Pretty Please, Can We Sue You?

Updated from 8:13 a.m. ET March 7

As if the likelihood of winning a lawsuit against the manager of a mutual fund weren't slim enough already, Maryland is trying to make it virtually impossible.

In many cases, shareholders can sue their mutual fund manager only if they first ask the fund's directors to do so on their behalf. If shareholders want to sue the manager directly, they must show that the directors are not truly independent of the manager. The Maryland Legislature is considering a bill that would make it impossible to make this showing.

Complete Immunity for Conflicted Directors

The Maryland bill would require that courts treat any director who is independent under federal law as independent under state law as well.

Unfortunately, federal law requires independent directors to show very little independence. Under the law, a director can be independent even if he engages in transactions with the fund, used to work for the fund's manager, or owns stock in companies in which the fund invests.

Imagine a wayward money market fund manager who lost all of his fund's money investing in technology stocks, and then quit his job to join the fund's board. He would be an independent director under federal law, which means he could then refuse to sue his former employer on behalf of the fund. And the Maryland Legislature would consider his vote to be independent.

Federal law requires that just 40% of a fund's board of directors be made up of independent directors (this will increase to 50% when recently adopted rules take effect next year), which means funds will always be able to find ostensibly "independent" directors to reject shareholder lawsuits -- regardless of how biased they may actually be.

Even if you don't live in Maryland, the proposed legislation still could restrict your ability to sue a mutual fund incorporated there. A fund can incorporate anywhere, regardless of where its offices are located, and Maryland's management-friendly laws have made the state one of the most popular homes for funds.

Last year I wrote about a questionable transaction between the State of Wisconsin Investment Board and two Heartland bond funds just before the funds wrote down the value of their portfolios by 70% and 44% in a single day. Milwaukee-based Heartland is incorporated in Maryland.

The deal appeared to have been the brainchild of the chairman of Wisconsin's investment board, Jon Hammes, who also is an independent director of the funds.

It isn't clear whether Hammes, as investment board chairman, took advantage of the funds, but the question has been raised. Under the proposed Maryland law, however, Hammes would have the chance to vote down any shareholder lawsuit against the Wisconsin board.

In most other areas of mutual fund governance, independent directors must meet the stricter standards of the Securities and Exchange Commission, which is authorized by Congress to deem a person to be nonindependent if he has a conflict of interest not covered by the narrow federal law.

The SEC has never had to formally deem a director to be nonindependent, choosing instead to warn funds that it would not tolerate the counting of directors with significant conflicts toward the 40% independent minimum.

In fact, in late 1999 the SEC published a laundry list of relationships between directors who were independent under federal law but who would draw the SEC's fire if counted toward the 40% independent director minimum.

Yet under Maryland law, directors who could never pass muster under SEC standards would be deemed independent, no matter how biased in favor of management they might be. Some Maryland legislators apparently believe that a director who was formerly employed by the fund's manager can exercise independent judgment when deciding whether to sue his former employer.

Compensation Packages or Payoffs?

The board of the Dreyfus Funds illustrates the problem. The chairman is Joseph DiMartino, who previously was president of the funds' manager, the Dreyfus Corp.

DiMartino is technically an independent director under federal law, but the SEC probably has told the funds that they cannot count DiMartino toward the 40% independent minimum. That's why 100% of DiMartino's fellow directors are truly independent -- to fend off a SEC lawsuit claiming that the board doesn't meet the 40% minimum.

Under Maryland law, however, courts would be required to give DiMartino the deference afforded a truly independent director, even when considering whether a Dreyfus fund should sue DiMartino's former employer.

Even the trade group for fund managers, the Investment Company Institute, appears to disagree with the Legislature on this point. The ICI has specifically recommended that former officers of a fund's manager not serve as independent directors.

DiMartino's former affiliation with Dreyfus Corp. isn't the only evidence that his judgment might be less than independent. The funds pay DiMartino $805,537 annually, or 4.5 times the $176,613 received by the next-highest-paid Dreyfus director, and more than twice as much as any other fund director in the industry.

Top-Dollar Director The best-paid directors at five other large fund companies don't get even half of what Dreyfus pays Joseph DiMartino.

Source: SEC filings

The Maryland legislation is in response to a 1997 court finding that the amount of directors' compensation or the number of funds they supervise (DiMartino oversees 194) could disqualify them as independent under Maryland law.

The court's questionable holding did not stick, and virtually every court since has rejected its argument that compensation or extensive board duties may adversely affect a director's independence.

Nonetheless, the fund industry pushed legislation that threw out the baby with the bath water, ensuring that even Hammes and DiMartino's independence could never be questioned. It also insisted that the law be retroactive, in order to cut off lawsuits that have been crawling through the courts for years.

Unreasonable Reasoning

Reasonable people could disagree about whether a director's compensation, or the large number of boards on which he serves, could impair his independence. Although this kind of fact-specific determination is generally best left to courts, I would concede that one could defensibly prohibit, for example, courts from judging directors' independence based on the number of fund boards on which they serve.

But one could not reasonably argue that a director who qualified under the very narrow federal definition of independence must always be considered independent for all purposes.

I'll be testifying against the legislation at hearings in Annapolis, Md., on March 7. If you'd like to join me in fighting for fund shareholders' rights or want to give Maryland legislators an earful, go to the Fund Democracy Web site for more information.

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Update: The March 7 hearing was rescheduled for March 28. So there's still time to visit Fund Democracy's Web site and let the Maryland legislature know your views.