ing and furnishing investment advice with respect to about one-half of the total assets of the mutual fund industry. In the case of such a publicly-held adviser a duty to maximize its profits-at the expense of the fund-runs from those in control of the adviser to its own shareholders. Thus, the adviser's representative on the fund's board must constantly face pressures from the public shareholders of the investment adviser which conflict with his duties to the public shareholders of the fund. Outside the public utility field, prices of goods and charges for services are normally determined at arm's length by the forces of competition. Thus, in an ideal competitive situation the interaction of competing investment advisers, vying for the patronage of the various funds, might be relied upon to set the fee rates at a level that is fair to the funds, giving the funds the kind and quality of services they require at a reasonable cost. Such competitive forces, however, have not in fact existed in the mutual fund industry with respect to advisory fees. Instead, a sellers' market exists in which the investment adviser, wearing one hat, sets his own fee without fear that the fund's board, on which he wears his other hat, can or will bargain effectively with him, much less actually shop around for competitive offers. Nor has it made much difference in the past whether the adviser's representatives on the board of the fund were persons actually affiliated with the adviser or merely persons who were chosen for the fund's board by the adviser since the fund board, regardless of its willingness to act effectively in the fee area, does not in fact have the means to do so. In the absence of competition or arm's-length bargaining, the basic fiduciary obligation of fairness must serve as an effective substitute. It is certainly not breaking any new legal ground to state that the investment adviser and the directors of the fund owe a fiduciary duty to the public shareholders of the fund, and that the law must be especially watchful when such fiduciaries place themselves in positions of conflicting loyalties. As the Supreme Court stated in the classic case of Geddes v. Anaconda Copper Mining Co.:* "The relation of directors to corporations is of such a fiduciary nature that transactions between boards having common members are regarded as jealously by the law as are personal dealings between a director and his corporation, and where the fairness of such transactions is challenged the burden is upon those who would maintain them to show their entire fairness and where a sale is involved the full adequacy of the consideration. Especially is this true where a common director is dominating in influence or in character" (emphasis added). Nevertheless, as we shall point out in more detail later on, the present provisions of the Investment Company Act do not provide an explicit and adequate means by which adherence to this standard of fairness can be enforced in respect to investment advisory and other management fees. Indeed, the "few elementary safeguards" placed in the statute in 1940-requirements of approval by unaffiliated directors and confirmation by shareholders-have thus for been applied in such a way as to shield the fees from judicial scrutiny rather than to enforce protections for fund shareholders. B. THE RECORD OF EXCESSIVE ADVISORY FEES Perhaps the problems inherent in the structure of the industry would merely be a matter of academic concern if the record showed that these built-in conflicts were always or most often resolved in favor of investment company shareholders. Unfortunately the record shows the opposite in far too many cases. It is clear that there are substantial economies of scale in the field of investment management. It does not cost ten times as much to advise a billion dollar fund as it costs to advise a $100 million fund. In the hearings on the Act in 1940, the then chairman of the board of Massachusetts Investors Trust, at that time the largest mutual fund, testified that "it is now almost axiomatic in the trust business that operating costs decline proportionately as the size of the trust increases." This view was confirmed some 20 years later when the Wharton School Report's examination of the operating ratios of mutual fund advisory organizations showed that economies of size were very pronounced. The Commission's Report of last December contains current proof of this undeniable fact. 254 U.S. 590, 599 (1921). * Senate Hearings 498. For example, between 1961 and 1964 the advisory fees received annually by one of the largest investment advisers increased from $1,200,000 to $3,400,000, an increase of almost 200 percent, while its operating expenses allocable to this business increased from $469,000 to $846,000, an increase of only 80 percent. Thus, the adviser's profits increased by almost $2 million in only three years. During the same four-year period the broker-dealer affiliated with this investment adviser received some $5,917,000 in fees for the execution of portfolio transactions and some $8,713,000 in sales charges, after payments to other brokerdealers. Other external advisers have experienced similar increases in their profit margins as the net assets of their funds and, as a result, their revenue from advisory fees have expanded dramatically, while the increases in the number of securities in the funds' portfolios and the size of the advisers' staffs handling them have been comparatively modest, or they have been decreased. Notwithstanding these economies of scale, the facts with respect to fees are clear: 1. The traditional formula for advisory fees in the investment company industry has been a flat 0.50 percent of average net assets per annum. In some cases an additional fee calculated in the same manner has been and is still charged for nonadvisory management services. 2. The Wharton School Report found that in 1960 all but 5 of the 174 mutual funds whose investment advisers were surveyed were compensated on the basis of the value of the funds' assets, and that more than 80 percent of the funds paying their advisers on this basis paid a flat rate regardless of the size of the fund. The rate charged by more than 72 percent of the advisers was 0.50 percent or more of the average net assets. 