 $1,000,000 or over 8.0 5. 0 4.0 3.0 2.5 2.0 1.0 6.0 4.0 3.7 2.4 2.0 1.6 .8 In 1966 Financial AS'ervice Corporation received only 4.4% on all funds sold. This is gross. From this the salesman must be paid and the office staff for proper investor service to be maintained. Frankly, it is very difficult to make a reasonable profit on this small percentage. The S.E.C. says that if the sales charge is reduced that more people will buy mutual funds and thus sales will increase and perhaps so would total income to the industry. We are not at all sure this is so. In any event, we feel that mutual funds are still going to have to be sold and serviced. There simply must be enough mark-up to accomplish this. We believe that if it is reduced any from its present level that the business will become so marginally profitable-if profitable at all- that it would be unattractive for firms to remain in the mutual fund business. 85-592--68-pt. 2-24 PAGENO="0370" 784 2. "Elimination of contractual plan" The S.E.C. position is that the contractual plan should be eliminated. This is the plan whereby the investor sets a specific goal for himself to invest periodically. usually monthly, until he reaches that goal. The cost that he pays on this invest- ment if he reaches the goal is about the same as if he made a lump-sum invest- ment. On the smaller plans, it Is a little greater and on the larger plans it is a little less. However, he pays more of his costs the first year than he pays in sub- sequent years. The amount of costs paid in the first year is usually about 50% of his investment (although in larger plans it becomes smaller than this). His costs in subsequent years is usually about half of the regular charge of say 8% so that in the end his costs would come out to be around 8%. The S.E.C. would like to eliminate these plans in order to protect those who buy them and then, for one reason or another, sell out before the fund has had an opportunity to produce a profit for them. We agree with them in that it would be desirable if no one ever took a loss on his investment plan. ELowever, if this plan is eliminated, it is going to eliminate the only opportunity that many Ameri- cans will have to accumulate money in a sound way, through mutual funds. For example, one mutual fund sponsor who has been selling contractual plans for many years presented these figures. From the years 1949 through 1965, 225,000 plans were effected. Of these, 202,000 had profits amounting to $211 mil- lion. Twenty-three thousand bad losses of $4 million. The average loss per ac- count was only $178. Isn't it unreasonable to kill a system that, as shown in the above figures, has produced profits of $211 million dollars just to save losses of $4 million? Another important reason we believe the contractual plan should con- tinue is simply to encourage the salesman to sell as many members of the Amer- ican public as possible on thrift and investing in the American economy. This is a difficult job. Look at what the salesman has to go through in order to accomplish his mission and earn commissions. He must get an appointment with a man whom he believes has the ability to save some money. In times as busy as these this in itself is quite time-consuming. He must find out the situation of the indi- vidual-if he is in a position to invest. Then usually, if the individual is in- terested, he has the salesman sit down and explain it to both him and his wife. After the investor buys, the salesman must continue to stay in touch with him to have any administrative errors corrected, and over the years to continue to encourage him to invest. As you might imagine, all of this takes many hours and in some cases many days to accomplish. If it were not for the contractual plan, fQr every $100 a month customer, the salesman would receive only $4 on that $100 invested. This would be $4 a month, but as you can see be would have to sell a great many of them in order to make a living. This simply is not enough in earnings for the amount of hard and creative work involved. He simply could not make a living in the business without the contractual plan. But, of even greater loss than this would be the fact that millions of Ameri- cans would not be given the opportunity to accumulate money, a little at a time, on a monthly basis, in ownership of American industry. The contractual plan in mutual funds is probably the best opportunity that millions of them will evei have to become financially independent-to depend on themselves rather than someone else-particularly, the government. 3. The S.E.C. w~a~ts the authority to regulate mwaagement fees to be sure that they are "reasonable" Financial Service Corporation is not directly engaged in this phase of the business. However, it is difficult for us to understand why in a very competitive business such as mutual funds a government agency should control the amount of profits made. The mutual funds business is~ far from a public utility type of operation. There are over 200 funds, each competing with each other for the business with the investing public in America. Why not let competition control the management fees that are charged? If General Motors is alert enough and smart enough to make the kind of car the public wants to buy, we do not believe the government should control their profit per car. Competition should control this. Why isn't the same true in mutual fund management companies? If a fund can manage the public's money so well that they continue to want to buy it, why shouldn't their profits be greater than the funds that are not as alert and able? T'~n't this the essence of the dynamic qualities of the American free enterprise economy? PAGENO="0371" 785 In. COfleilision., the niutual fuiid ifl(lUStry 11:1 America seems to l)e serving it*~; clients well. It provides a sensible way for most Aiiierhans to ilivest in stocks. The investnieiit is for the 1oi~g-term. The commission is received only once. Yet the service mUst continue. This must l)e taken into account whei~ e*valuatiiig the cost of I)Urchase. ~ investment must be soh(l aiid therefore the salesman must receive enough compensation to keep them in the business. The COflhl)etitioll is great ainolig funds aiid therefore the competition should coiitrol what the iiiaii- agers receive rather than the goverunietit. We at Financial Service corporation agree with the paragraph on the Dc- cember 6, 1066 lVaii Strcet Jour~iai editorial entitled "A Litthe rfoo Active." "The danger here is that if Congress does everything the S.TIIC. wants, it may not merely be producing more equitable fees anti practices. It may succeed in making the industry unprofitable or so marginally Profitable as to be unattrac- tive. in that event, the whole industry, the investor and the whole economy will suffer." STATEMENT OF INVESTORS MUTUAL. Ixc., INVESTORS STOcK Fe ND, ircc., I~ vi~sions SELECTIVE FUND, iNC., AND iNVESTORS VARIABLE PAY~uEN'r FUND, INC., MIN- NEAPOLIS, MINN. Gentlemen, the following views with respect to subject bills are submitted to the Committee by Investors Mutual, Inc. (M:utual), Investors Stock Fund, Tue. (Stock). Investors Variable Payment Fund, Inc. (Variab]e), and Investors Selective Fund, Inc. (Selective) (collectively `Funds") of Minneapolis, Mm- uesota. These funds collectively have uissets totaling' in excess of $6 billion, about 1 million shareholder accounts and represent apl).rOxirnat.ely 15% of the mutual fund iTI(lustry. I. GENERAL PROVISIONS A. In `lepencience of fu ni~i directors Section 10 of the Investment Company Act of 1940 presently requires that registered investment compa flies using a principal underwriter for distri butioii of it.s securities must have a majority of its board of directors composed of Persons who are not "affiliated persons" of such principal underwriter. A lesser ratio is required with respect to the investment adviser. At the present time, and for some years irior hereto, the boards of directors of subject Funds have been substantially more independent than these statutory minimums. This hide pendence has been legitimate in fact and in practice, arid has resulted in two negotiated reductions in the advisory fee in addition to the first reduction in 1963. The present 12 man board,s of the Fumis are each composed of 10 directors who are independent of IDS antI 2 directors who are affiliated with IDS, its principal underwriter and investment adviser. `We consider that most fund activities which the SEC considers to be abuses would be alleviated if they would support measures to increase awl insure the independence of the Fund I)irectors. We were greatly surprised when the SEC Report dlii not reconimend strengthening the independent directors. To this end we suggest amending the Investment Company Act as follows: (1) Require that the chief eaecuti*ve officer of the Fund be unaffihiated with the adviser or underwriter. (2) At least S0% of all Fund directors to be unaffiliated with the adviser or underwriter. (3) The insertion of a provision to iiisure truly ifl(Tependent (lirectors along the following lines `No person affiliated with, in control of, or affihia ted with aiiy person in control of any adviser or underwriter for any registered investment com- pany, shall directly or indirectly, suggest, direct, counsel, cause, command, induce, procure, recommend or in any way attempt of influence the selection of aiiy unaffihiateci director of any investment company with which such adviser or untlerwriter is affiliated anti all directors affiliated with such adviser, underwriter or person in control thereof shall be ineligible to vote upon the election of any director who is required to be unaffihiated." B. (`ompe~i sation to directors, officers and employees The amendment to Section 15(d) (1) proposes, `inter alia, that (1) advisory fees of mutual funds and (2) all compensation of fund "officers asd directors", etc. should be judged by a legislative standard as to whether they were "reason- PAGENO="0372" 786 able" and that the AS~J~YC would be empowered to sue in court to enforce its posi- tion in this area. In claimed support for these two proposals the SEC points out that under the existing court decisions advisory lees are now judged by a `~waste" standard. The SEC also claims that this is a different rule of law than normally prevails for other corporations. (Actually it is the same rule of law that applies to all corporations that have contracts approved by their shareholders.) How- ever, apart from the legal situation with respect to "açlvisory fees", as to fund officers and directors, no claim is made by the SEC that a different rule of law is applicable to their compensation than is applicable to the compensation of corporate ea~ecutires generally. Thus, the reason the SEC claims as justification for changing the law to have "advisory fees" judged by a different standard has no application to compensation of fund "officers and directors". (Compare Technical Statement of SEC pages 1-b). We accordingly suggest that H.R. 9510-9511 be amended at page 20, lines 2 and 4, to strike the words "officer, director" where same appear. Many of the complaints of the SEC really constitute a criticism of the services rendered by some Fund directors. This could be remedied by good directors, but if H.R. 9510 is passed in its present form, it is our opinion that it would increase the difficulty of obtaining good directors for the Funds because the statute would encourage suits by the SEC against them over their compensation by a different rule of law than applies to corporations generally. We consider this to be an unreasonable provision. Various legal restrictions now make it difficult to get good directors. The Federal Reserve Act prohibits all bank directors from serving as directors of open end Funds. The Investment Company Act restricts the ability of Investment Bankers to serve as fund executives. (See Sec. 10 (b) (3).) Many brokers and dealers are not candidates for Fund directors because they desire to sell securities to the Funds. (See Sec. 10(b) (1) of the Investment Company Act.) Thus, the area of eligible Fund directors is narrow and we hope Congress will not restrict it further by unreasonably encouraging litigation against directors and officers over their compensation. C. Breach of fiduciary duty Heretofore the SEC could take action against an officer, director or affiliated person of a mutual fund if he were guilty of "gross misconduct or gross abuse of trust". It is now proposed to change this standard and to authorize the SEC to take action against such persons If there is any "breach of fiduciary duty". What is a "breach of fiduciary duty?" This standard practically defies descrip- tion. It is not a sufficiently definite standard upon which to base a violation of the act. "A fiduciary relationship" extends to every possible case in which there is confidence reposed on one side and resulting superiority and domination on (the) other. Warren v. Pf cii, 346 Ill. 344, 178 NE 894, 900. If the practically unlimited power to intervene in what they consider "breach of fiduciary duty" cases is given the SEC, under their interpretation practically anything that a person does `that they consider should not have done or should have been done differently in a corporation they would consider to be a "breach of fiduciary duty". No showing has been made that there is any subslwtntial wrong- doing in these mutual fund companies. Hence, it is submitted, there is no reason to change the present standard. If violation occur the present act is sufficient for the purpose. In our opinion the proposed amendment to Section 36 would confer too much power based on too indefinite a standard. The proposed standard is vague and uncertain. We recommend no change in this section of the statute. If any amendment is made to this section it should be fashioned on the lines of the pattern Congress provided with respect to Banks and Savings and Loan Associations in dealing with a similar problem in the Financial Institutions Supervisory Act of 1966 (80 Stat. 1028). An amendment as follows is suggested: "SEc. 36. The Commission is authorized to bring an action in the proper district court of the United States or United States court of any territory or other place subject to `the jurisdiction of the United States, alleging that a person serving or acting as officer, director, member of an advisory board, investment adviser, or depositor, or as principal underwriter, if `such registered company is an open-end company, unit investment tust company, or face-amount certificate company, has in such capacity been guilty within five years of `the commencement of the action or is about to engage in any `act or practice, in respect of any registered investment company for which such person so serves or acts, consti- tuting a breach of fiduciary duty and (1) that the company has suffered or will PAGENO="0373" probably suffer substantial financial loss or other damage or that the interests of its shareholders could be seriously prejudiced by reason of such violation or practice or breach of fiduciary duty, and (2) that such violation or practice or breach of fiduciary duty is one that involves personal dishonesty on the part of such director, officer or person or will operate as a fraud upon the company or its shareholders." D. Affiliation of fund officers For some purposes *such as voting on advisory and underwriting contracts, according to some arguments, it is claimed that an ofjlcer (President) and director of a Fund who is completely unaffiliated with the adviser or underwriter must be considered the same as a director affiliated with the adviser and under- writer because he is an officer of the Fund and that the President of the Fund is prohibited from voting on the advisory and distribution contracts. If such cons~truction is correct it is wrong in principle because the Preisdent is probably the most knowledgeable person on the subject. We consider that if the president or officer of the fund company has no affiliation with the adviser or underwriter he should be permitted to vote on such vital matters as advisory and underwriting contracts. It is not logical to place independent directors in the same boat with nonindependent directors and disqualify the independent directors the same as the non-independent directors when the independent directors have absolutely no conflict of interest. The statute should be based on a distinction made between (1) persons affiliated with the Fund, and (2) persons affiliated with the adviser or underwriter. This could be accomplished in one respect by amending Sec. 15(c) of the Act to read as follows: "* *. * (1) by a majority of the directors who are not parties to such contract or agreement or affiliated persons of any such adviser or underwriter, or (2) etc." E. Fund holding companies The proposal designed to restrict Fund Housing Companies from investing in shares of other funds (See 12(d) (1) ) would prevent IDS (a registered in- vestment company) from investing for its pension and retirement plan in shares of funds managed by it. We suggest that a statutory eaemnption allowing such transactions be added to any amendment on this subject. F. Interested persons The proposed Section (19) defining "Interested Person" in (A) (iii) and (B) (iv) has a three year retroactive provision with respect to any person who has bad any "direct or indirect material business or professional relationship with such investment adviser". The agreement between the SEC and the 101 Task Force also applies to certain persons in such capacities who have been within that classification within the past two fiscal years of the company. Such eco post facto application of the law is too broad and is also unfair. It would seem to be sufficient if such provisions were restricted to persons who have anp such prohihited relationship following the enactment of the bill. Also, the definition of "member of the immediate family" seems too broad-to the extent it includes persons who are not members of the immediate family. In- cluding "brothers and sisters" is clearly too broad and it is submitted that on chil- dren ~the bill should be limited to those children who are in locus parenti. Why should any person be penalized for conduct of persons who are beyond their con- trol and from whom they have no right to obtain information? It would be suf- ficient if the SEC after notice and hearing could decree such persons to be interested. As the bill states that common directorship does not give rise to interested person category, we suggest that commnon "officers" should be placed in the same category or that the bill be a'mended to provide ewceptions from interested person classification for persons who "by reason of being a common director or officer of any other investment company having the same investment adviser or principal underwriter." (Amend. (A)) G. Deferred effectiveness of management fee legislation We submit that a two year period would be necessary to adjust management contracts to the requirements of this legislation-rather than one year. H. Adviser furnishing information to funds The proposal to amend Section 15 (0) (lines 15-21) to require advisers and underwriters to furnish certain information which the Funds need in negotiathig PAGENO="0374" 788 contracts to the Funds has a loophole in it, in that if an adviser and a Fund wrote a contract solely for investment advice (and not for any housekeeping services) the Fund would only be able to compel information from the adviser with respect to investment advice. Our Funds have no difficulty heretofore in obtaining such in- formation from IDS, but if the bill passed in its present form, IDS would not be required by law to furnish data with respect to services (other than investment advisory services) furnished under a separate contract. Since the advisory serv- ices are the smaller part of such contracts, this could constitute a serious bar- rier to getting all the information needed to negotiate for all services. We sug- gest that this section of the bill be corrected so that advisers and underwriters would be required to furnish statistics with respect to all services, investment ad- visory and housekeeping, if requested. I. Short term trading If it is considered, that short term trading by highly speculative funds is a. hazard the SEC has authority to compel special disclosure in the prospectus pointing out the turnover of portfolio securities, and the hazards involved, if' hazards they be. If this is a problem it should be dealt with directly and not used as a bogeyman in an attempt to support other legislation that is unrelated to~ short term trading. (cf. Senate Hearings, p. 65-66.) IL MANAGEMSNT FEEs A. Basis for determining rea~onableness of management fees The bill proposes to amend Section 15 to provide that `the fees of the investment companies be reasonable according to a legislative formula that may have other factors added thereto. See proposed amendment to Section 1~(d) (2). We are for reasonable fees but the proposed standard allegedly designed to accomplish this we considered to be one sided and not practical. In our statement to the Senate Committee we set forth the nature' of our objections to the manner in which the SEC proposed `to define the word "rea~sonable" in H.R. 9510-9511. (See Senate Hearings p. 1183-1185). In his statement to the House `Committee Chairman Cohen of the SEC said With reference to this matter. "* * * somehow the bill and our accompanying language at leart worried some people as to its scope. Sc the suggestion was to eliminate the specification of those ,particula'r factors, and make it perfectly clear that the court would con- sider any factor which was relevant in reaching any determination of reason- ableness. Now, if this would serve to alleviate some concern in this area, while I have not taken this up with the Commission as such, we had some discussions about it. I am convinced that this is an area in which the Conimission would be most sympathetic." It is concluded from the statement of Chairman Cohen that it is in order to strike proposed Section 15(d) (2) as same appears on pages 20 and 21 of HR. 9510-9511 and renumber the remaining subsections' (3), (4), (5) and (6) ac subsections (2), (3), (4) `and (5). We also oppose the proposal to authorize the SEC to initiate fee litigation against mutual fund companies. If it could be worked out we would not oppose a provision authori~ing Funds to have such matters determined by the courts in a proceeding in the nature of a declaratory judgment. B. Separate statement of management fees H:R. 9510 proposes that the consideration for investment advice be separately stated from the consideration received for all other services covered by the advisory contract. (H.R. 9510, Section 15(a), page 17, line's 19-21). We fail to see any benefit to the Fund `shareholders in this proposal. The SEC proposal for spparate statistics will do away with twenty-seven `years of experience' and the whole industry will be launched on a statistical program that will require many years to furnish a base of experience for future decisions. It i's our opinion that the e.vpense ratio of the Fund is `the more important factor and that the fees would be better evaluated when considered in relation to total services furnished, hence, we oppose a requirement that a statement of the consideration for investment advice be separately made. We suggest, accordingly, Section 15(a) (1) of the Act be not changed. PAGENO="0375" 789 III. SALES LOAD A. The 5% proposal What about the proposal to amend Section 22(c) (1) to reduce the sales load about 50%? Is this proposal good or bad for the Fund shareholders? The present sales load of Fund shares varies greatly. There are about 34 "no load" funds. Sales charges of some other funds go up to 8% %. The proposed cut to 5% for the sales charge is an extreme proposal. The philosophy behind it is also extreme. The proposal is that the fee should be fixed )y law and by the rules and regulations of the SEC. Why? No substantial profits by tbe~ underwriter or their salesmen are being made out of this distribution. The fees are not the subject of illegal agreements. Nobody is profiteering from the present scale of fees. The fact that Fund shares can be jought for "no load" or as high as 8% % indicates complete freedom in the field. Why then should Congress fix a fee? Congress might well bejustified, as other legislative bodies have been, in prohibiting grossly euorbitant commissions but we see no justifica- tion for Congress fixing the day to day commission for all Funds and then em- powering the SEC to fix it even lower. We do not see that any case has been made for fixing the day to day commission for all funds and then empowering the SEC to fix it even lower. In a few states people can buy life insurance from a savings bank at a low sales charge, or buy it from a life insurance company and pay a more substantial sales cost even in excess of that charged by most mutual funds. Should all life insurance companies be compelled to change to the lower sales charge imposed by savings banks sellers of life insurance? What is there then in the mutual fund situation that calls for fixing a sales charge for mutual funds below that which is now producing a loss or a slight profit at best? $. Inconsistency of SEC proposal to cut sales commission Through the 34 years that the SEC has administered the Securities Act it has constantly encouraged the training and upgrading of the sales forces of invest- ment companies and securities brokers and dealers and in the Securities Act Amendments of 1964 Congress passed extensive legislation to further this policy. Partially as a result of such policies and to a considerable extent on its own independent initiative, IDS at very considerable expense has created a sales force for the sale of Fund shares that is composed entirely of full time salesrner~ and all are fully trained in the sale of Fund shares. We consider the proposal of a 50% cut in commissions to be contrary to the best long term interests of the Fund shareholders because their ability to meet normal redemptions would be hazarded. Such far reaching changes should be based on adequate information which the Commission did not present. This is apparent from the December 2, 1966 Report of the Securities and Exchange Commission on the Pu4blic Policy Implica- tiOns of Investment Growth to the Committee on Interstate and Foreign Com- merce (House Report No. 2337) "Such a reappraisal (of the practices and procedures in the securities markets 1) requires fuller data concerning the securities holdings and trading patterns of institutional investors than is now available. While this information can be ob- tained by the Commission with respect to investment companies, there is a lack of reliable and comprehensive data concerning the securities holdings and trad- ing activities of most other types of institutional investors, including pension funds. Closing this informational gap is an indispensable step to adequate anal- ysis of the problems raised by the institutionalization of the stock markets." (page 26) The stated purpose of this bill is to arrest the growth of mutual funds because of some conversations "with people in the securities industry, with `executives of listed corporations and with students of the markets", (Senate transcript p. 66) and others. It is asserted that "* * * there is' a mounting public disquiet about some of the market implications of the greatly accelerated Mutual Fund growth * * (Senate transcript p. 66) it is submitted that the foregoing does not set forth a legitimate legislative purpose and is not `a proper substitute for "closing the informal gap" on the basis of adequate facts. Also, there i's no showing that the growth of mutual funds is as large a's that of "pension funds, equity Investments by Insurance companies, * * * assets 1 Matter In parenthesis supplied. PAGENO="0376" 790 managed by banks and other professional trustees and types of investment com- panies other than Mutual Funds * * *"~ (Senate Record, Page 66). In fact on June 30, 1086 the total asset~ of just four banks in the United States exceeded the total assets of the entire mutual fund industry: Billions Bank of America $15, 619 Chase Manhattan 13, 597 First National City Bank of New York 12, 588 Manufacturers ~anover 6, 849 Total 48, 653 During the House hearings some statements tended to asSume that mutual fhnds were the persons causing the increased institutionalization of the market. Actually there is no showing that they are other than a small part of it. Mention was made in the Senate hearings that Federal Savings and Loan As~ sociations made no sales charge, but further inquiry would have disclosed that in their last record year they spent a total of $122 million in advertising and this was the shareholders' money. This is part of their "sales charge" and the cost is a continuing one. C. $EC proposal will work adversely to present law If the drastic proposal to cut the sales charge by 50% is adopted it will also work in a manner contrary to the objective that Congress expressed in the 1004 legislation. The greatly reduced sales compensation could not do anything other than lower the qnality of solicitation. The recruitment, training and compensa- tion oct these salesmen to meet the high standards imposed by the company and the statute has been costly. In the past 27 years IDS has clistrilbuted on the average over $186 million worth of our Fund shares yearly and the profit after taxes to IDS from such distribution has average only $276,000 per year. Should such minimal profits be attacked? If the sales charge is reduced as proposed in HR. 9510 we feel it would inter- fere with our ability to contract for full time, high grade, highly trained sales- iiien; for skilled sales investigators; for high standards for acceptance of new business; for continuous customer servicing and for free transfers between affiliated funds, all of which we consider to be most desirable. D. $ection 22(d). An anti-rebate proviMon Much mention has been made of Section 22(d) and it has been claimed that it is an anti-trust provision prejudicial to a free market and that nothing like it exists elsewhere. One SEC witness even went so far as to contend that this created a "monopoly". (See testimony of Prof. Wallich.) Nothing could be fur- ther from the truth. This provision merely requires that all shareholders who buy the same mutual fund on the same day pay the same price; i.e., the "cur- rent public offering price described in the prospectus". Each fund is free to choose the commission to be paid and these vary widely from no-load to about 8% %. Nothing in the law prohibits a shareholder from selling his shares at any price he chooses. Section 22(d) is thus in effect an Anti-Rebate provision with respect to the sales commission. It is a provision against fee splitting. It pro- hibits discrimination against purchasers of mutual funds. Every state in the union has a similar provision prohibiting rebate of any portion of the sales com- mission paid on any life insurance contract. Both laws are designed to guarantee against salesmen discriminating in favor of one purchaser as against another. 22(d) exemplifies exactly the same legislative purpose for mutual funds that the Anti-Rebate provision of the State Insurance Laws supply for life insurance. The North Carolina law is a good example, it prohibits: Insurance Laws of North Carolina. 