This is the accessible text file for GAO report number GAO-03-763 
entitled 'Mutual Funds: Greater Transparency Needed in Disclosures to 
Investors' which was released on June 16, 2003.

This text file was formatted by the U.S. General Accounting Office 
(GAO) to be accessible to users with visual impairments, as part of a 
longer term project to improve GAO products' accessibility. Every 
attempt has been made to maintain the structural and data integrity of 
the original printed product. Accessibility features, such as text 
descriptions of tables, consecutively numbered footnotes placed at the 
end of the file, and the text of agency comment letters, are provided 
but may not exactly duplicate the presentation or format of the printed 
version. The portable document format (PDF) file is an exact electronic 
replica of the printed version. We welcome your feedback. Please E-mail 
your comments regarding the contents or accessibility features of this 
document to Webmaster@gao.gov.

This is a work of the U.S. government and is not subject to copyright 
protection in the United States. It may be reproduced and distributed 
in its entirety without further permission from GAO. Because this work 
may contain copyrighted images or other material, permission from the 
copyright holder may be necessary if you wish to reproduce this 
material separately.

Report to Congressional Requesters:

June 2003:

Mutual Funds:

Greater Transparency Needed in Disclosures to Investors:

GAO-03-763:

GAO Highlights:

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

Why GAO Did This Study:

The fees and other costs that investors pay as part of owning mutual 
fund shares can significantly affect their investment returns. As a 
result, questions have been raised as to whether the disclosures of 
mutual fund fees and other practices are sufficiently transparent. GAO 
reviewed (1) how mutual funds disclose their fees and related trading 
costs and options for improving these disclosures, (2) changes in how 
mutual funds pay for the sale of fund shares and how the changes in 
these practices are affecting investors, and (3) the benefits of and 
the concerns over mutual funds’ use of soft dollars. 

What GAO Found:

Although mutual funds disclose considerable information about their 
costs to investors, the amount of fees and expenses that each investor 
specifically pays on their mutual fund shares are currently disclosed 
as percentages of fund assets, whereas most other financial services 
disclose the actual costs to the purchaser in dollar terms. SEC staff 
has proposed requiring funds to disclose additional information that 
could be used to compare fees across funds. However, other disclosures 
could also increase the transparency of these fees, such as by 
providing existing investors with the specific dollar amounts of the 
expenses paid or by placing fee-related disclosures in the quarterly 
account statements that investors receive. Although some of these 
additional disclosures could be costly and data on their benefits to 
investors was not generally available, less costly alternatives exist 
that could increase the transparency and investor awareness of mutual 
funds fees that make consideration of additional fee disclosures 
worthwhile.

Changes in how mutual funds pay intermediaries to sell fund shares 
have benefited investors but have also raised concerns. Since 1980, 
mutual funds, under SEC Rule 12b-1 have been allowed to use fund 
assets to pay for certain marketing expenses. Since then, funds have 
developed ways to apply Rule 12b-1 fees to provide investors greater 
flexibility in choosing how to pay for the services of individual 
financial professionals that advise them on fund purchases. Another 
increasingly common marketing practice called revenue sharing involves 
fund investment advisers making additional payments to the broker-
dealers that distribute their funds’ shares. However, receiving these 
payments can limit fund choices offered to investors and conflict with 
the broker-dealer’s obligation to recommend the most suitable funds. 
Regulators acknowledged that the current disclosure regulations might 
not always result in complete information about these payments being 
disclosed to investors.

Under soft dollar arrangements, mutual fund investment advisers use 
part of the brokerage commissions they pay to broker-dealers for 
executing trades to obtain research and other services. Although 
industry participants said that soft dollars allow fund advisers 
access to a wider range of research than may otherwise be available 
and provide other benefits, these arrangements also can create 
incentives for investment advisers to trade excessively to obtain more 
soft dollar services, thereby increasing fund shareholders’ costs. SEC 
staff has recommended various changes that would increase transparency 
by expanding advisers’ disclosure of their use of soft dollars. By 
acting on the staff’s recommendations SEC would provide fund investors 
and directors with needed information about how their funds’ advisers 
are using soft dollars.

What GAO Recommends:

GAO recommends that SEC consider the benefits of requiring additional 
disclosure relating to mutual fund fees and evaluate ways to provide 
more information that investors could use to evaluate the conflicts of 
interest arising from payments funds make to broker-dealers and fund 
advisers’ use of soft dollars.  SEC agreed with the contents of this 
report and indicated that it will consider the recommendations in this 
report carefully in determining how best to inform investors about the 
importance of fees. It also indicated that it will be considering ways 
to expand disclosure and improve other regulatory aspects of fund 
distribution and soft dollar practices.

www.gao.gov/cgi-bin/getrpt?GAO-03-763.

To view the full report, including the scope and methodology, click on 
the link above. For more information, contact Richard Hillman at (202) 
512-8678 or hillmanr@gao.gov.

[End of section]

Letter:

Results in Brief:

Background:

Additional Disclosure of Mutual Fund Costs May Benefit Investors:

Independent Directors Play a Critical Role in Protecting Mutual Fund 
Investors:

Changes in Mutual Fund Distribution Practices Have Increased Choices 
for Investors, but Have Raised Potential Concerns:

Soft Dollar Arrangements Provide Benefits, but Could Also Have an 
Adverse Impact on Investors:

Conclusions:

Recommendations:

Agency Comments and Our Evaluation:

Appendixes:

Appendix I: Scope and Methodology:

Appendix II: Comments from the Securities and Exchange Commission:

Appendix III: Comments from the Investment Company Institute:

Appendix IV: GAO Contacts and Staff Acknowledgments:

GAO Contacts:

Acknowledgments:

Tables:

Table 1: Fee Disclosure Practices for Selected Financial Services or
Products:

Table 2: Current and Proposed NYSE and NASDAQ Corporate Governance 
Listing Standards Compared to those Currently Required or Recommended 
for Mutual Fund Boards:

Figure:

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

Abbreviations:

ECN: electronic communications network:

FSA: Financial Services Authority:

ICI: Investment Company Institute:

NAV: net asset value:

NYSE: New York Stock Exchange:

SAI: Statement of Additional Information:

SEC: Securities and Exchange Commission:

SRO: self-regulatory organization:

Letter June 9, 2003:

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

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

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

To address these concerns, this report responds to your January 14, 
2003, request that we review issues relating to the transparency and 
appropriateness of certain fees and practices among mutual funds. 
Specifically, our objectives were to review (1) how mutual funds and 
their advisers disclose their fees and related trading costs and 
options for improving these disclosures, (2) mutual fund directors' 
role in overseeing fees and various proposals for improving their 
effectiveness, (3) changes in how mutual funds and their advisers pay 
for the sale of fund shares and how the changes in these practices are 
affecting investors, and (4) the benefits of and the concerns over 
mutual funds' use of soft dollars and options for addressing these 
concerns.