3. Prior to 1960 the fund managers, with rare exceptions, made no move to lower these fees. Many funds grew in net asset value from $50 million to $500 million or even $1 billion, and the 0.50 percent advisory fees remained constant. This was true regardless of performance and in good or bad markets. Fund managers with outstanding performance, mediocre performance and poor performance were generally paid at the same rate of approximately 0.50 percent per annum, while their advisory fees continued to grow, principally as a result of sales effort in marketing the fund's shares to the public. In instances too numerous to ignore this is still the case. 4. Although a few investment managers had earlier given recognition to the unfairness of such an arrangement and had made modest provisions for scaling down the fees on assets in excess of a fixed amount, it was not until 1960, when the Commission authorized the Wharton School of Finance to conduct a study of the industry, that the pressures on advisers' fees started building. The scope of the Wharton School study was significantly expanded later in 1960, and the Wharton School Report was finally released in 1962. Between 1959 and 1962, 50 shareholder derivative suits were brought against the advisers to most of the major funds. (Most of these suits were eventually settled, and we shall discuss this private litigation in more detail later, although we would only note here that these suits have not resolved the problem adequately and under existing law, as interpreted by the courts thus far, cannot do so.) In 1961 the Commission launched its Special Study of Securities Markets. Nevertheless, despite these pressures and despite the further dramatic growth of the mutual fund industry from $18 billion in 1960 to $38 billion in 1966, in many cases no substantial reduction has been achieved to date. Although limited scale-downs from the basic 0.50 percent fee are now widespread, often the amount of the scale-down is small and ineffective, except at the very highest levels. The median advisory fee paid by the 59 externally managed mutual funds with net assets of $100 million or more in fiscal years ending in 1966 was still 0.48 percent, down only 0.02 percent from the traditional 0.50 percent rate. C. COMPARATIVE ADVISORY FEES This pattern of relatively inflexible fee schedules, which reflects indifference to the equity of sharing with the funds the economies of scale, is not characteristic of other areas of investment management where the forces of competition are able to operate, such as pension and profit-sharing plans managed by banks and investment advice provided to individual clients. Even within the mutual fund industry those funds which are internally managed-that is, those which are managed in the conventional corporate pattern by their own officers and directors for whom conventional limitations on individual compensation exists have compensated their managers on a scale that, although among the very highest in the business world generally has been substantially less than the excessive fees paid to many of the external advisers. Mutual fund advisory fees per dollar of assets managed are substantially higher than the fees charged by banks for investment management services to pension and profit-sharing plans, funds of comparable size and purpose which are in a position to negotiate effectively the charges which they pay, particularly since the trustees of the plans actually select the adviser, rather than are selected by it, as is the case with most mutual funds. Competitive forces are thus at work, with the result that economies of scale are in effect passed on to their clients. Because substantial scale-downs for size are available, typical advisory fee schedules published by banks for investment management service to pension and profit-sharing plans call for a fee of 0.06 percent of total asset value for a pension or profit-sharing plan portfolio of $100 million, or about oneeighth of the typical advisory fee paid by mutual funds of comparable size, and the pension fund or profit-sharing plan may be able to negotiate further savings. The few mutual funds which have been organized as vehicles for equity investment for banks pay management fees which follow a similar pattern. We do not suggest that mutual fund advisory fee rates should be the same as fees for pension and profit-sharing plans. Since the services required by the two investment media and the indirect benefits received by banks and fund advisers from their management functions are not precisely the same, some difference in the fee rates charged to mutual funds and to pension and profitsharing plans at any given size level may be justifiable. But neither this difference in functions, which exists principally in the area of management services provided rather than the area of investment advice, nor the fact that such services, frequently only ministerial, are provided nor any possible difference in performance can justify the existing pattern of charges levied on investment companies, which is eight times as high as the typical fee for pension and profit-sharing plans. As industry representatives have noted, the fees charged by banks and other investment advisers to individual clients on relatively small amounts of assets are often as high or higher than those charged to investment companies, but, as the size of the assets managed grows, even when the amounts by comparison with investment companies are relatively modest, the fees scale down sharply. Indeed, the very same investment advisers that charge their multimillion dollar fund clients advisory fees in the neighborhood of 0.50 percent often charge their nonfund clients with portfolios of only $1 million to $2 million-relatively insignificant when compared with the assets of the typical large funds-substantially less, and fees on larger nonfund portfolios are subject to negotiation of even lower rates. The Wharton study found no evidence of the existence of higher costs which might provide some justification for the substantially higher management remuneration obtained from fund clients. As we mentioned before, the internally managed mutual funds pay substantially less for their investment advice than do the externally managed companies, while still rewarding management handsomely. The estimated management cost ratios during the fiscal years ending in 1966 of the 11 internally managed investment companies with assets of $100 million or more ranged from a low of 0.12 percent to a high of 0.40 percent of average net assets. The median management cost ratio during this period for these internally managed investment