58-54.4(8). Rebates. "n' * * offering to rebate * * * any rebate of premiums on the contract * * Such laws are of long standiag in the insurance industry. See Appendix "A" for list. These laws are designed to protect the public by giving a "fair shake" to all purchasers of life insurance. The purpose of 22(d) of the Investment Company Act of 1940 is the same; i.e., to guarantee that fund shares sold to each shareholder on the same day are sold at the same prictl and that there is no discrimination against shareholder applicants, that there is no rebate of sales commissions and that all applicants are treated alike. Thus, there is no reason to repeal 22(d) unless it is desired to make it possible, for discrimination to exist daily in the sale of the same mutual fund and there PAGENO="0377" 791 is a desire to permit mutual fund salesmen to offer a rebate of all or a portion of the sales commission as an inducement to purchase mutual fund shares. Per- sons who think such practices are desirable differ from the 1940 Congress that enacted 22(d) to prol~ibit these well recognized evils. One purpose of this anti-discrimination provision is to guarantee that the fund receives in cash the full net asset value on the date of the sale. If this did not result existing shareholders of the fund would be discriminated against. E. Comparison to stock ecochange firms The bill is an attempt with reference to the sales charge to cast the distribu- tion of Mutual Fund shares in the same mold as transactions in stock on the stock ecrehanges. It is true that a number of stock exchange brokers have estab- lished mutual fund departments and have salesmen specializing in the sale of mutual funds, hut a very substantial portion of shares of mutual funds are sold by direct selling organizations wholly unrelated to stock exchange brokers. But the mutual funds that are sold by stock exchange firms are usually sold in an entirely different manner from the manner in which those firms conduct their stock exchange operations. Thus, the fact that some stock exchange brokerage houses sell mutual fund shares outside the stock exchange, in addition to their regular stock exchange business, is no justifiable reason to regulate the sale of mutual fund shares in a comparable manner to stock exchange transactions. These sales operations are two entirely separate businesses with completely dif- ferent attributes and should be so considered by the Congress. F. Distinctions from stock ecochange operotions The usual sale of a mutual fund share is a more complex and time consuming operation than the sale of shares on the stock market by a stock broker. The structure, portfolio, investment objective and restrictions, sales load and other material features of each fund is complex and requires considerable explanation to each applicant. Federal laws, in effect, require that the sale of a mutual fund share be a more ecopensive operation than the sale of a share on a stock ecvchange. The mutual fund business is entirely different from the sale of listed stock on exchanges. It is more similar to the sale of life insurance but a mutual fund sale by law requires more explanation than is required by law even for insurance material features of each fund is complex and requires considerable explanation quires much more explanation and understanding than the purchase of ordinary shares of stock. The duty of clearly explaining the investment is placed upon the salesman, most of whose sales in our company, which comprises about 15% of the industry, are made by direct contact, by direct sales in the home or office. Why should the compensation of a mtual fund salesman who makes most of his sales by personal solicitation on the basis of a prospectus that must be fully esplained in detail in the prospect's home or office, be restricted to the ,same compensation as is received by a stock broker who sits at his office telephone most of the day and takes orders for listed stocks. To require similar compensation for these dissimilar services would not be fair or reasonable. One requires more work than the other. Also, most mutual fund purchases are long term invest- ments while stock exchange securities are held for relatively shorter periods of time. The stock exchange broker has more turnover and he gets a commission both on the purchase and sale of a listed stock. Our mutual fund salesmen receive no qommission for, nor is any charge imposed on, the redemption or transfer of our fund shares to any of our other funds. At the present rate all shares listed on the New York Stock Exchange turn over completely in 5.2 years on the basis of last year's sales when 10 billion shares were listed and 1,809,351,000 sold (see New York Stock Exchange Fact Book, 1966) and trading is up this year. The salesman of listed stocks on the stock exchange is the beneficiary of this heavy turn over. 0. so-called self-regulation In the hearings there has been some mention of self-regulation with respect to the sales charge of fund companies as an alternative to the drastic reduction to 5% maximum as requested by the SEC. The term "self-regulation" is misleading in the context in which it has been used in the hearings. Soiue believe that it means industry regulation "without government interference." (See remarks at lines 13-iS, p. 600, typewritten transcript, House Hearings, October 17, 1967.) Others use the term to mean industry regulation of the NASD type "with govern- ment interference." Actually "self-regulation" of the NASD type is similar to PAGENO="0378" 792 what Metternich said about "non-intervention," i.e. that "non-intervention was a political and military term that meant the same thing as intervention." Thus some of the proponents (Mr. Haack) are using the term "self-regulation" when what they actually refer to is "self-regulation that may ?~e not self-regulation," since it is outside regulation by the SEC in the last analysis, with the SEC having authority `to abrogate the "self-regulation" of the industry. Thus, this confusion of terms exists. The dialogue on this point has been referring to different things without precise definition. One is talking about pure industry self-regulation and the other is talking about giving the SEC an absolute right to abrogate the self- regulation of the industry. These are exact opposites. It is our view that self-regulation which confers power on the SEC to override industry self-regulation would be very hazardous and unwise in view of the al- ready expressed opinion of the SEC in favor of the cut to 5% which they presently propose. With the SEC holding such views, the mutual fund industry could look forward eventually to having the SEC carry out their 5% proposal. For reasons previously stated with respect to the SEC's proposal to cut the sales charge to 5%, we consider that same would not be in the best interests of fund shareholders whether it was brought about directly by legislation or indireet,1~ by the SEC through mis-called "self-regulation." We also consider it inadvisable to have the sales charges of the mutual fund industry controlled in the first instance by what are essentially stock brokers oriented to Stock Exchange firms. Their basic business is so different and foreign to the sale of mutual fund shares in the form of direct sales and by contractual plans that the two should not be mixed. That the NASD style of so-called "self-regulation" is not true self-regulation is readily apparent from the following provision of NASD provision in the Securities Exchange Act of 1934. "eec. 15A. (k) (1) The Commission is authorized by order to abrogate any rule of a registered securities association, if after appropriate notice and opportunity for hearing, it appears to the Commission that such abrogation is necessary or appropriate to assure fair dealing by the members of such association, to assure a fair representation of its members in the administration of its affairs or other- wise to protect investors or effectuate the purpose of this, title." The leverage of such power can be used to accomplish such SEC objectives as a 5% sales charge, even if' the industry's "self-regulation" did not 50 provide in the first instance. CONCLUSION The basic question that is presented to Conjress by the SEC proposals in H.R. 9510 is whether the proposed radical changes in the mutual fund business are warranted by any facts disclosed in the SEC Report to Congress and the testi- mony before the Committee. The very drastic and revolutionary changes proposed should certainly not result from presumptions and mere expressions of personal opinions, and especially in the area of mutual funds, which by the wording of the same Report have been operated in an honest atrd proper manner to the benefit of millions of investors. The SEC Report states, inter alia: (P. VIII)_"* * * on the whole investment companies have been diligently managed by competent persons and that the general record of the industry is one of which it can be justly proud." (P. 1)-"In this report the Commission finds that on the whole the invest- ment company industry reflects diligent management by competent persons." (P. i)-"Tjnder the guidelines established by the Act the investment company industry has acted responsibly to provide a useful and desirable means for in- vestors to obtain diversification of investment risks and professional investment management." (P. 71)-"The investment company industry has attracted many men of high professional competence and integrity because of their efforts and because of the salutary provisions of the Act serious abuses in transactions between invest- ment companies and their affiliated persons have been reduced to a minimum." It is submitted that there is nothing in all the present studies and reports that justifies such violent changes as are proposed in HR. 9510-9511. The wide public satisfaction with the mutual fund Industry, as evidenced by Its continued growth with full disclosure, does not indicate that the public is complaining. At the Senate hearings Senators stated that they had received no demands for such drastic legislation and members of the House of Representa- PAGENO="0379" 793 ~tiVes have made similar statements. In fact, no person has disclosed any wide- spread demand for any of this legislation. When a prospective investor considers purchasing a mutual fund he considers the sales commission and the management fee together which are prominently printed on the front page and repeated elsewhere in the official prospectus. He knows how much he is undertaking to pay in each category-sales and manage- inent. The only conclusion one can reach is that the SEC proposal to reduce the sales charge is clearly deRigned to reduce the sales of mutual fund shares.2 We believe it would have that effect. (And we now know it is intended to have that effect.) In our own mutual funds, contract negotiations are certainly carried on as arm's length transactions. The investment advisory and the distribution contracts are continuously studied by a Special Committee of independent members of the Board of Directors, which makes reports and recommendations to the entire Board. In such studies, they take into consideration all elements that should be -considered and this has resulted in bargaining negotiations with the investment -adviser and distributor. We believe that any independent Board of `Directors of mutual funds should and will re~ort to this `same extensive study and will review these matters and negotiate the contracts in the best Interests of their share- holders. The officers an.d directors of our Funds, as we believe is true of other mutual funds, firmly believe that our mutual fund shares offer an exceptionally fine investment media for the small investor, and this apparently has been the conclusion of the SEC as indicated by their foregoing quotations. We do not think that any law should `be passed that would be prejudicial to mutual fund shareholders or to prospective mutual fund shareholders. Any effort `that would set such fees by law or permit the SEC to set them would `be to completely discredit not only the business ju~ment but in some respects `the integrity and honesty of the officers and directors of the funds, and if such would cause small investors not to be approached and have mutual funds explained to them or would cause redemptions `by existing shareholders, it would certainly in our opinion be against the public interest. In the SEC Report and the Senate and House hearings, no evidence is given of any extensive research in the area of sales and sales charges of mutual funds to justify the recommendation tha't has been made. On the other hand, facts show that mutual fund salesmen are now well-trained and informed (at considerable expense), that they are making an honest but certainly not an exorbitant income from such sales,8' and that the distributor of our funds has actually operated at a loss from underwriting in some years and made small profits in other~. We submit that no proper legislative purpose has been shown to justify the principal changes proposed in the bill (see Senate Transcript of, Hearings at pages 65 and 66). The SEO admits that no study has `been made `to justify the proposals to reduce commissions. E~onsequent1y, the effect of this legislation is speculative and the consequences cannot be predicted. APPENDIX "A" INSURANCE ANTI-REBATE STATUTES The following is a citation to the principal Insurance Anti-Rebate Statute in each of the 50 states and the District of Columbia: Alabama Insurance Code, Title 28, § 90(4) (8); Alaska Statute § 21.36.100; Arizona Statute § 20-449; Arkansas Statute § 66-3005(8); California In- surance ,Code §~ 750, 751; Colorado Statute § 72-14-4(10) (a); Connecticut Statute Chapter 676, § 38-59; Delaware Statute, Title 18, § 534(8) (A) ; District of Columbia Code Annotated, § 35-715; 18A Florida Statute Annotated § 626.0611 (1960) ; `Georgia Statute § 56-704(8)'(a) ; Hawaii Statute, Chapter 181, § 643(h); Idaho Statute § 41-1314; Illinois Statute Annotated, Chapter 73, § 763; Burn's Indiana Statutes, Section 39-5304(A) (8); Iowa Code Annotated, Title XX, Chapter 507B, Section 4(8); Kansas Statutes Annotated 40-2404(8); Kentucky Revised Statutes, Section 304.932; Section 1214(A) (8), Title 22, Revised Statutes of Louisana; Section 2905(8), Chapter 25, Title 24, General Statutes of Maine; 2Th4s was first written before this fact was confirmed by oral testimony at Senate hear. ings. (See pages 65-66 of typewritten `Senate Hearings, S. 16~9, July 31, 1067.) See Senate Hearings, p. 65. PAGENO="0380" 794 Article 48A, Section 224~ Annotated Code of Maryland; Section 4(a) (8), Chapter 176D, Annotated Laws of Massachusetts; Michigan Statutes Annotated, Section 24.12024; Minnesota 5tatutes Annotated 72~13; Mississippi Statutes § 5681; 19 Missouri Statute Annotated, § 375$36(8) (Supplement 196~.) ; Montana Statute § 40-3510; Nebraska Statute § 44-361; Nevada Statute, Title ~7, § 686.160; New Hampshire Revised Statute Annotated, § 417 :4(8); New Jersey Statute Annotated, § 17:2913-4(8) (Supplement 1966); New Mexico Statute § 58-0- 12(8); New York Insurance Law § 209; Section 58-54.4(8), General Statutes of North Carolina; Section 26-30-04(8), Revised Code of North Dakota; Section 3904.21(G), Ohio Revised Statutes, Anriotated; Oklahoma Statutes Annotated, Title 36, Section 1204(8); Oregop Revised Statutes, Section 739.540; 40 Purdori's Pennsylvania Statutes Annotated, Section 275; Section 27-29-4(8), General Laws of Rhode Island; Section 37-1213(3), General Statutes of South Carolina; Section 31-13-16, South Dakota Code; Section 56-1204(8), Tennessee Revised Statutes; Section 4(8), Article 21~21, Vernon's Civil Statutes Annotated; Section 31-27-14, Utah Code Annotated; Section 4724(8), Title 8, Vermont 5tatutes Annotated; Code of Virginia, Section 38.1-52(8) (a); Revi~ed Code of Washington 48.30.140; Section 33-11-9, 1\~Jichie's. West Virginia. Code; Section 207.04(1) (h), Wisconsin Statutes; Section 26-158(8) (a), Wyoming Statutes. STATRMENTOF NORMAN ABR&HAM, PREsIDENT, POOLED FUNDS, INC. Mr. Chairman and members of the ~omm1ttee, my name is Norman Abraham. I am the founder and President of Pooled Funds, Inc., one of the two existing registered investment companies which has an investment policy contemplating investment in the shares of other mutual fund~. Mr Milton Mound, President of First Multifund of America, Inc., the other such fund, has already appeared be- fore you. Each of these funds would be in effect abolished by the proposed changes to Section 12(d) of the Investment Company Act of 1940. On pages 311 through 324 of its Report, the SEC proposed legislation which would "prevent the creation and operation of fund holding companies". By giving funds of this type that name, the SEC was obviously attempting to equate them to the public utility holding companies whose operations were, for good and suffi- cient reasons, severely controlled and regulated by the Public Utility Holding Company Act of 1935. The name so given by the SEC is, of course, completely misleading, since a public utility holding company necessarily operates by virtue of ~ontrol of subsidiaries, whereas a fund of this type is already limited by law to holding not more than 3% of the outstanding stock of other investment com- panies, or 5% in the case of certain "specialty" companies. I will attempt to establish that not one of the dangers ~ited by the SEC in its Report is actually applicable to either fund of this type presently registered and that legislation can be passed which would bbviate any such dangers in future funds of this type without abolishing them. The first danger cited by the SEC is that funds of this type will control portfolio mutual funds. The Report admits that such control is very difficult in the case of domestic investment companies in view of the 3% and 5% limitations. However, it is indicated that affiliated funds might be created each of which could invest up to such limits. Pooled Funds, Inc., has undertaken to the SEC that no such affiliated funds will be created, arid is in accord with the suggested compromise which ha~ been presented to the SEC which would extend the 3% limit to all affiliates. We also support the provisions of the proposed compromise which would prohibit us from voting shares of portfolio funds except in the same proportion as all other shareholders so vote, and from redeeming more than 1% of an under- lying fund's outstanding shares during any period of less than thirty days. These provisions of the proposed compromise completely solve any problem which there might have been in relation to control of portfolio funds or sizable redemptions of underlying funds in the case of adverse market conditions. In our case, we also expect to be able to minimize the problem, without any legislation, by switching, without sales load, portfolio funds held by us to other more conservative funds in the same group in the event of adverse market conditions. The next danger cited by the SEC is that there are two layers of advisory fees. Pooled Funds, Inc. meets this problem by reducing its advisory fee by the advisory fees of its portfolio funds. First Mhltifund of America, Inc. meets the PAGENO="0381" 795 same problem by the use of a contingent fee, which depends on the fund beating the Dow Jones Industrial Average. The SEC also suggests that there is a layering of administrative expenses. This is a fact, but it is offset by other factors not mentioned by the SEC; it is much less expensive to operate a fund of this type than to operate a normal mutual fund, as it will not be necessary to maintain the large research department which is necessary for most mutual funds. It may also be expected that any increase in administrative expenses will be more than made up by the savings in sales charges which necessarily will be enjoyed by investors in these funds. The last danger cited by the SEC is that of double sales loads. Pooled Funds, Inc. has no sales load, and First Mu'ltifund of America has a sales load of 1l/~%. We support the provisions of the proposed compromise which would limit sales loads to 1%%. Not only would this solve the double sales load problem cited by the SIi3C, but experience indicates that funds having no or a small sales load generally do not reach the lifrge size achieved by some mutual funds having sale's loads; Thus, even if a number of new funds of this type were to be formed, the impact on the industry could be expected to be negligible. The SEC Report then attempts to indicate that funds of this type have no utility as an investment vehicle. The problem is stated by the SEC in terms of diversification of underlying portfolio securities which, of course, is not the diversification achieved by a fund of this type. A purchaser of mutual fund shares is not purchasing an interest in a portfolio; he is purchasing manage- inent. A holder of shares of more than one fund receives the judgment of the managers of each fund, not just that of one management. An the Report itself notes, most mutual fund investors agree wih this concept. The Report states (page 207): "Moreover, a majority ç~f mutual fund investors hold shares in more than one fund." The SEC then argues that funds of this type will not be able to invest in only the best performing funds but, if they grow big enough, will have to go to the second best. The difficulty with this argument is, of course, that what is the "best" mutual fund is not necessarily an easy matter to determine. Should that fund be considered best which has performed the best in the past six months, one year, three years, or five years? What about funds which have consistently performed well in rising markets, but poorly in declining markets? In short, `there is no such thing as a few "best" funds with all the others being second best. The final SEC objection is that a fund of this type can avoid investment restrictions by investing in funds which do not themselves have such restric- tion. This argument, of course, ignores the fact that a domestic fund of this type must continuously have in effect, to sell its shares, an effective prOspectus disclosing these matters. In its attempt to paint as black a picture as possible of funds which invest in other funds, the SEC does not in its Report point out the advantages to investors of such funds. There are at least three major advantages to investors of these funds over the conventional mutual fund. The first advantage has already been briefly discussed, namely, that a fund which invests in other funds provides directly to an inventor that which most mutual fund investors have attempted to provide for themselves: diversification of portfolio management. As noted above, most mutual fund investors hold shares in more than one fund, for the simple reason that most people do not wish to trust all of their investment money to any one management. A fund wbich holds several funds not only provides directly this advantage sought by most mutual fund investors, but is in a much better position than such investors carefully to watch management performance on a continuous basis. The second advantage of a fund which invests in other funds is that the selec- tion of a particular mutual fund or funds for purchase is not, at the present time, an easy or simple one. In any rational selection of a mutual fund to be purchased, there must be weighed not only the past performance of various funds, but also the relative `amounts of sales loads, advisory fees, whether or not there is large unrealized depreciation in the portfolios, and the expense ratios of the various funds. Other factors would include whether or not dividends or `distribu- tions may be reinvested at asset value, whether or not there are other funds in the same group having a conservative investment policy to which the investment may be switched without sales load in declining markets, and whether or not th\e fund provides various shareholder services, such as periodic investment at a level load through a bank custodian. In addition, there are today more and PAGENO="0382" 796 more `new types of investment companies coming into existence, and the ad-~ vantages and disadvantages `of each must be carefully weighed before an in- formed decision may be made. These new types of investment'companies include funds with power to "leverage" by borrowing, funds having the power `to sell short and to deal in puts and calls, funds which engage in relatively heavy trading to take advantage of short-term changes in market conditions, and funds which have a portion of their portfolios in unmarketa'ble or other "restricted" securities. In short, the decision as to which fund or funds to purchase today is not a. simple one even for an informed investor. A final important advantage of a fund wlfleh invests in othe'r funds is that such a fund provides a medium through which investors may purchase fund~ shares at a lower sales load than would otherwise be available. This is even more true with funds of this type having no or a very small sales load. The SEC Report itself states on page 206 that: "The reduced loads charged on substantial pur- chases of fund shares benefit some investors. For a few very large ii~vestors the benefits can be substantial. However, the relatively slight reductions available at the initial breakpoints are far beyond the reach of most investors." A fund which purchases and holds shares of other funds, though, is in a position to take advantages of breakpoints not available to investors in those funds. Thus, the total overall sales loads paid by an investor in a fund of this type may be expected to `be much lower than if an investor `had purchased directly shares of one fund or several funds. A careful reading of the SEC Report as to "fund holding companies" makes it quite clear that this portion of the Report is basically an attack on Fund of' Funds Limited, a foreign fund of this type. It is only by a very careful reading' of this section that the reader is able ~to understand that most of the evils attributed to this type of fund are not applicable to domestic registered lnvest.~ ment companies or, iii particular, to Pooled Funds, Inc. or First Multifund of America, Inc. We are really small innocent bystanders who may be mortally wounded by a battle between the giants. I respectfully request this Committee not recommend the enactment of the amendments to Section 12(d) 1 of the In-~ vestment Company Act as proposed by the SEC, but that it enact such amend- ments only if there is included therein a compromise proposal relating to funds' of this type (a copy of which is attached), which compromise proposal I firmly' believe would fully eliminate any possible future dangers and `would permit the continued existence of an `investment vehicle which has great advantages to investors. PRoPosED AMENDMENT TO SECTION 7 OF S. 1659 (COMMITTEE PRINT) DEALING WITH REGISTERED FUND HoLDING COMPANIES Section 12(d) (1) of the Investment Company Act as proposed to be amended in Section 7 of the Committee Print of S. 1659 is further amended by redesignat- ing subparagraphs (-) and (-) thereof as subparagraphs (G) and (H) and inserting immediately after subparagraph (E') thereof a new subparagraph (F) to read as follows: (F) The provisions of this paragraph (1) shall not apply to securities pur- chased or otherwise acquired by a registered investment company `if- (i) immediately after such purchase or acquisition not more than 3 per centum of the total outstanding stock of the issuer of such issuer is owned by such registered investment company and any a1~lliated person of such registered investment company, (ii) `such registered investment company has not offered or sold after July, 1968 and is not proposing to offer or sell any security issued by it through a principal underwriter or otherwise at a public offering price which `includes a `sales load of more than 11/2 per centum. No issuer of any security acquired by a registered investment company pursu- ant to this subparagraph (F) should be obligated to redeem such security in an amount exceeding 1 per centum o'f such issuer's total outstanding securities during any period of less than thirty days. No such investment company shall exercise voting rights by proxy `or otherwise with respect to any security acquired pursuant to this subparagraph (F) except in accordance with instruc- `tions `from its security holders or in the same proportion as all other holders of such security exercise such voting `rights. PAGENO="0383" 797 STATEMENT OF DANIEL J. BATJM,* PROFESSOR OF LAW, INDIANA UNIVERSITY An Institutio~vali~ed Market: The Impact Upon Mutual Funds I What may properly be called the special report of the Securities and Exchange C'ommissioxi on mutual funds is a compromise.1 it is not an attempt to recommend those changes reasonably necessary to insure for the future adequate protection of fund shareholders, free securities markets, and proper safeguards in the funds' relations With portfolio corporations. The report attempts to meet p'reseiit needs generally in terms of minimal remedies.2 But perhaps this is not unwarranted. The special report is, after all, a report not of `the Commission's staff, but of the Commission itself, a body of five mdi- vi'duals, each with his own values, his own interpretation of the facts which are admittedly complex,3 In such a context the report of the Commission should not be condemned but praised, It has both integrity and vigor. Yet, this should not deter full inquiry into the state of the industry as the Congress intended when it authorized the Commission "at such times as it deems that any substantial further increase in size of investment companies creates any problems involving the protection of juvestors or `the public interest to make a study and investiga- tion * * * and from time to time report the results * * * and its recommenda- tion's to the Congress." II We begin with fundamentals. A mutual fund purchases' securities.5 its ability to find and exploit investments successfully depends in no small measure on the actions of the underlying portfolio company and other security holders in that company. To test the behavior of mutual funds, to determine' how they are fulfilling their statutory responsibilities, we must understand th~ implications of what the Commission acknowledges, namely, the growing institutionalization of the stock market.6 None would argue that institutions dominate the market. However, none should dispute the influence of institutions in s'peciflc major issues and industries'. Con- sider the facts, In the aggregate institutional investors, which include mutual funds, pension funds, trusts, insurance companies, are a mighty force. To il- lustrate, the Wharton Report studied a mutual fund industry from the period 1952-1958 when assets jumped from $3.9 billion to $12.2 billion. The mutaal fund industry of 1966 was more than triple the size of that in 1958.~ Similarly, "the $105.8 billion of `equity securities held at yearend 1965 by financial institutions was almost four times the $28.2 billion held at the end of 1955,~" The monies flowing to the institutions are not scattered, Rather, they are in- vested in relatively few issues listed on the New York Stock Exchange. Measured not in terms of outstanding stock, but rather trading volume h'ow imposing is the position of institutional investors, In New York Stock Exchange study for March 10, 1965 "th'e `trading volume o'f institutional investors and interme- diaries was the high'est recorded since the (NYSE) transaction studies began. *Professor School of Law, Indiana University (Indianapolis)'; co-author, "The Silent Partners: Institutional Investors and Corporate, Control"; member of the Ohio Bar., ` report represents an att,empt at Commission level to provide an evaluation of the Investment `company Industry.. Thiough the study has, depth, It Is a compromise, See, "The Prosecutors and the Judges",, Fortune, December, 196,6, 165, 2~10: "The details of the SEC's new mutual-fund stud,y * * * were handled by a small gr'ou'p on the staff who gathered data, argued fiercely among themselves as to recommendation,s the study should make, and wrote drafts of all the chapters. But there was th,en some extremely heavy editing by the commissioners, who did not agree with all the recommendations of the staff-and also had a lot to argue about among thems,elves." 2 SEC Report on the Public Policy, Impl~cations of Investment Company Growth, 89 Cong., 2d Sess., 6 (196,6), hereafter referred to as Report. See also, text discussion under IV~ It must be emphasized that the report is one of reco'mniendat,ions to Congres~ It is addressed to a political body., By definition the report has limitations. In his letter trans- mitting the report to Congress Chairman Cohen noted~ "Neither the Special Study nor the Wharton report was a report by the Commission. When those reports were published, the Comnii's'sion undertook to evaluate the public policy, questions that they raised. * * * This report is a result of that undertaking." Report at ix., ~ Section 14(b), Investmen,t Company Act of 1940. See, Hopper, "Antifraud and Disclosure Reuirements in Selling Investment Company Securities," CCH Conference on Mutual Funds, 15 (1966). Report at 275. See also, Baum and Stiles, The Silent Partners: Institutional Investors and Corporate Control (1965). Report at 275. 8 Id. at 277. Included in this figure are the equity securities held by mutual funds. PAGENO="0384" 798 The investors accounted for an estimated 31.4 percent of the total round-and odd-lot share volume during that day." Without becoming enmeshed In a statistical morass let us remember one ad- ditional fact: When we speak of institutional investors, we are focusing upon relatively few mutual funds and banks. Like so many aspects of our economy, institutional investors also have a propensity toward coii~centration. "Ir~ the mutual fund industry * * * decision-making power is highly concentrated. Eight advisory organizations control about half of the industry!s assets." ~° A survey by the Commission's staff found that 20 large banks manage nearly half of all noninsured private pension fund assets.11 Applied to specific issues, addressing ourselves only to investment companies, we begin to understand more fully the implications of investment company growth. Combined holdings of 425 investment companies totaled $8 billion in 30 issues at yearend 1964. In nine of the 30 stocks investment company holdings amounted to 10 percent or more of the outstanding sbare~. "Trading activity of the Investment companies in many of these stocks during the last half of 1964 was particularl3~ significant with e~et purchases amounting to as much as 39.3 percent of NYSE trading volume in. the shares of Southern Pacific CQ. and 34.9 percent of such volume in the shares of Union Carbide Co. In 13 of t~ie 30 stocks net purchases or sales amounted to 10 percent or more of NYSE volume during that period, and for 7 of these stocks it exceeded 20 percent or more." 12 The special report on mutual funds conceded that not only do investment company holdings account for a substantial portion of the outstanding stock in particular issues, but their holdings in particular industries can be significant. 