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

Results in Brief:

Although mutual funds already disclose considerable information about 
the fees they charge, regulators and others have proposed additional 
disclosures that could increase the transparency and investor awareness 
of the costs of investing in mutual funds. Currently, mutual funds 
disclose information about the fees and expenses that each investor 
specifically pays on their mutual fund shares as percentages of fund 
assets, whereas most other financial services disclose the actual costs 
to the purchaser in dollar terms. Mutual funds also incur brokerage 
commissions and other trading costs when they buy or sell securities, 
but these costs are not prominently disclosed to investors. To provide 
more information about the fees investors pay, SEC has proposed 
requiring mutual funds to disclose additional fee-related information, 
but these would not provide investors with the specific dollar amount 
of fees paid on their shares as others have proposed, nor would these 
disclosures be provided in the document generally considered to be of 
the most interest to investors--the quarterly statement that shows the 
number and value of an investor's mutual fund shares. Although 
continuing to consider the need for additional disclosures, SEC staff 
and industry participants noted that data on the extent to which 
additional fee information would benefit investors is generally 
lacking. However, continued consideration of the costs and benefits of 
providing additional disclosure appears worthwhile because some 
alternatives for providing fee information to mutual fund investors in 
quarterly statement could provide some benefit and may cost very 
little. Some industry participants have also called for more disclosure 
of information about the brokerage commissions and other costs that 
mutual funds incur when trading, but standard methodologies for 
determining some of these amounts do not exist and regulators and 
others raised concerns that such disclosures could be misleading.

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

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

Soft dollar arrangements allow investment advisers of mutual funds to 
use part of the brokerage commissions paid to broker-dealers that 
execute trades on the fund's behalf to obtain research and brokerage 
services that can potentially benefit fund investors but could increase 
the costs borne by their funds. Industry participants said that soft 
dollars allow fund advisers access to a wider range of research than 
may otherwise be available and can also be used to reduce fund 
expenses. However, others were concerned that these arrangements can 
create conflicts of interest between investment advisers and investors 
that could increase investors' costs. For example, fund advisers might 
use some broker-dealers solely because of the soft dollar services they 
offer rather than because of their ability to execute the fund's trades 
in the most advantageous way. Concerns were raised that investment 
advisers might trade excessively to obtain additional services using 
soft dollars, which would increase fund investors' costs. In a series 
of regulatory examinations performed in 1998, SEC staff found examples 
of problems relating to investment advisers' use of soft dollars, 
although far fewer problems were attributable to the advisers for 
mutual funds. In response, the SEC staff issued a report that included 
various proposals to address the potential conflicts created by these 
arrangements, including recommending that investment advisers keep 
better records and disclose more information about their use of soft 
dollars. Although this could increase the transparency of these 
arrangements and help fund directors and investors better evaluate 
their fund advisers' use of soft dollars, SEC has yet to take action on 
these proposed recommendations.

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

We obtained comments from SEC and ICI, who generally agreed with the 
contents of this report. The letter from the SEC staff indicated that 
as part of their responsibilities in regulating mutual funds, they will 
consider the recommendations in this report very carefully in 
determining how best to inform investors about the importance of fees. 
The letter from the ICI staff noted that our report presented a 
generally balanced and well-informed discussion of mutual fund 
regulatory requirements. However, the ICI staff were concerned over how 
we compare the disclosures made by mutual fund fees to those made by 
other financial products, and noted that mutual fund fee disclosures, 
which in some ways exceed the information disclosed by other products, 
allow individuals to make much more informed and accurate decisions 
about the costs of their funds than do the disclosures made by other 
financial service firms. We agree with ICI that mutual funds are 
required to make considerable disclosures that are useful to investors 
for comparing the level of fees across funds. However, we also believe 
that supplementing the existing mutual fund disclosures with additional 
information, particularly in the account statements that provide 
investors with the exact number and value of their mutual fund shares, 
could also prove beneficial for increasing awareness of fees and 
prompting additional fee-based competition among funds.

Background:

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

The incredible growth of mutual fund assets and in the number of 
investors that hold funds has raised concerns within Congress and 
elsewhere over the fees funds charge investors. In a report issued in 
June 2000, we found that the average fees charged by 77 of the largest 
stock and bond mutual funds had declined between 1990 and 
1998.[Footnote 2] In our report, we also concluded that although many 
mutual funds exist that compete for investor dollars, they conduct this 
competition primarily on the basis of their performance rather than on 
the basis of the price of their service, that is, the fees they charge. 
In updating the results of the analysis from our June 2000 report for a 
hearing on mutual funds in March 2003, we found that the average fees 
for this group of funds had increased slightly, due in part to some 
funds paying higher management fees to their investment advisers 
because of the effect of performance fees.[Footnote 3]

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

SEC is the federal regulatory agency with responsibility for overseeing 
the U.S. securities markets and protecting investors. Various self-
regulatory organizations (SRO) also oversee the activities of 
securities industry participants. NASD is the SRO with primary 
responsibility for overseeing broker-dealers. SEC is responsible for 
oversight of the SROs and it also oversees and regulates the investment 
management industry.

Additional Disclosure of Mutual Fund Costs May Benefit Investors:

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

Unlike Other Financial Products, Mutual Funds Do Not Disclose the 
Actual Dollar Amount of Fees Paid by Individual Investors:

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

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

Table 1: Fee Disclosure Practices for Selected Financial Services or 
Products:

Type of product or service: Mutual funds; Disclosure requirement: 
Mutual funds show the operating expenses as percentages of fund assets 
and dollar amounts for hypothetical investment amounts based on 
estimated future expenses in the prospectus.

Type of product or service: Deposit accounts; Disclosure requirement: 
Depository institutions are required to disclose itemized fees, in 
dollar amounts, on periodic statements.

Type of product or service: Bank trust services; Disclosure 
requirement: Although covered by varying state laws, regulatory and 
association officials for banks indicated that trust service charges 
are generally shown as specific dollar amounts.

Type of product or service: Investment services provided to individual 
investment accounts (such as those managed by a financial planner); 
Disclosure requirement: When the provider has the right to deduct fees 
and other charges directly from the investor's account, the dollar 
amounts of such charges are required to be disclosed to the investor.

Type of product or service: Wrap accounts[A]; Disclosure requirement: 
Provider is required to disclose dollar amount of fees on investors' 
statements.

Type of product or service: Stock purchases; Disclosure requirement: 
Broker-dealers are required to report specific dollar amounts charged 
as commissions to investors.

Type of product or service: Mortgage financing; Disclosure requirement: 
Mortgage lenders are required to provide at time of settlement a 
statement containing information on the annual percentage rate paid on 
the outstanding balance, and the total dollar amount of any finance 
charges, the amount financed, and the total of all payments required.

Type of product or service: Credit cards; Disclosure requirement: 
Lenders are required to disclose the annual percentage rate paid for 
purchases and cash advances, and the dollar amounts of these charges 
appear on cardholder statements.

Source: GAO analysis of applicable disclosure regulations, rules, and 
industry practices.

[A] In a wrap account, a customer receives investment advisory and 
brokerage execution services from a broker-dealer or other financial 
intermediary for a "wrapped" fee that is not based on transactions in 
the customer's account.

