Senator MCINTYRE. Do you generally approve of the idea that a standard be developed and when the performance of a particular fund exceeds that standard that the advisers could be rewarded as opposed to where the standard is not met, that the advisers would have to take a lesser fee?

Mr. WALLICH. That would seem fair to me, but I think then one would have to really carry it to the point of suggesting that the adviser should bear a penalty if things turn out badly. That isn't very practical, because the adviser may not have the resources from which to meet that.

One would, therefore, have a one-way arrangement. It would probably be—well, let me put it this way, it would be less than ideal but

better than what exists.

Senator MCINTYRE. Commissioner Owens talked at some length to this committee about the efforts being made between the industry and the SEC to try to work some compromises, and it seemed to me that one of the points he made was that the industry doesn't like this standard of reasonableness, doesn't like the fact that one judge might have to apply the yardstick. In the process of putting this bill together, some concessions were made to Senator Bennett about presumptions, you know, in favor of the directors having all, majority, or two-thirds voting for the particular fee and the stockholders having all agreed through their proxies that they had no objection. Still, the industry does not care too much for this provision, and they don't like the SEČ standing in the background.

As they point out and perhaps rightfully, as long as the SEC has its hand in there, there are certain pressures that could be exerted. But nevertheless the industry doesn't seem to want to be regulated in this area. Oh, they want it on 22-d. Oh, they have got to have it there. But nevertheless in this advisory fee, they don't have any suggestions as to who should overlook them, oversee them. They seem to think they are private corporations.

Can you suggest any manner or means that could possibly bring about what we would like to see, and that is some of the advisory fees coming down more in line with the size of the fund as opposed to what it was in 1940. Any comment that you could give would be helpful to the committee on that problem.

Mr. WALLICH. I am trying to examine into whether fuller information would create more interest on the part of the public and more pressure for lower fees, more competition. If, for instance, it were possible to require the funds not just to publish quarterly statements but to make available, maybe on request, every single transaction they perform, including intraquarter purchases and sales and if in that way it became apparent that many of them did rather futile things, perhaps there would be a little more pressure to charge less. This would do away with one of the dangers inherent in the one-way competition proposal, that is, higher fees for those that are successful, which has the effect of inducing management or could have the effect of inducing management to take extreme risks.

If things go well they get the extra reward; if things go bad, they are not responsible for the consequences other than that the fund's shares don't sell well. It is possible that greater publicity would bring greater competition, but it certainly cannot be proved.

I would like to see greater publicity for many other reasons as well. Senator MCINTYRE. One of the interesting things about this whole matter is, as far as the consumer is concerned, is that even when you give the publicity-I believe in Mr. Augenblick's statement yesterday, that he posed the average fund of $5,300, and then by applying a rule of development of experience that he had, he said that the cost of this average $5,300 portfolio to the consumer was somewhere in the vicinity of $26 to $27. Actually, I think that his percentage was a little prejudiced his way. I think it was a little more like $30 or $35. You see, this doesn't startle anybody as far as the consumer is concerned. It certainly didn't at that level look as if it is an extraordinary charge.

Mr. WALLICH. Well, on $5,000 the dividends might be $150 and the charge of one-sixth of that would be of the order of $30. If a tax were imposed by the Federal Government of that magnitude on people's dividend earnings, I am sure there would be an uproar. But the funds can impose what amounts to a tax, except it is termed income tax deductible and nobody seems to mind. What is the reason? People expect very high rates of return. Somebody figures he is going to make 20 percent a year or maybe a hundred percent a year, why worry about onehalf of 1 percent? If they have a realistic appreciation of what is ahead for them on average, which is the normal gain that the economy can yield in terms of dividend plus a little inflation, unfortunately, plus some growth from retensions of profit reinvested, all of this adds up to something in the area of less than 10 percent, I think one-half of 1 percent begins to look more significant.

Senator MCINTYRE. In your experience, do you find in the last year that the advisory fees have declined, I don't want to say substantially, but have declined to a degree of approval insofar as the consumer is concerned?

Mr. WALLICH. I haven't studied this. I looked at data produced by the Commission. It rather surprised me because of the large number of funds they found were still charging one-half of 1 percent.

