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Funds Choose More Independent Directors: But Many Prefer Option, Not Requirement

The growing number of independent directors on mutual fund boards has renewed the debate over whether industry best practices should become mandatory, but few believe any regulatory action will be taken soon.

In 2006, the vast majority (88%) of fund companies reported that 75% or more of their board seats were held by independent directors, up significantly from 2004, when it was 71%, according to a survey of boards representing 7,764 funds by the Investment Company Institute and the Independent Directors Council. Also in 2006, 78% of the companies reported having an independent director in board leadership or as chairman, although only 56% had an independent chairman. In 2004, 43% of fund companies had an independent chairman and 18% a lead independent director.

"In recent years, we have seen intense scrutiny of fund governance practices," said Amy Lancellotta, IDC managing director. "We undertook this survey to examine these practices across the industry. And it has shown that fund boards are continually seeking to improve their effectiveness, clearly to the benefit of millions of fund shareholders."

The ICI/IDC survey concludes that "fund governance practices have continued to evolve in response to emerging industry standards and often well in advance of, or in the absence of, explicit regulatory requirements."

But Mercer Bullard, founder of Fund Democracy, said the ICI/IDC survey looks like an attempt to forestall final action on a new rule proposal. "The reason you have regulations is not for those who voluntarily comply, but for those who refuse to comply," Bullard said.

An independent chairman requirement is meant to stop fund managers who might engage in conflicted transactions, he said, recalling the mutual fund trading scandals of 2003.

In 2004, the Securities and Exchange Commission mandated that 75% of board members be independent, including the chairman, but those requirements were overturned by a federal appeals court in the case Chamber of Commerce v. Securities and Exchange Commission.

The rules were intended to prevent fund-affiliated board members from putting the interests of the fund company ahead of the shareholders, but the court found the rules didn't keep with the spirit or intent of the Investment Company Act of 1940, and said the high cost of hiring an independent chair could hurt smaller fund companies.

Independent Outlook

By definition, independent or outside directors are not employees of the complex and do not have personal, financial or professional relationships with the fund, investment advisor or principal underwriter. Many firms value independent directors for their fresh, unbiased outlook on company matters.

The ICI/IDC survey found that 97% of independent directors said they had never been previously employed by the complex, though some boards consider a director to be independent if they ceased working for the company for a number of years.

Studies have shown that funds run by a board with an independent chairman often have lower fees and work to negotiate the lowest prices from service providers, though this is not always the case.

Todd Cipperman, principal and founder of Cipperman & Co., a law firm that specializes in the mutual fund industry, said board independence is important, but independence alone does not mean shareholder protection. If an independent director owns too many shares in the fund company, they're no longer really independent, Cipperman said.

"If the goal is to get better protection for shareholders, there is no empirical evidence that I'm aware of that shows having an independent director will stop bad things from happening," he said.

On the other hand, an interested director will have more to lose if something goes wrong, he said.

"Instead of a reliance solely on independence, funds should also review the effectiveness of the board and the quality of the board members," he said.

"Certain mutual funds will not have independent directors unless it is a rule," Cipperman added. "You have to ask yourself, what is it you want to accomplish? A mandated rule would be somewhat burdensome, and will be more expensive, especially for smaller companies."

Bullard said the notion that independence is more expensive is a red herring. "It is complete fiction created by members of the mutual fund industry," Bullard said. "It's all about power and conflicted chairmen of fund boards not wanting to give up their positions."

Edward C. "Ned" Johnson III is both CEO and chairman of the board of trustees for mutual fund heavyweight Fidelity Investments-and he and other Johnson family members hold a 49% stake of Fidelity-but more than 75% of Fidelity's board members are independent. Johnson has been one of the most vociferous opponents of the independent chairman rule.

"We believe the rule substantially limits the discretion of the board of directors, particularly independent directors, to exercise their freedom of choice to approve anyone of their choosing," said Fidelity spokesman Vin Loporchio. "Our chairman is also the CEO of our corporation, and we believe it has worked out quite well for our shareholders."

Barbara Roper, director of investor protection for the Consumer Federation of America, said she would like to see the SEC revisit the independent director rule and at the very least require a 75% independent board, but added that there is no way to predict how quickly the SEC will act.

"Things have been known to languish [at the SEC] for years without action," Roper said.

"This is not even on Chairman [Christopher] Cox's radar screen," Bullard agreed. "He could make a decision, but he seems bent on avoiding the topic altogether."

A spokesman for the SEC declined to comment on any plans to revisit the independent director rules.

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