Drowned by the din of arguments surrounding rules for independent directors and chairmen of mutual fund boards is the increasingly important role of another independent party: attorneys.
An important check in the balance between fund boards and fund companies, industry leaders have advocated independent counsel for years.
"This step seems so obvious and so essential that it's hard to imagine why it hasn't been mandatory ever since the industry began in 1924," said Vanguard founder and former chairman, Jack Bogle, during a speech he delivered in May 2000. In that speech, Bogle cast
down from the podium his "10 Commandments for Independent Directors."
Bogle's No. 1 commandment? "Thou Shalt Retain Independent Counsel." But retaining counsel is not required by regulators, although it is recommended. Most companies have not retained an independent counsel, citing cost, over-lawyering and a lack of expertise. But since then, the industry has weathered the scandal, causing more and more boards to hire outside, independent, counsel in an effort to rebuild credibility and increase their strength.
"Given the increasing amount of regulatory compliance matters being addressed by fund boards, such representation is beneficial to both the directors and the shareholders they represent," according to a 2005 report published by the Independent Directors Council, a subsidiary of the Investment Company Institute in Washington. "Directors increasingly recognize this practice as a key component of effective fund governance," the report notes.
In fact, the proportion of fund complexes in which independent directors have retained counsel other than the legal team already serving the advisor or the fund itself has increased from 32% to 51% between 1998 and 2004, according to an Independent Directors Council report. Meanwhile, the proportion of boards that either have no counsel or rely upon attorneys who work for the fund has dropped from 33% to 9% of the complexes surveyed.
"Structurally, it's a very important thing, if you're going to have real independence on the part of the fund trustees," said Don Phillips, a managing director of Chicago-based fund rater and researcher Morningstar.
Certainly, regulators have increased their emphasis on the importance of board members' independence. In 2004, the Securities and Exchange Commission adopted regulations demanding 75% of directors on each fund board (or, in the case of boards of three, two members) be independent, and that the chairman of each board be independent, too. Although the regulations were overturned for a second time on April 7 by the United States Court of Appeals for the District of Columbia, which ordered the SEC to collect more public comment (see related story, page one), many fund companies have gone ahead and met those goals, rather than wait for a final ruling.
"Boards are locked in like never before," Phillips said. "I think a lot of fund independent directors were profoundly embarrassed by the [market-timing and late-trading] scandals," he said. Although not directly involved, directors were largely considered asleep at the switch, Phillips said. "At the end of the day, the overarching principle is that it's other people's money - not your own - and the checks and balances start with the independent trustees," he said.
"With the compliance rule coming into place, and the scandals before that, independent trustees have really begun asserting themselves," said Bill Zitelli, a senior consultant with Philadelphia-based, SEC Compliance Associates. "Now, with the chief compliance officer and independent trustee counsel, they are looking at every single compliance order and asking, Hey, how are shareholders affected? Do we need to make shareholders whole?'" he said.
The benefits of independent counsel go beyond the shareholders' interest to those of the directors themselves, Zitelli said.
"The trustees face a significant amount of risk," Zitelli explained. That's because they deal with very technical regulatory issues and rules that are not written for laymen. Further, insurance policies that cover the funds generally will not cover indemnity cases brought against unaffiliated directors, he added.
Independent counsel plays an important role in making decisions about renewing investment advisory and distribution agreements - decisions that, in the past, may have been considered perfunctory on the part of the board.
"If there's a compliance issue, even one that's seemingly minor, trustees may not understand the nitty-gritty," Zitelli said. "They just really want to be covered. They want that security blanket," he said. "Independent counsel plays a significant role, and I think that's why the trustees are driving that trend," he added.
Furthermore, counsel from an independent law firm lends value because it inevitably deals with many different companies and has been exposed to various problems, said Margurite Bateman, managing director of the Independent Directors Council.
"Counsel tends to have its ear to the ground on developments in the area," she said.
But all the authority and assurances that independent counsel can offer doesn't come cheap. Retaining counsel for four quarterly meetings could range between $20,000 and $40,000 per year, Zitelli estimated.
And that doesn't include additional work that may be required outside of meetings, he said. "It's a double check on management and on the CCO," said Zitelli, a former chief compliance officer at SEI Investments in Oaks, Pa. "If they are doing their job right, independent counsel is a real pain."
"In that way, it's good," he said. On the other hand, because they err on the side of caution, independent counsel can create more work for the fund company's legal team and, in some cases, spend $20,000 on resources to correct a $1,000 loss to shareholders, he said.
For large fund complexes, the overall cost of independent counsel may be spread evenly over several funds, having a minimal impact on each.
But for a smaller fund complex with $10 billion or less under management, the cost of retaining independent counsel could be significant, making the decision to retain them less appealing, though probably no less important, said Kip Price, head of Global Fiduciary Review for Lipper of New York.
"The value is that the independent counsel works with the board, which works for the shareholders. The board is getting good advice and education so that it can adequately represent the shareholders," Price said.
Zitelli underscored the value of the independent counsel. Although they may create work for the fund attorneys, "without them, [those attorneys] have a more burdensome role. They have to be very unbiased, and represent the interests of not just the advisor, but the trustees and shareholders," he said.
Another option for a smaller company is to rely more on the CCO, whose interests are already aligned with independent directors, Zitelli said. Still, that is not ideal. "It's almost a relief if you are the CCO and the board has independent counsel who you can turn to discreetly to validate your opinion," he said.
Smaller funds can save on billable hours by asking the attorney from the independent counsel to attend meetings by phone, rather than in person, or ask for an associate, not a partner, at a firm to represent them, Bateman suggested.
Independent directors may also hire counsel only to handle specific tasks, Zitelli added, such as reviewing an agreement or the board's own self-evaluation process.
Exploring these options is important, Bateman agreed. "There is, I think, a feeling that having counsel has such benefits, that going without it is really not an option," she said.
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