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One of the guests on the Nov. 7, 2003 broadcast of Wall $treet Week with FORTUNE was Mercer E. Bullard, president and founder of Fund Democracy, a nonprofit advocacy group for mutual fund shareholders. Bullard, also an assistant professor of law at the University of Mississippi, testified last week for the Senate Committee on Governmental Affairs' Subcommittee on Financial Management, the Budget and International Security, which held a hearing on trading abuses in the mutual fund industry. What follows are excerpts of Bullard's 32-page written testimony.

Last June, I introduced my testimony before a House subcommittee with the following statements:

More than 95 million Americans are shareholders of mutual funds, making mutual funds America's investment vehicle of choice. These shareholders have made the right decision. For the overwhelming majority of Americans, mutual funds offer the best available investment alternative.

More than 95 million Americans still own mutual funds today, but they are no longer certain that they made the right decision, or that mutual funds offer the best available investment alternative.

Recent allegations of fraud have fundamentally altered Americans' perception of mutual funds. These allegations do not involve isolated instances of individual wrongdoing by low-level employees -- the proverbially "few bad apples." These allegations appear to involve the majority of mutual fund complexes, and wrongdoing by a large number of employees, including, in some cases, the executives at the highest levels of management.

The usual ways in which we respond to such crises do not apply here. When frauds occur that could not reasonably have been anticipated, perhaps because of some previously unidentified legal loopholes, we can close the loopholes and forgive the stewards of the industry. Structural reform generally is not needed.

The alleged frauds in this case, however, were open and notorious and violated express legal requirements. Fund stewards were on notice and failed to take action. There are no significant legal loopholes to close or grounds to excuse a fundamental failure of compliance. These systemic frauds have exposed a compliance system that is not working and is in dire need of structural reform.

Mutual Fund Reform

In this section, I propose certain measures that are needed to strengthen the independence and authority of fund directors. Strengthening measures, however, are not sufficient. These frauds reflect a systemic compliance failure in the sense that the current structure of fund oversight is not resulting in fund shareholders receiving the most fundamental and obvious forms of protection from actual and potential abuses that have been known to regulators and the fund industry for years. If shareholders are not being protected from the most obvious frauds, they cannot have any confidence that they are being protected from frauds that we have yet to or may never discover. I therefore strongly recommend that Congress create a Mutual Fund Oversight Board.

Finally, Congress should adopt long overdue reforms to ensure that fund fees and expenses are fully disclosed. These reforms, which already have been passed by the House Financial Services Committee, are critical to restoring investors' confidence and promoting competition in the mutual fund industry. Mutual funds have historically maintained a higher standard of ethics and professionalism than any other financial services provider. This high standard is attributable, in part, to the relative transparency of their fees and the strict regulatory regime under which they operate. The current scandal, however, has severely damaged their reputation, perhaps irreparably. Congress should take immediate steps to restore Americans' trust in this once proud industry.

A. Independent Fund Directors

As discussed above, recent frauds demonstrate systemic weaknesses in mutual fund compliance. These systemic weaknesses require immediate steps to strengthen the independence and authority of independent mutual fund directors, and the creation of a regulatory structure designed to ensure that fund boards of directors fulfill their responsibility to protect shareholders. As this subcommittee is aware, virtually all mutual funds are essentially a board of directors that oversees a nexus of contracts with different service providers. Recent frauds have implicated a variety of different legal requirements applicable to these service providers, but all of the frauds share a common element: the failure of mutual fund boards to satisfy fundamental standards of compliance oversight. I strongly recommend that Congress adopt the following requirements to restore Americans' confidence in mutual funds and ensure that the industry never again engages in frauds of the kind and scope that have recently been brought to light.

1. Independent Chairman

Congress should require that the chairman of a fund's board of directors be independent. As often noted by the Commission, a mutual fund is effectively dominated by its adviser, and this fact necessarily compromises the control normally exercised under state law by a board of directors. To compensate for this imbalance, it follows that additional requirements, beyond those provided under state law, are necessary for the board to effectively police the adviser's conflicts of interest and protect shareholders.

These additional requirements have become especially important in light of recently alleged frauds perpetrated, in part, by fund managers and, in one case, the chairman of the fund's board. It is self-evident that, where such frauds may be perpetrated by a service providers to a fund, an executive of that service provider cannot provide objective leadership to the fund's board. There is an inherent conflict between the board's duty to evaluate the adviser's conflicts of interest on the one hand, and the appointment of an employee of the adviser as the board's chairman on the other.

