Duties for independent mutual fund directors piling up

July 20, 2011

The people whose job it is to protect shareholders’ investments in mutual funds nowadays — members of fund boards of directors — not only may be called on to do more things than any time since the Investment Company Act of 1940 created their positions; but they also have more power than ever before when dealing with the managements whom they oversee.

That is especially true for independent directors, who have been required to hold a majority of all funds’ board seats since 2002 and who are increasingly assigned additional responsibilities, most recently resulting from the mutual fund insider scandals revealed in 2003 and the 2007-2008 financial crisis.

When Congress drafted the 1940 act to supplement state business laws with federal mutual fund regulations, it faced a challenge. Unlike ordinary companies with internal managements, mutual funds were managed by the external investment adviser firms that sponsored them — and that tended to pick agreeable people to serve on the boards.

There were differences in the Senate and House on how to provide for two categories of directors: those who were “affiliated with” advisers and those who were not. They could easily be on opposite sides of an issue, as when advisers wanted higher fees, which could raise shareholders’ costs.

While the Senate bill required independents to have a majority, the House bill gave “affiliated persons” up to 60 percent of board seats. The House bill, limiting independents to 40 percent out of fear that an independent majority might reject an adviser’s recommendations, became law.

Both houses agreed on two major points: Funds using affiliated advisers required boards with independent majorities and only majorities of independent directors could approve contracts with advisers and principal underwriters.

It would be 30 years before Congress would correct a major flaw in the act with a word change, replacing “affiliated person” with “interested person,” which reclassified board members who had ties to advisers but were not counted as “affiliated” directors.

It would take another 30 years — until January 2001, when most fund boards had independent majorities through some clause — that SEC Chairman Arthur Levitt and his fellow commissioners approved an SEC rule amendment requiring all funds to have them.

For Levitt and his team — led by two directors of the SEC’s Division of Investment Management, Barry P. Barbash and Paul F. Roye — it was the culmination of years of effort, starting in 1995.

That’s when Levitt called for “greater and more effective involvement by fund boards — especially independent directors” — at the Investment Company Institute’s annual meeting. By his return in 1998, he could announce an SEC Roundtable discussion on fund governance.

Held in February 1999, the roundtable paid off. Participants agreed on three key recommendations in addition to the one to require all fund boards to have independent majorities. The four were incorporated in a rule proposal in October 1999 and survived the rule’s final revision.

The other three:
1.    Existing independent directors should choose who would fill vacancies.
2.    Independent directors should have independent counsel.
3.    So that shareholders could judge independent directors’ independence, they should get more information about them.

Why did all this matter?

“A majority requirement will permit, under state law, the independent directors to control the fund’s ‘corporate machinery,’ i.e., to elect officers of the fund, call meetings, solicit proxies, and take other actions without the consent of the adviser,” the commission said.

In control, and armed with powers to represent shareholders in hand, the world did not wait long to give independent directors new work to add to their historic load.

Three examples illustrate major issues:

Mutual fund scandals
Cases of illegal conduct, brought against fund insiders starting in September 2003, confirmed the need to require all funds to have effective compliance functions. Proposed early in the year, rules were adopted by year’s end, providing “funds, their directors and advisers the tools they need to root out these evils,” as Roye told commissioners. They required funds to adopt and implement compliance policies and procedures and to designate chief compliance officers. Directors — including majorities of independents — had to approve them. CCOs would report directly to boards, which would control their pay.

Run on money market funds
After watching money market funds experience substantial losses on holdings in 2007-8, the Commission proposed a money market fund reform rule in June 2009. The goal: to make such funds more resilient to risks. (One fund “broke the buck” in September 2008 and priced shares at 97 cents, which led to a run primarily on institutional money market funds.)

Approved in January 2010 after revisions to reflect comments, the rule provided several new functions for money market fund directors. Examples: designate at least four credit rating agencies whose ratings will be used to determine the eligibility of securities, determine annually that the firms’ ratings “are sufficiently reliable,” and permit funds to take steps “to facilitate … orderly liquidation” if directors, including majorities of independents, approve.

Dodd-Frank Directive
When in July 2010, Congress passed and President Obama signed the Dodd-Frank Act, the SEC — like other agencies — was directed to replace references to credit ratings in its rules with alternative criteria of creditworthiness.

Although its reform package had barely become effective and although the Commission had “found no evidence that over-reliance on … ratings contributed to the problems that money market funds (had just) faced,” it had to comply with the new law.

It, therefore, responded in March with a rule proposal, which, among other things, would have a money market fund’s board determine that a security’s issuer has “the highest capacity to meet its short-term financial obligations.”

The Commission received comments in April but has yet to issue a final rule.

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