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U.S. Securities and Exchange Commission

The Role of Independent Investment Company Directors

Transcript of the Conference on the Role of
Independent Investment Company Directors

U.S. Securities and Exchange Commission, Washington, D.C.
February 23 & 24, 1999

February 23, 1999

Introductory Remarks 

Paul Roye, Director of the Division of Investment Management:  Good morning. I'd like to welcome you all to the SEC's roundtable on the role of independent investment company directors. We have a great program planned for you over the next two days. We will hear from independent directors and others on a variety of issues, key issues facing independent directors today.

First, I would like to thank our moderators and panelists for agreeing to contribute their time to our Roundtable, and I would also like to thank the SEC staff, many of whom worked to pull this program off behind the scenes. First, I'd like to highlight a few housekeeping matters. To the extent that during the course of the proceedings over the next two days you can't find a seat, we do have an overflow room down the hall to the left, where we have video monitors set up, where you can observe the proceedings. I would also like to remind you that the press is present, so any remarks will be on the record. Time permitting for each of the panels, we'll have an opportunity for questions. In your seats, you will find index cards.

If you have questions, if you could write them down on the cards, toward the end of each of the panels, we'll have SEC staff persons walking through to gather those cards and relay them to the moderators.

I would also like to point out that many of our panelists have prepared thoughtful papers on the subjects that we're going to cover over the next two days, and those are outside in the table outside the room.

To kick off our roundtable this morning, I would like to introduce Arthur Levitt, Chairman of the SEC. As many of you know, he has been a tireless advocate of enhancing independent director effectiveness. So I would like you to join me in welcoming the Chairman of the SEC, Chairman Arthur Levitt.

Chairman Levitt:   Thank you, Paul, and good morning. It's a pleasure to welcome everyone to the SEC roundtable on the role of independent investment company directors. I, too, would like to thank the moderators and the panelists for agreeing to participate in what I regard to be a very, very important endeavor. I would also like to thank the staff, which continues to work tirelessly on behalf of America's investors.

We are here today to discuss the increasingly important role that independent directors play in protecting fund investors, and precisely how their effectiveness may be enhanced. These issues are not academic, nor are they peripheral. They directly affect every mutual fund investor. Accordingly, I will ask the Commission to make improved investment company governance one of its top priorities. I expect that this roundtable will help shape our agenda on issues facing independent directors today.

As we all know, the growth of the mutual fund industry has been absolutely staggering. At the end of last year, the assets of mutual funds exceeded $5.5 trillion, up from just over $1 trillion in 1990. Mutual funds are the primary investment vehicle of choice for most Americans. At last estimate, over 66 million people were invested in mutual funds. We owe it to those 66 million people to ensure that funds are being run in their best interests. For that to happen, one word above all must define a fund's overall management structure, and that word, of course, is accountability. Without strong independent directors, accountability is nothing more than a word on a page.

Twenty years ago, the late Justice William Brennan described independent fund directors as watchdogs. The Investment Company Act, according to Justice Brennan, was designed to place the directors who are unaffiliated with a mutual fund's adviser in the role of independent watchdogs, who would furnish a "independent check upon the management of investment companies" – an independent check, a force for accountability on behalf of shareholders who depend on their independence to maintain the integrity of the fund.

This objective seems simple enough, so let me ask three straightforward questions, which I believe go to the very heart of our discussion over the next several days: First, are independent directors really effective? Second, do they, can they really act as a check on management? Third, are they serving the shareholders' interests above all else?

The answer to these questions will serve as a basis for our agenda on investment company governance. I hope that if there is one point that we can agree on it's this: regulators shouldn't be the only ones asking these questions. If a fund's management isn't proactively addressing these questions, what does that say about an investment company? If a fund's governance has no culture of independence and accountability, who looks after the investor's interests?

I realize that these are very difficult questions to answer. But can we afford not to answer them? Over the next two days, we will hear from independent directors, senior fund executives, legal counsel to funds, investor advocates, and leading academics. I hope that we can work together towards solutions that will improve the current system of fund governance.

As you know, we've designed the roundtable around a series of panel discussions. I would like to mention a few of these topics, and perhaps raise some additional more specific questions that I believe should be addressed to each panel. Following some general background by Paul, our first panel this morning deals with negotiating fund fees and expenses. Perhaps no other issue addressed by independent directors has as much impact on investors' returns than the level of fund fees. Now, while fund performance is unpredictable, certainly the impact of fees is not. As I've emphasized before, a 1 percent annual fee will reduce an ending account balance by 17 percent over 20 years.

Now, we all understand that directors aren't required to guarantee that their fund will be able to employ the lowest fees, but they are required to ask whether fund investors are really getting their money's worth. What do independent directors know about management's costs and management's profitability? If the fund assets under management have ballooned, have fees been reduced to reflect any economies of scale? Again, there are no simple answers to these questions, but they are necessary questions. They are, if I may say so, essential questions. Some, no doubt, might prefer that they go unanswered. But effective regulation and investor interests demand that we reassess our assumptions. Following fees, we'll discuss another important issue, fund distribution arrangements.

As you know, independent directors have special responsibilities under the Investment Company Act when fund assets are used to pay distribution expenses. They must determine that there is a reasonable likelihood that the payments will benefit the fund and its shareholders. Do directors really understand what payments are being made to whom and why? What are the implications of fund supermarkets to investors? Are the increased benefits to some shareholders at the expense of others? These are all questions that independent directors must consider. Fund portfolio brokerage is another area where I think that independent directors have a duty to ask some tough questions. Which broker is the fund using, and why? Why one over another? And if the adviser has soft dollar arrangements, in whose interests are they? Are they in the best interests of fund shareholders? Can soft dollar arrangements be used to reduce direct costs to the fund, as well as for securing research for the management company?

Now, our remaining panels will take a look at issues that have received a good deal of attention at the Commission and in the press in recent years. Mutual fund disclosure has been one of our top priorities. Our panel on fund disclosure will look at what directors can do to ensure that shareholder communications are clear, are easily understood by investors, and tell the whole story about the fund. Consolidation in the securities industry has become an increasingly common occurrence. It seems like we hear an announcement of a new merger or alliance nearly every day. What is the proper role of independent fund directors when fund advisers merge? Our panel on adviser and fund reorganizations is intended to address this issue. The question of when it's appropriate for a fund to value its portfolio using fair value pricing has been of concern in light of recent market volatility. The panel on valuation will address this and similar questions.

Finally, we'll discuss the special issues faced by independent directors of closed-end funds, variable insurance products funds, and bank-related funds. For example, in the past few years, we've seen increased activism by closed-end fund shareholders to reduce or eliminate trading discounts. What should the role of independent directors be when these shareholders clash with fund management? Finally, to close our roundtable tomorrow afternoon, we will have two distinguished panels that will focus on the larger question of how to enhance the effectiveness of independent directors. These two panels will draw upon discussions of the previous panels, to give us a sense of where we are and where we may be going. For example, when is a director truly independent? Does our current definition under the law still reflect reality? Should a majority of all of the directors of a fund be independent rather than just the 40 percent that the law currently requires? Should a former officer of a management company be able to serve as an independent director without a two, three, or even a five-year hiatus? And should fund management pay directors for their services?

In overseeing a fund's operations, how should directors strike a proper balance between indifferent acquiescence and overzealous interference with management? In a worst-case scenario, when management and the board are at an impasse and on the road to proxy fights and litigation, do the directors really have the tools to protect the interests of fund shareholders? Should independent directors, for example, have the right to terminate the investment adviser's contract? I know I'm asking lots of questions, and some of you are probably thinking of that line, "Question everything, learn something, answer nothing." Well, I really hope that, together, we will begin to develop the right answers. The purpose of this roundtable is not to have the Commission tell independent directors how to do their jobs. I want you to tell us how you do your jobs. We want to know what works under the current system, and more importantly than that, we want to know what doesn't work. I want to make clear at the outset that I do not favor government intervention in this area. But to think that the results of this will merely be some lukewarm effort at best practices I think mistakes the purpose of this roundtable. The industry has done extremely well at policing itself, has read the signals, and has acted upon them promptly and appropriately, but the need is greater today than ever. The industry, for the most part, has been responsive, but at a time when more people than ever are investing in mutual funds, and the vast majority of them have never experienced a down market. The public and private sector together need to be asking these questions and need to be generating substantive responses, not cosmetic fixes. I regard this roundtable as an essential first step in that process. While the Commission is not afraid to search for solutions alone, I'm quite confident, judging by today's participation, that together we can serve the investor interest.

In that spirit, I've asked our moderators, all of whom are current or former senior Commission staff members, to challenge the panelists, to ask some tough questions, and I expect our panelists to give us their frank and their honest answers. If you think that a current practice does not serve investors' interests, speak up. If you think that a Commission rule of position is ineffectual, or some action that we have taken is inconsistent with what we set forth, let us know about it. No matter what our conclusions are, there's one thing of which I am absolutely certain: board independence does not come from a specific legal structure. I've often said that I don't believe in constituent boards representing different interests, but I believe passionately in boards made up of men and women of good, sound independent judgment. Board independence comes from directors who do their jobs aggressively. I said it before, but it's worth repeating: independent directors must take their jobs and their fiduciary duties seriously. Independent directors must have the courage to question fund managers and the status quo. Without that, even our best proposals for improving investment company governance will certainly fail.

I have every confidence that working together in a spirit of openness, of creativity, and with the determination above all else to see to it that investor interests are jealously, fearlessly, courageously protected, I believe we will succeed. Thank you.



Overview - Role of the Independent Director  

Mr. Roye:  I would like to thank Chairman Levitt for those remarks. He has raised a number of provocative and challenging questions that we will discuss over the next two days. As the Chairman has noted, we are very enthusiastic about the roundtable and this unique opportunity to explore the role and key issues facing independent investment company directors today. Before our panels get started, I thought it would be helpful to provide some background on the duties of fund directors, how these duties have evolved over time, how investment company directors are different, how their responsibilities are different from the general responsibilities of corporate directors, why Congress imposed upon independent investment company directors special responsibilities. The special role of independent investment company directors can be explained in part by the unique nature of the typical investment company structure.

Unlike a regular operating company, investment companies are not operated by their own employees. Instead, funds normally rely on external service providers, like the fund's investment adviser, to conduct the fund's day-to-day business, including managing the fund's portfolio and providing administrative services. In return, these service providers receive a specified fee from the fund pursuant to various agreements with the fund. Additionally, the officers of funds are usually affiliated with the fund's adviser, or the other outside service providers, such as the fund's administrator or underwriter. Consequently, the interests of fund management and shareholders of a fund are not completely aligned.

A fund's investment adviser has a separate interest in the maximization of its own profits. In contrast, officers of an operating company are paid directly by the company, often have an equity interest in the company, and devote themselves to profit maximization to benefit both the company and themselves. While a fund's management and fund shareholders have some common interests, such as seeking outstanding investment performance, there are important areas in which these interests may conflict, such as the level of management fees.

Because of the conflicts of interest in the investment company structure, independent directors play a crucial role in ensuring that fund shareholders' interests are protected. Indeed, the courts, as Chairman Levitt has alluded to, refer to this role as a watchdog, to protect the interests of fund shareholders. Since investment companies, like other corporations, are organized pursuant to state law rather than federal law, the Investment Company Act is not the only source of authority for the management power of investment company directors. State law is the basic source of director authority, while the Investment Company Act functions to impose specific additional duties and responsibilities on fund directors, both affiliated and independent. State laws generally impose the specific duty of care on directors, which requires them to discharge their responsibilities in good faith and to exercise the degree of skill, diligence, and care that a reasonably prudent person would exercise in the same circumstances in a manner he or she reasonably believes to be in the best interests of the company.

This duty requires directors to obtain adequate information about matters they are called upon to decide and exercise their business judgment with respect to matters on which the board is expected to act. The business judgment rule, which is a construct of state common law, is important in applying this duty of care. The business judgment rule provides that directors will not be found liable for their actions, provided that they act reasonably and in good faith for the best interests of the corporation, even if their decisions turn out to be erroneous. State law also imposes a duty of loyalty. This duty prohibits directors from converting to their own personal benefit opportunities that properly belong to the company. Thus, the interests of the corporation must take precedence over the interests of the individual director. State law, particularly in Delaware, Massachusetts, and Maryland, where most investment companies are organized, has in recent years been catching up to the role envisioned for investment company directors under the 1940 Act, but still has some way to go.

Now, in 1936-1939, the SEC did an investment trust study which identified the need for federal regulation in the area of investment companies. It was determined that disclosure under the 1933 and 1934 Acts was not enough. Additional regulatory authority was required to control the conflicts of interest inherent in the structure of the industry. Congress, in passing the Investment Company Act in 1940, placed unique responsibilities on the independent investment company directors, imposing duties on fund directors that are more fundamental and pervasive than those of directors of conventional corporations. The Act, among other things, requires independent directors to review and approve the contracts with the fund's investment adviser and principal underwriter, imposes the duty to select the accountants that prepare the fund's financial statements, as well as gives the directors responsibility regarding the pricing of the fund's portfolio securities. The structure and purpose of the Investment Company Act reflects Congress's judgment that it was appropriate to entrust to independent directors the primary responsibility for safeguarding the interests of mutual fund shareholders and to protect the conflicts of interest and the financial affairs of the fund. Congress could have chosen to address the conflict of interest problem through alternative means, such as mandating an internalized management function, but it instead chose to rely on independent directors. But Congress recognized that certain relationships between directors and management would impair the ability of directors to effectively police conflicts. Prior to the adoption of the Investment Company Act, a fund's board was often comprised mostly of individuals who worked for the investment adviser. Thus, fund boards were dominated by the fund's adviser, which was hardly an adequate check on the adviser's actions. As a result, in 1940, Congress required that 40 percent of the directors on a fund's board be unaffiliated with the fund or its adviser. The function of this provision was to supply an independent check on management and to provide a means for the representation of shareholder interests in investment company affairs.

Twenty years after the Act was adopted, questions arose regarding the effectiveness of this governance structure. In 1962, the Wharton School at the University of Pennsylvania completed a study of the mutual fund industry that was authorized by the Commission. This study offered a comprehensive review of the mutual fund industry, the first done since the Investment Trust Study in the '30s. The study found, among other things, that the main problems affecting funds related to potential conflicts of interest between fund management and shareholders, and the possible lack of arms-length bargaining between funds and their managers. The study found that actual decision making functions, in many cases, were in the hands of a few individuals who functioned in multiple capacities with the fund and the adviser.

Additionally, the study found that fees charged by advisers to funds tended to be substantially higher than those fees charged by the same advisers to most of their non- fund clients at comparable asset levels. The study noted that the relatively high rates commonly charged by advisers did not appear to be a consequence of extensive services rendered to, or expenses incurred on behalf of, the funds. The Wharton Report found that as of 1960, most advisers were not sharing the economies of size with the funds and the shareholders, and noted that four out of every five funds had no breakpoints in their advisory fees as those funds got larger. The Commission transmitted the Wharton Report to Congress indicating that it would evaluate the public policy questions raised in the report with a view to determining and formulating appropriate regulatory and enforcement proposals.

In 1966, the Commission issued the PPI Report, more formally known as the Report on the Public Policy Implications of Investment Company Growth. In the PPI Report, the Commission concluded that the abuses which had prevailed prior to the enactment of the 1940 Act had largely been eliminated, but expressed concerns that fees paid by funds to their advisers might be higher than necessary, and determined that such fees were, in part, due to limitations on the effectiveness of unaffiliated directors. The PPI Report found that while unaffiliated directors performed a valuable service to fund shareholders, their usefulness was limited by several factors, including working part-time, working without independent staff, usually without independent counsel, and from obtaining most of their information about fund operations from employees of the fund's adviser. In large measure, as a result of the PPI report, Congress amended the 1940 Act in 1970 to strengthen the definition of independent director.

So today, an independent fund director, in addition to not being an affiliate of a fund's investment adviser, cannot be an immediate family member of an affiliated person of an adviser, cannot have a beneficial interest in securities issued by the adviser or the principal underwriter or any of their controlling persons, cannot generally be a registered broker dealer or affiliated with a broker dealer or have an affiliation with any recent legal counsel to the fund. To enable directors to effectively serve the fund and its shareholders when negotiating with management over fund advisory and underwriting agreements, Congress also imposed a statutory duty on fund directors to request and consider any information necessary to evaluate the terms of both advisory and underwriting contracts. To ensure that directors could carry out this obligation, Congress also imposed a statutory duty on fund management to furnish this information to the directors. Moreover, Congress imposed a statutory fiduciary duty on the fund's adviser with respect to receipt of compensation from the fund. In combination, these statutory amendments were designed to rebalance the scales regarding the conflicts of interest between the funds and their managers.

In 1992, the Division of Investment Management conducted a study of the regulation of investment companies to determine whether existing regulations imposed unnecessary constraints on investment companies and whether there were gaps in investor protection. A portion of the study re- examined the adequacy of investment company governance structure. The Division concluded that the governance model embodied in the Act was sound and had served investors well. However, the Division recommended legislation that was never enacted to strengthen director independence. The Division recommended that the Investment Company Act be amended to require that the minimum proportion of independent directors be increased from 40 percent to a majority, that independent director vacancies be filled by the remaining independent directors, and that independent directors be given the authority to terminate advisory contracts. These and other recommendations to strengthen director independence will be discussed during the roundtable.

Since the passage of the 1940 Act, the investment company industry, for the most part, has been remarkably free from the scandals that have plagued other areas of the financial service industry. The trust and confidence many investors have in the mutual fund industry is due in no small part to the vigilance of fund directors and the Commission, in ensuring compliance with the Investment Company Act's core investor protection concerns. However, fund directors and we as regulators cannot become complacent. We must remain on guard and continue to challenge, probe, and ask the difficult questions. Changes in the financial markets, development of new financial instruments and investment strategies, and technological advances, require that independent directors be active and inquiring, and that we as directors consider measures to assist directors in fulfilling their responsibilities.

The statute and the Commission asks much of fund directors, and we may ask more of directors in the future, but we also recognize that the Commission has an obligation to directors as well. And I want to assure fund directors that we will aggressively and vigorously pursue reports by directors of violations of federal law and not sit idly by. It is appropriate that almost 30 years after the 1970 amendments to the Investment Company Act, and as we approach the new millennium, that we consider how we can strengthen the Investment Company governance structure.

Today, we are holding our roundtable in the William O. Douglas Room, dedicated to the former Chairman of the Commission, and a distinguished Supreme Court Justice. Justice Douglas succinctly summarized the mission of the SEC when he said, simply, "We are the investor's advocate." In the fund boardrooms, it is the independent directors who are the investor's advocate. Millions of Americans are relying on independent directors to protect their interests. We hope that this roundtable will highlight ideas and approaches that can lead to enhancing effectiveness of independent directors in advocating and protecting the interests of fund shareholders. We thank you for coming, and hope you enjoy the roundtable.


Mr. Roye:  We will get started with our first panel, on the director's role in negotiating fees and expenses.


Negotiating Fees and Expenses 

Mr. Sirri:  Good morning, and welcome to the first panel of our two-day roundtable on the role of investment company independent directors. I'm Erik Sirri. I'm the Chief Economist with the Securities & Exchange Commission. The first panel is going to be discussing the role of independent directors in negotiating fees and expenses. I think we all understand what a charged topic it is. It's an emotionally charged topic. I think it's something that lies at the core of independent directors' role in overseeing fund companies. By my reading, the rhetoric around this particular topic has been fairly high. It has been high in the press. It has been high in discussions inside advisers, and it's even been high here at the Securities & Exchange Commission. It's a topic we care desperately about.

Let me emphasize that the topic of this roundtable is about the role of independent directors in setting fees and expenses as opposed to being about fees and expenses themselves. I think we best serve the role of this roundtable by focusing on independent directors and exactly what their tasks are. I understand that the topics of fees and expenses are intertwined with directors' roles, but we're going to try and focus specifically on directors themselves, as opposed to the general topic of fees. Now, to help us separate those problems, the staff of the SEC has prepared a short handout that summarizes some studies of fees and expenses that were done by other parties. It's important to note that in summarizing these studies, the staff tried to be objective. We're in no way ratifying or advocating the results of those studies. Rather, what we really meant to do was provide a concise, one-page summary and description of what those studies conclude, and in that way sort of push aside some of the rhetoric, and let us concentrate on the issues at hand.

We have with us this morning five very distinguished members that I think we're very fortunate to take some of their very valuable time. I would like to say a few words about each of them. The introductions will be very brief, and in no way can possibly do justice to their individual personal accomplishments.

First, we have with us Bob Pozen. Bob is the President and Chief Executive Officer of Fidelity Management & Research. He has responsibilities for all of Fidelity's portfolio managers, for their analysts, and for their traders around the world. Before he was at Fidelity, he worked at the Washington, DC law firm of Caplan & Drysdale, and before that, he was a professor at NYU. Next, we have with us Ken Scott. Ken is a Senior Research Fellow at the Hoover Institution and a Ralph M. Parsons Professor of Law and Business at Stanford Law School. Professor Scott spent five years after law school in private practice at Sullivan & Cromwell in New York, and at Musick, Peeler, and Garrett, in LA He is the author of two books on corporation law and securities regulation, and also on retail banking in the electronic age.

Next we have with us Bruce MacLaury. Bruce was the president of the Brookings Institution from 1977 to 1995, and after he retired from Brookings, he was given the title of Professor Emeritus, and continues his affiliation there. He also served as Vice President of the Federal Reserve Bank of New York and in the Treasury Department as Undersecretary for Monetary Affairs. Dr. MacLaury is currently a director of the American Express Bank, the National Steel Corporation, The St. Paul Companies, and The Vanguard Funds, and he has served as director of Dayton Hudson Corporation for 15 years.

Fourth on our panel is John Markese. John is the president of the 170,000- member Chicago-based American Association of Individual Investors. He earned his doctorate in finance at the University of Illinois. John has also served as a portfolio manager and consultant to individuals and to pension plans. Finally, we have Harold Evensky. Harold is a CFP in his own firm of Evensky, Brown & Katz in Coral Gables, Florida. Mr. Evensky received his bachelor's and master's degrees from Cornell University. In 1998, Mr. Evensky testified before the House Subcommittee on Finance and Hazardous Materials in the US House of Representatives on the topic of mutual fund expenses. In addition, he has written for and is quoted frequently in the national press and is the author of Wealth Management. What I have asked these five panelists to do is to give a brief five-minute opening statement, after which I hope there will be enough on the table for us to begin an honest give-and-take discussion. To begin this discussion, I've asked Bob Pozen to tee up some issues associated with negotiating fees and expenses and an overview of the legal requirements for the approval of advisory and other service contracts. Bob.

Mr. Pozen:  Thank you. I will outline the regulatory requirements I've been asked, for negotiating fees, and then I'm going to make a few comments about what I believe are some deficiencies of the current regulatory framework. The current regulatory framework is, the key case is a case named Gartenberg, and the judge said that a fee may not be, and I quote, "so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arms-length bargaining." That's a pretty vague standard, and I think that it's helpful to sort of think about what independent directors do in terms of looking at a series of factors, and these factors, I think, can be usefully grouped into three categories. First is what I call process factors. When the independent directors approve the contract, it's very important what process they go through. Judges will look at what the qualifications of directors are, what information they have been given, at the carefulness of their deliberative process, and they will also look whether they got advice from independent counsel.

The second set of factors really has to do with the quality of what is being provided by the adviser. Obviously, directors look at the quality of investment management, the expertise of the people involved, the research process, compliance responsibilities, and performance statistics along various parameters. They also need to look at other services that are provided by the adviser, the range of funds, for instance, whether they have international funds, sector funds, and the range of services, consolidated statements funds, all these types of things. The third set of factors has to do with financial. And there, there are a number of things that directors need to look at. They look at the cost of the services provided, the adviser's cost of providing the services. They look at the payments that are received by the adviser. These include comparison of expense ratios and looking at the structure of the fees. The courts also ask that independent directors look at so-called spin-off benefits. These are some potential ancillary benefits that the adviser may receive. Last of all, the advisers are required to present information, and independent directors look at profitability. The courts have said there is no one correct method of evaluating profitability, there are a series of different methods, and independent directors can look at profitability from a number of perspectives. I think that gives you a sort of summary of the current process.

Now, I would like to, just in the rest of my time, express three concerns about deficiencies in the regulatory process. The first is that the '40 Act, the whole structure of the '40 Act, is based on the concept of one fund and one set of directors. This historically was probably accurate at the time the '40 Act was passed, but now almost all directors are dealing in the context of a complex. In the context of a complex, the key questions are allocation questions. For example, most complexes have research that's done that's spread among a number of funds, have a trading desk that serves a number of funds, have found systems that serve investors from many different funds. So that in that sense, the Act isn't responsive to the way things are, and there are a lot of allocation questions. The second deficiency is one that the SEC has chosen to take a position on that I have always believed doesn't make any sense. The SEC's position is that independent directors are not allowed to see sales and promotional expenses. They're not allowed to consider them, unless there is a 12b-1 plan in place.

Now, in a context of a load fund with a big 12b-1 fee, that makes sense, to look at the 12b-1 revenues and the sales loads and then to look at the sales and promotional expenses, which you're allowed to do. But in the context of a no-load fund, everyone realizes that the investment manager is using its own resources to pay for the promotional expenses, but unless you have a 12b-1 plan, you're not allowed to show those promotional expenses in the revenues and expenses to the directors. The only argument I've heard that attempts to support this position is that maybe the directors would allow the management fee to be bloated up and artificially inflated, and therefore some part of the management fee might actually be going artificially to support distribution. I happen to think that's a very weak argument, and that most of the no-load funds have fees that are competitive and at the median or below, so it's very hard to think that these fees would be bloated, and of course it's something the directors can see very easily. So I think most people have found that the directors do want to see all the revenues and all the expenses, and it's an anomaly that you can't have the directors consider promotional and sales expense in the context of many no-load funds.

The third deficiency, I think, is probably the most important, and that is that there's a 300-pound gorilla that's not sitting at this table or even represented here, and that's all the hedge funds in the United States. Since Congress recently expanded the number of shareholders that there can be in a hedge fund from 100 to 500, we've witnessed a very great expansion of hedge funds. There are now over 1200 hedge funds with over $110 billion in assets; and, despite what happened in Long Term Capital this year, they're continuing to grow. Now, most hedge funds have a very simple fee structure: 1 percent management fee plus 20 percent of the profits, 20 percent of the upside; nothing of the downside. Now, there are tremendous implications of hedge funds for this fee discussion we're having. Let me outline several of them. One is that hedge funds are the biggest competitors for portfolio management talent with the mutual fund industry. But the mutual fund industry has not given a fair playing field to compete against hedge fund managers and the best portfolio management talent in this country will go to a small number of wealthy elite and will not be available to the middle class public shareholders of mutual funds. Now, the question is this a fair playing field? And the answer is clearly, no. And neither the SEC nor the Congress has really done anything about this. And, basically, hedge funds are unregulated. There's been a total abdication here. And I know that there are a lot of people who feel and I would agree with them that it would be inappropriate to apply the full '40 Act to hedge funds; but I'd suggest that there are three things that can be done and should be done in terms of imposing regulation on hedge funds that offer their interest to US investors.

First of all, they should be required to disclose their holdings twice a year. We are, as mutual funds are required to list every holding twice a year. This is very important because as we've seen from Long Term Capital, the holdings of these hedge funds are very important in terms of the dynamic of the marketplace. It is almost impossible to find out what these people hold or how leveraged their holdings are. The second thing is the mutual fund industry has been very aggressive in adopting a very tough code of ethics for personal investing and for lots of personal conflicts of interest. There is no code of ethics requirement. There is no personal conflicts of regulation in the hedge fund area. I think that is really inappropriate.

Last of all, I think that the SEC should require every hedge fund as it requires mutual funds to have symmetrical performance fees; that is, if you're going to get 20 percent of the upside, if things don't go well, you ought to lose 20 percent on the downside. These three simple regulations would go a long way to making mutual funds have a fair playing field in terms of competing with hedge funds. I think the last thing I want to say about hedge funds is that they show you how successful independent directors are in the mutual fund area. These very sophisticated investors in hedge funds paid, in my estimate, over 3 percent in management fees in 1998 – on average over 3 percent in management fees. By contrast, independent directors have been very aggressive in terms of dealing with fees for mutual fund shareholders and that independent directors have clearly done a much better job in terms of bargaining and negotiating for fees lower for the mutual funds' public shareholders – and they're the representatives of the public shareholders – than these sophisticated investors have done for themselves. Thank you.

