Nevertheless, all three actions resulted in judgments for the defendants.

The courts viewed the fact that the advisory contracts had been approved by the shareholders-and in one case by the unaffiliated directors-as changing-this is the important point-as changing the applicable standard from fairness or reasonableness, which would otherwise apply, to the much more permissive standard of waste.

But the statutory purpose, and the congressional requirement enacted in 1940, has been perverted. The congressional requirement of approval by the shareholders and a majority of the unaffiliated directors, which was intended to act as a protection for the shareholders, has actually insulated the fees from judicial scrutiny and deprived the shareholders of the benefit of judicial protections they would otherwise have enjoyed.

In essence, we are asking you to take away those barriers, those restrictions, which you never intended to place there in the first instance.

The courts also relied on the fact that the rates under attack were typical of—and in one case lower than those prevailing in the investment company industry generally. The courts suggested that the problem of advisory fees is a result of an industrywide pattern of external management which initially calls for legislative action.

Although judicial examination of advisory fees in the courts has not to date acted as an effective substitute for competition and for arm'slength bargaining, most of the cases that were brought have been settled under conditions which resulted in new advisory contracts somewhat more favorable to the funds. Nevertheless, as has been indicated previously, after these settlements, the median advisory fee paid by the largest funds, the 59 externally managed funds with net assets of $100 million or more was still 0.48 percent.

F. THE COMMISSION'S PROPOSAL

I would now like to deal with our proposal.

Our proposal to deal with this problem is a cautious one, and, I might say, a genuinely conservative one. Some thoughtful commentators have proposed that only a restructuring of the industry by forced internalization of the investment advisory function will be sufficient to deal with the advisory fee problem. Although such a drastic step would presumably bring about the same savings for all investment companies that have been achieved by those that have already internalized voluntarily, we have not adopted this proposal.

Nor do we ask Congress to establish a schedule of fees or to give us authority to set fees ourselves.

I might say parenthetically there are many representatives of the industry who have called upon me and have urged that in their view they would prefer to see the Commission do it than the court. We deliberately determined that this problem should be dealt with by the courts because of the courts' long experience with dealing with problems of this kind.

Again I must refer to Judge Friendly, a noted jurist, a man who was a Wall Street lawyer, a man who dealt with at least one of the cases to which I have referred. And I believe his testimony deals with

this problem fully and adequately. It has been submitted to the committee and been made public.

We ask only that by specific language in the act Congress make explicit the authority of the courts to determine as a matter of Federal law whether, in a particular situation, the fund's advisory fee is reasonable.

It is more correct to describe this proposal, as I did a little while ago, as one which would remove the existing legal fetters that have resulted from statutory provisions originally designed to protect investment companies against overreaching rather than to shield fiduciaries from a fair accounting for such practices and their consequences.

In so doing, Congress would merely make clear that it never intended to restrict the courts in the application of the well-established standard of fairness in transactions between fiduciaries and the investment companies they serve.

Specifically, the Commission recommends that section 15 of the act be amended to provide that compensation received for any service rendered directly or indirectly to a fund or its shareholders by an investment adviser, principal underwriter or officer, director or controlling person of the investment company shall be resonable.

For the determination whether advisory fees are reasonable, the bill lists certain specific factors for consideration and provides that all other appropriate factors may also be considered.

The specific factors listed are the extent to which the fees reflect a sharing of the economies of size, the nature, extent and quality of the services provided-and I emphasize the quality-and the value of all other benefits received. The proposed legislation provides that the directors of an investment company must request and evaluate the basic information necessary to determine the reasonableness of compensation under this standard, and that the investment adviser is under a duty to furnish that information.

Obviously, since our proposal will not eliminate the basic conflict of interest inherent in the typical investment company structure, an adequate means of enforcement of the standard is essential. Where such enforcement is necessary in a particular case, the bill contains important protections for those rendering services to investment companies.

