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Turning Directors Into Savvy Watchdogs


Viewed as watchdogs by some and lapdogs by critics, mutual fund boards have arguably seen their responsibilities grow alongside the complexity and demands of the business. Directors have recently come under fire as a result of Eliot Spitzer's probe into fund trading, as they were presumably unaware of the violations. Questions of board due diligence and the adequacy of the governance structure obviously emerge.

Critics of the board structure point to a lack of independence and blame overtaxed directors, generous compensation, a high retirement age, a dearth of independents, lack of personal investment, the definition of independence and affiliated chairpersons. While all valid, some core issues still remain unearthed.

Equally valid are compliance policy adherence, board information sources, board financial expertise, contract renewal processes, sales practice transparency and the opacity of board decisions.

Several fund groups cited in the ongoing Spitzer probe engaged in some level of collusion that involved or purposefully excluded compliance personnel. An appointed chief compliance officer (CCO) should be an independent, participating member of the board. The CCO should provide reports that expose "exception events," and head up an all-independent compliance committee.

A second critical issue is the scope of board information. A board's reasonable business judgment based on partial or non-comparable data may result in invalid conclusions. An independent board support group (BSG), outside the sponsor's sphere, whose mission is to service directors would clearly promote purity and applicability of information flow.

Independent board members should be required to attend investment company business education classes -- alone, without the accompaniment of fund management. Taken one step further, an independent certification program would foster the concept of confident, savvy watchdogs with honed sleuthing skills.

At the heart of a board's responsibilities is advisory contract renewal. Using an onerous amount of information, a board must determine whether the performance of a sponsor warrants renewal of an advisory contract for another year. Key to the process is a stringent outline of what information must be reviewed and in what form. For instance, should the board demand a lower advisory fee if a fund places in the fourth quintile in a peer group?

In the limelight of late, all distribution schemes should be comprehensively disclosed to a board; absent a regulatory requirement or firm SEC guidance, voluntary disclosure is unlikely. Most importantly, any sales arrangements whereby an advisor realizes a level of tertiary benefits, e.g., soft-dollar payments, etc., should be fully analyzed by the board and justified by the advisor. Any activity that builds distribution muscle and/or secures shelf space, such as revenue sharing and directed brokerage, should be disclosed and reviewed.

Similar to the current requirement that contract renewal rationale be disclosed in a fund's statement of additional information (SAI), the ability for investors to see the reasoning behind critical board decisions, surely will promote competition and diligence.

Prior to Mr. Spitzer's realization that several fund groups were in direct violation of their own policies, directors could have potentially done more to prevent fraud. More hard-nosed questions could have been posed and a healthy level of skepticism could have been employed.

The fund business is undoubtedly moving into an era whereby boards will ask more, probe more, trust less. Armed with a rigorous education, a CCO in their ranks, independent administrative support amongst other items, fund governance will finally attain a higher standard.

Jeffrey C. Keil is vice president, Global Fiduciary Review, at Lipper. Money Management Executive welcomes letters to the editor or op-ed pieces at: elizabeth.barney@thomsonmedia.com.

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