78 companies, representing approximately two-thirds of the assets of all invest- ment companies, held more than 10 percent of five major aerospace companies. In Lockheed Aircraft Corporation alone their holdings amounted to 17.3 of out- standing common stock, and in Northwest Airlines, Inc., 29 percent.13 Prom what has been stated the Commission concluded that institutions cafi contribute to shaping the market: "The growing institutionalization of the secu- rities markets tends to make the marketS for the issues in which ~nstitutiona1 investors are significant more susceptible to sharp, sudden and erratic price fluc- tuations. As the irregular and relatively infrequent transactions of institutional investors in sizable blocks of securities becomes more and more significant and the relative importance of broad streams of smaller 100-share orderS from individual investors dwindles, the auction markets find it increasingly difficult to maintain the high degree of depth, liquidity, and continuity which they have traditionally sought to achieve. Even when a large institutional investor makes a conscious effort to avoid upsetting the market by adhering to gradual programs of accumu- lation or disposition, its activities tend to have a marked effect on the prices of the securities involved." `~ It is in this setting that the Commission recommended no "major new legisla- tion" as a result of the institutionalization of the market. Rather, the agency urged that the informational gap be closed "with respect' to pension funds and other institutional investors through amendments to existing Federal regula- tory statutes and through other appropriate means. * * ~ 15 We do not quarrel with the Commission's recommendations. We do ask, how- ever, if the market is institutionalized, don't certain results necessarily flow immediately to investment companies? III Elsewhere in the Commission's report on mutual funds we are told that the larger the fund the greater is the tendency to invest in relatively few stocks." Id. at 279. In 1965 institutional purchases and sales of commOn stock reached the highest volume ever recorded. Although 1965 also was a year of record trading activity in the securities markets, generally, institutional trading in recent years has Increased at a much greater rate than overall trading volume. Id. at 278. LO Id. at 301. In mid-1966 the assets managed by the three largest advisers, constituted 28.5 percent of all mutual fund assets. The $5.2 billioh in mutual fund itsse+.~ managed by IDS constituted 13.5 percent of total Industry assets. Ibid. ~1 Ibid. It should be noted that these same banks manage assets for other Institutional Investors and for personal and common trusts. 12Id. at 291. laId at 293. 1~Id. at 301. 15Id at 303. PAGENO="0385" 799 (A) t the end of their fiscal year 1964, despite substantial net capital inflow be- tween 1958 and 1904, half of the 10 (largest) funds had reduced the number of common stock issues held by them from the number held at their fiscal yearends 1958. The largest fund, Investors Mutual, Inc., reduced its holdings by 37 percent from 208 to 131 issues. The largest reduction was 44 percent-from 165 to 92- for Fidelity Fund, Inc." `° Based on fund activity alone we are also told that the ability to both buy and sell is hampered when size reaches a given level and a limited investment policy is pursued. Examples, though dated and therefore understated, were not lacking in the report. A fund manager for a complex authorized in September 1962 tbe purchase of 443,000 shares of a company for two funds under its management. By March 1963 less than half the purchase order of one fund and less than 10 per- cent of that of the other had been filled. During this period the price per share had increased from $40 to $48.17 But perhaps even more alarming is an example given on the sell side. An advisor for one of the largest funds spotted unfavorable factors affecting one of their portfolio securities. A decision was made to sell 220,000 shares when the market stood at $57 a share. (In this regard it should be noted that the report does not indicate whether the 220,000 constituted all that the fund possessed of the ques- tioned issue.) However, before the fund's "selling program" could be effected the price per share had dropped to the midforties.'8 If mutual funds were pension funds, there might be less reason to be disturbed. If mutual funds could buy for long-term holding, there might even be benefit in the rapid absorption of the floating supply of stock. But mutual funds are not pension funds. They are subject to the demands that are imposed by their own internal and industry structure. The mutual fund Industry is concentrated and dominated by billion-dollar enterprises. The structure of a mutual fund generally requires it constantly to sell fund shares in order to meet redemptions. In turn, the sales effort in no small way is financed by the give-up device resulting from brokerage. Add to this the need ~ to sustain a given distribution "policy" and we can better understand the pressure on mutual funds to trade. They, unlikq pensions funds, cannot anticipate with any precision the demands that will be made upon the entity.'9 Now couple these facts with that of an institutionalized market. What is the meaning for mutual funds? How important to fund shareholders, to `free securities markets, and to relations with portfolio corporations is the impairment of port- folio mobility and flexibility? The Commission stated: "Should the growth of the largest funds and fund complexes continue these funds might soon reach the point-relative to the size and conditions of the markets and the economy-where their portfolio mobility would `be so seriously impaired as to affect gravely the interests of their shareholders. It is indeed pOssible that the future investment experience of the largest funds, even if their size's were to continue near the present levels achieved only recently, might be so affected. This is underscored by the fact that other institutional investors, pension funds in particular, have also enjoyed phenomenal growth and are contributing to the growing problems of portfolio mobility. For these reasons, questions pertaining to large fund size and to the need for maximum size limitations on individual funds and fund com- plexes must be reexamined periodically in the context of the changing conditions in `the securities markets and the economy." `° Iv The difficulty with the Commission's position is that in a very real sense the future which it fears already is here. Taking the facts as given, without any thorough analysis of institutional behavior, we know that because of size mutual funds now cannot exercise their best judgment. They can neither buy nor sell ~` Id. at 295-96. The Dreyfus Fund, Inc. and National Investors Corp. were identified in the Wharton Report as having more than 40 holdings of one percent or more of the outstanding voting stock of portfolio companies on September 30, 1958. Id. at 295. See also, Report at 255. 11 Id. at 256. 18 Ibid. 19 With the development ~f the fund of funds how much more difilcult is the position of mutual funds. The threat of massive redemptions is not one to be taken lightly. Id. at 299. 20 Id. at 263. 85-592-68-pt. 2-25 PAGENO="0386" 800 when prudence dictates. The implications of mobility and flexibility made rigid for the mutual funds has a bearing on many of the recommendations of the Commission. A. Size Tim4tations Awaiting the results of study yet to be undertaken the Commission made no recommendations respecting size limitations on mutual funds. Investment policy may continue as it has. All that is provided from the point of reality is found in the five-percent-rule already in the Act,.2' Any company five percent or more of the outstanding stock of wbkh is held by an investment company will be treated as an affiliated person of that investment company. In the words of the Commission "this definition is significant because most transactions between in- vestment companies and affiliated persons require prior Commission approval. Such approval can be granted only if the Commission finds `that the terms of the proposed transaction, including the consideration to be paid or received, are reasonable `and fair and do not involve overreaching on the part of any person concerned.' ~ 22 Neither portfolio rigidity nor portfolio control are prohibited by the Act. Surely, however, there is a need to do more than simply study. Isn't portfolio rigidity in view of the present industry structure itself unhealthy? Ought we not concern ourselves at the very least with controls over the dollar amount that any mutual fund complex may invest in any single issue, keeping in mind the standard not of outstanding shares but trading volume? This suggestion is not intended in any way to criticize the Commission's evaluation of give-ups, which, if accepted, might ease somewhat the pressure to trade for the sake of generating brokerage. The point is that the Commission might not have gone far enough. The danger signs clearly are present. Why wait until substantial injury results? Should portfolio rigidity be permitted to solidify, then we must recognize that for many purposes investment companies may become locked into given issues, that is, there may not exist the opportunity to sell a "locked" issue with rela- tive ease and without substantial loss. Are we not therefore compelled to ask bow the shareholders of the mutual funds will be protected by the managers of their monies? We are assuming a not unreal situation where unfavorable factors in a portfolio company require sale, and the fund because of the size of its holdings simply is not In a position `to extricate itself.~ At this point the import of the Commission's Investment Trust Study in 1940 shouh,l be reviewed: "Investment companies may serve the useful role of representatives of the great number of inarticulate and ineffective individual investors in industrial corporations in which investment companies are also interested. Throughout the course of the exstence of such industrial corporations, various problems are pre- sented to their stockholders which require a degree of knowledge of financial and management practices not possessed by the average stockholder. Investment companies by virtue of their research facilities and specialized' personnel are not only in a position to adequately appraise these situations but also have the financial means to make their support or opposition effective. These investment companies can perform the function of sophisticated investors, disassociated from the management of their portfolio companies. They can appraise the activi- ties of the management critically and expertly, and in that manner not only serve their own interests but the interest of the other public stockholders." 24 To `argue that investment companies do not possess sufficient control to sway management will not suffice. Some mutual funds do hold sufficient stock to make their views felt.25 But, quite aside from percentage of outstanding stock, let us not forget that portfolio management for a number of reasons, including stock options, has an interest in not seeing any substantial block of stock sold in a way that will depress the market price of that company's issue. To answer `as the Commission has that other institutional investors share the same problem as mutual funds is not to respond full or fairly.26 It is the 21 $ectlon, 2(a)(3)~, Investment Company Act of 1940. 22 Report at 308. 23 Id. at 256. Further, the Wharton Report found that the three largest fund groups had 338 separate holdings consisting of one percent or more of the voting shares of a portfolio company. Over half of these holdings exceeded two percent. Id. at 308 211d. at 310. ~ In 1958 indIvidual funds possessed ~,0 percent or more of the voting stock in 34 different Issues, and five to nine percent in five others. Id. at 308 note 7. 231d. at 310-11. PAGENO="0387" 801 same as saying: "If X commits a harmful act, Y should be permitted to do the same." It relegates all to the same common denominator. Further, it ignores the facts. Mutual funds, not pei~sion funds, are the more active traders, and consequently suffer the most from a rigid portfolio position. And, it must be emphasized, mutual funds have a history of government regulation which has given to them the imprimatur of a quasi-fiduciary in the eyes of the fund share- holders. B. Fund shareholders There is a premium paid by those who invest their monies in mutual funds. Some would call it a premium for experience; others would term it a payment for safety; both are correct. Indeed the Commission report does not deny the prem- ium; only the amount is brought into question. We believe the Commission has recommended too little; it has not faced an underlying problem: Fund share- holders, particularly in the larger funds for reasons already stated, may not be getting either the benefit of experience or safety. How can they? If a fund manager in the exercise of his experience business judgment spots weak factors in a portfolio holding and decides to sell but cannot because of the amount held, surely the fund shareholder suffers. Can it be denied that in such a situation the fund shareholder is in much the same posture as one who holds for speculation? His fund manager hopes for investment growth, but is limited In what he can do to insure it; the securities ride the wave of chance. V The Commission's report makes a fundamental assumption: The structure of the mutual fund industry is basically sound. The agency's recommendations are designed to improve that structure. The thrust of these comments questions the Commission's basic assumption. STATTMENT OF ERNEST L. FOLK, III, PROFEsSOR OF LAW, UNIvERSITy OF NORTH CAROLINA AT CHAPEL HILL* I. COMPENSATING MANAGERS AND ADVISORS OF INvESTMENT COMPANIES (Section 8 of the Investment Company Amendments of 1967, amending Section 15 of the Investment Company Act of 1940) Section 8 of the Investment Company Amendments of 1967 deals with the critical problem of the level of management fees charged by investment advisors and principal underwriters to the mutual funds which they serve under con- tract. The proposed rewriting of Section 15(d) imposes a statutory standard of "reasonable" compensation, impliedly grants a private right of action to enforce the standard, and places the burden of demonstrating reasonableness upon the objector. I favor enactment of this provision with one reservation.1 ~t. I first point out that the proposal is a very moderate one. First of all, it de- clares, in the context of mutual fund management fees, a criterion which has been universally applied to compensation of managerial personnel in corporation law, namely that aggregate compen~ation must be reasonable and reasonably related to the services performed for the paying entity. It is hardly radical to suggest that such a well established standard of fairness, should explicitly apply to mutual funds as well. Secondly, the proposal is designed to overcome the effect of several decisions which have invoked certain restrictive rules of state corporation law so as to make it extremely difficult to. give effect to a "reason- ableness" test. It seems to me quite appropriate that in a field, subject to com- prehensive federal regulation, Congress should adopt federal rules whose prime purpose is to undo limitations derived from state corporation law which are primarily relevant to entirely different sorts of enterprises. Finally, the proposal places upon the objector the burden of proving `reasonableness by a "preponder- ance of evidence that such compensation is unreasonable." Although I think this. unduly favors management. I cite it as a clear instance of the bill's notable restraint in regulating advisor- underwriter fees. The conservatism of the Proposal is further underscored by *The views presented in this statement are personal and should not be attributed to the University of North Carolina or to its School of Law. `In/re, pp. 803-804. PAGENO="0388" 8Q2 the fact that neither the bill, nor the SEC's report, would effect any change in the unique structure of the externally managed mutual fund. Accepting that structure as it has developed over the years, the bill would only employ moderate and protective safeguards against abuses, )oth demonstrated and potential. 2. Reasonableness of fees-Ea~istiinhi law' The sequence of litigation challenging the advisory fee charged many mutual funds by their advisor-underwriters is well known. Few of these decisions went to final judgment, although many were settled with some downward revisions of the fees. Litigation under state law standards is demonstrably inadequate to the risk of insuring fair and reasonable fees in the industry. These decisions, coupled with the facts found by the Wharton and SEC Reports demonstrate the need for congressional intervention. This, I believe, is shown by the state law standards employed by the courts in testing the levels of the fees. (a) Judicial Views-Absent shareholder ratification, courts diverge on the validity of a transaction between a corporation and a director, officer or con- trolling person; but the probable majority view is that the transaction stands if it is found to ~e fair (upon judicial scrutiny) and was approved by a majority of directors h~tving no direct or indirect interest in the transaction. If share- holders ratify the transaction, despitesonie variance among the courts, this factor is given substantial weight. The Delaware courts view ratification as shifting the burden of proof to the objector to sl~ow thaf the fransaction is unfair. In the litigated mutual fund cases, where sharehOlder ratification typically is involved, this burden is to "convince the court that no ijerson of ordinary, sound business judgment would be expected to entertain the view that the consideration was a fair exchange for the value which was given." Even if "waste" of corporate assets is alleged, judicial security is limited, for "if * * * ordinary businessmen might differ on the sufficiency of the terms" of the contract, fee, et,c, "then the court must validate the transaction." Saae v. Brady, 40 Del. Cli. 474, 486, 184 A. 2d 606, 616 (Ch. 1962). Although not an imposs~ble burden, it is manifestly a heavy one. Most importantly, it will almost invariably be the applicable standard since overwhelming shareholder ratification of contracts with investment advisors may be bad for the asking. Under state law standards, probably persons of "ordinary, sound business judgment" will not deem the compensation unreasonable so long as the fee is not too far from the classic level (1/2 of 1% of average net assets with some scale- down at high levels) long prevailing in the `industry for externally managed funds. Even if this standard were a satisfactory one in theory, Sawe v. Brady demonstrated the difficulty of applying it to a concrete situation because of the unavailability of comparative data to measure the reasonableness of the fee paid by a particular fund. For instance, absent such information, `a court cannot ra- tionally assess the quality af services furnished by the advisory organization, or its level of profits, or the reasonableness of expenses incurred. Finally, several able judges have visibly winced at the restrictions of this rule which has required them to sustain fee schedules which seemed to them excessive, but not so much so as to point to fraud or over-reaching, or otherwise to a violation of the applica- `ble standards. See ~8a~~e v. Brady, 40 Del. ~h. 474, 497-98, 184 A. 2d 602, 616-17 (`Ch. 1962); Aeampora v. Birkland, 220 F. Supp. 527 (D. Cob. 1963). It is clear, then, that the prevailing state-law judicial tests are inadequate to deal with the problem of excessive fee levels. And the fact that they are excessive is indicated by the number of cases which were settled with advisory fee reductions. To put the m'atter into context, it must be remembered that this entire fee is borne pro rata by the shareholders of the fund since the amount, whatever it may be, is skimmed off the gross revenue of the fund before distributions are made. (b) ~$tate $tcmtutes.-A development not noted `by the SEC Report but impor- tant for the future is the advent of statutes specifically validating transactions, otherwise doubtful or involving conflict of interests. Several otates, most impor- tantly Delaware, have statutes which uphold transactions between a corporation and a director or afficer, or between interlocked corporations, if full disclosure is made to the director and the transaction `is approved by a majority of the dis- interested directors "in good faith"; or if the shareholders ratify the transaction after full disclosure; or, in any event, if the transaction is fair to the corporation as of the time it `is made. Delaware Gen. Corp. Law § 144(a) ~2 If any one of these conditions is met, the transaction is substantially immunized from attack. 2 The reference is to the newly enacted Delaware General Corporation Law, signed by the Governor on July 3, 1967. PAGENO="0389" 803 I believe that these statutes would make it even more difficult for mutual fund shareholders to challenge advisory fees than has been true under the judicial doctrines. rihus full disclosure to all directors in the case of an investment com- pany-will end the matter if the directors act in "good faith" which ordinarily they could show, for "good faith" is a less rigorous standard than "fairness." In all events, ratification by the shareholders after disclosure-which, of course, the Investment Company Act authorizes-would be conclusive even if director ap- proval were not. Accordingly, these stktutory standards would not ease the ob- jector's burden, and probably they would increase the effort necessary to win a judgment for the fund or affect a satisfactory settlement. (c) Finally, I point out a new and somewhat unnoticed development occur- ring in the state law of fiduciary duty which, ultimately, is involved in any deter- mination of reasonable management compensation. This is the ten4ency of some courts to apply to situations, involving definite although subtle interest conflicts, the famous "business judgment" test. This concept originally meant that if the directors of a corporation, acting without any conflict of interests or otherwise in breach of duty, approved a transaction, it is immune from attack even if it proves to be wrong, even disastrous to the corporation. Originally, it was not applied when directors did have an interest conflict; there the orthodox rule required full "judicial scrutiny" of the transaction to discover and extirpate any taint of wrongdoing. Several relatively recent decisions in corporation law are susceptible to the interpretation that the business judgment rule has been applied beyond its original contours to uphold a transaction in which interest conflicts inhered. Warshc&w v. Calhoun. 221 A.2d 487 (Del. Sup. Ct. 1966) ; Case v. New York Central RB., 15 N.Y.2d 607, 256 N.Y.S.2d 607 (1965), cf. Cheff v. Mathes, 199A.2d 548 (Del. S. Ct. 1964). Although these decisions deal with prob- lems altogether outside the mutual fund field, I believe that they point a warning signal for Congress to consider in determining whether legislation on mutual fund fees is necessary. Should this line of decisions grow, I believe that it would be an easy step for a court to rule that the compensation level for an advisory organization lies within the business judgment of the directors, or at least those not affiliated with the advisor-underwriter. Sawe v. Brady's language, already quoted, is indeed a bridge to that result since it frames the test in terms of whether "ordinary businessmen" would differ on the sufficiency of the terms. I say this even though taking full account of ~axe v. Brady's significant warning that "the business community might reasonably expect that at some point" the management fee woul4 be adjusted downward to "reflect the diminution in the cost factor." 40 Del. Ch. 474, 498, 184 A.2d 602, 616-617 (Del. Ch. 1961). 3. The reasonableness standard of the bill Despite some attack upon the supposed vagueness of the "reasonableness" standard, the test is as precise as it is possible in an area requiring fact deter- minations in particular cases. Indeed, the test of management compensation in state corporate law is one of "reasonableness", with additional content derived from the subsidiary standards applied in the mutual fund cases and by manipu- lating the burden of proof depending upon ratification. Thus, the general stand- ard is the only conceivable one which could do justice to all situations covered by it. In my judgment, the bill appropriately identifies the components of the "reason~ ableness" standard without limiting the factors to be considered by the courts. The four designated factors are the ones which judicial dedsions and informed discussion have viewed as significant. Flexibility is guaranteed by subsection (d) (2) (E) referring to "such other factors as are appropriate and material." 4. Burden of proof My chief doubt about the provision lies in its placing the burden of proving unreasonableness on the party Objecting to the fee level. Even when reasonable- ness is the criterion, it will be difficult for the outsider to secure the data which will enable him to establish the unreasonableness of compensation, especially in light of the factors comprising reasonableness under the statutes. Most of these factors relate to internal matters, information on which is not likely to be available to the objector. For instance, it will require considerable effort to obtain, if the effort is successful. facts bearing on the quality of services rendered to the fund or to the advisor's other clients ((d) (2) (13)), economies of scale within a complex of funds managed by a single advisor ((d) (2) (C)), PAGENO="0390" 804 and the value of all benefits received by the advisor by reason of his relation to the fund ((d) (2) (D)). Much of this information is in the possession of the investment advisor, a separate corporate entity, to whose books and records a mutual fund shareholder's inspection rights do not extend under state law, although liberal discovery may somewhat ease the task. I conclude that the bill should place the burden of proving reasonableness upon the defendants because they are in the best position to produce relevant data- far more so than the outsider seeking to obtain records and infdrmation of which be necessarily has only vague knowledge. Indeed, state corporate law has often recognized that a fiduciary is in a better posture to prove the reason- ableness or fairness of his action than the challenger is to establish the con- trary. Unless the burden is imposed on the defendants, I believe that the proposed law may effect only a paper change-from the restrictive state law standards currently applicable, to a theoretically ge~nerous federal standard impaired in practical effect by its pendant burden-of-proof rule. An additional reason for placing the burden of proof on the advisor-under- writer, and affiliated persons is that they are properly viewed as fiduciaries for the fund and for its shareholders. Although some sharply contest this view, contending that the advisor bargains at arms length with the fund. whose interests are protected by the unaffihi.ated directors, the fact is that even state law now tends to view a person or entity in control of another as having at least some respoNsibilities of a fiduciary character Instances include a controlling share- holder who may or may not also be a director or officer of a corporation. But the principle is not necessarily limited to one whose control is achieved through means other than shareholdings. Thus, in the mutual fund fee cases control is exercised through the affiliated directors, coupled with the facts that the advisor is usually the fund's founder and that the contract between advisor and fund is for practical purposes not terminable either by the unaffihiated directors, the fund shareholders, or by someone seeking to stage a proxy fight and substitute another advisor. * Accordingly, I believe that the bill should place the' burden of proving reason- ableness on the defendants. If so, it should also make clear that this burden remains there even, though the contract is approved by a majority of unaf- ffliated directors or by vote of the shareholders. If this is thought to be too strong, I would suggest the following alternatives: (1) The burden of proof should never shift `as a result of shareholder ratification, but (2) the burden of proof could `shift to the objector if, but only if, the contract is specifically approved by a majority of directors, none of whom is an "interested person" within the meaning of that term as it would be defined in proposed Section 2(a) (19) (see Section 2(3) of the Investment Company Amendments Act of 1967). As indicated later,3 I believe that this definition should be enacted, for it is essential for protecting fund shareholders from serious conflicts of interest, not touched by existing law, `that the statutory provisions go beyond the some- what narrowly defined "affiliated person" (Section 2(a) (3) and embrace others whose interests may be at least as adverse to the fund and its shareholders as "affiliated persons." Thus, if the contract `has the approval of a majority of genuinely disinterested directors-whether or not affiliated under the existing definition-it would seem appropriate to permit the burden of proof to shift to the objector. I reiterate my main contention that any enactment should impose on the defendants the burden of proving reasonable compensation (subject `to possible modifications as noted above), rather than, as in the proposed `bill, requiring the objectors to demonstrate unreasonableness by a preponderance of the evidence. II. FIDUCIARY DUTIES AND THEIR ENFORCEMENT The Investment Company Amendment of 1967 would more effectively enforce the fiduciary duties of fund directors, advisors, underwriters, and others in position of control or significant influence. I comment on several which I think are essential. 