companies was 0.24 percent, or one-half of the median advisory fee rate for the 59 externally managed funds of the same size, whose advisory fees ranged from a low of 0.24 percent to a high of 0.66 percent of average net assets. For example, Massachusetts Investors Growth Stock Fund, Inc., had a management cost ratio of 0.26 percent in 1966, and Massachusetts Investors Trust, the other member of the largest internally managed fund complex, had a management cost ratio of only 0.13 percent, which was less per dollar of assets managed than almost every other fund in the industry. Nevertheless, these two internally managed funds were still able to pay the five trustee-directors of the two funds compensation totaling $2,223.093 for the year 1966, or an average of almost $450.000 for each trustee. Additional payments of $241,457 each were made to two other directors of the smaller of the two funds who are affiliated with and devote most of their time to the principal underwriter for both funds. These payments, which are quite handsome by any standard for executive compensation, were made by funds which paid less for advisory services per dollar of assets managed than virtually every externally managed fund in the industry. The Commission has found no evidence that it is substantially more costly to the external investment adviser to perform these services than it is to the internally managed fund, and these management compensation figures bear this out. We do not wish to be misunderstood. Our reference to the handsome profits enjoyed by investment advisers only emphasizes that by any objective standard the advisory fees paid by a number of the funds are excessive and, that this is due, in the main, to the mechanical application of a formula related only to the assets of the fund-regardless of the extent to which the growth of these assets is caused by aggressive sales efforts without any proportional increase in the costs of advising the fund. Moreover, these charges are not in fact attributable to any proportional increase in the advisers' expenses, nor are they related in any systematic way to the investment performance of the funds. They result largely from the failure to allow the funds to share in the economies of scale. It should be stressed, however, that the Commission does not believe that investment advisers should not make reasonable profits. The Commission is not here to suggest that any particular level of profits is excessive. Prevailing profit margins, however, demonstrate what was characterized in 1940 as axiomatic—that economies of scale in the management of investment companies do exist. Our point here is that in many instances such economies are not shared on any equitable basis with the investment companies owned by millions of American shareholders on whose behalf there cannot be brought to bear any of the procedures available where competition and the process of negotiation are realities. Chart A demonstrates this basic fact, which has been developed in all recent studies of which we have knowledge. The bottom area of the chart shaded with diagonal lines shows the expenses of fund management actually incurred per dollar of assets managed at asset levels between $100 million and $1 billion by one typical external adviser and the extent to which this expense figure declined as the size of the fund grew. The upper area shaded with dots shows the range of advisory fee income resulting from the advisory fees generally charged by external fund managers. The upper limit of this range is based on the fee schedule of an external manager with the traditional flat 0.50 percent advisory fee rate, and the lower limit of this shaded area is based on the fee schedule of an external manager with one of the lowest rates. The white area between the two shaded areas represents the profits that would be realized by the adviser whose expenses are represented on the chart if it charged the low rate in the range of advisory fee income. The area shaded with dots also represents the additional profit that this adviser would realize if it charged the traditional advisory fee rate of 0.50 percent. You will note that even the fees received by an adviser who shares the economies of scale with the fund result in quite a profitable operation, while the flat 0.50 percent fee still charged by some advisers merely retains all of the benefits of size for the adviser as additional profit. D. THE CONTROLS PRESENTLY AVAILABLE. It is appropriate now to consider what controls in this area presently exist either as a result of the provisions of the Act, competitive pressures or otherwise, and whether these controls are adequate. Turning first to the provisions of the Act, we believe that it was recognized in 1940, when the Investment Company Act was passed, that a real potential for conflict of interest did exist with respect to the investment advisory fees paid by externally managed investment companies. In other areas, such as transactions between investment companies and persons affiliated with them, Congress enacted strict controls over conflicts of interest. Advisory fees, however, were then regarded as not presenting a serious problem because the investment company industry was so small that the conventional practice of computing fees upon the basis of a percentage of a fund's assets was not regarded as likely to produce excessive fees. Indeed, it was not then contemplated by representatives of the industry that some investment companies would grow anywhere near their present size. For example, the chairman of Massachusetts Investors Trust testified in 1940: "*** [A]n open-end trust could never be a billion dollar company or a five hundred million dollar company, because redemptions, which are a fixed percentage, around 8 or 10 percent, get to be so large, when your fund gets to those 1/ Expenses based on actual experience of an extemal adviser to a large growth fund. DS-4701 14-47) big proportions, that you could not resell that amount of shares; and we therefore claim that economic conditions absolutely take care of this situation, and that there never will be an open-end investment trust with assets like life insurance companies and large banks."" As of 1966, however, there were 1 fund with net assets over $2 billion, 8 between $1 billion and $2 billion, 7 between $500 million and $1 billion and 18 between $250 million and $500 million. As the Supreme Court recognized in the leading Senate Hearings 500. |