Changing Attitudes

The Investment Company Institute (ICI), which is the lobbying group for the mutual fund
industry, has a long and well documented history of opposing soft dollars(1) generated in third
party brokerage arrangements. At the same time the Investment Company Institute and many
individual executives from the mutual fund industry, speaking on their own, have made
comments and statements suggesting that the regulation and enforcement approach for soft
dollars generated in bundled undisclosed institutional brokerage arrangements should not be
changed from the current (benign) approach.(2) (3) (4)

It may seem incongruous that an organization or individuals from an industry could, for very
long, sustain an argument that a procedure that is disclosed, documented and identifiable is
riskier to the welfare of institutional investors than a procedure which is not disclosed, lacks
transparency, and (from all claims) seems not to be auditable; but, so far, this position appears
to have been successful.

Recently, however, there have been a couple of indications that the ICI and the mutual fund
industry may be moving away from the idea that better disclosure of institutional clients’
commissions would be a bad thing. It seems the explosive growth of hedge funds and the ability
of hedge funds to use clients’ brokerage commissions to buy undisclosed services and favors
from full service broker dealers appears to have caused a change of philosophy at the ICI and in
the mutual fund industry.

For me, the first evidence of this potential change in philosophy came on what was supposed to
be the last day of the “Comment Period” on “Commission Guidance Regarding Client
Commission Practices Under Section 28(e) Of The Securities Exchange Act of 1934”.(5) On
September 7, 2006 two comment letters from highly placed individuals in ICI and in the mutual
fund industry requested that the SEC ‘level the competitive playing field’ by mandating
compliance with Section 28(e) for all types of advisors.(6) From these two letters it’s obvious that
the authors’ main concern is competitive encroachment, by hedge funds, into a process that,
until recently, mutual funds had dominated (i.e. quid pro quos in exchange for client
commissions / order flow). I’ve copied and pasted the relevant portions of these letters below.

(1) Excerpt from “Comment Letter” Dated September 7, 2006 from Elizabeth Krentzman,
General Counsel to the Investment Company Institute (now a partner at Deloitte Consulting,
Securities Regulation):

“Level Playing Field for All Investment Advisers

While the interpretive guidance helps ensure a strong regulatory framework for soft
dollar practices of investment advisers and accounts subject to Section 28(e), we continue to
believe that the Commission should prohibit the use of client commissions outside the safe
harbor by all investment advisers, regardless of the type of client account involved. As we noted
in our comment letter on the proposed interpretive guidance, advisers to investment companies
and advisers to pension funds under ERISA may be prohibited from using commissions outside
the safe harbor, whereas advisers to other types of accounts are free to do so (registered advisers
must provide appropriate disclosure in Form ADV).4 This regulatory disparity, especially when
combined with other forces exerting downward pressure on overall commissions, may create
strong incentives for broker-dealers to favor hedge fund and other advisers who have greater
freedom to use soft dollars to make payments outside of the Section 28(e) safe harbor.5

Changing Attitudes by Bill George 11/7/2007 Page 1 of 3

 We urge the Commission to adopt a rule under Section 206(4) of the Investment Advisers
Act that will prohibit an investment adviser from using client commissions to pay for any
products or services that fall outside the safe harbor. The Commission also should pursue the
recommendation of the NASD Mutual Fund Task Force that the SEC urge the Department of
Labor (with respect to non-ERISA retirement accounts) and the federal banking agencies to
require all discretionary investment advisers not subject to the SEC’s jurisdiction to comply with
the standards of the safe harbor. This approach will ensure that all advisers treat investors
equitably in connection with the adviser’s use of brokerage, and that broker-dealers do not have
an incentive to favor advisers who are permitted to use client commissions outside the safe
harbor.”

(2) Excerpt from “Comment Letter” Dated September 7, 2006 signed by several members of the
legal department at T. Rowe Price:

“Need to Level the Playing Field. The interpretive guidance has effectively clarified the
regulatory framework for soft dollar practices under Section 28(e). Unfortunately not all advisers
are subject to this Section 28(e). Accordingly, we urge the Commission to take steps to level the
playing field by prohibiting the use of client commissions outside the safe harbor by all
investment advisers, including hedge funds, regardless of the type of client account involved.
This change would ensure that all advisers treat investors equitably in connection with their use
of brokerage, and that broker-dealers do not have an incentive to favor advisers who are
permitted to use client commissions outside the safe harbor. Without such regulatory parity, all
advisory clients would not be afforded the same protections relating to their adviser’s use of
brokerage. Mutual funds and certain advisory accounts could also be subject to regulatory and
competitive disadvantages compared to other types of accounts.”

