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| Best Practices: On the Board |
Fund Follies
Gayle B. Ronan
08/01/2005
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There are bad doctors, bad lawyers, even bad mutual fund employees,” says
James Bodurtha, the independent chairman of Merrill Lynch Funds who is also
chairman of the Independent Directors Council (IDC), an affiliate of the
Investment Company Institute (ICI), the mutual fund lobbying group. For Bodurtha
and every director who takes fiduciary responsibility seriously, the recent
spate of mutual fund industry scandals involving late trading, inappropriate
market timing activities and misuse of nonpublic information about fund
portfolios was as inconceivable as it was embarrassing. But the misdeeds were
not widespread. “It’s a mistake,” Bodurtha says, “to generalize and tar a whole
industry based on the actions of a few.”
Yet the Securities and Exchange
Commission did just that, in the eyes of many fund directors, when it amended
the Investment Company Act of 1940 to require that 75 percent of any given fund
board, including the chairman, be independent. (The prior mandate was 40
percent.) The ruling is scheduled to go into effect January 16, despite the lack
of evidence that greater independent control of any board would have prevented
the scandals. The SEC itself has acknowledged, in a 78-page report released on
May 3, that there is no conclusive evidence that investors in funds with
independent chairmen benefit from stronger fund performance or lower fund
fees.
TOP VIEW
The SEC has been hard-pressed to justify a new rule requiring mutual fund boards
to boost their number of independent directors, issued in response to the
scandals of the recent past. But those serving on mutual fund boards may find
this diktat is the least of their regulatory problems. |
In fact, the poster child for the industry scandals, Putnam
Investments, was also the poster child for “good” governance. It had a
supermajority—75 percent—of independents, independent staff and independent
counsel.
The lack of proof or support for how the amendments will improve
governance prompted SEC commissioners Cynthia Glassman and Paul Atkins to take
the unusual action of dissenting, accusing the other three of engaging in
“regulatory fiat.” This is also why the U.S. Chamber of Commerce filed a lawsuit
on behalf of several of its mutual fund members—unnamed of course—claiming the
SEC’s uncharacteristic speed and lack of due diligence was unlawful. There is a
possibility that when the court rules, it will reverse the SEC’s amendments
involving independence and send it back to do its homework. The SEC declined to
comment on the issue, citing the pending litigation.
Only Skin Deep
If the SEC really wants to improve the lot of shareholders,
evidence is increasingly pointing to another tactic: requiring that directors
have skin in the game. A study released in April called “Does Skin in the Game
Matter? Director Incentives and Governance in the Mutual Fund Industry,”
by professors Martijn Cremers (Yale School of Management), Joost Driessen
(University of Amsterdam), David Weinbaum (Cornell University) and Pascal
Maenhout (INSEAD) found that significant fund ownership by independent directors
correlates strongly with well-run funds and higher returns for shareholders.
The study found, however, that ownership by independent directors mattered
only if nonindependent directors also had large investments. “Contrary to recent
moves to expel nonindependent directors from the boardroom,” Cremers says, “it
is exactly those funds in which the nonindependent directors’ incentives were
aligned with those of the shareholders that we find the strongest fund
performance.”
Further, the study found no correlation between fund
performance and the number of independent directors on the board. “Independence
does matter, but it is not the whole story,” Cremers explains. What is optimal
is to attract those directors who believe in the funds—with share holdings and
low cash compensation. “The bottom line,” he adds, “is that if the SEC wants
directors to think like shareholders, then maybe the best way to do that is to
make them shareholders.”
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