Mr. Sirri:  Thank you, Bob. Our next two panelists are independent directors themselves, so what we have asked them to do is say a few words about the practice of what actually goes on inside a boardroom when the time comes to negotiate with the adviser over the advisory contract. I have asked Bruce MacLaury to begin. I wonder, Bruce, if you would say a few words about how that process works for you?

Mr. MacLaury:  Thank you, Erik, and let me say it's a pleasure to be here today. I'd like to express my appreciation to Chairman Levitt and the Commission for their interest in hosting this roundtable. I have always though of my role as an independent director of Vanguard to be an enviable one in the field of mutual fund directors. As most of you know, Vanguard Group has a unique structure in which the Vanguard funds and, therefore, the shareholders, own the management company. This structure gives the Vanguard fund directors and the fund shareholders some distinct advantages. First, unlike much of the industry, the Fund's management company has no shareholders to serve other than the Fund shareholders. The interests of the management company and the board of directors are structurally aligned. There's no room for conflict of interest.

Second, the Vanguard Group provides administrative distribution and advisory services to all of its funds at cost. And, third, we use independent investment managers for some of our actively managed funds, but in all of these arrangements, the funds are not dependent upon the adviser for administrative services and so cannot be held captive. All of the advisory agreements are negotiated at arms-length, are competitive and can be terminated when necessary. Although our corporate structure is unique, our approach to the selection and compensation of investment managers is not unique. Like everyone else, we seek talented managers to provide the highest quality investment management for our funds. When we are selecting new managers, and I emphasize the word, "new managers," we consider what Jack Bogle, the founder of Vanguard, refers to as the four P's: people, philosophy, portfolios and performance. In that order. People, we mean experience, conviction and integrity. Philosophy, it must be clear and it must be aligned with the intent of the fund. Portfolios, they have to reflect that philosophy and performance, that's the final step in this looking for a new manager.

Only when we are satisfied with these four P's do we negotiate the advisory fee and then we obviously are looking for a competitive rate. In our advisory fee structures, we make extensive use of two features that enhance shareholders' interests, we believe: incentive fees and breakpoints. Incentive fees are a critically important way of aligning the interests of the advisers with the interest of fund shareholders. I am talking about what's called fulcrum fees in which the adviser's fee increases when the fund outperforms its benchmark and decreases when the fund under performs its benchmark. They should not be confused with what Bob just referred to or the hedge funds' performance fees that are often used by advisers of non- mutual fund accounts. With performance fees, there is usually a minimum or a base fee with additional fees paid for high relative performance but no fee penalty for poor performance. Fulcrum fees, on the other hand, adjust the adviser's compensation both on the upside and the downside. They, therefore, align the performance with both the adviser and the investor.

Second, breakpoints. With the phenomenal growth of mutual funds over the past decade, we believe it is imperative to incorporate breakpoints into the adviser's fee. There has been a lot of talk about whether investors benefit from economies of scale. One way to make sure that fund shareholders enjoy the benefits of larger asset size is to negotiate scaled fees, fees that decrease as a percentage of the fund's assets as the fund grows. Using these scale fees acknowledges that it is the dollar amount paid to the adviser that is meaningful and that advisers should not be the only ones who benefit from asset growth. Thirty-two of Vanguard's 109 funds are managed by external advisers, 32 out of 109 by external advisers. The remainder of the funds, mainly index funds and fixed income funds are managed internally at cost and that works out at cost to be less than one basis point for those internally managed fees for the advisory cost. Twenty of the externally managed funds are subject to incentive fees, twenty out of 32, and 26 of the 32 have fee arrangements that include breakpoints.

The average outside equity adviser fee is about 15 basis points. The average outside bond adviser or fixed income adviser is less than 3 basis points for the advisory fee. Once we have an adviser in place, we do focus first and foremost on the adviser's performance; and, with the support of the Vanguard staff, the board undertakes comprehensive quarterly reviews to assess whether the fund is being managed consistently over time and whether the fund has competitive results over various time periods. We also review a broad range of categories to see whether the risk characteristics of the fund as it is actually managed match what we have said to investors that the fund represents, such things as price earnings, yield, stability and performance, relative broad market, turnover, concentration, industry diversification and the like. We also consider advisory costs on a continuing basis. We have re negotiated advisory fees on a number of occasions, adding both breakpoints and incentive fees. By implementing complex-wide fee reductions in 1996, we estimate that we have saved Vanguard's shareholders approximately $30 million in advisory fees in the last couple of years from what they would have been had this reduction not been negotiated in 1996.

By including breakpoints in our advisory fees, we have assured our shareholders that growth in asset size will automatically – and that's the key phrase – automatically mean reductions in advisory fee rates. Our high standards for quality performance from advisers is not just a statement of theory. There have been at least nine significant adjustments in the lineup of advisers over the last five years, including both replacements of advisers and reallocations of assets. Let me close by emphasizing that the Commission's spotlight on the role of independent directors is both appropriate and timely. An open forum like this is an excellent way to stimulate discussion of the issues. It should be apparent that boards work best when the possibilities for conflict of interest are minimized so that truly independent directors can exercise their best judgment on behalf of the interest of the shareholders. At Vanguard we believe that that task is made much easier by the structured alignment between the interests of the fund's shareholders and the management company that Jack Bogle engineered more than two decades ago. Thank you.

Mr. Sirri:  Bruce, thank you very much. Next will be Ken Scott. Ken, I believe, is a director on more than one fund company. So I wonder if you could talk about what it's like working for different fund families and perhaps how those processes differ.

Mr. Scott:  By way then of establishing a background framework, I do serve on the boards of two different complex companies. One is the old Benham Funds which are now a segment of the American Century operation, the old 20th Century operation. And the other is RCM which is now Dresdner RCM; but the funds there of which I am board member are highly atypical. That is to say, they are essentially investment pools for the institutional clients of the firm. They therefore have only a few dozen investors, they are not retail funds, the investors are highly sophisticated. I don't think they need me on the board to protect or look at their own interests; therefore, these are very much apples and oranges. It makes more sense, I think, to talk about the apples which are the retail funds which are what most of the people here I presume have an interest in. There are several questions that have been raised here by Erik, by Chairman Levitt and by others, and part of them have to do with what do directors do and what can you expect of directors. I'll say a few words about that and how the theme here is how can directors be more effective. What directors can do to be more effective is one part of the picture. I think the other part of the picture which I haven't heard a lot about is what can the SEC do to help directors be more effective. My impression is that the level on which that subject has been pursued at the Commission is a rather negative concept. That is, they can help by bringing more suits against directors. This is the World War I general, you know, who encourages the troops by executing a few.


And I would like to suggest the possibility that there can be positive assistance in various forms. And by that I do not mean simply giving sermons about doing our duty.

Okay. So looking at the directors' performance – well, it seems to me directors in the typical retail complex which Vanguard clearly is not, are monitors of the management company which is a separate organization in terms of its investment performance, its shareholder service, its total costs. I don't think a focus on the management fee is particularly well-conceived. You're really focusing on total cost for total performance. To perform that kind of a role, you need to be able to do rather objective measurements of performance, both in service and in terms of portfolio. And it seems to me, there the issue is the role of the director in pushing to get objective measurements of quality of service, of returns in relation to risk. There's a lot of focus on total returns. The treatment of risk both in terms of the SEC prospectuses and I suspect sometimes internally in the complexes is much cruder. The name of that game is devising appropriate benchmarks that include measures that are for both of return and risk and monitoring the performance of the fund managers with respect to the benchmark and also with respect to adherence to the risk levels that are implied by the benchmark. And, you know, bar graphs as a measure of volatility as a measure of risk are, again, a very primitive way to go about this. On objectively measuring costs, it's in relation to what? Well, it's in relation to, among other things, the size of the fund and the size of the complex. And what we have been doing internally for several decades is following a regression methodology to try to establish a cost benchmark that is sensitive to the particulars of the cost environment. The second part of this, though, is what do you do with the measurements assuming you have the data which I don't think has ever been much of a problem in obtaining, and have found an appropriate way to measure it. And one answer to what you can do, of course, is disclose. And I think there could be more disclosure, for example, in prospectuses of relevant benchmark information. But the other thing, of course, the concept of the independent director is something about bargaining, that the independent directors are supposed to use that information derived from their measurements to bargain. And here I think there are two concepts of the role of the board that have never really been sorted out or very clearly distinguished. One concept of the role of the board, of the independent directors on the board is keep it reasonable. Keep the fee reasonable. You're an outer check, if you like, on the management company. The major check, the greater check is, of course, this is a competitive industry, and the greater check is in the marketplace. But that this is a secondary kind of check. And, therefore, you invoke things like business judgment rule and so on. A second concept is that the independent directors are there to be an independent bargaining agent for the shareholders. It has never been completely clear that that is really what the '40 Act is all about. And here you have to distinguish between a standard of conduct and a standard of liability. The standard of liability clearly is duty of care, gross negligence, business judgment rule, that kind of thing. What is, however, the standard of – not the liability rule, but the conduct norm that one could say the '40 Act is striving for or that the SEC is striving for, is it the independent directors as independent directors – we're just – we're not interested persons of the adviser. That's what the statute really simply says. Are we supposed to be there as a line of defense against management overreaching or management failure, a safeguard against the extremes, or are we supposed to be there as bargaining representatives on behalf of the shareholders? And, of course, those are the polar positions; you can be somewhere along the continuum. If the SEC believes that it wants the bargaining representative point of view, then I think it should give serious consideration as to how it might support that. And the conclusion I think that some might draw, at least tentatively from recent cases like Yacktman and Navellier is that you're no independent, you may be a disinterested director, you're not an independent director if you're subject to removal by the management company. Independence is a question not of fees, not of your compensation, you know, this is a kind of misdirection. It fascinates Barrons and the Wall Street Journal. I don't think it should fascinate people who think hard about these matters. Independence is a question of how did you get on the board and how do you – how can you be taken off the board. Who puts you there and who keeps you there? Who can take you off? If the answer to that question is the management company, then you are not independent of the management company. And if you are not independent of the management company, the notion that you can act in an arms-length bargaining capacity, vis--vis, the management company is silly. And so I think that there are some issues here that really require a little harder analysis on the part of the SEC as well before we simply deliver another sermon.

Mr. Sirri:  Thank you, Ken. Our final two panelists have a different role. They're here as investor advocates. They have said at times and I think they've expressed themselves to think that at times they felt that fees might be too high and I would like them to share those views with us. So, John, I wonder if you could speak about what you think about fees and how you think that reflects back on independent directors.

Mr. Markese:  Thank you, Erik, and good morning, everyone. I know you represent all different activities. We have press here, SEC people, I'm sure from the industry and so forth, but you all might be individual investors also and hope you are. For a moment, think about your mutual funds if you have them, your investments. I'm going to talk about two disconnects. And the two disconnects I think are in essentially key disclosure and understanding, the ability of individuals to make reasoned judgments on those disclosures. And, secondly, the disconnect between independent directors and fund shareholders. Okay. Times up on your thinking about your mutual funds. Do you feel you have any influence on independent directors? On expenses, for instance, and fees? Do you feel you have any influence whatsoever on who is selected as an independent director? In fact, do you even know who your independent directors are of your funds? My guess is not. I don't think you can answer most of those questions. It would be unusual if you could. So we have a problem with how we select or how independent directors are selected, number 1. They are nominated by essentially the companies. Are they good people? I hope so. Are they independent? Well, if you're nominated then you're not in any way connected to the shareholders, I would guess there is a serious disconnect. You have no influence, you don't know the process selection and you don't have really a way of communicating, nor do directors have a feeling of contact with their shareholders is my guess in general. Present company obviously excluded. Secondly, the SEC has pushed very, very hard for disclosure and I commend them for that. We have fee tables today. We have very elaborate definitions of expense ratios, for instance; but let me challenge you to do this. How many of you actually know your expense ratio on your mutual fund? Secondly, have you ever multiplied that expense ratio out times the amount of money you have in a fund?. Have you ever looked at a competing fund, one you've thought about and looked at the fee charges for your fund in dollars versus another fund that you're considering in dollars? Probably not. What we have also is a problem of basis points. We're looking at maybe a quarter percent difference, maybe half a percent at worse, and that's pretty bad. When you look at expense ratios, it probably falls by the wayside. But if you think about a quarter of a percent over 20 years difference times the amount of money you've had invested in that fund, those are enormous differences. So I think we have two serious disconnects that we need to rectify. I also have to comment on all these studies. You have probably three of them before you on our mutual fund expense is too high. There's another one out by Morningstar I think just hot off the press. As an ex-academic and professor, if you give enough data and a big enough computer I can probably tell you anything you'd like to hear. You can slice and dice this any way. My comments are I think in general we have seen some economies of scale, but certainly not enough. And if you look at all the data, I think the ICI and Lipper and Morningstar and all their studies, probably the conclusion you would reach if you looked at it and you beat on it for awhile intellectually is that basically we have seen a decline in some ways – if you measure fees and expenses including loads – because we have had a decline in front-end loads.

Finally, individual investors realized that 8.5 percent as a front-end load is probably exorbitant, but it took a while. It took a while for them to understand they are actually paying that load and then they started multiplying out eventually. So now we have front-end loads that are lower and we have, let's call them distribution fees, that continue on. So we have had a move in the industry simply because we could not longer do that. Disclosure kept I think the industry from charging 8.5 percent. So you will see some declines in expenses simply because we've moved. The second thing is we have seen a move towards no- load funds and some of those are low cost funds. The index funds, for example, and we have seen moves towards families. Fidelity, for one, Vanguard probably is the leader in a crusade, a missionary zeal against the cost of the industry. When you factor that all together, what has happened over time is that we have seen probably some economies of scale. When you take out all the index funds, the institutional funds, the international funds and you break it down for load versus no-load, we have had declines probably in the load area simply due to the fact that we moved from front-end loads to continuous loads 12b-1. And in the no-load industry if we pull out the Vanguards and Fidelities, probably expenses have gone up if anything.

So I see it as a problem. I think there are a few things we can do. Number 1, I would expect independent directors to somehow be a process of the individual investor. In other words, let's get nominations out there. Let's get people who are obviously competent, qualified, but there is some connect with their actual shareholders rather than appointments strictly by the companies themselves. Secondly, independent directors should be pushing to have fees printed out on their statements in dollars so all of you can look at the actual cost you incur with your mutual fund on a quarterly, semi-annual and annual basis. Simple to do? I think so. Although I'm not a computer programmer, I suspect it would be some cost to the industry, but I think it would be small. We're getting more connects then. We're getting where we have feedback from investors to fund directors. We have funds giving better disclosure. We have people able then to make intelligent decisions based upon that. I would also tell you that the comments about breakpoints are very important. No one envisioned funds in the $50 billion to $60 billion to $70 billion range. And the fact that we don't have very many breakpoints tells me that effectively we have not been passing on the economies of scale to the individual investors. So I would encourage all of that. I think the SEC has helped that competition would do that; but if you look at the industry, it requires sort of a grassroots effort of individual investors to say, "I can make a decision by looking at my actual costs and comparing it and I can influence my independent directors, those directors who should be influencing the funds to make those decisions. I think we could do more on both those accounts. Thank you.

Mr. Sirri:  John, thank you. Harold, do you want to wrap up for us?

Mr. Evensky:  Well, first, I'd like to think the Chairman and the staff of the SEC and the panel for including me in what I think is an extraordinary opportunity. I definitely feel like a little fish in a very big pond. I am immensely complimented to be here; but the reality is I'm the one person that deals every day with this with clients. I mean, this is my business. I also want to preface it by saying since I tend to be perceived as a critic of the mutual fund industry, I am not. I think it is probably one of the most extraordinarily positive industries in the United States if not the world. And, as I've said before, my clients would be ill-served and I'd be out of business without it. So, with that preface, in preparing for the roundtable, I've been reading and discussing with many others the issue of independent directors and fees and expenses. I have reached a number of conclusions and really a lot more questions, but I will start with my conclusions. Are fund fees an important issue to the individual investor? Absolutely. Unfortunately, the recent market's extraordinary performance I think has masked for most if not all investors the importance of fees in terms of long-term returns. Have fees dropped as a result of the explosive growth of fund assets? I really don't think it's that complicated of an issue. And my conclusion is the no and the evidence is overwhelming. Two recent studies that contradict this conclusion I don't believe addressed the question at hand; namely, if fees and expense is attributable to the management of the fund dropped over time to reflect the fund's growth in asset size. Specifically, the ICI study, "Trends and Ownership Cost of Equity Mutual Funds," developed an interesting measure. They call it total shareholder cost. And while possibly of interest for some discussions in this case, the definition I don't think has validity. At best, the study demonstrates an almost negligible 8 basis points reduction in the expense ratio of the 100 largest funds from roughly '80 to '97. The asset-weighted drop was only 5 basis points and the median was just 3 basis points. This was during a period the average asset base rose over 20- fold from $282 million to $5.8 billion. Morningstar's follow-up study to the ICI study I think confirms this conclusion. Lipper's Analytical Services Third White Paper I believe also fails to demonstrate any substantive reduction in cost. Even if you accept the analytical adjustments recommended by the study and limit it to the fairly narrow universe they studied, reductions calculated from '86 to '97 were a minuscule 1.2 basis points. Do investors have enough information to evaluate the fees they are paying? My answer to that one is more equivocal. All fee schedules in the prospectus and data provided in the statement of additional information provides much useful information, it neither provides the information in a way that's meaningful to most investors, nor does it provide all of the information necessary.

For purposes of presenting meaningful fee and expense disclosure for the assumption I believe of the rational investor should be jettisoned in favor of the real investors described by behavioral finance. And, basically, I'm not going where John had suggested. Regular statements to individual investors reflecting how much they have actually paid, similar to those required of investment advisers such as myself would be more meaningful. As to additional information, if what I consider debatable compensation practices such as soft dollars and performance compensation are allowed, a more detailed, more accessible, and more meaningful disclosure should be provided. In regard to negotiation of fees or independent directors doing their job in accordance with the law. Based on my own clearly amateurish legal research, the answer seems to be yes. The problem I believe if there is one may be with the law, not the directors. According to some legal scholars, during the development of Section 36(b) there as a shift in the standard of judging management fees from reasonableness to fiduciary duty. The result seems to have become a standard that provides what I believe is a significant barrier to challenge. To quote from the Gartenberg case referred to by Mr. Pozen, one that I understand is the current legal basis, it does indeed say the adviser manager must charge a fee that is so disproportionately large that it bears no reasonable resemblance to the service rendered and could not have been the product of arms-length bargaining. With standards as broad as that, no independent director could reasonably be expected to argue too strenuously against most adviser fee recommendations. Are funds competitive? Yes. As Mr. McNabb, managing director of Vanguard noted in his recent congressional testimony with the universe of 10,000 mutual funds, there are many low-cost mutual funds in almost every investment category. If there is no problem, vis--vis, the independent director and fees and there is indeed competition among firms and funds, is there, in fact, a problem with fees? My answer to that is, yes. How else can you explain that at best, the static nature of the fees in spite of a stupendous growth in mutual fund assets, how can you explain the range of expense ratios for funds of generally similar characteristics? For example, I did a quick study in a narrow universe of almost 1,000 large cap domestic managers and I found the expense ratio ranged from roughly 20 basis points to 300 basis points. I screened for high quality national and municipal fixed income funds, had a universe of 80 funds with expense ratios from 15 to 120 basis points. It is difficult to understand how arms-length negotiations could result in ranges of expenses as narrowly defined in similar styles unless we use a fiduciary standard of so disproportionate as the measure. Even more important, given that there are many low expense choices, who do so many investors invest in high expense funds? The answer can't be performance as many studies have shown a high correlation between high expenses and low performance. It can't be because the high expense funds offer better services; many of the lower expense funds are recognized for their superior services. The answer seems to be that as behavioral finance experts have demonstrated, many investors simply make non-rational decisions. My conclusion is that the problem is not simply the directors or the funds, but as Pogo said, "The enemy is us, the individual investor." It seems to me that the challenge for the SEC, the funds and advisers like myself is how to work together to help the investor make better decisions. Now, for my questions which, except for the last, are in no particular order, has the investors in funds or the owners should fund managers that are not publicly traded provide information similar to publicly traded firms? For example, senior management compensation costs and profits attributable to the fund. Should fund managers provide the investor owners with details of non-direct fees and expenses such as soft dollars and trading floor arrangements?

Should fund fee benchmarks used by the independent directors in making their decisions be disclosed? If Vanguard funds are offered at cost, is it reasonable to assume that by subtracting Vanguard's costs from those of a comparable fund, the difference is the fund's profit? Should the SEC and/or fund industry develop more appropriate fee benchmarks to assist investors in making their decisions? Can independent directors effectively meet their fiduciary responsibilities in each fund if the director serves on boards of multiple funds for the same family? Why aren't all the directors independent? Why does there seem to be a relation between high independent director compensation and high fund expenses? Why is there a perception of many reports and retail investment advisers that fund management independent directors are not sensitive to the issue of fund expenses? Can independent directors give the wide latitude for determining acceptable fees provide any additional protection over and above that afforded by all the directors in setting fees? Should there be a legal standard for fees? Is the current legal fiduciary standard required of the independent director adequate to protect the public in setting reasonable fees? And, finally, is the independent director an effective system for establishing fund fees? Is the independent director even relevant in negotiating fees? Is Mr. McNabb right in asking if it really matters whether fund fees are too high or whether the fund industry is sufficiently price-competitive? Should the question be, is better and more effective disclosure coupled with free-market competition a more effective mechanism for protecting the consumer's interest? I look forward to a discussion of these issues. And thank you.

Mr. Sirri:  Thank you, Harold. I told you there would be a lot to talk about. I think a lot of what we said here harks back here to the comments of the Chairman a few minutes ago about whether directors are, in fact, really effective, whether they are, in fact, independent. And whether independent directors are, in fact, serving shareholders. Let me begin our informal dialogue by reflecting on a statement that Ken Scott made about certain fund shareholders not needing him. I think you were talking between the Dresdner Fund shareholders, the institutional ones. I think your remark was, "Gee, they don't need me as an independent director, because they can take care of themselves." If I step back from this, I'm an economist, I'm not an attorney, so as the chief economist I'll step back from this and I'll say, "My gosh, we've got an industry where there's 10,000 funds," when we have simple products with much fewer numbers like peanut butter, we don't regulate the price of peanut butter. We make sure the price is on the jar. We make sure the ingredients are there; but then we basically let the market price peanut butter. What's the reason why we can't be content here to let the market price funds? Why is it that independent directors have such an instrumental, important role here in a way that the market wouldn't be able to solve that problem? John or Harold, I know that's something you think about.

Mr. Markese:  Just a quick comment. The price of peanut butter is on the jar, but the price of management fees isn't on your statement, so there is a difficulty in making that comparison. We don't have effective disclosure. Again, I challenge all of you to go home and multiply your expense ratio times the amount of money times the year you've been in it and add it up and, again, we don't have the price of peanut butter on the jar in the mutual fund industry.

Mr. Evensky:  That was exactly my observation, that there's not the information available for investors to make intelligent decisions. If there were more information, as I've suggested, I'm not sure of what the role of the independent director, vis--vis, setting of fees would be.

Mr. Sirri:  You're saying that things like a fee table where expenses are clearly laid out are not the equivalent of putting the price on the jar.

Mr. Evensky:  I'm suggesting that it's not remotely equivalent. It is not – it is demonstrably not meaningful to the average investor in terms of what is their cost. I would be very pleased in my business if that's the only information I ever had to give a client. It would be much easier for the independent adviser to charge significantly higher fees if someone was not in effect getting on a regular basis, monthly or quarterly, a dollar amount that they have paid for our services.

Mr. MacLaury:  I think your analogy of peanut butter deserves to be pushed a step further. The fact that the price of peanut butter is on the jar tells me nothing except what I have to pay for that jar. The relevance, it seems to me in this context, is whether there's another jar with the ingredients beside it that is also priced and I can see the unit cost per pound of peanut butter or per ounce. If we are talking about dollars on statements, that tells me how much I am paying for my service, but it does not tell me what I could get that service for down the street or from another complex. It seems to me the question that we need to face here is – it's very hard to argue against more information. We, but we also know that we are suffering from information overload. The question is comparative costs for similar products and that does not come from dollars on statements. I'm not opposed to dollars on statements, but I am saying that it will not solve the problem that people are talking about.

Mr. Sirri:  Bruce, do you ever as an independent director have discussions worrying about or considering whether your investors have the information they need to do comparison shopping? Is that something that enters discussion amongst you?

Mr. MacLaury:  Well, I think, coming from Vanguard, the answer is that costs are costs are costs and we are very, very sensitized to it and that providing the information for the investor in terms of benchmarks both as to fund performances and with respect to expenses is something we talk about and think about a lot.

Mr. Pozen:  I guess I would generally disagree. I think the fee table is an excellent summary of fees. It also includes for a hypothetical $10,000 investment what the actual dollar amount of the fees will be year by year so that it is, in fact, quite easy. I think if you compare the disclosures that mutual funds make to pension funds, insurance companies, and banks, you will see that our disclosure is much, much better. Second of all, in terms of getting comparative information on expenses, I think that the amount of comparative information that's available on expenses is overwhelming. There are so many different magazines that publish this, there are so many different studies that are available, there are so many different measuring firms that do this, that anyone who claims that they can't easily find what another equity fund or money market fund charges in expenses really just isn't spending any time doing it. Obviously, somebody like Vanguard spends a lot of time advertising that it's a low expense place. The third is that I think that we should realize that these studies that show that, for instance, that if you take Vanguard and Fidelity out of no-load expenses, then the expenses look differently ignore the obvious. Fidelity has brought down its fees substantially. Vanguard has low-cost fees. We do happen to be the two largest complexes in the United States and growing quite rapidly. I think that shows that there are a segment of the population that seems to be quite persuaded and quite impressed by the fact that we're delivering good performance at low fees. On the other hand, when we get to the issue of comparability, there are clearly lots of people who are paying different fees for mutual funds because they are getting a different package of services. Some people want more guidance, more hand-holding, more advice. Some people want more asset allocation. There are just so many different things and Vanguard has been able to keep its low cost because it's focused on the investor doing a large part of the work. Nothing wrong with that, but I just say that you have a lot of choices that are being made by people who are not going to the most low-cost alternatives because they are looking for a different package of services. I think that the independent directors do have a role in this and I think – I'm sure that Bruce and Ken would agree with me that, you know, having sat through more director board meetings than I choose to remember, the independent directors are, in my experience, quite knowledgeable, they are quite aggressive about getting information. These issues are discussed, but they're discussed in the context of what are the costs here, what are the expenses here, what are you delivering? What is the quality of product? What is the range of product? What is the range of services? So that the independent directors have played a role. I would agree with Ken's configuration. This is a very vigorous marketplace. There is huge amount of competition. There is very good disclosure about fees, including this dollar amount in the fee table. And the independent directors are really a secondary device that then provides another way to make sure that the shareholders are getting a decent deal.

Mr. Scott:  On the question of what can – if you assume a competitive market, largely competitive, I want to get back to that point: how competitive and what are the limits of competition. But if you assume a competitive market, then what is the role of the independent director? I think it is quite a limited role. I think what you're talking about is the competitive market works through customers switching. Well, it's one thing to switch from one brand of peanut butter to another brand of peanut butter. I do not have a very high switching cost. The transaction cost is pretty low. Even if I am switching from one automobile to another automobile, you know, the automobile I have if I decide that I don't like its performance all that well, my investment in that automobile is running down over time. I can at some point probably make a relatively low cost transition. I get to the point where I want to buy a new car anyway. But what I think what you're looking at is what is the measure of transaction cost in switching in this particular industry, in this kind of product. And it is not almost zero as it is with the peanut butter. It is partly an information cost and that gets us back into the realm of disclosure, it's partly over the way the market has performed in the last half-dozen/dozen years, it's partly all the deferred capital gain tax that I will trigger if I make my decision to switch. Is that a full lock-in? No. Is it in some instances a fairly significant transition transaction cost? Yes. It's within that margin of the transaction cost in switching, it seems to me, that you're exploring whether or not the independent director can save a bit or does not save a bit in terms of the factors that bear on your decision to switch. Coming back to the point, though, of peanut butter as the appropriate image, with peanut butter as with most products, what I am buying, what the price tag tells me I am going to get, is already there. It's in the bottle. When you buy a mutual fund, you're not buying something in the bottle. You're buying some future expectations. You're buying future performance. And that means that determining comparability is far, far more difficult than when we're talking about peanut butter or automobiles. And, so, you know, what can be done to assist people in that regard and to assist people in general to know about what they are buying when they are buying a mutual fund? The data we get in the prospectus is all historical data, backward looking. This is what it did in times past. Well, to the extent that the past is a good predictor of the future which, of course, every prospectus denies, and which every investor disregards, you know, it does have some value. But, you know, what do you do internally within a complex in looking at the performance of your portfolio managers? You do not reward them on the basis of what they did two years ago. In most complexes, I think – I don't know, I'll speak for just one I'm familiar with, what you're looking at is the benchmarks that you've established for the manager and how the manager performs with respect to those benchmarks in the time periods to come. Well, if that's what makes sense to us, how is the benchmark doing vis--vis his bogey? Wouldn't you think that that would be the kind of information that would be more relevant to investors than how this manager or some other manager did in times past with respect to some other benchmark or bogey. I would think that forward-looking disclosure and this, of course, has always been a problem at the Commission, but I would think that forward-looking disclosure would actually be of greater investor value.