1. Definition of "interested person" Section 2(3) of the `bill would add Section 2(a) (19) to the 1940 Act defining a new term "interested person" which would then be employed elsewhere in the Act, notably in Section 10 (relating to permitted and prohibited affiliations of 3lnfra, pp. 804-806. PAGENO="0391" 805 fund directors), Section 15 (required approval of advisor-underwriter contracts), and Section 32(a) (relating to approval of financial statements by independent accountants). One of the often used key terms of the 1940 Act is "affiliated person." For instance, Section 10 imposes percentage limitations on the number of directors who may be "affiliated persons", of the investment advisor or underwriter, while under Section 15(c) investment advisory contracts must be approved by a majority of directors who are not parties to the contract or "affiliated persons" of a party, unless the fund shareholders ratify the contract. Section 2(a) (3) defines `~afflhiated person" to include one who owns or controls more than 5% of the voting stock of another, one who is an officer, director, or partner or em- ployee of the other person, or one who is "directly or indirectly controlling, controlled by, or under common control with" the other person. Under Section 2(a) (9) ownership of 25% of the voting securities of a company raises a pre- sumption of control. The "control" definition is unfortunately limited by raising another presumption that "a natural person shall be presumed not to be a con- trolled person." This cluster of terms, although seemingly inclusive, is in fact inadequate and inhibiting. Certain loopholes permit relationships, strongly savoring of serioia~ interest conflicts, to flourish uncorrected. For instance, a director is not an "affiliated person" even though he owns 4.99% of the stock of the investment advisor. Thus, his vote on the advisory contract counts as one of the all-im- portant unaffihiated director votes, although certainly he is hardly disinterested. Again, the son of the controlled share holder of the principal underwriter or advisor is not an "affiliated person," although he too is scarcely a disinterested director when voting on the contract between the fund and his father's firm. Even if it could be argued that such persons are "controlled" by the advisor or underwriter, this contention is defeated since the fact of "control", under existing law (Section 2(a) (9)), must be affirmatively proven because a natural person is presumed not to be "controlled." As a final instance, the attorney on retainer of the advisor or underwriter is not an "affiliated person" under present law; establishing that he is a "controlled" person encounters the difficulties just noted. Since the critical term in the existing law-"affiliated persons"-does not come close to covering all persons who have a significant economic or other interest in a fund's advisor-underwriter, it is clear that decisions which must be made by unaffihiated directors are being made by interested directors. Indeed, since the advisor normally is in a position, to secure the election of all the direc- tors of the fund, it would be fatuous to suppose that one holding such control will knowingly place on the fund's board persons who will be other than kindly disposed to the advisor's interests. This is not to suggest that unaffiliated direc- tors breach their duty. It is to declare emphatically that many such unaffiliated directors are in a posture of unavoidable conflict of interests, even though they do their best to resolve those conflicts as decent and honorable men. But the very existence of such conflicts deflects the main thrust of the Act: that a certain percentage of directors will be the disinterested, dispassionate protectors of the interests of the fund shareholders especially when the critical question of the advisory contract is to be voted upon. One need not suppose that an unaffihiated director is necessarily subservient to the advisor. However, his delicate position of subtle dependence will dispose him to resolve doubts in favor of the advisor, to stress in his own mind the quality of services actually rendered rather than investigate the possibilities of improvement, to silence nagging doubts that the compensation formula may be producing excessive compensation as fund assets grow, to soften the probing question or forego the extra hours of independent inquiry into comparative statistics and information, or to ignore suspicions as to the propriety of sales practices under the fund underwriter's auspices. Con- gress in 1940 no doubt believed that unaflihiated directors would pursue such efforts on behalf of the fund and doubtlessly in some measure these expectatiorts have been fulfilled. But the fact of mere partial fulfillment is disquieting, and the failure has occurred in crucial areas of fund operation. For example, almost none of the externally managed funds took steps to reduce compensation under the classic one-half of 1% of net assets formula, until pressure was generated by the Wharton School Report and, more tangibly, the numerous shareholder derivative suits challenging operation of the formula. It could reasonably be supposed that truly disinterested fund directors would have anticipated the undue swelling of compensation under a rigid formula and PAGENO="0392" 806 would have urged reduction of compensation so that the advisor would pass on to the fund shareholders some of the economies of sale. As Chancellor Seitz stated in &t~ve v. Brady, 40 Del. Oh. 474, 497-98, 184 A. 2d 602, 616-17 (Del. Ch. 1962), "t is not to be assumed that `an independent board would wait until the fees paid under the management contract warranted a finding of waste before attempting to negotiate a better deal," for "ideally a truly independent and active board would be expected to be alert to the factors" bearing' on the reason- ableness of compensation. In this case, Chancellor Seitz assumed without decid- ing that "an independent board was not present" despite the requisite number of unaffiliated directors. The bill's provisions would go far towards correcting these deficiencies in the original act. Section 10(a) would be revised so that no more than 60% of the board will be "interested persons." This sttbstantially enlarges the correspond- ing prohibition in original 10(a) which barred a like percentage of persons who are investment advisors or "affiliated persons" of the adviser. The enlargement derives from the much broadened definition of "interested person" in Section 2(a) (19). Similarly, the prohibitions of Section 10(b) are reframed in terms of "interested" persons rather than "affiliated" persons as in the original act. Most significant is the effect on Section 15(c) which presently requires ap- proval of the advisory contract by "a majority of the directors who are not parties to such contract or agreement or affiliated persons of any such party'~ (un- less ratified by the shareholders). The new provision would require approval by a majority who are neither parties to the contract nor "interested persons of any such party." It would add three additonal safeguards. First, ratification by shareholders is deleted-quite properly, I believe, because it has been a convenient northwest passage around the existing statutory re- quirement of approval by a majority of non-affiliated directors. Indeed, ratifica- tion even with full disclosure, is hardly any safeguard at all, because it can be so easily obtained from shareholders who have little interest in what they are being asked to vote on if, indeed, they understand what they ~re doing let alone its legal significance. Secondly, the directors must vote on the advisory contract "in person at a meeting called for the purpose of voting on such approval." This ipsures that each disinterested director will have specific notice of the purpose of the meet- ing. Presence at the meeting at least insures a forum for a free exchange of views and ideas, whether or not it does in fact occur. Thirdly, all directors would have a specific duty in this `context: to "request and evaluate" information "reasonably necessary to determine the reasonable- ness of compensation." The advisor has a correlative statutory duty to provide such information. The first part of this provision probably only declares existing law, for directors always have a duty, when voting on compepsation, to consider its reasonableness. ilowever, the statutory declaration should bring home this duty much more sharply to all directors and stand as a continuing reminder when the common-law duty may be forgotten. After all, most corporate directors are not lawyers; a specific statutory statement is apt to be quite meaningful to them. The definition in Section 2(a) (19) of "interested person" is more inclusive than the older term "affiliated person." (A) It includes any "member of the immediate family" of a natural person who is himself an "affiliated person." This would cover the example, eupra, p. 805, of the son of the founder and chief stockholder of the advisor, who under present law may be an "unaffihiated" director. (Incidentally, "member of the immediate family" is itself specifically defined at the end of Section 2(a) (9).) (B) It includes anyone who has a direct or indirect beneficial interest in securities issued by the advisor or others as well as certain fiduciaries (such as trustee, executor or guardian) who hold such beneficial interests. (C) It includes any person who currently or within the past three years, has "any direct or indirect material business or professional relationship" with the advisor or others. This would cover the situation described, supra p. 805, of the attorney for the advisor who may at present sit as an unaffihiated director of the fund. (D) The definition makes clear that it extends to "interested persons" of an investment advisor, principal underwriter, regular broker, or investment banker and any controlling persons of such entities. PAGENO="0393" 807 2. Enforcement of breaches of duty Section 36 of the 1940 Act authorizes the SEC to proceed against certain per- sons for "gross misconduct or gross abuse of trust" towards an investment com- pany. This provision has been ineffective. For one thing, the very terms them- selves exclude most situations involving ordinary breaches of duty or conflict of interests. The adjective "gross" connotes something much more serious, perhaps bordering on the criminal. Secondly, when the SEC has used this provision to challenge certain types of duty breach, it has been unsuccessful precisely because the activity complained of lacked the degree of turpitude sug- gested by the language of Section 36. See SEC v. Insurance Securities, Inc., 254 R.2d 642 (9th Cir. 1958). Compare Aidred mv. Trust v. SEC, 151 F.2d 254' (1st Cir. 1945). Finally, the SEC has been reluctant to use this section to stig- matize conduct, which may well be questionable, with the pejorative terms "gross misconduct or gross abuse of trust," apart from the fact that the conduct may not itself be so "gross" as all that. Because the present Act lacks any general provision for the SEC to challenge breaches of duty-and, indeed, the very presence of Section 36 may be inter- preted adversely to implying other and wider enforcement powers in the stat- ute-most of the important litigation has been instituted by private j~arties in state courts. This is most obviously true of the cases attacking the advisory fee; and, as indicated earlier, the courts unfortunately invoked state law restrictions which proved to be inappropriate to the difficult and subtle problems in the litiga- tion, although outstanding judges, such as Chancellor Seitz in Delaware, re- cognized the anomaly. Quite clearly, the statute should give the SEC standing to invoke court aid in situations not now encompassed by the narrow terms "gross misconduct or gross abuse of trust." Section 20 of the Investment Company amendments would permit an action if certain persons have or will engage "in any act or practice con- stituting a breach of fiduciary duty" to the 1~und. This includes the offenses covered by existing language, but the merit of the proposed revision is that it will permit challenge of many other types of duty breach or interest conflicts. Both in the existing law and under the proposed language, the same persons will be covered: officers, directors, investment advisors, depositors, and principal underwriters. 3. SEC intervention in certain private actions under the Investment Company Act of 1940 Section 23 of. the Investment Company Amendmeilti~ of 1967 would amend Section 44 of the 1940 Act by adding new provisions authorizing the SEC to intervene ss a party in any action growing out of two of the major new sub- stantive provisions which have been proposal. The first would permit SEC participation in any action seeking to enforce the standard of reasonableness (new Section 15(d)) which would govevn the compensation charged to' a fund by its investment advisor or principal underwriter. See discusuion of this sub- stantive provision, supra at pages 801-804. The second would authorize SEC intervention in private actions enforcing the prohibition in new Section 15(g) against certain transfers of the assets or securities of an investment advisor in the change of control occasioned by such transfers would "likely * * * impose additional burdens on the investment company or limit its freedom of future action or otherwise is inequitable to such investment company." I believe that it would be desirable to authorize SEC participation in both classes of suits when instituted by private parties. Both proposals involved new, and in some respect novel, statutory provisions. I believe that SEC expertise on these topics would be of material aid to courts in developing a sound body of case law, since the SEC could thus bring to bear its accumulation of data and information demonstrating the need for enactment of these substantive provi- sions. Intervention is particularly needed in management fee cases if, as the bill provides, the burden of proving the unreasonableness of a particular fee rests throughout the case on the plaintiff.4 Since this is a heavy burden to be carried by a private party, the balance in favor of the fund and its advisor-underwriters, would be slightly redressed if the objector has the material support of the SEC. Accordingly, I favor enactment of the changes in Section 44 of the 1940 Act (as provided for in Section 23 of the Amendments). I have indicated earlier my view that the burden should rest upon the defendants to prove the reasonableness of the fee. See pp. 803-804. PAGENO="0394" 808 III. CONTRACTUAL PLANS (FRONT-END LOAD ARRANGEMENTS) (Section 16 of the Investment Company Amendments of 1967, amending Section 27(a) of the Investment Company Act of 1940) The SEC proposes an amendment which would make unlawful the front-end load feature of certain contractual plans for buying mutual fund shares. Needless to say, this does not in~terfere with the established and sound practice of pur- chasing mutual fund shares over a more or less lengthy "contract" period, so long as the sales load is distributed evenly over all payments. This proposal is less radical than it appears at first blush since it does not interfere with sales on a "level-load" basis, and since the existing Act already partly regulates front-end load plans by forbidding deduction of more than 50% of the aggregate payments for the first year. However, this proposal has met heavy resistance from the industry because it would abolish a rather strong incentive to sell funds and collect an unusually large commission at the outset. I concur with the proposal to amend the Act to eliminate the front-end load feature. 1. I believe that an overwhelming case has been made out, both ~y the Wharton School Report and the SEC Study, for this proposal. Evidence shows the extent to which many mutual funds purchasers fail to complete their payments, and that most defaults occur within two or three years of initiating the contract, so that a disproportionate amount of money paid by the purchaser never is invested for him. Even if a contract plan is carried to completion, mathematically it is impossible for the investor to have working for him (on a front-end load plan) the same amount which would have been working for him over the same time period (on a level-load plan). See the statistics in the SEC Study at page 235. Full disclosure of all facts pertinent to the front-end load plan does not afford adequate protection because of (1) the difficulty of many investors in under- standing the plan, (2) their failure to realize, when contemplating a default on payments, the consequences of the default; and (3) the fact that salesmen have such a strong economic incentive to push front-end load plans that they are unlikely to indicate the advantages of a level-load plan. Since the Investment Company Act, unlike the Securities Act of 1933, does not predicate its regulation solely upon a disclosure philosophy ~ut has incorporated substantive safeguards, I believe it would be consistent with the Act's premises to extend this needed protection to unwary investors. More particularly, I believe that the front-end load plan imposes upon such investors a heavy and substantial risk of loss on top of all normal investment risks; and that since this is most likely to happen to investors least able to bear the risk of loss, it should be outlawed. 2. I address myself to several misconceptions promoted by industry sources concerning front-end load funds: (A) The front-end load plan is chiefly defended on the ground that it encour- ages systematic savings. Assuming this to be so, the effectiveness of the supposed deterrent would depend upon the investor's knowledge of the consequences of default-and, more particularly, on his knowledge of these consequences at the time he must decide whether to default or not. The Wharton Study indicated widespread ignorance of the mechanics of the front-end load plan, and to that extent the deterrence is unlikely to operate. Such deterrence as there is necessarily less pointed and dramatic than the loss of a house, consumer goods, or insurance upon non-payment of an instalment. One is less affected by knowing-if he does know-that he has ~t small investment relative to the amount actually paid in. Thus the argument for stimulus to systematic savings is, at best, a weak one, and the losses are out of proportion to what little may be achieved in the way of prompting savings. If this is genuinely a concern of the industry, it would seem that fairer means could be devised. (B) Even if an investor consciously elects to default on payments and bear the adverse effects, I do not believe that it is fair and equitable to exact what is in effect a penalty, especially since the default may be prompted by economic or personal troubles or needs. To state it otherwise, such consequence is at variance with the general philosophy of the federal securities act of protecting investors, and inconsistent with one object of mutual funds in affording a better investment medium than securities selected haphazardly or ignorantly. The fact that some investors may later resume payments and get their status restored does not justify the loss to others who cannot or do not wish to resume payments. Also the fact that the investment actually made, if retained with the fund, njay catch up with the heavy initial load is equally inapposite; apart from the fact that the PAGENO="0395" 809 asset value may not increase, the purpose of all investment is, after all, to enable the investor to secure capital appreciation and income. Thus, no investor should be expected to pay for losses due to heavy commissions on the first year of payment by contributing a portion of his capital appreciation for this purpose. The reason- ableness of a commission, or the timing of its payment, should be measured by the amount actually invested, not by the prospects for later performance of the invest- ment; to argue the contrary would justify higher than ordinary commissions on "growth" as against stable "income" stocks. (C) Some have contended that the front-ençl load feature for mutual funds does not `differ in substance from similar heavy commissions in early years to insurance salesman, or large early year interest payments on a house mortgage or other goods purchased "on time." The critical difference is that both the insured and the home owner have immediate enjoyment of the benefits or goods for which they have contracted. Death benefits for the insured who `dies the next day are not `scaled down, nor does the home owner `receive only a half or some part of his house.5 In contrast, the purch'aser o'f mutual `fund shares' under a front-end load plan finds that after one year o'f payments, his investment is only one half of the total amount paid. Moreover, the insured, `besides getting full protection at once, also `presumably receives, so long a's he holds the policy, various services of his ins'urance agent, such as aiding him in processing a claim, etc. In contrast, once the front-end load plan has `been sold, there is little more for the mutual fund salesman to do; and `because the greatest part of the commission has been earned in the first year, he lacks economic incentive to' wo'rk further with the investor under the plan or encourage his continuance. In short, the front-end load plan is essentially, and probably `solely, a salesman's incentive to induce someone to initiate, but not necessarily to complete, the plan agreed upon. 3. Assuming that the prime reason for the front-end load plan is to quickly aug- ment salesmen's commissions, it would be difficult to argue that this incentive is needed to promote the legitimate and desirable growth of the industry. Four major states-California, Illinois, Ohio, and Wisconsin-either prohibit or sub- stantially regulate front-end load plans; and in California, which bars such plans, more mutual fund shares are sold than in any other state.6 This indicates that whatever incentive is afforded to salesmen, it is one which can and should be dropped, without serious detriment to the industry. IV. SALES LOADS `(Section 12 of the Investment Company Amendments of 1967, amending Section 22 of the Investment Company Act of 1940) The SEC has proposed key amendments to the 1940 Act restricting the sales load on mutual fund shares to a maximum of 5% of the amount actually in- vested in the fund. Because this is the most controversial provision of the bill and would, apparently, have widespread impact in the idnustry, I comment in detail on this provision, and particularly on the objections made to this proposal. I state at the outset that I endorse this proposal subject to the SEC's discretionary power to grant exemptions in appropriate situations. 1. The typical sales load of 8.5% measured as a percentage of the total amount paid by the customer (or approximately 9.3% of the amount actually invested in the fund) seems needlessly high. This 9.3% figure is roughly four and one-half time,s greater than the total commissions charged for a "round trip" (purchase and sales) of shares listed on the New York Stock Exchange.7 It con- trasts unfavorably with the aggregate charges for purchase and sale of securi- ties traded over-the-counter, on the basis of statistics from industry sources summarized in the SEC Study at page 212.8 Perhaps most markedly, it con- The analogy with house purchases is also misleading, since the fact that a large pro- portion of early-year payments goes to interest simply reflects' the fact that the loan is larger in early than in, later years. See Investment Company News. Vol. 7, No. 4 (April-May 1967), p. 3. for statistics on sales by states. 1966 California sales amounted to $1,042,005,000, with New York second with sales of $564,001,000. This is nine times greater than the commission for a purchase alone, However, I agree that comparisons are pronerly made between the mutual fund sales charge (9.3%) and total commissions for a "round trip" since mutual funds redeem their shares without any charge or a miniseule charge at most. "SEC Study" refers to Report of the ~EC on Public Policy Implications of imvestmene Company Growth (1966), H. Rept. No. 2337. PAGENO="0396" 810 trasts with the existence of (1) no-load funds which, while relatively small in relation to the load funds, are nonetheless substantial investment companies and with (2) the closed-end funds on which sales charges are normal stock exchange commissions. Like stock exchange commissions, the much higher mutual fund sales load is not subject to competitive forces working in favor of the customer seeking a lower commission; but it stands at a rigid and fixed level' protected against downward competitive pressures by the resale price maintenance provi- sions of the Investment Company Act.~ The sales load itself is also supplemented indirectly by the mutual funds, either in the form of give-ups to brokers vigor- ously promoting sales of a fund's shares, or indirectly by the fact that the fund * itself prepares much of the sales literature. I believe that, in view of these factors, the mutual fund load is excessive. This is, I subni~t, especially true in light of the great (and, on the whole, deserved) increase in the size of the funds since 1940, whose economies of scale should operate both to reduce the sales load and the investment advisory fee. 2. Objeetioas to the Proposed 5% Ma~~~mum.-Before considering the specific industry objections, I stress that the 5% figure is not a rigid ceiling. The bill would specifically empower the SEC, by rule or order, to exempt persons, securi- ties or transactions from the 5% figure. The relevant and familiar standard is whether the requested exemption is "necessary or appropriate in the `public interest and consistent with the protection of investors and the purposes" of the Act. Where the SEC has administered the Act in other areais, it ha's em- ployed its exem'ptive powers in a fair and just manner so as to achieve the test's objectives of `serving the public interests and protecting investors. Accord- ingly, the exemptive power given here `sho~ild carry persuasive weight in estab- lishing a fixed ceiling. (a) It is suggested that 5% i's an arbitrary, indeed capricious, figure without foundation in economic studies. It is apparently true' `that the S~O Study `ha's not reported specific economic data for choosing `5% rather than some lower or higher figure. It would seem, however, entirely fair to adopt a percentage figure lying roughly halfway between the aggregate `2% commission for `stock exchange `commission's and the existing 9.3% `sales charge (8.5% load). It seems no more objectionable than the N'ASD"s `declaration of a 5% ceiling (`subject to ex'ceptions) for charges on transaction's in over-the~counter stocks. For rea'son's later indicated, I doubt that a comprehensive study of all economic factors and impacts would enable the `Congress to come `nip with a more exact percentage figure, in view of the `many varia'ble's. Coupled `with the exemptive power,, the `5% figure seems appropriate. Its fairness is indicated by the fact that many funds have `been able to exist and serve their shareholder's `without exacting any sales load at all. (`b) It has `been s'uggested that the SEC would enter t'he area of ratemaking for the `first time `by `having power to administer a 5% `ceiling, and that t'hi's converts the investment `company industry into a `pu'bli'c utility. The fact is that Congress in 1940 deci'ded to treat investment companies a's a type of public utility when it established t'he `comprehensive `regulation of the 1940 Act. Although "rate making" did not figure prominently, `Section 27(a) of the 1940 Act did indeed confine sales load's to a 9% `maximum and also limited initial `sales load's in `connection with `front-end load (contractual) plan's. The issue i's not whether investment `companies `shall `become public `utilities-for they are that already-but whether a `certain ty'pe o'f regulation of sales charges is appropriate. (`c) It is contended in industry sources tha't cutting the `sales load to 5% from existing levels `will `drastically `reduce the profitability of `many `broker- dealers, especially `s'mall firm's. I put to one ,si'de the tendency of virtually any industry `confronted `with possible regulation to claim that irreparable economic injury `will `result, and especially the `di's'position to play u'pon sympathies for "small `business". Turning to the merits, the chief `contention's are based upon a study by Booz-Allen Applied Research, Inc., for NASD, indicating that a large number of firm's would have fallen into a net losis position if the 5% fi'gure `had `been in effect `d'uring 1966. I believe that this type o'f speculative conclusion `should not `carry the weig'ht whi'c'h the industry `would `urge: (A) The study evidently a's'sumed that there would `be no changes at all in method's of operation, number of personnel, etc.; `but merely applied the 5% Investment Company Act of 1940, § 22(d). PAGENO="0397" * 811 figure to existing operations. But surely if lower aggregate revenues are reasonably to be anticipated, prudent firms would seek to enhance the efficiency of their procedures. The study `does not `consider, for example, whether an excessive number of persons are engaged in heavy selling of mutual funds. or whether sales efforts are scattered over marginal prospects. (B) The study also assumes that the level of commissions for other types of securities business will remain unchanged. In fact, the commission rate struc- ture, `at least for New York Stock Exchange transactions, may well be altered upward. In all events, one cannot assume for t'he indefinite future that the com- missions for each type of securities business will continue at present levels. (0) AssumIng arguendo `that some firms will suffer from, a lowered rate, the real question is whether mutual fund purchasers should be called upon to under- write inefficient firms, excessive sales efforts, or unduly low commissions (if such is the case) on other forms of business. I find it difficult to believe that the typically small investor who buys mutual funds should have to furnish a sub- sidy of this sort. (D) Th~ 1940 Act, by its somewhat limited regulation of mutual fund sales charges, necessarily impaired the profit-making potential of some firms selling mutual fund shares. Evidence presented at the time to the Senate showed that sales loads had ranged as high as 20%, and th'at front-end load charges for the first year bad exceeded the 50% figure allowed by the 1940 Act. Thus, Congress has already exhibited willingness to balance the interests of investors in mutual funds against the interest of sales organizations in securing as high a level of charges as possible, and to extend protection of investors even at some cost to the profit-making potential `of the sellers. (d) It has been suggested that since load funds to give a quantity discount (unlike stock exchange commissions), this a'ccords the fund investor a "break" not available to purchasers of exchange-listed shares. This contentio'n is hardly relevant, since the "breakpoint" for a reduced sales `load comes only at high purchase levels, even when it is available for a contract with purchases spaced out over a period of years. Thus, `the SEC Report indicates that the first break- point for many funds occurs at an investment of $12,500 (when the load drops from 8.5% to 7.5%) .~° Since most mutual fund purchasers are small investors, it is doubtful that many receive the benefit of even this relatively small reduc- tion in sales load. In all events, prime consideration should be given to aiding the small investor in seeing that a greater proportion of his funds `actually go to work for him with the fund rather than into a sales commission which produces nothing for him. (e) It is suggested that no comparison with a stock exchange commission is valid because the mutual fund purchaser acquires, not a security in the usual sense of the word, `but a type of "service". Sometimes, comparisons, highly favorable to the mutual fund, are made to show how large an aggregate com- mission the investor would have to pay if he were to attempt to duplicate this "service" by buying a small liumber of shares of many stocks. Granting that the purchaser does indeed receive a significant "service" through a mutual fund, the conc1usion-~that sales loads should not be disturbed-does not follow. First, the mutual fund purchaser pays each year for that "service" through the fund expenses deducted from the fund's gross income for advisory or administra- tive fees, annual reports, prospectuses, and so forth. Thus, he pays an annual fee for this service. The sales load does not compensate for any service performed by the fund; its function is simply to provide a profit-the amount of which is, of course, disputed-for the sales organization. This is demonstrated by the fact that closed-end companies and no-load funds similarly provide an invest- ment "service" paid for through deductions from the fund's gross income. The argument from the fund's "service" functio'ns, as applied to sales loads, is so far off base as to be, in my judgment, misleading. 3. Alternative 1: Repealing Resale Price Maintenance Provision of the 1940 Act.-A possible alternative is to place no ceiling on sales load but repeal Section 22(d) of the 1940 Act precluding dealers from selling mutual fund shares except at the price determined by the underwriter. This provision has, of course, precluded price competition among funds and their salesmen to attract customers by giving price reductions out of the commission. Indeed, it has generated a dif- ferent sort of competition with an upward thrust to prices, for it induces funds 10 SEC Report at p. 210. PAGENO="0398" 812 to raise sales loads in order to stimulate brokers to maximize their efforts to sell the fund's shares. Although I quite frankly do not like legally authorized resale price main- tenance by any industry-and I speak on this from my own experience as a former attorney in the Department of Justice's Antitrust Division and from teaching antitrust-I am reluctantly led to believe that this alternaive would no be preferable to a ceiling on sales loads. Like it or not, resale price main- tenance is a fundamental part of the securities industry, and of the investment company business in particular. Repeal of this provision might have~ undesirable repercussions not readily determinable at this time. It might prompt defensive measures among investment companies seeking to preserve the status quo and *thereby create complex and difficult antitrust problems. Moreover, repealing Section 22(d) would not apparently affect the price levels charged by some mutual funds selling shares through their own sales organizations (the so-called "captive" sales force) rather than through broker- dealer channels. Even if price resale maintenance were outlawed, this would not preclude such funds from setting the prices at which their own employees could sell the shares. Indeed, there may be some disturbing side-effects. For instance, if such funds could continue to charge comparatively high loads, this Would lure salesmen away from broker-dealers into "captive" sales forces; and if loads could be thus stabilized, other funds, currently selling through broker-dealers, might shift to internal sales organizations. Thus, a long-range effect could be diversion of business away from smaller broker-dealers who are said to depend on mutual fund sales, to funds with internal sales organizations. I doubt any major competitive impact of sales-load price-cutting by broker-dealers seeking to keep or attract business away from funds with internal sales organizations. True, a lower sales load offered by a broker-dealer would be a good talking point to a customer. However, it is at least doubtful that mutual fund prospects would do much shopping around, especially to look for lower sales loads; after all, they have not done so in the existing situation where no-load funds can be obtained. In sum, I doubt that repeal of Section 22(d) standing alone would quickly, and perhaps not at all, bring mutual fund customers the supposed advantages of competition among salesmen. The benefits of repeal seem to me too conjectural to make such a move a predictably effective means of redressing the problems of excessive sales charges. 4. Alterna'tiVC 2.-One variant of the first alternative is to repeal Section 22(d) and require that each fund make its shares available to all broker-dealer mem- bers of the NASD at the net asset value of the shares plus a reasonable under- writers' spread. If this became law, broker-dealers could obtain mutual fund shares at "wholesale" prices and then retail them at prices determined by com- petition among themselves. This does, indeed, have much to commend it. However, it also creates problems. First, it would require repeal of Section 22(d) and resale price maintenance, and to that extent alters established marketing pat- terns in the industry. Secondly, it would compel substantial changes in methods for those funds utilizing their own internal sales organizations; for they, too, would presumably have to sell "wholesale" to broker-dealers who would (and should) be free to compete with the fund's own salesmen. Thirdly, it would be necessary for some body (presumably the NASD) to determine what is a rea~on- able spread properly charged by the fund to broker-dealers selling fund shares. While this alternative seems attractive, I think that its hoped-for benefits may outweigh its difficulties. Besides requiring all funds to give up traditional resale price maintenance, it would compel funds with "captive" sales forces to change their methods of doing business and in effect establish competition with them- selves. On balance, I believe these two alternatives are less attractive than setting a maximum sales load of 5%, which is a remedy addressed to the specific problem of exCessive sales charges. In particular, I think that the approach suggested by the SEC is ultimately a more conservative one than alternatives which would precipitate changes in industry structure and established marketing methods. 5. AlternatiVe 3: NA~D Regulation.