[End of table]

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

Various Alternatives Could Improve Fee Disclosure, but the Benefits 
Have Not Been Quantified:

In recent years, a number of alternatives have been proposed for 
improving the disclosure of mutual fund fees, which could provide 
additional information to fund investors. In response to a 
recommendation in our June 2000 report that SEC consider additional 
disclosures regarding fees, SEC has introduced a proposal to improve 
mutual fund fee disclosure.[Footnote 6] In December 2002, SEC released 
proposed rule amendments, which include a requirement that mutual funds 
make additional disclosures about their expenses.[Footnote 7] This 
information would be presented to investors in the annual and 
semiannual reports prepared by mutual funds. Specifically, mutual funds 
would be required to disclose the cost in dollars associated with an 
investment of $10,000 that earned the fund's actual return and incurred 
the fund's actual expenses paid during the period. In addition, the 
staff also proposed that mutual funds be required to disclose the cost 
in dollars, based on the fund's actual expenses, of a $10,000 
investment that earned a standardized return of 5 percent.

The SEC's proposed disclosures have various advantages and 
disadvantages. If adopted, this proposal would provide additional 
information to investors about the fees they pay when investing in 
mutual funds. In addition, these disclosures would be presented in a 
format that would allow investors to compare fees directly across 
funds. However, the disclosures would not be investor specific because 
they would not use an investor's individual account balance or number 
of shares owned. In addition, SEC is proposing to place these new 
disclosures in the semiannual shareholder reports, instead of in 
quarterly statements. Quarterly statements, which show investors the 
number of shares owned and value of their fund holdings, are generally 
considered to be of most interest and utility to investors. As a 
result, SEC's proposal may be less likely to increase investor 
awareness and improve price competition among mutual funds. According 
to SEC staff, they are open to consider additional disclosures if the 
benefits to investors appear clear, but have decided to continue 
pursuing approval of the proposed disclosure format from their December 
2002 rule proposal. This proposal has received a wide range of 
comments. Most comments were in support of SEC's proposed requirement 
to include the dollar cost associated with a $10,000 investment. For 
example, one investment advisory firm commented in its letter that the 
new disclosures SEC is proposing would benefit investors by allowing 
them to estimate actual expenses and compare costs between different 
funds in a meaningful way.

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

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

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

Although the total cost of providing specific dollar fee disclosures 
might be significant, the cost might not represent a large outlay on a 
per investor basis. As we reported in our March 2003 statement, the 
Investment Company Institute (ICI), the industry association 
representing mutual funds, commissioned a study by a large accounting 
firm to survey mutual fund companies about the costs of producing such 
disclosures.[Footnote 8] The study concluded that the aggregated 
estimated costs for the survey respondents to implement specific dollar 
disclosures in shareholder account statements would exceed $200 
million, and the annual costs of compliance would be about $66 
million.[Footnote 9] Although these are significant costs, when spread 
over the accounts of many investors, the amounts are less sizeable. For 
example, ICI reported that at the end of 2001, a total of about 248 
million shareholder accounts existed. If the fund companies represented 
in ICI's study, which represent 77 percent of industry assets, also 
maintain about the same percentage of customer accounts, then the 
companies would hold about 191 million accounts. As a result, 
apportioning the estimated $200 million in initial costs to these 
accounts would amount to about $1 per account. Apportioning the 
estimated $66 million in annual costs to these accounts would amount to 
about $0.35 per account.

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

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

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

Trading and Other Costs Impact Mutual Fund Investor Returns, but Are 
Not Prominently Disclosed:

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

Other trading-related costs that can also affect investor returns 
include potential market impact costs that can arise when funds seek to 
trade large amounts of particular securities. For example, a fund 
seeking to buy a large block of a particular company's stock may end up 
paying higher prices to acquire all the shares it seeks because its 
transaction volume causes the stock price to rise while its trades are 
being executed. Various methodologies exist for estimating these types 
of trading costs, however, no generally agreed upon approach exists for 
accurately calculating these costs.

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

Academics and Others Have Also Called for Increased Disclosure of 
Mutual Fund Trading Costs, but Others Noted that Producing Such 
Disclosures Would be Difficult:

Academics and other industry observers have also called for increased 
disclosure of mutual fund brokerage commissions and other trading costs 
that are not currently included in fund expense ratios. In an academic 
study we reviewed that looked at brokerage commission costs, the 
authors urged that investors pay increased attention to such 
costs.[Footnote 14] For example, the study noted that investors seeking 
to choose their funds on the basis of expenses should also consider 
reviewing trading costs as relevant information because the impact of 
these unobservable trading costs is comparable to the more observable 
expense ratio. The authors of another study noted that research shows 
that all expenses can reduce returns so attention should be paid to 
fund trading costs, including brokerage commissions, and that these 
costs should not be relegated to being disclosed only in mutual funds' 
SAIs.[Footnote 15]

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

The majority of certified financial planners we interviewed also 
indicated that disclosing transaction costs would benefit investors. Of 
the 15 with whom we spoke, 9 stated that investors would benefit from 
having more cost information such as portfolio transaction costs. For 
example, one said that investors should know the costs of transactions 
paid by the fund and that this information should be disclosed in a 
document more prominent than the SAI. Another stated that brokerage 
commissions should be reported as a percentage of average net assets. 
Overall they felt that more information would help investors compare 
costs across funds, which could likely result in more competition based 
on costs, but they also varied in opinion on the most appropriate 
format and place to present these disclosures. The planners who did not 
think transaction costs should be disclosed generally believed that 
investors would not benefit from this type of additional information 
because they would not understand it.

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

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

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

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

Independent Directors Play a Critical Role in Protecting Mutual Fund 
Investors:

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

Mutual Fund Boards of Directors Are Responsible for Protecting 
Shareholder Interests:

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

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

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

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

* the nature and quality of the adviser's services,

* the adviser's costs to provide those services,

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

* the volume of orders that the manager must process,

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

* the independence and conscientiousness of the directors.

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

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

Critics Suggest Independent Directors Could Do More to Assert Their 
Influence and Reduce Fees:

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

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

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

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

Industry participants also said that having mutual fund boards put out 
their advisory service contracts for bid may not produce expected 
savings and could increase fund shareholders' costs. According to staff 
at one fund company, they would not likely bid on contracts to manage 
mutual fund assets at the same rate that they bid for pension fund 
assets because their costs to manage and administer mutual fund assets 
are higher. They said that pension fund assets are offered to 
investment advisers in a large pre-existing pool. In contrast, mutual 
fund assets must be accumulated over time from many investors. Each 
time a fund's board hired a new investment adviser, the fund's 
shareholders costs would also likely go up because all the accounts 
would have to be transferred to the new adviser and the fund would 
likely incur additional document preparation, legal, and customer 
service costs. For example, we identified a case in which a small fund 
had removed its investment adviser, which resulted in a significant 
increase of fund expenses. In this case, the fund's investment adviser 
resigned and a majority of the fund's board of directors voted to take 
over the fund's management. The decision was submitted to the 
shareholders for a proxy vote and passed. As a result the fund's 
expense ratio went from 1.8 percent in 2001 to 3.4 percent in 2002. The 
fund attributed this significant increase to a number of one-time 
items, which consisted primarily of legal expenses associated with the 
removal of the investment adviser and the management of the fund's 
portfolio.