Mr. Sirri:  Let me highlight what I think is going on here. I think a conflict that we've realized or at least an issue that disclosure is important and it's critical because it's what allows investors to comparison shop. It's the input to that shopping decision that we all feel is so important as consumers. On the other hand, people's ability to do that is somewhat suspect in the belief of a couple of our panel members. But there is another point I think that we haven't quite dealt with. The SEC has done some surveys and other folks have done surveys that showed that even if there is complete and accurate disclosure, individuals don't really ingest and process that information. If you survey investors, they tend not to know what the cost of their funds are or how they're structured. So my question to you is what does that say then? Does that put a special responsibility back to the independent directors? Or are you just – can you rest comfortably knowing that you have full complete and accurate disclosure and, therefore, you're off the hook?

Mr. Pozen:  Well, I can say that I think for many investors while fees are a factor, the most important thing they're interested in is the net performance of the fund. And I think the SEC has developed a very good standardized formula for performance. They also don't let you cherry pick, so you have to give, if you're going to give one year's performance, you also have to give five years and ten years. And I think that you would find in your survey that a lot more shareholders knew how their funds did in terms of net performance than they did about expenses. So I think that if you spend more and more time on trying to have more and more fee and expenses disclosure, it's a little bit missing the boat because the main thing is what the actual performance is. Now, I would like to understand better Professor Scott's suggestion. I would be very interested in a more forward looking information in the prospectus. But I'm not sure exactly – I think we would all be very interested, I think every one in this room, in fact, every cocktail party I go to people say, "Well, tell me, Bob, what is the one fund that's going to be the best next year." If I knew that information, you know, if we all knew that information, then we could disclose it, but we really don't. And I think that all we can say is that these are the investment objectives. This is what it has done in the past and I think the Commission has given some sense of the volatility returns, given some sense of the background. Unfortunately, I think that the thing that people are most interested in is what's going to be the net performance in the future is the most difficult for us to give disclosure without just really allowing people to hype funds which we really wouldn't want to happen.

Mr. Sirri:  Bruce?

Mr. MacLaury:  It seems to me disclosure about the future, this comes back to one of Ken's points in the peanut butter, infamous peanut butter jar. The idea is that we are buying as investors an unknowable future with respect to performance; but we are buying a knowable future with respect to costs. That's a key element which has been mentioned here before, but it's why the disclosure of cost is so important. It's one thing that the investor can know about the future. Not about the net performance, not about the whole performance. So I at least think that that's a key. And I think in direct response to your question, Erik, does the fact that investors despite all the best disclosure one can imagine, are they going to ignore that disclosure and make their bet. The answer is yes; and, yes, that does put an added responsibility on independent directors, it seems to me, inevitably.

Mr. Scott:  Just one thing. I wasn't suggesting that you in the prospectus would predict how the fund would do next year. That is beyond us all. All I was saying was that internally we do and externally I presume one could disclose an existing fact. What benchmarks have you established for this fund that this manager is going to try to aim for in some specified future period? Always subject to change. You can decide that you're going to change your strategy or whatever and if you give – if there's agreement on that and there's notification of that, no problem. But the disclosure is of a fact. What is the benchmark for which this manager is trying to manage this fund?

Mr. Sirri:  Let me use my prerogative and move us on to what I think is another important topic that is quite related to this. In 1998, The New York Times published an article that said, and I quote: "When independent directors of two fund families, the Navellier and Fundamental Funds, asserted the legal authority to remove portfolio managers at some of those funds, they swiftly found themselves the targets of nasty proxy battles waged by the fund managers. And, in the case of the Navellier directors, a shareholder lawsuit." This suggests at least to me that it is perhaps difficult to terminate an adviser. My question then is how can a board really effectively, especially the independent members, really effectively negotiate a contract with an adviser? Is it the case that they're armed with only two weapons, a peashooter and a thermonuclear bomb with nothing in between? It's a yes or no decision? What is the club that they have to really hold an adviser's feet to fire? How do you contract in that world?

Mr. Pozen:  I'd just start off by saying that there were a number of remarks that were made that suggested that at least in some situations that the independent directors were just people chosen by the management company and then the management company had the ability to throw out the independent directors. I think everyone on this panel and I'm sure everyone in this room who has been involved with boards of mutual funds knows that both those statements are untrue. Every board that I've been involved with and know about has the independent directors taking the lead role in choosing other independent directors. And I would say it is generally the commonplace rule that independent directors serve as the nominating committee for new independent directors. Second of all, I know of no – I guess I don't know of anyplace in which the management company even thinks that it has the ability to throw out independent directors. Now, given that context and the practicalities that you cite – I mean remember, these independent directors threw out the manager and then the shareholders, remember, they felt that they wanted these managers. I think that raises an issue as to whether these, you know, independent directors were representing the interests or explaining the interests that they were representing. But I don't think it is just an all or nothing situation. Again, if you sat through these negotiations and these discussions, there are lots of middle grounds. There are lots of times in which the Fidelity independent directors have suggested certain types of fee reductions, they've suggested certain breakpoints, they've suggested a number of these things. These things are discussed and it isn't an all or nothing situation; but at least my experience has been that the independent directors do play a very useful role in structuring fees and bringing them down and changing them and considering the relevant facts without this being nuclear war or nothing. There are a lot of grounds in between.

Mr. Evensky:  It seems to me that the question of fees vis--vis fees is a moot point. As I said I – a simple study I came up with fees in a fairly narrow universe between 20 basis points and 300 basis points but my understanding of the law with the basis of fiduciary duty in the Gartenberg case, anything within that range is defensible. So, certainly at the table I would say between Vanguard and Fidelity the funds are sort of the same. The ones who – whether it's the independent directors and/or the other directors in the funds have made I believe very good decisions for their investors but there are many funds that perhaps have not. But I don't know without changing the criteria of the law what an independent director could do. So under current circumstances I don't think they need either a peashooter or a nuclear bomb. They can only make the observations but there's no basis for pushing it further at this time.

Mr. Markese:  Just a comment. I guess the question becomes the independence of the independent director we keep coming back to the same issue. And, you know, as Bob said they're nominated by the company and then they nominate other directors, independent directors. But that goes back to the heart of the matter that there's no shareholder representation in the selection or nomination. When you have a body that is originally nominated – in essence, that will perpetuate itself. Without any connect to individual investors who are the shareholders I think they don't have that power, Erik. You know, the peashooter or the thermonuclear bomb. It's really an influence that's a ground swell from the shareholders. I think probably that ultimately is the only way they're going to have influence.

Mr. Sirri:  I wonder if Ken or Scott – Ken or Bruce – do you feel that when you're in that negotiation that you have sort of the suitable arsenal, the suitable basket, of what you want to have to negotiate? If, in fact, it is a negotiation model, which I think is one of the points that Ken raised earlier.

Mr. Scott:  Well, I certainly think the answer is that if the board so used its role it does have a certain amount of clout and can use it. I think probably we've all experienced that. The amount of the clout, you know, I was posing it in polar terms. Obviously, the amount of clout you have is a function of institutional factors such as what the law says is the percentage of outside directors or the process by which vacancies are filled. I think in response to John's comment, at the outset in a new complex and a new fund obviously the directors are chosen by management. There's no – there should be no illusions about that. But then if they are, indeed, in mind to be independent or independence develops over time that tie to the initial source of appointment becomes attenuated. People change, management turns over, directors turn over, new people come in. I think as a sociological matter, not that I know that a study has ever been done, you would expect to see that there would be a growing degree of independence and, after all it's a matter of degree and not on or off, developing over time. I do find it kind of interesting I guess – it was in one of these studies – Lipper or something, suggesting that over time – you said older funds. That's what we're talking about. There was a different trend visible on those funds than in the newer funds. Well, you know, what's the explanation? This may be a kind of factor. So that I think a lot of things bear on it, the composition of the nominating committee, the time from initial establishment, the attitude of the individual board members. If the individual even under the present state of law – if the individual board members have an attitude of independence how far can they push it? Well, what I was using was Navellier and Yacktman to suggest there are limits as to how far they can push it. But note that those limits, nonetheless, give them quite a bit of potential bargaining power because in both cases, you know, okay, the independent director was lost, they were gone. The shareholders knew the name on the fund. That's not too surprising. But the fight was a costly fight. It was a costly fight to the funds. They shrank enormously in assets. It was also costly to the independent directors or defendants in lawsuits. So, again, you have to make a kind of nuance judgment about the degree of your clout and what warrants trying to actually make use of it. But is there some bargaining power if the directors are sufficiently independent in attitude that they want to use it? You know, of course there's some.

Mr. MacLaury:  Erik, it seems to me your question brings to heart the uniqueness of the structure of Vanguard. I won't keep harping on it. But to the notion that we as a board of directors are negotiating or bargaining with the management company is foreign to my experience. The fact of the matter is that, as I said, a very high proportion of the funds that are done are managed by Vanguard are managed internally. Therefore, the directors as in any corporation not just the fund, as in any corporation, have to be assured that the management is watching its costs, that its meeting its budgets and so forth and so on. That's how we control the costs of internally managed. In effect, we are not negotiating – the board is not negotiating with the outside advisers. It is the management company that is negotiating with the outside advisers for the – and we, the board, are ratifying in effect those agreements that are reached. It's a very different set-up and so this whole nexus of issues that arises in terms of bargaining power, independence, and so on, simply doesn't arise in the same fashion in our unique set-up.

Mr. Evensky:  I want to go back to the question of independence. I think it's the issue that John's raised a couple of times. I'm willing to accept and I believe the independent directors as boards mature become independent of the funds but they're also independent of the shareholders. That's the problem. John asked at the beginning how many of you know your independent directors? I'd ask how many independent directors know anything about the shareholders? The answer is generally zero. So when an issue such as Yacktman and Navellier, and Yacktman in particular, when that comes up I, representing my clients, I hear from Don Yacktman. He calls up well in advance saying there's a problem. He knows his clients and in some cases directly, usually people like myself, and in effect is in a position to lobby. There's a personal relationship. The only time the client hears is when it's totally blown up and the independent directors are asking for support from someone that they are totally independent of and have no relationship with. So there's a real structural problem with being independent of both sides – of both parties.

Mr. Scott:  And I think you're describing, you know – John, the problem with your solution, the shareholders somehow take over and deal with the process of selection and election of outside directors. I think this is an illusion. You're talking about the world of publicly-held companies. I don't care whether they're mutual funds or they're New York Stock Exchange. You have these hundreds of thousands of shareholders and they are not going to be the ones who themselves organize and nominate and elect directors in that sense. That isn't the way it works for a mutual fund. It's not the way it works for any company on the New York Stock Exchange, either. Institutional investors, large holders, there is some prospect of their playing that role. Individual small holders, no.

Mr. MacLaury:  The only case that I can think of, there probably are others, where what I'm hearing suggested is in practice is with TIAA-CREF and there it's a membership organization and the membership does both on the directors of the TIAA-CREF board. But that's – I agree with Ken. I do not see this as a model that is implementable. Fine as it sounds in theory to have shareholders, in effect, by plebiscite elect the directors other than through the nomination process that we have described. One other thing, whether directors are staying in touch with shareholders – one of the things that clearly we do and I'm sure other boards do as well is that we insist that the management company survey. We don't have to insist very hard, they would do it anyway, shareholder surveys. Find out what shareholders think about the services and performance that is being provided then we get some feedback. Similarly essays in the press, not always reliable but there's something to be learned from that. How does the press rank the various fund families and their surveys? So it's not as though we were sitting there in isolation in some dark room. We do know what shareholders think about the funds and whether we are representing them well.

Mr. Sirri:  Chairman Levitt?

Chairman Levitt:  Professor Scott raised an interesting point about the relationship of shareholders to corporate boards as well as investment company boards. Whereas I'd be curious to know how the panel would compare or analogize the responsibilities of a corporate director with those of investment company directors?

Mr. Pozen:  Let's say that because of the statute and the regulations the independent director of a mutual fund has more specific responsibilities in very focused areas like advisory fees, etceteras. I would say that most of the people who are independent directors of mutual funds and also serve on industrial boards would say they get much more extensive information in the mutual fund context about expenses, fees, costs, than they do get in the industrial context. It's at a much broader level. I would echo what Bruce said, is that again Fidelity, most of the large complexes do survey our customers, our shareholders, both in terms of their satisfaction and in terms of specifically how well problems were handled and how well – how fast phones were answered and all these things. That information is given to the independent directors. So I think most independent directors would say that the amount – if you just see the amount of information they get in the board books it's much more extensive than industrial companies and much more specific in detail.

Chairman Levitt:  And you think that they are as influential as corporate directors?

Mr. Pozen:  I actually – well, it's again difficult to make a general statement but I actually think that they are more influential because you have to have a majority of independent directors to approve the advisory contract every year and that gives them a lever, it's not an all or nothing situation, but that gives them a lever that I believe makes them more powerful because of this specific statutory role that they've been given.

Mr. Scott:  My answer would be that I think there are at least three differences. There's clearly a legal difference in the legal framework and the structure of position – of statutory powers and obligations and so on in the mutual fund compared to the corporate fund. That tends to work potentially toward the mutual fund independent director having a stronger position. Secondly, the mutual fund is relatively speaking a narrow product line kind of business. I think it is possible for the independent directors, either initially or over time, to have a better grasp of the business than is true probably for a great many large New York Stock Exchange-type companies. The third distinction though cuts the other way. That is that to some degree there are large stockholders on New York Stock Exchange companies who can significantly potentially play a role in the corporate governance of the firm either directly through contact or potentially by taking positions in proxy contests or takeover bids. There's no counterpart to that in the mutual fund world. Therefore, the kind of incentive that a large block holder has because of a large economic stake in the firm to pay attention and to exert influence over the management of the firm and its performance simply is lacking in the mutual fund world.

Mr. Sirri:  Well, time is running short. Let me shift this to one last topic that I think has been certainly in the press a lot and has been a concern of some folks. It concerns the question of the growth of the fund industry and fund assets and people's perceived inequality there with the decline in fees. I know we touched on that earlier. Let me put a little bit of structure on that problem and then ask you a very precise question. Let's take a world where there are two different funds, both funds have a size of $100 million. The first fund over a period of time grows to $150 million and it does that because over this period of time new assets are gathered, new accounts are gathered, and so there are more investors in the fund. The fund grows from $100 to $150 million. Take the second fund and it's at a different point in time. That fund, too, grows from $100 to $150 million but it does so not because it gathers new investor accounts and not because it gathers new investor assets but, rather, because the market goes up. It's invested well and the market goes up say 50 percent over this period and that fund, too, rises from $100 to $150 million. So here you have two funds and each has grown from $100 to $150 million and for each of them their fees have risen 50 percent. So the question I would ask you then is, is it equally true that for each of those funds that their cost structures have also risen by 50 percent? Are the costs equivalent for those two funds? The point being here that the conventional way that funds charge is through a flat asset-based fee. In that world the second fund has the same number of accounts, the same number of investors, and it's not clear to me that the costs have risen 50 percent. Perhaps you could argue they could, they have, for the first fund. I wonder since the fund charges treat those two the same I wonder how we think about that problem?

Mr. Scott:  Can I view that as a rhetorical question?


Mr. Sirri:  No, it's actually – it is an actual question.

Mr. MacLaury:  Well, let me take a stab. I'll take it at face value it is an actual question. I would say by your hypothesis the costs have not risen comparably in the two complexes, funds, that you site. But the question seems to me that's not the question that we should be answering. The question we should be answering is so what? Does it mean that we should be a rate that there should be somewhere in the United States a rate-making agency on the model of a public utility that is going to scrutinize the costs of one firm as opposed to another firm and insist that there be a reduction and that there are excess profits that either are to be taxed or are to be otherwise disposed of or prevented from occurring. That's the bogeyman that I see in your question.

Mr. Sirri:  Please don't misunderstand me. I didn't mean to say that there was a role for a central planner there. It may be, in fact, that it was a role for an independent director to say, "Oh, my gosh! Our assets have grown for a different reason and we might treat that case differently."

Mr. MacLaury:  But I guess my bottom line is that that's where this question of competition – whether competition exists in the marketplace among funds or not is paramount. Yes, you could see a role for directors but I would say first and foremost it is competition and whether one of the funds wants to become not $150 million but $250 million and is willing to reduce fees along the way if it can afford to do so to take that advantage.

Mr. Pozen:  Well, I think that the – you know, all the data we have here, the Lipper studies and the other studies, show that the large funds, most large funds in the United States, do have a form of breakpoint and do reduce fees and that those fees are reduced through breakpoints and those breakpoints are triggered by change in assets no matter how they go about that. Second of all, I think that to ask the question between $100 and $150 million is actually not a particularly useful way to ask the question because the level of cost and change between $100 and $150 million may be very different than let's say if you have a fund at $10 billion or $20 billion. I suggest to you that when – you can have diseconomies of scale as well as you can have economies of scale. The third point which is more of a conceptual point, therefore, I address it to Ken, is that the process of renewal of the advisory context tends to be on a yearly basis as required by statute. But really the business is a much broader time frame. I think Bruce was referring to this. I mean you can spend millions of dollars building a fund to $100 million and lose money for 10 years and then you can actually have profits for a few years and then it depends what you want to do in the future. So that I think when you view that problem you'd have to see it over not just one – different asset sizes but you'd also have to see it over time frames that were different in order to make an intelligent answer.

Mr. Sirri:  We're coming down to the end of our time so I think I'm safe in asking this one final question. Is there anything that the SEC could do to help independent directors in their jobs? Is there something that you would like from us? Is there something we're not doing that we should do or is there something we are doing that we shouldn't be doing to help in this process of getting more effective oversight from independent directors as regards to the fee-setting process?

Mr. Evensky:  I'll take a shot. One would be changing the standards with which fees are judged to make a tighter band for independent directors to work within; two would be revisiting the form of disclosure information to the public so that they become part of the process in working with the independent directors and making competition more effective; and three, and the last one I haven't got a clue how to accomplish is to eliminate the total disconnect between the independent directors and the shareholders.

Mr. Pozen:  I have to go back to the points I made in my original opening statement about hedge funds. Ultimately we're talking about performance. What we want to do here is to get to the middle class public shareholders of the United States who own mutual funds the best talent you can managing those funds. As I've said, the single most important thing that the SEC could do is to level the playing field a little more between mutual funds and hedge funds. It probably will never be fair and level but it's so disparate now that that is really a significant factor in terms of the quality of the performance that we really deliver to our shareholders. It's really a sad thing that the whole structure is geared to make it very attractive to a very small group of wealthy shareholders and not to the broad base of the American public.

Mr. Scott:  Yeah, that comment could of course cut two ways. If you look at the performance of the hedge funds the management – the portfolio managers are more highly compensated and the performance is much higher, as well, even if you are doing it on a risk adjusted basis. Even if I do it in terms of Sharpe ratios and so on. I know there are some studies that are about to come out in which a universe of some 3,000 hedge funds, domestic and foreign, and their performance over a substantial period of time has been analyzed. So you could make the argument that maybe the change ought to be not that you extend regulation to your competitor, which is the usual way in which people who talk about level playing fields have in mind. But that perhaps there could be some rethinking of the nature of the incentive fee structure within the mutual fund industry, as well. I would just like to go back to the point that I opened with, that – you know, there are carrots and sticks. The emphasis tends to be on let's see if we can take a larger stick and, you know, and execute a few more and encourage the rest. I really think that there are limits as to how far and how effective that kind of an approach can ever be and that a more constructive as well as a more palatable way to think about it is what are the things within the framework of the SEC's say current regulatory authority that independent directors would, if you surveyed them and talked to them and so on, knowing your constituents, would say that it would be helpful in their performance of their responsibility. One thing it seems to me is to – you have to go beyond asking the questions. You have to go to the level of what do you do with the information? How do you process the information? Then what is the role that you are going to play? If you have the bargaining agent model rather than the check on managerial extremes model what are the things that might strengthen that? That would take us into another panel or another discussion.

Mr. Sirri:  John, do you want to have a quick last word?

Mr. Markese:  Yes. Number one, I don't think it's fantasy to think that we can have share representation among the individual investors. There's some communication process. I think it's within the power of the SEC and their purview to do so. Secondly, I think NASD and the SEC have had an initiative to define what just is an independent director when it comes to audit committees of corporations and the board of directors. I think probably the SEC can do the same thing for the independent directors of mutual funds. Thank you.

Mr. Sirri:  You know, by no means I don't think we did not cover ever topic. We did not spend as long as we would have liked to on every topic. But I certainly think that our panels did a fine job in giving us their candid and honest responses and I'd like to thank them. Thank you very much.

(Panel adjourned.)


Fund Distribution Arrangements 

Ms. Richards:  Welcome back to this morning's second panel. My name is Lori Richards. The topic for our panel this morning is mutual fund distribution arrangements.

Long, long ago, in 1980, the Commission permitted the use of fund assets to pay expenses associated with selling a fund's shares if approved by the fund shareholders, by its board, and perhaps most critically, by the fund's independent directors. Thus were born so-called 12b-1 plans. In adopting Rule 12b-1, the Commission noted that it was concerned about the conflict which may exist between the interests of a fund in paying for distribution expenses and the interests of its adviser in increasing its assets under management.

The Commission also expressed concern about the likelihood that the fund would benefit from paying distribution-related costs and about the fairness to existing shareholders. Because of these concerns, the Commission placed particular responsibility on the fund's independent directors to review and approve the fund's 12b-1 plan and to make a determination that the plan is reasonably likely to benefit the fund and its shareholders.

Well, the mutual fund industry and the way in which mutual funds are sold have changed since 1980. Today mutual funds are the investment of choice for millions of American households and assets under management are robust. This was not the case in 1980. When they buy mutual funds, investors are now offered a myriad of alternative sales charge arrangements. In addition to front-end sales charges, there are ongoing asset-based charges and contingent deferred sales loads payable when investors sell their shares.

The way in which mutual funds are distributed has changed, too. Funds are sold directly by fund complexes through broker dealers and more and more through fund supermarkets and by investment advisers. Fund distribution is big business. Bloomberg estimates that in 1998 alone, fund companies spent more than $1 billion on marketing and promotion. This makes the directors role in reviewing distribution and in deciding what is in the best interests of shareholders perhaps more difficult than was the case in 1980.

We have a wonderful panel here this morning to share their views. I would like to quickly introduce them.

Paul Haaga is executive vice president and director of Capital Research and Management.

Charles Schwab is founder, chairman, and co-chief executive officer of the Charles Schwab Corporation, and has been a director of the Charles Schwab funds for many years.

Jessica Bibliowicz is president and chief operating officer of John A. Levin and company and is also an independent director of the Eaton Vance Mutual Funds.

Phillip Kirstein is general counsel of Merrill Lynch Asset Management Group.

Faith Colish is an attorney in private practice focusing on securities laws and is also an independent director of Neuberger and Berman Funds. With that, I would like to start. Each panelist has agreed to offer a three-to-five-minute introduction. Paul?

Mr. Haaga:  Thanks. Is the mike on? Good. Lori, it really is great to be back. I can't believe it's been 22 years since I left the Commission, but that's how long it's been, and I'm delighted to be back in the building, and see old friends. I was particularly poignantly reminded of being here, though, when I had a cup of coffee.


Mr. Haaga:  I think every other place on the planet, coffee has improved in the last 22 years, but not here at the SEC. So that was a good memory. I submitted a statement that you can pick up out in the hall. The statement suggests that we're all spending too much time labeling – or to use a more familiar term in this city, legalistic parsing of words – that time and effort and energy could be better spent on analyzing, and I think it's particularly true when you look at 12b-1 expenses, that we ought to expend a limited amount of time deciding what is distribution and what is not. The more relevant questions are, is this of good value to shareholders, are we paying the right amount? Directors are smart, conscientious people. I've spent a lot of time with them, and that keeps getting reinforced for me. They know how to ask the right questions, if we just educate them about the business and then give them appropriate information. Now, there are a number of fictions and lists of irrelevant factors, like in the 12b-1 release, that we walk them through, and I would just suggest those are not helpful and they can even distract from the real purpose of getting at the real issues.

I agree with what Bob Pozen said in the earlier panel about distribution expenses. It ought to be relevant to a fund board, whether they've got a 12b-1 plan or not, how the adviser spends its profits. And to say, as I've heard people on panels back in the early 12b-1 debates, that it doesn't matter whether the adviser uses its profits to build up his business or dumps it in a landfill is just nuts. I mean, if I said that to directors, they would look at me like I had two heads. Of course, it's relevant. The mere fact that it's distribution shouldn't make it irrelevant. I think some of this parsing comes from the fact that there is, as I said in my statement, a historical antipathy toward distribution expenses. I think that has always been mostly wrong. I think it is really wrong as distribution expenses get merged with ongoing advice and servicing expenses. I think we're going to need to just eliminate our antipathy and start calling them what they are and evaluating them the right way. The next thing I would like to suggest is that we should not focus in looking at distribution, that we and the directors should not focus exclusively on fees and expenses. Those are important, but there are a number of other issues that are at least equally important.

One is the effectiveness of the distribution method. Don't look just at sales, look at redemption's. If shares are being sold and then quickly redeemed, you ought to ask about whether they're being sold in the right way. Look at the services provided by the participants in the distribution system. Are those services effective? Are they cost-effective? Look beyond the immediate sale. Look at the appropriateness of the charges. Look at the time period over which they're charged, how different shareholders pay different amounts, what are the shareholders paying, and what are they getting? Do the fees line up the interests of the sellers, or distributors, and the shareholders? If they're all paid up front, there's no incentive not to have the shares redeemed. In fact, there's an incentive to churn them. So you probably want to have a mix of up front and paid over time. Look at sales practices. I know directors have a hard time getting at sales practices. We have a hard time getting at sales practices. We have 100,000 brokers who have sold our shares. We can't sit with all of them. We can't listen to their phone calls. But there are things we can do. We can look at where we sign our, or with whom we sign a selling group agreement. We can look at the materials we're giving for the brokers to purchase. We can also look at what kinds of funds we are forming and how we are presenting them, as ways to get at it. But I think it's very relevant for directors to at least ask a fund sponsor, "What are you doing to ensure that your funds" – or "Do the most you can to ensure that your funds are being sold the right way." A couple of things I just wanted to comment about quickly, if I could, about the other panels, and then I'll turn it back over. I think we're excessively focused on what fees and expenses used to be and not enough focused on what they are now. The more we talk about economies of scale and how much fees have come down, the less we talk about what are the fees and expenses now?

Now, there was a Morning Star article that just came out, I guess last Friday, and American Funds was the best of the load fund families. I'm not sure how they calculated it. But it calculated the cost at 2.59 percent in 1984 and 1.42 in 1998. Now, would you really feel happier if it had been 3.59 or 4.59 in 1984 and was now 1.42? I don't think so. Shareholders pay current expenses, not past expenses. What has happened to expenses over time is really just one indication of what they ought to be and whether they're appropriate, but it isn't the whole ball game, and I'm worried that it's becoming the whole ball game. With that, let me pass it on.

Ms. Richards:  Thank you. Charles Schwab.

Mr. Schwab:  Thank you, Lori. Good morning, everyone. Thank you for having me here and, in particular, Chairman Levitt, thank you for inviting me here to your panel for the discussion about the role of the independent director. I have been a dependent director, for the last 10 years, and I have that perspective. We started the Schwab funds about 10 or 11 years ago. But I have been an independent board member, and continue to be, of four S&P 500 companies, so I do come with a hat of fiduciary responsibilities with respect to those corporations, and of course with respect to our funds, even though I'm a dependent director. I have submitted a written statement, and I thought I would not go into all the details of the written statement. They're there for you to peruse, and maybe ask questions about later. But I thought I would, since some of the conversation going on out there is about supermarkets, in particular mutual fund supermarkets, that I would give you a little perspective on the origins of the supermarkets, and our role in establishing those supermarkets, and so on.

