MAY-JUNE 1967 perform poorly, there is no reason for my paying you anything, or perhaps at the most enough to cover your basic expenses." Though there are important problems that must be resolved before an optimum theory of this sort can be developed-such as the yardsticks to be used to measure performance, how well to reward a management that performs successfully and how much to penalize one for unsuccessful results the approach does seem a reasonable starting point. Enter a False Issue Nor is the SEC totally indifferent to such an ap proach. The Commission is aware that the rewards to management for good investment results should be high. Thus, it states (page 145) that, “the sustained investment performance of a company would be an appropriate consideration in evaluating the reasonableness of its advisor's compensation." Despite this recognition of the significance of relating compensation to performance, the Commission apparently is reluctant to put this relationship into practice. It has recommended that the Investment Advisors Act be amended to outlaw compensation on the basis of a share of capital gains or appreciation of the funds-although such a fee clearly would be most directly tied to performance--and it remains wedded to the comparison theory of fee determination. Apparently to bulwark its opposition to fees based on a share of capital gains, the Commission quotes from the Senate Report on the Investment Advisers Act of 1940: " 'Individuals assuming to act as investment advisors at present can enter profit-sharing contracts which are nothing more than “heads I win, tails you lose" arrangement" (page 345, fn.). In 1940, the regulatory concern in the investment company field was with "unscrupulous tipsters and touts" and "frauds and misrepresentations." By its own assertion, however, as previously indicated, the Commission now feels that such abuses have been substantially eliminated, and that "on a whole the investment industry reflects diligent management by competent persons." In employing the "heads I win, tails you lose" argument, therefore, the Commission, in effect, is painting the current industry with the same black tar that existed in 1940-hardly a “fair or reasonable" implication. A fee related to a percent of assets accrues to the investment advisor under any conditions, but one tied directly to profits could under certain circumstances be nonexistent. Thus the investment advisor who is willing to have the fee related to performance would run a real risk of not being paid for his work. The "heads I win, tails you lose" analogy disappears in the context of modern mutual-fund management with its attendant overhead and a profit-related theory specifically designed to prevent this from occurring. Therefore, it seems strangely inappropriate to rule out this one form of fee arrangement, as the Commission is suggesting, especially since it conforms with its own broadly stated policy. Quite the contrary, the logic is on the side of the Commission's exploring the full implications of such a theory to determine the advisability of encouraging rather than eliminating its use. Toward Rapprochement While the introduction of a performance criterion for fees seems desirable, the health of the mutual fund industry would be even better served by a basic reorientation of approach. What is required is closer cooperation between the SEC and the industry, a more realistic appraisal of the regulation required, and a more effective distribution of supervisory responsibilities both for the protection of the investor and the public interest. When the U.S. securities laws were originally being debated, a fundamental philosophic issue that had to be hammered out was the form regulation should take. The underlying issue was between those who desired an all-powerful supervisory commission and those favoring greater private authority. The compromise was self-regulation. Perhaps the primary ground for resorting to this regulatory mechanism was practicality or expediency-the sheer difficulty of attempting to have a relatively slow-moving administrative agency supervise an unusually dynamic industry. But, in addition, it was felt that participation by the regulated would make regulation more palatable and increase awareness of the goals of regulation. Dearth of Self-Regulatory Bodies Originally, the organized exchanges represented the only official self-regulatory bodies. The Securities Exchange Act did not provide any detailed system of regulation of the over-the-counter market but rather entrusted broad rule-making powers to the Commission in this respect. Eventually, Section 15A of the Securities Exchange Act brought the self-regulation principle to the over-the-counter market by providing for the registration of any qualified association of broker-dealers to govern its members. The National Association of Securities Dealers, Inc., thus far is the only association to register with the Commission under Section 15A and has issued rules applicable to investment-company underwriters, as required by the Investment Company Act, which specifically delegates certain functions to “a securities association registered under Section 15A of the Securities Exchange Act of 1934." In reviewing the history of the NASD, the Special Study of the Commission noted that while it played a relatively small role at first, it has emerged as an established part of the regulatory scheme exerting a substantial influence on numerous phases of the securities industry. Presently, however, the scope of NASD operations has become too large to permit effective supervision. The securities traded over the counter are diverse in kind, price, quality and activity; while the dealers handling these transactions range from giant, diversified organizations to small specialized shops. Commenting on this growth, the