A LEVEL PLAYING FIELD

Two comment letters sent to the SEC on the last day of the formal comment period for the
recently approved Commission Guidance Regarding Client Commission Practices Under
Section 28(e) of The Securities Exchange Act of 1934 seem to indicate heightened concern
from the mutual fund industry about Section 28(e) compliance and the appropriate use of
institutional clients’ brokerage commissions.

The comment letters were sent by Ms. Elizabeth Krentzman, General Council of the Investment
Company Institute (ICI), and Mr. Henry Hopkins, General Council of T. Rowe Price Associates.
Both of these letters request that regulators enforce a "level playing field" for all investment
advisors relative to the application of Section 28(e) of The Securities Exchange Act of 1934, and
the legal requirements of the Employee Retirement Income Security Act (ERISA).(1)

In her letter Ms. Krentzman stated, "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."

And in his letter Mr. Hopkins wrote, "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."

This sudden concern from the mutual fund industry, about becoming non-competitive with
regard to the use of their clients' commissions to gain favors from the brokerage industry
actually seems to come from fear of the equal application of the SEC’s approved guidance to
bundled brokerage arrangements and third party brokerage arrangements, and from a concern
that the anticipated interpretive guidance on disclosure and transparency will complicate their
ability to continue to misuse clients’ commissions in bundled full service brokerage
arrangements.

Level Playing Field / William T. George 11/2/2007 Page 1 of 4

The mutual fund industry undoubtedly recognizes that best way to ensure a level playing field
for all advisors and clients is to mandate full disclosure of institutional brokerage commissions
paid by advisors, and at the same time mandate full disclosure of the services provided to
institutional advisors by brokerage firms (these disclosure requirements should be imposed on
both proprietary services and on services produced by independent service providers). But,
does the mutual fund industry really want a level playing field, or do they only want to sustain a
competitive advantage?

It should come as no surprise that, in the face of a mandate for disclosure and transparency, the
ICI, which is a powerful lobbying force for the mutual fund industry(2), wants to restrict how other
advisors might use client commissions to gain competitive advantage (over mutual funds) in
brokerage relationships. The record of the ICI's comment letters and its lobbying positions
demonstrate sustained campaigns against fully disclosed brokerage arrangements and
independent research providers.* At the same time, the ICI has actually advocated the
continuation of bundled undisclosed brokerage arrangements. And a brief survey of the public
record seems to demonstrate a cavalier attitude toward the abuses of the firms the
ICI represents (and, even perhaps, the firms from which it draws its executives).(3)

Disclosure and transparency of bundled commission arrangements would allow regulators to

test brokerage arrangements for statutory compliance [Section 28(e), ERISA, and other
statutes]. And it would very effectively enhance the compliance and oversight process by
providing the information necessary for mutual fund directors, plan trustees, plan beneficiaries
and account owners to know how institutional brokerage commissions are being used. Once full
disclosure and transparency of brokerage arrangements is mandated, and enforced, I don't see
any advantage to restricting investment advisors' discretion when using clients' brokerage
commissions subject to the constraints of advisors' statutory and fiduciary obligations.

Background
As you probably know, Section 28(e) is an amendment to the Securities Exchange Act of
1934. This amendment was passed in 1975 after the U.S. Congress forced the brokerage
industry to abandon its historical fixed-price brokerage commission structure and implement
"fully negotiated" commissions. Section 28(e) defines a "safe harbor" under the terms of which
an investment advisor can "pay-up" from its "fully negotiated" execution and clearing rate,
and for the excess commissions paid over that "fully negotiated" rate, an advisor
can receive research services which are defined within Section 28(e). Services purchased with
client commissions by investment advisors using their investment discretion, which do not
qualify under the safe harbor defined in section 28(e) are subject to the tests of advisors'
fiduciary responsibility.

Prior to the implementation of fully negotiated commissions on May 1, 1975 and the passage,
of Section 28(e), soon thereafter, all institutional brokerage arrangements were bundled service
arrangements. Investment advisors would pay a fixed commission rate and they could receive a
variety of services in a "bundle". Shortly after May 1, 1975, Congress passed Section 28(e) and
investment advisors realized that, within the safe harbor of 28(e), they could buy valuable
investment research from independent research providers* by merely instructing a broker to pay
the independent research provider(s) out of the excess commission "paid-up".

* Independent research providers are research providers who have no affiliation with a full-service broker. A common
complaint of securities analysts and research specialist's at full service brokerage firms is that the multiple goals, in
full-service brokerage firms, can create conflicts of interest. It can be a career limiting move to suggest that the
security of an investment banking client of the full service brokerage firm is overvalued, and it would be unwise to
suggest that a security for which the brokerage firm “makes a market” is overvalued. And, can an analyst at a full
service brokerage firm criticize a security that the full-service firm has selected for a mutual fund portfolio, when the
full service brokerage firm acts as investment advisor to the fund?

Level Playing Field / William T. George 11/2/2007 Page 2 of 4

Soon a new kind of institutional brokerage evolved to respond to the requirements of Section
28(e) and to facilitate the acquisition of independent research by institutional advisors. This new
institutional brokerage operating model became known as “third party brokerage” because it
served the needs of the new "third party" in the transaction. (The new third party was the
independent research provider).

Soft Dollar Brokerage

Later, because of its unique adaptation to the requirements of Section 28(e), third party
brokerage became known as "soft dollar brokerage”. This is unfortunate because soft dollars
are not unique to third party brokerage. [However, in contrast to the soft dollars generated in
bundled brokerage arrangements, the soft dollars in third party brokerage arrangements are
unique because of the level of documentation (transparency and disclosure) in third party
brokerage arrangements].

More accurately, soft dollars are any brokerage commission arrangement where an investment
advisor "pays-up" from its fully negotiated commission rate and for the excess commission paid
receives services "provided by" the broker. This definition properly includes services that are
provided in the bundled services brokerage arrangements of full service brokers. Unfortunately,
until recently bundled full services in institutional brokerage arrangements have escaped
significant attention from regulators. They also have escaped oversight by mutual fund directors,
account trustees, account owners and investment plan beneficiaries. One reason these bundled
service arrangements have escaped scrutiny may be because they are inadequately
disclosed.(4) By design, bundled services brokerage arrangements facilitate obscuring the
underlying transactions which facilitate investment advisors’ use of clients’ brokerage
commissions in exchange for “services” provided by brokerage firms.

The Value of Transparency and Disclosure

The lack of accounting (transparency and disclosure) obscures the transactions in the "bundle
of services" and prevents oversight. Recent investigations have shown that the investment
advisory and full service brokerage industry have used clients’ commissions in ways that harm
their clients. They use the excess brokerage commissions "paid-up" in full service undisclosed
brokerage arrangements to buy "services" that do not conform to the requirements of Section
28(e), the Employee Retirement Income Security Act (ERISA) , or fiduciary responsibility.(4)

Since late 2000, it's become obvious (to the public) that institutional client commissions have
been used, in institutional bundled brokerage services arrangements, to gain such favors as: full
service brokerage sales assistance in mutual fund distribution, wrap account arrangements, and
separate account introductions, receiving consideration for an allocation of hot stock in initial
public offerings (investment banking) and being allowed to “flip” the stock during the lock-up
period, or as an inducement to allow a fund manager or market timer to "late trade" mutual
funds. These examples are not exhaustive, there are a number of more creative and more
egregious arrangements that have recently been investigated (e.g. corporate executives
directing retirement plan brokerage to gain favors in investment banking arrangements,
or to gain allocation of IPO's for corporate executives or owners - in some instances referred to
as "Friends of Frank” - or buy-side traders directing brokerage in exchange for a night of dwarf
tossing, table dancing, or hosting bachelor parties, etc.).(5)

As you can see, in most cases the benefits derived from these favors have not been allocated
back to the "direct benefit" of the accounts whose brokerage commissions paid for these
favors. The "direct benefit" test is one test of ERISA compliance.

Level Playing Field / William T. George 11/2/2007 Page 3 of 4

In closing, I would like to suggest that the first step to ensuring a level playing field and the first
step to ensuring the appropriate use all institutional advisors clients’ commissions is complete
disclosure of institutional brokerage commissions paid, and complete disclosure of the services
provided in exchange for those commissions. Regulators and the public should not be distracted
by the mutual fund industry’s suggested approach for ensuring a level playing field; it doesn’t
address the real problem.

Footnotes
(1) To see the comment letters from Elizabeth Krentzman, General Council of the ICI and Henry Hopkins,
General Council of T.Rowe Price Associates > http://www.sec.gov/comments/s7-13-06/s71306.shtml

(2) What is the Investment Company Institute (ICI)? >

http://mutualfunds.about.com/cs/tradeassociations/a/ici.htm

(3) ICI's position on "soft dollars", fully disclosed third party brokerage, independent research, and on the
use of directed brokerage commissions to influence brokerage relationships >
http://www.ici.org/statements/nr/03_news_soft.html#TopOfPage
and http://www.ici.org/statements/cmltr/03_sec_soft_com.html#TopOfPage
More on ICI's position on directed brokerage >
http://www.ici.org/statements/cmltr/04_nasd_dir_brokerage_com.html#TopOfPage

Paul Haaga, Chairman of the Investment Company Institute 2002 through 2004, advocated more
aggressive regulation of directed brokerage, at the same time he was Executive Vice President
and Director of Capital Research and Management Company, Los Angeles (the parent company
of, and investment advisor to, The American Funds > http://www.ici.org/newsroom/contacts.html

A Strange Silence From The Investment Company Institute, article titled, "Exiles On Wall Street"
> http://www.ksg.harvard.edu/leadership/Pdf/ExilesOnWallStreet.pdf

NASD Press Release: American Funds and Capital Research and Management Fined by NASD
for Directed Brokerage violations >
http://www.nasd.com/PressRoom/NewsReleases/2006NewsReleases/NASDW_017294

State of California Files Fraud Lawsuit Against American Funds and Capital Research and
Management for directed brokerage violations http://ag.ca.gov/newsalerts/2005/05-021.htm

(4) Speech by former SEC Chairman, Arthur Leveitt Before the Securities Industry Association Annual
Meeting in Boca Raton, FL on November 9, 2000 (see section titled “Sticky” Brokerage Commissions).
http://www.sec.gov/news/speech/spch420.htm

(5) For highly authoritative testimony on this subject, please see the transcript of, Mutual Funds: Trading
Practices And Abuses That Harm Investors. This transcript contains expert testimony submitted before
the U.S. Senate Committee on Governmental Affairs Subcommittee on Financial Management, The
Budget, and International Affairs Subcommittee - this hearing was held November 3, 2003 >
http://a257.g.akamaitech.net/7/257/2422/23mar20041230/www.access.gpo.gov/congress/senate/pdf/108
hrg/91038.pdf

Level Playing Field / William T. George 11/2/2007 Page 4 of 4