Wednesday, September 19, 2007

Investment Companies - Independent Directors - part 3

Fund Portfolio Brokerage

SEC Roundtable discussion

Mr. Eisenberg: Okay. Thank you. Let me begin this afternoon's session of the roundtable which will deal with the fund brokerage and disposition of fund brokerage. My name is Mike Eisenberg and I'm Deputy General Counsel at the Commission. I'd like to briefly introduce the members of the panel. Henry Hopkins who is sitting next to me is with T. Rowe Price. I think he is generally well known to many of you. He's been at T. Rowe Price since 1972, and he's the chief legal counsel for T. Rowe Price & Associates, and he sits on most of their committees, chairs the Ethics Committee and is familiar I think generally with the operations of T. Rowe in all its aspects as one of the largest no-load fund groups in the country. Sitting next to him is Heidi Stam. Heidi was Associate Director of the Division of Investment Management before she went to the Vanguard Group where she is one of the chief legal officers of the Vanguard Group. John Hill is at the far end. John is an independent director of the Putnam Group of funds, and he is the chairman and managing director of First Reserve Corporation, an investment firm that acquires and builds diversified energy companies. Before that and in an earlier incarnation, he was with the Office of Management and Budget and with the Federal Energy Administration. Anne Jones who I think is also familiar to many of you is a former director of the Division of Investment Management, and she later, when she left the Commission, became the general counsel of the late, lamented Federal Home Loan Bank Board and the FSLIC. She was then appointed by President Carter as a commissioner of the Federal Communications Commission, but she is a independent director of the IDS Group of funds and practiced at Sutherland Asbill for a number of years, retired just a few years ago, but is still a member of the board of IDS.

We have two members of the Wall Street segment of our group. We have two independent directors, two inside counsel, and we have one member from Goldman Sachs, another from Merrill Lynch. Duncan Niederauer is Managing Director of the Equities Division of Goldman Sachs and joined US Share Trading in 1998 after spending three years as head of Global Portfolio Trading. Prior to that he worked in derivatives and Japanese products trading in Tokyo. So I think that we have someone well qualified to talk about portfolio trading. The final member of our family is James Smyth. I think it's pronounced "Smith", but it's spelled with a "y." Now, James Smyth's distinction is that he went to Brooklyn College, which is my alma mater, but he graduated long after I did. He is currently with Merrill Lynch's Citation Group which – and its affiliate which is called Broadcort Capital, which is part of the Equity Markets Group. Merrill Lynch never does things simply. Jim recently was appointed the Global Coordinator for all Equity Soft Dollar-directed Activity. Besides its current client base at Merrill Lynch's largest institutional managers, Citation's customer base is made up of many of the largest global pension consultants as well as plan sponsors, so I think we have two people from member firms that are intimately aware – involved with soft dollars and soft dollar trading.

I'm going to give you first some background with respect to the origin of soft dollars, if you'll bear with me. I think that this discussion of soft dollars and the use of brokerage and the fund industry and the role of directors with respect to allocation of fund brokerage requires some background. It's been a long time since I viewed soft dollars from the point of view of the Commission. The last time for me was during the 1960s when I was a member of the staff. The staff of the Special Study of Securities Markets saw the New York Stock Exchange's fixed minimum commission rate regime as a primary target. How could we most clearly demonstrate to the Commission and to the Congress that the fixed commission rate scheme was not in the public interest? The evidence was plain enough. New York Stock Exchange member firms were willing to give away or give up 50, 60, 70 percent or more of their commission dollar on mutual fund and other institutional trades to other brokers at the direction of fund managers who directed the fund brokerage to them. So Fidelity Management, to pick a name from the air, could direct Fidelity's fund brokerage to Solomon or Goldman or Merrill or any other New York Stock Exchange member firm and direct them to give up a major portion of their commission for executing the trade to any other member of the New York Stock Exchange.

If a member firm was willing to give away half or more of its commissions, we reasoned in a brilliant insight to the staff, that there must be a lot of fat in the commission dollar which was being charged to the investors of the funds. What services were these and other member firms providing to the fund managers in return for this give-up? Research, of course, and some of it was quite valuable, much of it was fairly pedestrian, economic and statistical reports, and some of it was just junk which was immediately discarded by the portfolio managers. The definition of "research" was elastic to say the least and it still is. The other service that commanded serious give-up dollars was the sale of fund shares. Reciprocal, it was called, a recipe for sales. Other services were also cause for reward through the give-up mechanism. Of course, member firms who executed trades also provided research, sales and other services. Since it was all bundled together with the execution, it was referred to as soft dollars.

The New York Stock Exchange was unable to hold on to its monopoly. A member could at that time give up only to another member of the club; and, soon, regional exchange give-ups were available. Most New York Stock Exchange members were also regional members and then also members of the NASD. Since many regional-only firms sold fund shares and couldn't execute a serious order, the give-up was a significant additional reward for fund sales, most of which were already subject to an 8.5 percent front-end load. Then the give-up by reasonable extension became available to all members of the NASD. You could give up to any other NASD member. The staff, consisting of David Silver, Gene Rothberg and I, conducted an inquiry on the record asking fund management why they were not directing give-ups to their own fund distributors who were NASD members and recovering the directed commissions for the benefit of the funds – recapture. Had they informed the independent directors of the availability of recapture? Would they have an affiliate join a regional exchange, such as the Pacific, to receive give- ups?

We held hearings on how the give-ups really worked and Dick Phillips headed the 1966 mutual fund study which added to the findings of the Special Study. Moses v. Bergin, the 1st Circuit, 1970, made clear the legal responsibilities of the management companies to disclose recapture options to directors and the director's duty to at least consider them as a matter of business judgment. The impending abolition of fixed rates in the Exchange commission structure and its give-up progeny alarmed the research firms who maintained that their products were necessary for the guidance of the fund management in their roles as managers. Research, they said, was a benefit to the funds and their shareholders, not to mention the management companies. So instead of resulting in an unbundling of services, the funds paying dollars for identified services separately, like x-dollars for execution, y-dollar for research, and z-dollars for record keeping and so on, the brokerage community vigorously protested the demise of soft dollars for research. Sales reciprocal and increased commission rates was more difficult to defend; but that later was accommodated by Rule 12b-1 fees, which we talked about this morning.

Chairman Casey abandoned the vision that the Commission had when it achieved negotiated rates, and he agreed to support a legislative effort which would make it legal to mutual funds and other advised accounts to pay up, pay more than the best price available for the research that they were getting through the execution of portfolio trades so long as the research being paid for was deemed valuable by the adviser and the trustees or directors of the funds. And that was Section 28(e) in the 1975 Act amendments. 28(e) authorized additional payment as was the case with the original give-up which was at bottom, the use of fund assets to pay for research directed to the manager. The brokers did not want to un bundle research from execution and the advisers generally supported them. As long as they were getting services for "free," and that's in quotes, that is, at the expense of the funds, they were happy. They did not want to pay hard dollars for research or break out the amount of fund commission dollars that they were using for research for everyone to see. Consequently, the unbundling never occurred. Research remains embedded in brokerage commissions; that is, bundled, even though we have, "negotiated rates," and have had them since 1975. The more things change, the more they remain the same. Executing firms can receive payments for research and third party payments still proliferate; that is, payments directed to firms providing 28(e) research, safe harbor type materials. If there is any doubt as to how close we are coming full circle, there is the step-out transaction to consider as well, which we will.

In 1986, there was a Commission release, under the guise of clarifying the 28(e) safe harbor that actually broadened the scope and confused the definition, at least in my personal view of best execution even further. Some say it clarified it. The Commission was more recently – has more recently required significant additional ADV disclosure and placed greater emphasis on monitoring the use of soft dollars through statements and proceedings focusing on the fund directors' role in monitoring the allocation of fund brokerage and the manager's duty to fully disclose soft dollar arrangements. We have brought cases recently dealing with the misuse of soft dollars for services which were clearly outside of the safe harbor realm, and so on, including a recent action against the broker for continuing to direct soft dollar payments without inquiry when it was apparent that the payments were in violation of the adviser's fiduciary duty to his advised accounts. Don't worry. This is going to end in a minute. The reason for this extended discussion of this is because unless the background sinks in, it's going to be difficult to understand the discussion.

A recent OCIE report – Office of Compliance and Examination – suggested important additional disclosure of soft dollar use by inspections management companies. We take it as a given that more precise and clearer disclosure is appropriate. It should be done. The OCIE report was quite clear on that subject. The issues confronting the Commission and its staff in our attempt to make fund directors more effective and what we will discuss in this panel are whether soft dollar practices have gotten out of hand, whether directors are effectively monitoring the allocation of fund brokerage, whether fund directors are sufficiently alert to the possibility of lower rates or using brokerage with the reduction of fund expenses, whether some of the research being provided is really just routine and relatively worthless, or merely serving to camouflage reciprocal for sale of fund shares, which is permissible only at best execution rates. And what is best execution anyway? Whether the 1986 release should be revised to better define best execution and the scope of research, whether 28(e) has been stretched too far in an era of negotiated rates and whether the research exemption permit should be modified. And, finally, whether the Commission should through disclosure or rule making require the unbundling of reciprocal services paid for with commission dollars. Now, with that brief little introduction, I'd like to introduce Henry, who will explain what I just said.

Mr. Hopkins: Thank you, Mike. I want to say, number 1, our soft dollars practices have not gotten out of control. Directors are monitoring soft dollars practices. Directors are alert to the possibility of lower rates. Research generally is very valuable.

Mr. Eisenberg: Can you hear him?

Mr. Hopkins: The SEC '86 Release should not be revised except to fine-tune, and 28(e) has not been stretched too far. So those are my thoughts and we can all now stop.

Mr. Eisenberg: All right, Heidi, your turn.


Mr. Hopkins: You know, Mike was mentioning that I was the chairman of the Ethics Committee at T. Rowe Price, and, actually, I've been the chairman since I think it was 1972 when we first adopted a written formal code of ethics. I will never forget Mr. Price – there is a Mr. Price who started our firm, Mr. T. Rowe Price, and he was living at the time. But he was –
Mr. Eisenberg: I hope so.

Mr. Hopkins: Well, he was not actively involved, but he was still getting research. And I will never forget having to explain the code to him, because if he wanted to continue to receive research, he would have to agree to abide by the code even though he was no longer an employee. And he read the code and he looked very disgusted, as he did quite often. And he said, "Henry, I could not possibly sign this. You have to understand that I always viewed myself as a gentleman. I would never ask a client to purchase a security for the first time unless I had already taken a major position in it."


Mr. Hopkins: So, it shows you there are different ways of looking at things. And from his perspective, that was the appropriate way, the high-road way. I might say I never did convince him that the code made a lot of sense, and he, in fact, did not sign and did not continue to receive research. First of all, Andy Brooks is the head equity trader at T. Rowe Price and he implored me today that if I said anything right, versus saying something wrong, to get the point across that when it comes to whether you're getting the lowest possible commission, that really pales in comparison to whether you get best execution. That you can clearly get best execution even though you may pay a higher commission rate. And that is not true for all types of transactions, but certainly for the more difficult transactions which traders pride themselves on doing better than anyone else; that is, that is, the rule of the game.
What I'd like to do just briefly is to give you an overview of how we approach the whole area of brokerage and trading at T. Rowe Price. First of all, for many, many years, we have had what we call the Equity Brokerage Control Committee which basically looked at soft dollar arrangements. The control over the trading function was really spread out among many different people in the firm. Recently, we decided to bring together all of those oversight control arrangements and to put it under the one committee which previously had been the committee that was just looking at soft dollar arrangements. That committee is now called the Equity Brokerage Trading Control Committee. We have similar committees, one for our fixed income taxable and one for our municipal bond department. Obviously, when it comes to soft dollar arrangements, those are not major players in the other two areas. It's solely on the equity side.

To give you an idea of the importance we place upon this entire function, the members of the committee are the head of the research department, we have the head trader, we have a representative from legal. You always have to have a representative from legal on every committee. And Jack LaPort, who's in charge of all small investing, and David Testa, who is the Chief Investment Officer of the firm and also a member of our Management Committee. So this is clearly a high-powered committee which is really representing all the constituencies within the investment side of our firm. Whereas, in years past this committee solely was responsible for overseeing and, in fact, improving every and all relationships with soft dollars, the committee now has a far broader oversight function. Number 1, in addition to approving and denying all soft dollar requests, it also oversees the allocation of trades among clients. That is, the formal procedures which we have written up and are placed within the trading department manual which govern how we allocate trades among clients.

As an example, if you have 10 clients that have put in orders totaling a million dollars in one security and you only execute half that order during the day, how do you allocate the half-million dollar of a million dollar trade among the clients? These procedures make certain that over a period of time every client is treated fairly and equitably. The committee also reviews best execution. It reviews trades to make certain that the trading department on an overall basis, on individual trades, is achieving best price and execution.

It also generally reviews commission levels. It reviews all cross-transactions. Now, as you know, Rule 17a-7 requires that all cross-transactions effected must be presented for approval by the boards of the funds effected at the meeting. But here we also have an internal committee which reviews all cross-transactions before they go to the boards to make certain that there are no problems. They also monitor the use of affiliated brokers and underwriters under Investment Company Act rules. Finally, it reviews with great care the statements made in our ADV as well as in our prospectuses and statements of additional information regarding our brokerage and trading practices, including the allocation of trades for soft dollar services. So the committee is by far a major oversight committee. Even more so, it is responsible for maximizing our relationships with all of our brokers. Even if we did not have the ability to soft dollar services, we would still have this committee and the committee's responsibility would be to make certain that the trading department was, in fact, using the brokers that we deem have given us the best service to the maximum extent.

Mr. Eisenberg: And your position is that you do not pay up? Is that right?

Mr. Hopkins: The position is as stated both in our ADV and in our fund prospectuses and statements of additional information is that we do not knowingly pay up. As an example, Instinet has two levels of commission payments. I'm not exactly sure of the exact cents it is, but if you wish to, let's say, receive soft dollar services, you would have to pay at 6 cents; whereas, if you did not want to receive any credit for soft dollar services, you would only pay, let's say, 2 cents. The feeling is that if we are paying the 6 cents, we are clearly paying up, so we do not receive an soft dollar credits via Instinet because of that two-level commission structure.

Mr. Eisenberg: Do you think people that pay 6 cents a share are paying up?

Mr. Hopkins: In that context, they clearly would be. On a quarterly basis, this committee reports or meets and reviews the objectives and targets it has established at the beginning of the year. As an example, after soliciting and receiving extensive input from all the research analysts and portfolio managers, we basically rate all brokers to try to develop some target percentages as to the amount of business that we would like to place with those firms. We also get dollar suggested amounts based upon the same type of survey. What we want to do is to make certain that the – that the research we receive from broker-dealers, the research which is of great benefit to us and which has assisted us in making rewarding investment decisions, that those individuals are rewarded by receiving the lion's share of our brokerage allocations – always consistent, of course, with best price and execution.

Mr. Eisenberg: Are there members of the boards on this committee? Or are these just management people?

Mr. Hopkins: This is a committee solely of internal people. On an annual basis, we review with the boards our entire brokerage program, including the various policies that we have developed as to how we allocate soft dollars, our policies on execution, best execution, as well as the policies relating to how we allocate trades on a fair basis among clients. And, so, the boards of our funds are well aware of what our formal, written documented policies are. And they approve of those. On a continuing basis, they receive mandated reports, such as the reports on cross-transactions, use of affiliated brokers, on underwriters, as well as getting information overall on our brokerage and the commission rates that we are generating.

Mr. Eisenberg: You give them average cents per share and the rest of that kind of information.

Mr. Hopkins: Right. As far as the directors, themselves, you know, reviewing trades on an individual basis, they do not do that. They simply approve our policies and we give them overall reports at the end of the year which basically quantify whether we have or have not met the goals that we have established at the beginning of the year. So that's how we do it. Now, Heidi can tell us how they do it.

Ms. Stam: Okay. Thank you. I'll start my discussion with a very fundamental premise and that is that commissions are valuable assets of the fund and the fund shareholders. Commissions and transaction costs are unavoidable in the purchase and sale of securities. These costs reduce the total return to fund shareholders and really they should only be incurred when the portfolio manager expects that the transaction will benefit the fund. Commissions should not be used to benefit the investment adviser. After all, commissions are paid with the shareholders' money and so it's only right that the shareholders get the benefits from them. And this is the foundation of Vanguard's approach to any question involving brokerage allocation. I think it is important to start with a fundamental policy. Now, I'll give you a little bit of a sense of how it works in practice. I'm going to cover a few different topics; (1) best execution, (2) use of directed brokerage programs, (3) soft dollars, and I'll talk a little bit about monitoring and how we do that. Every adviser has a duty of best execution. And what exactly does that mean? Put very simply, a client's total cost or proceeds in each transaction should be the most favorable under the circumstances. But it is very important to note, and I think Henry made this point as well, that cost in this case does not equal commissions paid. It's the quality of the execution in terms of the market impact that is a key determinant of the total cost of the transaction to the fund. Let me give you a simple example. There is surely no benefit to shareholders if we save 3 cents a share on a commission when the trade is being executed at 6 cents above the market price for that share at that point in time.

Mr. Eisenberg: When you're talking about cents per share, you're presuming that the execution is going to be the best execution and that cents per share is a separate component. Now, I understand that you look at the whole trade.

Ms. Stam: It's a totality. I mean we're looking at a lot of factors here when we determine what is best execution. I'll go through some of those factors for you. We look at all of our trades on the basis of market impact and we look at it from a number of different perspectives. We actually, you know, sort of slice this data numerous different ways so that we can see what the quality of our execution is. So we look at the total cost of execution by fund. We look at it by adviser. We look at it by broker. We consider whether we have a widespread distribution across the brokerage community. We consider how our execution compares relative to the experience of the marketplace. We consider the data short term and long term, how has it been over the last quarter, how has it been over the last year, how has it been over the last five years. We look at the trends. Is the total cost going up? Is it going down? Is it relatively flat? The analyst or analysts who interpret this data take into account many different factors which might affect total cost and there are countless factors that go into the equation. Some of them would be, for example, the availability of an electronic-crossing network, the funds' investment strategy, an investment strategy, an investment objective, the size and timing of trades, and there are just countless other factors that come into the mix.

All this information and our analysis is shared with our fund board and if the data were to suggest that there was a question about the selection of a broker or the quality of the execution, we would investigate that matter immediately and report our results to the board. Consistent with our fundamental policy, that commissions are valuable assets of the fund and its shareholders, we have successfully used directed brokerage programs to reduce the expenses of our funds. For example, our board has approved a program whereby we ask our advisers to direct a portion of their trades through brokers who will rebate a portion of the commission back to the fund. The rebates are used to offset regular administrative expenses of the funds, such as custodial fees. We believe that these directed brokerage arrangements provide direct and very tangible benefits to our shareholders. For example, if we look at Vanguard's Windsor II fund for the fiscal year ended October 31, 1998, the funds' direct brokerage arrangements resulted in a savings which is equivalent to .01 percent of the average net assets of the fund.

Now, while that does not seem like a very large amount, let me put it to you in dollars. At the size of Windsor II, 0.1 percent of average net assets amounts to more than $2 million in savings for that funds' shareholders through our directed brokerage program. And all of these amounts are fully disclosed in the funds' shareholder reports. Now, while we strongly believe that directed brokerage arrangements can benefit our shareholders, directed brokerage – directing brokerage through a particular broker has to be beneficial only if the execution is good. And, again, we are always concerned with the total cost of the trade to the fund. So as with all of our trades, we are going to be looking very closely at the total cost of the trades executed under our directed brokerage. And, in addition, the advisers who are participating in these programs do not have any commitments to use any particular brokers so that they are free at all times to exercise their duty of best execution. Let me shift a little bit and take a little bit of a look at soft dollars. Again, consistent with our fundamental policy that the fund is the entity that should be benefiting from the commission dollars, we have a pretty stringent policy with respect to the use of soft dollars.

We do not use soft dollars with respect to our internally managed funds. For some of our actively managed equity funds, we do recognize that there can be more than one broker that is able to obtain the best available price and most favorable execution for a particular transaction. And in that case, our advisers are authorized to select a broker who provides research services, but the research services have to be used by the adviser to benefit the fund. And in these cases, we are really talking about research that is generally provided to all clients who trade with the broker and while volume of trading may be a consideration to the broker in determining which clients receive the research services, the advisers to the Vanguard's funds do not have any firm commitments to trade with any particular broker. I mean, obviously, our volumes are very high, so in many cases, we are reaching volumes that well exceed any brokers' expectation of trading volumes.

Mr. Eisenberg: Heidi, you're talking about the sub advisers? The nine or ten funds that we heard about this morning.

Ms. Stam: I think it's 32.

Mr. Eisenberg: 32. 32 sub advisers. And they can go ahead and they direct the trades to the brokers. Ms. Stam: Yes, they do.

Mr. Eisenberg: Right. Now, do they pay up?

Mr. Eisenberg: No. None of the Vanguard funds are authorized or permitted to pay up at all. So even the advisers who do use what we are referring to collectively as sort of – as soft dollars, they are not paying up for any of these materials.

Mr. Eisenberg: So if we were to compare the level of payment of brokerage rates with the sub advised funds and with the directly advised funds, you would come out with the same price.

Ms. Stam: I think you're going to be seeing a real range of prices depending upon the nature of the particular transaction and the particular fund. As I mentioned at the beginning, what goes into that equation of what constitutes best execution for any particular transaction takes into account a number of different factors, and you cannot just lump everything together and say, "On average, you know, what is best execution?" You have to be looking at the fund involved, the nature of the trade, the difficulty of the trade, the timing of the trade, and, you know, the fund involved. For example, on the Index funds, a very important objective of those funds is tracking the Index. And, so, the people who are trading for those Index funds are going to have that in mind when they are executing their trades, unlike an adviser to an actively managed equity fund who might have other considerations in mind and their trading practices may be different. But the fact of the matter is when we analyze the data, we take that into account. And that's what our internal analysts do. They will get the data, they will see the comparative data, but they understand what the fund's objectives are and what they are doing and they are able to run down any issues that arise.

Now, let me say, no – no Vanguard fund will pay up for research services, but again, monitoring is of key importance to us, and we look at all of our trading activity on a regular basis. To the extent particularly that we engage in directed brokerage or soft dollar arrangements as I described, we are looking very closely to make sure that our total trading costs are the lowest they can be under the circumstances. Monitoring for these purposes include regular discussions with our advisers regarding their trading practices, regular reporting to our internal staff and to our board, extensive data analysis, and periodic audits that we conduct internally.

Mr. Eisenberg: Heidi, does your – do the Vanguard funds have a committee of the board which reviews brokerage practices?

MS. STAM: The entire board reviews brokerage practices on a regular basis and when each of the funds are reviewed – which the funds are reviewed on a regular basis, and they talk with the portfolio managers for those funds, you can be sure that they're going to discuss the funds' trading experience and best execution at that time as well, in addition to the regular reports prepared for them internally. I guess if I – if I could sort of sum up how I think the issue should be approached, I mean if you're talking about, you know, what should the advisory company be concerned about and what should the board be concerned about, I think it's very important – I mean there's really a range of practices that are permissible under the law and that can be accomplished consistent with the best interests of the funds and the shareholders. I think it is very important for the advisers to insure that they are providing the boards with a very clear statement of what their philosophy is and what their approach is to brokerage allocation and, in order to insure that the board understands that approach, to provide them the information the board needs to understand how that philosophy, how that approach is being implemented. If you look at the flip side and consider what fund directors need to be doing, they need to understand the adviser's philosophy. How is the adviser approaching this issue of brokerage allocation, soft dollars, directed brokerage, and they need to be able to understand as a general matter how these allocations are made. They should be receiving the information they need to analyze the activity so that they can satisfy themselves that the funds' brokerage, a very valuable asset, is being used for the benefit of the funds shareholders.

Mr. Eisenberg: Let me ask both of you, first Henry, Heidi talked about recapture and the directed brokerage arrangements which are used, at least to some extent, for the benefit of the funds in the sense of reducing expenses. Does T. Rowe do that, also?

Mr. Hopkins: We do not do that. This is an issue which was brought to the boards and it's really their final determination as to whether to seek to do that or not. One other point I'd like to make and that is that even though we have a committee which oversees this, we really have about 40 individual people that oversee it and those are the portfolio managers. I can assure you, you know, their compensation is, to a certain extent, based upon how well they perform. And if they are not getting an excellent job performed on the trading desk for their fund or funds, they are going to raise a lot of issues. And so the portfolio managers are also really the watchdogs to make certain that the trading function is being performed up to snuff.

Ms. Stam: I totally agree with what Henry's saying. I mean the portfolio managers care intensely about the quality of their execution. So to the extent that the firm and the board has sort of watchdogs on the job to determine what kind of execution they're getting, I think the portfolio managers do serve that function.

Mr. Eisenberg: Yes, but some portfolio managers are torn – a lot of portfolio managers never saw a research report that they couldn't do without.

Ms. Stam: We have plenty at Vanguard.

Mr. Eisenberg: So, yes, they want to get best execution for performance. On the other hand, they need or want the street research. What do you feel about unbundling? Supposing that there were moves made by the Commission to push the unbundling of research from execution so it at least was identifiable? Is that something your management company would support, Henry?