Special Study indicated that the over-the-counter market had outpaced the ability of the regulatory agencies to obtain essential information and made it difficult to devise solutions for new problems created by the growth. It does not seem unreasonable to assume that administration of this huge, complex business would require the full-time absorption of a self-regulatory agency. Columbia Journal of World Business Since 1940, the mutual fund industry has grown dramatically and mutual fund sales now constitute an important part of the activity of the broker-dealer community. Separated from one another, it is clear that the regular over-the-counter business and investment-company operations of the securities industry are each of mammoth scope. Moreover, their problems are different, since each is engaged in different types of activity. Yet, supervision of the investmentcompany segment is merely an adjunct of the NASD activities. This may have been appropriate in 1940, but it seems hardly suitable now to cope with the new problems arising from the growth of both the over-the-counter and investment-company phases of the NASD responsibilities. Two Likely Candidates In view of the importance of an appropriate ratemaking policy in the investment-company area, and the very real chance that the theory recommended by the SEC could have deleterious effects on the industry, it would appear prudent, before instituting any rate-making changes, to create a regulatory structure more in keeping with the greatly expanded role that the industry now occupies in the securities field. For this purpose, it is suggested that the investment-company industry, in cooperation with the SEC, create a securities association that would be registered under Section 15A of the Securities Exchange Act and would serve as the self-regulatory body for the investment companies.10 In addition to the NASD, which now handles the administration of investment companies. there are two organizations in this field that are termed by the SEC Special Study as quasi-regulatory: (1) the Investment Company Institute, which was organized about 1940 as an authoritative industry group to work with the Commission and has served as an information and discussion center for the invest ment-company industry while encouraging adherence to high ethical standards by all elements within the industry; and (2) the Association of Mutual Fund Plan Sponsors, which restricts its membership to firms sponsoring contractual plans. One of these orga MAY-JUNE 1967 nizations could be the basis of the new securities association. One of the initial jobs of such an agency would be to explore pricing implications in the investmentcompany area to develop a theory of rate-making that will satisfy both the public interest as well as the need to protect the investor. The SEC, in its normal overseer capacity, could review consequent recommendations to make certain they conform to the objectives of the securities acts. NOTES 1 2 3 4 5 6 7 8 9 10 See Report of Special Study of Securities Markets to the Securities and Exchange Report of the Securities and Exchange Commission on the Public Policy Implications of Wharton School of Finance and Commerce, A Study of Mutual Funds, House Report Vance, Sanders & Co., a sponsor of large mutual funds, has questioned the validity of some The Special Study discovered that of the nearly 5,000 broker-dealers registered with the F. William Graham, II, and Richard C. Bower, "Corporate Responsibility in Pension Fund Based on Figures published in FundScope, April, 1966. The Investment Company Act of 1940, Section 22. To achieve this purpose with sufficient latitude, an amendment to the Securities Exchange "association of brokers or dealers." Hon. WALLACE F. BENNETT, PIONEER FUND, INC., Senate Banking and Currency Committee, DEAR SENATOR BENNETT: I wish to acknowledge and thank you for your kind letter of May 23 asking whether I would wish to testify before the Senate Banking and Currency Committee with respect to the Senate Bill 1659 incorporating the Securities and Exchange Commission's Regulations concerning mutual funds. I would very much appreciate that opportunity, particularly since the proposals will have a substantial effect on the mutual fund industry as a whole and on many medium and small size securities dealers, a significant portion of whose income is derived from the sale of mutual funds. With respect to the medium and small securities dealers I, for one, view with some apprehension the economic implications to that group recognizing that if that group were to be economically squeezed out of the securities, market the result would be an increasing concentration in the distribution of securities by the larger securities dealer firms. I believe there is a place for both large and small dealers and that both tend to compliment one another in the orderly marketing and distribution of securities. The Securities & Exchange Comission's proposed recommendations limiting the sales charges on sales of mutual fund shares and on the sale of contractual plan shares is an indication, I believe, of a failure to sufficiently recognize the difference between the sales and marketing efforts involved in the shares of mutual funds as compared with the buying and selling of securities of companies whose shares are traded either on a national exchange or on the over-thecounter market. The time, effort and initiative which is involved in the sale of mutual funds can more comparably be related to that which a life insurance salesman has to make to sell life insurance rather than the efforts of a securities dealer in listed and unlisted securities. It is my view, and I think that of a number of others, that the sale of mutual fund shares has represented a significant source in encouraging the savings habit by people especially