Requiring that the chairman be independent will remove this conflict and ensure that the fund's independent directors have complete control over the board. The Commission staff has suggested that an independent chairman is unnecessary because the independent directors already can "influence the agenda and the flow of information to the board." It is not enough, however, that the independent directors "influence" the information they receive; nor is the staff's position consistent with the principle underlying directors' affirmative statutory duty to "request and evaluate" the information necessary to evaluate the advisory contracts. Indeed, the staff's suggestion that fund boards designate a "lead independent director" acknowledges the need for independent directors to exercise authority beyond that afforded by their numerical superiority. Formally appointing an independent director as chairman would better fill that need. There can be no better demonstration of this fact than recent allegations that the chairman of the board of the Strong fund complex, who is also the chief executive officer of the fund manager, personally engaged in market timing the funds whose boards he commanded for the purposes of exploiting stale prices.

The Commission's position also contradicts current trends in corporate governance. Recent corporate scandals have caused leaders in corporate law and practices to reconsider common assumptions about corporate governance. In June 2002, for example, The Conference Board convened the Commission on Public Trust and Private Enterprise to "address the causes of declining public and investor trust in companies, their leaders and America's capital markets." In its report, the Commission on Public Trust specifically recommended that the position of board chairman not be held by a member of management.

If we are to learn anything from alleged frauds in the fund industry, it is that accepted standards of conduct for funds' boards of directors need to be reexamined. I recognize that requiring that a chairman be independent in law will not guarantee that he or she will be independent in fact, but it is beyond dispute that -- all things being equal -- a legally independent chairman is more likely to be truly independent than a person with ties to management.

2. Authority and Representation of Independent Directors

Congress also should take steps to ensure that independent directors have the authority and representation necessary to counter the domination of the fund's manager. As discussed immediately above, mutual funds have a uniquely conflicted structure that necessitates an especially strong and independent board. Congress should take five steps to improve the effectiveness and independence of independent fund directors.

The first two steps are related. First, Congress should increase the minimum percentage of independent directors on a fund board from 40 percent to 75 percent. Second, Congress should prohibit any fund from requiring that board action necessitate the approval of a non-independent board member. This second step is necessary to prevent the circumvention of the independent directors -- 75 percent control, for example, by adopting a provision that requires the approval of 80 percent of the board for any board action. These measures, in tandem, will ensure that independent fund boards have the authority to act when necessary to address conflicts of interest and detect and prevent fraud.

Third, Congress should ensure that fund directors actually "represent" fund shareholders in a meaningful way. Many current fund directors have never been approved by shareholders. Mutual funds normally do not have annual shareholders meetings, and fund directors typically are appointed for an indefinite term. Congress should prohibit any person from counting as an independent director unless that person has been approved by shareholders at least once every five years.

Fourth, Congress should require that independent directors be found annually by a majority of the other independent directors, after reasonable inquiry, not to have any material business or familial relationship with the fund or any significant service provider to the fund that is likely to impair the independence of the director.

Finally, Congress should require that independent directors form a committee of their peers that shall have responsibility for selecting and nominating independent directors. This committee should be required, at a minimum, to adopt qualification standards for the selection of nominees that are disclosed in the fund's registration statement.

3. Definition of Independent Director

Without an adequate definition of independence, no law can ensure that independent directors will be effective advocates for fund shareholders. In many respects, the current definition of independence permits persons with significant conflicts of interest to serve as independent directors. Congress should amend the standard for independent directors to disqualify the following persons:

• Any natural person who has served as an officer or director, or as an employee within the preceding ten years, of an investment adviser or principal underwriter to the fund, or of any entity in a control group with the adviser or underwriter; and
• Any natural person who has served as an officer or director, or as an employee within the preceding 10 years, of any entity that has within the five preceding years acted as a significant service provider to the fund, or of any entity in a control group with the service provider.

Furthermore, Congress should authorize the SEC to prohibit any class of persons from serving as independent directors who the SEC determines are unlikely to exercise an appropriate degree of independence.