At a guess, pure guess, I would have had, it would have been fewer than they seem to show.

Senator MCINTYRE. Do you agree with Commissioner Owens when he says that when you have a fund of $100 million and in the period of 10 years it expands to a fund of $1 billion that it should not cost 10 times as much to operate and manage that fund?

Mr. WALLICH. I am sure that that is so. Perhaps one can break down the type of expenses. Safekeeping and physical management of the securities may be proportionate to the size of the portfolio. That depends on the size of the blocks in which the stocks are held. Then, there are the trading costs which are not included in the advisory or any other feature. They are just deducted from the assets of the fund, a loss to the stockholder.

Finally, there is the pure advisory fee which depends on the size of the research staff. According to my views of security analysis, most of the research work is not very helpful, it could be reduced, but even if it gets done, it certainly should not be proportionate to the size of the fund. There must be economies of scale in this research.

Senator MCINTYRE. So you generally agree with what the Commissioner said here last Tuesday?

Mr. WALLICH. Yes, sir.

Senator MCINTYRE. In your appearance and statement to this committee 2 years ago, you seemed at that time more certain of the beneficial results which would flow from repeal of section 22(d) than you are this morning. I think you suggest some further examination of this request. I would like to ask what sort of further study would you suggest on the effects of repeal of 22 (d), and how long do you think this study should be expected to take?

Mr. WALLICH. Senator, the nature of the study would probably have to do principally with marginal distributing firms. There are many small firms around the country that sell mutual funds. It is quite possible that we might find that many of these firms engage in a lot of other activities and the mutual funds are not very decisive to them, and that a shrinkage of business would not be that vital.

On the other hand we might find that this is not so. As to the time, I would think anything over 2 years is excessive for that kind of thing and it could well be done in less.

Senator MCINTYRE. Thank you very much, Dr. Wallich.

Senator PROXMIRE. Thank you, Dr. Wallich for very helpful testimony.

Our next witness is Prof. Ernest Folk, professor of law, University of Virginia. You have a very detailed paper here which we will make a part of the record. You might wish to highlight your statement. (The statement may be found at p. 160.)

STATEMENT OF PROF. ERNEST L. FOLK III, PROFESSOR OF LAW, UNIVERSITY OF VIRGINIA

Mr. FOLK. Would you like for me to spend about 8 or 10 minutes? Senator PROXMIRE. We would appreciate it.

Mr. FOLK. Mr. Chairman and members of the committee, I am honored at the opportunity to speak to the committee on this matter. I have been teaching law for some 10 years, presently at the University of Virginia Law School. I have specialized in corporation and securities regulations, and I was reporter for the new Delaware corporation law which was enacted back in 1967.

My concern in the whole matter is, I think, entirely unbiased and one that is directed to the public interest. I have not consulted with the SEC or any industry groups involved with any litigation nor have any connection with any such activities. I thought that I would address myself to several of the questions concerning what we might broadly call fiduciary duties and the management fee problem.

In my statement I have gone into some detail on the question of management fees. In my opinion, the proposed amendment, that is section 8, which would amend section 15 (d), is a very desirable provision. It is a very moderate provision to begin with.

I think its importance lies in the fact that it does provide the legal criterion, recognized by statute, which has been universally accepted in measuring compensation in the corporate field.

The major importance of this provision, though, I think lies in the fact that it overcomes the restrictive effect that has been built into a number of the cases as a result of State law decisions, most notably in Delaware, involving mutual fund litigation over the permissible level of management fees.

We have had some very restrictive decisions here primarily turning upon the burden and quantum of proof. It appears to me that the new proposal would go a good deal of the way, not as far as possible, but it would go a good deal of the way toward undoing some of these restrictive provisions.

In my statement I have gone into detail discussing the background of these decisions, but I don't think there is any point in my redoing that. However, there are two other points that do relate to this that I would like to stress at this juncture bearing upon the adequacy of State law as it is presently constituted to deal with the problem.

