The fight for independence may already be a foregone conclusion, but fierce battles are still being waged.
The Securities and Exchange Commission is urging a federal appeals court to dismiss a U.S. Chamber of Commerce lawsuit aimed at blocking a key governance reform requiring mutual funds to have an independent chairman. This week, the chamber is scheduled to submit a rebuttal brief.
In a brief filed in the District of Columbia U.S. Circuit Court of Appeals, the SEC blasted the chamber, saying it has failed to provide sufficient evidence that its members would be harmed by the new provision adopted last July. While the chamber maintains it has standing to bring the suit on the grounds that at least 30 of its three million members are mutual fund advisors, the SEC argues that none of these fund advisers have come forward to explain a single instance that would illustrate harm. The Commission also challenges the chamber's justification for the suit, based on its own fund investments.
The SEC defended its position that 75% of a fund's board of directors and its chairman be independent of fund management by referencing the widespread abuse uncovered in the recent market-timing and late-trading scandal. "The Commission adopted the amendments in the face of mounting evidence that mutual fund managers were misusing their trust to favor themselves at the expense of fund investors, thereby inflicting huge losses on investors," the court document said. As a result of that behavior, investors lost more than half a billion dollars, the SEC lawyers said.
The appellate court is scheduled to hear the SEC's oral argument on April 15. After the three judges assigned to the case have heard both sides, one of the judges will write an opinion to be submitted for final decision, which could be months from now. The deadline for funds to comply with the independent chairman rule is Jan. 16, 2006.
The chamber is opposed to the rule because it believes the SEC does not have the authority to tweak governance standards for the fund industry. Rather, it would prefer that the Commission deferred to Congress on the matter. "The SEC has over-reached its authority, resulting in a rule that is bad for investors and contrary to the intent of Congress," said Stephen Bokat, general counsel and head of the chamber's legal arm, the National Chamber Litigation Center.
In its written argument, the SEC stated that Congress granted the regulatory agency the power to issue exemptions on the way funds operate their business, either "conditionally or unconditionally," so long as the exemptions are consistent with the public interest and helped improve investor protection. It is a practice that the Commission has used for more than 50 years. In 2001, the SEC granted exemptions to the funds in which independent directors held a majority, eclipsing the 40% level required by the 1940 Act.
The SEC scoffed at the chamber's notion that the conditions of the independent rule were arbitrary and capricious, a litmus test for federal regulation. The argument outlined that the conditions were designed to regulate transactions that involve conflicts of interest and require independent oversight. As a matter of policy, many in the fund industry have opposed more stringent rules for trustees, particularly Fidelity Investments. The Boston fund giant, which has more than $1 trillion of the $7.5 trillion in mutual fund assets, has tremendous clout in Washington and some industry observers suspect it could be pulling the strings on the chamber's legal bout with regulators.
Even among SEC commissioners, this was a hotly contested issue as evidenced by the narrow 3-2 decision to codify it last summer. However, as a matter of law, SEC attorneys contend that it is well within their authority and that is far from arbitrary or capricious. The prevailing sentiment at the Commission is that while the chamber is entitled to view it as an ill-conceived policy, it does not mean that it is illegal.
Another sticking point laid out in the SEC brief was the chamber's suggestion that the Commission failed to consider data showing that funds with independent chairmen lagged in performance compared to those funds chaired by management. The data in question was a report commissioned by Fidelity and prepared by industry consultants Geoff Bobroff and Thomas Mack. The SEC acknowledges that this study found that in the past, some independently chaired funds as a group did not perform as well as some management-chaired funds.
However, the report does not mention advisor fees being lower as a result of the new rule, its impact on future performance of the funds or the fund company members of the chamber, the SEC charges. Additionally, Vanguard founder Jack Bogle ran a similar screen and found that independently chaired funds actually performed better than those headed by an executive from the management company. Furthermore, the rule is not designed to enhance fund performance but rather to eliminate conflicts of interest.
The SEC maintains that the chamber has failed to show that any of its members will endure "concrete and particularized" harm that will impair their returns in any way. "[The Chamber of Commerce] has offered no credible support for its contention that conditioning reliance on the exemptive rules upon an independent chair will adversely affect fund performance," the brief said.
Still, Congress has asked the Commission to deliver a report to it by May on the impact independent chairmen would have on fund fees and performance (see MME 12/13/04). Congress' requirement is part of a new $388 billion omnibus spending bill that both houses have approved and President Bush is expected to sign. The SEC questions the practicality of a report justifying independent board chairmen simply because there are only 14 funds with a track record with independent chairmen, nine of which are bank-managed funds required to do so under the Glass-Steagal Act.
Even though the legal battle will continue, fund complexes are already making arrangements for implementation. The Independent Directors Council task force last Wednesday released a series of guidelines for fund companies to consider that will help ensure a smooth transition to an independent chairman. The guidelines include how to set an agenda for and manage board meetings, negotiate advisory contracts and gauge the qualifications of the chair.