As a starting point, I would have to suggest that I have a deep, long-term passion for no-load funds, so you might get my perspective on that. In fact, when I was in business school, I used to look with great interest towards the T. Rowe Price funds in the middle '50s. Little, teeny ad in the Wall Street Journal, about three inches high and maybe one column across, "No load." I was really curious about that, and found out what a great deal it was.

Moving forward, in the early 1980s, when Congress passed legislation concerning the IRA, to broaden the IRA for a wide set of Americans, I, too, wanted to have an IRA account. Our company at that time was about, oh, five years old, maybe six years old, and I wanted to have an IRA, but I wanted to have in my IRA a variety of funds. I wanted five different funds, and of course, I wanted no-load funds. So I went to my back office and said: "Look, this is what I want to do. Would you call these five different no-load fund companies and buy some shares," T. Rowe Price being one of them, and a few of the others. It was sort of unheard of, but they did that, and then they logged it into my account. It was a little bit cumbersome at the beginning. And I thought more about this, that other people might want to have the same kind of capability – have a single statement, have a choice of a variety of funds So, with that notion, about, I think it was 1983, a woman who worked for us on a consulting basis, Mary Templeton, filed with the SEC a request for a no-action letter concerning our ability to charge a fee, a transaction fee on the purchase of no-load funds through Schwab, which, fortunately, the SEC approved it, with certain requirements. That was the beginning and I called Mary Templeton, the mother of our Mutual Fund Marketplace. I might be the father. Mary was a great contributor, and I think she had worked with and around the SEC in years before that, but I owe her a great deal of responsibility for the early steps in the early '80s.

Then, moving fast forward, to the early 1990s, the concept of the mutual fund OneSource. As we saw people buying no-load funds through Schwab, one would say that was probably the world's most expensive spot to buy a no-load fund, being that you had to pay a transaction fee. But we saw people found that they really loved the ability for choice, they had the ability for a single statement, they had ability to access, go into branch offices, and so on, to talk about mutual fund choices. We also provided additional information for making comparisons among the no-load funds.

One of our bright young people came up with the idea, if we went to the mutual fund companies and suggested to them, if they would carve out a little piece of their management fees, advisory fees, and we replaced that, we would act as custodians, we would act as the place where we would hold all the – provide the monthly statements, and so on, that we could convince a few mutual funds, no-load funds, to give us a small portion of their advisory fee for supplanting certain costs, that we would then be able to offer our mutual funds, our no-load funds, to the public for exactly the same price as the funds did themselves. We went to about 10 or 15. I think we got 10 to accept, and Neuberger Berman was one of the first ones to accept, one of the leaders, actually, who accepted our notion, and we did a pilot through 1991. Well, we became very enthusiastic about this, and by the beginning of 1992, we broadened it and launched it as what we call Charles Schwab's OneSource Funds. And, of course, it met with great success in the marketplace and many, many different fund groups have adopted our formats, which we're pretty proud about. There are great advantages for the customer in this whole thing. Certainly, the advantage to the mutual fund marketplace is that it's completely open architecture, meaning any fund can come into that. We do have certain specifications.

We try to get in our one-source category the best breed, meaning the funds with the – we try to discourage the 12b-1 fees in our OneSource. We have funds in our total, our bigger mutual fund marketplace which is represented by 1,700 funds that have some 12b-1s, but in our OneSource, it's the best of breed. We try to provide, of course, a broad selection, information. The comparative information is extensive. Low cost is very attractive to our investor group. We presently have about 2 million accounts that have these various no-load funds. It provides them great liquidity. Certainly they have choices of access to approach any of our 293 offices where they can talk to someone face-to-face or the ability to call in to any of our national centers 24 hours by seven days a week, and of course, now the explosion of the Internet and all the advantages that the Internet provides, instant access for all kinds of information about their particular things. So we have seen great success in this area, and we continue to fight, or we continue to request mutual funds, that what we're doing is simply replacing a portion of the fee that they're charging and we're trying to provide best breed, and provide the record keeping, servicing, custodial services, and complete access to their account on the various three or four forms I've mentioned.

So now we have about $150 billion of mutual fund assets that we are custodians for, representing about 1,700 funds in total, of which 1,000 are in our mutual fund OneSource, represents about 120 different mutual fund families. In conclusion, I think, when I look at this from an independent director's perspective, I hope and request of our board members, when they look at our fees and so on, that it's what is the value being offered, and what is the comparative value, meaning other funds or even other financial services. Sometimes I take them on a trip to analyze what banks offer, and the same comparable kind of things for insurance companies. So, at any rate, it's nice to be here this morning. Thank you, Lori.

Ms. Richards:  Thank you. Jessica.

Ms. Bibliowicz:  Thank you. It's really a pleasure for me to be here today. As was mentioned, I am an independent director of Eaton Vance, but I got there in kind of an interesting way. I was formerly president of a mutual fund company, so I was really on the other side of the table. And when I sat down with the nominating committee, I said: "You know, why are you picking me? Are you sure you mean this?" One of the directors pointed out, "You know which questions to ask and you know how to ask them." So I think that, you know, we're really seeing a movement among independent directors to really bring people in who do understand the industry well and who will ask a lot of questions, and I think that's really quite critical. In my role as president of a mutual fund company, obviously, you get to learn the rules, the 12b-1 plans, and everything quite well. Am I talking without a mike the whole time? Did you all hear any of that? There we go. Thanks. It was pretty irrelevant, anyway.


Ms. Bibliowicz:  I just mentioned quickly that I was president of a large mutual fund company before becoming an independent director of Eaton Vance. And one of the – when I asked the independent directors why they were picking me, why the nominating committee was looking at me, they said, "Because you know the questions and you know how to ask them." And obviously, I feel very strongly that that is my role as an independent director. Interestingly enough, as president of a fund complex, you do spend a lot of time with investors doing seminars with the sales force understanding where the pressure are and where the interesting topics are to shareholders. One of the key influences, obviously, is what this panel is about, is distribution and what is happening in the world of distribution. And I want to kind of change the subject a little bit from the world of supermarkets to the world of what is happening when an intermediary sells mutual funds and the actual 12b-1 plans themselves.

I do believe that it is very important for shareholders to be part of a robust mutual fund company. I think that really is key for them. That allows the mutual fund company to really attract the best talent possible. You heard a lot in the last panel about, you know, lowering of fees and e everything else, and I think that's critical, but I also think it's important that talent be behind funds. There are no other better predictors of future performance than strong talent and strong support within a mutual fund company. That being said, independent directors have to look very closely at these fees, and distribution fees are probably among the toughest, for not only shareholders, also for the intermediaries, but very much for the independent directors, as well, to get through.

When we started our multi-class pricing over at Smith Barney, people used to accuse me, and sort of take some solace in the fact that there were only 26 letters in the alphabet, and therefore I could only come up with 26 different versions of how to price these things. I told them they should get nervous when some of the fund companies started using Roman numerals in their classes, because that became infinite in terms of what we could do. I think we're all very sensitive to the confusion that it has caused among investors. However, I do want to compliment the SEC and the fund industry for really trying to put forward to investors exactly what these different classes mean, when they are advantageous, and when they will tend to not be as advantageous. For example, front-end loads for the longer-term shareholder have advantages over, you know, the C-shares or the pay-as-you-go for shorter-term shareholders. I do believe, however, these pricing options are extremely important, because mutual funds very often are not just sold in the world of mutual funds, and I think you alluded to this point, Chuck. They are part of a more general financial services plan with other products in there, and very often, a representative of a client needs more than one option to show the client to make sure that we are doing the best possible job for clients. At the end of the day, in this world of pricing, clients look at their performance and it is net of all fees.

What I would like to contrast this to, and I think it's really an issue for all of us to look at, is in the world of load pricing, the services are all inclusive. You get the management company. You also get the salesmen and their ability to service the accounts. It is all-inclusive. What has changed in the industry landscape, which I think we have to take a close look at, is very often in the world of the supermarkets and other places, maybe 50, 60 percent of the business is now being done through a world of investment advisory fees. These fees aren't being looked at by independent directors. They really are out of that domain. They can be, in fact, more expensive than what clients will pay on a load basis. Typically, investment advisory fees charged start at about 1.5 percent. As we know, there's a cap on the internal 12b-1 expenses of 75 plus 25. So very often, we have investors really not looking at their fee in addition to what they're paying for the fund themselves. I think this is an area where a lot of investors, again in good markets, aren't looking closely at it, but long-term, it will really impact how their performance is and what they think they're paying for.

So, you know, in a sense what this leads me back to is that while we have created a lot of confusion with the alphabet soup, is it time to start looking at the prospect of negotiated commissions in the world of mutual funds? I know this is sacrosanct, but it's really happening outside the prospectus environment. It's happening in the world of investment advisory fees as we speak right now. They are negotiated. It's not done by class. It's not done by status. It's really done on a point of sale basis, what is right for that particular client. Do we need to look at pricing in the mutual fund industry as a whole to try and create some equality there? Because I think one of the issues that we're seeing right now is that no-load fund groups have a tremendous advantage over load funds, simply because they report performance on that no-load basis. What happens to the fee after that is not reflected in performance, and we all know that performance is not a predictor of the future, but it is what sells mutual funds. Therefore, I think it's clearly an interesting competitive issues when they are viewed against a fund that is all-inclusive, where the service and the investment management are tied into one, where boards are overseeing both sides, whereas in the no-load world, it is really not happening that way. I think this is one of the real challenges we face to make sure that investors are looking at all elements of what they're paying for financial services.

Ms. Richards:  Thank you, Jessica. Phil?

Mr. Kirstein:  Thank you. First, I would like to thank Chairman Levitt and Paul Roye and Lori Richards for asking me to participate in the panel this morning. As many of you know, Merrill Lynch was on the cutting edge of creating what is referred to today as multi- class shares. And I did furnish a statement which you can read at your leisure, if you're interested in it, which gives more of the history. I think it is important to note that when 12b-1 was adopted in 1980, the Commission and most of the fund observers at the time did not anticipate that plans would use the rule the way it has been used, really, since the adoption, and that is to pay for dealer compensation. Instead, the Commission envisioned that the rule would be used to pay for advertising and other periodic sales promotion activities, and it would be relatively small in nature, 25 basis points or less.

However, the industry soon developed other plans, and the first CDSC order was granted to E.F. Hutton in 1982. This was important, because what E.F. Hutton did was take Rule 12b-1, marry it with the contingent deferred sales charge, and figure out a way to pay the salesman up front and yet not have the money come out of the shareholder's initial investment. In essence, what this did was to allow the shareholder to make a decision, certainly in the load fund context, whether or not he wanted to pay up front or over time – pay me now or pay me later. The reaction of the industry and investors was swift, to the 12b-1 funds that were created in the mid-1980s, and the money came flowing into those funds.

Merrill Lynch, at that time, made a decision, two decisions, really. The first one was not to create clone 12b-1 funds by copying, taking their existing front-end load funds. The reason we did this was that we did not want to divert the cash flow into two vehicles. We also resisted converting the existing front-end load funds to 12b-1 and CDSC funds, because we did not think it was fair to our shareholders who had already paid the front-end load to now share in what would be the 12b-1 fee, although obviously funds that did do that charged the 12b-1 fee only on "new assets."

In 1988, after we received an exemptive order from the SEC, we became the first complex to offer our open-end funds with two pricing options. We left it up to the shareholder to decide which option was the most advantageous for him or her, given their own individual circumstances, such as the amount of money being invested and the likely length of investment. We thought this was important from a disclosure standpoint, because what we did was we had both pricing options within a single prospectus, and this allowed the shareholder or the investor to make an informed decision as to which option was most suitable.

Six years later, we started offering investors four pricing choices with different combinations of sales charges, 12b-1 fees, and other features. Much as Jessica indicated, we took a lot of heat both from the industry at the time, as well as internally, about, you know, we're going to have a whole page in the New York Times and the Wall Street Journal just with our various classes. In fact, Arthur Zeikel even said, "You know, this is going to be more than people can understand." And I threatened that, until we had A to Z classes, I wasn't going to be satisfied.

The Merrill Lynch fund directors have wrestled with Rule 12b-1 for more than 15 years, and they have had the benefit of legal memoranda from both outside and inside counsel, as well as the opinions of various judges who have considered 12b-1 plans in the context of litigation. For sure, they have received quarterly and annual reports as required by the rule, as well as reports pursuant to the NASD conduct rule, which shows how much can be charged and how much has been collected.

However, at the end of the day, the directors wishing to exercise their fiduciary obligations under both the '40 Act and state law are left to deal with the factors originally set forth in the 12b-1 releases which accompanied the proposal and the adoption. As might be expected, these factors are not particularly relevant to the way most 12b-1 plans are utilized today, i.e., to pay for dealer compensation. I think it's time for the Commission to amend Rule 12b-1 to permit directors to cease trying to put a square peg in a round hole. The rule can continue to play its traditional and important role of safeguarding assets, or safeguarding a fund against a wasting of fund assets on distribution-related activities.

However, for 12b-1 plans which are being used to pay dealer compensation, directors should be able to consider factors which are more relevant and which have received some focused guidance from the staff, which will be a better evaluation of 12b-1 plans. Some of the factors which we should consider going forward would be the nature and quality of the services rendered, the necessity of continued distribution – and I might add, as you all know, that if you have an open-end fund without distribution, you have a wasting asset – the possibility of reduced expenses as the fund grows larger, comparative 12b-1 fees of other funds, the success of a distribution effort under the current structure, the nature and completeness of shareholder disclosure of the pricing options available to investors, and finally, compliance with the NASD sales charge rule.

In addition, some of the procedural requirements should be revised to make the rule more workable. For example, the quarterly reports in this context probably could be eliminated without anybody being harmed in any way. These are only suggestions, and I'm sure other people may have other thoughts which should be considered. That concludes my statement. I'll look forward to discussing these issues. Thank you.

Ms. Richards:  Thank you, Phil. Faith?

Ms. Colish:  I guess it's now good afternoon, everybody. I'm very happy to be here and honored to be in such distinguished company. As Lori mentioned, I'm technically a disinterested director, but let's say an outside director of Neuberger and Berman Funds. I'd like to just start out by telling you a little bit about how those funds are set up. I don't think they're unique, but I think their structure is relevant to the whole distribution issue. Actually, we started out with a series of free- standing funds with different investment objectives, some of them dating back to the early 1950s. In, I believe it was 1993, all of those funds were reorganized into three, what I call clumps. We have the equity funds, the fixed income funds, and a third clump on which I'm also a director, which is the so-called Advisers Management Trust, or AMT funds, which are specifically for distribution through variable annuities and variable life, and where their shareholders, for the most part, are insurance companies who use them as funding vehicles. I'm a director, or trustee technically, of the equity group which includes, at this point, I believe it's a total of eight portfolios. There are value funds. There are growth funds. There are small cap, large cap, one international fund, one socially responsive fund. And all of these portfolios are part of the hub, or feeder of this fund structure.

At the time this structure was set up, it was the judgment of Neuberger and Berman management, and the board was persuaded that it was a reasonable judgment, that by going to a master feeder structure, sometimes known as a hub and spoke, we would have the flexibility to have different marketing styles similar to what you would get with a multiple class structure, but with the additional possibility of having a private label fund. If, say a bank, or some other financial service provider wanted to have its own name on a fund that would be managed by Neuberger and Berman, a separate spoke or feeder could provide a vehicle for that, which was probably the only distinction, really, in terms of the choice between those two formats. At this point, we have three feeders. The first feeder is made up of what were the original retail funds. And, by the way, those funds are all no-load and they have no 12b-1 fees. This is true both for the equity group and the fixed income group, on which I'm not a director, but which I believe has about seven or eight different kinds of fixed income portfolios, all the way from money market funds to longer-term high-yield bond funds. Subsequently, a second – and that, just for our reference, is known as "the funds." We have the portfolio, which is the hub. Then we have the funds, which is the group of what used to be the original separate retail funds. Then, about two or three years later, a second feeder was created, which contains most but not all of the portfolios, and is sold only on an institutional basis, typically, to 401(k) plans, through investment advisers, through broker dealers.

It also is no-load. It does not have a 12b-1 plan, but it does envision that the adviser, the distributor – I'm not sure exactly which, but they're under common ownership, so it's the same ball of wax. I should say both the fund and the adviser will make payments to the real distributors, who are these plan sponsors, consultants, and other people who are the link or the connection between the fund and the ultimate investors. And that, as I think I mentioned, is called "the trusts." We now have a third spoke, which is called "assets," and which does have a 12b-1 plan, and that also is only for distribution on what we would consider an institutional basis, primarily through broker-dealers. There have been discussions which are much too premature for any announcement on my part. But other modes of distribution are, I'm sure, constantly under review, and the initiative for these developments, I would say, always comes from management. I can't think of an instance when someone on the board said, "Hey, how would you like to do a load fund?" But that subject might come up in, as I way, with the initiative for management, who have some extremely experienced and highly capable people. I don't know how many of you in the room know Stan Etchner, but I think he is a recognized genius and leader in this area, and with an excellent staff of marketing people who are constantly exploring how to promote this aspect of the business.

When the board is asked to consider a plan, we obviously look at cost, we look at fairness, we look at disclosure, and we can talk about all those issues in greater detail, but I assure you that we don't just rubber stamp anything. On the other hand, we don't feel that we are necessarily the technicians, the experts in the area. I started my professional career, as was mentioned, I'm a securities lawyer, and I started out at the SEC in 1960, in the General Counsel's Office. I see some colleagues in the room who remember those days. I worked for a lawyer, a wonderful man named Dave Ferber. My job was to read a lot of cases and gather a lot of material, and sort of digest it a little bit for Dave, who would then write a brief or do the real – how should I say – the final work. Some of you also may remember Parliament cigarettes had a slogan that said they were the thinking man's filter. And I decided that was my job description. I was the thinking man's filter.


Ms. Colish:  I still am, I believe. At least that's what I try to be. And I think, to some extent, that's what I do as a fund director. I mean, I'm not necessarily the decision maker. I don't feel I'm qualified or expected to be the decision maker. But I am supposed to ask questions. I am supposed to be part of the filtration process, through which a collective, collegial decision is made, with all of the best that my mind and the minds of my fellow directors brought to bear on it, so that without necessarily it being an adversary relationship – which we certainly hope it doesn't become, it shouldn't be – that the subject is looked at from every possible angle, and there are situations in which questions come up about, you know, "How will this work," or "What does this really mean," or "We don't understand it, please explain it to us," that do result in responses saying, "We'll get back to you." And we get a lot of data, both in the planning stage and, you know, reflecting the administration of these various programs that we do our best, as serious-minded and I hope intelligent people, to evaluate and to be a good sounding board for the people who really run the fund.

Ms. Richards:  Faith?

Ms. Colish:  I'm running out of time?

Ms. Richards:  Yeah.

Ms. Colish:  I just want to take 30 seconds to say that I have some very real concerns about Rule 12b-1. I think it's a very useful tool, but I'm very concerned about some staff comments recently, which I think create an enormous problem for fund directors in terms of how to administer a 12b-1 plan and also whether everybody now has to have one, as opposed to what it originally was, is something to solve a problem. I think the problem has now been created, to some extent, by the SEC or the staff, to which everybody may have to respond by having the 12b-1 plan.

Ms. Richards:  Thank you. Well, I've heard from three of our panelists some criticism of Rule 12b-1, and in particular of the factors that the Commission set forth in 1980 as suggestions for matters that fund boards should consider in adopting 12b-1 plans. I would like to expose this a little bit more to some of the other panelists. In particular, what factors should fund boards consider in reviewing and approving a 12b- 1 plan? Should directors consider the business realities existent today, the competitive environment in which funds are offered, the need, as Phil said, to continue to compensate broker dealers to maintain fund shareholders, the existence of contingent deferred sales loads, and the long- term commitments inherent in contingent deferred sales loads? How would you suggest – and I heard from three of you that you would suggest – that the factors be updated?

Ms. Bibliowicz:  I would just say that – this time I'm going to get it right – that when the 12b-1 rules were first designated in 1980, they were clearly for an advertising campaign or some finite activity. I think common usage for 12b-1s today is that they do finance commissions to brokers and then that financing gets paid back through the 12b-1 process, and/or the CDSC, at the end, if the client should choose to leave the fund. When you go through the regs and you go through the balancing as an independent director, it really never comes up that way, and I think that we've got to look at how these things are written so that they, in fact, reflect what is really happening in the industry and what the 12b-1 is truly being used for. It doesn't look that way, and it's very difficult for a fund, an independent board director, to really go through it and try and match the two up. I think it's easy for them to – not easy, but it's important for them to look at, you know, is this fair; are the charges right; is this a profitable thing, or is it really being used for expenses? They can look pretty closely at that, and look at a lot of data that's being given to them. But it's not really how the regulations were written in the first place, and I think that's something that we should all look to change. It just doesn't make any sense.

Mr. Haaga:  In fairness to the Commission, and the people who wrote the original – the original factors say, you know, "These are factors to be considered only to the extent they're relevant." So they are not written in stone. The problem is that outside counsel just doesn't feel comfortable, unless they walk everybody through the factors, so I'm constantly – it's been 12 years now since we adopted our 12b-1 plan, and I keep having to tell people what the problem was every year, when we renew it. I guess I would suggest I don't think we need factors. I think directors need an underlying finding, i.e., the benefit to shareholders. They'll find the factors. The questions that you just cited, Lori, are good ones, and directors will find more. I would give them a standard for approval, but don't tell them what questions to ask.

Mr. Schwab:  Lori, I would make a comment about 12b-1. I think the investor really votes with their feet. My personal perspective at Schwab, most people tend to go away from 12b-1 funds, if it's fully disclosed, easy to see, they choose the lower-cost funds. OERs are very important. It is now well disclosed in Morningstar and now we have Moody's and Standard and Poor is coming to the fore, in terms of more analysis in its disclosure. We have Value Line. And informed investors make those choices, and I think you need to keep, the SEC needs to keep – make sure that this is on the front page or the second page. And full disclosure, I think, is really the thrust we should maintain.

Ms. Richards:  Turning now to fund supermarkets, Chuck, you mentioned some of the benefits to fund supermarkets. They provide investors with choice. I guess I'm wondering about some of the criticism of fund supermarkets. It's been said that fund supermarkets put an upward pressure on fees, and that they may impair the relationship between a fund and its shareholders. How valid are those claims?

Mr. Schwab:  Well, we submitted an analysis of 500 funds that we cleared in our mutual fund marketplace in 1994 and between the following five years and we saw a decline in OERs. We have a paper on that if anyone is interested in that particular paper. As to the other aspect of supermarkets, in some sense the mutual fund industry is a little bit parochial or very parochial. We have a whole new world that is evolving right now. Informed investors want choices. They want information. They want comparatives. They want all these things. They want transparency. They want low cost. That's what the future is all about. The old mutual fund companies in some respects, all due respect to them, they've been in business for 50 or 100 years – maybe not 100 years, maybe 75 years, is about being somewhat parochial, about trying to maintain a family. They think that's a good thing. That's wonderful. They should be able to maintain that, but the new investor is all about these new things I mentioned.

Ms. Richards:  And what about the claims that investors who buy shares directly from a fund are in some way subsidizing the expenses that are incurred for services provided to the investors that buy through a supermarket?

Mr. Schwab:  Well, we have found that it's just the opposite actually. That our transaction fee based funds actually end up being the ones that sort of subsidize the great value of the NTF funds. But we could debate that. We'll show you our numbers.

Ms. Richards:  Chairman Levitt?

Chairman Levitt:  Chuck, the fund expenses, the supermarket expenses has gone from 25 to 30 to 35 I understand. As you look to the role of the independent director, if you represent a major part of that fund, maybe more in some instances than 50 percent of the fund, is that director really in a position to question whatever the fee may be?

Mr. Schwab:  Well, obviously, they do have a basis for questioning any and all fees. And we, as a firm, are dependent upon the competitive structures out there. We want to put forth the most competitive funds possible. Our investors are very smart. If they see an excess amount of fees being charged by us or by the fund, it's a quick decision: They move to the lower fee funds, and we see that on a continuing basis. So, as to what are they getting for, now, our new funds coming on board would pay 35 basis points. They get incredible value, a little fund group that might come on board now has the ability of accessing us through any of 295 branches. They can access their account and information about that fund 24-hours-7-days-a-week. They can also then go on the Internet. A little mutual fund management company has no capability of offering any of these things. We spend hundreds of millions of dollars a year in providing the infrastructure for all these things. And for 35 basis points on a $10,000 transaction, $35 a year is an unbelievable value when you compare it to any other choices.

Chairman Levitt:  I don't question that and I think the standard of ethics manifested by your operation is as fine as any that the industry has ever seen; but I want to highlight some of the possible ambivalence an independent director may feel in terms of making judgments which can conflict with business practice You have a very commanding position, and it would be more difficult for an independent director to exercise that judgment than in a situation where your involvement was less considerable.

Ms. Colish:  May I comment on that? As you mentioned Neuberger Berman – which, by the way, it spent a huge amount of money to pay PR people to drop the "and" from the name, so it's Neuberger Berman – was one of the first or earliest to become a part of your program. And we've been, for the most part, extremely happy with it. I think to the extent that we have had a concern is that it's been so successful and you have sometimes become the 800 pound gorilla to us, although so far a very benign one.

But I think our response has been to not put all our eggs in one basket. Neuberger Berman represents approximately altogether say between 50 and 60 billion in assets which is not tiny. It's more than I have on my person, but it's not a giant. It's not a Fidelity. It's not a Vanguard. And I think although they do spend a lot of money and a lot of effort on shareholder service and telephone communications and they have their own web site, it really is very hard to compete with giants like a Fidelity, who are not only big, but they are obviously very well run and they spend zillions of dollars on technology. And it would be absolutely prohibitive, I think, for a fund organization even of the healthy size of a Neuberger to try and replicate that. And, so, what you offer, I think is a real plus to us.

We do look at the cost and we do look at, for example, the fact that you have an omnibus account and we pay one transfer agency fee or transfer agency fee for one shareholder for all of your accounts and the saving we have in transfer agency fees is considerable. And that, to some extent, is our justification to a large extent for what the fund is willing to pay or to authorize or be comfortable with the manager paying as a trade-off. Plus the fact that we are, as I'm sure you know, not how should I say, "We're not dating you exclusively." We do have other marketing arrangements. There are other supermarkets, there are other organizations. You certainly have the premiere and when the name – when supermarkets come up, everybody thinks of Charles Schwab, but there are other names and there are other competitors of yours whom we look to as actual or potential outlets and so there is competition on that level as well. And I think all of these things are very much, to the extent of our ability to absorb and organize this information is something that our board spends a lot of time on.

Mr. Schwab:  I would just mention that we probably take the more active investors of your group. We have a high service content. They have access to us by telephone all the time. Your more passive investors might buy your fund, sit it there for 10-15-20 years and never hear from them. We hear from our people every day.

Ms. Richards:  Paul?

Mr. Haaga:  I don't want to distract us from talking about the problems with supermarkets, but I did want to pick on something Chuck said. Investors are not moving away from 12b-1 funds and they shouldn't move away from 12b-1 funds. What he said just sort of brings up the whole issue and why we have these fictions going on. The same funds are paying the same fees to his supermarket for the same services. Some of them are adopting 12b-1 plan, some of them are not. The ones that are not are getting the money some place. It isn't family money that the sponsors have. It's coming from the funds.

And the idea that investors ought to prefer the funds that don't tell you what they're spending on distribution over the ones that do is nonsense. You know, if you're spending money on distribution, say it. If you're not spending money on distribution don't say it; but don't pretend that there are no expenses there for a fund that doesn't have a 12b-1 plan. Look at the total picture. I think the press, as I said in my outline, the press has come around to realizing that just pointing the finger at 12b-1 funds is not productive and you got to look at the big picture. How about the rest of us coming around, too?

Ms. Bibliowicz:  I would just add one thing to take a little bit of the pressure off of Chuck. I think that, you know, it is not just the supermarkets that are very distribution focused, there are a lot of companies right now that distribute other funds and in all cases you see a lot of pressure on the fund companies to really sort of pay for the big bricks and mortar of that distribution. I think as an industry, we will all be forced to look very closely at that and make sure that consumers really understand.

