The wait for details on the SEC's new fund independence rules is over, for last Tuesday, the Commission released its final regulations.

The new rules will require that all fund board chairmen, as well as 75% of the board's members, be independent of management. It will also mandate that at least once a year, the board analyze the effectiveness of its committee structure and number of funds it oversees, that independent board members meet at least once each quarter without management to privately discuss any issues they have, and that independent directors be given full authority to hire "employees, advisers and experts" to fulfill their watchdog duties.

There is one exception, however. At fund groups with only three board members, the SEC will consider the new requirement met if only two directors, that is, a lower 66.6% threshold, are independent.

The new rule also stipulates that fund boards retain all materials used in consideration of their renewal of a fund's advisory contract for a period of six years and have the past two years' documentation readily available for inspection.

The rule will take effect Sept. 7, with compliance mandated by Jan. 16, 2006. That gives fund boards 16 months to come into full compliance.

The new regulations follow a June 23 3-2 split vote in favor of the proposals, designed to empower fund trustees and make boards more independent. The original, hotly debated regulations were initially floated for comment this past January as part of the SEC's larger goal to reform mutual fund regulations and better empower boards.

Criticism at All Levels

The proposed regulations caused dissension among industry participants, many of whom support further board independence, and fund company executives, many of whom believe that requiring both a 75% supermajority of a board and its chairman to be independent is a vast regulatory overreaction.

SEC Commissioners Cynthia Glassman and Paul Atkins voted against adopting the regulations as proposed. In a 12-page-long opinion, the two said that they believe the 75% independence threshold, along with mandating an independent chair, is unnecessary. They noted that although proponents think the new regulations will "strengthen the hand of the independent directors" at a minimal cost, there is no hard evidence to support such a claim. Moreover, the two argue, the SEC hadn't made a serious assessment of previous regulatory reforms to gauge if they are inadequate or entertained alternative solutions.

The SEC last mandated new rules governing mutual fund governance in January 2001 when it required, among other things, that a majority of fund board members be independent along with their counsel, who may not also serve as counsel to the fund. Previously, the 40 Act had only stipulated that 40% of a board be classified as independent.

But Commissioners Glassman and Atkins weren't the only regulators with harsh words. In its regulatory release, the SEC openly implored independent directors who are responsible for electing new trustees to look beyond minimum, broad-based statutory independence requirements. "We urge independent directors to examine whether a candidate's personal or business relationships suggest that the candidate will not aggressively represent the interests of fund investors," the SEC said. "Persons who have served as executives of the fund advisor or who are close family members of employees of the fund, its advisor or principal underwriter would, in our opinion, be poor choices for candidates."

The SEC also encouraged boards to select independent directors "who have the background, experience and independent judgment to represent the interests of fund investors."

All in the Family?

Although the SEC did not specifically cite any funds that had violated the spirit of that independence rule, several fund groups could fall under that characterization.

Case in point is the Jacob Internet Fund, managed by Jacob Asset Management of New York, which debuted in 1999 at the height of the Internet frenzy. The fund is managed by Ryan Jacob, the former star portfolio manager of the Kinetics Internet Fund, which rewarded investors with an eye-popping 196.1% return in 1998 and an even more stunning $216.4% return in 1999.

When Jacob left Kinetics to strike out on his own, he appointed his uncle, Dr. Leonard Jacob, a medical doctor who has served as the executive of two pharmaceutical firms for several years, to his fund board, anointing him as an "independent" director. But the doctor's family ties to the fund company's founder had fund governance critics and even the Investment Company Institute's top brass scratching their heads.

In a press conference last October at which the ICI announced its own series of board management "best practices," Matt Fink, then president of the ICI, referred to a certain fund company founder who had given his uncle a board seat. Later that same month, the Jacob Internet Fund filed a prospectus amendment with the SEC, noting that its fund board had recently voted to re-classify "Uncle Len" as an interested director.

But it isn't just relatives the SEC now appears to object to. The Commission is also concerned with former fund executives who return to a complex after the required two years' absence to serve as so-called independent directors. While the SEC's new rules do not change the current minimum absence, the SEC cautions that former executives who return after such a short period may not, in fact, be independent. Detractors have long said that former executives serving as independent directors may be detrimental to board governance and not be able to participate in arm's-length negotiations with advisory firms.

In their opposition letter, Commissioners Glassman and Atkins noted that the SEC's own acknowledgment of the existence of differences between statutory independence and real independence, suggests the need for an amended law. However, while the SEC can implement rules to carry out investment company statutes, it would, literally, take an act of Congress to redefine what constitutes trustee independence.

The example often cited involves Joseph DiMartino, the 60-year-old chairman of the board of the Dreyfus Funds in New York. In 1994, DiMartino resigned his various executive posts within Dreyfus and its affiliates, but just a year later, became the fund group's chairman of the board and an independent board member in 1997. Since then, there's been a debate over whether DiMartino is truly independent, even if he meets the current minimum standards of law. His current $815,000-plus annual compensation for serving as board chairman has also raised eyebrows.

Dreyfus has long considered DiMartino an independent chairman and continues to do so. "One hundred percent of the board members of the Dreyfus funds are independent, including the chairman," Dreyfus said in a statement, adding, "Joseph S. DiMartino continues to qualify as an independent director under current law."

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