With a potentially groundbreaking governance proposal pending, requiring an independent chairman, there's been a lot of bickering in the mutual fund industry about how to address conflicts in the boardroom.
In light of the debate the fund scandal has generated, it is clear there is no cure-all for the problems plaguing the fund business. But with much of the impropriety that has been uncovered occurring at or near the top of fund management, rethinking the culture of the boardroom is certainly a great place to start.
But first, it is important to distinguish the really important reforms of the proposed rule from the ones that are less meaningful or controversial. Establishing a board made up of 75% independent directors is very good symbolism, but is mostly cosmetic for many funds. As a practical matter, all fund boards are at least two-thirds independent and in many cases upping the number to 75% wouldn't mean much of a change at all. In fact, a seven-person board with five independent directors would qualify in either case. A quarterly meeting of the board that excludes management would also be required. Again, there is no controversy here. It is something the trustees must do to get back on track.
The question of the hour really revolves around the independent chairman rule, which would require funds to designate a disinterested chair to lead the board in its fiduciary responsibility. That has caused quite a stir among some of the biggest fund shops, with strong arguments being made on both sides. The reason the SEC has proposed the rule is in part symbolic, in that only the independent members represent the shareholders, while the non-independent members represent the shareholders and the advisors.
"I think it is important to emphasize, for the benefit of shareholders, that the board is led by outsiders given the fact the board has to negotiate advisory fees and oversee the function of the advisor," said Jock Patton, lead trustee for the ING Funds.
"The non-independent members will still be on the board, the advisor still runs the business in a day-to-day fashion and agenda-setting and determining the focus of the board is not something that requires direct expertise," he said.
Fidelity Investments, the nation's largest mutual fund complex, recently voiced its criticism of the provision, arguing that the decision to have an independent chairman should be left up to the board. In support of its argument, Fidelity CEO Ned Johnson pointed out that a number of fund companies involved in the recent scandals already had independent chairmen in place. He also owns part of the management company and has a stake in Fidelity funds, which he believes aligns his interests with those of the shareholders. Johnson stressed the importance of having a chairman who represents the management company because of their expertise in the nuances of the fund business.
However, not all industry professionals share that sentiment. Don Phillips, managing director of fund research firm Morningstar, showed his support for an independent chairman in his testimony before the Senate Banking Committee in late February. "While in U.S. operating companies, the chairman and CEO are often the same person, such an arrangement presents a conflict of interest in funds that does not exist in operating companies."
He argued that fund companies are different than operating companies in that they owe their loyalty to both the fund shareholders and the fund management company's stockholders. "Only independent fund directors have a singular fiduciary responsibility to fund shareholders," he said.
Then there's the question of whether an independent chairman would truly assume that mantle. "Independence in the ways boards manage themselves is much more a product of the individuals that are involved and their relationships with each other than it is any particular set of regulatory rules," said Mark Perlow, an investment management attorney and partner at law firm Kirkpatrick & Lockhart. "The rules should set the baseline for what's acceptable." He further argued that independence in operation is more contextual, noting that he has seen both scenarios work. With three-quarters of the board independent, however, he believes the boards will be able to decide for themselves.
Another divisive issue is whether there should be a cap on the number of boards on which a fund director serves. At Fidelity, each director oversees at least 291 funds, according to Morningstar. "We think it's impossible for directors overseeing this many funds to spend enough time to truly do the due diligence necessary to make sure each fund is run exclusively in the best interests of shareholders," wrote Morningstar analyst Christopher Traulsen, in a report.
But Patton doesn't think there should be a restriction due to the setup of mutual funds, which have no employees or operations other than those delegated to the advisor. He argues that advisory fee negotiation and performance are both susceptible to statistical analysis. "By taking the data we get from independent third parties, we can quickly identify those funds which underperform or have relatively high fees. So the exercise on a fund-specific basis can be narrowed very rapidly. Even though you may have a very large number of funds, you end up working on a very small number of problems," he said.
As for directors' other duties, namely cost and compliance, Patton noted these are complex-wide issues that should be treated as such. If a fund complex has too many different directors, it could have too many people looking at the same issue in different ways and ending up getting in each other's way. Patton warned that this sort of approach is "inefficient, costly and not productive." Additionally, it ties up management by making them attend multiple meetings to discuss the same issue when they should be attending to the daily operations of the business.
Still, the fact remains that fund directors are on the hot seat and faced with many new challenges amid a widening trading scandal. New York Attorney General Eliot Spitzer blasted the fund board at Bank of America's Nations Funds for its negligence of market-timing and late-trading abuses. As part of Spitzer's $675 million settlement with BoA and FleetBoston, eight of the 10 Nations trustees were forced to step down.
"I'm assuming the BoA case is aberrational," Patton said. "And if it isn't, there will be difficulty attracting and retaining board members because no one wants to set themselves up for personal liability in a witch-hunt environment."
Perhaps the most difficult problem for fund directors to resolve is oversight of the distribution channel, which at many funds is a multi-tiered structure comprised of many different affiliates. When there is tiered distribution, multiple distributors and omnibus accounts that aggregate business functions beyond the sight of the board, it's extremely difficult for directors to police it.
The SEC and Congress are now examining a host of distribution issues, including the use of soft dollars, revenue sharing and directed brokerage. In theory, funds should be getting the lowest reasonable price for brokerage with best execution. Soft dollars distort that analysis and have the effect of subsidizing the management fee by paying with shareholder dollars for items that many believe should be paid for out of the advisor's pocket.
MFS Investments recently announced that it would ban all soft-dollar arrangements; instead it will pay cash for research and overhead items such as Bloomberg terminals and periodical subscriptions. Other firms are following suit. "Soft dollars are not in the interest of investors, and they should not be permitted," Patton said.
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