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

Although they do not frequently change advisers, mutual fund directors 
engage in other activities to lower fees. Industry officials said that 
advisers typically institute management fee "breakpoints" based on the 
level of fund assets or performance. These breakpoints reduce the level 
of management fees when funds exceed certain asset levels, thus as a 
fund's assets grow, the investment adviser's fee is reduced for those 
additional assets above the levels set in the breakpoint. Directors 
could also approve performance fees as a part of an investment 
adviser's compensation that would reduce the fee the adviser was able 
to charge if the fund's performance fails to meet or exceed a specified 
performance benchmark, such as the Standard & Poors 500 Stock Index. 
Industry officials also stated that advisers will at times offer to 
waive management fees, and may also waive or cap certain expenses such 
as certain transfer agency fees. Noting that the fees for mutual funds 
in the United States are lower compared to those of other countries, 
SEC and ICI officials attributed this to the role and influence of U.S. 
funds' board of directors because such independent oversight is not 
always required in other countries.

Mutual Funds Already Employ Many Practices Being Suggested to Improve 
Public Company Governance:

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

* independent directors constitute at least two thirds of the fund's 
board,

* independent directors select and nominate other independent 
directors, and:

* independent counsel for the independent directors.

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

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

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

Table 2: Current and Proposed NYSE and NASDAQ Corporate Governance 
Listing Standards Compared to those Currently Required or Recommended 
for Mutual Fund Boards:

Governance requirement: Board must have a majority of independent 
directors; NYSE/NASDAQ listing standards: Currently required: No; 
NYSE/NASDAQ listing standards: Proposed requirement: Yes;  Mutual 
funds: Required by statute or SEC rule[A]: Yes; Mutual funds: ICI 
recommended best practice: Yes.

Governance requirement: Independent directors must be responsible for 
nominating new independent directors; NYSE/NASDAQ listing standards: 
Currently required: No; NYSE/NASDAQ listing standards: Proposed 
requirement: Yes; Mutual funds: Required by statute or SEC 
rule[A]: Yes; Mutual funds: ICI recommended best practice: Yes.

Governance requirement: Audit committee must consist of only 
independent directors[B]; NYSE/NASDAQ listing standards: Currently 
required: Yes; NYSE/NASDAQ listing standards: Proposed requirement: Yes; 
No; Mutual funds: Required by statute or SEC rule[A]: No; 
Mutual funds: ICI recommended best practice: Yes.

Governance requirement: Standards that define who qualifies as an 
independent director[C]; NYSE/NASDAQ listing standards: Currently 
required: Yes; NYSE/NASDAQ listing standards: Proposed requirement: Yes; 
No; Mutual funds: Required by statute or SEC rule[A]: Yes; Mutual 
funds: ICI recommended best practice: Yes.

Governance requirement: Independent directors required to meet 
separately in executive sessions; NYSE/NASDAQ listing standards: 
Currently required: No; NYSE/NASDAQ listing standards: Proposed 
requirement: Yes; Mutual funds: Required by statute or SEC 
rule[A]: No; Mutual funds: ICI recommended best practice: Yes.

Source: GAO analysis of ICI Best Practices, statutes, SEC rules, and 
NYSE and NASDAQ rule proposals.

[A] SEC requires the board of directors of any fund that takes 
advantage of various exemptive rules to meet these requirements and SEC 
staff indicated that, as a result, almost all funds must comply.

[B] Although fully independent audit committees is not a requirement 
for funds, SEC has adopted a rule to encourage fund boards to have 
audit committees consisting exclusively of independent directors by 
exempting such committees from having to seek shareholder approval of 
the fund's auditor.

[C] Both the NYSE and NASDAQ definitions of director independence 
currently apply only to members of the audit committee, but their rule 
proposals would extend this definition to the full board.

[End of table]

According to industry participants, most mutual fund boards already 
have the corporate governance practices recommended by these various 
standards in place. Officials of the fund companies and the independent 
directors that we interviewed told us that the majority of their boards 
consisted of independent directors, and, in many cases, had only one 
interested director. For public companies, some commenters have called 
for boards of directors to have supermajorities of independent 
directors as a means of ensuring that the voices of the independent 
directors are heard. As noted above, this practice has already been 
advocated by ICI's best practice recommendations and one fund 
governance consulting official said that a 2002 survey conducted by his 
firm found that, in 75 percent of the mutual fund complexes they 
surveyed, over 70 percent of the directors were independent. An 
academic study we reviewed also found that funds' independent directors 
already comprised funds' nominating committees and most funds have 
self-nominating independent directors.

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

Changes in Mutual Fund Distribution Practices Have Increased Choices 
for Investors, but Have Raised Potential Concerns:

Concerns have been raised over changes in how mutual funds pay for the 
distribution of their shares to investors. SEC Rule 12b-1 allows mutual 
fund companies to use fund assets to pay expenses for distributing 
their funds through broker-dealers, and has evolved into a means for 
fund companies to offer investors a variety of ways to pay for the 
services of financial professionals, such as broker-dealer staff or 
financial planners. However, 12b-1 fees remain controversial among 
mutual fund researchers because, in addition to increasing a fund's 
overall expense ratio, funds with 12b-1 fees may be more costly to own 
in other ways. In a recent study, SEC staff recommended rule 12b-1 
modifications to reflect changes in how funds are being marketed, but 
as of May 2003, SEC had not proposed any amendments. Concerns also have 
been raised as to whether the disclosure of 12b-1 fees is sufficient 
and whether, another distribution practice--referred to as revenue 
sharing, in which investment advisers make payments to broker-dealers 
for selling and marketing their funds--could limit the number of mutual 
fund choices offered to investors. Revenue sharing also may result in a 
broker-dealer's failure to recommend funds from which the brokerage 
firm is not being compensated by the funds' advisers, which some 
suggest could conflict with broker-dealers' responsibilities to 
recommend suitable investments.

12b-1 Plans Provide Alternative Means for Compensating Financial 
Professionals but Also Raise Concerns Over Costs:

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

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

In the adopting release for the rule, SEC presented various factors 
that directors should consider when approving a fund's 12b-1 plan. 
These factors were offered to provide guidance to directors in 
determining whether to use fund assets to bear expenses for fund 
distribution. The nine factors are shown in figure 1.

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

[See PDF for image]

[End of figure]

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

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

12b-1 Plans Provide Additional Ways for Investors to Pay for Investment 
Advice and Fund Companies to Market Fund Shares:

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

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

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

12b-1 Fees Raise Some Concerns Over Cost of Funds:

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

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

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

SEC Report Recommended That Rule 12b-1 Be Updated to Reflect Changes in 
Fund Marketing:

In a December 2000 report on mutual fund fees and expenses, staff in 
SEC's Division of Investment Management recommended that SEC consider 
reviewing the requirements of rule 12b-1 that govern how funds adopt 
and renew their 12b-1 plans.[Footnote 25] The division's staff noted 
that modifications might be needed to reflect changes in the manner in 
which funds are marketed and distributed and the experience gained from 
observing how rule 12b-1 has operated since its adoption in 1980. The 
report noted that the development of multiple fund share classes permit 
investors to choose how distribution expenses are to be paid--for 
example, up front, in installments over time, or at redemption. Many 
funds that offer shares through broker-dealer fund supermarkets also 
adopt 12b-1 plans to pay for the fees that the sponsoring broker-dealer 
charges the funds sold through their supermarket. The division's report 
noted that because these 12b-1 plans are essential to the funds' 
participation in these supermarkets, such plans could be viewed as 
indefinite commitments. Also since 1980, some fund distributors have 
been using 12b-1 receivable revenues as collateral to obtain loans to 
finance their distribution efforts. The SEC staff noted that such 
changes illustrate that 12b-1 fees have come to be used in different 
ways than were originally envisioned under the rule and that changes 
may be needed to reflect current practices. Because of these changes, 
the report noted that SEC should consider whether it needed to give 
additional or different guidance to fund directors with respect to 
their review of rule 12b-1 plans, including whether the nine factors 
published in the 1980 release of rule 12b-1 were still valid (shown in 
fig. 1 of this report).