4. Mutual Fund Oversight Board

Although the proposals discussed above will strengthen fund boards, they will not be adequate to ensure that the kinds of frauds discussed above do not reoccur. These frauds reflect a failure by independent fund directors that cannot be explained solely by a lack of independence or authority. These frauds reflect systemic compliance failures that require structural changes in the way that fund boards are regulated. Recent frauds demonstrate that the Commission staff has too many responsibilities and not enough resources to provide adequate oversight of fund boards. I strongly recommend that Congress create a Mutual Fund Oversight Board that would have examination and enforcement authority over mutual fund boards. The Board would be charged with identifying potential problems in the fund industry and ensuring that fund boards are actively addressing these problems before they spread. The Board would be financed from assessments on mutual fund assets to provide an adequate and reliable source of funding. Board members would be persons with specific expertise in the fund industry and would be appointed for five year terms by the Commission to ensure their independence. This model, which ideally combines the strengths of independent, expert oversight with the advantages of a reliable and adequate funding source, would do more to restore confidence in the fund industry and protect fund shareholders than any changes in the makeup, qualifications or authority of fund boards.

B. Fees and Expenses

Congress also should act promptly to eliminate two major gaps in mutual fund fee disclosure: portfolio transaction costs and compensation paid to brokers for selling fund shares. As discussed below, current SEC rules and positions provide investors with a misleading picture of the costs of fund ownership and the incentives of brokers from whom they buy fund shares. With America's investors experiencing a crisis in confidence in the mutual funds, fee disclosure reform is more important than ever.

1. Portfolio Transaction Costs

As stated by the Commission, "fund trading costs incurred in a typical year can be substantial." The Commission cites studies that estimate that brokerage commissions alone cost about 0.30 percent of equity funds' net assets. Other studies estimate that market spread, or the amount by which the price of a security is marked up or marked down, costs about 0.50 percent of equity funds' net assets, and that "opportunity costs may amount to 0.20 percent of value."

Another study found that the mean brokerage and market spread costs for a sample of equity funds was 0.75 percent of assets, or almost three-quarters of the mean expense ratio of 1.09 percent. The brokerage and spread costs constituted an even larger percentage of the total costs of funds with the highest trading costs, with mean brokerage and spread costs equaling 1.54 percent of assets and the mean expense ratio equaling only 1.24 percent. Thus, portfolio transaction costs can be the single largest fund expense, exceeding all other fund expenses combined. These costs are not, however, included in fee information provided in the prospectus. Transaction costs vary greatly among funds, and full disclosure of these expenses will help hold fund advisers accountable for their trading practices.

Fuller disclosure of portfolio transaction costs also will provide a collateral benefit in connection with funds' soft dollar practices. In short, transaction cost disclosure will subject fund expenditures on soft dollar services to market forces, and thereby provide a practical solution to the problem of regulating soft dollar practices. For some transaction costs, fashioning disclosure rules will be a relatively easy task. Fund brokerage commissions already are disclosed in the Statement of Additional Information as a dollar amount. Converting this dollar amount to a percentage of assets and including it with other expenses in the expense ratio in the fee table would be simple and inexpensive.

Providing disclosure regarding other types of transaction costs will be more difficult, but no less necessary. There are no standardized methods for calculating spread costs, market impact or opportunity costs. Nor are these concepts, unlike fund brokerage, generally understood by the investing public. Nonetheless, the Commission has been able to develop effective, standardized, quantitative disclosure tools in other contexts, such as funds' investment performance and expense ratios. There are a number of private companies that already provide fund advisers with quantitative assessments of their funds' transaction costs for self-evaluative and board review purposes. The SEC's inspection staff routinely considers these quantitative assessments when evaluating a fund adviser's obligation to obtain best execution of fund transactions. It should not be difficult, over time, to develop quantitative tools to measure fund transaction costs and disclosure formats that will provide this information in a way that helps investors understand these costs.

The Commission has objected to the disclosure of fund portfolio transaction costs on the grounds that the disclosure of brokerage commissions, while easily comparable and verifiable, would be incomplete, and the disclosure of other components of transaction costs, while completing the transaction cost picture, would not lack comparability.

This objection misunderstands the purpose of fee disclosure rules. The purpose of fee disclosure rules is to ensure that investors have the information they need to make informed investment decisions. Thus, the issue is not whether the disclosure is theoretically perfect or complete, but rather whether it provides information that facilitates better investment decisions. For example, Commission-mandated standardized investment performance is imperfect and incomplete in a number of ways. It is calculated net of fees, notwithstanding that this does not accurately portray a fund adviser's pure stock picking ability before expenses. It arbitrarily measures performance at 1-, 5-, and 10-year intervals, and not periods in between. It is based on only one of a number of different methods of calculating an internal rate of return. In advertisements, it is permitted to show the returns of a single class, even though the performance of other classes may have been different.