But I want to go back to the original point which is no-load is not necessarily no-load and no-cost. I think that while some people are terrific at picking funds on their own and playing on the Internet and doing their thing, we still see a preponderance of investors who really do seek advice, whether it's in the load world or whether it's in the fee world. And, you know, again, a lot of these funds, while they show performance on a no-load basis which makes them look terrific, what about those funds that are then wrapped in investment advisory fee and what is the ultimate client actually doing in their own portfolio? And there doesn't seem to be a lot of focus on that because, again, very often, they are more expensive through that network. I am sure that, you know, the services provided might make it worth it, but the clients aren't seeing it and they're not seeing it bundled. And I think we've got a responsibility to try and look at that even though it's outside of our world. What are independent directors supposed to say about that?

Ms. Richards:  Phil?

Mr. Kirstein:  I would just like to add to those comments in the sense that I think what we have here is different levels of service. And the fund supermarkets or the traditional no-load funds have provided a certain level of service. They've provided the record keeping and they provided statement reporting, etceteras. But the people who have traditionally bought the loads and there may be some shift in people going on the Internet and there's probably going to be kind of a muddy middle ground that will develop over time. But there are still a lot of people that want to have some financial assistance from a consultant with that decision to, which fund to buy, how to allocate their assets, what percent should be in municipal bonds, how much should be in taxable, equity, how much in and outside the US, etceteras. And those are services that people have traditionally and are still obviously, as Paul said, willing to pay for. And, so, it's just a question of what type of service you want and there's no question that the supermarkets or the no-load groups are providing one level of service and if you want a higher level of service, you're going to pay a little bit more for it.

Mr. Schwab:  I would just say Schwab is not against load funds, per se. We are actually in favor of independent investment advisory services. Jessica and I were talking about that earlier. Her funds use our investment advisory services where they can buy many load funds on a net asset value basis sold primarily to independent investment advisers or through that network. And we just take the loads off and the independent advisers charge an annual fee for customization of the management of those accounts.

Ms. Richards:  Chairman Levitt?

Chairman Levitt:  Phil, I'd like to ask you about Merrill's setup charge for marketing a new fund. What do you charge management to distribute that fund? And I also understand you have a preferred list of funds. How does one get on that list?

Mr. Kirstein:  I don't mean to beg off the question, but I think most of the questions that you're asking pertain more to the broker-dealer operation than to the asset management operation, Pierce Fenner & Smith. I'm not totally familiar with what you referred to as, quote, "setup charge," or the criteria for being on the preferred list, but I'll be happy to get back with it.

Ms. Richards:  Well, this raises I think a broader issue. A number of brokerage firms require funds to pay for shelf space in their distribution operations or for so-called setup fees for new funds. How do fund boards or do they – do fund boards monitor and watch those expenses?

Ms. Colish:  So far, it hasn't come up in my experience as a fund director, so I really can't comment. I would assume they would, but I haven't had to do it.

Ms. Bibliowicz:  I would just add that board members are typically aware of them. However, I think when it comes to looking out for the actual shareholder, that taking that into account is not something you can do if you're deciding whether or not breakpoints should be established or total fund expenses, while you're sensitive, I think really the issue is if the fund company thinks that that's an appropriate business expense, you know, they've got to deal with it. But I think the potential conflicts of the independent director would be to stay out of that and make the decisions that keep the funds competitive and reasonably priced to the ultimate shareholder. So I think typically we know about it, but you really want to make the decision in favor of the shareholder, not for the expenses that are being paid to a distributor or to some other format.

Mr. Haaga:  I would agree with what Jessica said. The directors generally know about it and it is – "it" envelopes a lot of things. People call it revenue sharing. You can also call it cost sharing. A lot of the payments are made for actual account maintenance and they're made on a per-account-basis. They're doing the same kinds of things that the – the brokers are doing the same kinds of things the supermarkets are doing. You know, the origin of this – I don't mean to defend the distribution system too much, but the origin of this was the dealers coming to the fund firms and saying we're incurring greater expenses in distribution. We want to have some – we want you to share in paying those expenses; but, by the way, don't pass them on to the shareholders. So I think that's a good thing, not a bad thing.

Ms. Richards:  Should directors consider those kind of inducements in reviewing and approving the fund's 12b-1 plan?

Ms. Colish:  If I may, I'd like to respond to that a little bit obliquely because it relates to the issue that I sort of stuck in at the end of my original statement. When 12b-1 was adopted, it was contemplated as something needed to solve a specific problem and to be used primarily for distribution or – I forget exactly the word that was used, but that was the gist of it. Among the things that have developed, there have been a number of changes in the business environment and regulatory gloss over the years. But we are now at a point where I wouldn't say everybody has a 12b-1 plan, but it is a very, very common phenomenon and you're frequently at a competitive disadvantage if you don't have one. It's not a special problem that you need to solve, you just need to run a little faster to keep up. So I think that's one aspect of the rule that really is out of sync with reality.

The other, and this is a more recent development. This concept that 12b-1 money is used for activities that are primarily distribution related. As you know, Doug Scheidt published, or a letter was published over his signature, in October in which he seems to – not "seems to." I think it's pretty clear he's saying that if any distribution events happen, let alone are contemplated, there must be a 12b-1 plan, whether it comes out of the fund's pocket or, for that matter, arguably out of the adviser's pocket. Frankly, as a fund director and with some very excellent outside counsel, we are troubled by how to deal with that. If, for example, we can justify every penny of the money that's being paid to a third party, a Schwab, for example, on the basis that it saves us shareholder servicing costs, accounting costs, transfer agency costs, but it in fact results in sales, do we have to somehow carve out a portion of that fee and say, "Well, this really needs a 12b-1 plan." As I indicated, two of our three spokes don't have 12b-1 plans. Do we have to now adopt one, which by the way, as I'm sure you all know, since it's an existing fund would require a shareholder vote, to just stay even. I think that that letter at least suggests that someone's changing the rules on us in the middle of the game and we really are perplexed as to what to do with it.

Ms. Richards:  Paul has suggested that the amount of time spent by directors parsing out the different parts of the fees and, in particular, Faith, you mentioned parsing out the different components of a fund's supermarket fee, that that process just doesn't make sense. And that instead of labeling fees, the director's inquiry should be focused on whether the service is appropriate. And Paul has suggested a new paradigm. I would like to, Paul, ask you if you could expand on that and explain to us how you think this new paradigm should work.

Mr. Haaga:  Well, I didn't really carry it all the way through to what we ought to do next; but just on Faith's – I will get to that. On Faith's comment, you know, the consequences of having as 12b-1 plan are that you get some good governance principles. You get majority independent directors, you get a particular review and focus on those expenses, that's the main consequence. The other consequence is you get kicked out of the 100 percent no-load mutual fund association. We're talking about 12b-1 as though it were a terrible thing to have. It's a disclosure and identification of how money is spent and good governance. And, so, I guess in answer to Lori's statement, I would suggest that some of the things that 12b-1 requires of directors could maybe go beyond distribution expenses. They aren't the only important expenses, they aren't the only expenses that require careful review. They're not the only ones over which there are potential conflicts.

Ms. Colish:  I support what you said in terms of the governance issues. I remember when the rule was being considered, one of the commentators referred to this nominating committee of independent directors as the principle of immaculate selection, and I think it's a very good idea. I happen to be a member of boards that have a substantial majority of outside trustees and we have only outside trustees on the nominating committee and I think all of those are very wholesome and we are very comfortable with them. But I think the suggestion you're making about this category, treatment of categories and we get into the issue of what an adviser can spend his legitimate profits on, for that matter what a supermarket could spend its legitimate profits on, that really takes you into rate making which I am hearing the SEC does not want to do.

Ms. Richards:  I'd like to touch quickly on something that a couple of the panelists raised in their opening statements. And that's the potential for investor confusion that's created by multiple classes and multiple fee structures. Do you think that directors have a role in alleviating investor confusion that's caused by multi-class, multi-fee structures? Phil?

Mr. Kirstein:  Well, I think they have a role insofar as there's disclosure in the prospectus, the registration statement and they're responsible for it. And I think it's important that you spell out as clearly as possible in the prospectus what the various choices available to the public are. And I think to a large extent that's been well done through the fee tables. Somebody on the earlier panel pointed out it isn't just a theoretical thing, that it's 10 basis points or 50 basis points or 150 basis points, but there is an example in there, you know. Whether or not the fee table could possibly be improved, I guess we can consider doing something along those lines the same way as we could improve it in terms of investment performance with more variation. I do think there is pretty good disclosure in the prospectus now, especially in the fee table. And I think at the end of the day, the bottom line is really the investment performance. Obviously, in a money market fund, fixed income funds, the expense ratios are extremely important. And they're important in an equity fund. But for people to make an investment decision that I'm going to buy Fund X because the expense ratio is 91 as opposed to 92 and they lose sight of what the investment experience and what the portfolio manager has achieved or is likely to achieve going forward really misses the point. I can remember a news article or one of the magazines that was doing a survey on money market funds. And they picked out one of our government institutional funds which had – and they recommended it. And they said you should go in – you know, this was one of the three funds with – and it was totally done on the basis of expense ratio. They never looked at the return. And the return on that fund happened to be lower than some other government funds that we offered because of the fact that the board, because it was an institutional fund and it was very hot money, had put a very restrictive investment parameter on what the average weighted life of the fund could be. And that, I just think that's very typical. You can't lose sight, and we shouldn't lose sight and I think the director shouldn't lose sight, that the end game is not trying to get the lowest possible expense ratio over everything else.

Ms. Richards:  I'd like to ask one final question as we're running out of time. If you were to make one recommendation to the Commission today, one recommendation to the Commission concerning fund distribution, what would that be? Start with Paul.

Mr. Haaga:  Get better coffee. No. I guess consistent with what I've been saying all along, I do say keep your eye on the ball and don't get distracted by 12b-1, non-12b-1. Don't get distracted by some of the historical concerns. Let's look at the industry now. Let's look at the industry where it's going and let's look at what's best for shareholders and not be kind of bound in by the old, old terms, the old definitions and the old rules.

Ms. Richards:  Chuck?

Mr. Schwab:  I'd just say keep the eye on the ball in terms of clear, crisp, simplistic disclosure of all these various expenses and performance, for that matter. What I find in my own experience is the more complicated the alphabet gets, the less sophisticated are the investors. And where I find more sophisticated investors, when they've got the information or they have the advice from an independent adviser, that they tend to buy the ones that have great performance with lowest fees.

Ms. Richards:  Jessica?

MS. Bibliowicz:  I would just say, you know, reputation is probably one of the most critical selling points. And I think that the industry and the SEC working closely together to continue to achieve that is just absolutely critical. I think it's been a great association between the two. But I would add that with the alphabet soup that's been created and some of the confusion, is it because pricing is really so driven by a prospectus matter and should we at some point, again, open up the issue as to whether or not negotiated commissions are the best thing for shareholders or put it to rest. I think looking at it in today's world of multiple pricing as well as fee-based pricing, I think the discussion would be very interesting and very lively.

Mr. Kirstein:  I would go back to my opening statement. It isn't a perfect world. If it was a perfect world, I think I'd be more inclined to agree with Paul that we could eliminate this whole idea of factors and 12b-1 and get to the bottom line. But we don't live in a perfect world. There are plaintiffs out there. There are lawyers. There will be depositions and directors will be asked, "Did you consider the nine factors that were promulgated in 1980, or 1978?" And, therefore, I think it is worthwhile for the SEC to go back and to put out some additional guidance today that will be more relevant to the way the 12b-1 plans are being utilized.

Ms. Richards:  Faith?

Ms. Colish:  As a clean-up batter, I have a chance to say I agree with everything that's been said. But as a securities lawyer sitting on a board, I find that this subject is extremely complicated. I think that my fellow directors who are not securities lawyers are heroic for grappling with them. I am not saying that we have a system that is broken and has to be discarded, but I would like to suggest that in looking at this subject, you try to go back to first principles. What are we trying to accomplish here? And maybe just put aside for a moment all of the technicalities and the gloss and the litigation and the nine points that you have to check off and start from first principles and say, "What is the goal here?" And "Is there a shorter line between the two points?" Or "Do we really need such a Goldberg structure to protect the public?"

Ms. Richards:  Thank you. On behalf of Chairman Levitt and the entire Commission, I'd like to thank our panelists. There were a number of questions from the audience that we didn't get a chance to touch on. So I would encourage those members of the audience that have questions to approach the panelists directly. Thank you.

(The panel was adjourned.)


Fund Portfolio Brokerage 

Mr. Eisenberg:  Okay. Thank you. Let me begin this afternoon's session of the roundtable which will deal with the fund brokerage and disposition of fund brokerage. My name is Mike Eisenberg and I'm Deputy General Counsel at the Commission. I'd like to briefly introduce the members of the panel. Henry Hopkins who is sitting next to me is with T. Rowe Price. I think he is generally well known to many of you. He's been at T. Rowe Price since 1972, and he's the chief legal counsel for T. Rowe Price & Associates, and he sits on most of their committees, chairs the Ethics Committee and is familiar I think generally with the operations of T. Rowe in all its aspects as one of the largest no-load fund groups in the country. Sitting next to him is Heidi Stam. Heidi was Associate Director of the Division of Investment Management before she went to the Vanguard Group where she is one of the chief legal officers of the Vanguard Group. John Hill is at the far end. John is an independent director of the Putnam Group of funds, and he is the chairman and managing director of First Reserve Corporation, an investment firm that acquires and builds diversified energy companies. Before that and in an earlier incarnation, he was with the Office of Management and Budget and with the Federal Energy Administration. Anne Jones who I think is also familiar to many of you is a former director of the Division of Investment Management, and she later, when she left the Commission, became the general counsel of the late, lamented Federal Home Loan Bank Board and the FSLIC. She was then appointed by President Carter as a commissioner of the Federal Communications Commission, but she is a independent director of the IDS Group of funds and practiced at Sutherland Asbill for a number of years, retired just a few years ago, but is still a member of the board of IDS.

We have two members of the Wall Street segment of our group. We have two independent directors, two inside counsel, and we have one member from Goldman Sachs, another from Merrill Lynch. Duncan Niederauer is Managing Director of the Equities Division of Goldman Sachs and joined US Share Trading in 1998 after spending three years as head of Global Portfolio Trading. Prior to that he worked in derivatives and Japanese products trading in Tokyo. So I think that we have someone well qualified to talk about portfolio trading. The final member of our family is James Smyth. I think it's pronounced "Smith", but it's spelled with a "y." Now, James Smyth's distinction is that he went to Brooklyn College, which is my alma mater, but he graduated long after I did. He is currently with Merrill Lynch's Citation Group which – and its affiliate which is called Broadcort Capital, which is part of the Equity Markets Group. Merrill Lynch never does things simply. Jim recently was appointed the Global Coordinator for all Equity Soft Dollar-directed Activity. Besides its current client base at Merrill Lynch's largest institutional managers, Citation's customer base is made up of many of the largest global pension consultants as well as plan sponsors, so I think we have two people from member firms that are intimately aware – involved with soft dollars and soft dollar trading.

I'm going to give you first some background with respect to the origin of soft dollars, if you'll bear with me. I think that this discussion of soft dollars and the use of brokerage and the fund industry and the role of directors with respect to allocation of fund brokerage requires some background. It's been a long time since I viewed soft dollars from the point of view of the Commission. The last time for me was during the 1960s when I was a member of the staff. The staff of the Special Study of Securities Markets saw the New York Stock Exchange's fixed minimum commission rate regime as a primary target. How could we most clearly demonstrate to the Commission and to the Congress that the fixed commission rate scheme was not in the public interest? The evidence was plain enough. New York Stock Exchange member firms were willing to give away or give up 50, 60, 70 percent or more of their commission dollar on mutual fund and other institutional trades to other brokers at the direction of fund managers who directed the fund brokerage to them. So Fidelity Management, to pick a name from the air, could direct Fidelity's fund brokerage to Solomon or Goldman or Merrill or any other New York Stock Exchange member firm and direct them to give up a major portion of their commission for executing the trade to any other member of the New York Stock Exchange.

If a member firm was willing to give away half or more of its commissions, we reasoned in a brilliant insight to the staff, that there must be a lot of fat in the commission dollar which was being charged to the investors of the funds. What services were these and other member firms providing to the fund managers in return for this give-up? Research, of course, and some of it was quite valuable, much of it was fairly pedestrian, economic and statistical reports, and some of it was just junk which was immediately discarded by the portfolio managers. The definition of "research" was elastic to say the least and it still is. The other service that commanded serious give-up dollars was the sale of fund shares. Reciprocal, it was called, a recipe for sales. Other services were also cause for reward through the give-up mechanism. Of course, member firms who executed trades also provided research, sales and other services. Since it was all bundled together with the execution, it was referred to as soft dollars.

The New York Stock Exchange was unable to hold on to its monopoly. A member could at that time give up only to another member of the club; and, soon, regional exchange give-ups were available. Most New York Stock Exchange members were also regional members and then also members of the NASD. Since many regional-only firms sold fund shares and couldn't execute a serious order, the give-up was a significant additional reward for fund sales, most of which were already subject to an 8.5 percent front-end load. Then the give-up by reasonable extension became available to all members of the NASD. You could give up to any other NASD member. The staff, consisting of David Silver, Gene Rothberg and I, conducted an inquiry on the record asking fund management why they were not directing give-ups to their own fund distributors who were NASD members and recovering the directed commissions for the benefit of the funds – recapture. Had they informed the independent directors of the availability of recapture? Would they have an affiliate join a regional exchange, such as the Pacific, to receive give- ups?

We held hearings on how the give-ups really worked and Dick Phillips headed the 1966 mutual fund study which added to the findings of the Special Study. Moses v. Bergin, the 1st Circuit, 1970, made clear the legal responsibilities of the management companies to disclose recapture options to directors and the director's duty to at least consider them as a matter of business judgment. The impending abolition of fixed rates in the Exchange commission structure and its give-up progeny alarmed the research firms who maintained that their products were necessary for the guidance of the fund management in their roles as managers. Research, they said, was a benefit to the funds and their shareholders, not to mention the management companies. So instead of resulting in an unbundling of services, the funds paying dollars for identified services separately, like x-dollars for execution, y-dollar for research, and z-dollars for record keeping and so on, the brokerage community vigorously protested the demise of soft dollars for research. Sales reciprocal and increased commission rates was more difficult to defend; but that later was accommodated by Rule 12b-1 fees, which we talked about this morning.

Chairman Casey abandoned the vision that the Commission had when it achieved negotiated rates, and he agreed to support a legislative effort which would make it legal to mutual funds and other advised accounts to pay up, pay more than the best price available for the research that they were getting through the execution of portfolio trades so long as the research being paid for was deemed valuable by the adviser and the trustees or directors of the funds. And that was Section 28(e) in the 1975 Act amendments. 28(e) authorized additional payment as was the case with the original give-up which was at bottom, the use of fund assets to pay for research directed to the manager. The brokers did not want to un bundle research from execution and the advisers generally supported them. As long as they were getting services for "free," and that's in quotes, that is, at the expense of the funds, they were happy. They did not want to pay hard dollars for research or break out the amount of fund commission dollars that they were using for research for everyone to see. Consequently, the unbundling never occurred. Research remains embedded in brokerage commissions; that is, bundled, even though we have, "negotiated rates," and have had them since 1975. The more things change, the more they remain the same. Executing firms can receive payments for research and third party payments still proliferate; that is, payments directed to firms providing 28(e) research, safe harbor type materials. If there is any doubt as to how close we are coming full circle, there is the step-out transaction to consider as well, which we will.

In 1986, there was a Commission release, under the guise of clarifying the 28(e) safe harbor that actually broadened the scope and confused the definition, at least in my personal view of best execution even further. Some say it clarified it. The Commission was more recently – has more recently required significant additional ADV disclosure and placed greater emphasis on monitoring the use of soft dollars through statements and proceedings focusing on the fund directors' role in monitoring the allocation of fund brokerage and the manager's duty to fully disclose soft dollar arrangements. We have brought cases recently dealing with the misuse of soft dollars for services which were clearly outside of the safe harbor realm, and so on, including a recent action against the broker for continuing to direct soft dollar payments without inquiry when it was apparent that the payments were in violation of the adviser's fiduciary duty to his advised accounts. Don't worry. This is going to end in a minute. The reason for this extended discussion of this is because unless the background sinks in, it's going to be difficult to understand the discussion.

A recent OCIE report – Office of Compliance and Examination – suggested important additional disclosure of soft dollar use by inspections management companies. We take it as a given that more precise and clearer disclosure is appropriate. It should be done. The OCIE report was quite clear on that subject. The issues confronting the Commission and its staff in our attempt to make fund directors more effective and what we will discuss in this panel are whether soft dollar practices have gotten out of hand, whether directors are effectively monitoring the allocation of fund brokerage, whether fund directors are sufficiently alert to the possibility of lower rates or using brokerage with the reduction of fund expenses, whether some of the research being provided is really just routine and relatively worthless, or merely serving to camouflage reciprocal for sale of fund shares, which is permissible only at best execution rates. And what is best execution anyway? Whether the 1986 release should be revised to better define best execution and the scope of research, whether 28(e) has been stretched too far in an era of negotiated rates and whether the research exemption permit should be modified. And, finally, whether the Commission should through disclosure or rule making require the unbundling of reciprocal services paid for with commission dollars. Now, with that brief little introduction, I'd like to introduce Henry, who will explain what I just said.

Mr. Hopkins:  Thank you, Mike. I want to say, number 1, our soft dollars practices have not gotten out of control. Directors are monitoring soft dollars practices. Directors are alert to the possibility of lower rates. Research generally is very valuable.

Mr. Eisenberg:  Can you hear him?

Mr. Hopkins:  The SEC '86 Release should not be revised except to fine-tune, and 28(e) has not been stretched too far. So those are my thoughts and we can all now stop.

Mr. Eisenberg:  All right, Heidi, your turn.


Mr. Hopkins:  You know, Mike was mentioning that I was the chairman of the Ethics Committee at T. Rowe Price, and, actually, I've been the chairman since I think it was 1972 when we first adopted a written formal code of ethics. I will never forget Mr. Price – there is a Mr. Price who started our firm, Mr. T. Rowe Price, and he was living at the time. But he was –

Mr. Eisenberg:  I hope so.

Mr. Hopkins:  Well, he was not actively involved, but he was still getting research. And I will never forget having to explain the code to him, because if he wanted to continue to receive research, he would have to agree to abide by the code even though he was no longer an employee. And he read the code and he looked very disgusted, as he did quite often. And he said, "Henry, I could not possibly sign this. You have to understand that I always viewed myself as a gentleman. I would never ask a client to purchase a security for the first time unless I had already taken a major position in it."


Mr. Hopkins:  So, it shows you there are different ways of looking at things. And from his perspective, that was the appropriate way, the high-road way. I might say I never did convince him that the code made a lot of sense, and he, in fact, did not sign and did not continue to receive research. First of all, Andy Brooks is the head equity trader at T. Rowe Price and he implored me today that if I said anything right, versus saying something wrong, to get the point across that when it comes to whether you're getting the lowest possible commission, that really pales in comparison to whether you get best execution. That you can clearly get best execution even though you may pay a higher commission rate. And that is not true for all types of transactions, but certainly for the more difficult transactions which traders pride themselves on doing better than anyone else; that is, that is, the rule of the game.

What I'd like to do just briefly is to give you an overview of how we approach the whole area of brokerage and trading at T. Rowe Price. First of all, for many, many years, we have had what we call the Equity Brokerage Control Committee which basically looked at soft dollar arrangements. The control over the trading function was really spread out among many different people in the firm. Recently, we decided to bring together all of those oversight control arrangements and to put it under the one committee which previously had been the committee that was just looking at soft dollar arrangements. That committee is now called the Equity Brokerage Trading Control Committee. We have similar committees, one for our fixed income taxable and one for our municipal bond department. Obviously, when it comes to soft dollar arrangements, those are not major players in the other two areas. It's solely on the equity side.

To give you an idea of the importance we place upon this entire function, the members of the committee are the head of the research department, we have the head trader, we have a representative from legal. You always have to have a representative from legal on every committee. And Jack LaPort, who's in charge of all small investing, and David Testa, who is the Chief Investment Officer of the firm and also a member of our Management Committee. So this is clearly a high-powered committee which is really representing all the constituencies within the investment side of our firm. Whereas, in years past this committee solely was responsible for overseeing and, in fact, improving every and all relationships with soft dollars, the committee now has a far broader oversight function. Number 1, in addition to approving and denying all soft dollar requests, it also oversees the allocation of trades among clients. That is, the formal procedures which we have written up and are placed within the trading department manual which govern how we allocate trades among clients.

As an example, if you have 10 clients that have put in orders totaling a million dollars in one security and you only execute half that order during the day, how do you allocate the half-million dollar of a million dollar trade among the clients? These procedures make certain that over a period of time every client is treated fairly and equitably. The committee also reviews best execution. It reviews trades to make certain that the trading department on an overall basis, on individual trades, is achieving best price and execution.

It also generally reviews commission levels. It reviews all cross-transactions. Now, as you know, Rule 17a-7 requires that all cross-transactions effected must be presented for approval by the boards of the funds effected at the meeting. But here we also have an internal committee which reviews all cross-transactions before they go to the boards to make certain that there are no problems. They also monitor the use of affiliated brokers and underwriters under Investment Company Act rules. Finally, it reviews with great care the statements made in our ADV as well as in our prospectuses and statements of additional information regarding our brokerage and trading practices, including the allocation of trades for soft dollar services. So the committee is by far a major oversight committee. Even more so, it is responsible for maximizing our relationships with all of our brokers. Even if we did not have the ability to soft dollar services, we would still have this committee and the committee's responsibility would be to make certain that the trading department was, in fact, using the brokers that we deem have given us the best service to the maximum extent.

Mr. Eisenberg:  And your position is that you do not pay up? Is that right?

Mr. Hopkins:  The position is as stated both in our ADV and in our fund prospectuses and statements of additional information is that we do not knowingly pay up. As an example, Instinet has two levels of commission payments. I'm not exactly sure of the exact cents it is, but if you wish to, let's say, receive soft dollar services, you would have to pay at 6 cents; whereas, if you did not want to receive any credit for soft dollar services, you would only pay, let's say, 2 cents. The feeling is that if we are paying the 6 cents, we are clearly paying up, so we do not receive an soft dollar credits via Instinet because of that two-level commission structure.

Mr. Eisenberg:  Do you think people that pay 6 cents a share are paying up?

Mr. Hopkins:  In that context, they clearly would be. On a quarterly basis, this committee reports or meets and reviews the objectives and targets it has established at the beginning of the year. As an example, after soliciting and receiving extensive input from all the research analysts and portfolio managers, we basically rate all brokers to try to develop some target percentages as to the amount of business that we would like to place with those firms. We also get dollar suggested amounts based upon the same type of survey. What we want to do is to make certain that the – that the research we receive from broker-dealers, the research which is of great benefit to us and which has assisted us in making rewarding investment decisions, that those individuals are rewarded by receiving the lion's share of our brokerage allocations – always consistent, of course, with best price and execution.

Mr. Eisenberg:  Are there members of the boards on this committee? Or are these just management people?

Mr. Hopkins:  This is a committee solely of internal people. On an annual basis, we review with the boards our entire brokerage program, including the various policies that we have developed as to how we allocate soft dollars, our policies on execution, best execution, as well as the policies relating to how we allocate trades on a fair basis among clients. And, so, the boards of our funds are well aware of what our formal, written documented policies are. And they approve of those. On a continuing basis, they receive mandated reports, such as the reports on cross-transactions, use of affiliated brokers, on underwriters, as well as getting information overall on our brokerage and the commission rates that we are generating.

Mr. Eisenberg:  You give them average cents per share and the rest of that kind of information.

Mr. Hopkins:  Right. As far as the directors, themselves, you know, reviewing trades on an individual basis, they do not do that. They simply approve our policies and we give them overall reports at the end of the year which basically quantify whether we have or have not met the goals that we have established at the beginning of the year. So that's how we do it. Now, Heidi can tell us how they do it.

Ms. Stam:  Okay. Thank you. I'll start my discussion with a very fundamental premise and that is that commissions are valuable assets of the fund and the fund shareholders. Commissions and transaction costs are unavoidable in the purchase and sale of securities. These costs reduce the total return to fund shareholders and really they should only be incurred when the portfolio manager expects that the transaction will benefit the fund. Commissions should not be used to benefit the investment adviser. After all, commissions are paid with the shareholders' money and so it's only right that the shareholders get the benefits from them. And this is the foundation of Vanguard's approach to any question involving brokerage allocation. I think it is important to start with a fundamental policy. Now, I'll give you a little bit of a sense of how it works in practice. I'm going to cover a few different topics; (1) best execution, (2) use of directed brokerage programs, (3) soft dollars, and I'll talk a little bit about monitoring and how we do that. Every adviser has a duty of best execution. And what exactly does that mean? Put very simply, a client's total cost or proceeds in each transaction should be the most favorable under the circumstances. But it is very important to note, and I think Henry made this point as well, that cost in this case does not equal commissions paid. It's the quality of the execution in terms of the market impact that is a key determinant of the total cost of the transaction to the fund. Let me give you a simple example. There is surely no benefit to shareholders if we save 3 cents a share on a commission when the trade is being executed at 6 cents above the market price for that share at that point in time.

