A system which some industry lawyers say has become an anachronism for large mutual fund complexes - having one board of directors for each mutual fund in a complex - may be headed for extinction.
Mutual fund complexes which consist of a significant number of mutual funds should have only one or a few boards of directors, a special committee formed by the Investment Company Institute said last week. The ICI Advisory Group on Best Practices for Fund Directors said such a system should reduce expenses, eliminate redundancies and increase the leverage which fund boards have when negotiating contracts with the investment advisers who manage fund assets.
If widely followed, the committee's recommendation could mean substantial structural changes for a majority of mutual funds. In addition, the one-board-per-complex structure would eviscerate one of the arguments which plaintiffs' lawyers have made in suits challenging the independence of mutual fund directors.
The Fund Directors Committee found that "except in unusual circumstances, single-fund boards make no sense," said Richard Phillips, a lawyer at Kirkpatrick & Lockhart in Washington. The change to a one-board-per-complex structure will provide better accountability of investment advisers to fund boards, better knowledge for fund directors and better leverage for boards in negotiating with advisers, Phillips said.
The recommendation with respect to changing the structure of fund boards was one of 15 which the Fund Directors Committee made in a 32-page report made public Thursday. The ICI's board of governors still must review the report's findings and vote on whether to adopt them for the ICI.
The recommendations, if adopted, would be voluntary for ICI members.
It was unclear when the ICI board of governors would consider the Fund Directors Committee's report. ICI executives and committee members were not available to comment on the report.
When the Investment Company Act established the rules for mutual funds in 1940, a mutual fund complex normally consisted of only one or two funds. At the time, having a single board of directors for each fund was practical. In the past 20 years, however, the industry has changed as fund advisory firms have sponsored multiple funds within the same mutual fund complex. Now, roughly 70 percent of the approximately 10,600 funds in existence are part of mutual fund complexes which include at least 25 funds, according to Morningstar, the Chicago fund rating firm. For example, Fidelity Investments of Boston, the largest mutual fund company, has more than 200 fund boards overseeing its funds.
Fund shareholders in five lawsuits filed in the past 12 months have ridiculed the multiple-board system, saying that part-time directors can be little more than rubber stamps as they hold dozens of separate meetings in which they examine the operations of individual funds.
The Fund Directors Committee, in its report, said criticisms of the system are baseless. But, it said that having a single board or a limited number of boards in larger fund complexes provides efficiencies that benefit shareholders. The committee did not identify the specific size at which a fund complex should drop the one-board-per-fund structure.
Executives last week generally reacted favorably to the report as setting best practice goals for the industry, but predicted some of the recommendations would meet resistance. One proposal, having special outside attorneys for independent directors, may cause smaller fund groups to protest that the added legal expense is not necessary, said Barry Barbash, a lawyer at Shearman & Sterling in Washington, D.C. There also will be opposition to the proposal that former executives from a fund adviser be permanently barred from serving as independent fund directors, Barbash said.
"There will be a vocal minority who say that was an unwarranted position," Barbash said.
Other proposals included in the committee report are:
Fund boards should be comprised of at least 67 percent independent directors, up from the current 40 percent requirement imposed by law;
Directors should invest in funds on whose boards they serve;
Independent directors should designate at least one so-called "lead" director to serve as spokesperson for the group and coordinate independent directors' efforts;
Boards should periodically review their own performance;
Independent directors should meet separately from interested directors on certain issues.
The SEC is in the midst of drafting proposed changes to its own regulations regarding independent directors and expects to issue its proposals this summer, Christopher Ullman, an SEC spokesperson, said last week.
SEC Chairman Arthur Levitt initiated the scrutiny of fund directors in February when he held a two-day conference on the subject. In March, Levitt said the SEC would propose changes to its rules to strengthen the independence of directors. On the same day Levitt made his announcement, the ICI said it had formed the Fund Directors Committee to propose best practices for the industry.