WASHINGTON - If the test for success for new regulations is that they contain a little something to annoy just about everyone, the SEC staff has hit a home run with the rules it has proposed for mutual fund directors.
The SEC's proposed rules governing mutual fund directors either go too far or do not go far enough in altering mutual fund governance, according to lawyers, regulators and industry observers. Proposals that require more disclosure from mutual fund directors and define what makes a lawyer who represents directors independent go too far, some industry lawyers said in interviews during the past two weeks. The SEC issued the proposed rules Oct. 13.
But aspects of some of those same proposals do not go far enough, according to one critic who will have a say over the final form the rules take - SEC Commissioner Isaac C. Hunt, Jr.
The new SEC directors' rules should require directors to disclose the amount of money they have invested in each fund in the fund complex in which the director serves, Hunt said in a speech here last month at a conference on mutual fund regulation sponsored by the American Bar Association-American Law Institute. That information and some other background about directors' potential conflicts of interest should be included in mutual fund prospectuses and not relegated to less prominent disclosure documents, Hunt said.
The SEC proposal calls for directors to disclose how many fund shares they own in the mutual fund complexes they govern without giving a fund-by-fund breakdown. The proposal also requires that disclosure about directors' potential conflicts of interest be made outside the prospectus in documents such as proxy statements, annual reports and the prospectus supplement, known as the statement of additional information.
That may not go far enough, according to Hunt. The aggregate fund holdings of directors could prove to be misleading to investors because aggregate holdings do not show when a director moves his or her investments from one fund to another within a fund complex, Hunt said. For example, a director could switch from one fund to another out of a concern about a change in the portfolio manager of a fund, Hunt said. Investors should be able to follow when a director moves assets within a complex, Hunt told an audience of about 125 mutual fund lawyers and consultants in a speech at the conference.
Ultimately, the SEC's proposals, if adopted, will benefit both fund shareholders and the mutual fund industry by making information about directors' potential conflicts of interest readily available to all, Hunt said.
"No one ever wants his integrity questioned," Hunt said. "It's not only insulting, it's bad for business."
Hunt, one of five SEC commissioners, ultimately will have a vote on the final language in the SEC directors' rules proposals. The vote will not come before next year, but the debate on aspects of the proposals seems likely to intensify in the coming weeks. The public has until Jan. 28 to comment on the proposals.
The more controversial aspects of the SEC's proposals will have two key effects if adopted. They will force directors to tell the public more about themselves and their families and they may cost some lawyers business while reducing directors' ability to rely on lawyers who have long represented them.
With respect to disclosure, the proposed rules and an accompanying SEC interpretive release require that directors disclose, in certain circumstances, significant personal business transactions in their proposal stages - in addition to existing business relationships - that might produce conflicts of interest. Funds also must disclose instances of so-called cross-directorships, cases in which an executive at a fund adviser serves as a director of a company where a fund director is an officer. In some cases, the rules call for directors to disclose personal information such as loans they and immediate family members have received from entities related to a fund adviser.
These additional disclosures have mutual fund lawyers worried, if for no reason other than increased disclosure makes fund documents longer and sometimes more difficult to read. The trend toward gradually increasing disclosure requirements in prospectuses has come to be known among lawyers as "prospectus creep," essentially a cycle marked by regulators streamlining prospectus requirements and then gradually grafting new requirements onto the streamlined prospectuses. The new rules for directors suggest that prospectus creep may be moving to other disclosure documents, said David Butowsky, a lawyer in the New York office of Mayer, Brown & Platt of Chicago.
"Now instead of prospectus creep, instead we will have SAI [statement of additional information], annual report and proxy [statement] creep," Butowsky said.
The issues the new rules present are less esoteric for mutual fund lawyers who represent independent directors. The new rules do not require independent directors to hire their own lawyers. When directors do hire a lawyer, however, the directors must hire a lawyer who has no significant relationship to a fund adviser and its affiliates.
That proposal, if adopted, will result in at least some independent directors losing counsel that they have long relied on, fund lawyers said. Because of the size of many of today's financial services companies and law firms, it will be difficult in some cases for directors to find lawyers who are knowledgeable about mutual fund law but who do not work for a law firm that in some manner represents an affiliate of the fund adviser, lawyers said.
There is an alternative to simply prohibiting directors whose lawyers represent a fund adviser from also working for independent fund directors, said Robert Zutz, a lawyer in the Washington, D.C. office of Kirkpatrick & Lockhart LLP of Pittsburgh, Pa. Lawyers could be required to make detailed disclosures to independent directors about the lawyers' potential conflicts of interest and then the directors could decide whether to hire the lawyers, Zutz said. In addition, each state has laws that govern lawyers' conflicts of interest and how they must be treated, Zutz said.
- Lee Barney contributed to this story.