Mr. Eisenberg:  When you're talking about cents per share, you're presuming that the execution is going to be the best execution and that cents per share is a separate component. Now, I understand that you look at the whole trade.

Ms. Stam:  It's a totality. I mean we're looking at a lot of factors here when we determine what is best execution. I'll go through some of those factors for you. We look at all of our trades on the basis of market impact and we look at it from a number of different perspectives. We actually, you know, sort of slice this data numerous different ways so that we can see what the quality of our execution is. So we look at the total cost of execution by fund. We look at it by adviser. We look at it by broker. We consider whether we have a widespread distribution across the brokerage community. We consider how our execution compares relative to the experience of the marketplace. We consider the data short term and long term, how has it been over the last quarter, how has it been over the last year, how has it been over the last five years. We look at the trends. Is the total cost going up? Is it going down? Is it relatively flat? The analyst or analysts who interpret this data take into account many different factors which might affect total cost and there are countless factors that go into the equation. Some of them would be, for example, the availability of an electronic-crossing network, the funds' investment strategy, an investment strategy, an investment objective, the size and timing of trades, and there are just countless other factors that come into the mix.

All this information and our analysis is shared with our fund board and if the data were to suggest that there was a question about the selection of a broker or the quality of the execution, we would investigate that matter immediately and report our results to the board. Consistent with our fundamental policy, that commissions are valuable assets of the fund and its shareholders, we have successfully used directed brokerage programs to reduce the expenses of our funds. For example, our board has approved a program whereby we ask our advisers to direct a portion of their trades through brokers who will rebate a portion of the commission back to the fund. The rebates are used to offset regular administrative expenses of the funds, such as custodial fees. We believe that these directed brokerage arrangements provide direct and very tangible benefits to our shareholders. For example, if we look at Vanguard's Windsor II fund for the fiscal year ended October 31, 1998, the funds' direct brokerage arrangements resulted in a savings which is equivalent to .01 percent of the average net assets of the fund.

Now, while that does not seem like a very large amount, let me put it to you in dollars. At the size of Windsor II, 0.1 percent of average net assets amounts to more than $2 million in savings for that funds' shareholders through our directed brokerage program. And all of these amounts are fully disclosed in the funds' shareholder reports. Now, while we strongly believe that directed brokerage arrangements can benefit our shareholders, directed brokerage – directing brokerage through a particular broker has to be beneficial only if the execution is good. And, again, we are always concerned with the total cost of the trade to the fund. So as with all of our trades, we are going to be looking very closely at the total cost of the trades executed under our directed brokerage. And, in addition, the advisers who are participating in these programs do not have any commitments to use any particular brokers so that they are free at all times to exercise their duty of best execution. Let me shift a little bit and take a little bit of a look at soft dollars. Again, consistent with our fundamental policy that the fund is the entity that should be benefiting from the commission dollars, we have a pretty stringent policy with respect to the use of soft dollars.

We do not use soft dollars with respect to our internally managed funds. For some of our actively managed equity funds, we do recognize that there can be more than one broker that is able to obtain the best available price and most favorable execution for a particular transaction. And in that case, our advisers are authorized to select a broker who provides research services, but the research services have to be used by the adviser to benefit the fund. And in these cases, we are really talking about research that is generally provided to all clients who trade with the broker and while volume of trading may be a consideration to the broker in determining which clients receive the research services, the advisers to the Vanguard's funds do not have any firm commitments to trade with any particular broker. I mean, obviously, our volumes are very high, so in many cases, we are reaching volumes that well exceed any brokers' expectation of trading volumes.

Mr. Eisenberg:  Heidi, you're talking about the sub advisers? The nine or ten funds that we heard about this morning.

Ms. Stam:  I think it's 32.

Mr. Eisenberg:  32. 32 sub advisers. And they can go ahead and they direct the trades to the brokers. Ms. Stam:  Yes, they do.

Mr. Eisenberg:  Right. Now, do they pay up?

Mr. Eisenberg:  No. None of the Vanguard funds are authorized or permitted to pay up at all. So even the advisers who do use what we are referring to collectively as sort of – as soft dollars, they are not paying up for any of these materials.

Mr. Eisenberg:  So if we were to compare the level of payment of brokerage rates with the sub advised funds and with the directly advised funds, you would come out with the same price.

Ms. Stam:  I think you're going to be seeing a real range of prices depending upon the nature of the particular transaction and the particular fund. As I mentioned at the beginning, what goes into that equation of what constitutes best execution for any particular transaction takes into account a number of different factors, and you cannot just lump everything together and say, "On average, you know, what is best execution?" You have to be looking at the fund involved, the nature of the trade, the difficulty of the trade, the timing of the trade, and, you know, the fund involved. For example, on the Index funds, a very important objective of those funds is tracking the Index. And, so, the people who are trading for those Index funds are going to have that in mind when they are executing their trades, unlike an adviser to an actively managed equity fund who might have other considerations in mind and their trading practices may be different. But the fact of the matter is when we analyze the data, we take that into account. And that's what our internal analysts do. They will get the data, they will see the comparative data, but they understand what the fund's objectives are and what they are doing and they are able to run down any issues that arise.

Now, let me say, no – no Vanguard fund will pay up for research services, but again, monitoring is of key importance to us, and we look at all of our trading activity on a regular basis. To the extent particularly that we engage in directed brokerage or soft dollar arrangements as I described, we are looking very closely to make sure that our total trading costs are the lowest they can be under the circumstances. Monitoring for these purposes include regular discussions with our advisers regarding their trading practices, regular reporting to our internal staff and to our board, extensive data analysis, and periodic audits that we conduct internally.

Mr. Eisenberg:  Heidi, does your – do the Vanguard funds have a committee of the board which reviews brokerage practices?

MS. STAM: The entire board reviews brokerage practices on a regular basis and when each of the funds are reviewed – which the funds are reviewed on a regular basis, and they talk with the portfolio managers for those funds, you can be sure that they're going to discuss the funds' trading experience and best execution at that time as well, in addition to the regular reports prepared for them internally. I guess if I – if I could sort of sum up how I think the issue should be approached, I mean if you're talking about, you know, what should the advisory company be concerned about and what should the board be concerned about, I think it's very important – I mean there's really a range of practices that are permissible under the law and that can be accomplished consistent with the best interests of the funds and the shareholders. I think it is very important for the advisers to insure that they are providing the boards with a very clear statement of what their philosophy is and what their approach is to brokerage allocation and, in order to insure that the board understands that approach, to provide them the information the board needs to understand how that philosophy, how that approach is being implemented. If you look at the flip side and consider what fund directors need to be doing, they need to understand the adviser's philosophy. How is the adviser approaching this issue of brokerage allocation, soft dollars, directed brokerage, and they need to be able to understand as a general matter how these allocations are made. They should be receiving the information they need to analyze the activity so that they can satisfy themselves that the funds' brokerage, a very valuable asset, is being used for the benefit of the funds shareholders.

Mr. Eisenberg:  Let me ask both of you, first Henry, Heidi talked about recapture and the directed brokerage arrangements which are used, at least to some extent, for the benefit of the funds in the sense of reducing expenses. Does T. Rowe do that, also?

Mr. Hopkins:  We do not do that. This is an issue which was brought to the boards and it's really their final determination as to whether to seek to do that or not. One other point I'd like to make and that is that even though we have a committee which oversees this, we really have about 40 individual people that oversee it and those are the portfolio managers. I can assure you, you know, their compensation is, to a certain extent, based upon how well they perform. And if they are not getting an excellent job performed on the trading desk for their fund or funds, they are going to raise a lot of issues. And so the portfolio managers are also really the watchdogs to make certain that the trading function is being performed up to snuff.

Ms. Stam:  I totally agree with what Henry's saying. I mean the portfolio managers care intensely about the quality of their execution. So to the extent that the firm and the board has sort of watchdogs on the job to determine what kind of execution they're getting, I think the portfolio managers do serve that function.

Mr. Eisenberg:  Yes, but some portfolio managers are torn – a lot of portfolio managers never saw a research report that they couldn't do without.

Ms. Stam:  We have plenty at Vanguard.

Mr. Eisenberg:  So, yes, they want to get best execution for performance. On the other hand, they need or want the street research. What do you feel about unbundling? Supposing that there were moves made by the Commission to push the unbundling of research from execution so it at least was identifiable? Is that something your management company would support, Henry?

Mr. Hopkins:  I think, you know, if we were to ask that question and, again, I have not asked the question so any response I have is purely a guess; but I think that their view is that the current system seems to be working well. There is a lot of the third part research which is of significant value and the payment of those through the soft dollar allocation seems to be working well. I will say that we are not a proponent of excessive use of soft dollar commitments. In fact, for the last few years, we have only utilized about 10 percent of the available commission dollars to satisfy any type of research, sort of semi-commitments. So, it's still – it's a fairly small percentage of our commission business, and the trading department likes it that way because it gives its – it gives it its maximum flexibility in being able to really go anywhere they think they can get best price and execution as opposed to fulfilling any type of soft dollar commitment.

Mr. Eisenberg:  Heidi?

Ms. Stam:  I think that as you mentioned, you know, portfolio managers and trading departments, they understand what research is valuable to them, and they understand what they don't want, perhaps. And I think that, certainly, we would not have any problem making determinations based on hard dollars as to what we would like to purchase and what we would not like to purchase. So I don't think we would have any objection to unbundling.

Mr. Hopkins:  The only other thing you have to understand is that the third party research which sort of has a price tag on it really represents only a very small percentage of the overall research we're provided by brokers. And, so, even if there were not – if there was not a Section 28(e) and even if we did not receive any third party research, we would still have this committee which would oversee and develop targets for brokerage firms based upon what they have brought to the plate. Have they been valuable in providing our research analysts and portfolio managers with ideas? How they executed transactions. We certainly want to reward those brokers that have performed well in the past year, both in the trading function as well as in the research function.

Mr. Eisenberg:  Let me just ask the two of you. You represent very large fund complexes, among the largest in the country. Put yourself in the place of a counsel to a smaller, more modest fund group which does not have the brokerage clout that either Vanguard or T. Rowe has. Is what's good for you also good for them?

Ms. Stam:  I really think you have to ask them. I think it's a little unfair for you to ask us. I don't know, maybe Henry can do better.

Mr. Hopkins:  We certainly know a lot of smaller shops in Baltimore, some of which are offshoots of our firm, and I will say that they certainly have had no problem getting research coverage. So I think the brokerage community has done a very good job in providing coverage to both large and small firms.

Mr. Eisenberg:  Now, before we turn to the brokers, just try and give us an idea of what percentage of your brokerage is done through electronic trading or alternative systems which range closer to 2 cents a share than they do for the 6 cents a share?

Mr. Hopkins:  Certainly. The electronic methodology for effecting transactions has been growing over the past few years. Currently of our listed business, about 10 percent is effected electronically. When it comes to over-the-counter, it's about 12 percent. So this is a growing area. With the advent of certainly the Index funds and the semi-Index funds, electronic trading is certainly a wonderful alternate way of effecting transactions and I would just surmise that we probably will continue to increase the percentage that these effected electronically.

Mr. Eisenberg:  What are we talking about? 12 percent of what? I mean, how much?

Mr. Hopkins:  Our total commission dollars I think was around 43 million. That's straight commission listed.

Mr. Eisenberg:  Heidi?

Ms. Stam:  I don't know if I can give you that figure, but we do use alternative trading systems extensively. As you know, we have a large, a large number of funds that are indexed and those trading networks are very efficient for trading the large baskets of stocks that we trade for the index funds. I would point out that – and we do use them to a great extent. I don't know that I could put a percentage on it for you, but I think it's certainly in excess of 10 or 15 percent. It's closer to 25 percent for the index funds. I would point out that the way these alternative trading systems work, it is not going to be the ideal marketplace for every trade. Again, going back to the initial analysis of what constitutes best execution, you have to take into account what it is you're trying to accomplish for the fund, what is the fund's investment objectives, and how is that fund and its shareholders going to be served by how you implement this trade? I think that is a factor that certainly comes into play.

Mr. Eisenberg:  I want to ask Jim Smyth of Merrill, who heads, in effect, their soft dollar arm, to describe how that works, what they do, and then ask Duncan to follow up along the same lines, and then we'll get into a little further discussion.

Mr. Smyth:  As Mike mentioned, I am responsible for Merrill Lynch's domestic soft dollar business and also responsible for the coordination globally of Merrill Lynch's soft dollar product. Citation is Merrill Lynch's designated soft dollar service provider. It was created in 1985 to offer our institutional customers the opportunity to use agency listed equity activity to obtain independent third party investment- related research and services. Citation handles all soft dollar sales and administrative functions, which include relationships, direct relationships with the fund managers on all soft dollar activity, reconciliation of soft dollar activity with those managers, the distribution of monthly soft dollar reports detailing the fund managers' global trade activity, vendor payment detail, and commissions generated.

We are also responsible for vendor coordination, where we handle all vendor activities, including review of all submitted invoices for 28(e) qualification. We have a dedicated person who works with the vendors, as well as a general counsel on premises to review services where appropriate. The written agreement that we have on behalf of the fund manager is between the vendor and Merrill Lynch Citation, not between the vendor and the money manager, and we assure that all invoices are sent directly to Citation as opposed to being sent directly to the money manager. To digress a minute, if I may, proper control from a management standpoint is clearly our number one priority in this business, and obviously we consistently review our control practices to assure they are properly adhered to and assure employees are complying with proper procedures. From a trading standpoint, I thought I would describe how we interact with Merrill Lynch. Citation does not have its own trading capability, per se, but instead uses Merrill Lynch's listed equity sales and trading personnel to execute soft dollar trades on behalf of fund managers, thus assuring seamless, best execution and one-stop shopping for our fund manager customers.

Merrill Lynch agrees – and we've talked a lot about best execution on this panel – Merrill Lynch agrees with many independent surveys that find the commissions are actually a very small part of the total execution cost on any trades. Market impact or quality execution is a significantly more important factor. Merrill Lynch commissions, which, by the way, are the same for Merrill Lynch's own internal research versus soft dollars, so I think the term, Mike, that we used, was pay up. Customers do not pay up from a commission standpoint at Merrill Lynch.

Mr. Eisenberg:  Do you have a posted rate? Do you have a standard rate which yields the services that your affiliate provides?

Mr. Smyth:  The rates differ by customer.

Mr. Eisenberg:  Do they differ by service?

Mr. Smyth:  Tell me what you mean.

Mr. Eisenberg:  In other words, you have one level of service and you pay 6 cents a share for it. You have another level, like the Instanet thing –

Mr. Smyth:  No.

Mr. Eisenberg:  – you have another level of service.

Mr. Smyth:  No.

Mr. Eisenberg:  You pay 4 cents a share?

Mr. Smyth:  No.

Mr. Eisenberg:  So each management company negotiates with you, and you charge them different amounts, or you charge them the same amount?

Mr. Smyth:  Different amounts, depending upon whatever is negotiated, obviously, depending on the amount of volume that is done with the particular fund manager. But if, just to make sure we're on the same page, for a free, as we call it, internally free, or research-type trade, it is the same commission, the same gross commission as a soft dollar trade for a particular fund manager.

Mr. Eisenberg:  And you were told by the Merrill Lynch traders –

Mr. Smyth:  Right.

Mr. Eisenberg:  – that these guys are okay for soft dollars?

Mr. Smyth:  Yes.

Mr. Eisenberg:  You don't care what Merrill Lynch charges them?

Mr. Smyth:  From our standpoint in Citation, we do not get involved in determining what the cents per share is. We will, however, and are the liaison between the manager and Merrill Lynch in terms of determining the "ratio" that could be charged for the services that are provided.

Mr. Eisenberg:  Give us an idea what ratios we're talking about.

Mr. Smyth:  The most common ratios now – and obviously cents per share has been squeezed over the past X years, ratios have also been squeezed. So for your bigger fund managers, you're talking about ratios anywhere in the 1.5 to 1.75 range, approximately. So back to the trading process for a moment. We then segregate. So fund managers are able to use – we don't have our own separate trading function. Fund managers are able to use their relationship person on the sales trading side to execute their trades for best execution. The trades are identified as such by the sales traders from the orders from the fund managers. We then segregate those trades identified as soft into a Merrill Lynch Citation account to facilitate 28(e) disclosure. From a customer service standpoint, we have dedicated customer service representatives assigned to each fund manager client. They prepare and distribute welcome letters to any new clients detailing the responsibilities of Citation and the responsibilities of the fiduciary in the arrangement, in the soft dollar arrangement that we have created. They distribute copies of the SIA brochure on best practices, advise clients of any new SEC releases or developments, and we maintain and review soft dollar accounts on a daily basis with representatives from the individual fund managers, as well as field all customer inquiries which range from trading activity to vendor payment.

Mr. Eisenberg:  Have you rejected requests for soft dollar payments? What kind of things do you reject, things that are obviously not 28(e)?

Mr. Smyth:  Vendor-type payments?

Mr. Eisenberg:  Yes.

Mr. Smyth:  Rent is a clear example.


Mr. Smyth:  Airplane tickets, lodging at various conventions, et cetera. So, you know, obviously, from our standpoint – and in summary, what we'll talk about is the fact that we at Merrill Lynch feel we take a very conservative view. But again, in summary, assuring proper control is really our lifeblood, and as I like to say, what kind of lets us sleep at night. The know your customer principle for us applies to both the fund manager as well as the vendors alike. Citation, it controls and challenges where necessary, and coordinates all vendor payments. We assure detailed record keeping and consistently work with the fund managers in terms of proper communication. Knowledgeable employees on rules and regulations of 28(e) are critical. Our motto is basically, question everything. In general, as I said earlier, we take a very conservative approach or view of safe harbor, and we strive to keep our fund managers – we strive to keep our fund managers, we strive to help our fund managers avoid falling into the cracks of 28(e).

Mr. Eisenberg:  Duncan, do you want to follow up with that?

Mr. Niederauer:  Sure. When Jim and I talked about how to divide up the sell side part of this panel, given that Jim has had about 20 year of experience in the soft dollar arena, and I think I've had about maybe 20 weeks, we thought that it would be good if I talked a little bit more about my trading background, how we view our firm's relationships with our customers, and where we see some of these other services that, to a firm like ours, might have been viewed as nontraditional historically, but have clearly gotten very much into the mainstream of how we interact with our customers every day. So we kind of let Jim handle the administrative and control aspects, which we certainly have things like that in place as well, although not to as large a scale. And I'll try to focus on some of the trading issues. I think our real objective as someone who aspires to be a, or hopefully continues to aspire to be a leader on the sell side is to be a key counter-party for all of our clients, two of whom are sitting to my right, so I'll be careful what I say, and to provide all the necessary services to be viewed as such. Now, historically, I think it was certainly the view at firms like ours that to provide this array of services that one would have to provide to be viewed as a key counter-party was something that we had difficulty, at least philosophically, coming to terms with internally. I think our problem was we were comfortable with the traditional services that we provided, and some of these other services seemed a bit far away from what we were doing. You know, the word "cannibalization" would often come up, et cetera, et cetera.

I think in the new world, I don't know whether we should all think about unbundling mechanically or philosophically, but the fact of the matter is, whether you want to talk about portfolio trades or soft dollar trades – and, you know, I came into this panel, I don't even – I didn't even know what, and I'm not sure I still know what a posted rate is. But we already feel like the way the landscape is being carved up, there are different prices associated with different services that a broker like ourselves should provide, and it should come as no surprise to any of us that the price for each of those services depends on what the client is requesting of you at each point along the way. Now, my trading perspective, in having been fairly involved in our own electronic trading effort, is that those services that we are asked to provide are not just the research and other value added services along the way the clients might ask for, but we also start to evaluate the different services that our clients request of us based on what parts of the firm it has to touch on its way through the factory. Vanguard, for example, does a lot of stuff with us that does not require use of the full Goldman Sachs factory. It tends to very electronic. It tends to be a lot of portfolio trades. It's not quite no touch business, but it's as close to no touch as we come within the walls of Goldman Sachs. A lot of the business that we do with Andy at T. Rowe Price, who Henry mentioned earlier, is more what we would think of as the traditional stuff, Andy calling our sales trader, sales trader talking to the trader, quite often capital commitment required. If it isn't, you know, how do we access liquidity, in the marketplace, et cetera, et cetera? So I think it's our view that, going forward, firms that are only able to provide one or a handful of services will ultimately fail, and –

Mr. Eisenberg:  Is research a part of that? I mean, you talked about using capital, and you talked about facilitating a trade.

Mr. Niederauer:  Sure.

Mr. Eisenberg:  And that's part of execution. Is research a part of that?

Mr. Niederauer:  I think there is still a component of everyone's business that they view as Henry alluded to earlier. In their internal committee, I think everybody wants to still pay firms like us some quotient for the perception of the valuation that's placed on the research provided. I think everyone – and I'll get to this in my conclusions, so I don't want to pre-empt it – I think we're all stopping a little bit short of ultimate totality, which would really be to completely UN bundle that and assign a specific dollar value to that, although I think that might be happening. So I think going forward, we think flexibility, broad array of services, those are going to be the keys to success. I think another thing that we've seen happen is you've got consolidation of assets on the buy side that everyone has read all the research reports about. I think we all agree that's happening. That's also coinciding with continuing fragmentation of liquidity, and I think it's also coinciding with our largest customers' desire to find fewer counter- parties with whom to execute their business. You know, put aside the fact that you might need research from 200 people. You know, I for one, and maybe it's because I've worked at a big firm my whole career, I'm not sure there are 200 firms that can do an effective job of executing, so we're starting to get a lot of clients coming to us saying, "Can you work with us as we try to consolidate our key counter- parties?" I think if we believe that that's a trend that's here to stay, firms like ours are going to have to do a few things, even if historically it's made us a little uncomfortable, to broaden out that array of services that we're willing to provide, and I think some of those are some of the things we're talking about on the panel today. Soft dollars? You know, a lot of you in the room I'm sure know of our stance on the religious right against soft dollars for a long time.


Mr. Niederauer:  I guess as of what, Mike, three or four months ago, we kind of softened that stance, no pun intended, and we can get into later why we think we might have done that. I think even though we are going to be in it, I think it is unlikely you will see a firm like ours be in it to the extent someone like Merrill Lynch is in it. I think we are going to continue to, as we do it, it will be for a very limited number of customers, and they will be – it should be assumed that they will be among our most important customers.

Mr. Eisenberg:  Duncan, is your full service price similar to the price that the Merrill Lynch people charge?

Mr. Niederauer:  Yeah, I would imagine so. I mean, I feel like there's a five or six cent a share rate, that's kind of the standard full service rate, and I guess that's a posted price, so maybe I've learned something today. But if that's the price that's out there, I think Jim said it best, that if that's your sort of standard-bearer price, then that's the gross price for everything and then you just negotiate around that, because different services may have attached to them the payment of other funds.

Mr. Eisenberg:  I just want to make sure I heard this right. If Henry came to you and said, "We want your bare bones rate, we want what Heidi gets," you would give that to them, but their service would diminish?

Mr. Niederauer:  But it's different. What I'm trying to get across is there's different rates for different services. You know, if T. Rowe Price and their active fund management – and I'm using that as an illustration, because it's obviously not the only thing that T. Rowe does.

Mr. Eisenberg:  Let's talk about Fidelity. Pozen is not here.

Mr. Niederauer:  Okay.


Mr. Niederauer:  If someone like that comes into our desk, and only to our regular desk, it is sort of what we would call the, you know, the traditional brokerage that we're all familiar with, and someone else only comes into a desk where there is an electronic transmission of orders, those orders are handled, you know, as a group of orders, rather than each having to be touched, I think it's common sense, I hope, to say that that trade should not have attendant to it the same commission, because I'm not having to provide the same amount of research. That's much more of an electronic model when we deal with the people, and the people we deal with, most at Vanguard them happen to be the class of index fund managers to whom Heidi referred earlier.

Mr. Hopkins:  If Andy comes in with a very difficult trade, which might use your capital, and he says, "I want you to get 2 cents a share on this," it's going to be doubtful that you're going to be able to accede to that request, because the business isn't going to make you any money.

Mr. Niederauer:  Well, it's different, because what I would say is different about that, and this is the trader in me talking, is on a principal trade, where there's real capital commitment to be done, I don't think any of us in this room cares whether it's two cents, four cents, or six cents. I think we care about I'm not buying it from you at a quarter of the figure or, you know, three quarters. So I think that's how we try to do that stuff. And, in our commitment of capital, I think that's another resource that we are doling out consistent with our view of the quality of the customer, and that's the new paradigm that I think we're all trying to work our way through here.

Mr. Smyth:  I think, Duncan, if I may, I think we just need to make sure when we talk about same price, when I gave the example earlier, when I said that the "free" or Merrill Lynch internal research price, I'm strictly talking about listed agency business.

Mr. Niederauer:  Do you mean you do that for zero, Jim? Is that what we're understanding?

Mr. Smyth:  No. But it is that rate, because obviously, in effect, and the way at least I look at it, and I may be wrong, is that basically, because it is not free, Duncan, don't we really soft dollar Merrill Lynch's or anybody's research, for that matter, in effect? So from that standpoint, we're strictly talking listed agency. Again, when we're talking about portfolio trading, when we're talking about over the counter, when we're talking about a capital commitment, to me, obviously, that is something that falls outside of 28(e). So I'm strictly talking listed agency transactions, where there is no adding up or bidding up or whatever term it was that we used earlier, Mike.

Mr. Eisenberg:  Okay. Duncan.

Mr. Niederauer:  Now, I think the other thing that we are very focused on, and I won't spend too much time on this, because if I talk about best execution, too, there's going to be nothing left for Ann and John to talk about here at the end of the panel. But I think it's something that we all struggle with. It's something we all focus on. I think it's at best, especially for institutional firms, a difficult thing to get our arms around, but I think we try to do things at Goldman Sachs that hopefully will serve as illustrations of our commitment to trying to derive it and trying to help our clients navigate their way through this for this fragmented liquidity landscape. I think our objective is to have access to all venues of liquidity so that the clients can access them directly or through us. I think for those of you who are familiar with some of the investments we've made in ECNs and alternative trading systems recently, I think we think it's going to be critically important to be involved in that part of the landscape as well. To ensure best execution, we've got to go beyond just the traditional exchanges. And I think Heidi made the point about that, you know, ECNs may never be an alternative trading system, may never be the be all to end all, but they're certainly going to be relevant as far as we can tell, and I think it's incumbent on us to use them intelligently and help advise our clients on when their use is most called for. Just a few thoughts, and I will be the human hedge clause for a minute. If I look forward and try to make a couple of predictions, these are my own predictions. I don't think these are the predictions necessarily of Goldman Sachs. But some of them might be. I think if we succeed in achieving our objectives and defining a new service paradigm, I think what you will see is that the competitive bar, particularly for sell side firms, will be raised. That's obviously a little self- serving, because we think that's a good thing for us. We want to challenge ourselves. We want to make it harder and harder to be a meaningful counter-party to our most important clients. And I think raising the competitive bar is good for all the participants in this equation, and we stand committed to do that, and we intend to do that by providing this broader array of services.

A few people on the panel have touched on totality. You know, I for one believe that when we think about our relationships with Fidelity or Putnam or Vanguard or T. Rowe, or anybody, you know, IDS, I think that those are all – I think we are going to think about those correctly as we would like to think the clients will, more and more with a holistic view. You know, what are they doing with us, not only in the listed agency world, but globally, in all our different products, in all our different divisions, et cetera. And I think that's the relationships we should all be striving to have. Whether we take that to its ultimate conclusion as Mike was saying a few minutes ago, and you really un bundle everything, if you took totality to its conclusion, we would sit down with all our major accounts in December. We would say, "What's the fee for the year 2000?" And they would say, "Well, it sounds like, you know, we value all your services globally at X," and we would just provide all those services. I doubt it, but I mean that's where it could be headed. One other thing that I would personally like to see happen is, if soft dollars and all these other directed relationships, et cetera, are going to remain an important part of the equation, as long as there's an NYSE and a NASDAQ – and I, for one, would love to see a merger of the two – as long as there is going to be that distinction, and NASDAQ is not a commissionable market, I find it difficult to comprehend, as a practitioner, why the Commission seems to focus on the principal part of risk less principal rather than the risk less part of risk less principal. You know, having traded a lot of NASDAQ stocks in my career, I can assure you there are a tremendous number of trades that are absolutely agency in spirit and in execution. And I'm a little confused as to why, even in the new release, despite some of the AIMR recommendations and the DOL recommendations, I would be on the side that would say risk less principal trades should be taken into account, and we should figure that out, as an industry to try to assess that. It would be great if NASDAQ went to a commission, but if they don't, I wish we would figure it out. Lastly, I think that, as I said earlier, best execution will require us using ECNs more and more and more. I don't think these electronic marketplaces are a figment of someone's imagination. I don't think they're here today and gone tomorrow. I think they will be meaningful and I think it's incumbent on us, as sell side firms in particular, to work with our counter-parties on the buy side to understand how to use them most effectively to achieve best execution.