Mr. Hopkins: I think, you know, if we were to ask that question and, again, I have not asked the question so any response I have is purely a guess; but I think that their view is that the current system seems to be working well. There is a lot of the third part research which is of significant value and the payment of those through the soft dollar allocation seems to be working well. I will say that we are not a proponent of excessive use of soft dollar commitments. In fact, for the last few years, we have only utilized about 10 percent of the available commission dollars to satisfy any type of research, sort of semi-commitments. So, it's still – it's a fairly small percentage of our commission business, and the trading department likes it that way because it gives its – it gives it its maximum flexibility in being able to really go anywhere they think they can get best price and execution as opposed to fulfilling any type of soft dollar commitment.

Mr. Eisenberg: Heidi?

Ms. Stam: I think that as you mentioned, you know, portfolio managers and trading departments, they understand what research is valuable to them, and they understand what they don't want, perhaps. And I think that, certainly, we would not have any problem making determinations based on hard dollars as to what we would like to purchase and what we would not like to purchase. So I don't think we would have any objection to unbundling.

Mr. Hopkins: The only other thing you have to understand is that the third party research which sort of has a price tag on it really represents only a very small percentage of the overall research we're provided by brokers. And, so, even if there were not – if there was not a Section 28(e) and even if we did not receive any third party research, we would still have this committee which would oversee and develop targets for brokerage firms based upon what they have brought to the plate. Have they been valuable in providing our research analysts and portfolio managers with ideas? How they executed transactions. We certainly want to reward those brokers that have performed well in the past year, both in the trading function as well as in the research function.

Mr. Eisenberg: Let me just ask the two of you. You represent very large fund complexes, among the largest in the country. Put yourself in the place of a counsel to a smaller, more modest fund group which does not have the brokerage clout that either Vanguard or T. Rowe has. Is what's good for you also good for them?

Ms. Stam: I really think you have to ask them. I think it's a little unfair for you to ask us. I don't know, maybe Henry can do better.

Mr. Hopkins: We certainly know a lot of smaller shops in Baltimore, some of which are offshoots of our firm, and I will say that they certainly have had no problem getting research coverage. So I think the brokerage community has done a very good job in providing coverage to both large and small firms.

Mr. Eisenberg: Now, before we turn to the brokers, just try and give us an idea of what percentage of your brokerage is done through electronic trading or alternative systems which range closer to 2 cents a share than they do for the 6 cents a share?

Mr. Hopkins: Certainly. The electronic methodology for effecting transactions has been growing over the past few years. Currently of our listed business, about 10 percent is effected electronically. When it comes to over-the-counter, it's about 12 percent. So this is a growing area. With the advent of certainly the Index funds and the semi-Index funds, electronic trading is certainly a wonderful alternate way of effecting transactions and I would just surmise that we probably will continue to increase the percentage that these effected electronically.

Mr. Eisenberg: What are we talking about? 12 percent of what? I mean, how much?

Mr. Hopkins: Our total commission dollars I think was around 43 million. That's straight commission listed.

Mr. Eisenberg: Heidi?

Ms. Stam: I don't know if I can give you that figure, but we do use alternative trading systems extensively. As you know, we have a large, a large number of funds that are indexed and those trading networks are very efficient for trading the large baskets of stocks that we trade for the index funds. I would point out that – and we do use them to a great extent. I don't know that I could put a percentage on it for you, but I think it's certainly in excess of 10 or 15 percent. It's closer to 25 percent for the index funds. I would point out that the way these alternative trading systems work, it is not going to be the ideal marketplace for every trade. Again, going back to the initial analysis of what constitutes best execution, you have to take into account what it is you're trying to accomplish for the fund, what is the fund's investment objectives, and how is that fund and its shareholders going to be served by how you implement this trade? I think that is a factor that certainly comes into play.

Mr. Eisenberg: I want to ask Jim Smyth of Merrill, who heads, in effect, their soft dollar arm, to describe how that works, what they do, and then ask Duncan to follow up along the same lines, and then we'll get into a little further discussion.

Mr. Smyth: As Mike mentioned, I am responsible for Merrill Lynch's domestic soft dollar business and also responsible for the coordination globally of Merrill Lynch's soft dollar product. Citation is Merrill Lynch's designated soft dollar service provider. It was created in 1985 to offer our institutional customers the opportunity to use agency listed equity activity to obtain independent third party investment- related research and services. Citation handles all soft dollar sales and administrative functions, which include relationships, direct relationships with the fund managers on all soft dollar activity, reconciliation of soft dollar activity with those managers, the distribution of monthly soft dollar reports detailing the fund managers' global trade activity, vendor payment detail, and commissions generated.

We are also responsible for vendor coordination, where we handle all vendor activities, including review of all submitted invoices for 28(e) qualification. We have a dedicated person who works with the vendors, as well as a general counsel on premises to review services where appropriate. The written agreement that we have on behalf of the fund manager is between the vendor and Merrill Lynch Citation, not between the vendor and the money manager, and we assure that all invoices are sent directly to Citation as opposed to being sent directly to the money manager. To digress a minute, if I may, proper control from a management standpoint is clearly our number one priority in this business, and obviously we consistently review our control practices to assure they are properly adhered to and assure employees are complying with proper procedures. From a trading standpoint, I thought I would describe how we interact with Merrill Lynch. Citation does not have its own trading capability, per se, but instead uses Merrill Lynch's listed equity sales and trading personnel to execute soft dollar trades on behalf of fund managers, thus assuring seamless, best execution and one-stop shopping for our fund manager customers.

Merrill Lynch agrees – and we've talked a lot about best execution on this panel – Merrill Lynch agrees with many independent surveys that find the commissions are actually a very small part of the total execution cost on any trades. Market impact or quality execution is a significantly more important factor. Merrill Lynch commissions, which, by the way, are the same for Merrill Lynch's own internal research versus soft dollars, so I think the term, Mike, that we used, was pay up. Customers do not pay up from a commission standpoint at Merrill Lynch.

Mr. Eisenberg: Do you have a posted rate? Do you have a standard rate which yields the services that your affiliate provides?

Mr. Smyth: The rates differ by customer.

Mr. Eisenberg: Do they differ by service?

Mr. Smyth: Tell me what you mean.

Mr. Eisenberg: In other words, you have one level of service and you pay 6 cents a share for it. You have another level, like the Instanet thing –

Mr. Smyth: No.

Mr. Eisenberg: – you have another level of service.

Mr. Smyth: No.

Mr. Eisenberg: You pay 4 cents a share?

Mr. Smyth: No.

Mr. Eisenberg: So each management company negotiates with you, and you charge them different amounts, or you charge them the same amount?

Mr. Smyth: Different amounts, depending upon whatever is negotiated, obviously, depending on the amount of volume that is done with the particular fund manager. But if, just to make sure we're on the same page, for a free, as we call it, internally free, or research-type trade, it is the same commission, the same gross commission as a soft dollar trade for a particular fund manager.

Mr. Eisenberg: And you were told by the Merrill Lynch traders –

Mr. Smyth: Right.

Mr. Eisenberg: – that these guys are okay for soft dollars?

Mr. Smyth: Yes.

Mr. Eisenberg: You don't care what Merrill Lynch charges them?

Mr. Smyth: From our standpoint in Citation, we do not get involved in determining what the cents per share is. We will, however, and are the liaison between the manager and Merrill Lynch in terms of determining the "ratio" that could be charged for the services that are provided.

Mr. Eisenberg: Give us an idea what ratios we're talking about.
Mr. Smyth: The most common ratios now – and obviously cents per share has been squeezed over the past X years, ratios have also been squeezed. So for your bigger fund managers, you're talking about ratios anywhere in the 1.5 to 1.75 range, approximately. So back to the trading process for a moment. We then segregate. So fund managers are able to use – we don't have our own separate trading function. Fund managers are able to use their relationship person on the sales trading side to execute their trades for best execution. The trades are identified as such by the sales traders from the orders from the fund managers. We then segregate those trades identified as soft into a Merrill Lynch Citation account to facilitate 28(e) disclosure. From a customer service standpoint, we have dedicated customer service representatives assigned to each fund manager client. They prepare and distribute welcome letters to any new clients detailing the responsibilities of Citation and the responsibilities of the fiduciary in the arrangement, in the soft dollar arrangement that we have created. They distribute copies of the SIA brochure on best practices, advise clients of any new SEC releases or developments, and we maintain and review soft dollar accounts on a daily basis with representatives from the individual fund managers, as well as field all customer inquiries which range from trading activity to vendor payment.

Mr. Eisenberg: Have you rejected requests for soft dollar payments? What kind of things do you reject, things that are obviously not 28(e)?

Mr. Smyth: Vendor-type payments?

Mr. Eisenberg: Yes.

Mr. Smyth: Rent is a clear example.


Mr. Smyth: Airplane tickets, lodging at various conventions, et cetera. So, you know, obviously, from our standpoint – and in summary, what we'll talk about is the fact that we at Merrill Lynch feel we take a very conservative view. But again, in summary, assuring proper control is really our lifeblood, and as I like to say, what kind of lets us sleep at night. The know your customer principle for us applies to both the fund manager as well as the vendors alike. Citation, it controls and challenges where necessary, and coordinates all vendor payments. We assure detailed record keeping and consistently work with the fund managers in terms of proper communication. Knowledgeable employees on rules and regulations of 28(e) are critical. Our motto is basically, question everything. In general, as I said earlier, we take a very conservative approach or view of safe harbor, and we strive to keep our fund managers – we strive to keep our fund managers, we strive to help our fund managers avoid falling into the cracks of 28(e).
Mr. Eisenberg: Duncan, do you want to follow up with that?

Mr. Niederauer: Sure. When Jim and I talked about how to divide up the sell side part of this panel, given that Jim has had about 20 year of experience in the soft dollar arena, and I think I've had about maybe 20 weeks, we thought that it would be good if I talked a little bit more about my trading background, how we view our firm's relationships with our customers, and where we see some of these other services that, to a firm like ours, might have been viewed as nontraditional historically, but have clearly gotten very much into the mainstream of how we interact with our customers every day. So we kind of let Jim handle the administrative and control aspects, which we certainly have things like that in place as well, although not to as large a scale. And I'll try to focus on some of the trading issues. I think our real objective as someone who aspires to be a, or hopefully continues to aspire to be a leader on the sell side is to be a key counter-party for all of our clients, two of whom are sitting to my right, so I'll be careful what I say, and to provide all the necessary services to be viewed as such. Now, historically, I think it was certainly the view at firms like ours that to provide this array of services that one would have to provide to be viewed as a key counter-party was something that we had difficulty, at least philosophically, coming to terms with internally. I think our problem was we were comfortable with the traditional services that we provided, and some of these other services seemed a bit far away from what we were doing. You know, the word "cannibalization" would often come up, et cetera, et cetera.

I think in the new world, I don't know whether we should all think about unbundling mechanically or philosophically, but the fact of the matter is, whether you want to talk about portfolio trades or soft dollar trades – and, you know, I came into this panel, I don't even – I didn't even know what, and I'm not sure I still know what a posted rate is. But we already feel like the way the landscape is being carved up, there are different prices associated with different services that a broker like ourselves should provide, and it should come as no surprise to any of us that the price for each of those services depends on what the client is requesting of you at each point along the way. Now, my trading perspective, in having been fairly involved in our own electronic trading effort, is that those services that we are asked to provide are not just the research and other value added services along the way the clients might ask for, but we also start to evaluate the different services that our clients request of us based on what parts of the firm it has to touch on its way through the factory. Vanguard, for example, does a lot of stuff with us that does not require use of the full Goldman Sachs factory. It tends to very electronic. It tends to be a lot of portfolio trades. It's not quite no touch business, but it's as close to no touch as we come within the walls of Goldman Sachs. A lot of the business that we do with Andy at T. Rowe Price, who Henry mentioned earlier, is more what we would think of as the traditional stuff, Andy calling our sales trader, sales trader talking to the trader, quite often capital commitment required. If it isn't, you know, how do we access liquidity, in the marketplace, et cetera, et cetera? So I think it's our view that, going forward, firms that are only able to provide one or a handful of services will ultimately fail, and –

Mr. Eisenberg: Is research a part of that? I mean, you talked about using capital, and you talked about facilitating a trade.

Mr. Niederauer: Sure.

Mr. Eisenberg: And that's part of execution. Is research a part of that?

Mr. Niederauer: I think there is still a component of everyone's business that they view as Henry alluded to earlier. In their internal committee, I think everybody wants to still pay firms like us some quotient for the perception of the valuation that's placed on the research provided. I think everyone – and I'll get to this in my conclusions, so I don't want to pre-empt it – I think we're all stopping a little bit short of ultimate totality, which would really be to completely UN bundle that and assign a specific dollar value to that, although I think that might be happening. So I think going forward, we think flexibility, broad array of services, those are going to be the keys to success. I think another thing that we've seen happen is you've got consolidation of assets on the buy side that everyone has read all the research reports about. I think we all agree that's happening. That's also coinciding with continuing fragmentation of liquidity, and I think it's also coinciding with our largest customers' desire to find fewer counter- parties with whom to execute their business. You know, put aside the fact that you might need research from 200 people. You know, I for one, and maybe it's because I've worked at a big firm my whole career, I'm not sure there are 200 firms that can do an effective job of executing, so we're starting to get a lot of clients coming to us saying, "Can you work with us as we try to consolidate our key counter- parties?" I think if we believe that that's a trend that's here to stay, firms like ours are going to have to do a few things, even if historically it's made us a little uncomfortable, to broaden out that array of services that we're willing to provide, and I think some of those are some of the things we're talking about on the panel today. Soft dollars? You know, a lot of you in the room I'm sure know of our stance on the religious right against soft dollars for a long time.

Mr. Niederauer: I guess as of what, Mike, three or four months ago, we kind of softened that stance, no pun intended, and we can get into later why we think we might have done that. I think even though we are going to be in it, I think it is unlikely you will see a firm like ours be in it to the extent someone like Merrill Lynch is in it. I think we are going to continue to, as we do it, it will be for a very limited number of customers, and they will be – it should be assumed that they will be among our most important customers.
Mr. Eisenberg: Duncan, is your full service price similar to the price that the Merrill Lynch people charge?

Mr. Niederauer: Yeah, I would imagine so. I mean, I feel like there's a five or six cent a share rate, that's kind of the standard full service rate, and I guess that's a posted price, so maybe I've learned something today. But if that's the price that's out there, I think Jim said it best, that if that's your sort of standard-bearer price, then that's the gross price for everything and then you just negotiate around that, because different services may have attached to them the payment of other funds.

Mr. Eisenberg: I just want to make sure I heard this right. If Henry came to you and said, "We want your bare bones rate, we want what Heidi gets," you would give that to them, but their service would diminish?

Mr. Niederauer: But it's different. What I'm trying to get across is there's different rates for different services. You know, if T. Rowe Price and their active fund management – and I'm using that as an illustration, because it's obviously not the only thing that T. Rowe does.

Mr. Eisenberg: Let's talk about Fidelity. Pozen is not here.

Mr. Niederauer: Okay.


Mr. Niederauer: If someone like that comes into our desk, and only to our regular desk, it is sort of what we would call the, you know, the traditional brokerage that we're all familiar with, and someone else only comes into a desk where there is an electronic transmission of orders, those orders are handled, you know, as a group of orders, rather than each having to be touched, I think it's common sense, I hope, to say that that trade should not have attendant to it the same commission, because I'm not having to provide the same amount of research. That's much more of an electronic model when we deal with the people, and the people we deal with, most at Vanguard them happen to be the class of index fund managers to whom Heidi referred earlier.
Mr. Hopkins: If Andy comes in with a very difficult trade, which might use your capital, and he says, "I want you to get 2 cents a share on this," it's going to be doubtful that you're going to be able to accede to that request, because the business isn't going to make you any money.

Mr. Niederauer: Well, it's different, because what I would say is different about that, and this is the trader in me talking, is on a principal trade, where there's real capital commitment to be done, I don't think any of us in this room cares whether it's two cents, four cents, or six cents. I think we care about I'm not buying it from you at a quarter of the figure or, you know, three quarters. So I think that's how we try to do that stuff. And, in our commitment of capital, I think that's another resource that we are doling out consistent with our view of the quality of the customer, and that's the new paradigm that I think we're all trying to work our way through here.

Mr. Smyth: I think, Duncan, if I may, I think we just need to make sure when we talk about same price, when I gave the example earlier, when I said that the "free" or Merrill Lynch internal research price, I'm strictly talking about listed agency business.

Mr. Niederauer: Do you mean you do that for zero, Jim? Is that what we're understanding?

Mr. Smyth: No. But it is that rate, because obviously, in effect, and the way at least I look at it, and I may be wrong, is that basically, because it is not free, Duncan, don't we really soft dollar Merrill Lynch's or anybody's research, for that matter, in effect? So from that standpoint, we're strictly talking listed agency. Again, when we're talking about portfolio trading, when we're talking about over the counter, when we're talking about a capital commitment, to me, obviously, that is something that falls outside of 28(e). So I'm strictly talking listed agency transactions, where there is no adding up or bidding up or whatever term it was that we used earlier, Mike.

Mr. Eisenberg: Okay. Duncan.

Mr. Niederauer: Now, I think the other thing that we are very focused on, and I won't spend too much time on this, because if I talk about best execution, too, there's going to be nothing left for Ann and John to talk about here at the end of the panel. But I think it's something that we all struggle with. It's something we all focus on. I think it's at best, especially for institutional firms, a difficult thing to get our arms around, but I think we try to do things at Goldman Sachs that hopefully will serve as illustrations of our commitment to trying to derive it and trying to help our clients navigate their way through this for this fragmented liquidity landscape. I think our objective is to have access to all venues of liquidity so that the clients can access them directly or through us. I think for those of you who are familiar with some of the investments we've made in ECNs and alternative trading systems recently, I think we think it's going to be critically important to be involved in that part of the landscape as well. To ensure best execution, we've got to go beyond just the traditional exchanges. And I think Heidi made the point about that, you know, ECNs may never be an alternative trading system, may never be the be all to end all, but they're certainly going to be relevant as far as we can tell, and I think it's incumbent on us to use them intelligently and help advise our clients on when their use is most called for. Just a few thoughts, and I will be the human hedge clause for a minute. If I look forward and try to make a couple of predictions, these are my own predictions. I don't think these are the predictions necessarily of Goldman Sachs. But some of them might be. I think if we succeed in achieving our objectives and defining a new service paradigm, I think what you will see is that the competitive bar, particularly for sell side firms, will be raised. That's obviously a little self- serving, because we think that's a good thing for us. We want to challenge ourselves. We want to make it harder and harder to be a meaningful counter-party to our most important clients. And I think raising the competitive bar is good for all the participants in this equation, and we stand committed to do that, and we intend to do that by providing this broader array of services.

A few people on the panel have touched on totality. You know, I for one believe that when we think about our relationships with Fidelity or Putnam or Vanguard or T. Rowe, or anybody, you know, IDS, I think that those are all – I think we are going to think about those correctly as we would like to think the clients will, more and more with a holistic view. You know, what are they doing with us, not only in the listed agency world, but globally, in all our different products, in all our different divisions, et cetera. And I think that's the relationships we should all be striving to have. Whether we take that to its ultimate conclusion as Mike was saying a few minutes ago, and you really un bundle everything, if you took totality to its conclusion, we would sit down with all our major accounts in December. We would say, "What's the fee for the year 2000?" And they would say, "Well, it sounds like, you know, we value all your services globally at X," and we would just provide all those services. I doubt it, but I mean that's where it could be headed. One other thing that I would personally like to see happen is, if soft dollars and all these other directed relationships, et cetera, are going to remain an important part of the equation, as long as there's an NYSE and a NASDAQ – and I, for one, would love to see a merger of the two – as long as there is going to be that distinction, and NASDAQ is not a commissionable market, I find it difficult to comprehend, as a practitioner, why the Commission seems to focus on the principal part of risk less principal rather than the risk less part of risk less principal. You know, having traded a lot of NASDAQ stocks in my career, I can assure you there are a tremendous number of trades that are absolutely agency in spirit and in execution. And I'm a little confused as to why, even in the new release, despite some of the AIMR recommendations and the DOL recommendations, I would be on the side that would say risk less principal trades should be taken into account, and we should figure that out, as an industry to try to assess that. It would be great if NASDAQ went to a commission, but if they don't, I wish we would figure it out. Lastly, I think that, as I said earlier, best execution will require us using ECNs more and more and more. I don't think these electronic marketplaces are a figment of someone's imagination. I don't think they're here today and gone tomorrow. I think they will be meaningful and I think it's incumbent on us, as sell side firms in particular, to work with our counter-parties on the buy side to understand how to use them most effectively to achieve best execution.

Mr. Eisenberg: Duncan, one thing. You said that Goldman recently changed its policy and that you were going to tell us why.

Mr. Niederauer: I think there were a few reasons, and I would articulate three quickly. Number one is one of our partners, Tom Healy, was invited to be on a couple of the committees that reviewed and made some recommendations about how the rules might be redrafted. I think our being invited to participate in the topic made us feel like we at least had some ability to exert a modicum of influence on the outcome. Number two, I think we are encouraged by the Commission's work and by other groups' work that this whole component of the business seems to be more symmetrical, talking from a sell side person's perspective. We think there's less room for misappropriation. We think there's a much more balanced view in terms of due diligence. And I think that tone of the rules made us feel a lot more comfortable. I would be remiss not to mention the third reason, which is simply, reality would dictate that, you know, I guess it's always a good thing to be willing to change your mind about things, and this stuff is clearly here to stay. Our clients were asking us to be involved. These were not clients that we don't feel we know well. These were clients we feel we know very well. Going back to my point about consolidating counter- parties, we just felt like this was an important thing to do, because it was becoming a increasingly relevant part of the whole, you know, daily volume that was going through, and for us not to participate was probably not only a disservice to our customers, but to ourselves, as well.

Mr. Eisenberg: Jim, did you want to add anything?

Mr. Smyth: Just the one thing, which I thought of after the fact, was you had asked a question of Henry and Mike about smaller fund managers, and I don't know whether this really answers that question. But at the AIMR conference in Phoenix last year, I thought it was very interesting on the breakout panel on soft dollars, one of the representatives that I presume was on from Goldman was a small fund manager from somewhere in Florida, and basically he emphasized that soft dollars for him were even more critical than to a T. Rowe or IDS, or any of the other big fund managers. And basically, using the term "lifeblood" again, he basically said that without that, he wouldn't be able to afford, and obviously compete, from an overall research standpoint. So I thought I would just mention that.

Mr. Eisenberg: Since merger of the New York Stock Exchange and NASDAQ is beyond the scope of this panel, I'm going to ask Ann to turn to the discussion of the point of view of the directors – basically, what information management brings to you, how much, what kind of information, what do you do with it, what do you consider in terms of best execution, and how do you know that best execution and soft dollars are being appropriated correctly? Ann.

Ms. Jones: Like any other –

Mr. Eisenberg: Excuse me. I just want to say, both Ann and John represent funds which are retail funds, and not no-load funds, so they sell through brokers, and are not like T. Rowe and Vanguard. Go ahead, Ann.

Ms. Jones: And, of course, IDS is sold through our network of investment advisers, which is sort of the trademark –

Mr. Eisenberg: They used to call it a captive sales force, but we don't do that anymore.

Ms. Jones: No, it doesn't sound right in this age of liberation. The nice part about this panel, I think, from an independent director's point of view, is that we're dealing with an asset of the funds, and therefore something that belongs to shareholders, and our principle job, it seems to me, is to make sure that it's used for the benefit of the shareholders. I wouldn't know best execution of a particular trade if it tripped me. I don't think I need to know that. I think I need to know the policy of the investment adviser about how trades are allocated. I think I need to know what soft dollars are used for to make sure that they're in compliance with rules of the Commission and with basic common sense about are the shareholders benefiting. And I think I need to get regular reports from – in our case, IDS is different from a lot of other funds, in the sense that we have full time in-house counsel for the directors, and a full-time chairman of the board.

Mr. Eisenberg: That's a little unique, and it might be worth talking about that, especially since Les is in the audience.

Ms. Jones: He'll correct me if I make a mistake about his role. No, really, I take great comfort in being on the IDS board. I won't say as opposed to some others, but I do think we have some built-in protections. I think Les thinks I put more emphasis on that than I should, but I think it's great to have someone who is there on site in Minneapolis all the time, readily available to ask and to answer questions from the investment adviser. And questions do come up to him on a regular basis on pricing matters and on soft dollars, and he is there with an ongoing dialogue with the funds, and we directors, we also have independent outside counsel, but not used probably to the extent that boards without Les Ogg, who is our general counsel, would use outside counsel. There is, I think, a closer relationship and a more steady and constant oversight available this way, and as I say, I take great comfort in that. We, as a board, we do not have a special committee of the board on brokerage allocation and soft dollars. The report is made to ho board as a whole. We approve the policy statement and we get regular reports on how soft dollars are spent. I know, because the directors tour – "tour" is too casual a word – visit the trading department, talk to the traders on a fairly regular basis, and get regular reports. There is a committee who reviews all of the soft dollar expenditures much like the ones that Heidi and Henry spoke about. There's always someone from the legal department of the investment adviser, as well as Les representing us, and from the portfolio manager and some of the trading desks. And it's regularly monitored. I also take comfort on this subject, as opposed maybe to some others, that I really do think, as both Heidi and Henry mentioned, that the portfolio managers and the independent directors have a lot in common here. We're basically on the same side, maybe for different reasons, in the sense that we are supposed to be the watchdogs.

But the portfolio manager has a huge stake in the correct execution of trades. His compensation, his reputation, his ratings all depend on this. So he is not going to let money be thrown away. In response to Mike's comment that there were some people who never saw a research report that they could live without, the material that the funds, the IDS funds get for the soft dollars, the researcher, are reviewed for usefulness about every six months, and regularly reevaluated both from the point of view of are they used, but also how many people, and how many of the fund analysts and portfolio managers actually use them. And they have a very tough policy. I think more often than not, on a particular day, more things will be rejected not because they are outside the bailiwick of what is appropriate under 28(e), although also for that reason, but they just don't see them as being worth giving up – giving up is the wrong word – and so there is very tight control, And we meet regularly with the, in this case, a young woman, who is, I think, probably chairman, but anyway, the person who does the report for this committee to the board. And there is something about interacting with her and the other members of the trading department on a regular face-to-face basis that it's one of those intangibles, but it does inspire trust or distrust, I suppose, could be. But it so happens this is a very carefully monitored and watched process.

Mr. Eisenberg: Anne, is it your perception that the trading people negotiate hard with the Goldmans and the Merrills of the world to get the lowest price, and is it your perception also that they're really not paying anything for this research they're getting?

Ms. JONES: As hard as it is for me to say that – because I think I swallow the same way you do, you know, there's no such thing as a free lunch – I think that's exactly right. I mean, I agree with everything that's been said. They do not – price is important as sort of a given. You get – you're big. You have a lot of money to put out there, so you do get the best price. Execution you are very concerned about. And they watch very carefully, and when there are, as there have been recently, rumors or whatever, of a particular investment banking house, you know, being in some kind of trouble, boy, they want to watch that, because the execution and the ability to commit capital is critical.

Mr. Eisenberg: What about electronic trades and the, I guess, expanding two cents a share, or whatever it is per trade, especially for large capitalized companies?

Ms. Jones: Well, it's my understanding from talking to the trading department that they are using electronic – you know, they have access to the stock exchange and Instanet, and they are using that more. And I don't know this, but I have to believe that that kind of trading will increase. I mean, it is, the Internet is, even though I wouldn't – don't know how to access it, telecommunications expert that I am, I think it's just going to grow and become a bigger part of –

Mr. Eisenberg: Having heard here that Instanet has two levels of trading, you're going to go back and check to see which level they're at, right?

Ms. Jones: Absolutely. But there are built-in protections here. And it's also comforting, as an independent director, to know and have someone, the head of the trading department, say to you, "Look, you know, mistakes do get made." I mean, there is not an operation in this world where a mistake isn't made. They review every trade at the end of every day. They have what they call, I think, an error file. It is immediately reconciled and always, the customer is made whole. I mean, they swallow their mistakes. And that, you know, you see this on a systematic, regular basis with lots of good reports and records, and you feel comfortable about it, but you never let down your guard. You get these reports constantly.

Mr. Eisenberg: Is some of the trading, some of the brokerage allocated to people who sell IDS fund shares?

Ms. Jones: I don't believe so. I don't think they pay for shares, selling of shares.

Mr. Eisenberg: I don't say that they're paying, I'm just saying do they allocate. And if there were, you would take an extra special look at that?

Ms. Jones: Yes.

Mr. Eisenberg: To make sure you're getting best execution?

Ms. Jones: Yes, because market share is becoming a very – I mean, I think that's the whole distribution system and the need to increase market share is, I think, where independent directors need to spend – where I feel I need to spend a lot of my time and focus a lot of my concerns, because I think that's an area where there could be dangers yet to be specified, I think. But I think that's a – this is an area that at least in the IDS funds, and I gather in all of the large funds it's an area that is, probably because the Commission has been clear about what is and isn't acceptable, it's an area that everyone seems to be happy to live within the rules, with the occasional question about what does it really mean in the release. But I think for, the most part, it's –

Mr. Eisenberg: Would you like to see services unbundled from brokerage?

Ms. Jones: You know, from the point of view of you wouldn't need these committees doing all this checking and all, I mean, and from the point of view of someone who doesn't really like to haggle about price when I go buy something myself, and I don't really know what I'm getting, it sounds simple. But I think that probably there were good reasons why the Commission agreed to this initially, back in the late '70s or early '80s, whenever, and I'm not sure that I know enough to say that –

Mr. Eisenberg: You were here when they did that, weren't you? But you weren't responsible.

Ms. Jones: I wasn't responsible. I'm still not responsible. I really don't know. On the face of it, it seems like that would – the simple approach would be nice.

Mr. Eisenberg: Okay. John, we'll talk about Putnam and how they view the same areas we have been discussing.

Mr. Hill: And I'll keep my comments brief, because I think a lot of the practices we have heard discussed here today on this panel are duplicated with some variations at Putnam. I think the key point I would like to make is, at least on a philosophical basis, Putnam trustees take the brokerage issue quite seriously. One, it is an asset of the fund, as several of my colleagues have pointed out. And as a result, we have a general fiduciary obligation to make sure that asset is used both directly and indirectly to benefit the shareholders and no one else. So it's important to us from that perspective. I think we also think it's important, and equally important in some ways, to the issues discussed this morning, such as 12b-1 and management fees, because brokerage expenses are huge expenses of the funds, you know, in some cases probably dwarf what are paid effectively in management fees. So just given the sheer scale, we think it's important. It's also important because investors can look at management fees and custody costs and transfer agency costs and see what their fund is costing, but brokerage is really hidden. This is one area where it is hard for an investor to really know what's going on and whether or not they're being well served. So I think because of that, trustees have a particular obligation to make sure that the assets are being used to get the lowest possible costs and the broadest range of service.

So that's sort of our going in philosophy. Duncan mentioned, and I can understand why, he talked about his clients on the right, and I'm sure when he thinks of his clients, he thinks about the people he deals with on a day- to-day basis. I would suggest that at least at Putnam the clients are the trustees. Your clients in the brokerage firms really are representing the shareholders, because we're the ones who are there to make sure ultimately that it's done right. We do have a robust brokerage policy. Obviously, as Ann and Heidi and others mentioned, we cannot do trading, we cannot look at every trade. So we basically deal with the complexities of the issues and our responsibilities by having a fairly robust policy that's articulated each year in the advisory contract, what we expect, what the policies are, plus the monitoring that we're going to do and the data that is going to be required for monitoring. That's all spelled out in the contract. The policy that's essentially at Putnam is best execution and best net price. Putnam, I think just like Henry said, their stated policy and the stated policy of the trustees is to not knowingly pay up, or best execution and best price. That gets to be complex. It takes a lot of data to analyze that issue. And we get a lot of data. We have a regular brokerage committee that meets on a regular basis to review data throughout the year to make sure that we are getting the best execution at best net price.

Mr. Eisenberg: You're talking about a board committee?

Mr. Hill: Talking about a board committee. And it really is dominated by independent trustees. Now, that best execution can be a complex issue. That doesn't mean necessarily the lowest possible price. Probably some of the best execution occurred, in my experience, last August and September when liquidity in the markets melted down. And I will applaud firms like Merrill and Goldman for the way they stepped up and executed trades in markets where there was very little liquidity. Now, those were not cheap trades, I'm sure to shareholders at one level, but at another level, they were very effective trades and done so on a very good basis. Our committee looks at issues when there are special circumstances like that, and just draw their own conclusions. We do want to look at the issue of best execution and best net price, in spite of the complexities. We do get a – I have with me a book that we get on a regular basis that has all the data. This used to be thicker. We're getting smarter, so we can boil it down, to take a look at. But we also look at brokerage allocation, according to the various categories for execution for proprietary research for third party research. We do direct brokerage to use for paying our custody expenses and various expenses of the fund. We do look at, quite heavily and closely, at third party research, what we pay for that. That's actually a fairly small part of the brokerage at Putnam. I think that reflects in some degrees at least the trustees were dubious about the whole enterprise.

Virtually none of the trustees came out of the financial world, and are not familiar with the history of 28(e) and Mayday and all of that, so we look at it more as people involved in industrial businesses who do not understand a lot of the Greek here, and I think we would be just as happy to see it all unbundled and these things priced independently. But again, we look at it quite carefully. We look at the use of brokerage for, as well, for fund sales. Again, that's an issue that we take seriously, because it is so rife with the possibilities for potential for conflict. We want to see, for example, on a regular basis who were the big sellers of the funds and how much brokerage did they get for this period, and we particularly like it when we see the two or three largest sellers of the funds getting no commission directed brokerage for those fund sales. So the bigger the inverse relationship, the happier we are. But it is permissible, and there are some firms that need that brokerage, and as long as there's best execution, because they don't have the research or the services they can provide, as long as there's best execution, we are willing to permit some of that on a limited basis. In terms of monitoring, I would just like to sort of reaffirm something that Heidi said, and that Ann said. One of the best monitors of brokerage, best execution, I think, are the portfolio managers, particularly in most of the large firms where their compensation is set heavily on their performance.

They're the first line of defense to make sure of the best execution, because it relates directly into performance. The second level of monitoring is the trading group, who does this daily. They also use outside sources, such as Able, Moser, and Plexus, to review their trading, which I think is helpful. Again, it's not perfect data, but the more data you can add, I think, to the pool, the better. And finally, you have the monitoring of the trustees, through all these various reports that I have described. On a regular basis, we get together with the head of trading. I think we sort of view it putting him on the hot seat for an hour or two, shoot a lot of questions to him, ask him a lot about the data we see. We're trying to get not just his answers, but sort of a qualitative feel for how he feels about his job, how he approaches his job. I think Putnam did something quite brilliant several years ago. They hired a senior trader on the sales side out of Goldman Sachs, who knew all the tricks and all the trades passed down on the other side, and he's been enormously helpful, I think.

Mr. Eisenberg: That's why they changed their policy, right?

Mr. Hill: Exactly.


Mr. Hill: He's been enormously helpful in, I think, getting our average price commission trades down, I mean agency trades. That's 0.5 cents a share for the last couple of years. He's been quite effective, I think, in helping aggregate our brokerage with a limited number of firms to maximize our clout, not only for research, but for events like last August and September. So I think again, regular meetings with this fellow and his staff are also very important, just so we can look him in the eye and draw our own measure, if you will.
Mr. Eisenberg: We have a couple of questions. One of the things I wanted to straighten out, maybe ask Duncan, since he's the trader here, would you just tell us about a step-out transaction and how that works?

Mr. Niederauer: Yeah, I'll take a shot at that, because it's become certainly more prevalent in what we do. And one of the questions that I think was in the overview actually was if we're involved in step-outs, are we typically involved as the person executing the trade and stepping out or the firm to whom the step-out steps out to, I guess.

Mr. Eisenberg: Steppee, or something?

Mr. Niederauer: The step-in, I guess, whatever. So it's another one of these things that, you know, for the life of me, I don't, I must confess, I don't understand it. It always seems when you think about a lot of this stuff, there must be an easier way to figure this all out. But what typically happens is, if there is a desire to – you know, a large client has a desire to pay a smaller brokerage firm who is an NYSE member, who can clear their trades, but that firm is not confident that it is – that the person they would like to get those commissions to for payment for other services, they're not confident that that same firm has the distribution or execution capabilities to get a good report for the fund. So the fund will then call a firm like Goldman Sachs or Merrill Lynch, ask us to execute the trade. We execute the trade, and then the client will say to us, "Okay, now that you've done it, and I've gotten a good execution, I need you to step out."

Or effectively, another word that you might hear called, we used this word earlier, "give up," and that doesn't mean give up in terms of put up the white flag. It means effectively take the execution you've achieved and give part of that execution to another firm so that that firm will then report it to the client, book it, charge them a commission, et cetera. It seems like a very round-about way of getting that secondary broker paid, but it's something that we're asked to do, I would say, certainly more and more, not less and less. I don't know if I did that justice. I don't know if anybody wants to add to that, but it's basically, you know, we execute the trade. That way the trade is not in a queue or somewhere, the trade is not broken up, and we typically give not all the trade, but part of that execution. We just broker it to somebody else, who then books it to the actual customer.

Mr. Eisenberg: But they don't do very much, do they, the other guys?

Mr. Niederauer: The other guy just books the trade.

Mr. Eisenberg: He books the trade.

Mr. Niederauer: Yeah. We execute the trade. We do all the work, Mike, as far as I can tell.

Mr. Eisenberg: They get a part of that commission.

Mr. Niederauer: Does that sound fair to you, Mike?.

Mr. Eisenberg: That sounds like a give-up. How much does he give away, or whatever adjective you want to use?

Mr. Niederauer: It will vary. And again, if you're looking at totality, I'm not sure we really care, trade by trade. You know, personally, if someone wants to pay somebody $20,000, I would rather give up 100 percent of one trade than a percent of 100 trades. But, you know, I mean, it's usually viewed – again, it's viewed more holistically.

Mr. Smyth: I think you'll find that, for the bigger brokers like Merrill and Goldman, that step-outs where we're doing the execution by far exceeds the step-ins where execution is done elsewhere and the commission is given up to another broker.