It provides, among other things, that the party attacking the reasonableness of compensation-and I emphasize that it is the party attacking the reasonableness of compensation-must carry the burden of proving that it is unreasonable, if all other requirements of the act have been met.

It should be noted—and I also wish to emphasize this-that in this respect our suggestion for statutory amendment is more favorable to the advisers than the rule laid down by the Supreme Court in the Geddes case, in which it was held many years ago with respect to transaction involving comparable conflicting interests that "the burden is on those who would maintain them to show their entire fairness . . (254 U.S. at 599.)

The statutory standard will not become effective until 1 year after passage of the act, in order to give the industry a fair opportunity to review existing advisory contracts. Even then an exceedingly short statute of limitations of only 2 years is provided for actions to enforce that standard.

Monetary recovery would be allowed only against persons who have received unreasonable compensation, and such recovery would be limited to the amount of the compensation deemed excessive.

In this regard too, I think we are departing from the judicial

standard.

Finally, a finding that compensation is unreasonable would not be deemed a violation of the act for purposes of criminal prosecution or administrative disciplinary proceedings under any of the acts administered by the Commission. Thus, enforcement of the standard would be left entirely to the courts, with the Commission having the right to initiate suits and to intervene in any private suit.

This is another area to which Judge Friendly adverted at some length, and I do not wish to take the time of the committee to refer to his testimony. It is part of the record.

We understand the industry to agree with the basic concept that investment advisory fees should be reasonable, but to defend existing fee levels by two main arguments: First, that in the generally rising markets of recent years, mutual fund investments, despite the present level of costs, have generally proved profitable; and, second, that it would cost the average mutual fund shareholder considerably more if he attempted to manage his own modest portfolio of, say, $4,000 with the advice either of a bank or of an investment counselor.

Both of these suggestions are probably true but, in our judgment, totally irrelevant. The mere fact that the stock market has gone up in recent years does not justify unreasonable compensation for those in a fiduciary position, particularly mutual fund managers who cannot claim the credit for the rise. I doubt if the industry would agree that its fee rates should be reduced substantially if the market turned down.

Similarly, the possible costs to an investor who tried to run his own $4.000 mutual fund have no bearing on this issue.

The investment adviser and the directors of the investment company have a fiduciary responsibility to that corporation and all of its shareholders to assure that the company is not subject to an unreasonable

fee.

The situation which would prevail if the company did not exist is irrelevant to that duty.

Moreover, mutual funds are in fact sold as a group investment, not as an investment tailored to the needs of an individual.

The economies and the advantages to be derived from investing as part of a group are one, if not the principal, argument used by sellers of mutual fund shares. The industry should not be permitted to ignore the nature of the investment vehicle and the purposes for which it created it and sold it.

This legislative proposal does not require that the Congress determine whether and to what extent fees charged in particular cases are justified. We ask only that the Congress clearly express on the face of the statute that management compensation is subject to the long accepted standard of fairness.

It would thus make clear that the courts may decide on the basis of the evidence before them in particular cases whether fees received are fair, without being restricted by the present unwarranted limitations on the judicial function in the fee area, which come about, with

out any intention on the part of the Congress, as a result of what the Congress then thought to be elementary safeguards for the benefit of the investor.

This committee has already, as I stated, released the statement of a prominent Federal judge, with wide experience in commercial and financial matters both as a judge and as a corporation lawyer, to the effect that the standard proposed by the Commission is a familiar one and an appropriate one for judicial application.

G. THE INDUSTRY'S RESPONSE

I would like to turn now to the industry's response to our invitation to speak to us regarding our proposal.

The industry in opposing this legislation with its strict-perhaps too strict-limitation on personal legal liability, while professing adherence to the basic concept of reasonableness, seems to be contending that adherence to fiduciary obligations should not be enforceable in respect to advisory fees.

The industry did make a counterproposal in a letter to the Commission dated April 18, 1967. Under this proposal no advisory fee could be found to be unreasonable unless it was proved by "clear and convincing evidence that the approval (of the advisory contract) by directors ***was a clear abuse of business judgment."