Mr. Eisenberg:  Duncan, one thing. You said that Goldman recently changed its policy and that you were going to tell us why.

Mr. Niederauer:  I think there were a few reasons, and I would articulate three quickly. Number one is one of our partners, Tom Healy, was invited to be on a couple of the committees that reviewed and made some recommendations about how the rules might be redrafted. I think our being invited to participate in the topic made us feel like we at least had some ability to exert a modicum of influence on the outcome. Number two, I think we are encouraged by the Commission's work and by other groups' work that this whole component of the business seems to be more symmetrical, talking from a sell side person's perspective. We think there's less room for misappropriation. We think there's a much more balanced view in terms of due diligence. And I think that tone of the rules made us feel a lot more comfortable. I would be remiss not to mention the third reason, which is simply, reality would dictate that, you know, I guess it's always a good thing to be willing to change your mind about things, and this stuff is clearly here to stay. Our clients were asking us to be involved. These were not clients that we don't feel we know well. These were clients we feel we know very well. Going back to my point about consolidating counter- parties, we just felt like this was an important thing to do, because it was becoming a increasingly relevant part of the whole, you know, daily volume that was going through, and for us not to participate was probably not only a disservice to our customers, but to ourselves, as well.

Mr. Eisenberg:  Jim, did you want to add anything?

Mr. Smyth:  Just the one thing, which I thought of after the fact, was you had asked a question of Henry and Mike about smaller fund managers, and I don't know whether this really answers that question. But at the AIMR conference in Phoenix last year, I thought it was very interesting on the breakout panel on soft dollars, one of the representatives that I presume was on from Goldman was a small fund manager from somewhere in Florida, and basically he emphasized that soft dollars for him were even more critical than to a T. Rowe or IDS, or any of the other big fund managers. And basically, using the term "lifeblood" again, he basically said that without that, he wouldn't be able to afford, and obviously compete, from an overall research standpoint. So I thought I would just mention that.

Mr. Eisenberg:  Since merger of the New York Stock Exchange and NASDAQ is beyond the scope of this panel, I'm going to ask Ann to turn to the discussion of the point of view of the directors – basically, what information management brings to you, how much, what kind of information, what do you do with it, what do you consider in terms of best execution, and how do you know that best execution and soft dollars are being appropriated correctly? Ann.

Ms. Jones:  Like any other –

Mr. Eisenberg:  Excuse me. I just want to say, both Ann and John represent funds which are retail funds, and not no-load funds, so they sell through brokers, and are not like T. Rowe and Vanguard. Go ahead, Ann.

Ms. Jones:  And, of course, IDS is sold through our network of investment advisers, which is sort of the trademark –

Mr. Eisenberg:  They used to call it a captive sales force, but we don't do that anymore.

Ms. Jones:  No, it doesn't sound right in this age of liberation. The nice part about this panel, I think, from an independent director's point of view, is that we're dealing with an asset of the funds, and therefore something that belongs to shareholders, and our principle job, it seems to me, is to make sure that it's used for the benefit of the shareholders. I wouldn't know best execution of a particular trade if it tripped me. I don't think I need to know that. I think I need to know the policy of the investment adviser about how trades are allocated. I think I need to know what soft dollars are used for to make sure that they're in compliance with rules of the Commission and with basic common sense about are the shareholders benefiting. And I think I need to get regular reports from – in our case, IDS is different from a lot of other funds, in the sense that we have full time in-house counsel for the directors, and a full-time chairman of the board.

Mr. Eisenberg:  That's a little unique, and it might be worth talking about that, especially since Les is in the audience.

Ms. Jones:  He'll correct me if I make a mistake about his role. No, really, I take great comfort in being on the IDS board. I won't say as opposed to some others, but I do think we have some built-in protections. I think Les thinks I put more emphasis on that than I should, but I think it's great to have someone who is there on site in Minneapolis all the time, readily available to ask and to answer questions from the investment adviser. And questions do come up to him on a regular basis on pricing matters and on soft dollars, and he is there with an ongoing dialogue with the funds, and we directors, we also have independent outside counsel, but not used probably to the extent that boards without Les Ogg, who is our general counsel, would use outside counsel. There is, I think, a closer relationship and a more steady and constant oversight available this way, and as I say, I take great comfort in that. We, as a board, we do not have a special committee of the board on brokerage allocation and soft dollars. The report is made to ho board as a whole. We approve the policy statement and we get regular reports on how soft dollars are spent. I know, because the directors tour – "tour" is too casual a word – visit the trading department, talk to the traders on a fairly regular basis, and get regular reports. There is a committee who reviews all of the soft dollar expenditures much like the ones that Heidi and Henry spoke about. There's always someone from the legal department of the investment adviser, as well as Les representing us, and from the portfolio manager and some of the trading desks. And it's regularly monitored. I also take comfort on this subject, as opposed maybe to some others, that I really do think, as both Heidi and Henry mentioned, that the portfolio managers and the independent directors have a lot in common here. We're basically on the same side, maybe for different reasons, in the sense that we are supposed to be the watchdogs.

But the portfolio manager has a huge stake in the correct execution of trades. His compensation, his reputation, his ratings all depend on this. So he is not going to let money be thrown away. In response to Mike's comment that there were some people who never saw a research report that they could live without, the material that the funds, the IDS funds get for the soft dollars, the researcher, are reviewed for usefulness about every six months, and regularly reevaluated both from the point of view of are they used, but also how many people, and how many of the fund analysts and portfolio managers actually use them. And they have a very tough policy. I think more often than not, on a particular day, more things will be rejected not because they are outside the bailiwick of what is appropriate under 28(e), although also for that reason, but they just don't see them as being worth giving up – giving up is the wrong word – and so there is very tight control, And we meet regularly with the, in this case, a young woman, who is, I think, probably chairman, but anyway, the person who does the report for this committee to the board. And there is something about interacting with her and the other members of the trading department on a regular face-to-face basis that it's one of those intangibles, but it does inspire trust or distrust, I suppose, could be. But it so happens this is a very carefully monitored and watched process.

Mr. Eisenberg:  Anne, is it your perception that the trading people negotiate hard with the Goldmans and the Merrills of the world to get the lowest price, and is it your perception also that they're really not paying anything for this research they're getting?

Ms. JONES: As hard as it is for me to say that – because I think I swallow the same way you do, you know, there's no such thing as a free lunch – I think that's exactly right. I mean, I agree with everything that's been said. They do not – price is important as sort of a given. You get – you're big. You have a lot of money to put out there, so you do get the best price. Execution you are very concerned about. And they watch very carefully, and when there are, as there have been recently, rumors or whatever, of a particular investment banking house, you know, being in some kind of trouble, boy, they want to watch that, because the execution and the ability to commit capital is critical.

Mr. Eisenberg:  What about electronic trades and the, I guess, expanding two cents a share, or whatever it is per trade, especially for large capitalized companies?

Ms. Jones:  Well, it's my understanding from talking to the trading department that they are using electronic – you know, they have access to the stock exchange and Instanet, and they are using that more. And I don't know this, but I have to believe that that kind of trading will increase. I mean, it is, the Internet is, even though I wouldn't – don't know how to access it, telecommunications expert that I am, I think it's just going to grow and become a bigger part of –

Mr. Eisenberg:  Having heard here that Instanet has two levels of trading, you're going to go back and check to see which level they're at, right?

Ms. Jones:  Absolutely. But there are built-in protections here. And it's also comforting, as an independent director, to know and have someone, the head of the trading department, say to you, "Look, you know, mistakes do get made." I mean, there is not an operation in this world where a mistake isn't made. They review every trade at the end of every day. They have what they call, I think, an error file. It is immediately reconciled and always, the customer is made whole. I mean, they swallow their mistakes. And that, you know, you see this on a systematic, regular basis with lots of good reports and records, and you feel comfortable about it, but you never let down your guard. You get these reports constantly.

Mr. Eisenberg:  Is some of the trading, some of the brokerage allocated to people who sell IDS fund shares?

Ms. Jones:  I don't believe so. I don't think they pay for shares, selling of shares.

Mr. Eisenberg:  I don't say that they're paying, I'm just saying do they allocate. And if there were, you would take an extra special look at that?

Ms. Jones:  Yes.

Mr. Eisenberg:  To make sure you're getting best execution?

Ms. Jones:  Yes, because market share is becoming a very – I mean, I think that's the whole distribution system and the need to increase market share is, I think, where independent directors need to spend – where I feel I need to spend a lot of my time and focus a lot of my concerns, because I think that's an area where there could be dangers yet to be specified, I think. But I think that's a – this is an area that at least in the IDS funds, and I gather in all of the large funds it's an area that is, probably because the Commission has been clear about what is and isn't acceptable, it's an area that everyone seems to be happy to live within the rules, with the occasional question about what does it really mean in the release. But I think for, the most part, it's –

Mr. Eisenberg:  Would you like to see services unbundled from brokerage?

Ms. Jones:  You know, from the point of view of you wouldn't need these committees doing all this checking and all, I mean, and from the point of view of someone who doesn't really like to haggle about price when I go buy something myself, and I don't really know what I'm getting, it sounds simple. But I think that probably there were good reasons why the Commission agreed to this initially, back in the late '70s or early '80s, whenever, and I'm not sure that I know enough to say that –

Mr. Eisenberg:  You were here when they did that, weren't you? But you weren't responsible.

Ms. Jones:  I wasn't responsible. I'm still not responsible. I really don't know. On the face of it, it seems like that would – the simple approach would be nice.

Mr. Eisenberg:  Okay. John, we'll talk about Putnam and how they view the same areas we have been discussing.

Mr. Hill:  And I'll keep my comments brief, because I think a lot of the practices we have heard discussed here today on this panel are duplicated with some variations at Putnam. I think the key point I would like to make is, at least on a philosophical basis, Putnam trustees take the brokerage issue quite seriously. One, it is an asset of the fund, as several of my colleagues have pointed out. And as a result, we have a general fiduciary obligation to make sure that asset is used both directly and indirectly to benefit the shareholders and no one else. So it's important to us from that perspective. I think we also think it's important, and equally important in some ways, to the issues discussed this morning, such as 12b-1 and management fees, because brokerage expenses are huge expenses of the funds, you know, in some cases probably dwarf what are paid effectively in management fees. So just given the sheer scale, we think it's important. It's also important because investors can look at management fees and custody costs and transfer agency costs and see what their fund is costing, but brokerage is really hidden. This is one area where it is hard for an investor to really know what's going on and whether or not they're being well served. So I think because of that, trustees have a particular obligation to make sure that the assets are being used to get the lowest possible costs and the broadest range of service.

So that's sort of our going in philosophy. Duncan mentioned, and I can understand why, he talked about his clients on the right, and I'm sure when he thinks of his clients, he thinks about the people he deals with on a day- to-day basis. I would suggest that at least at Putnam the clients are the trustees. Your clients in the brokerage firms really are representing the shareholders, because we're the ones who are there to make sure ultimately that it's done right. We do have a robust brokerage policy. Obviously, as Ann and Heidi and others mentioned, we cannot do trading, we cannot look at every trade. So we basically deal with the complexities of the issues and our responsibilities by having a fairly robust policy that's articulated each year in the advisory contract, what we expect, what the policies are, plus the monitoring that we're going to do and the data that is going to be required for monitoring. That's all spelled out in the contract. The policy that's essentially at Putnam is best execution and best net price. Putnam, I think just like Henry said, their stated policy and the stated policy of the trustees is to not knowingly pay up, or best execution and best price. That gets to be complex. It takes a lot of data to analyze that issue. And we get a lot of data. We have a regular brokerage committee that meets on a regular basis to review data throughout the year to make sure that we are getting the best execution at best net price.

Mr. Eisenberg:  You're talking about a board committee?

Mr. Hill:  Talking about a board committee. And it really is dominated by independent trustees. Now, that best execution can be a complex issue. That doesn't mean necessarily the lowest possible price. Probably some of the best execution occurred, in my experience, last August and September when liquidity in the markets melted down. And I will applaud firms like Merrill and Goldman for the way they stepped up and executed trades in markets where there was very little liquidity. Now, those were not cheap trades, I'm sure to shareholders at one level, but at another level, they were very effective trades and done so on a very good basis. Our committee looks at issues when there are special circumstances like that, and just draw their own conclusions. We do want to look at the issue of best execution and best net price, in spite of the complexities. We do get a – I have with me a book that we get on a regular basis that has all the data. This used to be thicker. We're getting smarter, so we can boil it down, to take a look at. But we also look at brokerage allocation, according to the various categories for execution for proprietary research for third party research. We do direct brokerage to use for paying our custody expenses and various expenses of the fund. We do look at, quite heavily and closely, at third party research, what we pay for that. That's actually a fairly small part of the brokerage at Putnam. I think that reflects in some degrees at least the trustees were dubious about the whole enterprise.

Virtually none of the trustees came out of the financial world, and are not familiar with the history of 28(e) and Mayday and all of that, so we look at it more as people involved in industrial businesses who do not understand a lot of the Greek here, and I think we would be just as happy to see it all unbundled and these things priced independently. But again, we look at it quite carefully. We look at the use of brokerage for, as well, for fund sales. Again, that's an issue that we take seriously, because it is so rife with the possibilities for potential for conflict. We want to see, for example, on a regular basis who were the big sellers of the funds and how much brokerage did they get for this period, and we particularly like it when we see the two or three largest sellers of the funds getting no commission directed brokerage for those fund sales. So the bigger the inverse relationship, the happier we are. But it is permissible, and there are some firms that need that brokerage, and as long as there's best execution, because they don't have the research or the services they can provide, as long as there's best execution, we are willing to permit some of that on a limited basis. In terms of monitoring, I would just like to sort of reaffirm something that Heidi said, and that Ann said. One of the best monitors of brokerage, best execution, I think, are the portfolio managers, particularly in most of the large firms where their compensation is set heavily on their performance.

They're the first line of defense to make sure of the best execution, because it relates directly into performance. The second level of monitoring is the trading group, who does this daily. They also use outside sources, such as Able, Moser, and Plexus, to review their trading, which I think is helpful. Again, it's not perfect data, but the more data you can add, I think, to the pool, the better. And finally, you have the monitoring of the trustees, through all these various reports that I have described. On a regular basis, we get together with the head of trading. I think we sort of view it putting him on the hot seat for an hour or two, shoot a lot of questions to him, ask him a lot about the data we see. We're trying to get not just his answers, but sort of a qualitative feel for how he feels about his job, how he approaches his job. I think Putnam did something quite brilliant several years ago. They hired a senior trader on the sales side out of Goldman Sachs, who knew all the tricks and all the trades passed down on the other side, and he's been enormously helpful, I think.

Mr. Eisenberg:  That's why they changed their policy, right?

Mr. Hill:  Exactly.


Mr. Hill:  He's been enormously helpful in, I think, getting our average price commission trades down, I mean agency trades. That's 0.5 cents a share for the last couple of years. He's been quite effective, I think, in helping aggregate our brokerage with a limited number of firms to maximize our clout, not only for research, but for events like last August and September. So I think again, regular meetings with this fellow and his staff are also very important, just so we can look him in the eye and draw our own measure, if you will.

Mr. Eisenberg:  We have a couple of questions. One of the things I wanted to straighten out, maybe ask Duncan, since he's the trader here, would you just tell us about a step-out transaction and how that works?

Mr. Niederauer:  Yeah, I'll take a shot at that, because it's become certainly more prevalent in what we do. And one of the questions that I think was in the overview actually was if we're involved in step-outs, are we typically involved as the person executing the trade and stepping out or the firm to whom the step-out steps out to, I guess.

Mr. Eisenberg:  Steppee, or something?

Mr. Niederauer:  The step-in, I guess, whatever. So it's another one of these things that, you know, for the life of me, I don't, I must confess, I don't understand it. It always seems when you think about a lot of this stuff, there must be an easier way to figure this all out. But what typically happens is, if there is a desire to – you know, a large client has a desire to pay a smaller brokerage firm who is an NYSE member, who can clear their trades, but that firm is not confident that it is – that the person they would like to get those commissions to for payment for other services, they're not confident that that same firm has the distribution or execution capabilities to get a good report for the fund. So the fund will then call a firm like Goldman Sachs or Merrill Lynch, ask us to execute the trade. We execute the trade, and then the client will say to us, "Okay, now that you've done it, and I've gotten a good execution, I need you to step out."

Or effectively, another word that you might hear called, we used this word earlier, "give up," and that doesn't mean give up in terms of put up the white flag. It means effectively take the execution you've achieved and give part of that execution to another firm so that that firm will then report it to the client, book it, charge them a commission, et cetera. It seems like a very round-about way of getting that secondary broker paid, but it's something that we're asked to do, I would say, certainly more and more, not less and less. I don't know if I did that justice. I don't know if anybody wants to add to that, but it's basically, you know, we execute the trade. That way the trade is not in a queue or somewhere, the trade is not broken up, and we typically give not all the trade, but part of that execution. We just broker it to somebody else, who then books it to the actual customer.

Mr. Eisenberg:  But they don't do very much, do they, the other guys?

Mr. Niederauer:  The other guy just books the trade.

Mr. Eisenberg:  He books the trade.

Mr. Niederauer:  Yeah. We execute the trade. We do all the work, Mike, as far as I can tell.

Mr. Eisenberg:  They get a part of that commission.

Mr. Niederauer:  Does that sound fair to you, Mike?.

Mr. Eisenberg:  That sounds like a give-up. How much does he give away, or whatever adjective you want to use?

Mr. Niederauer:  It will vary. And again, if you're looking at totality, I'm not sure we really care, trade by trade. You know, personally, if someone wants to pay somebody $20,000, I would rather give up 100 percent of one trade than a percent of 100 trades. But, you know, I mean, it's usually viewed – again, it's viewed more holistically.

Mr. Smyth:  I think you'll find that, for the bigger brokers like Merrill and Goldman, that step-outs where we're doing the execution by far exceeds the step-ins where execution is done elsewhere and the commission is given up to another broker.

Mr. Eisenberg:  Okay. There are a couple of questions that have been sent up. Let's see. Jim, let's say your funds wants Bloomberg machines, which cost Citation $1,000. Do you charge the fund 1,000 times 1.75, which equals 1,750? If so, how does a director judge best execution?

Mr. Eisenberg:  The way the process works – and again, when I talk about ratio – is that if a Bloomberg machine is $1,000, as stated, we will basically look for $1,750 in commissions. So, in effect, the ratio that we talk about applies to the vendor amount, and in effect, what we're looking for from the individual fund is, if it's 1.5, it's obviously $1,500 in commissions; if it's 1.75, it's 1,750. So the answer is that it is the 1,750 in commissions that we're looking for.

Mr. Eisenberg:  Henry, since T. Rowe Price finds the research it receives so useful, that is, valuable, don't you need to presume that you're paying up? I.e., if a broker is not providing the data, the commission would be lower?

Mr. Hopkins:  Well, the brokerage houses are not unbundling, so we are basically paying the same rate we would on any other transaction, regardless of whether we were soft or not.

Mr. Eisenberg:  Heidi, why doesn't Vanguard refuse research and demand to pay a lower brokerage fee, or else stop dealing with the broker? That's a tough position.

Ms. Stam:  Actually, we're very successful in getting, you know, the research we want, and not accepting or not taking materials that we don't want. On our index side of the house, I think as I mentioned, we tend to get a lot of material. We don't use it. We don't want it. We don't look at it. We know we don't pay for it. You know, our commissions, we look at them very closely, and particularly on the internal side, and these guys could probably tell you, we're clearly not paying for any research materials. So we kind of, we know, and this is not a problem for us. We suspect that there are issues out there with respect to other advisers who need to get a certain amount of research, and we would rather see them, you know, we certainly think they could pay for those materials in hard dollars.

Mr. Eisenberg:  To the two independent directors, if your management companies use soft dollars, do you re negotiate the advisory fee, since that involves reimbursement for research expenses?

Mr. Hill:  That's an interesting point. Each year, when we do our annual contract negotiations, when we think we're through in terms of decisions we've made, we then array all of the fees, compensation that's going to flow to the management company, based on the assets at that time, And one of the fees/assets for the management company that goes into our calculation is, in fact, the soft dollar expenses, which arguably is money that they would have had to spend out of their own pocket, if they wanted that service. So it becomes clearly a part of our focus on what we're doing each year in the annual contract in terms of total compensation, which to us is the only – the only way to look at compensation is total compensation.

Ms. Jones:  I can't improve on that. That's basically the way we handle it, as well.

Mr. Eisenberg:  Heidi and Henry, do your portfolio managers conduct a regular and vigorous analysis of execution quality amongst all the marketplaces, and do you do it quarterly?

Ms. Stam:  Yes. We do a thorough analysis of all the marketplaces, and our analysis will take into account all the different markets in which we trade. And they're very aware, as I think we have said consistently, and everybody on the panel has said, as to what the activity is, and the portfolio managers and the traders know exactly what the activity is in the different markets. And to the extent that we then take that data and then scrub it down again, through internal analysis, we're very much aware of what is going on in each of the marketplaces.

Mr. Eisenberg:  Go ahead, Henry.

Mr. Hopkins:  Our portfolio managers, I think, would view every trade as it occurs, and as it impacts their account. As I mentioned, they are very interested in the quality of the execution they're receiving from the trading desk, and they review it with great care and scrutiny.

Mr. Eisenberg:  And that winds up this panel. I hope that we have cast a little light, and not just heat, on this very difficult subject. We will take a 15-minute break. I would like to thank the panelists for their input, and please be back at 4 O'clock for the panel on valuation of securities and portfolio liquidity.

(A brief recess was taken.)


Valuation of Fund Portfolio Securities and Portfolio Liquidity 

Ms. Nazareth:  Good afternoon. Our final panel today is entitled Valuation of Fund Portfolio Securities and Portfolio Liquidity and I would like to introduce our panelists. Our first panelist to my left is Manley Johnson. He is the co-chairman and senior partner in the consulting firm of Johnson Smick, International. Johnson Smick provides information services on economic and political policy changes in major countries. Mr. Johnson is a former vice chairman of the Board of Governors of the Federal Reserve System. He currently serves as an independent director of the Dean Witter funds. Jean Gleason Stromberg serves as an independent director of the AARP Investment Program for Scudder, which includes 15 mutual funds managed by Scudder Kemper Investments in two managed investment portfolios. She has previously served as director of financial institution and market issues at the US General Accounting Office. She has also been a partner in private legal practice and earlier in her career, she worked at the Securities and Exchange Commission. Julie Allecta is a partner in the law firm of Paul, Hastings, Janofsky and Walker, where she heads up the investment management practice in the firm's San Francisco office. She began her career at the Securities and Exchange Commission where she worked in the Office of the General Counsel. Ed Cameron is a partner of Price Waterhouse Coopers and is global chairman emeritus of the Price Waterhouse Investment Management Industry Service Group. Mr. Cameron has more than 30 years' experience as an auditor and business adviser to investment management clients. Ken Domingues is chief accountant of the Commission's Division of Investment Management. He has previously served as chief financial officer of Franklin Resources, Inc., and is a former audit partner at Coopers and Lybrand. Finally, I have the pleasure of moderating this distinguished panel. I am Annette Nazareth. I am senior counsel to Chairman Levitt. And in my brief tenure with the Commission, I have also had the privilege of serving as the interim director of the Division of Investment Management prior to Paul Roye's arrival. Before we begin what we hope will be a lively and informative exchange concerning valuation of fund portfolio securities and portfolio liquidity, we thought that we would have Julie Allecta lead off with a brief overview of the relevant legal requirements that apply to valuation and liquidity. Julie?

Ms. Allecta:  Thank you, Annette. And thank you very much, Paul Roye, and Chairman Levitt, and Mike Eisenberg for putting together this program. I think we have had some very informative sessions today and I hope that this one will round out the day nicely. Valuation is one of the most critical functions of mutual funds. So far, we have been talking a lot about what goes on behind the scenes but valuation is something that affects every shareholder every day because shareholders have to buy and sell, based on the net asset value of mutual funds. And the importance of accurate daily pricing can't be overtated in this particular industry. There are two sections of the Investment Company Act that really lay out a very simple framework for this function. There is the definition of value in Section 2(a)(41), just a definitional section. And the rule under 2(a)(41), Rule 2a-4, which lays out the guidelines for determining securitie's value. And it is a very simple formula. It says, if there are market quotations, price the security at market. If market quotations are not readily available, then the security should be valued at fair value as determined in good faith by the board of directors. And I think what we are going to focus on in this panel is the notion of when market quotations are not readily available, what does it mean to value at fair value, what does it mean to value in good faith, and what does it mean that the value has to be determined by the board of directors. There are many, many layers of complexity underneath that fairly simple formula. I might also mention that there are some other aspects of valuation in the Investment Company Act. There are special sections that relate to money market funds, Rule 2a-7, and special valuation provisions for debt instruments with less than 60 days to maturity that are valued at amortized cost, which I don't believe we are going to get into. I will also point out that we are laboring here as an industry with very little solid guidance on this important function. The two key accounting series releases, ASR 113 and 118, were issued in 1969 and 1970 respectively. They are in need of updating. The Commission has periodically updated through guidelines to the registration statement, through no-action letters and through other forms of interpretation. But we are really working in an area where a lot of the current guidance has come out of the accounting industry and out of the industry's experience itself. I think with that introduction, Annette, I'll turn it back to you.

Ms. Nazareth:  Okay, thank you. I think I would like to start off by asking some questions of the independent directors on our panel and the reason for that is obviously our focus is on the role of the independent directors in this valuation process. So let me start by asking Manley and Jean, how do or should directors address the increasing numbers of fair value situations that they now encounter, such as foreign securities, thinly traded securities and large positions in small issues?

Ms. Stromberg:  Well, I'm going to break with tradition that has been established on some of the panels today and I am not going to try to sell you our funds.


Ms. Stromberg:  That is, in part, because the AARP program, most of you probably are too young for.


Ms. Stromberg:  I certainly include myself in that group. But it is also, I hasten to add, they are available to anyone and they are very well managed by Scudder Kemper for the more risk-averse among you. More importantly, perhaps, I am not going to talk so much about them and that's partly because I only recently joined the board and so I can't talk about personal experiences so much in this area but that won't keep me from talking. Our funds, I think, as with most funds, rely on the advisers to do the pricing on a daily basis. We expect that they will take care of it under the procedures that have been laid out by the board. In my case, prior to my time, but I am familiar with the procedures. Increasingly, the times that the fair value issues have come up, they come up in the context of on a daily basis and it's up to the advisers in many cases to have to deal with them right away. They don't have the luxury of talking to the valuation committee or the board before they make a decision about how they are going to price. And I could use just as an example what happens when the New York Stock Exchange closes and the prices at that point, nobody knows exactly what they are. That's not a reasonable time for the adviser to consult the board as a whole. Our procedures would, in any event, call for the adviser to deal with the valuation committee which, in our case, has one independent director and one inside director on it. Valuation committees, I think, are fairly common on boards and they differ, for practical reasons in a lot of cases, as much as for philosophical ones. The most important thing is that you can get hold of the people and that they know, have some idea, about pricing issues.

I think just generally that moving on to the board, and this is getting more to answering your question, Annette, there are two kinds of fair value pricing issues that tend to come up and one has come up more recently and that's the more philosophical one, the policy kind of one where, for example, with foreign securities or with market timing or with the AOL kind of situation where you go to the valuation committee, the valuation committee then comes to the board at a regular meeting and talks about the issue and how philosophically the board wants to deal with that kind of problem when it comes up consistent with the prospectus, consistent with the approach that the adviser has taken and with what the board wants to do. The other kind of valuation questions that come up are more specific and more traditional with thinly traded securities or similar things that tend to deal with one particular security. I'm not sure that there is any new learning on that kind of problem. And I think, again, it would go through the valuation committee and then to the board. If it does get to the board, I think it's unrealistic to expect, despite what the statute says and Julie's discussion of how critical this is, I think it's unrealistic to expect the board is going to pull a value – decide on a price by itself. It obviously will have to consult with advisers. And if the only issue were concerning that the adviser was likely not to be conservative enough and all the board had to do was say, well, that's too high, it ought to be lower, that would be easy. But, as you all know, that's not the issue. The issue also has to be correctly priced as best it could be. So it can't be – the price can't be too low or too high. So it is not a question of the board just coming in and saying, we think we'll be conservative. And it is unrealistic to think that that's what is going to happen.