Similar observations could be made about imperfections in the fee table. Indeed, one drawback of the expense ratio is that it is incomplete, and including commissions would make it a more complete measure of the cost of fund investing. Both standardized performance and the fee table have provided an undisputed net benefit to shareholders, notwithstanding their theoretical inadequacies.

The fact that there is more than one way to calculate the different components of fund transaction costs is not a reason to deprive shareholders of useful information about these costs. The Commission has suggested enhanced disclosure of funds' turnover ratios as an alternative to disclosure of actual transaction costs. Using the turnover ratio as a proxy for transaction costs, itself an imperfect measure, would be an inferior and inadequate substitute for disclosure of actual transaction costs.

2. Brokers' Compensation

The purpose of prospectus disclosure is to inform investors about the cost of investing in a fund. In contrast, the purpose of disclosure made at the point-of-sale is to inform investors about the economic motives of the person (referred to herein as the "broker") recommending the fund. Rule 10b-10 under the Securities Exchange Act accordingly requires that brokers disclose, to purchasers of securities, "the source and amount of ... remuneration received or to be received by the broker in connection with the transaction." This disclosure is known as the "trade confirmation" or "confirm." The Commission has, ill-advisedly, taken the position that Rule 10b-10 does not apply to sales of mutual fund shares.

The prospectus does not disclose all of the compensation that may be paid to brokers for selling fund shares. Even the compensation that is disclosed has no necessary relationship to the amount paid to a broker in a particular transaction. For example, the prospectus for two different mutual funds may show that an investor will pay the same front-end load of $500 on a $10,000 investment, but the broker selling the funds may be paid more for selling one fund over another.54 The broker payout for both of these funds may be lower than for a fund with a 1.00 percent 12b-1 fee, for which brokers often receive a flat, upfront payment substantially in excess of the amount of 12b-1 fees that the shareholder will pay in the course of a single year. The broker also may receive payments directly from the fund adviser or compensation in the form of fund portfolio brokerage commissions.

If an investor buys shares of IBM or Dell, his broker must send a confirm that shows how much the broker was paid in connection with the transaction. In contrast, if an investor buys shares in a mutual fund, the confirm is not required to provide this information. For a number of years, the Commission has stated that it recognizes this problem and is studying possible solutions. It is time for Congress to overrule the SEC's position that Rule 10b-10 does not apply to sales of fund shares and require that all compensation received by brokers in connection with sales of fund shares be disclosed on fund confirmations, as well as any information necessary to direct investors' attention to incentives that a broker may have to prefer the sale of one fund over another. Further, in light of regulators' discovery that brokers routinely fail to credit investors with commission breakpoints, Congress should consider whether fund confirms should include a separate box that shows the breakpoint schedule and how it was applied to the purchase.

C. Portfolio Manager Compensation

Congress should require that the amount and structure of portfolio managers' compensation be disclosed ("portfolio manager" hereinafter includes the portfolio management team). In many cases, the frauds described above have involved the portfolio managers of the affected funds. No one stands in a stronger fiduciary relationship with a fund than the person responsible for the actual management of the fund's portfolio. Portfolio managers often have conflicts of interest, however, and these conflicts of interest may be specifically related to their compensation. The SEC staff has noted that whether a portfolio manager's compensation turns on short-term or long-term, or pre-tax or after-tax performance may indicate whether the manager's and the shareholder's interests are aligned. Whether a portfolio manager is compensated for services provided to other mutual funds or other fund or non-fund clients, or for providing other outside services generally, also is highly relevant to shareholders who wish to evaluate the manager's commitment to a fund and the presence of conflicts of interest that the manager may have as a result of outside duties.

Disclosure of portfolio managers' compensation will cause fund managers to minimize such conflicts and enable shareholders to judge for themselves whether portfolio managers' are aligned with their interests.

Requiring disclosure of portfolio manager compensation is not a novel concept. Indeed, for years publicly-held companies have been required to disclose the compensation of their highest paid executives. Many mutual fund managers have been exempt from this requirement because the managers' executives work for a separate entity from the fund that is not publicly held. Nonetheless, the policies favoring disclosure of executive compensation by operating companies apply equally to mutual funds.

Executive compensation rules need to be adapted, however, to reflect the particular structure of mutual funds. Mutual funds typically do not pay their executives, as these executives are employed and compensated by funds' managers. In addition, the manager's highest paid executives usually are not the personnel who have the greatest impact on the fund?s performance. Thus, the executive compensation most relevant to mutual fund shareholders is that compensation received by the fund's portfolio manager or portfolio management team.