This would have the effect of putting the directors on trial, and particularly the unaffiliated directors, rather than the fees. It would neither be fair to the directors nor would it lead to effective enforcement.

As we have shown, under present conditions it is difficult for the unaffiliated directors to exercise their authority in the fee area.

The realities of the present situation, the provisions of the existing law and many years of actual experience demonstrate that the directors cannot in fact be effective in this area without an express standard by which to guide themselves and an effective means of enforcing it.

That is to say, we think that if that express standard is provided and and this means of enforcing it is provided, perhaps there will be introduced in the process that which the Congress intended in 1940.

As I say, our proposal is a cautious and careful one. We think it will do the trick, but perhaps it is not strong enough.

The only other proposal made by the industry to deal with problems in the area of advisory fees is the adoption of a relatively minor recommendation made in our report to eliminate existing anomalies whereby persons with strong economic and family ties to the adviser may still be classified as "independent" directors, or, to use the statutory term, "unaffiliated" directors.

Such a proposal, standing alone, would not only perpetuate the unsatisfactory situation which exists today with respect to advisory fees. As the industry must be aware, it would make it even easier for the industry to avoid the independent scrutiny of their management fees by the courts.

That is the effect of the proposal in our view.

Moreover, it is our view that nothing would be more unwise than to permit basic conflicts of interest to continue while providing immunity for the present management fee structure and levels, an immunity which exists nowhere else in our economy.

H

III. SALES LOADS

A. INTRODUCTION

Of all of the problems discussed in the Commission's report and dealt with in this bill, the one that has received the greatest attention is the cost of acquiring mutual fund shares. In 1966 investors paid about $300 million in mutual fund sales charges. But the effects of mutual fund sales charges are not limited to the people who pay them. Because the mechanisms by which savings are channeled into the capital markets are complex and sensitive, mutual fund sales charges affect everyone who has invested or who will invest in securities.

The two salient features of mutual fund sales loads are these: (1) mutual fund sales charges are not determined by the normal interplay of freemarket forces that shape most other prices; there is a price maintenance scheme in the statute, but a rather unusual one. I am sure the gentlemen of the committee are familiar with the fair trade laws in the States whereby a manufacturer or wholesaler fixes the price, and he has the job of enforcement.

In the 1940 act, there is a price maintenance scheme, the violation of which is a criminal offense, and the enforcement of which the SEC has an obligation to secure.

There is none other like it that I am aware of anywhere.

(2) The overwhelming majority of people who buy mutual fund shares pay sales charges that are many times higher than those that they would have had to pay had they invested in other types of securities.

Mutual fund sales charges are not free market prices determined by free competition. They are fixed under an exemption from the antitrust laws found in section 22(d) of the Investment Company Act. That section prohibits any securities dealer from selling mutual fund shares at a price other than the public offering price stated in the prospectus, and that price is fixed by the issuer and investment adviserunderwriter.

It is difficult to exaggerate the significance of section 22(d). It permits the fund's principal underwriters to fix sales charges and then requires the Federal Government to enforce adherence to those prices by every retail dealer whether or not he has a contract with the underwriter and whether or not he is engaged in the initial distribution of the fund's shares.

Section 22(d), as I have said, is unlike State fair trade laws, which leave the initiative for creating and for enforcing resale price maintenance entirely with the manufacturer. Under these laws price cutting normally is not a crime. If the manufacturer is not assiduous in enforcing his resale price maintenance program at his own expense, retailers will compete with each other in pricing their merchandise. And, as you gentlemen know, this goes on all the time even in the socalled fair trade States.

By contrast, section 22(d) of the Investment Company Act places the full force of the Federal Government behind resale price maintenance in the investment company field. If a retail dealer sells shares of a mutual fund for less than the price which is fixed by the fund manager and stated in the prospectus because the dealer believes lower charges will enable him to increase his sales and his profits, he is guilty