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

Concerns Raised over Adequacy of 12b-1 Fee Disclosure:

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

Revenue Sharing Arrangements Provide Additional Distribution Options 
and Are Increasingly Used to Compensate Fund Distributors:

Revenue sharing payments are compensation that investment advisers pay 
from their profits to the broker-dealers that distribute their funds. 
Some broker-dealers whose sales representatives market mutual funds 
have narrowed their offerings of funds or created preferred lists of 
funds, which then become the funds that receive the most marketing by 
these broker-dealer sales representatives. In order to be selected as 
one of the preferred fund families on these lists, the mutual fund 
adviser often is required to compensate the broker-dealer firms. 
According to one research organization official, there are 
significantly fewer distributing broker-dealers than there are mutual 
fund investment advisers. As a result, the mutual fund distributors 
have the clout to require advisers to pay more to have their funds sold 
by the distributing broker-dealers staff. For example, distributors 
sometimes require investment advisers to share their profits and pay 
for expenses incurred by the distributing broker-dealers, such as 
advertising or marketing materials that are used by the distributing 
broker-dealers.

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

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

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

Actual Amount of Revenue Sharing Occurring Is Unknown:

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

Some Industry Participants Are Concerned that Revenue Sharing Could 
Negatively Impact Investors:

The increased use of revenue sharing payments is raising concerns among 
some industry participants. Although revenue sharing payments are 
becoming a major expense for fund advisers, industry research 
organization officials told us that most fund advisers are not willing 
to publicly discuss the extent to which they are making such payments. 
A 2001 report on fund distribution practices states that "the details 
and levels of revenue sharing vary widely across the industry and are 
seldom codified in written contracts." In one industry magazine 
article, a mutual fund industry researcher referred to revenue sharing 
as "the dirty little secret of the mutual fund industry.":

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

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

Mutual fund officials' opinions about revenue sharing were mixed. Some 
of the fund officials with whom we spoke viewed revenue sharing as a 
cost of doing business, which enabled them to obtain "shelf space" for 
their funds with major broker-dealers and did not regard these 
arrangements as potentially conflicting with investors' interests. They 
explained that the payments are made directly to the brokerage firm and 
not to individual staff financial advisers. One fund official said that 
there would be no incentive for broker-dealers' sales staff to push 
certain funds, unless managers exerted pressure on sales staff to sell 
those funds. Officials of one large broker-dealer with whom we spoke 
said that their fund sales platform has an "open architecture" through 
which all participating funds' agreements and payments are the same, 
which creates a level playing field on which no funds are given 
priority. One fund official commented that NASD rules require that 
broker-dealers sales staff recommend funds that are most suitable to 
the individual investor's financial situation. However, in letters 
commenting on certain compensation arrangements among broker-dealers, 
ICI has stated that cash compensation creates potential conflicts of 
interest between the broker-dealer receiving the compensation and the 
customer because the sale of a recommended security could increase the 
compensation paid to the broker-dealer's sales representative.

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

Extent to Which Investors Are Told About the Potential Conflict That 
Revenue Sharing Creates Is Unclear:

Although revenue sharing payments can create conflicts of interest 
between broker-dealers and their clients, the extent to which broker-
dealers disclose to their clients that their firms receive such 
payments from fund advisers is not clear. Rule 10b-10 under the 
Securities Exchange Act of 1934 requires, among other things, that 
broker-dealers provide customers with information about third-party 
compensation that broker-dealers receive in connection with securities 
transactions. While broker-dealers generally satisfy the requirements 
of rule 10b-10 by providing customers with written "confirmations," the 
rule does not specifically require broker-dealers to provide the 
required information about third-party compensation related to mutual 
fund purchases in any particular document. SEC staff told us that they 
interpret rule 10b-10 to permit broker-dealers to disclose third-party 
compensation related to mutual fund purchases through delivery of a 
fund prospectus that discusses the compensation. However, investors 
will not receive a confirmation, and may not view a prospectus, until 
after purchasing mutual fund shares. According to SEC staff, the 
compensation-disclosure requirements of rule 10b-10 in large part are 
geared toward providing investors with information that is useful over 
a course of dealing with a broker-dealer, rather than just one 
transaction. Information disclosed following the first transaction in a 
security can help the investor determine whether to continue to use 
that broker-dealer for future transactions. That is particularly 
applicable in the context of mutual funds, given that investors often 
purchase fund shares over time in a series of transactions.

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

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

Soft Dollar Arrangements Provide Benefits, but Could Also Have an 
Adverse Impact on Investors:

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

Soft Dollars Pay for Research and Brokerage Services:

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

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

Soft Dollar Arrangements Have Evolved Over Time:

Many of the features of soft dollar arrangements that exist today are 
the result of regulatory changes in the 1970s. Until the mid-1970s, the 
commissions charged by all brokers were fixed at one equal price. To 
compete for commissions, broker-dealers differentiated themselves by 
offering research-related products and services to advisers. In 1975, 
to increase competition, SEC abolished fixed brokerage commission 
rates. However, investment advisers were concerned that they could be 
held in breach of their fiduciary duty to their clients to obtain best 
execution on trades if they paid anything but the lowest commission 
rate available to obtain research and brokerage services. In response, 
Congress created a "safe harbor" under section 28(e) of the Securities 
Exchange Act of 1934 that allowed advisers to pay more than the lowest 
available commission rate for security transactions in return for 
research and brokerage services and not be in breach of their fiduciary 
duty. In order to be protected against a claim of breach of fiduciary 
duty under this safe harbor, the adviser must make a good faith 
determination that the amount of commission paid is reasonable in 
relation to the value of the brokerage and research services provided 
by the broker-dealer.

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

Although the Complete Extent of Soft Dollar Use Is Unknown, Soft 
Dollars Could Represent a Significant Portion of Trading Commissions:

Because soft dollar research is often bundled, only aggregate value 
estimates of soft dollar arrangements are available. According to one 
industry research organization, the total amount paid in brokerage 
commissions for U.S. stocks totaled $8.6 billion in 2001, up from $7.7 
billion in 2000.[Footnote 29] Of this amount, industry participants 
estimate that 15 percent of total annual brokerage commissions, or 
roughly $1 billion, is used to obtain third-party research. However, 
this figure does not include the value of proprietary research, which 
cannot be unbundled as easily as third-party research. Moreover, in 
light of recent declines in fund assets, concern has been raised that 
advisers are under increased pressure to use soft dollars to pay for 
research rather than incur additional fund expenses.

