It doesn't happen very often. But when independent directors who sit on mutual fund boards become the focus of criminal allegations, lawsuits, investigations by the Securities and Exchange Commission or public scrutiny, fund companies and their boards of directors often find they must make an important decision. Should they ask the trustee to resign or stay the course?

At least a few mutual fund companies have had to deal with this thorny problem over the last few years, including American Century Investments of Kansas City, Mo., INVESCO Funds of Denver, and Dreyfus Corp. of New York. Each has seen one of its fund directors making headlines related to dubious outside activities.

Most recently, in early April, veteran Dreyfus fund director Martin D. Fife, along with several other individuals, was charged by the SEC with operating a fraudulent scheme that bilked $52 million from investors between 1999 and 2001. The SEC charged that Fife and his accomplices operated a phony high-yield trading program under various bogus business names. The SEC obtained restraining orders against the individuals and froze their assets.

According to public documents Dreyfus filed with the SEC, Fife had served as a fund director with oversight for 14 Dreyfus funds since 1974 and earned more than $67,000 last year for his board service. Fife has since resigned from the board, according to a Dreyfus spokeswoman, who added that Fife was never an employee nor an officer of Dreyfus Corp. She added that the SEC's allegations have no connection to the company or its funds.

In February, INVESCO faced the loss of one of its independent board trustees. Wendy Gramm, wife of Texas Senator Phil Gramm, resigned her board seat amid controversy over her role as a corporate director of Enron Corp. According to INVESCO fund filings, Gramm relinquished her board seat on Feb. 7 after announcing her intentions to resign at a fund board meeting.

Gramm, a fund director with INVESCO since 1997, had served as a member of the board's investment and management liaison committee, the derivatives committee and the nominating committee. She earned more than $94,000 last year for her board service.

Another case involves Nobel Laureate Myron Scholes, who won the 1997 Nobel Prize in economics. Scholes made headlines in 1998 when Long-Term Capital Management, a hedge fund that he co-founded and of which he was a principal, suffered huge losses as Russia defaulted on its loans and financial markets swooned. Scholes' hedge fund and the investment strategy came under intense scrutiny as a consortium led by the Federal Reserve Bank of New York arranged a bailout.

At the time, Scholes had been serving as a 17-year veteran independent director of one of the two American Century fund boards, with oversight for 38 funds. According to public documents, Scholes received more than $70,000 in board compensation from American Century last year.

According to spokesman Chris Doyle, American Century's fund board took no action to depose Scholes. He continues to serve on the board today as one of the group's longest-serving trustees.

"Our response was basically dictated by the response of shareholders," Doyle said. "From an investors' standpoint, it was a non-event. There's an understanding among the public that independent directors have outside interests and other business dealings that don't reflect on the funds."

At the time, Scholes had been also serving since 1992 as an independent trustee of the fund board of the Smith Breeden Family of Funds of Chapel Hill, N.C., as well as a board trustee for the funds sponsored by Dimensional Fund Advisors (DFA) of Santa Monica, Calif. since 1982. He continues to serve on both fund boards.

"The issue was examined by our board and outside counsel. But after studying it, they determined that it was of no consequence," said a spokesman for DFA. No action was taken.

Assessing Problems

Problems can arise when otherwise perfectly competent veteran fund directors find themselves in the hot seat, even if their questionable actions have nothing to do with their fund oversight responsibilities. Often it doesn't matter whether the allegations are true or baseless, because it's the perception among fund shareholders that concerns other fund board members and fund management.

There is no one recipe for dealing with an independent trustee whose non-fund activities have been called into question or gotten him or her into hot water, according to fund industry lawyers. Each case must be considered based on the individual circumstances.

"It depends on the nature of the action," said Barry Barbash, a partner with the law firm of Shearman & Sterling of Washington and former director of the SEC's division of investment management. In many cases, the underlying rules governing the funds mandate that a director cannot be removed unless there is a cause, he said. "An SEC proceeding, or even a lawsuit typically doesn't rise to the level of cause,'" Barbash added.

In such circumstances, it is often beneficial for members of a fund board to call an executive session to assess the seriousness of the situation. Sometimes the media attention proves to be much worse than the actual facts, Barbash said.

The trustees must then ask themselves what would be in the best interest of shareholders, Barbash said. Very often just the perception among fund investors may determine what action the board takes. If the allegations are expected to cause a significant problem or prevent the board from fulfilling its responsibilities, then it's time to have a frank discussion with that trustee, he added.

Sometimes the matter is delegated to the board's governance committee, said David Sturms, a partner with the law firm of Vedder Price Kaufman & Kammholz in Chicago. It should be taken seriously if it is a heinous crime or if someone has committed a felony or an act that has called his or her character or fiduciary responsibility into question, he said.

If it is a situation where a majority of the directors believe it is appropriate to remove that trustee, the committee chairman should talk with the director and ask the director to resign, or take other remedial action.

"You don't want to have to go through a formal removal process," Sturms added. That entails bad PR for the fund group, and typically takes time and a toll on everyone, he said.

"If there is a certain board member whose conduct is being questioned, it would be the gentlemanly thing to step down," said Les Ogg, vice president and general counsel with American Express Advisors of Minneapolis. Perception is critical, he added.

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