One of the developments that has occurred in recent years in corporate statutes is the addition of statutory provisions that explicitly and specifically validate various types of interested director transactions. It was adopted in Delaware, in New York, and in various other statutes. It virtually immunizes a transaction from judicial scrutiny as long as it has approval from a disinterested board of directors or ratification by the shareholders or judicial determination of fairness. Many of these statutes are worded quite liberally so that, for example in New York, it is only necessary that there be a disclosure of the fact of a director's interest, not the details and content of the transaction.

I suggest that this rather minimizes the disclosure that should be required and is probably a good deal less than what one would expect from the courts.

Secondly, I have also pointed out even in the case law in the States there have been several relatively recent decisions which are susceptible to a reading that the so-called business judgment rule will be applied in some areas which we thought of this as being matters of breach of duty. Several cases, despite the existence of conflicts of interest, have said that the transaction was essentially within the business judgment of the directors and, therefore, it will be allowed to stand.

My position, then, on this is that the State law background which has up to this point shaped the law governing the management fee is very restrictive in terms of promoting the interest which Congress, I am sure, is concerned about. In short, it seems to me the question. is one of taking Federal action within a Federal regulatory scheme to protect the shareholders and others who are concerned with investment companies.

The reasonableness standard of the bill has been criticized by some. I frankly think it is the only effective standard that we can get. It is as precise as we can be when we are dealing with a problem of this breadth and magnitude. The reasonableness standard is the standard which overall governs compensation under the State law.

The importance of the bill, it seems to me, is that it has built into the statute certain criteria, certain principles which pour some content into this abstract standard of reasonableness. I think, if I may say so, that the formulation, the listing of the components of a reasonableness standard in the 1967 version of the bill was more comprehensive and more descriptive of the problem as it arises in the mutual fund management fee context. Nonetheless, I think that the present bill, while I would prefer to see it expanded along the lines of describing the conduct of a reasonableness standard is a very important step.

I think it is quite important that the bill recognizes that the SEC has standing to raise the issue of reasonableness in the courts. It is, of course, a misconception to believe that either the courts or the SEC is really put into the posture of a fee setting agency. The SEC is not going to become a utility regulating agency in doing this. It is simply asking the courts to pass upon the reasonableness of the fee, and to the extent that it is unreasonable to cut it down.

There is I think another important reason why we need SEC intervention here, a very important one, and that is the fact that the shareholders of the fund normally are going to have to act through derivative suits, but the derivative suit, of course, in many States is very seriously hobbled with all sorts of restrictions, such as requiring a demand upon the shareholders and posting bond, matters of this types, which do make the action difficult. There are a great many other technical problems of the derivative action. True, at least in the first circuit, the requirement on the demand on shareholders was waived in Levitt against Johnson which is an excellent decision. But we cannot be certain that this will be universally followed.

The bill would require that the plaintiff wait 6 months before bringing an action, that is, 6 months after he has notified the SEC.

I am inclined to think that this is too long a period of time and that it might well be half, 90 days. Conceivably the statute of limitations might be tolled upon written notice to the SEC. On the burden of proof point, I think it is desirable that the bill limit the presumption of reasonableness to fees which have been approved by disinterested directors.

As I recall, the 1967 version had a general presumption of reasonableness, putting the burden upon the plaintiff to establish that it was unreasonable.

Personally I would prefer not putting the burden of proof upon the plaintiff at all, but putting it upon the fund itself. After all, this seems to me to be in accord with established concepts of fiduciary duty, if the person who benefits from a transaction of this character should have the burden of establishing its reasonableness.

Also, the fact is that the defendant, in this case the fund, has the most effective access to the information.

A point which is extremely important in the bill is the definition of the term "interested person," supplementing the existing definition of affiliated person. I think this is somewhat little noticed, but in my view this is one of the most important provisions in that it greatly expands the category of persons who will not be eligible to be counted in the approval of certain basic and important transactions.

The language, "Affiliated person," has been I think unduly restrictive, and I think we can cite any number of instances where it has had this particular effect.

One of the chief problems has lain in the fact that in order to establish that somebody is affiliated, at least in many instances, one has to establish that he is a controlled person, and yet there is a presumption that a natural person is not controlled. This has been a rock on which a number of the mutual fund cases have failed. I am thinking in particular of a case, Coran against Thorpe in the Delaware Supreme Court.