Let me just add one more thing. And that is, I think there are going to be increasing problems in this area, which is one of the reasons we're talking about it, I guess, with more foreign issues, more global kinds of problems, around-the-clock trading, the increasing, although it's hard to see how it can keep on increasing, but the continuing innovative products and innovative securities sort of pressure. I don't think, in light of all of these things, that, what Annette's question is focused on to some extent, the changes that are happening in the markets, that it's going to be sufficient to say that, therefore, the boards have to be even more careful than they were before and that they need better procedures and more monitoring and better oversight. Because, the fact is, the questions are getting too hard and it may be that there aren't any prices in a lot of cases. And it may be that the Commission will have to get a little more involved in setting some parameters for pricing – or at least trying to get some consistency across funds in treatment of some of these issues that keep on coming up. They can – ultimately, I suppose, you could say that at some point, some securities may not be appropriate for open-end companies to invest in. Nobody wants to get to that point. There is a great sort of sense of constitutional right to have open-end funds. But the answer to that is not going to be that the directors are the ones who have to come up with the price and if they can't come up with a price then it's their fault. At least the other possible approach is to define pricing more broadly and have there be more flexibility in it. And have everybody understand that through the prospectus and through the Commission's own concern about errors in pricing and whatever, to recognize that it may not be possible to have specific prices and have that – if that's considered to be a value, have that be something that's recognized.

Mr. Johnson:  I agree that the world is getting more complex and complicated and the financial markets are integrating globally and so fund complexes offer a lot more foreign securities as choices and options for investors. And so it is – these issues will keep coming up. What we generally try to do at the Morgan Stanley Dean Witter Funds is have the board try to adopt a set of procedures that deals with as many cases as we can reasonably think of. For the reasons that Jean mentioned, when these issues come up for fair value pricing and you have to make a decision to get your information in toward the end of the day, it's very hard for a board to discuss these things. So you really have to try to be prepared in advance and I think for that reason we try to cover as many things as we can with a detailed set of procedures which allows a portfolio manager to execute based on a board -approved and ratified set of procedures. When that doesn't work, of course, then the valuation committee comes into play. And in our case that's been relatively rare. But it happens on occasion and we have two board members involved on the valuation committee. Those board members can be any two because of the difficulty of finding board members on the spur of the moment. It is basically who is available among board members to deal with valuation questions. But again, the procedures that we've set up generally deal with most of the fair value questions and, again, those arise when you don't get market quotes. Then we go to broker-dealer quotes and take the average of two and in some cases if that can't be obtained, we go to one. But the procedures cover all of those various variations. Then, if the procedures do not handle a particular case, we go to the valuation committee, which is brought in, sits down with the portfolio manager and other management experts along with outside independent counsel and sometimes the outside auditor to consider the price, the proper price, the reasonable fair value pricing decision. That is generally the way we do it. If these situations get more complex over time, maybe the procedures need addressing for more and more cases. But you can't always anticipate those and from time to time you're going to have valuation committees brought in. But that is generally what we've done in that case.

We find that management has a lot of expertise in this area and there is nothing like a portfolio manager's background and understanding to deal with these questions. We understand that they come in with a bias and a potential bias so we think the independent directors and the outside counsel, the outside auditors are a good check on that. But the expertise is with the fund manager and where we concentrate is on a set of procedures that deal with all of the various situations that might come up. Then, of course, the board meets and considers these procedures as a full board and ratifies these procedures. So that's generally the way we've dealt with the situation. I can see that with a large fund complex like ours, we're able to hire a lot of outside expertise with our outside counsel. We can generally fund the best type of information and services and support sources for our decisions but for the smaller fund complex, where I think a lot of these tough cases tend to come up, where the expertise may not be there and they may not have the financial resources to purchase the kind of support that the large fund groups have, you may need more specific technical competence among the independent board members.

With the larger fund groups, though, I think that we – you really want a set of directors that provide sound judgment but I don't think you need to get into highly detailed technical expertise. I think you are looking for people with business, education, government policy background who have shown sound judgment and can be involved in a pricing committee and judge the adequacy of procedures and are used to dealing with systems and procedures that provide risk control and risk management. But having a director directly involved in actual pricing formulas, I think, is probably not an effective use of a director's time, although that might be a little different for smaller fund complexes where they don't have some of the resources that some of the large fund groups might have.

Ms. Nazareth:  Perhaps we can focus on that a little more because, obviously, the real challenge is for the smaller funds and the directors who have the same legal responsibilities whether they are working for a large fund or a small fund. They don't have the access to the kinds of technical expertise that you're talking about. What do the panelists – how do you think in that case directors can satisfy their duty?

Mr. Cameron:  Well, I think that independent directors shouldn't become involved in the day-to-day process in large, complex groups of funds where fair valuation is a day-to-day task. And if the directors have become involved, the independent directors have become involved in the day-to- day task, then I think that their independence becomes jeopardized because they are becoming part of management. But the portfolio valuation model has changed so dramatically since 2(a)(41) was introduced many years ago, in those days basically funds were investing in exchange listed equity securities and you had one pricing source and today it's far more complex. You've got multiple pricing sources, you've got matrix pricing, you've got dealer quotations and, as Manley commented, you should have multiple dealer quotations. You've got board appointed valuation committees and, as Julie pointed out in her paper, which is available outside, that the valuation committee can be composed of inside directors; it doesn't necessarily have to include outside directors as well because, in this day and age, it's very difficult with the daily requirement to fair value securities to be able to contact outside directors in their various places of business. You've got valuation consultants but as pointed out earlier, it is most important to get the sign off or the buy-in of the portfolio manager when you are fair valuing securities because it very important. But if you look at the increasing complexity of the business that perhaps is appropriate that there be a safe harbor for independent directors or all directors, for that matter, when they fair value securities because, certainly, the Commission has granted a safe harbor when companies disclose forward-looking information or what we would call forecasts. Certainly, if a forecast can be safe harbored, then directors in fair valuing securities in a portfolio using current or historical information could be safe harbored as well and I think there would be a great benefit to that.

(Question from Ms. Allecta.)

Mr. Cameron:  I am not certain whether it does or not but –

Ms. Nazareth:  The question was whether the business judgment rule would provide –

Mr. Cameron:  I don't think that I've heard that anyone considers that they have a safe harbor in fair valuation and therefore I would think that maybe it does cover it. But at least not in the minds of those people who are charged with the task of fair valuation.

Ms. Allecta:  Certainly a lot of the concerns that you raised are ones that I hear because I work with a lot of small boards as well as large boards. And there is a big difference in the resources and the way that pricing is approached. Certain things are common, big or small, and that is the need for developed procedures, rudimentary procedures or elaborate procedures, depending on the context, and some form of delegation. Because I think Ed's 100 percent right, you can't have the board involved in micro management. But you do have to have them involved in meaningful oversight, which means there has to be one or two or perhaps the audit committee or maybe even the full board, has to get some type of regular feedback. And when there are important pricing decisions, it has to have some involvement. I think 2(a)(41) is – does really – and 2a-4 together, does really require more board input on this decision than perhaps some other operational aspects of running a mutual fund. One of the litmus tests that I like to use is how much impact is a particular pricing decision going to have. You can debate the correct price to use for a Malaysian security but if it's only one security in a portfolio that's quite large, it's a meaningless debate in the overall context. A much less interesting or dramatic example might be the CMO component of a securities portfolio. Fixed income securities, the pricing procedures there might have a much more material impact on NAV and so I think the need for board involvement in procedures and guidelines really varies depending on the circumstance. Also before I give up the working microphone, I wanted to elaborate also on something that Jean raised which I think is a very important consideration. Maybe as we move into a more complex securities market, there are some securities that mutual funds should say, we just should not invest in. We are offering this kind of a product and perhaps certain types of exotic private placements or certain types of complex derivatives that are really unique securities just are not appropriate for incorporation in our public mutual fund. I see that decision being made much more frequently now than, say, five or six years ago, in part because these securities didn't exist or weren't readily available five or six years ago and there really is a difference being created. I hearken back to what Bob Pozen said this morning, that there is the hedge fund and there is the retail mutual fund and perhaps we not only have a difference in fees but we have a difference in portfolio composition driven in part by the need for correct daily valuation.

Mr. Domingues:  One other thought that you might consider for the smaller funds if directors are concerned about these kinds of securities not being handled properly, it may be useful for the director group to request a focus on out sousing the pricing function, which will permit going to pricing services or the use of pricing services with extensive experience and also access to pricing information. By the way, I should point out that I am relatively new to the Securities and Exchange Commission. All of my views come from my experience in public accounting or in industry with Franklin. I didn't hear a standard disclaimer beforehand so now you have it.

Ms. Nazareth:  Ken, you've raised an interesting issue. I think when you talk about the necessity of using outside pricing sources and advisers, I guess one of the questions I have is, what is the role of the board in monitoring the performance of those outside advisers and, in addition, what is the role of the board in – you know, in ensuring that the compliance procedures that the board has established are actually being followed?

Mr. Domingues:  That's a very good point. Particularly in the larger complexes where they might find something in the order of thousands of securities that are spread out over a variety of funds, obviously it would be impossible for a director group to even attempt to focus on individual securities. But I personally believe that the director groups should involve themselves in the entire process. Not only procurement with the portfolio management people but also the – how they are accounted for and what the settlement arrangements are, the pricing and fund accounting. I think if you, as director groups assign representative directors that can get into the process, it will tremendously improve their understanding of how it works and that will lead to a desire for more information. For instance, if the fund group uses multiple pricing sources, it would be very prudent to have some of the third party pricing vendors put on a presentation for the board group, talking about the different kinds of securities that the fund will invest in. And also have the pricing vendors explain the nuances of how their individual portfolios are developed by the third party pricing source. So it is a very appropriate activity for a board to become involved in.

Mr. Cameron:  Mutual funds don't have employees so they are in the enviable position they never make mistakes then. But if you are using a pricing source, the directors have the same oversight responsibility for an outside pricing source as they would for an internal pricing source. I think the responsibilities for oversight are the same.

Mr. Domingues:  That's true and most of the individual contracts that I have seen from the pricing sources all disclaim responsibility for their end product. They won't stand behind it and so that's even more reason that the directors should become very acquainted with the process and skills of the individual people that developed the matrix procedures that will be applied to the individual funds. So it is very important that the directors have a very deep understanding of how this process works.

Ms. Allecta:  So is it fair to say that there is consensus that while the directors don't have to ensure the accuracy of prices, they do have to understand the process, they do have to take responsibility for making sure there is a coherent and well understood process within the mutual fund organization?

Mr. Domingues:  Yes, I think so. There are a number of soft decision areas in the whole pricing process, tolerance tests, whether a security is acceptable, depending on the kind of security it is. If it's an emerging market security, the variance is going to be larger than it would for a domestic security, for instance. I think the directors need to weigh in on what kind of variance that they as a group are willing to live with to produce the result that is applied each day, usually on an automated basis, to come up with a daily net asset value for the funds.

Mr. Cameron:  I think in the fair valuation process, the process is much more important than the price ultimately determined, because that provides the basis on which the fair valuation process is done on a consistent basis, because if there isn't consistency in the process, that you're going to have aberrations in the price from day to day, if the individual fair valuation prices are determined without taking into consideration a consistent process.

Ms. Allecta:  Do you think shareholders, as a group, understand that the identical security in two different mutual fund portfolios could be valued, whether it's called market or fair value price, at a different price each day, that there is some degree of variation in pricing? Because I think that's a point that's not that well understood. And Ed's right. There are, particularly in a fair value area, there is no one right price. It's a subjective process, and it's having a fair process that gets to a reasonable price that is critical.

Mr. Cameron:  And there could be no one right or correct price, but there are also many different ways that you can fair value a security and reach a different conclusion.

Ms. Stromberg:  You may have noticed the independent directors are being quiet here. I'm not sure why Manley is, but I know why I am, and that is, listening to the lawyers and the accountants tell me that I'm the one who needs to understand all the processes and how the pricing works and everything else, I'm finding a little intimidating, because I thought they were the ones who understood that, and that they were the ones who would help me understand it. It's true that ultimately it is up to the director to have an understanding and to be sure that the procedures are in place and that there are compliance procedures and oversight. But far be it from me to tell you what the best procedures are, when I have before me Price Waterhouse's, you know, published book on what the best procedures are. I think we as directors look to our advisers to help us in this, and to take some responsibility for it, too.

Mr. Johnson:  Well, I would agree with that point. I mean, directors can't possibly know all the minutiae associated with fair value pricing. I think again, the procedures and risk control measures taken, I think, are what they should be evaluated on. And there is a question. I mean, when you're going to an outside pricing service, you know, what is the right decision? I mean, you go and you hire the best. At Morgan Stanley Dean Witter, we hire a couple of pricing services, one for fixed income securities and one for foreign securities, who are the renowned specialists in that area, and we basically make our decisions on hiring a pricing service based on reputation. And, of course, we evaluate the various approaches, but I mean, we can't get into the details of actually the pricing formulas, and we rely on the portfolio manager and others to say, "These are very good pricing formulas, these are the most reputable pricing firms, and they will give you the best pricing services." You know, is that where the line should be with directors? That's about the best we can do in that case.

Ms. Allecta:  One thing that's come up a couple of times, and I will point out, it's not always good to rely on the portfolio manager. The portfolio manager bought the security, and has an inherent bias, and edits out, in good faith, sometimes negative information about the price. It is fair, and certainly totally justified, and perhaps the only way to go to rely on somebody in management to give you the investment banking analysis, but maybe pick someone from operations or accounting. The problem is, in a very small fund complex, you maybe only have three people, and the person who is the portfolio manager is also the CEO and the COO, and there is more of a burden imposed on the director to at least listen with common sense, does this make sense, in terms of evaluation methodology.

Mr. Johnson:  Julie, that was my point earlier. And I think, for a large complex like ours, I mean, we've got outside counsel and the outside accounting firms, and we have our own independent directors audit committee. So we've got a lot of checks and balances in our system, but for the smaller complex, it's a little different.

Ms. Nazareth:  Why don't we turn our focus now to liquidity, which I know a lot of you are interested in. Let me ask this question. What is the difference between the independent director's role with respect to liquidity issues as compared to valuation issues?

Ms. Allecta:  I would say that, while liquidity is very important, it doesn't occupy the same central state as does valuation. Funds every day have to value and face valuation decisions. Very few funds face, on a daily, perhaps even ever basis, a real liquidity crunch, where they simply cannot honor redemption within the time frame permitted under the Act. So we monitor liquidity in a less rigorous fashion, because it doesn't have quite the same demonstrable impact on the integrity of the mutual fund itself. But it nonetheless is important, because an open- end fund is supposed to be able to honor redemption requests and maintain reasonable liquidity, and there are prescribed guidelines, 15 percent in the case of non-money market funds, and 10 percent for money market funds. I think the two concepts are often fused together, because often what creates a valuation issue is the fact that there's no liquid market to inform us as to the market price. There isn't that liquidity data point that we need. A restricted security, like a 144A security that trades in an active secondary private market, can have a market price, and a marketable security, because of the huge position owned by the fund in a very thin market, becomes illiquid, may need to be fair valued. So there is a certain crossover between the two concepts.

Mr. Cameron:  To me, liquidity is inseparable from valuation, because there are so many examples of, particularly in emerging markets, in what's happened in the last 18 months or so, that if you've got an exchange listed security and you can get a last sales price on your valuation date, and you've got a 100,000 share position, and that security has traded 10,000 shares in the last three months, is that a liquid security or not? I think that that's a security that should be considered for fair valuation, rather than taking the last sales price. So to me, particularly in certain markets, you cannot separate the concepts of liquidity and valuation.

Ms. Allecta:  How about staleness, Ed?

Mr. Cameron:  Staleness, the same thing is true. We found instances in emerging markets where the security hasn't traded for two months, and there, staleness of a price certainly makes that a candidate for fair valuation, as well, and there are many examples where mutual fund companies have fair valued securities in such an instance.

Mr. Domingues:  From the liquidity standpoint, funds tend to look at that more from a global fund point of view, and address the problems with the cash levels that are allowed to build up, and also to work out arrangements for inter-fund pricing in a fund group, or line of credit arrangements. So it's typically looked at more in a global sense than an individual security by security sense. The larger complexes will also monitor the cash flows during the day each day, to determine whether there is a problem building up, in which case there will have to be some delegated authority from the board at a relatively high level in the fund, to employ emergency procedures, such as inter-fund borrowings to make sure that the funds that are effected are covered, because when you have a crisis building up like we've seen in the emerging market countries, that will require some pretty quick movement on the part of the funds.

Mr. Cameron:  Liquidity could become an important issue with the Y2K problem, now that many fund complexes are increasing their line of credit, because if everyone decides to stuff their mattress, they're not only going to make withdrawals from banks, they're going to make withdrawals from fund companies, as well. So liquidity could be a big issue on the horizon, with Y2K just around the corner.

Mr. Johnson:  We find that a lot of the securities that are illiquid require fair value pricing, and we are very conservative on liquidity at Morgan Stanley Dean Witter. We have never really had a liquidity problem, knock on wood. But generally, we've always stayed well under the guidelines. And, you know, the way things are going globally in the financial world, I think that conservative practices on liquidity are going to be very important, and not reaching for every ounce of return, because I can't think of anything worse for a fund than to not be able to handle redemption. If you want to ruin your reputation, that's the fastest way to do it, I would think. So, you know, we have generally always been very conservative, well under the guidelines, on that, and we're happy to say we never had a liquidity problem, and we continue to evaluate our liquidity guidelines, and I think we'll continue to stay well under the official guides.

Ms. Allecta:  Well, now, to be devil's advocate here for shareholders, I'm paying for the line of credit which is becoming increasingly popular now so that you don't have to worry about liquidating securities because I'm the shareholder and it's a fund expense. And I'm paying for the lost return on the amount of the portfolio that isn't invested in accordance with its investment objectives. You are supposedly valuing the fund that I bought on the price at which those securities could be sold in today's market. So explain to me how I benefit from a conservative policy on liquidity.

Mr. Johnson:  Well, let's put it this way. When the crisis happens and you can't get your money out and the fund is going down in value dramatically, you're going to be happy that liquidity is – you know, is a conservatively followed issue for the fund. Now, again, the prospectus contains all of the information about what you're getting and, you know, there are some funds that are highly risky and they are set up that way and consumers or investors have numerous choices about how they want to invest their money. If it's all spelled out in the prospectus, then the investor knows what he or she is getting. Then, obviously, there are funds available that promise high yields based on higher risk. So I would say that liquidity, you know, there are tradeoffs in those particular cases. But still, I would say even if you are in those types of funds, there are some funds that are more liquid than others in that range. And I would say that it's better to be conservative on that issue than it is to be, you know, stretched for every ounce of return. At least, I think that's generally been our philosophy at Morgan Stanley Dean Witter and we have a lot of happy investors. –

Ms. Allecta:  I don't disagree. By the way, I think this is the kind of dialogue though that directors need to have, need to inquire about what's being done and why, what the rationale is. And perhaps there often isn't enough dialogue on the subject of liquidity and what it's costing and whether it's a value that should be reached for.

Ms. Nazareth:  I'm interested in what type of valuation procedure do the funds normally have when you have illiquid securities. Do you have a really wide bid/ask spread? Are there generally procedures that require that you go out to get three bids and you take the mid point or the lower? How do you satisfy, again, your obligations as a director in appropriately or fairly valuing these illiquid securities? Do you have some examples of how that's done?

Mr. Cameron:  Probably one of the best examples of that was when Drexel failed in the junk bond market. You had spreads like 50 to 90 and what do you do when you have a case like that? I think, again, you follow the process that has been established, whether you take the bid price or whether you take the mean between the bid and the ask or some other convention. But, again, consistency is very, very important. But again I think that the process should be established and it should be rigidly followed.

Ms. Allecta:  Although I would say don't follow the process over the cliff. There are times when you simply can't get three dealers to give you a reliable quote. Well, then somebody has to say, wait a minute, you need another process in this extraordinary situation. Drexel, the total freeze-up of the California and perhaps national municipal bond market after the Orange County debacle, there are situations that really do call for someone to say, we need to do a fair – a real fair value, bottom-up type of analysis. Fortunately, those are rare but they can be occurring with greater frequency.

Mr. Domingues:  My personal experience when Drexel failed is to be sure that you have a backup plan and fortunately we did have a backup plan. We had a pricing service that was very proficient in matrix pricing at the time and so Drexel failed and over the weekend we had a backup source in place, which is another alternative and another reason for directors to insist on a backup in – particularly in these days of very volatile price movements.

Ms. Nazareth:  I'd like to share with you, having been on the other side, having been advising traders on the trading floor on Wall Street when the asking funds suffered their tremendous debacle, it was really interesting to hear the difference in the specificity of what was required of the traders with respect to the pricing versus what had been asked before. I have to say, in that limited experience, what I saw was that prior to the time there were problems, even though CMO pricing is, by its terms, an art probably and not a science, there was really not a lot of specificity as to whether you were to give, you know, the bid, the ask, the mid point, whatever. And it was only when you could see that the funds were really very concerned because a substantial percentage of their portfolios were represented in those CMOs, that there was a very exacting instruction as to how to value the securities. And what was interesting, there was in some cases it was not what the understanding had been prior to that time. So you really were switching. Which sort of again goes back to one of our earlier points, which is what is the role of the independent director in ensuring that whatever the procedures are, it only makes sense if they are actually being followed.

Mr. Johnson:  Our procedure is call for the bid. But, obviously, if you can't get – can't get quotes, then the valuation committee kicks in and you have to work it out and look at your pricing service information and put your heads together. There are some situations where it just takes, you know, a lot of expertise brought to bear in just making a reasonable decision.

Ms. Stromberg:  I think that's probably the norm. That's one of the things your procedures do, is tell you that when things can't be priced within the procedures, then you need to kick it out to somebody else, up to a valuation committee if you have one or to the board if there isn't one.

Ms. Nazareth:  Are there any other – other than, as Ken had mentioned, lines of credit, are there other avenues that the board can take if you do have a liquidity problem with a fund? I mean, obviously you shouldn't be there in the first place –

Mr. Cameron:  You can manage to a higher level of cash which many funds choose to do rather than establish a line of credit.

Ms. Allecta:  There are also some strategies that you can employ that might add more liquidity to the portfolio in a down market where you don't want to sell your positions. We're running short of time and I wanted to mention something that's gotten a lot of play in the press lately that I think is befuddling many boards of directors and that is, when is it necessary to fair value because of changes that have occurred post market closings? And this mostly impacts the international, global funds. This is a problem, really, of more recent origin because funds haven't been so extensively invested in overseas markets prior to this decade. And a lot can happen in our electronically linked world between the time the Tokyo or Hong Kong exchange closes and when the securities traded on those exchanges or traded based on what happens in those markets are priced at 4:00 p.m. New York time. And it has become somewhat popular to essentially fair value, look at those Asian or European closing prices and say, does that still reflect fair value and – excuse me. Well, the fair value, does the market still reflect the fair value and, if not, to make an adjustment. And if you make an adjustment, how and what are the mechanics and do fund groups like Fidelity or Morgan Stanley Dean Witter that have lots of resources have an advantage here that the smaller groups don't resulting in disparity in pricing? Ed, you've maybe had some experience with this?

Mr. Cameron:  Well, I think that there are examples of that and you've probably read that there have been the Asian timers, I guess, for lack of a better word, that when there had been events that have occurred in the market in Malaysia, for example, which is 14 hours ahead of the US, that they would try to front run the market based on that knowledge. And then the reverse would happen when the US market would go up, then they would assume that the Asian markets would go up as well. So I think that there are a number of different things you can do. One is you can fair value on a somewhat macro basis, looking at what the futures market is doing there. You can change the timing of your valuation from the close of the New York Stock Exchange to 9:00 a.m., for example. Or you can try to identify those market timers and prevent the trades or you can institute a back-end load for any redemption within a 90-day period which would essentially strongly discourage the market timers. So there are things you can do but you have to look at the exact situation that you're in. It's very difficult to make a generalization about it.

Mr. Johnson:  You could conceive of a time when there's 24-hour trading. Then you've just got to pick a point, right? But we're far from that yet. But not in the currency markets.

Mr. Cameron:  But they're two different issues there. Malaysia was a good example of that. You've got the securities issue but the bigger issue was probably the currency issue.

Ms. Nazareth:  Why don't we close with a difficult topic, which is pricing errors. I'm sure the terror of all independent directors. At what point are directors typically informed of pricing errors? Ken, do you have an experience with that?

Mr. Domingues:  Often, I would say, it's after the fact.


Mr. Domingues:  When the board walks themselves through the process, it would be advisable to do that so they can see what kind of reports are generated by the system. Again, the tolerance reports. So they can also require a summary of these reports are routinely presented to them for board meetings. It will give them a sense of what's going on in individual prices. Some fund groups even have reports that show how the NAVs of the funds compare, changing each day, to their competition. And the trend of something like that will show – will give the directors a great deal of comfort that at least their fund is in the ballpark. And couple that with all these tolerance reports and summaries about them will again give them a sense of being able to monitor what's going on in the pricing as well as being able to determine what policies are in place for when the system will kick out prices that have not changed in, say, five days, six days, seven days or – and, you know, what is done when these things happen. So there is a way to anticipate it but often, I'm sorry to say, most often it happens after the fact.

Ms. Nazareth:  Jean, do you have any sense of what you'd do in this situation?

Ms. Stromberg:  Well, Manley and I were just agreeing that we would prefer to learn about the pricing error after the fact instead of beforehand –


Ms. Stromberg:  In part because, when we learn about it, we expect the adviser to tell us about it and also at the same time tell us what they've done to fix it. And why it happened and what they've done to make sure it doesn't happen again and where they are going to come up with the money to rectify the situation and that's normally the context in which I think the directors in maybe it's only the lucky funds, but in which the directors learn about the pricing errors is that when they've been solved to some point and then you continue to ask questions to make sure that it doesn't happen again.

Mr. Johnson:  We've generally had a good relationship on the pricing errors with the fund manager. They've adopted an internal policy of just writing the check no matter how small the error and I think they've seen that as a good business practice which we haven't argued with. But because of that, our sense is that they have a strong incentive not to make a lot of pricing errors and generally we don't have a lot but they are always reported back and we review those every board meeting.

Ms. Allecta:  I'm always curious, there is a well- accepted SEC-articulated standard for when a pricing error is so material that it affects NAV and shareholder level accounting. Do boards – Jean, do you ever – are you ever asked whether or not a particular error should result in a check being written to a shareholder, even though it falls underneath a predetermined threshold?

Ms. Stromberg:  No, I've never been asked that but that may be because I've only been on the board for a short period of time. This just reminds me though of something else I think it's important to remember about pricing and that is that the – unlike the other panels this morning where we were talking about independent directors, pricing is the responsibility of all the directors; it's not – the independent directors don't have some special statutory role and as Manley just said, to some extent we all have the same interests. The adviser and the inside directors are no more interested in having pricing problems than the outside directors are in most cases. There can be cases where there is some vague conflict, although unless it is a very material area it's hard to see where the conflict is. But I think it's important that independent directors always have some additional obligations because they are the ones who may feel more responsible as outsiders to understand and deal with issues. But in this case, this is one where in a lot of ways we're all in the same boat and I think it's important to remember that.

Mr. Johnson:  I would agree with that point. I mean, it's important to remember the fund manager does have first line fiduciary responsibilities, just as well as the outside directors. So in that sense, we're in the same boat. But it's true the outside director have a special responsibility in terms of protecting the shareholder. But at the same time, people shouldn't forget that fund managers have important fiduciary responsibilities that put them on the spot as well and give them a strong incentive to get it right.

Ms. Nazareth:  I would like to thank our panel very much.


Ms. Nazareth:  We had a few very good questions that unfortunately we weren't able to get to so feel free to come and ask the panel after this. Thank you.

(Whereupon, at 5:05 p.m., the meeting was adjourned)

Continue on to Part 2 (Day 2 of the Roundtable)