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

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

Disclosure of Soft Dollar Use to Mutual Fund Investors Is Limited:

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

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

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

Soft Dollars Benefit Investors in Various Ways, but Could Also Increase 
Investor Costs or Raise Conflicts of Interest:

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

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

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

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

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

Regulators and Industry Participants Have Proposed Alternatives for 
Mitigating Potential Conflicts Involving Soft Dollar Use:

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

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

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

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

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

We learned of another proposal related to soft dollars and brokerage 
commissions from an industry participant who was concerned that the 
general practice of full-service broker-dealers charging about $0.05 to 
$0.06 per share in commissions and then offering discounts in the form 
of soft dollars was serving to keep commissions artificially high. His 
first suggestion would be to ban soft dollar arrangements to obtain 
products and services with marginal research applications, forcing 
advisers to pay for these products with their own profits rather than 
with fund assets and therefore reducing the trading costs borne by fund 
investors. Another suggestion he had would have broker-dealers quantify 
the execution-only portion of their brokerage commissions. If this 
information were collected by SEC and reported as industry averages, 
mutual fund directors would have more information to use to evaluate 
their fund's trading activities.

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

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

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

Conclusions:

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

Given the cost of producing such disclosures and the lack of data on 
the additional benefits to investors, the SEC staff have indicated that 
they were not certain that specific dollar disclosures are warranted. 
However, we believe that actively weighing the costs and benefits of 
providing additional disclosure is worthwhile. In addition, other less 
costly alternatives are also available that could increase investor 
awareness of the fees they are paying on their mutual funds by 
providing them with information on the fees they pay in the quarterly 
statements that provide information on an investor's share balance and 
account value. For example, one alternative that would not likely be 
overly expensive would be to require these quarterly statements to 
present the information that SEC has proposed be added to mutual fund's 
semiannual reports that would disclose the dollar amounts of a fund's 
fees based on a set investment amount. Doing so would place this 
additional fee disclosure in the document generally considered to be of 
the most interest to investors. An even less costly alternative could 
be to require quarterly statements to also include a notice that 
reminds investors that they pay fees and to check their prospectus and 
with their financial adviser for more information. If additional fee 
disclosures such as these were used to supplement the existing 
information already provided in prospectuses and semiannual reports, 
both prospective and existing investors in mutual funds would have 
access to valuable information about the relative costs of investing in 
different funds.

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

Although the ways that funds use 12b-1 fees has changed over time, 
these fees appear to have provided investors with increased flexibility 
in choosing how to pay for the services of the individual financial 
professionals providing them with advice on fund purchases. As a 
result, they appear to provide benefits to the large number of 
investors that require assistance with their financial decisions. The 
revenue sharing payments that funds make to broker-dealers illustrate 
that mutual funds must compete to obtain access to the distribution 
networks that these firms provide. How and the extent to which these 
payments affect the overall level of fees that fund investors pay is 
not clear. However, by compensating broker-dealers to market the funds 
of a particular company, they can introduce a conflict with the broker-
dealer obligation to recommend the funds most suitable to the 
investor's needs. Further, even if the payments do not conflict with 
this obligation, the payments can result in financial professionals 
providing investors with fewer investment choices. Regulators 
acknowledged that the currently required disclosures might not provide 
needed transparency to investors at the time that mutual fund shares 
are being recommended for purchase. Having additional disclosures made 
at the time that fund shares are recommended about the compensation 
that a broker-dealer receives from fund companies could provide 
investors with more complete information to consider when making their 
investment decision.

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

Recommendations:

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

* considering the benefits of additional disclosure relating to mutual 
fund fees, including requiring more information in mutual fund account 
statements about the fees investors pay;

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

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

Agency Comments and Our Evaluation:

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

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

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

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

:

As agreed with your offices, unless you publicly announce the contents 
of this report earlier, we plan no further distribution of this report 
until 30 days from the report date. At that time, we will provide 
copies of this report to the Chairman and the Ranking Minority Member, 
Senate Committee on Banking, Housing, and Urban Affairs, and the 
Ranking Minority Members, House Committee on Financial Services and its 
Subcommittee on Capital Markets, Insurance, and Government Sponsored 
Enterprises. Copies also will be provided to the Chairman, SEC; the 
President, ICI; and other interested parties. The report will also be 
available at no charge on GAO's home page at http://www.gao.gov.

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

Signed by:

Richard J. Hillman 
Director, 
Financial Markets and Community Investment:

[End of section]

Appendixes :

Appendix I: Scope and Methodology:

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

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

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

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

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

[End of section]

Appendix II: Comments from the Securities and Exchange Commission:

UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 
20549:

DIVISION OF INVESTMENT MANAGEMENT:

June 2, 2003:

Richard J. Hillman Director, Financial Markets and Community Investment 
General Government Division 
U.S. General Accounting Office 
Washington, DC 20548:

Re: GAO Draft Report:

Mutual Funds: Greater Transparency Needed in Disclosures to Investors:

Dear Mr. Hillman:

Thank you for the opportunity to comment on the General Accounting 
Office's draft report on mutual fund expense disclosures to investors. 
The report reviews a variety of issues relating to mutual fund fees, 
including: how mutual funds disclose their fees and related trading 
costs; the role of mutual fund directors in overseeing fees; the effect 
on investors of changes in the way in which mutual fund shares are 
marketed and distributed; and concerns related to mutual funds 
managers' use of soft dollars to obtain research and other services. I 
commend the GAO for contributing to the public dialog about these 
important matters.

The report raises important issues concerning the impact of mutual fund 
fees on investors. The major conclusion of the report is that 
additional disclosure could help increase investor awareness and 
understanding of mutual fund fees and, thereby, promote additional 
competition by funds on the basis of fees. The report makes three 
recommendations, each of which we address below.

1. Additional Disclosure Related to Mutual Fund Fees:

First, the report recommends that the Commission consider the benefits 
of additional disclosure relating to mutual fund fees, including 
requiring mutual fund account statements to remind investors of the 
fees they pay.

We agree that shareholders need to understand the amount of fees that 
mutual funds charge. The primary focus of our disclosure effort has 
been to make fund fees and expenses more transparent to investors and 
to allow investors the ability to compare fees and expenses between 
different funds, as well as to educate investors about the importance 
of fees.

As you know, in December 2002 the Commission requested comment on a 
proposal to require mutual funds to include in reports to shareholders 
the dollar cost associated with a $10,000 investment.[NOTE 1] In the 
proposal the Commission requested comment on whether there are better 
vehicles than annual and semi-annual reports to shareholders in which 
to include additional disclosure about fund expenses. The Commission 
also asked whether requiring disclosure of the actual costs paid by an 
individual investor in his or her account statements would be 
preferable, and if so, what benefits individualized cost disclosure in 
account statements would provide to investors that disclosure in 
shareholder reports of an initial $10,000 investment would not.

We currently are receiving and evaluating comments on the rule 
proposal. In formulating our recommendation to the Commission on how to 
proceed on this issue, we will consider whether some form of disclosure 
in account statements, including the disclosure recommended in your 
report, should be required.

II. Revenue Sharing Arrangements:

Second, the report recommends the Commission evaluate ways to provide 
more information that investors could use to evaluate possible 
conflicts of interest resulting from any revenue sharing payments their 
broker-dealers receive.

