Wednesday, September 19, 2007

Role of Independent Investment Company Directors - Part 2

Fund Distribution Arrangements
Ms. Richards: Welcome back to this morning's second panel. My name is Lori Richards. The topic for our panel this morning is mutual fund distribution arrangements.

Long, long ago, in 1980, the Commission permitted the use of fund assets to pay expenses associated with selling a fund's shares if approved by the fund shareholders, by its board, and perhaps most critically, by the fund's independent directors. Thus were born so-called 12b-1 plans. In adopting Rule 12b-1, the Commission noted that it was concerned about the conflict which may exist between the interests of a fund in paying for distribution expenses and the interests of its adviser in increasing its assets under management.

The Commission also expressed concern about the likelihood that the fund would benefit from paying distribution-related costs and about the fairness to existing shareholders. Because of these concerns, the Commission placed particular responsibility on the fund's independent directors to review and approve the fund's 12b-1 plan and to make a determination that the plan is reasonably likely to benefit the fund and its shareholders.

Well, the mutual fund industry and the way in which mutual funds are sold have changed since 1980. Today mutual funds are the investment of choice for millions of American households and assets under management are robust. This was not the case in 1980. When they buy mutual funds, investors are now offered a myriad of alternative sales charge arrangements. In addition to front-end sales charges, there are ongoing asset-based charges and contingent deferred sales loads payable when investors sell their shares.

The way in which mutual funds are distributed has changed, too. Funds are sold directly by fund complexes through broker dealers and more and more through fund supermarkets and by investment advisers. Fund distribution is big business. Bloomberg estimates that in 1998 alone, fund companies spent more than $1 billion on marketing and promotion. This makes the directors role in reviewing distribution and in deciding what is in the best interests of shareholders perhaps more difficult than was the case in 1980.

We have a wonderful panel here this morning to share their views. I would like to quickly introduce them.

Paul Haaga is executive vice president and director of Capital Research and Management.

Charles Schwab is founder, chairman, and co-chief executive officer of the Charles Schwab Corporation, and has been a director of the Charles Schwab funds for many years.

Jessica Bibliowicz is president and chief operating officer of John A. Levin and company and is also an independent director of the Eaton Vance Mutual Funds.

Phillip Kirstein is general counsel of Merrill Lynch Asset Management Group.

Faith Colish is an attorney in private practice focusing on securities laws and is also an independent director of Neuberger and Berman Funds. With that, I would like to start. Each panelist has agreed to offer a three-to-five-minute introduction. Paul?

Mr. Haaga: Thanks. Is the mike on? Good. Lori, it really is great to be back. I can't believe it's been 22 years since I left the Commission, but that's how long it's been, and I'm delighted to be back in the building, and see old friends. I was particularly poignantly reminded of being here, though, when I had a cup of coffee.


Mr. Haaga: I think every other place on the planet, coffee has improved in the last 22 years, but not here at the SEC. So that was a good memory. I submitted a statement that you can pick up out in the hall. The statement suggests that we're all spending too much time labeling – or to use a more familiar term in this city, legalistic parsing of words – that time and effort and energy could be better spent on analyzing, and I think it's particularly true when you look at 12b-1 expenses, that we ought to expend a limited amount of time deciding what is distribution and what is not. The more relevant questions are, is this of good value to shareholders, are we paying the right amount? Directors are smart, conscientious people. I've spent a lot of time with them, and that keeps getting reinforced for me. They know how to ask the right questions, if we just educate them about the business and then give them appropriate information. Now, there are a number of fictions and lists of irrelevant factors, like in the 12b-1 release, that we walk them through, and I would just suggest those are not helpful and they can even distract from the real purpose of getting at the real issues.
I agree with what Bob Pozen said in the earlier panel about distribution expenses. It ought to be relevant to a fund board, whether they've got a 12b-1 plan or not, how the adviser spends its profits. And to say, as I've heard people on panels back in the early 12b-1 debates, that it doesn't matter whether the adviser uses its profits to build up his business or dumps it in a landfill is just nuts. I mean, if I said that to directors, they would look at me like I had two heads. Of course, it's relevant. The mere fact that it's distribution shouldn't make it irrelevant. I think some of this parsing comes from the fact that there is, as I said in my statement, a historical antipathy toward distribution expenses. I think that has always been mostly wrong. I think it is really wrong as distribution expenses get merged with ongoing advice and servicing expenses. I think we're going to need to just eliminate our antipathy and start calling them what they are and evaluating them the right way. The next thing I would like to suggest is that we should not focus in looking at distribution, that we and the directors should not focus exclusively on fees and expenses. Those are important, but there are a number of other issues that are at least equally important.

One is the effectiveness of the distribution method. Don't look just at sales, look at redemption's. If shares are being sold and then quickly redeemed, you ought to ask about whether they're being sold in the right way. Look at the services provided by the participants in the distribution system. Are those services effective? Are they cost-effective? Look beyond the immediate sale. Look at the appropriateness of the charges. Look at the time period over which they're charged, how different shareholders pay different amounts, what are the shareholders paying, and what are they getting? Do the fees line up the interests of the sellers, or distributors, and the shareholders? If they're all paid up front, there's no incentive not to have the shares redeemed. In fact, there's an incentive to churn them. So you probably want to have a mix of up front and paid over time. Look at sales practices. I know directors have a hard time getting at sales practices. We have a hard time getting at sales practices. We have 100,000 brokers who have sold our shares. We can't sit with all of them. We can't listen to their phone calls. But there are things we can do. We can look at where we sign our, or with whom we sign a selling group agreement. We can look at the materials we're giving for the brokers to purchase. We can also look at what kinds of funds we are forming and how we are presenting them, as ways to get at it. But I think it's very relevant for directors to at least ask a fund sponsor, "What are you doing to ensure that your funds" – or "Do the most you can to ensure that your funds are being sold the right way." A couple of things I just wanted to comment about quickly, if I could, about the other panels, and then I'll turn it back over. I think we're excessively focused on what fees and expenses used to be and not enough focused on what they are now. The more we talk about economies of scale and how much fees have come down, the less we talk about what are the fees and expenses now?

