No one in the mutual fund industry would fault Myron Scholes for serving as a mutual fund director at the same time his outside business interests are under scrutiny.
But, the Nobel prize winning economist whose prominence grew with the near failure and subsequent investigation of Long Term Capital Management last summer, is a notable exemplar of a controversial practice.
Scholes serves as an independent director on the boards of funds in three different mutual fund complexes: the Benham Group - part of the American Century Investments family of mutual funds - Dimensional Fund Advisors (DFA) and Smith Breeden Mutual Funds.
Serving on the boards of more than one complex is a long-standing practice and does not violate any laws. But, some people in the industry question the practice, saying it produces conflicts of interest that should be avoided.
"No man can serve two masters," said John Bogle, senior chairman and founder of the Vanguard Group. The practice is "completely ridden with conflict of interest and is completely unacceptable."
Fund complexes are competing with one another to attract investors' dollars, Bogle and others said. And complexes also ultimately are competing with one another for investment ideas, Bogle said. That combination makes it virtually impossible for directors to work for funds in more than one complex, according to Bogle and others.
"Increasingly everybody is competing with everybody," said C. Meyrick Payne, a senior partner at Management Practice of New York, a consulting firm that provides services to fund boards.
Bogle suggested a hypothetical situation in which he simultaneously served as director of both Fidelity Investments and Vanguard funds.
"I think it would make you a laughingstock," Bogle said. "I think it would make the two organizations a laughingstock."
But directors frequently serve on the boards of more than one fund complex. Management Practice estimates that seven percent of directors serve on boards of more than one complex.
Attempts to reach Scholes for comment were unsuccessful. Officials at DFA, the Santa Monica, Calif. money management firm, did not return a call seeking comment.
Michael J. Giarla, president of Smith Breeden Associates of Chapel Hill, N.C. said he did not believe Scholes' multiple roles represented a conflict of interest. If anything, directors serving more than one fund complex broadens their experience, Giarla said.
"They've seen how different fund companies operate," Giarla said. "I think that experience benefits shareholders."
Serving on the boards of fund complexes which do not compete is one means of avoiding any conflicts of interest, according to mutual fund industry lawyers. Doug Paul, associate counsel for American Century, said that is the case for Scholes and American Century. Scholes' service on the boards of more than one fund complex has not posed a conflict because the American Century funds' distribution, which is retail oriented, varies from DFA and Smith Breeden funds, Paul said. There also are substantial differences in products, Paul said.
Indeed, there is an informal industry practice which discourages directors from serving on boards for competing complexes, according to mutual fund industry lawyers and executives. However, that guideline has become more difficult to apply today as once hard-and-fast distinctions between fund companies' products and distribution channels are breaking down, some of these lawyers and executives say.
Directors and their lawyers have developed systems to identify and monitor potential conflicts. Fund boards have codes of ethics to guard against conflicts. The lawyers who advise independent trustees have established internal procedures to monitor such circumstances, industry lawyers said.
There also are legal limits. If a fund director obtained confidential information from serving on one group of funds, the director is bound to keep that information confidential, fund industry lawyers said.
"You don't reveal confidences," said Kenneth E. Scott, a professor at Stanford University law school and a director for funds in both the Benham Group and Dresdner RCM Capital Funds.
Given the checks in the system, the concern about directors serving on more than one fund complex may arise more from a sensitivity to public perception than from a fear that trade secrets will be revealed. But, perception matters when it comes to fund directors. Fund industry assets have surpassed those of banks and fund directors increasingly find themselves defendants in litigation challenging everything from their independence to the adequacy of their oversight of mutual fund fees.
"Independent trustees are more under fire now than they were 10 or 15 years ago," said John Winthrop, an independent director for the Pioneer Funds. "We are in a goldfish bowl."
Winthrop previously was a director for several funds managed by Alliance Capital Management in addition to Pioneer. Winthrop said he resigned his Alliance posts more than one year ago because of the press of commitments and fear of increased legal liability from serving on two complexes rather than one. Winthrop said his attorney advised him to stop serving on mutual fund boards entirely.
While it might have drawbacks, a system in which fund directors work for more than one complex may address one of the criticisms of fund directors. Scott, the Stanford law professor and fund director, said that having directors serve on more than one fund complex ultimately increases director independence from any one fund adviser. Serving on more than one complex has the effect of encouraging the development of a professional class of independent fund directors, Scott said.
The concept of professionals able to keep the confidences of competing clients has plenty of precedent in the mutual fund industry. Industry lawyers and mutual fund officials say that lawyers and accountants serve and keep secrets of clients who compete with one another. Firms which provide both distribution and back office support also work for fund groups which compete, industry officials and lawyers said.
"It's a lot like being a lawyer for competing clients. You have to keep your mouth shut," said Pamela Wilson, a partner at Hale & Dorr in Boston.
Bogle however questioned whether the concept was applicable to directors. Lawyers, accountants and others are service providers while fund directors have a fiduciary duty to the shareholders they represent, Bogle said.
The merits of either position notwithstanding, Wilson suggested the practice of directors serving on more than one fund complex may become even more common, said Wilson. With widespread mergers and acquisitions in the fund industry, independent directors may find themselves inadvertently serving on the boards of competing complexes.
"It's getting harder and harder to avoid at the same time it's getting harder and harder to manage," said Wilson.