A broker-dealer is generally required to disclose to its customer, in 
writing, at or before the completion of the transaction, that it has or 
will receive compensation from a third party for effecting the 
transaction for the customer. In particular, any broker-dealer that 
effects a purchase of fund shares for a customer must disclose to the 
customer the source and amount of any revenue-sharing payments that the 
broker-dealer receives, or will receive, from the fund's investment 
adviser.[NOTE 2] A broker-dealer may satisfy this disclosure 
obligation by, among other things, delivering to its customer a copy 
of the fund's prospectus, at or before completion of the transaction, 
if the prospectus contains adequate disclosures.[NOTE 3] Many funds 
disclose in their prospectuses information about their investment 
advisers' revenue-sharing payments to broker-dealers, which has the 
effect of facilitating the broker-dealers' compliance with that 
obligation.

The Commission is concerned about the disclosure of revenue sharing 
payments and recently has recognized that fund prospectuses are not 
designed to make the particular disclosures that broker-dealers must 
provide to their customers about their receipt of revenue sharing 
payments. The Commission therefore directed its staff to make 
recommendations to the Commission as to whether additional disclosure 
should be required or current disclosure further refined. [NOTE 4] 
The Commission's staff currently is reviewing these issues.

III. Soft Dollars:

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

The soft dollar report, among other things, recommended that the 
Commission amend form ADV to require more specific and meaningful soft 
dollar disclosure (including the availability of commission recapture 
to clients). The soft dollar report also recommended that the 
Commission require advisers who obtain soft dollar benefits from 
broker-dealers to maintain a detailed list of all products and services 
received from broker-dealers for soft dollars, and that broker-dealers 
provide to advisers a statement of products, services and research that 
they provided for the soft dollars.

The Commission has proposed amendments to Form ADV as recommended by 
the soft dollar report. The proposal would require an adviser who 
receives soft dollars to disclose the adviser's soft dollar practices 
and discuss the conflicts of interest that result. The proposed 
description of soft dollar practices must be specific enough for 
clients to understand the types of products or services the adviser is 
acquiring and to permit clients to evaluate the conflicts.

Additionally, the staff intends to make recommendations to the 
Commission concerning record keeping by including soft dollar record 
keeping requirements as part of an overall modernization of the record 
keeping requirements for investment advisers.

We recognize that investors need to be further educated about the fees 
and expenses that mutual funds charge. As part of our responsibilities 
in regulating mutual funds, we will consider the recommendations in 
your report very carefully in determining how best to inform investors 
about the importance of fees. Again, thank you for the opportunity to 
comment on your report.

Sincerely,

Paul F. Roye 

Director:

Signed by Paul F. Roye:

NOTES:

[1] Investment Company Act Release No. 25870 (Dec. 18, 2002).

[2] Rule 10b-10 under the Securities Exchange Act of 1934.

[3] See "Securities Confirmations," Exchange Act Release No. 13508 at 
n.41 (May 5, 1977); Commission brief, Cohen v. Donaldson, Lufkin & 
Jenrette Securities Corp., reported as Press v. Quick & Reilly, Inc., 
218 F.3d 121 (2d Cir. 2000) (No. 97-9159).

[4] See Press v. Quick & Reilly, Inc., 218 F. 3d 121, 132 n. 13 (July 
10, 2000).

[End of section]

Appendix III: Comments from the Investment Company Institute:

INVESTMENT COMPANY INSTITUTE:

MATTHEW P. FINK PRESIDENT:

June 2, 2003:

Mr. Richard J. Hillman:

Director, Financial Markets and Community Investment General Government 
Division:

U.S. General Accounting Office 441 G Street N.W. Washington, D.C. 
20548:

Dear Mr. Hillman:

Thank you for providing us with the opportunity to comment on GAO's 
draft report entitled Mutual Funds: Greater Transparency Needed in 
Disclosures to Investors. Overall, we believe that the draft report 
thoughtfully considers several approaches to enhancing the transparency 
of mutual funds in ways that should assist current and prospective 
mutual fund shareholders in achieving their long-term investment goals.

In our view, effective regulation and extensive transparency are 
critically important reasons why so many Americans have come to rely on 
mutual fund investments to help secure their retirement and support 
their children's education. Yet we are also aware that simply adhering 
to what has worked in the past does not guarantee success in the 
future. The mutual fund industry therefore is committed to working with 
you, the U.S. Securities and Exchange Commission and leaders in 
Congress to support meaningful regulatory reforms that will enable 
mutual funds to continue to earn the trust and confidence of tens of 
millions of individual investors.

The draft report's discussion of mutual fund regulatory requirements is 
generally balanced and well informed. We do have one suggestion that, 
if addressed, would clarify and strengthen the report's discussion of 
fee disclosure practices among various financial services firms.

Specifically, we are concerned about the impression conveyed by the 
draft report's assessment of mutual fund fee disclosures relative to 
other financial services products. We believe very strongly that mutual 
fund fees are disclosed more thoroughly, accurately and effectively 
than the fees of any other financial service or product. The fact is 
that every individual considering a mutual fund investment, whether on 
his or her own or with the help of an adviser, enjoys ready access to 
simple and easy-to-use fee information. This information is clearly 
presented in a strictly regulated fee table that must appear 
prominently at the front of every fund prospectus. The fee table 
provides critical information, like the fund's expense ratio, that 
makes exact comparisons among funds easy and reliable. The expense 
ratio, along with the required example showing the impact of all of the 
fund's fees on a standard $10,000 investment, provides
key information to prospective investors, as well as to the media, 
information providers and others who offer views about mutual fund 
investments.[NOTE 1]

We are convinced that these fee disclosures allow individuals to make 
much more informed and accurate decisions about the costs of their 
mutual funds than do the disclosures made by other financial service 
firms identified in the draft report. In particular, we are not aware 
of any other financial product or service that is legally required to 
provide standardized information that reveals the exact level of all of 
its fees and expenses and projects their impact in dollar terms, over 
various time periods. While the draft report does not suggest that 
mutual fund fee disclosures are inferior to those of other financial 
services, we are concerned that the discussion of products that provide 
"specific dollar disclosures" could convey this impression. For 
example, the draft report appears to cite favorably the manner in which 
specific costs are disclosed to mortgage borrowers. Omitted from the 
discussion, however, is the fact that mortgage borrowers often receive 
these disclosures as part of a blizzard of paperwork requirements, and 
that such disclosures are typically provided at a point when borrowers 
have little or no ability to evaluate similar costs among competing 
firms. As the Administration's Assistant Treasury Secretary for 
Financial Institutions said in late 2001, "[a]n effective disclosure 
scheme requires that borrowers are able to clearly understand their 
mortgage's terms and conditions and that the information be reliable. 
On both counts our current disclosure scheme appears to be lacking.
[NOTE 2]

We also would like to comment on the draft report's discussion of the 
duties of mutual fund independent directors. We believe the discussion 
is quite thorough, and provides a useful analysis of the manner in 
which they fulfill their fee-related responsibilities to fund 
shareholders. However, we remain concerned that mutual fund independent 
directors are too rarely given the credit they deserve for guarding 
against self-dealing, helping sustain the mutual fund industry's 
culture of strong compliance with the securities laws, and helping the 
industry remain largely free of major scandal. While there is 
compelling evidence that mutual fund directors have successfully 
overseen mutual fund fees, in part by negotiating schedules that 
produce substantial automatic reductions in fee levels when a fund's 
assets grow, we think it is important to stress that this is not the 
only important function independent directors perform. The report GAO 
authored three years ago - before the recent renewal of public 
attention to corporate governance matters --acknowledged that, "the law 
also places various other responsibilities [beyond fee-related duties] 
on fund directors that exceed those of the directors of a typical 
corporation.[NOTE 3] More recently, an analysis in The Boston Globe 
pointed out
that governance standards at "public companies [were] behind mutual 
funds [because] the Investment Company Act of 1940 spells out the legal 
responsibilities of funds to their investors. Public companies follow 
voluntary codes of ethics when it comes to governance. Second, the SEC 
directly regulates mutual funds [but at] public companies, it has no 
authority to set corporate governance rules."[NOTE 4]

Again, the Institute appreciates the opportunity to offer comments on 
the draft report. We also look forward to working constructively and 
expeditiously with you, the SEC and Members of Congress as the report 
is reviewed and the possibility of further regulatory improvements to 
an effective system of mutual fund fee disclosures are considered.

