While the Securities and Exchange Commission and the U.S. Chamber of Commerce grapple in court over whether Federal regulators have the right to dictate the composition of mutual fund company boards, the fund companies themselves appear not to be waiting for answers.
An SEC rule approved in 2004 would require 75% of all mutual fund boards, including their chairmen, be independent. The rule, scheduled to take effect this year, have been halted pending the outcome of a lawsuit lodged by the U.S. Chamber of Commerce, which argues that imposing such a policy would prove costly, impractical and inappropriate.
But a study just released by the Independent Director's Council, an affiliate of the Investment Company Institute, shows that the very year the SEC rule was first proposed, the industry surpassed the 75% target with 78% of all directors surveyed unfettered by ties to the managing companies. The 2004 levels represent a 7% increase in the ratio of independent, rather than interested, parties compared to 1994.
By 2004, 43% of the chairmen of the boards of surveyed funds were independent, while another 18% had an independent lead director. In 2002, only 42% had either, up from 22% in 1996. By 2006, according to the report, 60% of those surveyed said they planned to have an independent chairman.
"Groups have been looking at this issue in anticipation of the SEC rule, should the rule be upheld by the court," said Marguerite Bateman, managing director of the Independent Director's Council.
Steve Bokat, executive vice president of the National Chamber Litigation Center and general counsel for the U.S. Chamber of Commerce in Washington, put it more bluntly: "You've got to remember - people had an obligation hanging over their heads."
Obligatory or not, shareholder advocates like Mercer Bullard, an assistant law professor at the University of Mississippi in Oxford, Miss., and founder of Fund Democracy, say that the changes are good news for investors. Chairmen with ties to the advisor are less likely to demand information and to intimidate other concerned directors into silence. "It's bad for investors, and it's bad for the community," he said.
The ICI report, which tracks fund governance practices between 1994 and 2004, reflects data culled from biennial surveys of approximately 1,500 directors at about 8,000 funds. And while the specific funds and the directors questioned changed over the course of a decade, the data represents an undeniable trend. "As a group," the report states, mutual fund boards "have gravitated toward practices thought to best serve the shareholders."
For example, the study shows that in 2004, independent directors met more frequently than they did 10 years before. While most boards still reported meeting four times each year, 20% met five or six times in 2004, compared to 5% that met that frequently in 1994. Six percent of boards surveyed met seven or more times in 2004. In 1994, only 3% of boards met as often.
By 2004, more independent directors of mutual fund boards began retaining their own attorneys to help shepherd them through the regulatory environment and advise them on executive proposals. When the IDC began surveying fund boards about this issue in 1998, about 19% of independent directors had their own lawyers. In 1999, the ICI included independent counsel among its "best practice" guidelines. By 2004, 51% of independent directors had their own counsel. Meanwhile, the number of independent directors who rely on the same legal team that represents the fund and the advisor has sharply decreased from 33% in 1998 to 9% in 2004.
Unlike assigning independent directors and chairman, those shareholder-friendly trends are not required by, but rather, are a response to regulation. Boards are choosing to meet more frequently and rely more heavily on experts to decipher the scores of new rules that affect the entire industry, but not because they are being told to do so, Bateman said.
That difference represents the crux of the controversy surrounding the SEC's independent director and chairman rules.
The SEC argues that beyond increasing the 2001 requirement that 75% of board members are independent (itself a significant increase from the 40% rule set in 1940), the chairman of the board must also be independent. "Because the chairman of a fund board can have substantial influence on the fund board agenda and on the boardroom's culture, we expect that this requirement will advance a meaningful dialogue between the fund advisors and the independent directors," the SEC final rule on Investment Company Governance states. "We expect that funds and fund shareholders are likely to benefit from the amendments," the rule notes.
In a 2004 report to Congress, and in the wake of the 2003 market-timing scandals that tarnished the image of mutual funds, the Government Accountability Office acknowledged that while some boards may already operate according to the principles of the SEC rules, making those rules stick is critical to shareholders.
"Although such practices do not guarantee that funds will be well managed and will avoid abusive or illegal behavior, greater board independence could promote board decision making that is aligned with shareholders' interests and thereby enhance board accountability," the GAO report asserts.
But the Chamber counters that the SEC cannot dictate who board members may choose to lead them, since each fund had its own eccentricities. Furthermore, the Chamber argues, the SEC rule will impose undue expenses on funds, potentially cutting into shareholders profits.
Shareholder advocates like Bullard counter that the results of the IDC survey show that funds can adapt and have done so already. Further, most fund advisors said that the cost associated with an ensuring an independent chairman and board members is negligible, according to a 2005 report published by the Washington-based Mutual Fund Directors Forum, which supports the SEC proposals. Thirty-six of the 45 fund boards surveyed already had independent chairmen. Of those, 22 said that maintaining an independent chairman raised compensation costs, but 13 said those costs were less than $50,000. Nine of the 22 noted other costs associated with the transition. Two placed the cost somewhere between $150,000 and $500,000, and four were unsure of the precise amount.
"We've never contended it was impossible, or that there weren't mutual funds that wanted to do it," Bokat said. The issue, he said, is "crummy rulemaking." Bokat pointed to Vanguard and Fidelity, industry giants led by interested chairmen.
But it's the rogue firms that worry people like Bullard. "It's always for the minority that we adopt rules," he said. "With all apologies to all those who don't really need [independent directors], that's the way the world works," he said.
For its part, the ICI argues that while its own "best practice" guidelines suggest a two-thirds supermajority of independent directors, boards should be trusted to structure themselves in the way that makes most sense, not according to government regulations.
Bullard, who has filed an amicus curiae brief with the Consumer Federation of America in support of the SEC rules, disagrees. "I see their point in that you have to be careful, but [SEC-sanctioned former Strong Capital Management CEO] Dick Strong reviewing Dick Strong's compliance is not a good idea."
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