Now, there was a Morning Star article that just came out, I guess last Friday, and American Funds was the best of the load fund families. I'm not sure how they calculated it. But it calculated the cost at 2.59 percent in 1984 and 1.42 in 1998. Now, would you really feel happier if it had been 3.59 or 4.59 in 1984 and was now 1.42? I don't think so. Shareholders pay current expenses, not past expenses. What has happened to expenses over time is really just one indication of what they ought to be and whether they're appropriate, but it isn't the whole ball game, and I'm worried that it's becoming the whole ball game. With that, let me pass it on.

Ms. Richards: Thank you. Charles Schwab.

Mr. Schwab: Thank you, Lori. Good morning, everyone. Thank you for having me here and, in particular, Chairman Levitt, thank you for inviting me here to your panel for the discussion about the role of the independent director. I have been a dependent director, for the last 10 years, and I have that perspective. We started the Schwab funds about 10 or 11 years ago. But I have been an independent board member, and continue to be, of four S&P 500 companies, so I do come with a hat of fiduciary responsibilities with respect to those corporations, and of course with respect to our funds, even though I'm a dependent director. I have submitted a written statement, and I thought I would not go into all the details of the written statement. They're there for you to peruse, and maybe ask questions about later. But I thought I would, since some of the conversation going on out there is about supermarkets, in particular mutual fund supermarkets, that I would give you a little perspective on the origins of the supermarkets, and our role in establishing those supermarkets, and so on.

As a starting point, I would have to suggest that I have a deep, long-term passion for no-load funds, so you might get my perspective on that. In fact, when I was in business school, I used to look with great interest towards the T. Rowe Price funds in the middle '50s. Little, teeny ad in the Wall Street Journal, about three inches high and maybe one column across, "No load." I was really curious about that, and found out what a great deal it was.

Moving forward, in the early 1980s, when Congress passed legislation concerning the IRA, to broaden the IRA for a wide set of Americans, I, too, wanted to have an IRA account. Our company at that time was about, oh, five years old, maybe six years old, and I wanted to have an IRA, but I wanted to have in my IRA a variety of funds. I wanted five different funds, and of course, I wanted no-load funds. So I went to my back office and said: "Look, this is what I want to do. Would you call these five different no-load fund companies and buy some shares," T. Rowe Price being one of them, and a few of the others. It was sort of unheard of, but they did that, and then they logged it into my account. It was a little bit cumbersome at the beginning. And I thought more about this, that other people might want to have the same kind of capability – have a single statement, have a choice of a variety of funds So, with that notion, about, I think it was 1983, a woman who worked for us on a consulting basis, Mary Templeton, filed with the SEC a request for a no-action letter concerning our ability to charge a fee, a transaction fee on the purchase of no-load funds through Schwab, which, fortunately, the SEC approved it, with certain requirements. That was the beginning and I called Mary Templeton, the mother of our Mutual Fund Marketplace. I might be the father. Mary was a great contributor, and I think she had worked with and around the SEC in years before that, but I owe her a great deal of responsibility for the early steps in the early '80s.

Then, moving fast forward, to the early 1990s, the concept of the mutual fund OneSource. As we saw people buying no-load funds through Schwab, one would say that was probably the world's most expensive spot to buy a no-load fund, being that you had to pay a transaction fee. But we saw people found that they really loved the ability for choice, they had the ability for a single statement, they had ability to access, go into branch offices, and so on, to talk about mutual fund choices. We also provided additional information for making comparisons among the no-load funds.

One of our bright young people came up with the idea, if we went to the mutual fund companies and suggested to them, if they would carve out a little piece of their management fees, advisory fees, and we replaced that, we would act as custodians, we would act as the place where we would hold all the – provide the monthly statements, and so on, that we could convince a few mutual funds, no-load funds, to give us a small portion of their advisory fee for supplanting certain costs, that we would then be able to offer our mutual funds, our no-load funds, to the public for exactly the same price as the funds did themselves. We went to about 10 or 15. I think we got 10 to accept, and Neuberger Berman was one of the first ones to accept, one of the leaders, actually, who accepted our notion, and we did a pilot through 1991. Well, we became very enthusiastic about this, and by the beginning of 1992, we broadened it and launched it as what we call Charles Schwab's OneSource Funds. And, of course, it met with great success in the marketplace and many, many different fund groups have adopted our formats, which we're pretty proud about. There are great advantages for the customer in this whole thing. Certainly, the advantage to the mutual fund marketplace is that it's completely open architecture, meaning any fund can come into that. We do have certain specifications.

We try to get in our one-source category the best breed, meaning the funds with the – we try to discourage the 12b-1 fees in our OneSource. We have funds in our total, our bigger mutual fund marketplace which is represented by 1,700 funds that have some 12b-1s, but in our OneSource, it's the best of breed. We try to provide, of course, a broad selection, information. The comparative information is extensive. Low cost is very attractive to our investor group. We presently have about 2 million accounts that have these various no-load funds. It provides them great liquidity. Certainly they have choices of access to approach any of our 293 offices where they can talk to someone face-to-face or the ability to call in to any of our national centers 24 hours by seven days a week, and of course, now the explosion of the Internet and all the advantages that the Internet provides, instant access for all kinds of information about their particular things. So we have seen great success in this area, and we continue to fight, or we continue to request mutual funds, that what we're doing is simply replacing a portion of the fee that they're charging and we're trying to provide best breed, and provide the record keeping, servicing, custodial services, and complete access to their account on the various three or four forms I've mentioned.

So now we have about $150 billion of mutual fund assets that we are custodians for, representing about 1,700 funds in total, of which 1,000 are in our mutual fund OneSource, represents about 120 different mutual fund families. In conclusion, I think, when I look at this from an independent director's perspective, I hope and request of our board members, when they look at our fees and so on, that it's what is the value being offered, and what is the comparative value, meaning other funds or even other financial services. Sometimes I take them on a trip to analyze what banks offer, and the same comparable kind of things for insurance companies. So, at any rate, it's nice to be here this morning. Thank you, Lori.

Ms. Richards: Thank you. Jessica.