Very truly yours,

Matthew P. Fink:

Signed by Matthew P. Fink:

NOTES:

[1] As you note in the draft report, the system of mutual fund fee 
disclosure may soon be enhanced. Assuming it is adopted by the SEC, 
reports that are sent to mutual fund shareholders twice each year will, 
for the first time, prominently feature fee disclosures, including 
exact dollars and cents costs based on a fixed dollar amount of an 
investment. In addition, the SEC has proposed and may soon adopt 
changes to mutual fund advertising rules that will require references 
to the fee disclosures in fund prospectuses.

[2] "Mortgage Reform and Predatory Lending. Addressing the Challenges," 
Remarks of the Hon Sheila Bair, Assistant Treasury Secretary for 
Financial Institutions, November 8, 2001.

[3] "Mutual Fund Fees: Additional Disclosure Could Encourage Price 
Competition," U.S. General Accounting Office (June 2000), p. 88, fn. 9.

[4] Beth Healy, "A Model of Independence," The Boston Globe, July 5, 
2002:

[End of section]

Appendix IV: GAO Contacts and Staff Acknowledgments:

GAO Contacts:

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

Acknowledgments:

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

(250132):

FOOTNOTES

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

[2] U.S. General Accounting Office, Mutual Fund Fees: Additional 
Disclosure Could Encourage Price Competition, GAO/GGD-00-126 
(Washington, D.C.: June 7, 2000).

[3] U.S. General Accounting Office, Mutual Funds: Information on Trends 
in Fees and Their Related Disclosure, GAO-03-551T (Washington, D.C.: 
Mar. 12, 2003).

[4] Some funds charge what is known as a contingent deferred sales 
load, which is a charge that is a percent of the amount invested that 
declines the longer the investment is held and usually becomes zero 
after a certain period.

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

[6] GAO/GGD-00-126.

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

[8] GAO-03-551T. 

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

[10] A mutual fund transfer agent maintains shareholder account records 
and processes share purchases and redemptions. 

[11] See GAO/GGD-00-126, p. 78.

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

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

[14] J.M.R. Chalmers, R.M. Edelen, and G.B. Kadlec, "Mutual Fund 
Trading Costs," Rodney L. White Center for Financial Research, The 
Wharton School, University of Pennsylvania (Nov. 2, 1999).

[15] M. Livingston and E.S. O'Neal, "Mutual Fund Brokerage 
Commissions," Journal of Financial Research (Summer 1996).

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

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

[18] J.P. Freeman and S.L. Brown.

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

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

[21] NASD Conduct Rule 2830(d).

[22] Lesseig, Vance P.; Long, D. Michael; and Smythe, Thomas I. "Gains 
to Mutual Fund Sponsors Offering Multiple Share Class Funds," Journal 
of Financial Research (March 1990).

[23] Dellva, Wilfred L. and Olson, Gerard T. "The Relationship Between 
Mutual Fund Fees and Expenses and Their Effects on Performance," The 
Financial Review (February 1998).

[24] O'Neal, Edward S., "Mutual Fund Share Classes and Broker 
Incentives," Financial Analysts Journal (September/October 1999).

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

[26] As noted previously, instead of commissions, broker-dealers 
executing trades also could be compensated through markups or spreads.

[27] U.S. Securities and Exchange Commission, Inspection Report on the 
Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual 
Funds (Washington, D.C.: Sept. 22, 1998).

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

[29] Greenwich Associates, Commission and Soft-Dollar Practices in U.S. 
Equities (May 3, 2002).

[30] M. Livingston and E.S. O'Neal, "Mutual Fund Brokerage 
Commissions," The Journal of Financial Research (Summer 1996).

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

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

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

[34] In SEC Interpretation: Commission Guidance on the Scope of Section 
28(e) of the Exchange Act, Securities and Exchange Commission Release 
No. 34-45194 (12/27/2001), SEC clarified that the term "commission" for 
purposes of the Section 28(e) safe harbor encompasses, among other 
things, certain riskless principal transactions.

[35] Proposed Rule: Electronic Filing by Investment Advisers; Proposed 
Amendments to Form ADV, Securities and Exchange Commission, Release No. 
IA-1862; 34-42620 (Apr. 5, 2000).

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

GAO's Mission:

The General Accounting Office, the investigative arm of Congress, 
exists to support Congress in meeting its constitutional 
responsibilities and to help improve the performance and accountability 
of the federal government for the American people. GAO examines the use 
of public funds; evaluates federal programs and policies; and provides 
analyses, recommendations, and other assistance to help Congress make 
informed oversight, policy, and funding decisions. GAO's commitment to 
good government is reflected in its core values of accountability, 
integrity, and reliability.

Obtaining Copies of GAO Reports and Testimony:

The fastest and easiest way to obtain copies of GAO documents at no 
cost is through the Internet. GAO's Web site ( www.gao.gov ) contains 
abstracts and full-text files of current reports and testimony and an 
expanding archive of older products. The Web site features a search 
engine to help you locate documents using key words and phrases. You 
can print these documents in their entirety, including charts and other 
graphics.

Each day, GAO issues a list of newly released reports, testimony, and 
correspondence. GAO posts this list, known as "Today's Reports," on its 
Web site daily. The list contains links to the full-text document 
files. To have GAO e-mail this list to you every afternoon, go to 
www.gao.gov and select "Subscribe to e-mail alerts" under the "Order 
GAO Products" heading.

Order by Mail or Phone:

The first copy of each printed report is free. Additional copies are $2 
each. A check or money order should be made out to the Superintendent 
of Documents. GAO also accepts VISA and Mastercard. Orders for 100 or 
more copies mailed to a single address are discounted 25 percent. 
Orders should be sent to:

U.S. General Accounting Office

441 G Street NW,

Room LM Washington,

D.C. 20548:

To order by Phone: 	

	Voice: (202) 512-6000:

	TDD: (202) 512-2537:

	Fax: (202) 512-6061:

To Report Fraud, Waste, and Abuse in Federal Programs:

Contact:

Web site: www.gao.gov/fraudnet/fraudnet.htm E-mail: fraudnet@gao.gov

Automated answering system: (800) 424-5454 or (202) 512-7470:

Public Affairs:

Jeff Nelligan, managing director, NelliganJ@gao.gov (202) 512-4800 U.S.

General Accounting Office, 441 G Street NW, Room 7149 Washington, D.C.

20548: