MUTUAL FUND LEGISLATION OF 1967 MONDAY, JULY 31, 1967 U.S. SENATE. COMMITTEE ON BANKING AND. CURRENCY, The committee met, pursuant to notice, at 10:05 a.m., in room 5302, New Senate Office Building, Senator John Sparkman (chairman of the committee) presiding. Present: Senators Sparkman, Proxmire, Williams, McIntyre, Mondale, Spong, and Bennett. The CHAIRMAN. Let the committee come to order, please. Today the committee begins hearings on S. 1659, the Investment Company Amendments Act of 1967. (Copy of the bill and agency reports can be found at p. 897.) Congress passed the Investment Company Act of 1940 at a time when mutual funds with their 300,000 shareholders and total assets of $450 million played a minor part in our Nation's securities industry. Today, with 32 million shareholders and assets of over $40 billion, the funds occupy a far different position than was envisioned 27 years ago. The Investment Company Act has proven itself to be an effective example of Federal securities regulation. However, no one in 1940 could have foreseen the rapid growth of our Nation's investment companies or could have fashioned a regulatory pattern that would not in time require modification to keep pace with economic change. We should all, therefore, welcome this opportunity to reexamine legislation which was designed to fit an industry far different and smaller than that which exists today. The legislation before the committee is the result of 8 years of hard and diligent study by the Securities and Exchange Commission, its staff, and the academic community. And all should be commended for a job well done. The Commission in its underlying report and legislative proposals has, in my opinion, correctly emphasized the serious problems which have arisen due to the rapid growth of the industry over the past 27 years, especially in the area of mutual fund sales commissions and management fee charges. Serious questions have been raised as to whether existing law adequately serves the needs of investors or the investment company industry. While the precise proposals encompassed in this bill may not be the only possible solutions to the problems which have been raised, they do offer a constructive basis for consideration. Accordingly, I am sure that Congress will give these proposals careful and comprehensive consideration. The committee welcomes suggestions and assistance from all parties. I am, therefore, especially gratified by our list of witnesses for this week's hearings. These witnesses include distinguished members of the securities industry as well as the academic and legal professions. The committee also intends to hold additional hearings in the near future. At that time we expect to hear from other interested parties, including the New York Stock Exchange. Over 32 million Americans now own mutual fund shares. I am confident that as a result of our endeavors during the weeks ahead that this number will increase as more and more Americans gain confidence in the mutual fund industry and seek to provide for their personal future by investing in the future of their country's economy. Our witness for today is the Honorable Manuel F. Cohen, chairman of the Securities and Exchange Commission. Mr. Cohen, will you come around, please? STATEMENT OF MANUEL F. COHEN, CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION, ACCOMPANIED BY PHILIP A. LOOMIS, JR., GENERAL COUNSEL Mr. COHEN, Thank you. The CHAIRMAN. If you have anyone accompanying you, will you identify them for the record? Mr. COHEN. Yes. Mr. Philip A. Loomis, Jr., our general counsel, will sit with me. Members of the Commission and of our staff are in the audience wherever we could find a chair. We really didn't anticipate a "standing room only" crowd, although we are gratified to see everyone here. At the outset, Mr. Chairman, for the record, I want to thank you for the words you have just expressed. We have submitted to the committee, and I think there has been distributed to the press here and everyone interested, two documents. The CHAIRMAN. Now, Mr. Cohen, will you adjust that microphone? We want to be sure that everyone can hear. Mr. COHEN. We submitted to the committee, and I think there has been distributed to the press and others interested, certainly to every member of the committee, two documents. The first and the longer one is entitled "Statement of the Securities and Exchange Commission." The second is my testimony, and is a summary of the longer statement. We thought it might be of some interest to the committee to have a fuller statement on all of the points mentioned. My statement is slightly more than 50 pages. Because of the importance of the matter, I would like to stick as closely to the text as possible. However, as is customary, I do want to indicate that at any point I will be prepared to receive any questions and attempt to answer them. If I may begin, Mr. Chairman The CHAIRMAN. Yes. Go right ahead. Mr. COHEN. To repeat, it gives me great pleasure to testify today in support of S. 1659. The primary purpose of this bill is a simple one. It is to give a fair shake to the more than 4 million Americans-and I should say, Mr.. Chairman, the Americans who are interested in these funds are grow ing every day, and we are closer to about 4 million now than at an earlier point when we used a 3.5 million figure at any rate, it is the purpose of this bill to give a fair shake to the more than 4 million Americans who now own mutual fund shares and to the uncounted millions, as you have suggested, who will invest in such shares in the future. The bill will do so by reducing the sales loads imposed on the acquisition of fund shares where those loads are excessive and by providing a way in which unreasonably high management fees can be reduced. That is the sum and substance of the bill. Now, I should like to elaborate somewhat on it. A. MUTUAL FUND GROWTH AND THE ADEQUACY OF EXISTING REGULATION The investment company industry, and particularly the mutual fund segment, has grown dramatically since 1940. Mutual fund assets have risen during this period from less than $450 million to almost $45 billion. To give the committee some notion of the rate of growth, I might point out that at yearend 1952, fund assets amounted to only $4 billion. And from June 30, 1966, to the present time they have grown from $38.2 billion to an estimated $45 billion, a gain of almost $7 billion within approximately 1 year. There are now over 20 funds, each of which holds assets larger than the entire mutual fund industry in 1940. If the committee is interested in further information, our report contains exhibits which provide these additional figures. It is apparent from this growth that the mutual fund industry has come of age as a major segment in our financial community. It is no longer the infant, and to some extent the struggling industry that it was in the 1930's. The Investment Company Act of 1940, which reflected the modest size of the industry, had limited objectives. The purpose of its regulatory pattern was primarily to deal with specific and then recognized abuses. This it has done successfully. Beyond these abuses, and particularly in the area of conflicts of interest and costs to investors, a "few elementary safeguards"--and these are the words of the committee-were deemed adequate. These safeguards no longer meet the needs of the investing public. The tremendous growth of the mutual fund industry has brought unparalleled prosperity to those who have organized and managed mutual funds. It is also true that it has made possible substantial savings for mutual funds investors. I think all parties interested in the mutual fund industry have met with substantial success except in the areas to which I will advert later. Our report contains additional information showing, for example, the average annual income, pretax profits, and profit margins of investment advisers who were acting as advisers and underwriters for the fiscal years ended 1961 through 1965. Five out of the 10 advisers for which data is available-and I should say we don't have data for all of the advisers; this is a lack which we hope to fill in future months and years-but five of the 10 advisers for which data is available realized pretax profits of more than 50 cents on each dollar of gross advisory fee revenue. Only one corporation made profits of less than 30 cents on every dollar of advisory fee revenue. Now, despite all this, the unique structure of this industry and existing restraints on competition, some imbedded in the act itself-and I have particular reference to section 22(d)-have precluded mutual fund investors from sharing fairly in the potential savings inherent in the growth and the present size of this industry. Costs, with few exceptions, remain just about as high or higher than they were when the industry was substantially smaller. I should say in this connection that the traditional advisory fee of one-half of 1 percent is still in effect for many funds. Even among the larger funds by what I mean funds having assets of $100 million or more the median fee is 0.48 percent of net assets, just a fraction below one-half of 1 percent. These costs are also far higher than the cost of investing in other types of securities of comparable quality. As the chairman has pointed out, these problems have been studied by the Commission and for the Commission for almost a decade. We are convinced that the statute must be amended if most investors in mutual funds are to receive fair treatment. That is the sole reason for our being here today. After briefly discussing the background of our recommendations, I propose to explain first the principal areas in which congressional action is needed to assure fairer treatment to investors. These are: (1) the general level of management compensation; (2) the level of sales charges; and (3) the so-called front-end load plans. I will then conclude with a summary description of some of our other legislative proposals, many of which are complementary to the specific proposals encompassed within these three categories. B. BACKGROUND OF THIS LEGISLATION The studies which led up to this legislation include the reports of the Wharton School of Finance of the University of Pennsylvania and of the Commission's special study, which was conducted at the behest and with the encouragement of this committee. These studies questioned the adequacy of the protections afforded investors in the advisory fee, sales compensation and brokerage commission areas. These reports, however, were reports to the Commission, not reports of the Commission. The legislative proposals before you, on the other hand, are the result of the Commission's undertaking to evaluate the findings and conclusions contained in these reports and to submit to the Congress its own views, including appropriate legislative recommendations. We submitted our report, entitled 'Public Policy Implications of Investment Company Growth," on December 2, 1966, and our legislative proposals on May 1, 1967. Both reflected the unanimous views of the Commission. I know of few other legislative proposals to amend the Federal securities laws which have received more thorough consideration by the Commission than those we are discussing today. The President, in his consumer protection message to the Congress in February, and subsequently, recognized the particular interests of investors in mutual funds and urged the Congress to give careful consideration to the Commission's report and recommendations. He stated that, in his judgment, they provide a sound basis for meassures which will be beneficial to the investing public and promote the health and stability of the industry itself. Within the past few days, the Budget Bureau has further advised us, after reviewing a draft of my testimony and the statement of the Commission, that the legislation along the lines of this bill would be in accord with the President's program. The commission's report reflects our finding that, on the whole, the record of the investment company industry has been one of diligent management by competent persons. Existing regulatory controls on the whole have been effective in controlling the most acute abuses prevailing prior to 1940. I hasten to add, however, that this is not to say that through the years we have not had serious derelictions by some of those associated with registered investment companies. Fortunately, the Commissionand I think we have received a full measure of cooperation from the industry-has been able to contain these situations generally and to prevent a return to the widespread abuses which led to enactment of the Investment Company Act in 1940. C. THE MAJOR PROBLEMS: MANAGEMENT AND SALES CHARGES We have concluded, however, that this is not enough and that mutual fund shareholders need protection against excessive sales charges and advisory fees in connection with the acquisition and management of their fund investments. To a large extent, the need arises because of the interaction between the unique structure of the mutual fund industry and certain provisions of existing law. This interaction limits competition and permits unwarranted conflicts of interest between fund managers and public shareholders. Mutual funds, unlike other corporations, are not normally staffed and managed by their own officers and employees. There are a few exceptions, but the general pattern is the one I shall describe. The funds are controlled by outside organizations which, pursuant to contract, usually furnish them with investment advice and management services, sometimes including officers and employees as well. Given this structure, neither competition, even if it could exist under the present pattern, nor existing provisions of the act have been sufficient to assure equitable costs to mutual fund investors. The bill would deal with this situation essentially in this way: 1. By providing expressly that advisory fees and certain other management compensation must be "reasonable" and by making this standard enforceable in the courts to the extent necessary for effective implementation; 2. By providing a maximum on sales charges of 5 percent to purchasers of mutual fund shares, but giving power to the Commission to allow higher charges where necessary and particularly on small transactions. I should interpolate, if I may here, that we deliberately put that provision in the bill, although it was not necessary to have it there. |