SEC Strikes Down Fund Leadership
June 28, 2004
For mutual funds, it was the shot heard round the world.
A heated debate over whether mutual funds should have an independent chairman came to a head Wednesday, as the Securities and Exchange Commission voted to approve a new rule mandating that fund chairmen can no longer be employees of a fund's management company.
In a nail-biting three-to-two decision, the SEC adopted a rule that will force several thousand funds to reshuffle their governance structure in response to a widespread trading scandal that soiled the reputations of some of the nation's biggest fund houses. Another controversial rule requiring a 75% independent board was also approved
The move strikes a powerful blow to the balance of power at an overwhelming majority of fund companies, including fund giants Fidelity Investments and The Vanguard Group, whose chairmen have aggressively lobbied to maintain their posts.
"The leadership of the independent chairman will be the critical pivot point for avoiding potential conflicts of interest that can in the future lead to new forms of mismanagement, non-compliance and even fraud," said SEC Chairman William Donaldson, at the SEC's open meeting in Washington last week.
Tilting at William
Donaldson's sentiment, however, was not shared by all of his fellow commissioners, most notably Cynthia Glassman, one of the two Republican commissioners on the panel. Glassman argued that the independent chairman rule "will not help investors," and there is potential for "negative consequences." Underpinning her position is the fact that there has been no empirical data to support the claim that funds that have an independent chair perform better, have lower costs or are less susceptible to instances of fraud.
Donaldson countered Glassman's argument by saying that empirical evidence is not definitive and that rulemaking should be based on experience, anecdotal evidence and just plain common sense. "Neither logic nor the law says that rulemaking must be grounded in empirical evidence," said Commissioner Harvey Goldschmid, a Democrat who voted in favor of the rule.
Fellow Democrat Roel Campos echoed that sentiment, saying, "There are no empirical studies that are worth much." Overall, the proponents of the rule stressed the importance of getting the right information in the hands of the trustees. Throughout the scandal, it has been revealed that many board members were shielded from information that would have tipped them off to any wrongdoing.
Republican Commissioner Paul Atkins, however, scoffed at the notion that the rule would bring about positive change. "Gut feelings, even if dressed up as common sense or logic, are not sufficient grounds for reorganizing the boardroom," he said. "I'm concerned we're digging for fool's gold." He pointed out that tainted fund firms Putnam Investments, Bank One and Bank of America each had an independent chairman in place when the improper market timing and illegal late trading took place. Ultimately, it was Donaldson's vote that broke the deadlock between the Republican and Democratic commissioners.
Gaming the Cost
Another concern of the opposed was the additional cost that would come along with sweeping the boardroom floor of interested chairmen. Glassman questioned the merits of asking 80% of the fund industry to change its governance structure and requiring the shareholders to pay for it. "There is a countervailing pressure at work," Glassman said, adding, "The benefits are illusory, but the costs are real."
John Buckingham, portfolio manager of the $261 million Al Frank Fund, believes that the SEC is headed down the wrong path with the independence rule. "It's a big mistake," Buckingham said. "You're going to have less-informed people running mutual funds, and it's going to cost more money."
Rather, he favors letting the market dictate what is ultimately the right thing to do for the industry. "Shareholders can vote with their feet. We've already seen that with Janus having huge outflows." Buckingham also noted that 2004 is an election year, suggesting that regulators and politicians have to appear like they are doing something to combat the bad guys who stole money from the little guys.
Others had a more evenhanded response. "I don't think the cost will be oppressively burdensome," said Mark Perlow, an investment management attorney and partner at law firm Kirkpatrick & Lockhart. "But to do the job right, independent chairs will have to commit more time through more communication with management. And it's only fair that this person receive additional compensation."
"It will be a small cost in relation to all the potential good it can bring to investors if independent boards actually negotiate on behalf of investors' interest," said Gary Gensler, former undersecretary of the Department of the Treasury and author of The Great Mutual Fund Trap. "Much greater cost is the $100 billion of excess fees that are now bearing down on investors."
Although he acknowledged that this is a significant governance reform and that it addresses an "obvious and inherent conflict of interest," Gensler conceded that it is by no means a silver bullet. In order to make further strides on the governance front, he said that Congress needs to step in and more clearly define the independence of those directors and their actual duties.
Several Republican legislators on Capitol Hill applauded the SEC's action, including House Financial Services Chairman Michael Oxley (R-Ohio), Richard Baker (R-La.) and Sen. Peter Fitzgerald (R-Ill.)."There will be a new tone at the top," Fitzgerald said. "The result will be lower fees for investors because fund boards will negotiate harder."
The independent chairman rule will take effect some time during late 2005.
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