The SEC Takes Aim at Mutual Fund Directors
from Summer 1999
For half a century, outside directors of mutual funds have enjoyed virtual invisibility, which has helped them dodge the liability lawsuits that are almost routine for their counterparts in other corporations. But as most mutual fund board members may already suspect, regulators and shareholders are likely to hold them increasingly accountable on a variety of fronts, including costs, their compensation, and even losses brought on by a market turndown.
A collapse in stock prices could be a nightmare for mutual fund directors. Sixty-six million Americans have invested more than $5 trillion in mutual funds, according to the Securities and Exchange Commission, and the specter of even a small percentage of them joining in a class-action liability suit is truly daunting.
“It is only a question of time until mutual fund directors are sued as frequently as other business corporation directors,” predicts investor rights expert and Vanderbilt University law school professor Larry Soderquist. “The most usual claims would be that the independent directors are the lackeys of the financial advisers and don’t make independent decisions or that they are negligent. I see these guys as ripe for suits.”
Shareholder activists have already begun waging proxy contests to unseat directors, particularly those at poorly performing closed-end funds. In September 1998, Deep Discount Advisors, which owned shares in the Clemente Global Growth Fund, won a proxy battle to capture three of the nine board seats.
In March, SEC Chairman Arthur Levitt launched a regulatory initiative to bolster fund board independence while revving up enforcement. Said Levitt: “From negotiating and overseeing fund fees, to monitoring performance, to policing potential conflicts of interest, fund directors should be on the front lines in defense of the shareholder’s interest.”
To that end, Levitt has proposed new rules requiring mutual fund boards to have a majority of independent directors, versus the current requirement of 40%. New outside directors would have to be nominated by current outside directors, and the board’s outside counsel could no longer have ties to management. The SEC also will require more disclosure on issues such as director compensation and service on more than one board or multiple funds within a single fund family. At Fidelity Investments, for example, just 12 board members (three insiders and nine outsiders) are responsible for all 259 of the firm’s funds.
What have outside directors to fear most? Here are some of the hot button issues:
RISING FEES. There is no issue that better illustrates the potential conflict of interest between mutual fund managers and board members than the hefty fees paid to fund managers. Basic economics of scale argue that the dramatic increases in fund assets over recent years should have cut per-share costs and boosted shareholder returns. Instead, expense ratios have risen, thanks in large part to fees paid to fund managers. Worse yet, Morningstar, which monitors the mutual fund industry, found a positive correlation between management fees and director compensation, raising questions about whose interests directors are putting first. Expect regulators, activists, and other critics to keep up the drumbeat against high fees.
SOFT DOLLARS. These are the mutual fund equivalent of frequent flyer miles. They’re rebates that money managers receive for channeling some or all of their trades through certain brokerage houses. The SEC permits money managers to use soft dollars to buy research and other items that assist them in the investment process, but this ultimately costs shareholders more in transaction fees. Brace for increased SEC scrutiny of soft-dollar arrangements.
SHARE VALUATION. Last year, the SEC successfully sued two outside directors of the Parnassus Fund, accusing them of aiding and abetting the fund manager in overstating the fund’s net asset value. Said SEC enforcement chief Richard Walker: “The responsibility of directors to ensure that the assets of their fund are fairly valued goes to the core of a director’s duties.” Expect continued SEC attention to director oversight of share valuation.
DIRECTOR COMPENSATION. Directors should be paid partially in stock to bring their personal financial interests more in line with those of shareholders, argues Morningstar analyst Russ Kinnel. “Financial planners and brokers could help by demanding that directors take a stake in the fund,” Kinnel says. Expect others to take up this refrain.
PROXY VOTING. Although mutual funds hold some 20% of all outstanding U.S. stock, currently they are not required to disclose how they vote proxies on those shares. “The SEC should issue guidelines telling mutual fund directors that voting their proxies is a fiduciary responsibility and must be disclosed,” says shareholder activist Nell Minow, a principal of Lens Inc. Watch for other activists to join in this demand.
So what’s a mutual fund director to do? Get ready for increased public scrutiny. Remember, your prime role is to defend the interests of shareholders. Raise the tough questions about fund strategies, performance, fees—even your own compensation. And last but not least, make sure your fund’s insurance policy fully protects you.