Mr. Eisenberg: Okay. There are a couple of questions that have been sent up. Let's see. Jim, let's say your funds wants Bloomberg machines, which cost Citation $1,000. Do you charge the fund 1,000 times 1.75, which equals 1,750? If so, how does a director judge best execution?

Mr. Eisenberg: The way the process works – and again, when I talk about ratio – is that if a Bloomberg machine is $1,000, as stated, we will basically look for $1,750 in commissions. So, in effect, the ratio that we talk about applies to the vendor amount, and in effect, what we're looking for from the individual fund is, if it's 1.5, it's obviously $1,500 in commissions; if it's 1.75, it's 1,750. So the answer is that it is the 1,750 in commissions that we're looking for.

Mr. Eisenberg: Henry, since T. Rowe Price finds the research it receives so useful, that is, valuable, don't you need to presume that you're paying up? I.e., if a broker is not providing the data, the commission would be lower?

Mr. Hopkins: Well, the brokerage houses are not unbundling, so we are basically paying the same rate we would on any other transaction, regardless of whether we were soft or not.

Mr. Eisenberg: Heidi, why doesn't Vanguard refuse research and demand to pay a lower brokerage fee, or else stop dealing with the broker? That's a tough position.

Ms. Stam: Actually, we're very successful in getting, you know, the research we want, and not accepting or not taking materials that we don't want. On our index side of the house, I think as I mentioned, we tend to get a lot of material. We don't use it. We don't want it. We don't look at it. We know we don't pay for it. You know, our commissions, we look at them very closely, and particularly on the internal side, and these guys could probably tell you, we're clearly not paying for any research materials. So we kind of, we know, and this is not a problem for us. We suspect that there are issues out there with respect to other advisers who need to get a certain amount of research, and we would rather see them, you know, we certainly think they could pay for those materials in hard dollars.

Mr. Eisenberg: To the two independent directors, if your management companies use soft dollars, do you re negotiate the advisory fee, since that involves reimbursement for research expenses?

Mr. Hill: That's an interesting point. Each year, when we do our annual contract negotiations, when we think we're through in terms of decisions we've made, we then array all of the fees, compensation that's going to flow to the management company, based on the assets at that time, And one of the fees/assets for the management company that goes into our calculation is, in fact, the soft dollar expenses, which arguably is money that they would have had to spend out of their own pocket, if they wanted that service. So it becomes clearly a part of our focus on what we're doing each year in the annual contract in terms of total compensation, which to us is the only – the only way to look at compensation is total compensation.

Ms. Jones: I can't improve on that. That's basically the way we handle it, as well.

Mr. Eisenberg: Heidi and Henry, do your portfolio managers conduct a regular and vigorous analysis of execution quality amongst all the marketplaces, and do you do it quarterly?

Ms. Stam: Yes. We do a thorough analysis of all the marketplaces, and our analysis will take into account all the different markets in which we trade. And they're very aware, as I think we have said consistently, and everybody on the panel has said, as to what the activity is, and the portfolio managers and the traders know exactly what the activity is in the different markets. And to the extent that we then take that data and then scrub it down again, through internal analysis, we're very much aware of what is going on in each of the marketplaces.

Mr. Eisenberg: Go ahead, Henry.

Mr. Hopkins: Our portfolio managers, I think, would view every trade as it occurs, and as it impacts their account. As I mentioned, they are very interested in the quality of the execution they're receiving from the trading desk, and they review it with great care and scrutiny.

Mr. Eisenberg: And that winds up this panel. I hope that we have cast a little light, and not just heat, on this very difficult subject. We will take a 15-minute break. I would like to thank the panelists for their input, and please be back at 4 O'clock for the panel on valuation of securities and portfolio liquidity.

(A brief recess was taken.)


Valuation of Fund Portfolio Securities and Portfolio Liquidity

Ms. Nazareth: Good afternoon. Our final panel today is entitled Valuation of Fund Portfolio Securities and Portfolio Liquidity and I would like to introduce our panelists. Our first panelist to my left is Manley Johnson. He is the co-chairman and senior partner in the consulting firm of Johnson Smick, International. Johnson Smick provides information services on economic and political policy changes in major countries. Mr. Johnson is a former vice chairman of the Board of Governors of the Federal Reserve System. He currently serves as an independent director of the Dean Witter funds. Jean Gleason Stromberg serves as an independent director of the AARP Investment Program for Scudder, which includes 15 mutual funds managed by Scudder Kemper Investments in two managed investment portfolios. She has previously served as director of financial institution and market issues at the US General Accounting Office. She has also been a partner in private legal practice and earlier in her career, she worked at the Securities and Exchange Commission. Julie Allecta is a partner in the law firm of Paul, Hastings, Janofsky and Walker, where she heads up the investment management practice in the firm's San Francisco office. She began her career at the Securities and Exchange Commission where she worked in the Office of the General Counsel. Ed Cameron is a partner of Price Waterhouse Coopers and is global chairman emeritus of the Price Waterhouse Investment Management Industry Service Group. Mr. Cameron has more than 30 years' experience as an auditor and business adviser to investment management clients. Ken Domingues is chief accountant of the Commission's Division of Investment Management. He has previously served as chief financial officer of Franklin Resources, Inc., and is a former audit partner at Coopers and Lybrand. Finally, I have the pleasure of moderating this distinguished panel. I am Annette Nazareth. I am senior counsel to Chairman Levitt. And in my brief tenure with the Commission, I have also had the privilege of serving as the interim director of the Division of Investment Management prior to Paul Roye's arrival. Before we begin what we hope will be a lively and informative exchange concerning valuation of fund portfolio securities and portfolio liquidity, we thought that we would have Julie Allecta lead off with a brief overview of the relevant legal requirements that apply to valuation and liquidity. Julie?

Ms. Allecta: Thank you, Annette. And thank you very much, Paul Roye, and Chairman Levitt, and Mike Eisenberg for putting together this program. I think we have had some very informative sessions today and I hope that this one will round out the day nicely. Valuation is one of the most critical functions of mutual funds. So far, we have been talking a lot about what goes on behind the scenes but valuation is something that affects every shareholder every day because shareholders have to buy and sell, based on the net asset value of mutual funds. And the importance of accurate daily pricing can't be overtated in this particular industry. There are two sections of the Investment Company Act that really lay out a very simple framework for this function. There is the definition of value in Section 2(a)(41), just a definitional section. And the rule under 2(a)(41), Rule 2a-4, which lays out the guidelines for determining securitie's value. And it is a very simple formula. It says, if there are market quotations, price the security at market. If market quotations are not readily available, then the security should be valued at fair value as determined in good faith by the board of directors. And I think what we are going to focus on in this panel is the notion of when market quotations are not readily available, what does it mean to value at fair value, what does it mean to value in good faith, and what does it mean that the value has to be determined by the board of directors. There are many, many layers of complexity underneath that fairly simple formula. I might also mention that there are some other aspects of valuation in the Investment Company Act. There are special sections that relate to money market funds, Rule 2a-7, and special valuation provisions for debt instruments with less than 60 days to maturity that are valued at amortized cost, which I don't believe we are going to get into. I will also point out that we are laboring here as an industry with very little solid guidance on this important function. The two key accounting series releases, ASR 113 and 118, were issued in 1969 and 1970 respectively. They are in need of updating. The Commission has periodically updated through guidelines to the registration statement, through no-action letters and through other forms of interpretation. But we are really working in an area where a lot of the current guidance has come out of the accounting industry and out of the industry's experience itself. I think with that introduction, Annette, I'll turn it back to you.

Ms. Nazareth: Okay, thank you. I think I would like to start off by asking some questions of the independent directors on our panel and the reason for that is obviously our focus is on the role of the independent directors in this valuation process. So let me start by asking Manley and Jean, how do or should directors address the increasing numbers of fair value situations that they now encounter, such as foreign securities, thinly traded securities and large positions in small issues?

Ms. Stromberg: Well, I'm going to break with tradition that has been established on some of the panels today and I am not going to try to sell you our funds.


Ms. Stromberg: That is, in part, because the AARP program, most of you probably are too young for.

Ms. Stromberg: I certainly include myself in that group. But it is also, I hasten to add, they are available to anyone and they are very well managed by Scudder Kemper for the more risk-averse among you. More importantly, perhaps, I am not going to talk so much about them and that's partly because I only recently joined the board and so I can't talk about personal experiences so much in this area but that won't keep me from talking. Our funds, I think, as with most funds, rely on the advisers to do the pricing on a daily basis. We expect that they will take care of it under the procedures that have been laid out by the board. In my case, prior to my time, but I am familiar with the procedures. Increasingly, the times that the fair value issues have come up, they come up in the context of on a daily basis and it's up to the advisers in many cases to have to deal with them right away. They don't have the luxury of talking to the valuation committee or the board before they make a decision about how they are going to price. And I could use just as an example what happens when the New York Stock Exchange closes and the prices at that point, nobody knows exactly what they are. That's not a reasonable time for the adviser to consult the board as a whole. Our procedures would, in any event, call for the adviser to deal with the valuation committee which, in our case, has one independent director and one inside director on it. Valuation committees, I think, are fairly common on boards and they differ, for practical reasons in a lot of cases, as much as for philosophical ones. The most important thing is that you can get hold of the people and that they know, have some idea, about pricing issues.
I think just generally that moving on to the board, and this is getting more to answering your question, Annette, there are two kinds of fair value pricing issues that tend to come up and one has come up more recently and that's the more philosophical one, the policy kind of one where, for example, with foreign securities or with market timing or with the AOL kind of situation where you go to the valuation committee, the valuation committee then comes to the board at a regular meeting and talks about the issue and how philosophically the board wants to deal with that kind of problem when it comes up consistent with the prospectus, consistent with the approach that the adviser has taken and with what the board wants to do. The other kind of valuation questions that come up are more specific and more traditional with thinly traded securities or similar things that tend to deal with one particular security. I'm not sure that there is any new learning on that kind of problem. And I think, again, it would go through the valuation committee and then to the board. If it does get to the board, I think it's unrealistic to expect, despite what the statute says and Julie's discussion of how critical this is, I think it's unrealistic to expect the board is going to pull a value – decide on a price by itself. It obviously will have to consult with advisers. And if the only issue were concerning that the adviser was likely not to be conservative enough and all the board had to do was say, well, that's too high, it ought to be lower, that would be easy. But, as you all know, that's not the issue. The issue also has to be correctly priced as best it could be. So it can't be – the price can't be too low or too high. So it is not a question of the board just coming in and saying, we think we'll be conservative. And it is unrealistic to think that that's what is going to happen.

Let me just add one more thing. And that is, I think there are going to be increasing problems in this area, which is one of the reasons we're talking about it, I guess, with more foreign issues, more global kinds of problems, around-the-clock trading, the increasing, although it's hard to see how it can keep on increasing, but the continuing innovative products and innovative securities sort of pressure. I don't think, in light of all of these things, that, what Annette's question is focused on to some extent, the changes that are happening in the markets, that it's going to be sufficient to say that, therefore, the boards have to be even more careful than they were before and that they need better procedures and more monitoring and better oversight. Because, the fact is, the questions are getting too hard and it may be that there aren't any prices in a lot of cases. And it may be that the Commission will have to get a little more involved in setting some parameters for pricing – or at least trying to get some consistency across funds in treatment of some of these issues that keep on coming up. They can – ultimately, I suppose, you could say that at some point, some securities may not be appropriate for open-end companies to invest in. Nobody wants to get to that point. There is a great sort of sense of constitutional right to have open-end funds. But the answer to that is not going to be that the directors are the ones who have to come up with the price and if they can't come up with a price then it's their fault. At least the other possible approach is to define pricing more broadly and have there be more flexibility in it. And have everybody understand that through the prospectus and through the Commission's own concern about errors in pricing and whatever, to recognize that it may not be possible to have specific prices and have that – if that's considered to be a value, have that be something that's recognized.

Mr. Johnson: I agree that the world is getting more complex and complicated and the financial markets are integrating globally and so fund complexes offer a lot more foreign securities as choices and options for investors. And so it is – these issues will keep coming up. What we generally try to do at the Morgan Stanley Dean Witter Funds is have the board try to adopt a set of procedures that deals with as many cases as we can reasonably think of. For the reasons that Jean mentioned, when these issues come up for fair value pricing and you have to make a decision to get your information in toward the end of the day, it's very hard for a board to discuss these things. So you really have to try to be prepared in advance and I think for that reason we try to cover as many things as we can with a detailed set of procedures which allows a portfolio manager to execute based on a board -approved and ratified set of procedures. When that doesn't work, of course, then the valuation committee comes into play. And in our case that's been relatively rare. But it happens on occasion and we have two board members involved on the valuation committee. Those board members can be any two because of the difficulty of finding board members on the spur of the moment. It is basically who is available among board members to deal with valuation questions. But again, the procedures that we've set up generally deal with most of the fair value questions and, again, those arise when you don't get market quotes. Then we go to broker-dealer quotes and take the average of two and in some cases if that can't be obtained, we go to one. But the procedures cover all of those various variations. Then, if the procedures do not handle a particular case, we go to the valuation committee, which is brought in, sits down with the portfolio manager and other management experts along with outside independent counsel and sometimes the outside auditor to consider the price, the proper price, the reasonable fair value pricing decision. That is generally the way we do it. If these situations get more complex over time, maybe the procedures need addressing for more and more cases. But you can't always anticipate those and from time to time you're going to have valuation committees brought in. But that is generally what we've done in that case.