-I have some difficulty in determining the feasibility of this alternative, as I know of the proposal only from brief news- paper reports. I understand that the standard would be framed in terms of "reasonableness." Presumably, this would require the NASD to formulate more definite content to such a standard by rule-making. To the extent that the NASD might come forward with a 5% or G% figure, the result would presumably differ PAGENO="0399" 813 little from the SEC proposal which is subject to exemptions. To the extent that it is more vaguely worded, it would be less apt to give the investor the advantages hoped for, and it could easily involve the NASD in substantial administrative problems in policing the activities of firms and salesmen in charging "reasonable" sales loads. Also, for these broker-dealers not members of the NASD, presumably the SEC would have to formulate its own rules so that non-NASD members would not have certain advantages in freely fixing sales loads while NASD members remain subject to some type of industry-imposed restraint. I have no doubts that the NASD would act in good faith in formulating a standard and in effec- tively administering it, but I do not see that it would produce a better result than the proposed 5% ceiling (subject to SEC exemptive power). 6. Alternative 4: Sliding Scale.-Jf it believed that an immediate drop to a 5% maximum sales load would be too great an economic hardship on retailing mutual funds, consideration might be given to a gradual downward adjustment. For instance, the maximum load might be 7% for the first year after effective date, then 6% for one or more years, and then 5%. This would permit gradual enhancement of efficient sales practices to adjust to possibly lower revenues. If adopted in principle, either Congress could specify the sales load levels, or it would vest the SEC with discretion to determine when the several downward steps should be taken. However, I believe that Congress should make these spe- cific determinations as a matter of legislative policy. An analogy is the two- staged application of the Securities Acts Amendments of 1964 to over-the-counter issuers required to register with the SEC under Section 12(g) of the Securi- ties Exchange Act of 1934 (as amended), by which the new rules applied first to issuers with at least 750 shareholders, and then the following year to those with at least 500 shareholders. STATEMENT OF EDWARD S. HERMAN, ASSOCIATE PROFESSOR OF FINANCE, WHAR- TON SCHOOL, UNIVERSITY OF PENNSYLVANIA I. INTRODUCTION This statement deals only with the regulation of the management fee rate and the sales charge. These two areas are treated here in terms of the basic economic rationale of the SEC legislative proposals, with only a minimum of attention being given to the details of the various proposals. The basic point of this statement is that strengthened regulation along the lines suggested by the SEC is desirable because competition either has not worked or has worked perversely in the determination of both the manage- ment fees and sales charges of mutual funds. Moreover, it would not be easy to make competition work satisfactorily in these areas, even with drastic struc- tural reorganization of the industry. The SEC recommendations must therefore be regarded as a conservative compromise between nothing in an area where the market mechanism has worked badly, and more radical changes of uncer- tain effect. II. THE MANAGEMENT FEE RATE The evidence is clear that management fees charged mutual funds have been substantially higher than those charged other investors of comparably-sized portfolios.1 In the Study of Mutual Funds we tested the standard industry expla- nations of these high rates, and found that neither their level overall, nor the dif- ferentials found within the industry, could be explained in terms of performance, services rendered, or expenses. The industry has also relied heavily on the argu- ment that the individual mutual fund investor would not pay a lower manage- ment fee rate if he chose the alternative of private counseling. This may be true, but if advisory expenses per dollar of assets decline with increases in fund asset size (as is the case), and if the fund is paying a substantially higher rate than other clients of similar size, can the fund's directors, who have a fiduciary re- sponsibility to the shareholders, justify a high and inflexible rate on the ground that the shareholders cannot do better elsewhere? This would reflect a peculiar conception of directorial obligations! 1 documentation may be found in A Study of Mutual Funds, H. Rept. No. 22i74, 57th Cong., 2d Sees. (1962), pp. 480-95: Edward S. Herman,, "Mutual Fund, Management Fee Rates," Journal of Finance, May 1963, esp. pp. 368-74; and for developments subse- quent to the Wharton Report, S.E.C., Public Policy Implications of Investment Company Growth, II. Rept. No. 2337, 89th Cong., 2d Sess. (1964), Chapter III. PAGENO="0400" 814 The most plausible explanation of the high levels and relative inflexibility of mutual fund management fee rates rests on the structural characteristics of the industry and the resultant limitations on the effectiveness of competition. One relevant structural characteristic of the industry is the domination of the typical fund by a separate legal entity, the investment adviser, with whom the fund enters into a management contract. Given the origination of the fund by advisory personnel, and the crucial and active role of the dominant individuals associated with the adviser, the terms of the management contract have not ordinarily been a product of arms-length bargaining. The independent director requirement has not altered the situation in this regard, and there is little reason to believe that a tightening of the now hopelessly inadequate definition of an independent director will solve this problem. A second important structural aspect of this industry relates to the buyers of fund shares: typically they are not very affluent and they buy only a few thousand dollars worth of shares, which has made for a wide diffusion of fund shares. Furthermore, these small investors are not well informed on investment alternatives, including differences among the funds themselves. These buyer characteristics of the industry have made salesmanship important in the mer- chandising of fund shares; and this, in turn, has led to a de-emphasis on price in approaches to the buyer. The salesman could hardly stress differences in management fee rates (under 1%) without raising questions about differences in the much higher sales charge (8% or more). He therefore prefers to stress fund performance over the last 20 years, the virtues of equity investment and diversification, and the redemption privilege. The net result of the absence of arms-length bargaining in fixing fee rates, the wide diffusion of fund shares among relatively uninformed buyers, the de-emphasis of price by fund salesmen, and the possibility of redemption if dissatisfied, is that little pressure exists either within funds or between them to reduce manage- ment fee rates. The downward pressure on fee rates within the past decade seems to have been a result mainly of stockholder suits and publicity generated from outside the industry. I would like to note here that the buyer characteristics of the mutual fund market, and the importance of personal selling, make overall numbers of funds and national concentration ratios, very misleading in assessing th~ degree of competition in the industry. Every serious study of concentration-including those by Kaysen and Turner, and by Bain-stress the importance of the market definition in giving meaning to a concentration ratio. And the market must be defined ii~ terms of both seller and buyer alternatives. If 10 different encyclo- pedias are being sold door-to-door, if a salesman for one of them knocks at somebody's door, the quality and price of 10 different encyclopedias are not likely to be at issue. If the seller of fund X approaches a householder, there may be only one fund that is offered as a plausible option. The fact that there are 350 funds in existence is likely to be quite irrelevant to the contracting process in- volved in personal selling, which often approximates bilateral monopoly with an imbalance in bargaining position. The main policy alternatives that have been put forward to deal with the nianagement fee are as follows: (1) Do nothing, on the grounds that the problem is not serious, or that market adjustments will correct any abuses in the long run. I would reject this view because, while the problem is not of the first order of importance, it does not strike me as trivial (with management fees now approximately $150 million a year) ; and there is little evidence that in this area the market mechanism will operate more effectively in the future than it has up to now. (2) Reorganize the industry's structure by requiring each fund to be internally managed. Since internally managed funds have a simpler structure and tend to have lower fee rates, this would probably accomplish something; `but it is not clear how much would be achieved, given the fact that structural con- ditions would still be unfavorable to competition `on the management fee. Since this would be a drastic action, especially in view of the widespread public sale of the stock of outside advisory companies, I doubt if this change would be ~Torth the resultant disruption. (3) A third possibility woulld be the redefinition of an "independent director", or the use of other devices, to make some of all of the directors truly "lade- pendent" and capable of bargaining effectively with the external management firm. The SEC proposes a change in the definition of the independent director, PAGENO="0401" 815 and I think their suggestions are appropriate if the requirement is not to be completely devoid of meaning; but I am very dubious that this change will carry us very far toward solving the problem. As long as the organization of the fund, and the choice of directors, is in the hands of the individuals associated with external investment adviser, it will be difficult to transform the directors into a group capable of bargaining effectively on management fee rates. A move in that direction may be desirable, but its inherent limits should be obvious. (4) A fourth possibility is an extension of disclosure requirements. This is the traditional emphasis of the securities legislation, and a valuable one, but I think its capabilities have been seriously over-rated. It even shows some potential for becoming a reflex substitute for more effective, `but also more controversial, actions. This avenue is limited in the mutual fund area by the importance of salesmanship-und the salesman's pitch is beyond effective con- trol. It is also limited by the possibility of over-saturation of disclosure to a point where its value to the `buyer declines absolutely. Furthermore, the most important `kind of disclosure, a clear indication of the price and quality of alternatives, is exteremely difficult to present briefly and equitably. Thus, while more and especially better di'sclosure is unobjectionable, I have doubts as to its serviceability as the central element in establishing reasonable management fees. (5) Finally, we may establish a standard of reasonableness of fee `rates, stipulating the relevant criteria (including performance)2 in general terms, and leaving the `detailed elaboration of `these norms to the administrative and judicial process T'his is essentially the SEC proposal. It is, if `anything, un- duly conservative, accepting the industry's structure in its existing form, and surrounding `the application of `the standard of reasonableness with statutes of limitations on suits and other protections of the fund and its directors that seem a `bit excessive. Nevertheless, I would favor this proposal `as a minimum in an area where something should be done and where more drastic actions designed to increase competition are n'ot likely to be very effective. III. THE SALES CHARGE The case for limiting the size of the charge that can be levied in the sales of mutual fund shares rests on the fact that the market for fund shares is com- petitive only in a limited and somewhat perverse way. Competition is restricted, first, by the Act's section 22(d) provision for resale price maintenance. This is a significant restraint on price competition, and one that is desired by the in- dustry. A second limitation on competition stems from the uninformed na'ture of the small inves'tor market `that has been heavily tapped by the fund industry. As noted earlier, this has tended to encourage salesmi~nship and `to reduce further any possible price competition at the retail level. The price competition `that still remains involves mainly a bidding by issuers of fund shares for dealers to carry and push `their wares. Given this direction of competition, market penetration is increased by elevating the sales charge (`or the dealer's percentage of the charge) at the expense of the ultimate purchasers of shares. This is perverse or upside- down price competition. This peculiar type of competition resul'ts from the fact that, since a large frac- tion of fund shares purchasers are uninformed on the Complexities of stocks and investor options, they have to be "sold" their shares, they don't just buy them. They do not have a base of comparative knowledge that would permi't them to evaluate a salesman's pitch. The Prospectus that they are given is tedious and lacking in comp~trative information that would render these details meaningful. Thus, from the standpoint of the fund, selling shares is mainly a question of g~tting salesmen to push them; that is, increasing the dealers' take from the gross sale price. The truth of these contentions is demonstrated by `the fact that, in the study of Mutual Funds it was found `that sales of fund shares were much 2 Although a performance' basis for establishing management fee rates has considerable appeal, it is not easy to convert a complex variable like performance into a usable general standard'. The variety of possible formulas (number of years considered relevant, adjust- ments for differences in fund objectives, etc.) would make an informed evaluation of man- agement fee rate's by investors even less feasible than at present. And if the formulas were so arranged as to provide at l'ea~t some compensation even for atrocious performance, as is likely, performance standards are likely to work out as a "head's I win, tails y,ou lose" proposition (as the SEC has suggested). In the light of these considera'tions, I suspect that a general application of a performance standard would turn out to `be a source of further abuse. 85-502-68--pt. 2~-26 PAGENO="0402" 816 more closely and positively related to the size of the sales charge than the invest- inent performance of the fund. This indicates an irrational element in the market, based on buyer ignorance and its exploitation by salesmanshiP. This is what has led to an upside-down competition. It should be pointed out that buyers of fund shares have not generally been damaged as a result of their investments. On the contrary, many of them have done quite nicely. In principle, however, it seems unwise from the standpoint of both stability and equity to encourage large numbers of relatively uninformed small investors into a risky investment medium on the basis of intensive person- to-person selling. It has been suggested that a reduction in inflow, which might follow a curtailment of incentives to salesmanship, may make the funds more vulnerable in times of weakness (and high rates of redemption), thus forcing the sale of portfolio securities and a disruption of capital markets. This sort of argument can be levied against any change (including the original securities legislation), which almost invariably has some short term disruptive effects. What it disregards is the fact that stability and the continuity of growth of markets in the longer run depend in large part on their basic soundness. This will determine their ability to withstand real stress. If it is argued that a ceiling on the sales charge is an arbitrary and paternalistic device for handling this problem, the reply must be that the alternatives seem unpromising. To do nothing is to forego governmental paternalism of a limited kind of favor of a statutory umbrella for the unrestricted private exercise of significant monopoly power. An alternative to the SEC proposal for the 5% ceiling on the sales charge would be the elimination of the resale price maintenance pro- visions of section 22(d) ,~ which might inject some price competition into selling at `the retail level. Apart from the fact that the industry strongly supports this form of price regulation, it runs up against the previously discussed reluctance of dealers to compete on price. Thus there is a distinct possibility that by itself the abolition of 22(d) would have little or no effect on retail price competition. It is also argued with some cogency that if retail price competition did develop it would tend to strengthen the position of the large complexes that engage in direct selling, because they would be insulated to some extent (but by no means entirely) from the damage stemming from dealer disaffection with "cut" shares. A further alternative action that might be taken, either alone or in con junc- tion with those previously mentioned, would be a relaxation of restrictions on fund advertising. It is one of the paradoxes of the "disclosure" rules that a no-load fund cannot push very aggressively the fact that it im~poses a zero sales charge; when it goes beyond a "tombstone" and it easily runs afoul of the SEC's tendency either to require full disclosure or to permit virtually nothing in the way of publishing advertising. The situation might be significantly improved in terms of true investor knowledge if an intermediate ground for stressing im- portant facts were opened up. It is also suggested that mutual funds be required to disclose more fully the sales charge alternatives to the investor, perhaps on the front of the Prospectus. As noted earlier in regard `to the suggestion of a need for more extensive dis- closure in connection with the management fee, I feel that there are saturation limits `in using disclosure as a means o'f creating a more informed market. The problem of deciding on the appropriate comparative information under full dis- closure would involve serious regulatory problem's, although in principle they are not beyond resolution. Thus, while the abolition of resale price maintenance and improvements in disclosure (including comparative information) would tend to increase com- petition on the sales charge, and are thus desirable In their own right, I am skeptical about `their adequacy. The 5% ceiling has the virtues of simplicity, effectiveness in limiting a perverse competition, and equity in fixing a rate on the high side of security market selling costs. STATEMENT or DoNALD E. ScHWARTZ, AssoCIATE PROFESSOR or L~v, GEORCETOWN UNIvERsITY My niame is Donald E. Schwartz and I am an Associate Professor of Law at Georgetown University Law Center. Prior to my becoming a law professor in 1966, 1 was engaged in private law practice in New York City for five years and It should be pointed out that the elimination of the resale price maintenance provisions of section 22(d) is not in conflict with the 5% ceiling proposal and could be combined with It. PAGENO="0403" 817 prior to that I was employed for approximately two years as counsel to several mutual funds. I came to that position after two years on the staff of the Securi- ties and Exchange Commission. I have had the opportunity to become acquainted with and to observe a large number of persons in the mutual fund industry. I believe that, in the main, the 1)ublic is fortunate that this industry is managed by responsible and honest men. I believe that most of its managers are concerned with their responsibility for the welfare of small investors and, indeed, they think of their industry as the special medium for the small investor. I believe that H.R. 9510 and H.R. 9511 is in the interest of both the small investor and the industry. My statement is given in my individual capacity and not as a representative of any organization. However, my views with respect to this bill are not entirely singular. Shortly after the S.E.C.'s Mutual Fund Report was published in De- cember 1966, I discussed with a number of my colleagues at different universities, the desirability of forming a committee in order to demonstrate that support for mutual fund reform existed outside the Commission. Accordingly, a com- mittee of 15 law professors, plus one professor of finance, Professor Edward Herman, of the Wharton School of Finance, came into existence to lend our modest support to this proposal. While we may not have an identical point of view on each specific item in the bill, all of us are of a mind that the investment company industry is in need of reform and that the proposals embodied in the bill before you, represent sound reform. The Committee membership was composed entirely of persons free to speak their individual opinions without fear of em- barrassing any interest they represent. I am acquainted with many lawyers who share the views I express, but dannot speak out because of the loyalty they owe to their clients. I am convinced that support for this bill is much wider than the industry would have one believe. I shall discuss the three major areas of concern in H.R. 9510 and H.R. 9511; management fees, sales loads and contractual plans. Insofar as management fees are concerned, I consider the bill a modest pro- posal; much more drastic medicine might have been suggested. The structure of the typical mutual fund is at variance with that of most American corporations. The fund has no means for managing its own affairs. While the fund directors may make broad and necessarily vague policy decisions, the responsibility for defining and implementing those decisions is delegated to an outside group which charges a fee for the service. The outside group is no stranger to the fund; it usually consists of a corporation owned by the persons who' created the fund, and who usually sit as members of the fund's board of directors. The delegation to this outside manager is performed by the directors who have no affiliation with it, but who, in turn, were selected by those who are affiliated. Clearly, a director of a corporation is a fiduciary to his corporation and, in ac- cordance with most modern judicial opinions, to the individual shareholders of that corporation as well. The investment advisor, dominated by directors of the fund and performing those tasks which most corporations perform for themselves, should similarly be viewed as a fiduciary, if not by the courts then certainly by Congress. He is, of course, entitled to compensation when he renders services, not- withstanding the fact that the board of which he is a member determined the amount. But in his relationship as a fiduciary, he has learned to exercise restraint in the amount of his compensation which he directs the company to pay to him. If he failed to think of himself as a fiduciary, and instead regarded himself as a stranger dealing at arm's length, his good conscience would impose less restraint on the amount of his compensation he arranges to have paid to himself. Thus, this first and perhaps most important safeguard against excessive compensation would be broken down if the manager of the corporation thought that he was under no obligation to view the interests and welfare of the corporation and its owners when his fee was established. I submit to you that responsible representa- tives of the industry have stopped thinking of themselves as fiduciaries to the corporation and its owners. Thus, an esteemed attorney to the mutual fund indus- try stated at a conference at the University of Pennsylvania earlier this year that the adviser "is not a fiduciary as far as his fee is concerned. There he contracts with the stockholders and the stockholders are represented by the independent directors" (115 U. of Pa.L.Rer. 726, 745, Comments of Alfred Jaretzki, Jr.) Under this view, self restraint, becomes vitiated and protection against excessive com- pensation is shifted to the board members least involved in managing the affairs of the funds. I believe this view is erroneous and it has been permitted to de- PAGENO="0404" 818 velop because some representatives of the industry have hypnotized themselves into thinking that the formal structure they have woven produces a true arms length bargain merely because the formality of approval by independent directors was observed. Not all industry representatives agree, as demonstrated by testi- mony of Investment Company Institute spokesman before this committee. At the very least, this bill will achieve the desirable goal of clarifying for the mutual fund director just what is his obligation. The experience of the investment com- pany industry has demonstrated that however well-intentioned may be the so- called unaffihiated or independent directors, they have not succeeded in protecting shareholders from whatever fee the investment adviser has asked. Of course, the protection of the courts may be sought to protect the fund and the shareholders from paying an excessive fee. But, again, we cannot ignore his- tory. It must be apparent to anyone who has studied the history or the mutual fund litigation which has occurred since 1960, `that the courts are ill-disposed to invoke their judgment In the area of compensation. Once the fee imposed by the investment adviser has been adopted by the Board of Directors, and approved overwhelmingly by the shareholders-~a simple ritualistic exercise-the courts will upset this judgment only if it is proven by the person challenging the fee that the fOe is so excessive that it constitutes waste. Judge Friendly, in a state- ment submitted to the Senate Banking and Currency Committee during its hear- ing on 5. 1659, (at page 1015) and during the course of these hearings, character- ized the burden of the plaintiff in attempting to show such waste as being forced to prove that the fee was "excessively excessive" or "unreasonably unreasonable." Such a task is so burdensome as to be almost impossible. Thus, no plaintiff has prevailed in any such suit despite the fact that iii one case, Chancellor Seitz ob- served that while be eould not find as a matter of law that the fee charged in that case, amounting to the prevailing industry rate of one-half of one percent, con- stituted waste it was fast approaching that standard. ~aa~e v. Brady, 40 Del. Ch. 474,498,184 A.2d 602, 616-17 (Del. Ch. 1961) The combination of hurdles presented to the shareholders of a fund has proven insurmountable. The investment adviser feels no obligation itself to protect the best interests of the fund of the shareholder when the fee is established, assign- ing that task to so-called independent directors. The independent directors have simply not been up to the task. Finally, under the existing state of the law, the courts have been unable to provide the necessary protection. The only alternative then, is new federal legislation which will create a federal standard by which all management fees must be tested. I submit that proposed amendment to § 15(d) of the Act is the most modest approach to this problem. The bill merely tells us that all compensation paid by the fund to the adviser shall be reasonable and sets forth an outline of criteria to assist a tribunal in making that factual deter- mination. It leaves with the person challenging that fee the burden of proving by the preponderance of the evidence, that the fee is unreasonable. This is con- sistent with the approach undertaken by Congress in 1940 when it enacted the Investment Company Act. That statute outlawed what were the most fla- grant conflicts of interest in the investment company interest. The determination of the management fee is a clear conflict of interest which is incapable of redress under existing law. Personally, I believe this proposal is too modest, and I know that my view on this is shared by a number of my colleagues. Nonetheless, I think it not unrea- sonable to believe the bill stands an excellent chance of successfully accomplish- ing its purposes. First, it replaces an unrealistic state law standard with a fed- eral standard for determining the excessiveness of management compensation. Second, the statement in the bill with respect to the burden of proof although in my opinion unsatisfactory, at least overcon~es the extraordinary burden im- posed upon plaintiffs under present law, whereby if the fund was successful in obtaining shareholder ratification for the management fee, then the burden upon the plaintiff is to prove that the fee was so excessive that no reasonable person could have adopted such a fee. Excessive management fees have often been sus- tamed-on the basis of the fact that the overwhelming number of shareholders ap- proved of the transaction. Shareholder ratification under these circumstances constitutes a hollow act. Shareholders of a fund are asked, by means of a proxy statement to approve of the appointment of an advisor at a specilied fee or to dis- approve. They are left with no alternatives in between. They cannot renegotiate the fee imposed by the advisor. The mutual fund sharehcdcler is mit in the same position as a shareholder in other corporations in this matter. Elsewhere, he may PAGENO="0405" 819 feel free to reject a submitted transaction without fear of disrupting the corpora- tion. If the mutual fund shareholders reject an investment advisory contract, the fund is left with no management at all. Most important, of course, in an uncon- tested election, it is common knowledge that he who controls the proxy machinery can obtain the approval of anything be seeks; at least, there is no record of any experience to the contrary. That important legal consequences as to the meaning of the vote should flow from this exercise is the sheerest of legal casuistry. Third, the bill provides that the role of independent directors is to be enlarged. There is imposed upon them and spelled ~ut with some care the affirmative responsibility which they have in selecting the investment adviser and in nego- tiating and determining the fee to be paid to the investment adviser. Moreover, the added detachment of the persons who are to perform this function, as fi result of the amendment defining interested directors, increases the likelihood that inde- pendent judgment will be brought to bear on the question, particularly when coupled with the other provisions of the bill regarding Compensation. The safeguards of the bill are not as strong as I think conditions in the indus- try warrant, but they are a vast improvement over existing law. I believe the bill will work because I believe that the enactment of a federal standard spelling out guidelines, both for interested and unaffiliated directors &f mutual funds, will have a most salutary effect on the industry. I believe that those investment ad- visory fees which are not at the present time reasonable will become reasonable, more as a result of voluntary action initiated by the industry than by litigation. But to encourage that result and to emphasize the continuing nature of the man- agement's duties, I believe it is important to remove soffie of the temptations that exist under the present law for mutual fund managers to aggrandize themselves at the expense of the shareholders and the funds. When this proposal is labelled as modest, consider how much more drastic could have been the proposal to reform advisory fees. As mentioned earlier, I believe it would be appropriate for the bill to provide that the burden of justify- ing the reasonableness of the management fee should be imposed upon the man- agers of the fund. Plaintiff's task, while not insuperable under this bill, is none- theless difficult. Further, the bill could provide that the liability for charging an excessive fee would be imposed, not just upon those who received it, but upon those who approved it, that is, the so-called independent directors. The bill spe- cifically provides that the liability shall be limited to those who receive the excessive compensation. More drastic than either of the above, the bill could have insisted that all mutual funds be managed internally and not bv an outside investment advisor, in the same manner as other corporations. This is already the pattern of a number of mutual funds, including the oldest of the funds, Massa- ehusetts Investors Trust. Such management has proven to be less expensive to the fund and its shareholders and, if for no other reason, it would commend itself on that basis alone. I believe that if such a proposal had been made, it would merit serious consideration. I think the proposed § 15(d) is the very least which we can expect in a bill which considers itself Mutual Fund Reform legislation. I shall not comment in detail upon the provision hi the bill which would impose a 5% limitation on sales loads. There are large economic questions at stake in that issue on which I do not feel myself qualified to speak. However, I do wish to point out that the existing state of the law and pattern of mutual fund selling leaves investors defenseless against spiralling sales charges, which have the effect of making mutual fund shares increasingly expensive. Mutual fund shares are, as is commonly known, not bought but sold. Indeed, the industry has repeatedly argued that the effect of the load limitation would be to decrease the number of shares of mutual funds sold because the sellers would receive smaller compensation. It seems ironic that people will buy less of a good product when, without loss of quality, it becomes less expePsive. The reduction of the sales load would not make mutual funds any less attractive to own, only cheaper. But the industry's arguments are undoubtedly correct in that they recognize that the sale of fund shares depends upon the eagerness of the mutual fund salesman. A fund desirous of growing finds that the easiest way to achieve such growth is by adding extra inducement to the salesman to sell the shares of the fund. O rowth serves the investment adviser whose fee is