Ms. Bibliowicz: Thank you. It's really a pleasure for me to be here today. As was mentioned, I am an independent director of Eaton Vance, but I got there in kind of an interesting way. I was formerly president of a mutual fund company, so I was really on the other side of the table. And when I sat down with the nominating committee, I said: "You know, why are you picking me? Are you sure you mean this?" One of the directors pointed out, "You know which questions to ask and you know how to ask them." So I think that, you know, we're really seeing a movement among independent directors to really bring people in who do understand the industry well and who will ask a lot of questions, and I think that's really quite critical. In my role as president of a mutual fund company, obviously, you get to learn the rules, the 12b-1 plans, and everything quite well. Am I talking without a mike the whole time? Did you all hear any of that? There we go. Thanks. It was pretty irrelevant, anyway.


Ms. Bibliowicz: I just mentioned quickly that I was president of a large mutual fund company before becoming an independent director of Eaton Vance. And one of the – when I asked the independent directors why they were picking me, why the nominating committee was looking at me, they said, "Because you know the questions and you know how to ask them." And obviously, I feel very strongly that that is my role as an independent director. Interestingly enough, as president of a fund complex, you do spend a lot of time with investors doing seminars with the sales force understanding where the pressure are and where the interesting topics are to shareholders. One of the key influences, obviously, is what this panel is about, is distribution and what is happening in the world of distribution. And I want to kind of change the subject a little bit from the world of supermarkets to the world of what is happening when an intermediary sells mutual funds and the actual 12b-1 plans themselves.
I do believe that it is very important for shareholders to be part of a robust mutual fund company. I think that really is key for them. That allows the mutual fund company to really attract the best talent possible. You heard a lot in the last panel about, you know, lowering of fees and e everything else, and I think that's critical, but I also think it's important that talent be behind funds. There are no other better predictors of future performance than strong talent and strong support within a mutual fund company. That being said, independent directors have to look very closely at these fees, and distribution fees are probably among the toughest, for not only shareholders, also for the intermediaries, but very much for the independent directors, as well, to get through.

When we started our multi-class pricing over at Smith Barney, people used to accuse me, and sort of take some solace in the fact that there were only 26 letters in the alphabet, and therefore I could only come up with 26 different versions of how to price these things. I told them they should get nervous when some of the fund companies started using Roman numerals in their classes, because that became infinite in terms of what we could do. I think we're all very sensitive to the confusion that it has caused among investors. However, I do want to compliment the SEC and the fund industry for really trying to put forward to investors exactly what these different classes mean, when they are advantageous, and when they will tend to not be as advantageous. For example, front-end loads for the longer-term shareholder have advantages over, you know, the C-shares or the pay-as-you-go for shorter-term shareholders. I do believe, however, these pricing options are extremely important, because mutual funds very often are not just sold in the world of mutual funds, and I think you alluded to this point, Chuck. They are part of a more general financial services plan with other products in there, and very often, a representative of a client needs more than one option to show the client to make sure that we are doing the best possible job for clients. At the end of the day, in this world of pricing, clients look at their performance and it is net of all fees.

What I would like to contrast this to, and I think it's really an issue for all of us to look at, is in the world of load pricing, the services are all inclusive. You get the management company. You also get the salesmen and their ability to service the accounts. It is all-inclusive. What has changed in the industry landscape, which I think we have to take a close look at, is very often in the world of the supermarkets and other places, maybe 50, 60 percent of the business is now being done through a world of investment advisory fees. These fees aren't being looked at by independent directors. They really are out of that domain. They can be, in fact, more expensive than what clients will pay on a load basis. Typically, investment advisory fees charged start at about 1.5 percent. As we know, there's a cap on the internal 12b-1 expenses of 75 plus 25. So very often, we have investors really not looking at their fee in addition to what they're paying for the fund themselves. I think this is an area where a lot of investors, again in good markets, aren't looking closely at it, but long-term, it will really impact how their performance is and what they think they're paying for.

So, you know, in a sense what this leads me back to is that while we have created a lot of confusion with the alphabet soup, is it time to start looking at the prospect of negotiated commissions in the world of mutual funds? I know this is sacrosanct, but it's really happening outside the prospectus environment. It's happening in the world of investment advisory fees as we speak right now. They are negotiated. It's not done by class. It's not done by status. It's really done on a point of sale basis, what is right for that particular client. Do we need to look at pricing in the mutual fund industry as a whole to try and create some equality there? Because I think one of the issues that we're seeing right now is that no-load fund groups have a tremendous advantage over load funds, simply because they report performance on that no-load basis. What happens to the fee after that is not reflected in performance, and we all know that performance is not a predictor of the future, but it is what sells mutual funds. Therefore, I think it's clearly an interesting competitive issues when they are viewed against a fund that is all-inclusive, where the service and the investment management are tied into one, where boards are overseeing both sides, whereas in the no-load world, it is really not happening that way. I think this is one of the real challenges we face to make sure that investors are looking at all elements of what they're paying for financial services.

Ms. Richards: Thank you, Jessica. Phil?

Mr. Kirstein: Thank you. First, I would like to thank Chairman Levitt and Paul Roye and Lori Richards for asking me to participate in the panel this morning. As many of you know, Merrill Lynch was on the cutting edge of creating what is referred to today as multi- class shares. And I did furnish a statement which you can read at your leisure, if you're interested in it, which gives more of the history. I think it is important to note that when 12b-1 was adopted in 1980, the Commission and most of the fund observers at the time did not anticipate that plans would use the rule the way it has been used, really, since the adoption, and that is to pay for dealer compensation. Instead, the Commission envisioned that the rule would be used to pay for advertising and other periodic sales promotion activities, and it would be relatively small in nature, 25 basis points or less.

However, the industry soon developed other plans, and the first CDSC order was granted to E.F. Hutton in 1982. This was important, because what E.F. Hutton did was take Rule 12b-1, marry it with the contingent deferred sales charge, and figure out a way to pay the salesman up front and yet not have the money come out of the shareholder's initial investment. In essence, what this did was to allow the shareholder to make a decision, certainly in the load fund context, whether or not he wanted to pay up front or over time – pay me now or pay me later. The reaction of the industry and investors was swift, to the 12b-1 funds that were created in the mid-1980s, and the money came flowing into those funds.