We find that management has a lot of expertise in this area and there is nothing like a portfolio manager's background and understanding to deal with these questions. We understand that they come in with a bias and a potential bias so we think the independent directors and the outside counsel, the outside auditors are a good check on that. But the expertise is with the fund manager and where we concentrate is on a set of procedures that deal with all of the various situations that might come up. Then, of course, the board meets and considers these procedures as a full board and ratifies these procedures. So that's generally the way we've dealt with the situation. I can see that with a large fund complex like ours, we're able to hire a lot of outside expertise with our outside counsel. We can generally fund the best type of information and services and support sources for our decisions but for the smaller fund complex, where I think a lot of these tough cases tend to come up, where the expertise may not be there and they may not have the financial resources to purchase the kind of support that the large fund groups have, you may need more specific technical competence among the independent board members.

With the larger fund groups, though, I think that we – you really want a set of directors that provide sound judgment but I don't think you need to get into highly detailed technical expertise. I think you are looking for people with business, education, government policy background who have shown sound judgment and can be involved in a pricing committee and judge the adequacy of procedures and are used to dealing with systems and procedures that provide risk control and risk management. But having a director directly involved in actual pricing formulas, I think, is probably not an effective use of a director's time, although that might be a little different for smaller fund complexes where they don't have some of the resources that some of the large fund groups might have.

Ms. Nazareth: Perhaps we can focus on that a little more because, obviously, the real challenge is for the smaller funds and the directors who have the same legal responsibilities whether they are working for a large fund or a small fund. They don't have the access to the kinds of technical expertise that you're talking about. What do the panelists – how do you think in that case directors can satisfy their duty?

Mr. Cameron: Well, I think that independent directors shouldn't become involved in the day-to-day process in large, complex groups of funds where fair valuation is a day-to-day task. And if the directors have become involved, the independent directors have become involved in the day-to- day task, then I think that their independence becomes jeopardized because they are becoming part of management. But the portfolio valuation model has changed so dramatically since 2(a)(41) was introduced many years ago, in those days basically funds were investing in exchange listed equity securities and you had one pricing source and today it's far more complex. You've got multiple pricing sources, you've got matrix pricing, you've got dealer quotations and, as Manley commented, you should have multiple dealer quotations. You've got board appointed valuation committees and, as Julie pointed out in her paper, which is available outside, that the valuation committee can be composed of inside directors; it doesn't necessarily have to include outside directors as well because, in this day and age, it's very difficult with the daily requirement to fair value securities to be able to contact outside directors in their various places of business. You've got valuation consultants but as pointed out earlier, it is most important to get the sign off or the buy-in of the portfolio manager when you are fair valuing securities because it very important. But if you look at the increasing complexity of the business that perhaps is appropriate that there be a safe harbor for independent directors or all directors, for that matter, when they fair value securities because, certainly, the Commission has granted a safe harbor when companies disclose forward-looking information or what we would call forecasts. Certainly, if a forecast can be safe harbored, then directors in fair valuing securities in a portfolio using current or historical information could be safe harbored as well and I think there would be a great benefit to that.

(Question from Ms. Allecta.)

Mr. Cameron: I am not certain whether it does or not but –
Ms. Nazareth: The question was whether the business judgment rule would provide –

Mr. Cameron: I don't think that I've heard that anyone considers that they have a safe harbor in fair valuation and therefore I would think that maybe it does cover it. But at least not in the minds of those people who are charged with the task of fair valuation.

Ms. Allecta: Certainly a lot of the concerns that you raised are ones that I hear because I work with a lot of small boards as well as large boards. And there is a big difference in the resources and the way that pricing is approached. Certain things are common, big or small, and that is the need for developed procedures, rudimentary procedures or elaborate procedures, depending on the context, and some form of delegation. Because I think Ed's 100 percent right, you can't have the board involved in micro management. But you do have to have them involved in meaningful oversight, which means there has to be one or two or perhaps the audit committee or maybe even the full board, has to get some type of regular feedback. And when there are important pricing decisions, it has to have some involvement. I think 2(a)(41) is – does really – and 2a-4 together, does really require more board input on this decision than perhaps some other operational aspects of running a mutual fund. One of the litmus tests that I like to use is how much impact is a particular pricing decision going to have. You can debate the correct price to use for a Malaysian security but if it's only one security in a portfolio that's quite large, it's a meaningless debate in the overall context. A much less interesting or dramatic example might be the CMO component of a securities portfolio. Fixed income securities, the pricing procedures there might have a much more material impact on NAV and so I think the need for board involvement in procedures and guidelines really varies depending on the circumstance. Also before I give up the working microphone, I wanted to elaborate also on something that Jean raised which I think is a very important consideration. Maybe as we move into a more complex securities market, there are some securities that mutual funds should say, we just should not invest in. We are offering this kind of a product and perhaps certain types of exotic private placements or certain types of complex derivatives that are really unique securities just are not appropriate for incorporation in our public mutual fund. I see that decision being made much more frequently now than, say, five or six years ago, in part because these securities didn't exist or weren't readily available five or six years ago and there really is a difference being created. I hearken back to what Bob Pozen said this morning, that there is the hedge fund and there is the retail mutual fund and perhaps we not only have a difference in fees but we have a difference in portfolio composition driven in part by the need for correct daily valuation.

Mr. Domingues: One other thought that you might consider for the smaller funds if directors are concerned about these kinds of securities not being handled properly, it may be useful for the director group to request a focus on out sousing the pricing function, which will permit going to pricing services or the use of pricing services with extensive experience and also access to pricing information. By the way, I should point out that I am relatively new to the Securities and Exchange Commission. All of my views come from my experience in public accounting or in industry with Franklin. I didn't hear a standard disclaimer beforehand so now you have it.

Ms. Nazareth: Ken, you've raised an interesting issue. I think when you talk about the necessity of using outside pricing sources and advisers, I guess one of the questions I have is, what is the role of the board in monitoring the performance of those outside advisers and, in addition, what is the role of the board in – you know, in ensuring that the compliance procedures that the board has established are actually being followed?

Mr. Domingues: That's a very good point. Particularly in the larger complexes where they might find something in the order of thousands of securities that are spread out over a variety of funds, obviously it would be impossible for a director group to even attempt to focus on individual securities. But I personally believe that the director groups should involve themselves in the entire process. Not only procurement with the portfolio management people but also the – how they are accounted for and what the settlement arrangements are, the pricing and fund accounting. I think if you, as director groups assign representative directors that can get into the process, it will tremendously improve their understanding of how it works and that will lead to a desire for more information. For instance, if the fund group uses multiple pricing sources, it would be very prudent to have some of the third party pricing vendors put on a presentation for the board group, talking about the different kinds of securities that the fund will invest in. And also have the pricing vendors explain the nuances of how their individual portfolios are developed by the third party pricing source. So it is a very appropriate activity for a board to become involved in.

Mr. Cameron: Mutual funds don't have employees so they are in the enviable position they never make mistakes then. But if you are using a pricing source, the directors have the same oversight responsibility for an outside pricing source as they would for an internal pricing source. I think the responsibilities for oversight are the same.

Mr. Domingues: That's true and most of the individual contracts that I have seen from the pricing sources all disclaim responsibility for their end product. They won't stand behind it and so that's even more reason that the directors should become very acquainted with the process and skills of the individual people that developed the matrix procedures that will be applied to the individual funds. So it is very important that the directors have a very deep understanding of how this process works.

Ms. Allecta: So is it fair to say that there is consensus that while the directors don't have to ensure the accuracy of prices, they do have to understand the process, they do have to take responsibility for making sure there is a coherent and well understood process within the mutual fund organization?

Mr. Domingues: Yes, I think so. There are a number of soft decision areas in the whole pricing process, tolerance tests, whether a security is acceptable, depending on the kind of security it is. If it's an emerging market security, the variance is going to be larger than it would for a domestic security, for instance. I think the directors need to weigh in on what kind of variance that they as a group are willing to live with to produce the result that is applied each day, usually on an automated basis, to come up with a daily net asset value for the funds.

Mr. Cameron: I think in the fair valuation process, the process is much more important than the price ultimately determined, because that provides the basis on which the fair valuation process is done on a consistent basis, because if there isn't consistency in the process, that you're going to have aberrations in the price from day to day, if the individual fair valuation prices are determined without taking into consideration a consistent process.

Ms. Allecta: Do you think shareholders, as a group, understand that the identical security in two different mutual fund portfolios could be valued, whether it's called market or fair value price, at a different price each day, that there is some degree of variation in pricing? Because I think that's a point that's not that well understood. And Ed's right. There are, particularly in a fair value area, there is no one right price. It's a subjective process, and it's having a fair process that gets to a reasonable price that is critical.

Mr. Cameron: And there could be no one right or correct price, but there are also many different ways that you can fair value a security and reach a different conclusion.

Ms. Stromberg: You may have noticed the independent directors are being quiet here. I'm not sure why Manley is, but I know why I am, and that is, listening to the lawyers and the accountants tell me that I'm the one who needs to understand all the processes and how the pricing works and everything else, I'm finding a little intimidating, because I thought they were the ones who understood that, and that they were the ones who would help me understand it. It's true that ultimately it is up to the director to have an understanding and to be sure that the procedures are in place and that there are compliance procedures and oversight. But far be it from me to tell you what the best procedures are, when I have before me Price Waterhouse's, you know, published book on what the best procedures are. I think we as directors look to our advisers to help us in this, and to take some responsibility for it, too.

Mr. Johnson: Well, I would agree with that point. I mean, directors can't possibly know all the minutiae associated with fair value pricing. I think again, the procedures and risk control measures taken, I think, are what they should be evaluated on. And there is a question. I mean, when you're going to an outside pricing service, you know, what is the right decision? I mean, you go and you hire the best. At Morgan Stanley Dean Witter, we hire a couple of pricing services, one for fixed income securities and one for foreign securities, who are the renowned specialists in that area, and we basically make our decisions on hiring a pricing service based on reputation. And, of course, we evaluate the various approaches, but I mean, we can't get into the details of actually the pricing formulas, and we rely on the portfolio manager and others to say, "These are very good pricing formulas, these are the most reputable pricing firms, and they will give you the best pricing services." You know, is that where the line should be with directors? That's about the best we can do in that case.

Ms. Allecta: One thing that's come up a couple of times, and I will point out, it's not always good to rely on the portfolio manager. The portfolio manager bought the security, and has an inherent bias, and edits out, in good faith, sometimes negative information about the price. It is fair, and certainly totally justified, and perhaps the only way to go to rely on somebody in management to give you the investment banking analysis, but maybe pick someone from operations or accounting. The problem is, in a very small fund complex, you maybe only have three people, and the person who is the portfolio manager is also the CEO and the COO, and there is more of a burden imposed on the director to at least listen with common sense, does this make sense, in terms of evaluation methodology.

Mr. Johnson: Julie, that was my point earlier. And I think, for a large complex like ours, I mean, we've got outside counsel and the outside accounting firms, and we have our own independent directors audit committee. So we've got a lot of checks and balances in our system, but for the smaller complex, it's a little different.

Ms. Nazareth: Why don't we turn our focus now to liquidity, which I know a lot of you are interested in. Let me ask this question. What is the difference between the independent director's role with respect to liquidity issues as compared to valuation issues?

Ms. Allecta: I would say that, while liquidity is very important, it doesn't occupy the same central state as does valuation. Funds every day have to value and face valuation decisions. Very few funds face, on a daily, perhaps even ever basis, a real liquidity crunch, where they simply cannot honor redemption within the time frame permitted under the Act. So we monitor liquidity in a less rigorous fashion, because it doesn't have quite the same demonstrable impact on the integrity of the mutual fund itself. But it nonetheless is important, because an open- end fund is supposed to be able to honor redemption requests and maintain reasonable liquidity, and there are prescribed guidelines, 15 percent in the case of non-money market funds, and 10 percent for money market funds. I think the two concepts are often fused together, because often what creates a valuation issue is the fact that there's no liquid market to inform us as to the market price. There isn't that liquidity data point that we need. A restricted security, like a 144A security that trades in an active secondary private market, can have a market price, and a marketable security, because of the huge position owned by the fund in a very thin market, becomes illiquid, may need to be fair valued. So there is a certain crossover between the two concepts.