enlarged; whether growth helps the fund or its shareholders has, at least, not been shown. This growth is accomplished by increasing, not decreasing, the sales load and, thereby offer- ing a greater reward to the salesmen. So, for competitive purposes, mutual funds PAGENO="0406" 820 become more expensive. At the same time, § 22(d) of the 1040 Act says all dealers must sell shares of the mutual fund at the same price. The result is that the facts of life in the industry deprive the customer of interbrand competi- tion which would reduce the price and the law prohibits intra-brand competi- tion, insofar as the price is concerned. Under these circumstances, only a revision in the law can protect mutual fund purchasers from ever-increasing sales loads. The operations of the free market are curtailed in the sale of this particular product. The alternatives, as I see it, are either to reduce by law the sales load by placing a flexible limitation thereon, or by repeal of § 22(d) of the 1940 Act. The latter would, as I understand it, be especially upsetting to the equilibrium in the industry, and the industry does not favor repeal. Further, the repeal of § 22(d) would have no effect on those funds which are sold by internal dealer organizations, such as the funds managed by Investors Diversi- fied Services. The other alternative is some power of legal limitation on the sales load, and I am inclined to accept the Commission's proposal embodied in § 21 of the bill amending § 22 of the 1940 Act as the best proposal I have heard yet. Other means for reducing the cost of mutual funds shares should also be sought. The S.E.C.'s Rule 22d-1 prohibits a reduced sales load for persons act- ing as a group to gain advantage of a discount available to a large purchaser. This group purchase is resorted to in other commercial areas and it should be available here. Severe advertising restrictions have prevented the public from being adequately informed of no-load funds and may have caused higher sales loads made necessary by increased solicitation expenses which might be reduced by appropriate advertising format. Finally, I would address myself to the proposal to abolish contractual or front-end load plans. Earlier in my statement I suggested that the bill was a modest proposal and yet I favor a provision which is not so modest. In my opinion, there can be no temporizing with front-end load plans. All of the theo- retical justifications which have been expounded and all of the homage paid to the virtue and efficacy of full disclosure, do not detract from the hard experi- ence that many contractual plan owners have suffered, and which others will continue to suffer from the effects of this form of selling unless it is abolished. This is by virtue of the nature of the contractual plan and its potential custo- mers, and by the nature of the persons who are attracted to the sale of con- tractual plans. What we have is the least sophisticated investors being ap- proached by the least qualified salesmen. The result of this unfortunate encounter is all too often financial distress. The front-end load device is nothing more than a subsidy to the sales organization of the industry paid by those persons least able to afford it. Unconscionable methods of selling goods to custo- mers increasingly have shocked the conscience of the public and the courts. While the front-end load device is not conceived in fraud, it unfortunately too often affects people in a similar fashion. Congress' response to the experience with the device which is detailed in the S.E.C's Mutual Fund Report would most appropriately be the complete curtailment of the device. J. II. IIILSMAN & Co., Ixc., Atlanta, Ga., May 19, 1967. Hon. R0BEET G. STEPHENS, Jr., The House of' Representatives, Washington, D.C. Dmi~ Ben: The Securitiea & Exchange Commission has introduced certain revisions to the Investment Company Act of 1940 and the Investment Advisors Act of 1940' in S1G59. Effect of these amendments is' to decrease the dealer's/salesman's compensation by reducing the commission that will be paid such dealer or salesman by the mutual fund, and to prohibit the mutual funds from further compensating the dealer/salesman through reciprocal `business-that is, the fund in its purchase of securities on an exchange would be prohibited from directing part of the commission to those dealers or salesmen who have participated in the distribu- tion of such mutual fund shares. Proposed amendments, to me, are abhorrent and have been introduced by the SEC without any consideration of the economic impact on the security dealers PAGENO="0407" 821 Or the public, generally, Income from sale of mutual funds is an insignificant portion of my firm's business, but we do believe that the evangelistic effort of the many small security dealers and salesmen who specialize solely in mutual funds is beneficial to the whole industry. The small companies who do primarily nothing but mutual funds are in reality the John The Baptists of the free enterprise Systeni-jnvest in America-selling a participation in the capitalist system. While we are not interested in the small sales that are generally made by those who specialize in mutual funds (the average mutual fund share purchased today is $l,240-commission gross of about $86.80), we do feel that such sales representatives serve a very worth- while purpose and they introduce people into the investment community. Compensation paid for mutual fund sales is no where near as high as that paid for sale of a life insurance policy, yet the sales of each type of security, mutual funds and life insurance, is highly competitive with the other. An economic survey of the National Association of Security Dealers con- cludes that the largest firms in the NASD would suffer only 8% loss in net in- come as a result of the enactment of all SEC proposals, while the smaller firms would have income after taxes reduced by more than three times, Of these smaller firms operating in the black before the ~EiC proposal, three-fifths would be forced from a profit to a loss position. Thus, it is obvious that many, if not most, of these firms would be forced out of business by the SEC proposal. I hope that you will oppose these amendments with Mr. Sparkman, the pro- poser, and on the Floor of the House, at least until such time as the Securities & Exchange Commission provides some economic basis for their recommenda- tions, other than the fiat charge that profit in itself is evil. I feel that my industry and my country needs these voices in the wilderness crying out the virtues of the American system. I can't afford to go into the wilderness, and they can't afford to stay there with the reduced compensation. Sincerely yours, John J. E. MOCLELLAND, President. INVESTMENT COMPANY INSTITUTE, New York, N.Y., October 27, 1967. Hon. JOHN E. Moss, Ch~airman, Subcommittee on Commerce anI Finance, Rayburn House Office Building, Washington,. D.C. DEAR CONGRESSMAN Moss: In the course of Chairman Cohen's testimony on H.R. 9510 and 9511, he stated that the Investment Company Act of 1940 has bçen ineffective in controlling management fees. In so doing he made statements concerning the legislative history of the 1940 Act which call for correction. He argued that the statute had provided "a shield" (e.g. Hearings, p. 869) which protects the profits of the management company. He also implied that what he considers to be inadequacies in the statute stem from compromises in the original bill which were made while it was pending in the Congress on the eve of our involvement in the Second World War (Hearings, p. 19). Finally, during his final appearance before the Committee, Chairman Cohen concluded that the situation has developed since then to "defeat the very purposes of the Congress in j940 . . .". Or, as was also stated by Chairman Cohen: "We are trying to restore the statute to what the Congress intended to achieve in 1940". (Hearings, p. 870). Since we have been of the view that the primary question before the Congress is whether there is any condition in the mutual fund industry which calls for remedial legislation, in our presentation we did not focus on the legislative pur- poses which underlay the 1940 Act. However, in view of the repeated claim that the proposed legislation with respect to management fees is not novel because in 1940 Congress attempted to legislate in this area, albeit ineffectively, some com- ment is called for. The Record of the 1940 Act hearings is replete with evidence that the purposes of the Congress were not to reverse traditional corporate law and embark on regulation of management fees. The testimony before the House Committee of David Schenker, who managed the Bill for the SEC, is quite definite and clear on this point. It should be noted that in the following extract Mr. Schenker was testifying on the original bill, before there were any of the compromises that Chairman Cohen alluded to: PAGENO="0408" 822 "What have we done with respect to management contracts? There is not a single provision in section 15 which even remotely assumes to fla what they should be paid as compensation. "As `a matter of fact, in Senator Taft's State the "blue sky" laws were recently amended, and they have a provision that investment comptrny securities could not be sold in that State if the management and operating expenses exceeded 11/2 percent of the average total assets. "We do not have that. We feel that `is a question for the stockholders to decide. If they want to pay a man a million dollars to manage the fund and if they know they are paying him a million dollars and if they have the right to approve the payment of a million dollars, tMs bili says that is perfectly all right." (Emphasis supplied.) Investment Trusts and Investment Companies, Hearings, Senate Banking and Currency Committee, on 5. 3580, `76th Congress, April 9, 1940, page 252. We, of course, do not claim that this testimOny disposes of any of the issues before the subcommittee. We do feel that it does make it clear, contrary to SEO assertions, that the Congress is now dealing with proposed new and novel legislation and not with a reform or extension or existing law. We also believe that this testimony makes clear what Congress "lhtended to `achieve In 1940" with respect to management fees-namely, full disclosure and the right of share- holders to decide for themselves within `the framework of the traditional modes of corporate democracy. Moreover, the joint legal opinion of Gaston, Snow, Motley & Holt and of Sul- livan and Cromwell, which has been submitted fO~ the record, demonstrates that Chairman Cohen incorrectly implies (e.g. Hearings, pp. 47, 55) that the 1940 Act reduces the legal protections of shareholders which were previously available. Sincerely yours, ROBERT L. AUGENBLICK, President and General Counsel. INVESTMENT COMPANY INSTITUTE, New York, N.Y., November 6, 1967. Hon. G. ROBERT WATKINS, House of Representatives, 1015 Longwo'rth House Office Building, Tvashington, D.C. DEAR CONGRESSMAN WATKINS: In res~Onse to ~o~ir letter of November 3. 1967, asking us a number of questions with respect to te~tiinony on 11.11. 9510 and 9511 before the Subcommittee on Commerce and Finance of the Committee On Inter- state and Foreign Commerce, we respectfully submit the follo*ihg: Question No. 1. Throughout Chairman Cohen's testimony there were refer- ences to "conflicts of interests" between the adviser and thO fund and perhaps as it `applied to an individual director of the fflnd who was also connected with the adviser. (a) Are these "conflicts of interest" unusual in corporations generally? Answer. Possible conflicts of interest are normal and prevalent in almost all corporations and are regulated by law and good corporate practice. The pos- ~Ub1e conflicts may be of many types and degree. They may exist, for instance, when a board of directors votes on the compensation of officers who are Olso directors. They can arise when directors or officers have any type of personal dealings with their corporation or have any interest in other corporations which have transactions with their corporation. The manner in which the cobrts deal with conflicts of interest involving transactions betWeen corporations and direc- tors having an interest in the transaction is dealt with In the joint opinion of Gaston, Snow, Motley & Holt, and Sullivan & Cromwell, dated October 23, 1967, which has been supplied by us for the record. It is attached to this letter as Exhibit "A" in the event it is not otherwise in the record. Question No. 1 (b). Are they differOnt in the mutual fund Ihdustry from those found in other corporations? Answer. The potential conflicts of interest which exist in the mutual fund in- dustry, namely, that some of the directOrs of the fund ustially have ati interest in the management company, are no different in principle from those that are common in other corporations. Question No. 1(c). Is the corporate law that applies to thesO "conflicts of in- terest" different from that which applies to corporations generally? PAGENO="0409" 823 Answer. The corporate law that applies to the conflicts of interest which exist in the mutual fund industry is the same as that which applies to all other cor- porations, as shown by the attached opinion of Gaston, Snow, Motley & bit, `and Sullivan & Cromwell. Question No. 1(d). Are the remedies available to stockholders of mutual funds with respe'ct to abuses which may occur in connection with "conflicts of interest" any different from the remedies available to stockholders of corporations generally? Answer. The remedies available to stockholders of mutual funds with respect to conflicts of interest are the same as, those available to stockholders of other corporations, as shown by the attached opinion of Gaston, Snow, Motley & bolt, and Sullivan & Cromwell. Question No. 3. Chairman Cohen has said that the investment adviser of an investment co'n~pany controls the investment company would you comment on this? Answer. We think that Chairman Cohen is wrong in his assertion that the investment adviser controls the fund. This claim is not supported. A glance at the list of representative independent directors which we have furnished for the record shows them to be successful industrialists, executives, public officials, educators and administrators, attorneys and military men, who on the very face of it are hardly susceptible to control or domination by o'thers. A strong indication of the unsupportability of Chairman Cohen's claim is that over the years `the SEC has not, to our knowledge, take'n action in this area, as it would have had a duty to do, If the claim that the investment adviser controls the funds were true, the SEC would have been derelict in the responsibility imposed on it bylaw to rectify the situation. These legal responsibilities imposed on the SEC arise from Section 10(a) of the 1940 Act which requires that at least 40% of the fund's directors be inde- pendent of the investment `adviser, and from Section 10(b) which requires that a majority of the fund's directors be independent o,f its principal underwriter. Since the investment adviser and the principal underwriter is usually the same person, a majority of the fund's directors are required to be independent of the investment adviser. Th'e SEC has a plain duty to enforce these requirements for independent directors which prohibit an investment adviser from controlling the fund. Section 2(a) (9) of the 1940 Act contains explicit provision for procedures whereby the SEC on its own motion can determine whether a `director of a fund is "controlled." So far as we kno'w, the SEC has never availed itself o,f these pro- cedures to determine whether in fact the fund's directors are controlled and the board of the fund improperly constituted under Section 10(a) or 10(b). Its failure to do so is inconsistent with its Chairman's assertion now that the fund's `directors are con!trolled by the investment adviser. Section 2(a) (9) is also available' to individual shareholders as well as the SEC. Question No. 3. Has Chairman Cohen or any of the other Commissioners ever stated what they con'sider to' be reasonable compensation to be paid by a com- pany of a given size and performance? Answer. No. The SEC' has never stated what is believes to be a reasonable fee in any given case or what is a re'as'onable level of fees generally. During the hearings in the House and the Senate, the Chairman restricted himself to a number of very general `statements on this point, such as: "~ * * there are fee situations here that are excessive." (House Hearings, p. 874). "n' * * while w& by no means suggest that all investment advisory fees are unreasonable, or even that most of them are, it would be singular indeed, * * * if all fees have always been and always will be reasonable." (p. 833). "u * * we are not sug- gesting that any,one is too high or anyone is to low * * ~". (p. 837). Even though the S:EC' is seeking authority to proceed in court against an adviser whose fee it considers unreasonable, it `has not stated the extent to which, or the circumstances in which it plans to use this power if granted. It has asked Congress for the power to sue and ha's given no one any idea `of what it would do with this power. Without knowing what the Commission will do, industry has a somewhat better idea of what so-called strike suit lawyers will do. A change in the law as signicant as the one proposed by the SEC would be' an open invita- tion to widespread litigation which will involve fund officials in time-consuming and `costly lawsuits, thus diverting their energies from their main job of serving their shareholders. PAGENO="0410" 824 Question No. 4. One strong implication from the testimony of the SEC is that mutual fund shareholders are all small and perhaps unsophisticated investors who do not have the ability to evaluate whether the management fee they pay is too high. Also, it was stated that the fee as to each of these investors is so small that none of them would he inclined to question the fee. Are there substar~tial individual investors or institutions who invest in mutual funds who would have the sophistication and the economic interest in challenging the level of manage- ment fees if they were so inclined? Answer. The implication conveyed by the SEC that mutual fund investors lack the sophistication and the economic interest *to effectively protect themselves is not true. One of the most important areas of growh in the mutual fund business has been in investments by institutions such as banks, pension funds, college endowment funds, trustees, churches, labor unions, etc. A 1954 survey showed that 58 mutual funds representing about 66% of industry assets had a total of 35,821 institutional mutual fund shareholder accounts valued ta $283 million. By the end of 1966, a total of 74 funds had 707,705 institutional shareholder accounts valued at $4 `billion. ~any of these accounts are held or administered by highly sophisticated persons with broad financial experience. Yet not only do these people continue to invest in mutual funds but as far as can `be determined none of them have been involved in management fee litigation or have threatened such ~actions. For example, the following table `shows 15 of the most substantial investors in one of the large mutual funds which has a management fee rate of 1/2ofl%. LISTING OF 15 OF THE LARGEST ACCOUNTS OF A $2 BILLION MUTUAL FUND VALUED AT SEPT. 30, 1967 Registered owner Shares Net asset owned value 1. Northeastern Union's pension fund 243,200 $3,750, 100 2. A national union's pension trust 184, 898 2,851, 100 3. A large city bank as trustee for a chemical manufacturer's retirement plan 139, 102 2, 144, 900 4. An oil company's retirement plan 137, 599 2, 121, 700 5. A large city bank as trustee for a feed manufacturer's profit sharing plan 124, 159 1,914, 500 6. A nominee for a large city bank acting as a trustee 118, 138 1,832,400 7. A State treasurer as custodian for a school employees' retirement fund 88, 823 1,369,600 8. A board of trustees for a State teachers' retirement fund 80, 510 1,256, 800 9. Trustees for a restaurant chain's retirement fund 51, 471 793, 600 10. A large city bank as trustee for a machinery company's employee retirement plan____ 48, 765 751,900 ii. A manufacturer's employees profit sharing plan 47, 417 731, 100 12. A manufacturer's profit sharing trust 42, 8f5 661, 200 13. A board of pensions for a midwestern church 42, 744 659, 100 14. A large city bank as trustee for an appliance manufacturer's profit sharing trust~_ 40,603 627, 400 15. A large city beak as trustee for an auto dealers profit sharing plan 37, 576 ~ 40~ __... --- .___. ----- ._. Question No. 5. I understand some funds permit their stockholders to reinvest dividends at the net asset value without paying a sales load. Others provide dividends `be reinvested at the public offering price. In the industry generally, in terms of dollars, what is the approximate percentages of dividends reinvested at net asset value and at the public offering price? Answer. Most investment income dividends (both by dollars and by companies) are being reinvested at `asset value with no sales charge. Based on data collected by the Investment Company Institute for the first 6 months of 1967, 80% of the dollar amount of reinvested investment income was reinvested at net asset value (with no sales charge) and the remaining 20% at offering price (net asset value plus `applicable sales charge). Of the 302 funds listed in the Mutual Fund Panorama, compiled by Arthur Wiesenberger & Co., 211 companies, being 70% of -the total listed, provided for reinvestment of dividends at net asset value, 78 companies, `being 26% of the total, offered reinvestment of dividends at offering price, and the remaining 13 companies, being 4% of the total, made no provision fo'r reinvestment. Question No. 6. Would any reduction in sales which might result from the proposed reduction of sales charges to 5% have any effect on the ability of a fund to meet redemptions of its shares by shareholders, in view of testimony that the mutual funds receive almost enough cash from reinvestment of income dividends to meet redemptions? - Answer. Chairman C'ohen testified that he did not think that mutual funds would be forced into liquidation if sales declined as a result of the 44% reduc- PAGENO="0411" 825 tion in sales charges recommended by the SEC. He stated: "°` * * the amount of cash inflow to the funds solely from reinvestment of dividends almost equals the amount paid out each year by way of redemptions, almost equals it, so that you have got a built-in push in there." (House hearings, p. 125.) This testimony that reinvestment of dividends almost equals redemptions is in error. The follow- ing chart shows total mutual fund redemptions of investment Company Institute members for the years 1955-1967 and the cash flow from reinvestment of divi- dends by shareholders. This chart shows that for these years less than 25% of redemptions were met by reinvestment of dividends. Thus, a decline in sales can have the effect of putting mutual funds in a liquidating status. REINVESTMENT OF INVESTMENT INCOME DIVIDENDS-l955--67 (6 months) [Dollar Amounts in Millionsj Year Redemptions Reinvested dividend income Reinvested dividend income as a percent of redemptions 1955 1956 $442.6 432.8 $61.8 85.5 14.0 19.8 1957 405.7 106.8 26.3 1958 511.3 119.5 23.4 1959 785.6 159.9 20.4 1960 841.8 196.1 23.3 1961 1962 1963 1964 1965 1966 1967 (6 months) 1,160.4 1,122.7 1, 505. 3 1,874.1 1,962.4 2,005.1 1, 283. 9 213.8 255.3 285. 3 363.8 432.2 488.9 257. 8 18.4 22.7 18.9 19.4 22.0 24.4 20. 1 Question No. 7. To what extent do state "Blue Sky Laws" or the state securities administrators regulate sales loads? Would the proposed legislation supersede any of these regulations? Answer. The Commission's suggested maximum sales load of 5% would super- sede state law on the subject. Most states have Blue Sky Law and security com- missions which regulate the distribution of securities in the state. With respect to sales loads, at least twenty-three states have established maximum sales loads, some of which apply to all securities and some of which apply specifically to mutual fund shares. They range from 8%% to a maximum of 20%. Percent Alabama 215 Arizona 215 California 10-s 15 Georgia 2 15 Illinois LI 10 Indiana 15 Iowa ~20 Kansas 10 Kentucky ~15 Michigan 19 Minnesota 12 1O~2 15 Missouri l0-i2~/2 Percent New Hampshire 19 North Carolina 110 North Dakota 15 Ohio 19_is Oklahoma 15 Puerto Rico 1 81/2 South Carolina ~20 Tennessee 215 Texas 220 Wisconsin 1 3%2 15 Wyoming 220 1 This maximum applies specifically to investment company shares. 2 Maximum is for "selling expense" which includes commissions, salaries, adv~rtislng and other expense incurred in selling, but does not include legal tees or cost of prospectuses. Maximum "selling expense" also includes legal tees and cost of prospectuses. All these limits would be superseded by the Commission's bill. Chairman Cohen was originally under a misapprehension of bow the state securities admin- istrators felt about fedei~al securities legislation which would impinge on their duties. He stated in the Hou~se Hearings (p. 851, 852) that the North American Securities Administration Association had passed a resolution endorsing all of the SEC's recommendations. PAGENO="0412" 826 Chairman Cohen subsequently corrected his statement. The resolution passed by the State administrators on September 14, 1967, was to the opposite effect as follows: Whereas the Securities Administrators of many of the states of the United States have and for many years have bad ample authority under the laws of the states in which they serve to regulate and supervise the terms of securities and the fairness of the public offering and sale of securities and, Whereas such Securities Administrators have effectively exercised such au- thority as, in their judgment, has been for and in the best interest of persons residing in such states and, Whereas there is no evidence indicating any need or public demand for funda- mental change in the existing regulatory and supervisory structure and, Whereas legislation is pending from time to time before the Congress of the United States which if enacted will severely limit such state supervisory and regulatory authority: Now, therefore, be it Resolved, That this Association does hereby record its deepest concern as to the enactment by Congress of any legislation which would further limit the au- thority of state Securities Administrators under state laws to regulate and supervise the terms of securities and the term.s of the public offering and sale of such securities; and, be it further Resolved, That the Secretary of this Association be and he hereby is authorized and directed to transmit to the appropriate Congressional Committees duly certified copies of these Preambles and Resolutions. Question No. 8. Chairman Cohen indicated several times in his testimony that the provisions for approval of investment advisory contracts by stockholders and by the unaffihiated directors which were included in the Investment Company Act of 1940 for the protection of the stockholders have operated as a shield for the investment adviser which did not exist before the 1940 Act. Did these provisions change the existing law so as to reduce the protections available to stockholders of corporations generally and put the investment company stockholders in a worse position? Answer. No. It is not true that the requirements of the 1940 Act put the stock- holders of an investment company in a different position from other corporate stockholders. There was nothing in the law prior to the Act which in any way precluded approval of an investment advisory contradt by disinterested direc- tors or by stockholders, as shown in the attached opinion of Gaston, Snow, Motley & bit, and Sullivan & Cromwell. Question No. 9. The SEC entered an exhibit into the record which pertains to certain mutual fund advisers who have entered into arrangements with sub- advisers. It is claimed that because these sub-advisory agreements are at lower rates of payment than most conventional investment advisory arrangements, that this indicates that the rates charged under the conventional contracts are too high. Do you have any additional information with regard to these sub-advisory agreements, and would you comment on this claim? Answer. During the hearings the SEC ought to place importance on the unique arrangements that some eighteen mutual fund organizations have with so-called sub-advisers. Even the limited research that we have able to conduct in the last two weeks demonstrates that these arrangements shed no light on any of the issues underlying HR. 9510 and HR. 9511 The facts are: 1. All of these eighteen funds included in the SEC exhibit are very small- only two exceed $40 million. Thirteen of these were in the $10 million range in assets, with nine of these at less than $4 million. As far as we can determine, two of the companies on the SEC list had no assets as of June 30, 1967. 2. We hai~e been able to contact thirteen of the investment adviser organ iza- tions on the SEC list. Ten of these thirteen investment advisers report that they have recently or are now operating at a loss-even though, as the SEC claims, they apparently incur only modest costs in procuring investment advice from the sub-advisers. 3. The important fact about these investment advisers is that the sub-advisory contracts do not encompass the full range of management services provided by the investment adviser to the fund. In some cases the sub-advisory agreement did not even cover all investment advice. Thus, while the services being provided by each sub-adviser differ from arrangement to arrangement, they are not all-encompass- ing and are used to assist the adviser in carrying out his function. Question No. 10. "Some witnesses have raised questions about Section 22(d) of the Investment Company Act which in effect `fair trades' mutual fund shares PAGENO="0413" 827 Can you comment in detail as to the. necessity for 22 (d) in the mutual fund in- dustry and the likely effects if it was removed from the law ?" Answer. Section 22 (d) is similar in effect to the fair trade laws which exist in many states. It is also similar to anti-rebate laws dealing with life insurance commissions. Section 22(d) and these anti-rebate laws prohibit fee-splitting and thus prevent discrimination between customers. Every state in the union has such a law with respect to life insurance commissions. Section 22 (d) does not, of course, prohibit mutual funds from setting different sales charges from each other, and, in fact, sales. charges range from those of about 50 funds with no sales charge to funds with sales charges of 81/2 %. Moreover, there are reasons for Section 22(d) which are unique to the mutual fund industry. Upon request of the shareholder, his iputual fund shares must be redeemed by the fund at their current net asset value-this is required by law. In no other industry does the consumer have such an absolute right. Thus, to meet redemptions on an orderly basis which currently run on an industry-wide basis at about $2.5 billion per year, mutual fund underwriters must maintain a national distribution system. The repeal of Section 22(d) would cripple, if not end, the present system of distribution since the result would be that most transactions would take place in the over-the-counter market. These who recommend the repeal of Section 22(d) have not even purported to consider whether the over-the-counter market can insure adequate distribution just as they have not considered that a mutual fund shareholder has an interest in preserving a distribution system which makes possible the orderly redemption of his shares. The plain fact is that the over-the- counter market cannot sppport the distribution necessary to meet redemptions, especially during periods of market stress. (See Special Study of Securities Markets of the SEC, part 2, p. 798). Although the SEC has conceded that the repeal of Section 22(d) might lead to problems of price discrimination between customers and create competitive ad~ vantages for certain mutual fund underwriters, it was not until the House Hearings that Chairman Cohen finally stated: "In the first place, there is some un- certainty as to the consequences of repeal of Section 22(d) ." (House Hearings p. 849). Those who have day-to-day practical experience in the mutual fund business believe that the consequences are not uncertain-the effect would be highly disruptive to the mutual fund industry and would be injurious to the investing public. We enclose herewith a more detailed memorandum of our view of this subject. Sincerely yours, ROBERT L. AUGENBLICK, President. [Enclosures] EXHIBIT A GASTON, SNOW, MOTLEY & HOLT, Boston, Masa., SuLLIVAN & CROMWELL, New York, N.Y. October 23, 1967. INVESTMENT COMPANY INSTITUTE, New York, N.Y. DEAR SIRS: In connection with the testimony of Chairman Cohen before the Subcommittee on Commerce and Finance of the Committee on Interstate and Foreign Commerce of the House of Representatives concerning H.R. 0510 and H.R. 9511 and questions asked by various of the Committee members, you have asked us to review generally the standards applied by the courts to advisory fees and the remedies of a shareholder of an investment company who believes that the fees are too high. We have set forth below our view of the present state of the law in these respects. Before analyzing the position of an iftvestment company shareholder or the principles applied by the courts it is important to emphasize an important fact which puts the possible conflict of interest problems of investment company directors and stockholder remedies into perspective. The possibility of conflict of interest problems is common to all corporations, and the role played by non- interested directors, shareholders and the courts is no different for investment companies than for any other corporation. PAGENO="0414" 828 Chairman Cohen has implied that the requirements of the Investment Company Act of 1940 have somehow left investment company stockholders in a worse position than other corporate stockholders when dealing with a conflict of interest situation: viz. "Thus, the congressional requirement of approval by the shareholders and a majority of the unaffiliated directors which was intended to act as a protection for the shareholders, has actually insulated the fees from judicial scrutiny and deprived the shareholders of the benefit of judicial protection they would other- wise have enjoyed." (Statement of Securities and Exchange Commission before the Subcommittee on Commerce and Finance of the Committee on Interstate and Foreign Commerce on H.R. 9510 and H.R. 9511 on October 10, 1967, p. 40.) It is true that approval of an advisory contract by disinterested directors or by stockholders has an effect on the manner in which the courts review the problem. However, it is not true that these requirements of the Act put the stockholders of an investment company in a different position from other corpo- rate shareholders. There was nothing in the law prior to the Act which in any way precluded approval of an advisory contract by disinterested directors or by stockholders. There have been many court decisions which have considered the role of in- dependent directors, stockholders and the courts in resolving the potential con- flict of interest problem. In fact, there are a number of cases dealing with ar- rangements similar to those in the investment company industry. For in- stance, such a pattern is fairly common in the hotel industry where the cor- poration owning the hotel will engage a management company to operate the hotel for a fee. This pattern is also found to a certain extent in the insurance industry. The important point, however, is that these eases concern corpora- tions of all types and the principles applied are the same whether the corpora- tion involved is an investment company or not. A review of numerous decisions in this area indicates a framework for solving the conflict of interest problem as described below. Where there is a trans- action in question, whether in the forms of a contract or compensation arrange- ment, which is between the corporation and a director or between the corpora- tion and other corporations in which one or more directors have an interest, three basic situations present themselves. First, where the presence or vote of an interested director is needed for a quorum or for board approval; second, where the presence or vote of an interested director is not needed for a quorum or board approval; and third, where a majority of stockholders has approved of the traiisaction. In summary of the review below: where interested directors are making their own judgment of a transaction, they have the burden of convincing a court that it is reasonable and fair. Because of this conflict of interest their judgment is not in issue. It is assumed to be non-objective and the terms of the transac- tion are directly considered by the court. However, When non-interested direc- tors have applied their judgment, the assumption is that their judgment was correct or in the case of stockholder approval that they properly exercised their franchise. In order to invalidate the transaction in either of these cases, it must be shown that the transaction was so unreasonable or unfair that it was beyond the power of the directors to approve or of the majority stockholders to ratify the transaction to the detriment of the non-assenting stockholders. 1. VOTE OF NON-INDEPENDENT DIRECTORS NECESSARY FOR APPROVAL If the transaction is approved by a board in which the presence or the vote of an interested director is necessary for approval, when any stockholder com- plains that the transaction is unfair or overreaching the directors who would uphold this transaction have the burden of proving that it is fair and reason- able and entered into in good faith. If they fail, the transaction will be res- cinded and if thjury has been suffered, damages will be recovered for what was essentially an invalid transaction. Many different words are used to express the standard applied, but their import is clear. Because of the fact of self-dealing, where the vote of an interested director is necessary, the burden of showing that the arrangement is fair and reasonable is put on those who have the conflict of interest. Further, and most important, in this one instance the court itself decides whether the arrangements meets the standard of reasonableness, and then with great reluctance. However, 0 PAGENO="0415" 829 it has no choice. This follows from the fact that it cannot rely on the business judgment of the board. By definition the board cannot exercise its judgment ob- jectively, for its actions depend on the vote or votes of interested directors. Shlensky v. South Parkway Bldg. Corp., 19 Iii. 2d 268, 166 N.E.2d 793 (1960); Gottlieb v. Heyden Chem. Corp., 33 Del. Ch. 82, 88, 90 A.2d 660, 663 (Sup.Ct. 1952). The understandable reluctance of courts to directly judge the reasonableness of a corporate transaction except where there is no other alternative is ex- pressed in many decisions. The principle appears in the familiar American Tobacco case of Rogers v. Hill, 60 F.2d 109 (2d Cir. 1932), rev'd, 289 U.S. 582 (1933), where the compensation of six executives was attacked. Judge Swan, whose dissenting position in the Court of Appeals was later upheld by the Supreme Court, stated the principle as follows: "The determination of fair compensation for services is primarily for the directors. Courts hesitate to overrule the discretion of directors fairly exercised." (60 F.2d at 114) Another leading case expressing this reluctance is Seitz v. Union Brass ~ Metal Mfg. Co., 152 Minn. 460, 189 N.W. 586 (1922), where the court found in favor of the defendants who were charged with receiving eycessive salaries. "In determining whether salaries are excessive and unreasonable so that there should be a restoration courts proceed with some caution. An intolerable condi- tion might result if the courts should too lightly undertake the fixing of salaries at the suit of dissatisfied stockholders. An issue as to the reasonable value of the services of officers is easily made. It is not intended that courts shall be called upon to make a yearly audit and adjust salaries. The dissenting stockholder should come into court with proof of wrongdoing or oppression and should have more than a claim based on mere differences of opinion upon the question whether equal services could have been procured for somewhat less." (152 Minn. at 464-65, 1St) N.W. at 587-88) Particularly appropriate is the statement of the court in Cullen v. Governor Clinton Co., 279 App. Div. 483, 485, 110 N.Y.S.2d 614, 616 (1952), where a dissi- dent stockholder attacked a management contract between a corporation owning a hotel and a hotel management company. "Whether the hotel could better be operated through the medium of a manage- ment company presented a question of business judgment. If the decision had been arrived at as the result of an honest, prudent and careful belief of the directors that it was for the best interest of the hotel company, then that determi- nation would not be subject to interference by the courts, even though an error in judgment may have been committed." (2~9 App. Div. at 485, 110 N.Y.S.2d at 616) 2. APPROVAL BY INDEPENDENT DIRECTORS A different situation obt'ains when there is a disinterested majority of di- rectors able to consider the transaction. Here the courts recognize the basic representational structure of corporate form. That is, within limits of proper conduct, it is the duty and function of a board of directors to exercise their business judgment in determining whether a transaction is in the interest of the corporation. If a majority of the directors are not interested in the transaction and are free of domination by the interested director, then there is no reason to suspect or ignore their judgment unless on its face the terms of the transac- tion are so unfavorable to the corporation that it is beyond the board's power to approve it. Courts have used a variety of expressions, including "waste" and "gift of corporate property", to describe such unfavorable transactions. Regard- less of the words used, the principle is the same-i.e., the court will upset the decision of the board only where it concludes that the board's judgment is mani- festly out of line with what a reasonable man's business judgment could be. See Beard v. Elster, 39 Del. Ch. 153, 162, 160 A.2d 731, 737 (Sup. Ct. 1960). When such a transaction is challenged not only is the above standard applied, but the complaining party has the burden of showing that the arrangement was so ex- treme that it should be rescinded, This approach is partly a result of courts be- ing reluctant to interfere in the judgment of an independent board whose very function is to make this kind of decision. It also reflects the desirability of main- tainitig stability and certainty in affairs of corporations and their contracts with others. If, when challenged by a stockholder (or the SEC), independent boards of corporations generally were required to show the fairness of every contract PAGENO="0416" 830 approved in which one of the directors may have had an interest, corporate en- terprise would be severely hobbled. 3. APPROVAL BY STOCKHOLDERS Stockholder ratification of a transaction, assuming adequate disclosure of the relevant facts, does not essentially change the situation from that described in paragraph 2 above where an independent board has approved a transaction. Where there is no independent board, stockholder ratification is considered to have the sanie general effect as the approval of an independent board. Kaufman v. ~9hoenberg, 33 Del. Ch. 211, 91 A.2d 786 (Oh. Ct. 1952). The basic theory of corporate government is even clearer here. if the majority of the shareholders are in favor of a particular corporate transaction, the minority are bound by this decision of the majority. That is always the position of a dissenting minority shareholder in a corporate enterprise unless the state corporate law provides a right to receive fair value for his stock by appi~aisal as in the case of mergers or sale of assets. (A right which open-end shareholders have automatically at all times.) However, his property rights as a stockholder are such that, if there is a transaction amounting to a "waste" of the corporate property, this can be said to be something he did not bargain for and is not within the power of either a beard of independent directors or a majority of the stockholders to approve. As in the case of approval by independent directors, the underlying principles of corporate enterprise and corporate government require the complaining minority shareholder to show that the arrangement was so excessive that it improperly deprived him of a property right as a stockholder in the corporation. The standard applied is described by the courts in varying words such as "excessive", "waste", etc. These tOrms standing alone do not reveal the true nature of the judicial inquiry and protection difered to dissenting shareholders. A determination of "waste" or "excessive" does not involve the court's sub- jective judgment of what it would consider fair or reasonable compensation for the specific services rendered; that difficult decision is properly vested in the business judgment of corporate management or in the stockholders if the matter is submitted to them. The test is whether as a matter of law the compensation exceeds the range of reasonable business judgment, or, as stated in $a~ce v. Brady, "whether the cost . . . of obtaining advisory services bears some reasonable rela- tion to the value of the services rendered." 40 Dol. Oh. 474, 492, 184 A.2d 602, 613 (Ch.Ct. 1962) See also Rogers V. Hill, 289 U.S. 582, 591-92 (1933) ; Heller v. Boylan, 29 N.Y.S.2d 653, 668 (Sup.Ot. 1941), aff'd, 263 App. Div. 815, 32 N.Y.S. 2d 131 (1941); Kerbs v. Ua~ifornia Eastern Ai~'ways, Inc., 33 Del. Oh. 69, 74, 90 A.2d 652, 656 (Sup.Ct. 1952). This is an inquiry that the courts are qual- ified to make and offers shareholders of mutual funds the protection enjoyed by all stockholders under the general corporate law. GASTON~ SNOW MOTLEY & HOLT. SULLIVAN & CROMWELL. EXHIBIT To ANSWER TO QUESTION No. 10 SECTION 22(D) OF THE INVESTMENT COMPANY ACT OF 1940 During the course of the hearings on H.R. 9510 and 9511 a few witnesses commented on Section 22(d) of the Investment Company Act, and some members of the Committee appeared interested in the purpose of this statutory provision. Section 22(d) permits retail price maintenance in the mutual fund industry. In this sense it is not unlike the fair trade laws which exist in a number of states. Under such laws a manufacturer is permitted to fix the retail price of his product and has recourse to the courts should a dealer engage in price-cutting. However, 22(d) is even more closely analogous to the provisions of the laws of all 50 states which prevent fee splitting by prohibiting rebates of insurance commissions. The effect of these laws is that the sales commissions of particular companies are not subject to price-cutting and to discrimination between cus- tomers. As stated below, the necessity for Section 22(d) in the mutual fund industry goes further than in the case of insurance companies. At the outset it should be made clear that Section 22(d) does not require that all funds charge the same sales price, and as pointed out during the hearings, sales charges range from "no-load" funds to those charging a maximum of abQut 81/2%. It should also be noted that the SEC has bad regulatory experience PAGENO="0417" 831 with Section 22(d) since 1940. On April 15, 1960, a unanimous Commission en- dorsed the concept and purpose of Section 22(d) "Section 22(d) of the Act prohibits a registered investment company, its principal underwriter or a dealer from selling its redeemable shares to any person except at a current public offering price described in the prospectus. The purposes of the section are to prevent discrimination among purchasers and to provide for an orderly distribution of such shares by preventing their sale at a price less than that fixed in the prospectus." (Emphasis supplied.) (Investment Company Act Release No. 3015.) The Necessity for Orderly D~1stribution As the Committee is aware, a mutual fund is redeemable at the request of the shareholder. A mutual fund stands ready to buy back the investor's shares at the then current net asset value. This is a right of the shareholder, and there are no sales commissions payable on redemption. As a result of the redeemability feature shareholder redemptions, which stem from the completion of the investor's long range goals or other circumstances, are currently running `about $2.5 `billion per year, or about 6 percent of industry assets. Although mutual funds generally have sufficient cash or other liquid assets to meet `current redemptions, the major `source of funds for this purpose is new money obtained through sales to new or existing shareholders. Were it not for this source, the mutual fund would have to keep a `degree of liquidity which might not be consistent with the fund's investment appraisal of the market at a particular time. Stated another way, the shareholders would suffer in terms of investment performance if the mutual fund was forced to keep a large portion of assets in liquid form to meet redemptions. The retail price maintenance provisions of Section 22(d) assure an orderly and continuous system of distribution which would not `otherwise exist. For a proper understanding of this `point `it is necessary to examine the alterna- tives. Those who argue for repeal of Section 22(d), state that following such a repeal there would be a secondary market in mutual fund shares since the shares of a particular fund are "fungi'ble" commodities which would be subject to "free market pricing." The Alternatives to Section 22(d) 1. Reduction in Sales Undoubtedly, were Section 22(d) to be repealed, there would `be a secondary market in mutual fun'd shares. Such shares would be `tra'ded in much the same way and by the s'ame firms that handle over-the-counter securities gener- ally. Various trading firms would "make markets" in mutual fund shares, and over-the-counter retailers would acquire `shares from these wholesalers to meet customer demand. Firms would not tend to specialize in mutual fund shares since the salesman's income would be highly unstable where `competi- tors not specializing in mutual funds could under-cut the firm attempting to specialize in funds. This is exactly the situation which Section 22(d) w'as designed to prevent. Since mutual fund shar'es are sold as long-term invest- rnen'ts there is little speculative interest in acquiring this form oi~ equity in- vestment. If the mutual fund share became merely another security on the dealer's shelf there would `be relatively little `demand for it and it would not bb sold-especially since it would b'e competing with a hot $2 uranium stock or the latest speculative electronics issue. This is the reason that mutual fund shares, unlike other securities which hold forth the promise of short-term growth, must, like life insurance, depend on selling effort. Furthermore, suc~h selling effort depends on trained sales- men devoting their time with prospective customers In their homes and offices. The sales charge basically compensates the `salesman for this time and effort. A. salesman who devotes himself to `this kind of selling effort is not likely to remain in a business if aft'er he has made a successful sales presentation the customer he has convinced can simply go elsewhere `and acquire shares at bargain prices from a dealer's `shelf. In this situation the salesman ha's pro- vided a costly service, in terms of his time, and someone else who does not have similar costs profits from the salesman's work. As mu'tual fund sales- men tend to leave the field, the over-the-counter dealer will find his sales dropping off since he would not have a sales force specializing in funds. The traditional over-the~counter market cannot insure wide distribution of mutual fund shares. Aside fro'm the `fact that this could tend to reduce sales below 85-592-68-pt. 2-27 PAGENO="0418" 832 redemptions, there is a serious public interest question as to whether short terra trading in individual issues Should be encouraged at the expense of mutual funds, which would be the result of driving mutual fund salesmen out of the business. 2. Deteriora~tion of Sales Traiwing ond Supervision The ultimate result of a repeal of Section 22(d) would be to drive out of the mutual fund industry the trained professional full-time salesman. The prospective investor who has not heard of mutual funds or who is not motivated to make a long-term investment would thus, as a practical matter, be deprived of the oppor- tunity to make such an investment. To the extent that there were still firms spe- cializing in mutual fund shares, there would inevitably be a decreased emphasis on the training and supervision of salesmen. In 1963 the Report of the Special Study of Securities Markets spoke of the need for general tipgradlng of the quality of training and supervision in the securities industry and the "further development of secondary supervisory con- trols by industry members." A year later, with industry support, the Securities Acts Amendments of 1964 was `enacted. This legislation has resulted in improved self-regulatory controls. In many firms expensive automated techniques have been utilized to produce data for regulatory purposes, and firms have become increas- ingly selective in recruiting salesmen because of the increased costs of training, as well as the desire to avoid regulatory problems. No other retail business carries this kind of self-regulatory burden. This climate of self-regulation would be an early casualty of the repeal of Section 22(d). Price-cutting is obviously not con- ducive to budgeting for self-regulation. In the face of the recognition given by the SEO and almost every witness at the hearings to the value of the mutual fund for small and large investors, it is surely not in the public interest to take an approach which would inevitably lead to a deprivation of this form of Investment to those for whom it is most suited and which would lead to the deterioration of training and supervision' of salesmen 3. Adverse Market Consequences As noted above, one of the consequences of relegating the mutual fund share to the shelf of the over-the-counter market dealer would be a dramatic reduction in sales which would impair the industry's ability to meet redemptions. This factor could assume alarming implications in times of `market stress. During the period which followed the May, 1962 market break it is generally known that the over- the-counter market became almost completely dormant as many dealers and sales- men left the securities business. On the other hand, although redemptions of mutual fund shares had a moderate increase and sales were somewhat affected by the market break, the existence `of dealers and salesmen who specialized in mutual funds assured a healthy level of sales throughout this period. Such sales not only permitted mutual funds to act as stabilizing forces during the period of the break itself but undoubtedly contributed to the recovery of' the market as new money came into the general equity markets through the medium of the mutual fund. In fact, as shown in the attached Table, mutual funds have generally acted as stabil- izing forces' in times of market decline. Were it not for a strong distribution mechanism mutual funds would not have the ability to act as stabilizing `forces in the marketis. In the absence of Section 22(d) dealers making the secondary `markets in mutual fund s'har~s would, as a matter of economic self-interest, redeem their own inventories, adding to the pressures on the funds caused by redemptions of investors. These dealers would sharply restrict their market making function's, a's they generally did for over-the-counter `securities in the i\~tay 1962 market break. (See Speoka Study of Securities Markets of the SEC, Part 2, p. 789, Appendix 17II-~H). T'hus, investors would have had no market for their shares except the mutual fund itself, and, in the absence of a strong network of distribution the funds themselves might well be forced into net liquidation. The liquidation of their own portfolio securities to meet redemption in a time of market `stress would add to `chaotic market conditions and increase downward pressures on the stock exchanges instead of exerting the beneficial stabilizing influence that actually occurred in May, 162, an'd other `times of market `stress. 4. Price Discrimination The repeal of `Section 22(d) would `create a problem of price discrimination among customers. The `SEO ha's long embraced and endorsed the an'tidiscrimina~ tory ~urpoises of Section 22(d). In 1958 the SEC promulgated Rule 22d-4, which codified `prior Commission interpretations as to what practices `Constituted dis- PAGENO="0419" 833 criminatory pricing. In the absence of Section 22(d) it would ~e the unsophisti- cated customer who would pay the highest price. Sophisticated customer~ and those pureha'sing in volume would reap the benefits of `their ability to negotiate. The SEC ha's been critical of securities pricing mechanisms which permit snch discrimination. (See ~Specia1 ~S~tatty of Igeourities Markets of the ~S~EU, Part 2, pp. `627, ~ Conclusion There are a number of compelling question's which must he considered before any `serious consideration `can `be given to any modification of Section 22(d). Some of these are: 1. Would the small investor be deprived of the opportunity to learn of and invest in mutual funds because normal `distribution method's would `be disrupted by chaotic price-cutting? 2. Would the training and `supervision of mutual fund `salesmen deteriorate, contrary to the goal of the "protection o'f investors" contained in the federal securitie~ law's? 3. Would the non~so'p'bi'sticated investor have to pay more than the sophisti- cated investor for the `same mutual fund shares? 4. Would mutual fund's be forced into net liquidation of their portfolios which would have especially `serious consequences during times of market stress when dealers making markets in fund shares would redeem their shares wit'h ultimate adverse consequences to the over-all economy? None of the proponents of the repeal of Section 22(d) have even purported to examine these questions, much less to answer them. We believe that the answers are clear and that repeal of 5ec~f~n 22(d) would not be a responsible course of action in the public interest. MUTUAL FUND PORTFOLIO ACTIVITY AND INVESTORS PURCHASES AND REDEMPTIONS DURING PERIODS OF MARKET DECLINE Period Time Percent market Mutual fund managers (dollars in millions) - Mutual fund investors (dollars in millions) ~. decline Portfolio Portfolio Value of Value of purchases sales shares shares purchased redeemed 1. May to October 1946 2. Korean war outbreak (week ending June 30, 1950). 3. Eisenhower illness (week ending Sept. 30, 1955). 4. Oct. 1-21, 1957 5. Sept 1-30, 1960 6. January to March 1962 7. April 1962 8. January to April 1962 9. May28, 1962 10. May 3 to July 2, 1965 May 14 to June 28, 1965 ii. Apr. 18 to May 27, 1966 12. Aug. 15-29, 1966 6 months 1 week - - - do 3 weeks 1 month 3 months 1 month 4 months 1 day 2 months 6 weeks do 2 weeks -18. 2 -6. 9 -4. 3 -7. 3 -7. 3 -3. 3 -5. 9 -9. 0 -5.7 -5. 1 -10. 5 -5.4 -8. 7 $117. 2 $72. 1 13. 8 6. 2 16. 3 13. 0 81. 6 32. 4 255. 0 199. 1 1, 365. 1 856. 7 (1) (1) (1 1 235.0 1, 460. 3 1, 101. 1 1, 021. 0 718. 6 1,404. 1 1,186.4 474. 9 463. 9 $98. 8 $38. 7 9. 0 8. 2 22. 5 10. 1 46. 8 15. 9 177. 0 64. 9 922. 1 282. 4 260. 1 91. 3 1, 182. 2 373, 7 4.4 6.8 518. 6 234. 3 (1) (1) 673.9 370 3 104. 8 74. 6 Note-The preceding studies constitute coverage of all periods of important market decline since the end of World War II. The studies were based, in each case, on reports received from substantial portions of the industry with the following percentages of assets of Investment Company Institute's open-end members represented: 1-74.3 percent; 2-96.5 percent- 3-82.5 percent; 4-79.0 percent; 5-98.4 percent; 6-100.0 percent; 7-100.0 percent; 8-100.0 percent; 9-75.0 percent; 10-77.7 percent; 11-83.0 portent; 12-83.9 percent. 1 Not available. 2 Net. LEXINGTON RESEARCH & MANAGEMENT Coap., Englewood, N.J., May 12, 1967. Subject: Proposed mutual fund bilL Hon. WILLIAM B. WIDNALL, House of Representatives, Washington, DXI. DEAR MR. WIDNALL: Through our subsidiary, Templeton, Dobbrow & Vance, Inc., our `organization has been In the investment counsel business since 1938. We advise portfolios of pension trusts, church funds, trusts, colleges and wealthy PAGENO="0420" 834 families and individuals. We believe that we are among the 10 largest in the country uid the largest in New Jersey. About ten years ago we became actively iILvOlVe(l in the management, $ponsorsllip and selling of mutual funds. Our dis- tribu lion has been handled through our subsidiary, Renyx, Field & Co., Inc., which has a PE)~OX i inn tely 300 registered representatives from Florida to Maine. We have always attempted to conducit ourselves in a professional manner and have been very earnest and serious about our obligation to the public. \Ve believe that the proposed mutual fund legislation is exceedingly harmful awl unfair to usas managers as well as to our representatives and in the long run cant a ty to `the best publië interest for the following reasons: I. `l'he sales charge and front~end load as currently charged is needed to at- tract intelligent, high minded men to the business of providing financial planning to t he A niericail public. The product is too complex to be botight; It must be sold. It is to the ulvii ntage of the American economy to encourage the public to save. The (ant ract nat plan is the only vehicle available to the person of modest means in which he has a fair chance of building an estate for himself. Savings banks and life i nsura nec provide a low compounded rate of interest and give no protection against inflation. The SEC is being shortsighted in their proposals in attempting to protect roughly 15% of the public at the expeti~e of 85%. The majority is not only satislicl but pleased that some salesmuh at some point encouraged them to start a plan. Those who start a plan and do not complete it may suffer a small 19UOfl ccni('nc(' but no more than if they bought any product and sold it soon therea ~ter. But those who never start a plan to provide for their retirement suffer a !#OgyC(t/J. The way to eliminate abuses in mutual fund selling is not to outlaw a plati which has proved effective, but to encourage better men to enter the business. It is my contention `that the eliminatio~i of the front-end load or the i~éduct ion o~ the sales commission will drive the mutual fund salesmen to the insurance industry where commissions are more generous and need not be re- yealed `to the public. The net result will be that the average American will be denied an opportunity to build an estate through equity investing. 2. We are opposed to any legislation aimed at controlling management fees for three rca S0115 (a) The industry has on its own scaled down fees as volume of assets has grown. (b) Our fees have not been excessive since we have been making only modest profits (luring recent years and suffered substantial `loss~es in the early years of creating our business. (c) It is contrary to our free enterprise system to have government determine the profitability in a competitive industry. I know that `the issue before you is extremely complex and that it will require a `great deal of work and wisdom to produce legislation which is in the best public interest, short and long range, without needlessly hampering an industry which is providing an extremely important and valuable service to the public. If I can be of help to you in providing any facts or otherwise, I will be happy to do so. `I have no way of knowing where you personally stand on this issue, but if you agree with our viewpoint, I would appreciate it if you would communicate it to the House Tnterstate and Foreign Commerce Committee. Very truly yours, JOHN L. SCHROEDER, President. MAaTIN NELSON & Co., INC., ~$eattle, Wash., October 4, 1967. CoNGRESs oF THE UNITED STATES, House of Representatives, Committee on Interstate and Foreign Commerce, Washington, D.C. (Attention W. E. Williamson, Clerk). GENTLEMEN: We would like to submit for the record, and as testimony if desired by the Committee, a statement in strong `opposition to the S.E.C. pro- posals contained in HR. 9510 and 9511, Section 12(e), to restrict and regulate mutual fund sales charges. Our firm, Martin Nelson & Co., Inc. of Seattle is typical of the thousands of smaller broker-dealer firms in `the country which will be severely injured by these unreasonable proposals. We represent small business, Main Street U.S.A., PAGENO="0421" 835 and not Wall Street or a few large firms headquartered in New York City. I have been in the investment business in Seattle for 34 years and our firm employs 7 to 10 people. We are engaged in helping public investors with their investment problems and in the important task of providing capital for American industry, particularly the smaller local businesses. Mutual funds are a very important part of our work. They have done a fine job for many years for all of our customers who own them. The S.E.C. has in general done a good job of regulation in the securities indus- try. However, in this proposal it is attempting to establish, by legislation, com- pensation ceilings in a very competitive industry. Our industry is not a public utility, a light, water or gas business enjoying a monopoly market. There are some 250 mutual funds available for an investor, some of them with no sales charge. There are numerous broker-dealers through which he can buy them. Why is it necessary for the S.E.C. to ignore the forces of free competition which have been so successful in American business thus far? The proposed ceilings would, according to careful N.A.S.D. research, force many of the smaller firms in the securities industry out of business and severely curtail the income of most of the industry. The health of small business is of vital importance to the economic well `being of the entire country. There are many severe problems facing Congress and our nation today. Why is this legislation regulating and curtailing mutual fund sales compensation in a very competitive industry and which would injure so many smaller firms, really necessary? Yours very truly, MARTIN 0. NELsON. MILITARY AssocIATEs, INC., Little Rock, Ark., October 9, 1967. Re: H.R. 9510 and 9511. Hon. JOHN E. Moss, Tiouse Office Building, Washington, D.C. DEAR Mn. Moss: I wish to add my protest to the storm of other protests I have heard throughout the Nation to an effort on the part of the Securities Exchange Commission to reduce or tamper with in any way the commission structure of mutual fund sales. I understand by hearsay. (an article in Fortune Magazine) that this entire study was instigated and the proposals made at the behest of an employee of the SEC who is or has been a college profes'sor. I suggest that this gentleman has probably never managed a sales organization and has never been confronted with the staggering expense of training, managing and financing the proper cali- ber of men in a business such as this. I am head of one of the largest insurance sales organizations in the Nation. We also sell mutual funds through various broker-dealers with whom my men are individually licensed. We do business in over twenty states from California to Florida. It is a known fact that insurance agencies such as ours and many insurance companies spend many thousands of dollars in training a successful man and bringing him into his full capacity in this work. The sale of insurance and the sale of mutual funds is, under the best of circumstances, a difficult job. People do not voluntarily make investments nor do they voluntarily buy life insurance. It must be sold. We think mutual funds are the poor man's or the average man-in-the-street's, only workable me~Iium of investment. It has been this flow of money into the market which has given it the support it needed, the lack of which may have resulted in a run on the market with ensuing disastrous results. It has long been my observation that the mutual funds industry has some of the most poorly trained and poorly managed salesmen of any part of the finance industry in the Nation. I have known many of these people and it is only those who are associated with the big houses such as Merrill, Lynch and Dean Witter that you seethe unusually high class, well trained man. I suspect that much of this is due to the present difficulty and expense involved in hiring and training men. If you comply with the desires of the SEC you will succeed in putting many small people out of business. You will make it impossible to hire and train and PAGENO="0422" 836 manage high class men of the caliber necessary to handle an important job like this. Time and space will not permit me to say more, but please record my vigorous protest as well as that of my colleagues. If you desire additional information or further amplification of my remarks, I shall be glad to furnish same upon recluest. Yours very truly, LEE CAZORT, Jr., President. NORTH AMERICAN SECURITIES ADMINISTRATORS AssoCIATIoN, Ixc., Boston, Mass., October 24, 1967. Hon. HARLEY 0. STAGGERS, Chairman, House Interstate and Foreign Commerce Committee, Washington, D.C. DEAR CONGRESSMAN STAGGERS: We have been concerned about Federal Legis- lation, past, present and future, that strips the States of their traditional supervisory jurisdiction over the securities industry. The States were the pioneers in securities regulation for the protection of the public and in this respect they are still the pioneers. In this connection the enclosed resolution was adopted by the members of the North American Securities Administrators Association, Inn., at their Annual Conference held at Banif, Alberta, Canada, on September 14, 1967. Copies of this resolution are being sent to the members of the Sub-Committee on Commerce and Finance of House Committee on Interstate and Foreign Commerce. Very truly yours, FRANK J. DALEY, $ecretary. I, Frank J. Daley, hereby certify that I am the duly elected Secretary of North American Securities Administrators Association, Inc. I further certify that at a meeting of the members of the Association duly called and held at Banif, Alberta, Canada, on September 14, 1967, the foll~wing preambles and resolutions were duly adopted Whereas the Securities Administrators of many of the states of the United States have and for many years have had ample authority under the laws of the states in which they serve to regulate and supervise the terms of securities and the fairness of the public offering and sale of securities and, Whereas suoh Securities Administrators have effectively exercised such au- thority as, in their judgment, has been for and in the best interest of persons residing in such states and, Whereas there is no evidence indicating any need or public demand for fundamental change in the existing regulatory and supervisory structure and, Whereas legislation is pending from time to time before the Congress of the United States which if enacted will severely limit such state supervisory and regulatory authority: Now, therefore, be it Resolved, That this Association does hereby record its deepest concern as to the enactment by Congress of any legislation which would further limit the authority of state Securities Administrators under state laws to regulate and supervise the terms of securities and the terms of the public offering and sale of such securities; and be it further Resolved, That the Secretary of this Association be and he hereby is authorized and directed to transmit to the appropriate Congressional Committees duly certified copies of these Preambles and Resolutions. FRANK J. DALEY, ~eeretary. H. 0. PERT & Co., Kansas City, Mo., June 20, 1967. Hon. LARRY WINN, Jr., House of Representatives, Washington, D.C. DEAR LARRY: In regard to H.R. 9510 which is concerned with legislative pro- posals of the S.E.C., I presume that you will receive certain information from the securities industry which will have a general bearing on your, voting deci- sion. I thought it might be helpful to you to have some specific information on PAGENO="0423" 837 our understanding of the effects of the proposed legislation on our, operations. Although our main office is in Missouri, our Kansas City, Kansas branch is the only member firm office in that city and we are glad to say serves many of your constituents. In addition several of my partners and many of our employees reside in Johnson and Wyandotte Counties. We recently made a thorough analysis of the effect of the S.E.C. legislative proposals on our 1966 operations. As of December 31, 1966, H. 0. Peet & Co. bad been in business 29 years, had reported capital of $2,677,328, employed 44 regis- tered representatives and 46 other employees plus 9 partners. We were operating 4 branch offices and served more than 10,000 clients. In 1966 our gross commissions were broken down as follows: Percent Municipal bonds 1. 7 Over-the-counter gross commissions 7. 2 Mutual funds gross 23. 7 Listed commission business 65. 0 Underwriting gross 2.4 Included in the figures above representing listed commissions is a considerable amount of business directed to us by the various mutual funds. As a businessman, you can well appreciate the fact that it is oftentimes the "plus business" that makes the difference between profit and hrns in any given year. We have approximately half a million dollars invested in Exchange mem- berships. The commissions which we receive from mutual funds frequently rep- resent the difference between operating on a break-even basis, at best, and making a satisfactory return on our investment. The conclusion to be reached from the S.E.C. report would be that certain institutions (mutual funds) should essentially be prohibited from doing business with firms which raise capital for them (sell their shares) and that all this business should be channeled through the huge Wall Street firms. The implication here is that they are entitled to this business by virtue of their size whereas we should be deprived of this business specifically because we show our confidence in these financial institutions by recommending investment in them. Carried to its logical conclusion, this would imply that the nation would be better off with only one brokerage firm through which everyone must execute their orders. This firm, of course, would be severely regulated by a federal agency to a point where it ultimately operated on a non-profit basis. (Perhaps another Post Office department?) This could hardly be classified as engendering the profit motive concept of economic growth. In fact, it would in many ways be like your having a building inspector tell you that you could not purchase materials from a particular supplier because that supplier had contracted with you to build a building for him. Surely nothing could be further from your actual desires than such a dictum. Assuming the S.E.C. proposals were in effect during this period, the reduction of our net profit after partners' salaries and interest would have been minus 121%. If only those proposals concerning N.Y.S.E. volume discounts and any give-ups were in effect, the effect on our net profit would have been minus 96%. We would unquestionably have to reappraise our entire operation in the event that the S.E.C. legislative proposals become law. For example it would become difficult if not impossible to attract new capital into the firm. There would be no retained earnings and who wants to put capital into a profitless operation? I think we would be forced to consider merger, liquidation or consolidation and the net effect would be to greatly reduce the investment services now available to the public we serve. Aside from the immediate impact on profit, these legislative proposals would naturally affect our training program. For example we now have six men In training and in most instances our trainees are qualified as soon as possible (3 to 6 months) in the sale of mutual funds under partial registration with the N.Y.S.E. and a great deal of their time the first year or so is devoted to the sale of mutual funds. We have found that this is the only possible way they can come anywhere near making a living. I am sure our mutual fund sales would decline on a smaller sales charge but bow much I don't think we can even begin to estimate. This is an important part of a total training program which is necessary to develop fully qualified registered representatives. This is precisely the part of PAGENO="0424" 838 our over-all effort which best serves the smaller investor who is usually much better off o'wning mutual fund shares than dabbling in low priced speculative shares. It is these smaller investors who would suffer most from lack of service by curtailment of training programs, closing of smaller offices and liquidation of smaller investment firms. In addition I believe that our larger producers would definitely shy away from sale of mutual fund shares because of reduced commissions. After all it is profit potential that attracts the best producers and in order `to compete with other industries aud professions we must be able to compete in the vital area of compensation. On an over-all basis these legislative proposals appear to be aimed in essence at the revenue side of the securltie~ business. While the industry has long recog- nized and lived with a vast variety of regulation it is also a highly competitive industry and therefore appears unsuited `to a regulatory approach more appli- cable to possible monoplies. In fact these proposals would more likely create a monopolistic situation because only a few of the very largest companies in the business could operate profitably. They would dominate the industry and tend to concentrate in the larger cities and give less service in smaller corn- mun'ities. As a businessman I am sure you can understand the impact of a sudden loss of 40% of your gross and no reduction in your cost of doing business. It is my understanding that hearings begin this week in the Senate where this bill is known as S. 1059. We have not yet been informed about the House schedule but thought you might find this information useful in the near future. As to my own interest and qualifications, I first entered the securities business in 1934 in Denver, Colorado. I spent 14 years with Waddell & Reed as an officer, director and portfolio manager. I joined H.O. Peet in January, 1966 and became a partner in April, 1967. In all `those years I have never seen a regulative pro- posal less calculated to serve the public interest than a mere reduction in sales charges. I think this would have about the same effect as reducing haircuts from $2.25 to $1.25. There soon would be no barbers. With best wishes for your continued success, I remain Sincerely yours, ROBERT E. Grn~N. WADDELL & REED, INC., Kansas City, Missouri, July 28, 1967. Hon. LARRY WINN, Jr., House 0/flee Building, Washington, D.C. DEAR Ma. WINN: Thank you for your letter of June 15th, and your request that I again write you with the possibility that this letter might become a part of the hearing record on H. R. 5910. I cannot argue with the overall intention of the Security & Exchange Commission in their desire to further benefit the small in- vestor using the open-end investment trusts. I believe that the regulations on our industry have helped to develop the mutual fund industry, and I do hot object to the numerous and strict regulations that are now in effect. Two of the three main areas of the bill cover management fees, and sales com- mission. In both areas competition is keen. Various funds make a sales point of how their fees and expenses are being progressively reduced and state their position in the industry. Sales commissions run from nothing in the no-load funds to 8.75%. In each area there is competition, a choièe. The third area of the proposed legislation regards "contractual plans." sales costs in many contractuals are actually less than afforded to the cash buyer! I use a plan myself because it enables me to use relatively small amounts of money, gives me an objective, and supplies me with the discipline I need. The `terms of a contractual plan are so carefully spelled out for the buyer that they know an early liquidation will not be to their advantage. Amazing sums of money have been accumulated by people using contractual plans, and it has helped our registered representatives to be `able to sell and service the small but systema'tic investor. Without such programs we would simply have to confine our work to those with lump sums of cash. Here particularly is' a place where the suggested legislation would work to the disadvantage of the wage earner and the average sales person. Since my particular job is that of hiring, training and supervising registered representatives, I am quite aware of their average earnings and the work they do PAGENO="0425" 839 for their investors. Our industry is in no way an opportunity to make a fast dol- lar, but rather requires a career commitment in order to make even a respectable living. I do not feel that the Security & Exchange Commission has sufficiently con- sidered the cost involved in selling our product, and it seems to me that the opposite of what the Security Exchange Commission wants to accomplish will result if the legislation is passed in its present form. The Security Exchange Corn- misssion has admitted that the small investor who has employed the mutual fund method of investing has benefited substantially, but they do not realize bow ex- pensive it is for us to sell and service the accounts. If the present legislation is passed, it is my opinion that the large investor and the high positioned people in the industry will be unaffected, but the average mutual fund salesman and the small investor will be adversely affected. The investment business entails as much or more risk for those of us who are in the business as it does for the investor. It is vitally important when you accept these risks as a part of your life that there at least be the possibility of ~some rewards. The Security Exchange Commission legislation would so reduce the opportupity to make money that the commission strticture would be dealt a shat- tering blow. It is almost impossible to go the fixed cost route. Wages and costs have constantly increased throughout our land. By automat- ing bookkeeping, and dealing with larger amounts of money, our mutual fund companies have, as their records reveal, progressively decreased their internal management fees and expenses. In the same period our expenses have progres- sively increased, and the industry has not passed this increased cost on to the investor. When in area after area it has been necessary to increase prices due to wage demands, fringe benefits, etc., the industry has a splendid record of actually reducing management fees. Basically the agitation for this legislation has not come from our investors. We are in a highly competitive market. Our charges and costs are no more than are needed. The banks, insurance companies, savings & loan associations, etc., are able to far more aggressively solicit investment money than we are. I feel that the work we do is honorable, of long term benefit to the money market in the United States, and offers one of the best methods for the general public to be involved in our capitalistic free enterprise system. Sincerely yours, GEORGE D. CLELAND, Jn., Division Manager. OVERLAND PARK, KAN5., May 25, 1967. Hon. LARRY WINN, Jr., House of Representatives, Washington, D.C. DEAR Mn. WINN: The SEC Mutual Fund Bill has proposed that Congress give certain authority to the Securities and Exchange Commission which would eliminate, restrict, and change certain established operations, policies, and pro- cedures of the mutual fund industry. Although I am unopposed to beneficial elimination, restrictions or change, I cannot concur with the Bill as presented. The following deserve acjditional comment: 1. Elimination of front-end load contractual plans.-This niediuw of invest- ment is under criticism primarily due to the placing of a large part of the sales charge in the first twelve investments. Contractual Plans are a long-term invest~ mont which are sold by salesmen who must receive a commission sufficient for his labors. If sales charges and commissions were spread out over the life of the plan it would be physically impossible for the salesmen to earn $600 per month and give the service necessary to his clients. ($25.00 per month from 400 people at a commission rate of 6%). In addition, the Contractual Plan offers to the small investor the opportunity to share in the wealth of his nation through the inherent diversification of a mutual fund and its professional management which may not otherwise be available to him. * 2. Restrictioa of sales charges on lump sum investments-The bill as proposed seeks to set an arbitrary 5% of the net investment as the maximum s~les charge. This proposal is based on the NASD's "5% mark-up policy" on listed and unlisted securities. But, they fail to state that the NASID's 5% is charged both on the PAGENO="0426" 840 purchase and on the sale of a security. Mutual funds have varying percentages for sales charges, normally 8½ % only on the purchase. There is normally no charge for redemption. 3. Restriction of management fees to a level called "Reasonable."-The Bill proposes to restrict management fees to a reasonable amount. Therefore, current fees must be unreasonable. Yet, no definition of "reasonable" is given nor is any criteria given to determine what is and what is not reasonable. To determine a reasonable management fee would require a constant review of individual situations and I doubt whether such a system of review is possible. If constant review is not made, then a new standard or the current standard will become generally acceptable to the SEC and reasonable. The sole authority to determine what is reasonable to an individual manager or an industry will rest with the SEC. No avenue of joint agreement is available. 4. "Change" is a big word.-Change does not consist of just the present but also includes the past, and the future. It must also include the why, when, where and how of the change. To date the Mutual Fund Bill Includes the past and the present of the mutual fund industry. The future is unknown. It also includes the SEC's why, the SEC's when, the SEC's where and the SEC's how. The Bill's presentation does not include the investors, the general publics or the mutual fund industries viewpoints or feelings. The Bill does indicate the* SEC's view- points, feelings and recommendations. The above are some of my reasons for opposing this Bill, and I would appre- ciate you conveying my thoughts to the appropriate Committee. A reply at your earliest convenience certainly would be appreciated. Sincerely, ROBERT L. Cox. LONG BEACH, CALIF., Jnly 17, 1967. Subject: HR. 9510 (Investment Company Amendments Act of 1967). Congressman HARLEY 0. STAGGERS, Chairman, House Interstate and Foreign Commerce Committee, House Office Building, WasMngton, D.C. DEAR CONGRESSMAN STAGGERS: Having read and evaluated the SEO's legislative proposal to regulate the Mutual Funds' sales charges and management fees, I am prompted to emphatically oppose this legislation. The SEC's proposal to impose rate regulation by litigation or threat is un- sound. To place effective power to set sales charges and management rates solely in the hands of the SEC, Investors and Federal District Courts, would bring about chaotic business conditions in the Mutual Fund business. In my opinion, Congress should not entertain any proposal which would have such a devastating effect on the incentives of those who are already in the busi- ness or who might want to enter it. I urge that you legislate against this bill. Respectfully yours, KENNETH H. HOLDEN, Mutual Fund Sales Representative. SAN JOSE, CALIF., July 17, 1967. Subject: H.R. 9510 (Investment Company Amendments Act of 1967). Congressman HARLEY 0. STAGGERS, Chairman, House Interstate and Foreign Commerce, Committee, House Office Building, WasMngton, D.C. DEAR CONGRESSMAN STAGGERS: As a sales representative of many years and presently an employee of a large mutual fund, I am writing to express my con- cern over the proposals being made by the Securities and Exchange Commission. Their prOposed control and or regulatl~ns for maximum sales loads and man- agement fees are particularly perplexing. First, I wonder why mutual fund sales charges should be subject to Govern- ment control. These charges are disclosed to the public, atid competition being an important part of successful selling dictates to a great extent whether or not a customer chooses to buy. Funds do not represent the exclusive way of invest- PAGENO="0427" 841 lug in secui'ities, but the 47% cut in maximum sales charges recommended by the S.E.C. would make it unprofitable to solicit the small investors who would not otherwise invest in securities. Where individual securities are often sold by telephone, mutual fund sales are sold by time-consuming personal interviews where the small sales sometimes require more of a salesman's time than larger transactions. A mutual fund investor, regardless of the size of his investment, receives many services for his sales charge including professional management. Our particular company distributes part of the sales charges to the division manager, district manager, and the salesman, all of whom must be able to finance their operational costs and earn a profit. For these reasons it is hoped that you will not act favorably toward these S.E.C. proposals. Sincerely, RICHARD L. POPE. PIERMONT, N.Y., October 23, 1967. Representative JOHN E. Moss, Chairman, House Eubcommittee on Commerce and Finance, Interstate Foreign and Commerce Committee, Washington, D.C. DEAR Sin: I would like to contribute my views on mutual funds to your com- mittee hearings and for the record. I am an investor in mutual funds and also have done personal research in the field. I am both pained and distressed by some of the SEC charges and proposals made before Congress and your committee. If enacted into law, they would be a major disservice for the public as a whole. They would be detrimental to many mutual fund investors, such as my family and our savings in mutual funds. Among other things~, it could result in a loss of savings for my children's college in the future. I neither work in the mutual fund business nor in any way have a vested interest in the industry (except for my relatively modest investments in a few funds). I therefore would not benefit directly as a result of legislation that would either help or hinder the mutual fund industry. I am a full-time self-employed professional writer. I have four main points to make. First, the much publicized but highly improbable statement made by Mr. Cbhen of the SEC before your committee that a random investment in stocks in past years would have done as well as an investment in an average performance mutual fund: This is poppycock. I personally have done much better with my savings in mutual funds than I formerly did when I invested exclusively in the stock market. In fact, I wish I had heard about mutual funds a long time ago. But I had been put off of them by, among other things, the critical University of Pennsylvania study made for the SEC back around 1961 or so. (And some of the dire things that report had to say about funds certainly didn't work out later for me.) I used several large and well-known Wall Street brokerage houses and their recommendations when I invested in individual stocks. In 1964 I began switch- lug from stocks to mutual funds. My fund investments have done much better than stocks ever did for me. I enclose the record of all my actual Investments in one fund since 1964. You can use it as an actual example, if you wish, of a typical Investor In funds. I have invested, all told, in four different funds. I'll be glad to show you my actual records in each of the others, too, if you wish. In addition to my personal experience being an actual example that cofitra- diets Mr. Cohen's statement, it simply doesn't make sense to say that any person could have done better blindfolded in the stock market than in mutual funds. Such a statement is based on a hypothetical case, and it evidently lumps the performance of all different mutual funds together (in a scrambled mix like apples and oranges compared with plums and prunes), as the mutual fund industry has surely pointed out. It therefore is a highly misleading thing to say. He really should have known better. Besides, Mr. Cohen's statement makes no allowance for the fact that people being people often act in funny ways that are often unpredictable. Moreover, do you, for example, know of any person who would put his hard cash on the line PAGENO="0428" 842 in stocks cboseii at random, or with a dartboard. (Many people would probably do better if they did.) A real test would be an actual comparison of bow typical investors (if there are such animals) fared in the stock market versus the actual performance results of people in mutual funds. The mutual funds results are an open record, as you well ki~ow. Stock investments are not, but then perhaps Mr. Cohen, or Professor Samuelson of MIT, would give you their actual monthly stock broker accounts so you could compare what a supposedly informed investor has done in stocks versus the actual performance of mutual funds. I'll bet that on net balance the funds have done pretty well by comparison, if not better. For that matter, I'll match the return on my mutual fund investments, as documented on the enclosed form, with the stock market return received by either of those men during the same period. Or with any other person you may choose at random. My savings in this particular fund, for example, have in- creased in value by about 25 to 30 percent just this year (1966). Thus, my first j~oint; that the average person very likely and very probably can and is doing as well, if not a lot better, with his money in mutual funds than he could do in the ~toek market. Secondly, the much criticised contractual, or "front-load" plan, should be modified but not abolished. I personally would not invest in a contractual plan unless I had holes in my bead. However, I know people who do invest in them who, very frankly, would never be saving except that they are forced to via a binding contractual plan. As a result it is not at all unlikely that they and their kids will be financially a lot better off in the future, compared with how they would be if there was no contractual plan for théni to save with. Abolishing the plan now might not affect them, to be sure. But it would prevent other people from starting similar savings plans in the future. Again, people are funny animals and some of us may not do what is the most sensible and logical thing economically (or otherwise), we may not always do what is best for us, and allowances should be niade for human behavior. On the other hand, the front-load charge on a contractual plan may well be a rather stiff price to pay in advance. Perhaps the lion's share of the sales load charge could be spread over two years, rather than one year as now. And some- thing probably should be done for people who are forced to cancel out on a con- tractual plan after being in it for only a few years. Some refund allowance should be made on the excess sales charge they had paid in. In addition, something also could be done to cut down on some rather dishonest sales practices by some salesmen selling the contractual plan, though news of this kind of skullduggery may not have reached the SEC. Conclusion: Outlawing the contractual plan would be a disservice to a lot of people, and particularly to middle-income people who can really benefit from it over the long haul. It should, however, be reformed. Third, I oppose a reduction in the maximum allowable management fee paid to mutual fund managers. Cutting the. fee is a penny-wise and pound-foolish thing. A person like myself might save all of $5 to $10 a year as a result of the SEC's terrific and unrelenting campaign to prevent what they think *may *be price gouging in the industry (though I seriously doubt that it amounts to that much profiteering). Cutting down on the fee would, I strongly fear, cut down on the service and performance that people like myself get from our mutual funds. The funds would have less to spend for analysts and for other top-flight people to watch their investments. Phat not only would be a disservice to the many, many people who invest in funds, but it would end up costing a lot of us much more money than the mere $5 to $10 each of us would save on our fees each year. Sure, there are probably a few funds who are overpaid and underworked, and some fund people may make more money than they deserve. (Phat statement can go for lots of other groups, such as doctors, lawyers, and government employees.) PAGENO="0429" 843 There are also many crack mutual fund people who deserve every extra dollar they make in the business, within reasonable limits, of course. Or maybe with no limits so long as they continue to rack up the excellent performance results that the better funds have shown in the last couple of decades. I have absolutely no objection to any person being paid a good price for his efforts and job done. Clamp- ing down, however, on the allowable management fees puts a damper on intelli- gence, initiative and incentive (and I speak as a liberal Democrat and former Democratic committeeman). It's just not a good thing to do, and it's incompre- hensible since it's the sort of thing that rewards mediocrity. If the SEC believes that some mutual funds give a dollar's value for a dollar carried, it ought to single out such funds rather than punish all for the sake of a few. It should use a rifle and not a shotgun. Fourth, I am opposed to a reduction in the sales load charge from the present 9 percent down to 5 percent. This is another penny-wise and pound-foolish pro- posal. Again, it makes no allowance for the quirks and unpredictable behavior (and inertia, among other things) of people. (Literally speaking therefore, it is an inhuman proposal.) And, pray tell, what good really would this proposal do? And why five percent? Why not four or seven, or eleven, for that matter? If you cut sales commissions, I'd say that by and large the very best salesman in the field would leave for greener pastures. They would mostly be the fulitime salesmen in the business now, rather than the moonlighters and parttimers. Any good salesman can and probably will go to another field where he can make more money. And that would mean a loss for the public as well as a loss in sales for the mutual fund industry. Now, of course there are salesmen and there are salesmen. Nobody but nobody can tell you in advance for sure which salesmen Will leave the mutual fund field if sales commissions are so drastically reduced. I have met and known se~veral mutual fund salesmen, including some surprisingly bright and knowledgeable ones, as well as one who was a stumblebum. By and large, however, the character, morality, and intelligence of mutual fund salesmen taken as a whole are probably no different from the character traits, morality, and intelligence of many other people, including all the lawyers of the SEC, all congresmen, all businessmen and all nonprofit social workers, too. Suppose that the American people decided en masse to cut the salaries of Mr. Cohen and the people in the SEC, and all Congressmen, such as yourself, by a flat 45 percent or so, or by the same sharp reduction that Mr. Cohen recommends for mutual fund salesmen. Which employees of the SEC and which congressmen are most likely to quit and get other, better-paying jobs? You very likely would lose some of our very best SEC people and our very best congressmen. Why should such people work for so much less money? They are usually the ones who would earn, if not command, more money In other jobs. That may not be a perfect analogy, but it can give you an idea of which caliber salesmen are most likely to leave the field if you cut the sales charges. As a result, the mutual fund savings of literally millions of people, such as my- self, would probably suffer. My kids could conceivaby end up with less money for college in the future and I don't welcome that prospect. What hurts the mutual fund industry in this case can hurt its customers; i.e., the public. That is not to say, by the way, that I oppose all supervisioa and watchdog activities of the government, through `the SEC. Of cOurse not. However, there are times, alas, when we need protection from our friends rather than our enemies. To sum up, I strongly oppose two of the SEC mutaal fund proposals made be- fore Congress, and I feel that the third one to abolish contra~tual plans bO modi- fied rather than abolish this mutual fund purchase plan. And I hope that this letter can be made a part of the records of your hearings. Sincerely yours, ARThuR M. WATKINS. PAGENO="0430" ~1 01 rJ) 0 :: ; II J ~ coco II -~ F~o4~~ ~-"~r: F° _4F~ ~T" -~ * ~CO ~N) ~ ~ ~ II I iwJ C,, C) -v PAGENO="0431" PAGENO="0432"