A profound change in the way mutual fund governance is viewed is rippling through the industry, set off by revelations of abuses involving market-timing and late-trading, as well as by greater awareness of the sometimes high undisclosed costs borne by shareholders.
Much like the corporate scandals that led to the passage of the Sarbanes-Oxley Act and the creation of a slew of new requirements by the Securities and Exchange Commission (SEC) and the stock exchanges, these revelations have provoked outrage and stoked a groundswell of calls for mutual fund governance reform. Industry critics call the abuses a betrayal of trust and fiduciary responsibility, and accuse mutual fund boards of displaying a tameness toward management exceeding even that of corporate boards. Only a dramatic change in the culture of the industry and a meaningful improvement in the effectiveness and independence of mutual fund boards, they say, will halt abuses and rein in fees.
In short, mutual fund boards have been put on notice. They now face an unprecedented degree of scrutiny from regulators, legislators and investors, who are demanding that mutual fund boards become more involved and more accountable. Increasingly, boards are expected to ask more questions, have resources to independently measure the performance of the management company, and challenge fund management when it raises proposals that might run counter to the best interests of shareholders.
SEC Chairman William H. Donaldson underscored the new expectations of fund boards, and independent directors in particular, during a January 2004 Mutual Fund Directors Forum: “You are the investors’ first line of defense in ensuring that their interests are being served, that conflicts of interest are appropriately managed and disclosed, and that investors’ money is being managed responsibly. While the SEC shares this mission to protect investors, we cannot be in the boardroom when investors’ interests may be compromised. Investors are depending on you to stand up for them.”
Some independent directors may feel uncomfortable with this growing set of expectations and new level of accountability. But with the forces for reform now in motion, independent directors can and should seize the opportunity to improve governance, pushing the board to become more independent and effective as a result.
Renewed focus on governance
Mutual funds have become a primary investment vehicle for millions of American families, especially for retirement and college tuition savings. Some 90 million Americans have invested more than $7 trillion in mutual funds. According to the SEC, by the end of 2002, mutual funds were entrusted with approximately 21% of the $10.2 trillion US retirement market and 98% of the $18.5 billion placed in Section 529 college saving plans.
Well before mutual funds became such an important avenue for investment, the US Congress recognized the potential for abuse and conflict of interest inherent in investment companies. The Investment Company Act of 1940 established specific requirements for board independence and assigned unique oversight responsibilities to the board, including approving the fund’s contract with the investment adviser, valuing certain securities held by the fund, approving the management company’s advisory fee, and monitoring and protecting against conflicts of interest.
Critics charge that, despite this congressionally mandated “watchdog” role, trustees have acquiesced too readily to the demands of fund management companies, failing to protect investors from conflicts of interest, question excessive fees or halt ethical breaches such as short-term trading or illegal activities such as late-trading. The SEC has announced disciplinary actions or settlements against more than two dozen companies for those activities and others that harm long-term fund investors. And in case any mutual fund trustee remained complacent in the face of these developments, the SEC and New York Attorney General Eliot Spitzer forced out eight of the directors of one troubled fund as part of a civil-fraud settlement agreement, alleging that the board failed to look out for the best interests of long-term fund shareholders.
In addition to the stepped-up enforcement efforts, regulators and legislators have responded to these scandals with calls for new regulations aimed at increasing fund transparency and enhancing the effectiveness and independence of mutual fund boards. The US House Financial Services Committee, for instance, has approved an amendment that would require mutual fund boards to select a “lead independent director,” who would have the authority to place items on the agenda, call meetings and obtain outside advice on behalf of the independent directors. And, in June, the SEC formally adopted a number of new governance requirements, which:
- Increase the percentage of independent directors to 75% (from 40%) and name an independent chairman
- Require separate meetings of the independent directors at least once a quarter
- Provide for independent director staff
- Require an annual self-assessment
It’s not just legislators and regulators who are pushing governance reform. Joining the growing chorus for reform are some of the largest pension funds. The California State Teachers’ Retirement System recently adopted a new set of disclosure and independence standards that mutual funds must meet to receive investments from the pension plan. Other public pension funds are considering similar measures. Some large investors are going even further, calling on mutual fund directors to “fire” the management companies of poorly performing or poorly managed funds. While many in the industry view this approach – which, like an endowment or pension fund, treats the management company as a vendor – as an excessive remedy absent evidence of significant mismanagement or misappropriation, it underscores the growing demands for governance reform facing mutual fund directors.
Creating a culture of independence
Even as the discussions about new regulations continue, independent directors have the opportunity to take the lead in improving board governance by ensuring that the board truly is independent and qualified, and by increasing the transparency of the nominating process. First and foremost, the independent trustees need to take responsibility for nominating directors.
Like their corporate counterparts, many mutual fund boards have relied on the recommendations of management to fill board vacancies, even for independent directors. Sarbanes-Oxley, for example, addresses this concern, requiring corporate boards to establish a nominating committee of independent directors. Mutual fund boards can demonstrate their independence by doing the same. Already, we have seen movement in that direction as, increasingly, mutual fund director searches are originating with the boards, themselves, rather than the fund companies.
Nominating committees also need to have the resources to identify and attract the right trustees. Up until now, few mutual fund boards had their own staff or the resources to hire outside consultants, and had to rely on the fund management company for information and analysis. Regulators have recognized that this, too, must change if mutual fund boards are going to be as independent and effective as they need to be to safeguard investors’ money. Recognizing this need, the SEC’s proposed rules include a requirement that the fund authorize independent directors to hire their own staff to deal with matters on which they need outside assistance.
Finally, directors need to give careful consideration to the types of skills and expertise that the board should include. Along with a lack of independence, mutual fund boards have been criticized for lacking the financial and investment expertise to question the decisions and practices of mutual fund management. Directors need to be knowledgeable enough to assess how fund managers are performing, whether management fees are appropriate and what risk and compliance issues the funds face. Each board should establish minimum standards for the skills it should possess collectively. These could include investment management experience, financial expertise, and knowledge of risk analysis and investment law. The board can use its annual self-evaluation, which would be required by the SEC’s new rules, to continually review its composition and independence.
Where can individuals with the necessary skills be found? We believe that many highly qualified and independent candidates are available and willing to serve on mutual fund boards. Among the possibilities are retirees from mutual fund companies and investment companies, members of endowment, pension and foundation funds or their boards, institutional investors, academics in the area of finance, and attorneys who specialize in investment law. As fund boards assume more responsibility and independence, the pool of qualified candidates will continue to grow and boards are more likely to attract knowledgeable and effective professionals.
Conclusion
While many observers now argue that greater due diligence on the part of mutual fund boards may have prevented some of the worst of the abuses that have been revealed recently, it wasn’t long ago that some voices in the debate about mutual fund governance questioned the need at all for oversight by a fund board. After all, the argument went, mutual fund customers always could “vote with their feet” and leave underperforming or poorly managed funds, and effective regulation would prevent abuses. Many would consider that a naïve view today.
Mutual fund industry misdeeds have shaken confidence in the industry, one that millions of Americans are relying on to fund their retirement and their children’s education, and drawing renewed attention from regulators and legislators. Mutual fund boards – and independent directors, in particular – can take the lead in improving board governance by ensuring that the board is truly independent and qualified, and by increasing the transparency of the nominating process. To do this, boards need to take responsibility for nominating directors and establish standards for the collective knowledge and expertise directors must possess. Fortunately, we believe many highly qualified individuals will welcome the opportunity to join more independent and effective mutual fund boards.
By increasing the transparency of the nomination process so that investors can be confident that directors are not beholden to anyone and are free to make decisions in their best interest, mutual fund boards will go a long way toward rebuilding investor confidence.
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