Mr. Cameron: To me, liquidity is inseparable from valuation, because there are so many examples of, particularly in emerging markets, in what's happened in the last 18 months or so, that if you've got an exchange listed security and you can get a last sales price on your valuation date, and you've got a 100,000 share position, and that security has traded 10,000 shares in the last three months, is that a liquid security or not? I think that that's a security that should be considered for fair valuation, rather than taking the last sales price. So to me, particularly in certain markets, you cannot separate the concepts of liquidity and valuation.

Ms. Allecta: How about staleness, Ed?

Mr. Cameron: Staleness, the same thing is true. We found instances in emerging markets where the security hasn't traded for two months, and there, staleness of a price certainly makes that a candidate for fair valuation, as well, and there are many examples where mutual fund companies have fair valued securities in such an instance.

Mr. Domingues: From the liquidity standpoint, funds tend to look at that more from a global fund point of view, and address the problems with the cash levels that are allowed to build up, and also to work out arrangements for inter-fund pricing in a fund group, or line of credit arrangements. So it's typically looked at more in a global sense than an individual security by security sense. The larger complexes will also monitor the cash flows during the day each day, to determine whether there is a problem building up, in which case there will have to be some delegated authority from the board at a relatively high level in the fund, to employ emergency procedures, such as inter-fund borrowings to make sure that the funds that are effected are covered, because when you have a crisis building up like we've seen in the emerging market countries, that will require some pretty quick movement on the part of the funds.

Mr. Cameron: Liquidity could become an important issue with the Y2K problem, now that many fund complexes are increasing their line of credit, because if everyone decides to stuff their mattress, they're not only going to make withdrawals from banks, they're going to make withdrawals from fund companies, as well. So liquidity could be a big issue on the horizon, with Y2K just around the corner.

Mr. Johnson: We find that a lot of the securities that are illiquid require fair value pricing, and we are very conservative on liquidity at Morgan Stanley Dean Witter. We have never really had a liquidity problem, knock on wood. But generally, we've always stayed well under the guidelines. And, you know, the way things are going globally in the financial world, I think that conservative practices on liquidity are going to be very important, and not reaching for every ounce of return, because I can't think of anything worse for a fund than to not be able to handle redemption. If you want to ruin your reputation, that's the fastest way to do it, I would think. So, you know, we have generally always been very conservative, well under the guidelines, on that, and we're happy to say we never had a liquidity problem, and we continue to evaluate our liquidity guidelines, and I think we'll continue to stay well under the official guides.

Ms. Allecta: Well, now, to be devil's advocate here for shareholders, I'm paying for the line of credit which is becoming increasingly popular now so that you don't have to worry about liquidating securities because I'm the shareholder and it's a fund expense. And I'm paying for the lost return on the amount of the portfolio that isn't invested in accordance with its investment objectives. You are supposedly valuing the fund that I bought on the price at which those securities could be sold in today's market. So explain to me how I benefit from a conservative policy on liquidity.

Mr. Johnson: Well, let's put it this way. When the crisis happens and you can't get your money out and the fund is going down in value dramatically, you're going to be happy that liquidity is – you know, is a conservatively followed issue for the fund. Now, again, the prospectus contains all of the information about what you're getting and, you know, there are some funds that are highly risky and they are set up that way and consumers or investors have numerous choices about how they want to invest their money. If it's all spelled out in the prospectus, then the investor knows what he or she is getting. Then, obviously, there are funds available that promise high yields based on higher risk. So I would say that liquidity, you know, there are tradeoffs in those particular cases. But still, I would say even if you are in those types of funds, there are some funds that are more liquid than others in that range. And I would say that it's better to be conservative on that issue than it is to be, you know, stretched for every ounce of return. At least, I think that's generally been our philosophy at Morgan Stanley Dean Witter and we have a lot of happy investors. –

Ms. Allecta: I don't disagree. By the way, I think this is the kind of dialogue though that directors need to have, need to inquire about what's being done and why, what the rationale is. And perhaps there often isn't enough dialogue on the subject of liquidity and what it's costing and whether it's a value that should be reached for.

Ms. Nazareth: I'm interested in what type of valuation procedure do the funds normally have when you have illiquid securities. Do you have a really wide bid/ask spread? Are there generally procedures that require that you go out to get three bids and you take the mid point or the lower? How do you satisfy, again, your obligations as a director in appropriately or fairly valuing these illiquid securities? Do you have some examples of how that's done?

Mr. Cameron: Probably one of the best examples of that was when Drexel failed in the junk bond market. You had spreads like 50 to 90 and what do you do when you have a case like that? I think, again, you follow the process that has been established, whether you take the bid price or whether you take the mean between the bid and the ask or some other convention. But, again, consistency is very, very important. But again I think that the process should be established and it should be rigidly followed.

Ms. Allecta: Although I would say don't follow the process over the cliff. There are times when you simply can't get three dealers to give you a reliable quote. Well, then somebody has to say, wait a minute, you need another process in this extraordinary situation. Drexel, the total freeze-up of the California and perhaps national municipal bond market after the Orange County debacle, there are situations that really do call for someone to say, we need to do a fair – a real fair value, bottom-up type of analysis. Fortunately, those are rare but they can be occurring with greater frequency.

Mr. Domingues: My personal experience when Drexel failed is to be sure that you have a backup plan and fortunately we did have a backup plan. We had a pricing service that was very proficient in matrix pricing at the time and so Drexel failed and over the weekend we had a backup source in place, which is another alternative and another reason for directors to insist on a backup in – particularly in these days of very volatile price movements.

Ms. Nazareth: I'd like to share with you, having been on the other side, having been advising traders on the trading floor on Wall Street when the asking funds suffered their tremendous debacle, it was really interesting to hear the difference in the specificity of what was required of the traders with respect to the pricing versus what had been asked before. I have to say, in that limited experience, what I saw was that prior to the time there were problems, even though CMO pricing is, by its terms, an art probably and not a science, there was really not a lot of specificity as to whether you were to give, you know, the bid, the ask, the mid point, whatever. And it was only when you could see that the funds were really very concerned because a substantial percentage of their portfolios were represented in those CMOs, that there was a very exacting instruction as to how to value the securities. And what was interesting, there was in some cases it was not what the understanding had been prior to that time. So you really were switching. Which sort of again goes back to one of our earlier points, which is what is the role of the independent director in ensuring that whatever the procedures are, it only makes sense if they are actually being followed.

Mr. Johnson: Our procedure is call for the bid. But, obviously, if you can't get – can't get quotes, then the valuation committee kicks in and you have to work it out and look at your pricing service information and put your heads together. There are some situations where it just takes, you know, a lot of expertise brought to bear in just making a reasonable decision.

Ms. Stromberg: I think that's probably the norm. That's one of the things your procedures do, is tell you that when things can't be priced within the procedures, then you need to kick it out to somebody else, up to a valuation committee if you have one or to the board if there isn't one.

Ms. Nazareth: Are there any other – other than, as Ken had mentioned, lines of credit, are there other avenues that the board can take if you do have a liquidity problem with a fund? I mean, obviously you shouldn't be there in the first place –

Mr. Cameron: You can manage to a higher level of cash which many funds choose to do rather than establish a line of credit.

Ms. Allecta: There are also some strategies that you can employ that might add more liquidity to the portfolio in a down market where you don't want to sell your positions. We're running short of time and I wanted to mention something that's gotten a lot of play in the press lately that I think is befuddling many boards of directors and that is, when is it necessary to fair value because of changes that have occurred post market closings? And this mostly impacts the international, global funds. This is a problem, really, of more recent origin because funds haven't been so extensively invested in overseas markets prior to this decade. And a lot can happen in our electronically linked world between the time the Tokyo or Hong Kong exchange closes and when the securities traded on those exchanges or traded based on what happens in those markets are priced at 4:00 p.m. New York time. And it has become somewhat popular to essentially fair value, look at those Asian or European closing prices and say, does that still reflect fair value and – excuse me. Well, the fair value, does the market still reflect the fair value and, if not, to make an adjustment. And if you make an adjustment, how and what are the mechanics and do fund groups like Fidelity or Morgan Stanley Dean Witter that have lots of resources have an advantage here that the smaller groups don't resulting in disparity in pricing? Ed, you've maybe had some experience with this?

Mr. Cameron: Well, I think that there are examples of that and you've probably read that there have been the Asian timers, I guess, for lack of a better word, that when there had been events that have occurred in the market in Malaysia, for example, which is 14 hours ahead of the US, that they would try to front run the market based on that knowledge. And then the reverse would happen when the US market would go up, then they would assume that the Asian markets would go up as well. So I think that there are a number of different things you can do. One is you can fair value on a somewhat macro basis, looking at what the futures market is doing there. You can change the timing of your valuation from the close of the New York Stock Exchange to 9:00 a.m., for example. Or you can try to identify those market timers and prevent the trades or you can institute a back-end load for any redemption within a 90-day period which would essentially strongly discourage the market timers. So there are things you can do but you have to look at the exact situation that you're in. It's very difficult to make a generalization about it.

Mr. Johnson: You could conceive of a time when there's 24-hour trading. Then you've just got to pick a point, right? But we're far from that yet. But not in the currency markets.

Mr. Cameron: But they're two different issues there. Malaysia was a good example of that. You've got the securities issue but the bigger issue was probably the currency issue.

Ms. Nazareth: Why don't we close with a difficult topic, which is pricing errors. I'm sure the terror of all independent directors. At what point are directors typically informed of pricing errors? Ken, do you have an experience with that?

Mr. Domingues: Often, I would say, it's after the fact.


Mr. Domingues: When the board walks themselves through the process, it would be advisable to do that so they can see what kind of reports are generated by the system. Again, the tolerance reports. So they can also require a summary of these reports are routinely presented to them for board meetings. It will give them a sense of what's going on in individual prices. Some fund groups even have reports that show how the NAVs of the funds compare, changing each day, to their competition. And the trend of something like that will show – will give the directors a great deal of comfort that at least their fund is in the ballpark. And couple that with all these tolerance reports and summaries about them will again give them a sense of being able to monitor what's going on in the pricing as well as being able to determine what policies are in place for when the system will kick out prices that have not changed in, say, five days, six days, seven days or – and, you know, what is done when these things happen. So there is a way to anticipate it but often, I'm sorry to say, most often it happens after the fact.
Ms. Nazareth: Jean, do you have any sense of what you'd do in this situation?

Ms. Stromberg: Well, Manley and I were just agreeing that we would prefer to learn about the pricing error after the fact instead of beforehand –


Ms. Stromberg: In part because, when we learn about it, we expect the adviser to tell us about it and also at the same time tell us what they've done to fix it. And why it happened and what they've done to make sure it doesn't happen again and where they are going to come up with the money to rectify the situation and that's normally the context in which I think the directors in maybe it's only the lucky funds, but in which the directors learn about the pricing errors is that when they've been solved to some point and then you continue to ask questions to make sure that it doesn't happen again.
Mr. Johnson: We've generally had a good relationship on the pricing errors with the fund manager. They've adopted an internal policy of just writing the check no matter how small the error and I think they've seen that as a good business practice which we haven't argued with. But because of that, our sense is that they have a strong incentive not to make a lot of pricing errors and generally we don't have a lot but they are always reported back and we review those every board meeting.

Ms. Allecta: I'm always curious, there is a well- accepted SEC-articulated standard for when a pricing error is so material that it affects NAV and shareholder level accounting. Do boards – Jean, do you ever – are you ever asked whether or not a particular error should result in a check being written to a shareholder, even though it falls underneath a predetermined threshold?

Ms. Stromberg: No, I've never been asked that but that may be because I've only been on the board for a short period of time. This just reminds me though of something else I think it's important to remember about pricing and that is that the – unlike the other panels this morning where we were talking about independent directors, pricing is the responsibility of all the directors; it's not – the independent directors don't have some special statutory role and as Manley just said, to some extent we all have the same interests. The adviser and the inside directors are no more interested in having pricing problems than the outside directors are in most cases. There can be cases where there is some vague conflict, although unless it is a very material area it's hard to see where the conflict is. But I think it's important that independent directors always have some additional obligations because they are the ones who may feel more responsible as outsiders to understand and deal with issues. But in this case, this is one where in a lot of ways we're all in the same boat and I think it's important to remember that.

Mr. Johnson: I would agree with that point. I mean, it's important to remember the fund manager does have first line fiduciary responsibilities, just as well as the outside directors. So in that sense, we're in the same boat. But it's true the outside director have a special responsibility in terms of protecting the shareholder. But at the same time, people shouldn't forget that fund managers have important fiduciary responsibilities that put them on the spot as well and give them a strong incentive to get it right.

Ms. Nazareth: I would like to thank our panel very much.


Ms. Nazareth: We had a few very good questions that unfortunately we weren't able to get to so feel free to come and ask the panel after this. Thank you.
(Whereupon, at 5:05 p.m., the meeting was adjourned)


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