Merrill Lynch, at that time, made a decision, two decisions, really. The first one was not to create clone 12b-1 funds by copying, taking their existing front-end load funds. The reason we did this was that we did not want to divert the cash flow into two vehicles. We also resisted converting the existing front-end load funds to 12b-1 and CDSC funds, because we did not think it was fair to our shareholders who had already paid the front-end load to now share in what would be the 12b-1 fee, although obviously funds that did do that charged the 12b-1 fee only on "new assets."

In 1988, after we received an exemptive order from the SEC, we became the first complex to offer our open-end funds with two pricing options. We left it up to the shareholder to decide which option was the most advantageous for him or her, given their own individual circumstances, such as the amount of money being invested and the likely length of investment. We thought this was important from a disclosure standpoint, because what we did was we had both pricing options within a single prospectus, and this allowed the shareholder or the investor to make an informed decision as to which option was most suitable.

Six years later, we started offering investors four pricing choices with different combinations of sales charges, 12b-1 fees, and other features. Much as Jessica indicated, we took a lot of heat both from the industry at the time, as well as internally, about, you know, we're going to have a whole page in the New York Times and the Wall Street Journal just with our various classes. In fact, Arthur Zeikel even said, "You know, this is going to be more than people can understand." And I threatened that, until we had A to Z classes, I wasn't going to be satisfied.

The Merrill Lynch fund directors have wrestled with Rule 12b-1 for more than 15 years, and they have had the benefit of legal memoranda from both outside and inside counsel, as well as the opinions of various judges who have considered 12b-1 plans in the context of litigation. For sure, they have received quarterly and annual reports as required by the rule, as well as reports pursuant to the NASD conduct rule, which shows how much can be charged and how much has been collected.

However, at the end of the day, the directors wishing to exercise their fiduciary obligations under both the '40 Act and state law are left to deal with the factors originally set forth in the 12b-1 releases which accompanied the proposal and the adoption. As might be expected, these factors are not particularly relevant to the way most 12b-1 plans are utilized today, i.e., to pay for dealer compensation. I think it's time for the Commission to amend Rule 12b-1 to permit directors to cease trying to put a square peg in a round hole. The rule can continue to play its traditional and important role of safeguarding assets, or safeguarding a fund against a wasting of fund assets on distribution-related activities.

However, for 12b-1 plans which are being used to pay dealer compensation, directors should be able to consider factors which are more relevant and which have received some focused guidance from the staff, which will be a better evaluation of 12b-1 plans. Some of the factors which we should consider going forward would be the nature and quality of the services rendered, the necessity of continued distribution – and I might add, as you all know, that if you have an open-end fund without distribution, you have a wasting asset – the possibility of reduced expenses as the fund grows larger, comparative 12b-1 fees of other funds, the success of a distribution effort under the current structure, the nature and completeness of shareholder disclosure of the pricing options available to investors, and finally, compliance with the NASD sales charge rule.

In addition, some of the procedural requirements should be revised to make the rule more workable. For example, the quarterly reports in this context probably could be eliminated without anybody being harmed in any way. These are only suggestions, and I'm sure other people may have other thoughts which should be considered. That concludes my statement. I'll look forward to discussing these issues. Thank you.

Ms. Richards: Thank you, Phil. Faith?

Ms. Colish: I guess it's now good afternoon, everybody. I'm very happy to be here and honored to be in such distinguished company. As Lori mentioned, I'm technically a disinterested director, but let's say an outside director of Neuberger and Berman Funds. I'd like to just start out by telling you a little bit about how those funds are set up. I don't think they're unique, but I think their structure is relevant to the whole distribution issue. Actually, we started out with a series of free- standing funds with different investment objectives, some of them dating back to the early 1950s. In, I believe it was 1993, all of those funds were reorganized into three, what I call clumps. We have the equity funds, the fixed income funds, and a third clump on which I'm also a director, which is the so-called Advisers Management Trust, or AMT funds, which are specifically for distribution through variable annuities and variable life, and where their shareholders, for the most part, are insurance companies who use them as funding vehicles. I'm a director, or trustee technically, of the equity group which includes, at this point, I believe it's a total of eight portfolios. There are value funds. There are growth funds. There are small cap, large cap, one international fund, one socially responsive fund. And all of these portfolios are part of the hub, or feeder of this fund structure.

At the time this structure was set up, it was the judgment of Neuberger and Berman management, and the board was persuaded that it was a reasonable judgment, that by going to a master feeder structure, sometimes known as a hub and spoke, we would have the flexibility to have different marketing styles similar to what you would get with a multiple class structure, but with the additional possibility of having a private label fund. If, say a bank, or some other financial service provider wanted to have its own name on a fund that would be managed by Neuberger and Berman, a separate spoke or feeder could provide a vehicle for that, which was probably the only distinction, really, in terms of the choice between those two formats. At this point, we have three feeders. The first feeder is made up of what were the original retail funds. And, by the way, those funds are all no-load and they have no 12b-1 fees. This is true both for the equity group and the fixed income group, on which I'm not a director, but which I believe has about seven or eight different kinds of fixed income portfolios, all the way from money market funds to longer-term high-yield bond funds. Subsequently, a second – and that, just for our reference, is known as "the funds." We have the portfolio, which is the hub. Then we have the funds, which is the group of what used to be the original separate retail funds. Then, about two or three years later, a second feeder was created, which contains most but not all of the portfolios, and is sold only on an institutional basis, typically, to 401(k) plans, through investment advisers, through broker dealers.

It also is no-load. It does not have a 12b-1 plan, but it does envision that the adviser, the distributor – I'm not sure exactly which, but they're under common ownership, so it's the same ball of wax. I should say both the fund and the adviser will make payments to the real distributors, who are these plan sponsors, consultants, and other people who are the link or the connection between the fund and the ultimate investors. And that, as I think I mentioned, is called "the trusts." We now have a third spoke, which is called "assets," and which does have a 12b-1 plan, and that also is only for distribution on what we would consider an institutional basis, primarily through broker-dealers. There have been discussions which are much too premature for any announcement on my part. But other modes of distribution are, I'm sure, constantly under review, and the initiative for these developments, I would say, always comes from management. I can't think of an instance when someone on the board said, "Hey, how would you like to do a load fund?" But that subject might come up in, as I way, with the initiative for management, who have some extremely experienced and highly capable people. I don't know how many of you in the room know Stan Etchner, but I think he is a recognized genius and leader in this area, and with an excellent staff of marketing people who are constantly exploring how to promote this aspect of the business.

When the board is asked to consider a plan, we obviously look at cost, we look at fairness, we look at disclosure, and we can talk about all those issues in greater detail, but I assure you that we don't just rubber stamp anything. On the other hand, we don't feel that we are necessarily the technicians, the experts in the area. I started my professional career, as was mentioned, I'm a securities lawyer, and I started out at the SEC in 1960, in the General Counsel's Office. I see some colleagues in the room who remember those days. I worked for a lawyer, a wonderful man named Dave Ferber. My job was to read a lot of cases and gather a lot of material, and sort of digest it a little bit for Dave, who would then write a brief or do the real – how should I say – the final work. Some of you also may remember Parliament cigarettes had a slogan that said they were the thinking man's filter. And I decided that was my job description. I was the thinking man's filter.


Ms. Colish: I still am, I believe. At least that's what I try to be. And I think, to some extent, that's what I do as a fund director. I mean, I'm not necessarily the decision maker. I don't feel I'm qualified or expected to be the decision maker. But I am supposed to ask questions. I am supposed to be part of the filtration process, through which a collective, collegial decision is made, with all of the best that my mind and the minds of my fellow directors brought to bear on it, so that without necessarily it being an adversary relationship – which we certainly hope it doesn't become, it shouldn't be – that the subject is looked at from every possible angle, and there are situations in which questions come up about, you know, "How will this work," or "What does this really mean," or "We don't understand it, please explain it to us," that do result in responses saying, "We'll get back to you." And we get a lot of data, both in the planning stage and, you know, reflecting the administration of these various programs that we do our best, as serious-minded and I hope intelligent people, to evaluate and to be a good sounding board for the people who really run the fund.
Ms. Richards: Faith?

Ms. Colish: I'm running out of time?

Ms. Richards: Yeah.

Ms. Colish: I just want to take 30 seconds to say that I have some very real concerns about Rule 12b-1. I think it's a very useful tool, but I'm very concerned about some staff comments recently, which I think create an enormous problem for fund directors in terms of how to administer a 12b-1 plan and also whether everybody now has to have one, as opposed to what it originally was, is something to solve a problem. I think the problem has now been created, to some extent, by the SEC or the staff, to which everybody may have to respond by having the 12b-1 plan.

Ms. Richards: Thank you. Well, I've heard from three of our panelists some criticism of Rule 12b-1, and in particular of the factors that the Commission set forth in 1980 as suggestions for matters that fund boards should consider in adopting 12b-1 plans. I would like to expose this a little bit more to some of the other panelists. In particular, what factors should fund boards consider in reviewing and approving a 12b- 1 plan? Should directors consider the business realities existent today, the competitive environment in which funds are offered, the need, as Phil said, to continue to compensate broker dealers to maintain fund shareholders, the existence of contingent deferred sales loads, and the long- term commitments inherent in contingent deferred sales loads? How would you suggest – and I heard from three of you that you would suggest – that the factors be updated?

Ms. Bibliowicz: I would just say that – this time I'm going to get it right – that when the 12b-1 rules were first designated in 1980, they were clearly for an advertising campaign or some finite activity. I think common usage for 12b-1s today is that they do finance commissions to brokers and then that financing gets paid back through the 12b-1 process, and/or the CDSC, at the end, if the client should choose to leave the fund. When you go through the regs and you go through the balancing as an independent director, it really never comes up that way, and I think that we've got to look at how these things are written so that they, in fact, reflect what is really happening in the industry and what the 12b-1 is truly being used for. It doesn't look that way, and it's very difficult for a fund, an independent board director, to really go through it and try and match the two up. I think it's easy for them to – not easy, but it's important for them to look at, you know, is this fair; are the charges right; is this a profitable thing, or is it really being used for expenses? They can look pretty closely at that, and look at a lot of data that's being given to them. But it's not really how the regulations were written in the first place, and I think that's something that we should all look to change. It just doesn't make any sense.

Mr. Haaga: In fairness to the Commission, and the people who wrote the original – the original factors say, you know, "These are factors to be considered only to the extent they're relevant." So they are not written in stone. The problem is that outside counsel just doesn't feel comfortable, unless they walk everybody through the factors, so I'm constantly – it's been 12 years now since we adopted our 12b-1 plan, and I keep having to tell people what the problem was every year, when we renew it. I guess I would suggest I don't think we need factors. I think directors need an underlying finding, i.e., the benefit to shareholders. They'll find the factors. The questions that you just cited, Lori, are good ones, and directors will find more. I would give them a standard for approval, but don't tell them what questions to ask.

Mr. Schwab: Lori, I would make a comment about 12b-1. I think the investor really votes with their feet. My personal perspective at Schwab, most people tend to go away from 12b-1 funds, if it's fully disclosed, easy to see, they choose the lower-cost funds. OERs are very important. It is now well disclosed in Morningstar and now we have Moody's and Standard and Poor is coming to the fore, in terms of more analysis in its disclosure. We have Value Line. And informed investors make those choices, and I think you need to keep, the SEC needs to keep – make sure that this is on the front page or the second page. And full disclosure, I think, is really the thrust we should maintain.

Ms. Richards: Turning now to fund supermarkets, Chuck, you mentioned some of the benefits to fund supermarkets. They provide investors with choice. I guess I'm wondering about some of the criticism of fund supermarkets. It's been said that fund supermarkets put an upward pressure on fees, and that they may impair the relationship between a fund and its shareholders. How valid are those claims?

Mr. Schwab: Well, we submitted an analysis of 500 funds that we cleared in our mutual fund marketplace in 1994 and between the following five years and we saw a decline in OERs. We have a paper on that if anyone is interested in that particular paper. As to the other aspect of supermarkets, in some sense the mutual fund industry is a little bit parochial or very parochial. We have a whole new world that is evolving right now. Informed investors want choices. They want information. They want comparatives. They want all these things. They want transparency. They want low cost. That's what the future is all about. The old mutual fund companies in some respects, all due respect to them, they've been in business for 50 or 100 years – maybe not 100 years, maybe 75 years, is about being somewhat parochial, about trying to maintain a family. They think that's a good thing. That's wonderful. They should be able to maintain that, but the new investor is all about these new things I mentioned.

Ms. Richards: And what about the claims that investors who buy shares directly from a fund are in some way subsidizing the expenses that are incurred for services provided to the investors that buy through a supermarket?

Mr. Schwab: Well, we have found that it's just the opposite actually. That our transaction fee based funds actually end up being the ones that sort of subsidize the great value of the NTF funds. But we could debate that. We'll show you our numbers.

Ms. Richards: Chairman Levitt?

Chairman Levitt: Chuck, the fund expenses, the supermarket expenses has gone from 25 to 30 to 35 I understand. As you look to the role of the independent director, if you represent a major part of that fund, maybe more in some instances than 50 percent of the fund, is that director really in a position to question whatever the fee may be?

Mr. Schwab: Well, obviously, they do have a basis for questioning any and all fees. And we, as a firm, are dependent upon the competitive structures out there. We want to put forth the most competitive funds possible. Our investors are very smart. If they see an excess amount of fees being charged by us or by the fund, it's a quick decision: They move to the lower fee funds, and we see that on a continuing basis. So, as to what are they getting for, now, our new funds coming on board would pay 35 basis points. They get incredible value, a little fund group that might come on board now has the ability of accessing us through any of 295 branches. They can access their account and information about that fund 24-hours-7-days-a-week. They can also then go on the Internet. A little mutual fund management company has no capability of offering any of these things. We spend hundreds of millions of dollars a year in providing the infrastructure for all these things. And for 35 basis points on a $10,000 transaction, $35 a year is an unbelievable value when you compare it to any other choices.

Chairman Levitt: I don't question that and I think the standard of ethics manifested by your operation is as fine as any that the industry has ever seen; but I want to highlight some of the possible ambivalence an independent director may feel in terms of making judgments which can conflict with business practice You have a very commanding position, and it would be more difficult for an independent director to exercise that judgment than in a situation where your involvement was less considerable.

Ms. Colish: May I comment on that? As you mentioned Neuberger Berman – which, by the way, it spent a huge amount of money to pay PR people to drop the "and" from the name, so it's Neuberger Berman – was one of the first or earliest to become a part of your program. And we've been, for the most part, extremely happy with it. I think to the extent that we have had a concern is that it's been so successful and you have sometimes become the 800 pound gorilla to us, although so far a very benign one.

But I think our response has been to not put all our eggs in one basket. Neuberger Berman represents approximately altogether say between 50 and 60 billion in assets which is not tiny. It's more than I have on my person, but it's not a giant. It's not a Fidelity. It's not a Vanguard. And I think although they do spend a lot of money and a lot of effort on shareholder service and telephone communications and they have their own web site, it really is very hard to compete with giants like a Fidelity, who are not only big, but they are obviously very well run and they spend zillions of dollars on technology. And it would be absolutely prohibitive, I think, for a fund organization even of the healthy size of a Neuberger to try and replicate that. And, so, what you offer, I think is a real plus to us.

We do look at the cost and we do look at, for example, the fact that you have an omnibus account and we pay one transfer agency fee or transfer agency fee for one shareholder for all of your accounts and the saving we have in transfer agency fees is considerable. And that, to some extent, is our justification to a large extent for what the fund is willing to pay or to authorize or be comfortable with the manager paying as a trade-off. Plus the fact that we are, as I'm sure you know, not how should I say, "We're not dating you exclusively." We do have other marketing arrangements. There are other supermarkets, there are other organizations. You certainly have the premiere and when the name – when supermarkets come up, everybody thinks of Charles Schwab, but there are other names and there are other competitors of yours whom we look to as actual or potential outlets and so there is competition on that level as well. And I think all of these things are very much, to the extent of our ability to absorb and organize this information is something that our board spends a lot of time on.

Mr. Schwab: I would just mention that we probably take the more active investors of your group. We have a high service content. They have access to us by telephone all the time. Your more passive investors might buy your fund, sit it there for 10-15-20 years and never hear from them. We hear from our people every day.

Ms. Richards: Paul?

Mr. Haaga: I don't want to distract us from talking about the problems with supermarkets, but I did want to pick on something Chuck said. Investors are not moving away from 12b-1 funds and they shouldn't move away from 12b-1 funds. What he said just sort of brings up the whole issue and why we have these fictions going on. The same funds are paying the same fees to his supermarket for the same services. Some of them are adopting 12b-1 plan, some of them are not. The ones that are not are getting the money some place. It isn't family money that the sponsors have. It's coming from the funds.

And the idea that investors ought to prefer the funds that don't tell you what they're spending on distribution over the ones that do is nonsense. You know, if you're spending money on distribution, say it. If you're not spending money on distribution don't say it; but don't pretend that there are no expenses there for a fund that doesn't have a 12b-1 plan. Look at the total picture. I think the press, as I said in my outline, the press has come around to realizing that just pointing the finger at 12b-1 funds is not productive and you got to look at the big picture. How about the rest of us coming around, too?

Ms. Bibliowicz: I would just add one thing to take a little bit of the pressure off of Chuck. I think that, you know, it is not just the supermarkets that are very distribution focused, there are a lot of companies right now that distribute other funds and in all cases you see a lot of pressure on the fund companies to really sort of pay for the big bricks and mortar of that distribution. I think as an industry, we will all be forced to look very closely at that and make sure that consumers really understand.

But I want to go back to the original point which is no-load is not necessarily no-load and no-cost. I think that while some people are terrific at picking funds on their own and playing on the Internet and doing their thing, we still see a preponderance of investors who really do seek advice, whether it's in the load world or whether it's in the fee world. And, you know, again, a lot of these funds, while they show performance on a no-load basis which makes them look terrific, what about those funds that are then wrapped in investment advisory fee and what is the ultimate client actually doing in their own portfolio? And there doesn't seem to be a lot of focus on that because, again, very often, they are more expensive through that network. I am sure that, you know, the services provided might make it worth it, but the clients aren't seeing it and they're not seeing it bundled. And I think we've got a responsibility to try and look at that even though it's outside of our world. What are independent directors supposed to say about that?

Ms. Richards: Phil?

Mr. Kirstein: I would just like to add to those comments in the sense that I think what we have here is different levels of service. And the fund supermarkets or the traditional no-load funds have provided a certain level of service. They've provided the record keeping and they provided statement reporting, etceteras. But the people who have traditionally bought the loads and there may be some shift in people going on the Internet and there's probably going to be kind of a muddy middle ground that will develop over time. But there are still a lot of people that want to have some financial assistance from a consultant with that decision to, which fund to buy, how to allocate their assets, what percent should be in municipal bonds, how much should be in taxable, equity, how much in and outside the US, etceteras. And those are services that people have traditionally and are still obviously, as Paul said, willing to pay for. And, so, it's just a question of what type of service you want and there's no question that the supermarkets or the no-load groups are providing one level of service and if you want a higher level of service, you're going to pay a little bit more for it.

Mr. Schwab: I would just say Schwab is not against load funds, per se. We are actually in favor of independent investment advisory services. Jessica and I were talking about that earlier. Her funds use our investment advisory services where they can buy many load funds on a net asset value basis sold primarily to independent investment advisers or through that network. And we just take the loads off and the independent advisers charge an annual fee for customization of the management of those accounts.

Ms. Richards: Chairman Levitt?

Chairman Levitt: Phil, I'd like to ask you about Merrill's setup charge for marketing a new fund. What do you charge management to distribute that fund? And I also understand you have a preferred list of funds. How does one get on that list?

Mr. Kirstein: I don't mean to beg off the question, but I think most of the questions that you're asking pertain more to the broker-dealer operation than to the asset management operation, Pierce Fenner & Smith. I'm not totally familiar with what you referred to as, quote, "setup charge," or the criteria for being on the preferred list, but I'll be happy to get back with it.

Ms. Richards: Well, this raises I think a broader issue. A number of brokerage firms require funds to pay for shelf space in their distribution operations or for so-called setup fees for new funds. How do fund boards or do they – do fund boards monitor and watch those expenses?

Ms. Colish: So far, it hasn't come up in my experience as a fund director, so I really can't comment. I would assume they would, but I haven't had to do it.

Ms. Bibliowicz: I would just add that board members are typically aware of them. However, I think when it comes to looking out for the actual shareholder, that taking that into account is not something you can do if you're deciding whether or not breakpoints should be established or total fund expenses, while you're sensitive, I think really the issue is if the fund company thinks that that's an appropriate business expense, you know, they've got to deal with it. But I think the potential conflicts of the independent director would be to stay out of that and make the decisions that keep the funds competitive and reasonably priced to the ultimate shareholder. So I think typically we know about it, but you really want to make the decision in favor of the shareholder, not for the expenses that are being paid to a distributor or to some other format.

Mr. Haaga: I would agree with what Jessica said. The directors generally know about it and it is – "it" envelopes a lot of things. People call it revenue sharing. You can also call it cost sharing. A lot of the payments are made for actual account maintenance and they're made on a per-account-basis. They're doing the same kinds of things that the – the brokers are doing the same kinds of things the supermarkets are doing. You know, the origin of this – I don't mean to defend the distribution system too much, but the origin of this was the dealers coming to the fund firms and saying we're incurring greater expenses in distribution. We want to have some – we want you to share in paying those expenses; but, by the way, don't pass them on to the shareholders. So I think that's a good thing, not a bad thing.

Ms. Richards: Should directors consider those kind of inducements in reviewing and approving the fund's 12b-1 plan?

Ms. Colish: If I may, I'd like to respond to that a little bit obliquely because it relates to the issue that I sort of stuck in at the end of my original statement. When 12b-1 was adopted, it was contemplated as something needed to solve a specific problem and to be used primarily for distribution or – I forget exactly the word that was used, but that was the gist of it. Among the things that have developed, there have been a number of changes in the business environment and regulatory gloss over the years. But we are now at a point where I wouldn't say everybody has a 12b-1 plan, but it is a very, very common phenomenon and you're frequently at a competitive disadvantage if you don't have one. It's not a special problem that you need to solve, you just need to run a little faster to keep up. So I think that's one aspect of the rule that really is out of sync with reality.

The other, and this is a more recent development. This concept that 12b-1 money is used for activities that are primarily distribution related. As you know, Doug Scheidt published, or a letter was published over his signature, in October in which he seems to – not "seems to." I think it's pretty clear he's saying that if any distribution events happen, let alone are contemplated, there must be a 12b-1 plan, whether it comes out of the fund's pocket or, for that matter, arguably out of the adviser's pocket. Frankly, as a fund director and with some very excellent outside counsel, we are troubled by how to deal with that. If, for example, we can justify every penny of the money that's being paid to a third party, a Schwab, for example, on the basis that it saves us shareholder servicing costs, accounting costs, transfer agency costs, but it in fact results in sales, do we have to somehow carve out a portion of that fee and say, "Well, this really needs a 12b-1 plan." As I indicated, two of our three spokes don't have 12b-1 plans. Do we have to now adopt one, which by the way, as I'm sure you all know, since it's an existing fund would require a shareholder vote, to just stay even. I think that that letter at least suggests that someone's changing the rules on us in the middle of the game and we really are perplexed as to what to do with it.

Ms. Richards: Paul has suggested that the amount of time spent by directors parsing out the different parts of the fees and, in particular, Faith, you mentioned parsing out the different components of a fund's supermarket fee, that that process just doesn't make sense. And that instead of labeling fees, the director's inquiry should be focused on whether the service is appropriate. And Paul has suggested a new paradigm. I would like to, Paul, ask you if you could expand on that and explain to us how you think this new paradigm should work.

Mr. Haaga: Well, I didn't really carry it all the way through to what we ought to do next; but just on Faith's – I will get to that. On Faith's comment, you know, the consequences of having as 12b-1 plan are that you get some good governance principles. You get majority independent directors, you get a particular review and focus on those expenses, that's the main consequence. The other consequence is you get kicked out of the 100 percent no-load mutual fund association. We're talking about 12b-1 as though it were a terrible thing to have. It's a disclosure and identification of how money is spent and good governance. And, so, I guess in answer to Lori's statement, I would suggest that some of the things that 12b-1 requires of directors could maybe go beyond distribution expenses. They aren't the only important expenses, they aren't the only expenses that require careful review. They're not the only ones over which there are potential conflicts.

Ms. Colish: I support what you said in terms of the governance issues. I remember when the rule was being considered, one of the commentators referred to this nominating committee of independent directors as the principle of immaculate selection, and I think it's a very good idea. I happen to be a member of boards that have a substantial majority of outside trustees and we have only outside trustees on the nominating committee and I think all of those are very wholesome and we are very comfortable with them. But I think the suggestion you're making about this category, treatment of categories and we get into the issue of what an adviser can spend his legitimate profits on, for that matter what a supermarket could spend its legitimate profits on, that really takes you into rate making which I am hearing the SEC does not want to do.

Ms. Richards: I'd like to touch quickly on something that a couple of the panelists raised in their opening statements. And that's the potential for investor confusion that's created by multiple classes and multiple fee structures. Do you think that directors have a role in alleviating investor confusion that's caused by multi-class, multi-fee structures? Phil?

Mr. Kirstein: Well, I think they have a role insofar as there's disclosure in the prospectus, the registration statement and they're responsible for it. And I think it's important that you spell out as clearly as possible in the prospectus what the various choices available to the public are. And I think to a large extent that's been well done through the fee tables. Somebody on the earlier panel pointed out it isn't just a theoretical thing, that it's 10 basis points or 50 basis points or 150 basis points, but there is an example in there, you know. Whether or not the fee table could possibly be improved, I guess we can consider doing something along those lines the same way as we could improve it in terms of investment performance with more variation. I do think there is pretty good disclosure in the prospectus now, especially in the fee table. And I think at the end of the day, the bottom line is really the investment performance. Obviously, in a money market fund, fixed income funds, the expense ratios are extremely important. And they're important in an equity fund. But for people to make an investment decision that I'm going to buy Fund X because the expense ratio is 91 as opposed to 92 and they lose sight of what the investment experience and what the portfolio manager has achieved or is likely to achieve going forward really misses the point. I can remember a news article or one of the magazines that was doing a survey on money market funds. And they picked out one of our government institutional funds which had – and they recommended it. And they said you should go in – you know, this was one of the three funds with – and it was totally done on the basis of expense ratio. They never looked at the return. And the return on that fund happened to be lower than some other government funds that we offered because of the fact that the board, because it was an institutional fund and it was very hot money, had put a very restrictive investment parameter on what the average weighted life of the fund could be. And that, I just think that's very typical. You can't lose sight, and we shouldn't lose sight and I think the director shouldn't lose sight, that the end game is not trying to get the lowest possible expense ratio over everything else.

Ms. Richards: I'd like to ask one final question as we're running out of time. If you were to make one recommendation to the Commission today, one recommendation to the Commission concerning fund distribution, what would that be? Start with Paul.

Mr. Haaga: Get better coffee. No. I guess consistent with what I've been saying all along, I do say keep your eye on the ball and don't get distracted by 12b-1, non-12b-1. Don't get distracted by some of the historical concerns. Let's look at the industry now. Let's look at the industry where it's going and let's look at what's best for shareholders and not be kind of bound in by the old, old terms, the old definitions and the old rules.

Ms. Richards: Chuck?

Mr. Schwab: I'd just say keep the eye on the ball in terms of clear, crisp, simplistic disclosure of all these various expenses and performance, for that matter. What I find in my own experience is the more complicated the alphabet gets, the less sophisticated are the investors. And where I find more sophisticated investors, when they've got the information or they have the advice from an independent adviser, that they tend to buy the ones that have great performance with lowest fees.

Ms. Richards: Jessica?

MS. Bibliowicz: I would just say, you know, reputation is probably one of the most critical selling points. And I think that the industry and the SEC working closely together to continue to achieve that is just absolutely critical. I think it's been a great association between the two. But I would add that with the alphabet soup that's been created and some of the confusion, is it because pricing is really so driven by a prospectus matter and should we at some point, again, open up the issue as to whether or not negotiated commissions are the best thing for shareholders or put it to rest. I think looking at it in today's world of multiple pricing as well as fee-based pricing, I think the discussion would be very interesting and very lively.

Mr. Kirstein: I would go back to my opening statement. It isn't a perfect world. If it was a perfect world, I think I'd be more inclined to agree with Paul that we could eliminate this whole idea of factors and 12b-1 and get to the bottom line. But we don't live in a perfect world. There are plaintiffs out there. There are lawyers. There will be depositions and directors will be asked, "Did you consider the nine factors that were promulgated in 1980, or 1978?" And, therefore, I think it is worthwhile for the SEC to go back and to put out some additional guidance today that will be more relevant to the way the 12b-1 plans are being utilized.

Ms. Richards: Faith?

Ms. Colish: As a clean-up batter, I have a chance to say I agree with everything that's been said. But as a securities lawyer sitting on a board, I find that this subject is extremely complicated. I think that my fellow directors who are not securities lawyers are heroic for grappling with them. I am not saying that we have a system that is broken and has to be discarded, but I would like to suggest that in looking at this subject, you try to go back to first principles. What are we trying to accomplish here? And maybe just put aside for a moment all of the technicalities and the gloss and the litigation and the nine points that you have to check off and start from first principles and say, "What is the goal here?" And "Is there a shorter line between the two points?" Or "Do we really need such a Goldberg structure to protect the public?"

Ms. Richards: Thank you. On behalf of Chairman Levitt and the entire Commission, I'd like to thank our panelists. There were a number of questions from the audience that we didn't get a chance to touch on. So I would encourage those members of the audience that have questions to approach the panelists directly. Thank you.


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