Of course these calls for “a level playing field” have been complicated by the current legal
interpretation that hedge funds are not subject securities regulators’ jurisdiction. But if anything
changes in that regard it would then seem necessary to force sufficient commission disclosure
and transparency to audit all advisors compliance with Section 28(e) and to test for the
appropriate use of institutional clients’ brokerage commissions. If hedge funds become
regulated entities, it will then be very interesting to see the suggestions for disclosure and
transparency coming from the ICI and the mutual fund industry.

Footnotes:
(1) Soft dollar brokerage is defined in the SEC Office of Compliance Inspections and Examinations “Inspection
Report” released on September 22, 1998: “I. Soft Dollars Defined: The Commission has defined soft dollar practices
as arrangements under which products or services other than execution of securities transactions are obtained by an
adviser from or through a broker-dealer in exchange for the direction by the adviser of client brokerage transactions
to the broker-dealer. An individual or firm must exercise "investment discretion" over an account, as defined in
Section 3(a)(35) of the Exchange Act, in order to use client commissions to obtain research under Section 28(e) of
the Exchange Act ("Section 28(e)").” See the Inspection Report Section II item A, Soft Dollars Defined:
http://www.sec.gov/news/studies/softdolr.htm

(2) Investment Company Institute - Request for Rulemaking Concerning Soft Dollars and Directed Brokerage filed
with the SEC on December 16, 2003: http://www.sec.gov/rules/petitions/petn4-492.htm

Changing Attitudes by Bill George 11/7/2007 Page 2 of 3

(3) January 27, 2004 testimony by President Paul Schott Stevens, On Behalf of the Investment Company Institute
before the U.S. Senate Subcommittee Financial Management, the Budget and International Security, Committee on
Governmental Affairs. Hearing titled, Oversight Hearing on Mutual Funds: Hidden Fees, Misgovernance, and other
Practices that Harm Mutual Fund Investors. See, Section V. a. Soft Dollar Arrangements Should Be Significantly
Restricted: http://www.ici.org/statements/tmny/04_sen_stevens_tmny.html#P86_28814

(4) March 31, 2004 Statement of ICI Chairman, Paul Haaga before the U.S. Senate Committee on Banking Housing
and Urban Affairs hearing titled, Review of Current Investigations of and Regulatory Actions Regarding Mutual
Fund Industry: Fund Costs and Distribution Practices. See,
http://www.ici.org/statements/tmny/04_sen_haaga_tmny.html#TopOfPage
It should also be interesting to note that at the same time Mr. Haaga gave this testimony he was also an Executive
Vice President and Managing Director at Capital Research and Management, The American Funds. And less than a
year after this testimony was given, this investment management and mutual fund complex was being investigated
by several regulatory agencies, and was settling prosecutions and paying fines and penalties for engaging in some of
the abuses outlined in Mr. Haaga’s testimony. See, New York Times article published February 17, 2005 titled,
NASD Says Fund Family Paid Improper Fees by Riva Atlas, see:
http://www.nytimes.com/2005/02/17/business/17fund.html?n=Top/Reference/Times%20Topics/Organizations/N/N.
A.S.D.&_r=1&adxnnl=1&oref=slogin&adxnnlx=1194447630-eRAKYE/u1BndQTHHK7+qSA
and,
NASD (now FINRA) February 16, 2005 News Release:
http://www.finra.org/PressRoom/NewsReleases/2005NewsReleases/p013358

(5) See, the U.S. Securities and Exchange Commission website at:
http://www.sec.gov/rules/interp/interparchive/interparch2006.shtml

(6) See Comment Letters on Commission Guidance dated September 7, 2006 from Elizabeth Krentzman, General
Counsel - Investment Company Institute, and from Darrell Braman, Associate Legal Counsel, et. al. T. Rowe Price
at: http://www.sec.gov/comments/s7-13-06/s71306.shtml

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