of modest means while at the same time affording them a diversification of risk and a hoped for protection against inflation for their hard earned savings. In these times of increased longevity, people need every encouragement to in their early years provide economic security after retirement. Insurance, while serving as one answer in terms of imediate protection, does not represent as effective a defense against infiation as mutual funds have done over the past several decades. What I am saying is that the sales effort needed to encourage people to save, whether by means of insurance or mutual funds, particularly where in many cases they are new savers, is a task that requires much time and often repeated interviews with such people and is quite different from that involved in recommending the purchase and sale of securities for investors who have already accumulated some wealth. There is no question that the proposed legislation regulating management fees will be adverse to the management companies in the mutual fund industry. In support of its recommendations, the Securities & Exchange Commission's report leaves the implication that comparable services performed by banks are done at rates comparable with those charged by a mutual fund. The report fails to recognize the conventional minimum fee schedule that banks commonly use, which for a small investor would make the management of small amounts of investments significantly higher. Perhaps, and of gravest concern in this regard, is the far reaching effect of this legislation on other private sectors of our economy. The proposal limiting management fees represents, I believe, a substantial departure from our present rate regulation pholosophy. Up to now as I see it the regulation of rates has been justified in those industries which are in a monopolistic position. Certainly I think there would be a degree of unanimity in the statement that the mutual fund industry is not monopolistic and is in fact a highly competitive one. There are over 250 funds representing a wide range of investment philosophies and objectives. If we are to regulate fees in a highly competitive industry such as the mutual fund industry, where does the rate-making role of government stop? Apart from the broader significance of the expansion of rate-making controls contained in this bill there is the narrower significance of the effect of such ratemaking on the quality and composition of mutual fund managements. The Securities & Exchange Commission indicated in its recommendation that the industry in its management of funds invested was doing a good job. In light of that favorable comment here we have legislation designed to create sanctions against an industry which has been substantially free from criticism of mismanagement. I would not be able to predict that should rate regulations be enforced on management fees as to whether a better or lesser job would be done with respect to the management of funds. Investment is an art not a science and depends upon people. The question, of course, is whether with more and more restrictions the industry will still be able to attract people of first quality. This answer is unknown, but there is no question that should the answer be in the negative the many millions of small investors will in the end be worse off, which is the group the Securities & Exchange Commission has indicated it is most interested in protecting by the legislation now before your Committee. Very truly yours, JOHN F. COGAN, Jr., President. SAN JOSE, CALIF., August 22, 1967. Hon. JOHN SPARKMAN, MY DEAR SENATOR SPARK MAN: There is presently before the Congress legislation to amend the Investment Company Act of 1940. More specifically, an attempt is being made to limit the sales charge imposed on clients when purchasing shares of mutual funds. As an employee of J. Barth & Co., a securities firm headquartered in California, I feel that the proposed amendment would not only impose serious restrictions on my employer but also have a profound affect on my future in the securities business. The recommended changes use lower prices as the only factor in the public interest regardless of service, quality or other consequences. A reduction in sales compensation would slow the growth of "peoples capitalism", the widespread ownership of shares in American industry by millions of investors, which permits small savers to share in the profits and growth of our industries. I would appreciate your consideration of this proposed legislation as being a limitation on the continued development of free private enterprise in the mutual fund industry. Your truly, Hon. WALLACE F. BENNETT, Senate Banking and Currency Committee, Senate Office Building, Washington, D.C. SYDNEY RESNICK. HARRY P. SCHAUB, INC., Newark, N.J., June 22, 1967. DEAR SENATOR BENNETT: Thank you so much for taking the time to acknowledge receipt of my memorandum entitled "A Dealer Looks At The S.E.C. Report on Mutual Funds". In answer to your inquiry I would be very pleased if my observations could be included in the committee hearing's record. I have received a number of replies from other independent broker-dealers who voiced the hope that I could be present at the hearings to represent the dealer's viewpoint in person particularly with my background of having served on the NASD Committee which includes New Jersey, New York and Connecticut. I realize that the National Association of Securities Dealers, Investment Company Institute, various mutual funds, etc. will be represented. It does occur to me that the viewpoint of the smaller, independent retail investment dealer should be presented by someone who-because he is actually in the business on a day-to-day basis-is closer to the mutual fund investor than most of the "top brass" who will appear before you and your colleagues. |