Should Boards Be Blamed for Fund Follies?

Which type of dog are the boards of directors at mutual funds: watchdog or lapdog?

The fund industry and its critics are asking this question amid the widening fund scandal -- and the answers diverge greatly.

The scandal involves allegations that fund firms allowed hedge funds to engage in improper "market-timing" or illegal "late trading" of mutual funds to the detriment of individual and institutional investors. Directors are charged with overseeing the daily pricing of funds, and the Securities and Exchange Commission says the primary role of directors is to be the watchdog for fund investors' interests. If this is the case, should the boards have been able to flag questionable trading practices before they came to light in New York Attorney General Eliot Spitzer's complaint on Sept. 3?

"Yes, directors should've detected this -- it's as easy as rolling off a log," said Vanguard Group founder John C. Bogle. Bogle is a staunch critic of most fund boards -- he has called them "lapdogs in disguise" -- and he isn't alone. Mercer Bullard, a former SEC attorney and founder of fund shareholder advocacy group Fund Democracy also believes fund directors should've detected questionable activity and says the scandal provides further evidence of the "continued irrelevance of fund directors."

Others strongly disagree, noting that directors didn't have reason to do detective work for fraud until recently. "It would have been extremely difficult for any mutual board to have detected this -- until Spitzer, there wouldn't have been a reason for directors to have thought about it," said Barry Barbash, an attorney with Shearman & Sterling LLP in Washington and former director of the SEC's investment management division.

The scandal now has industry officials, critics and regulators poring over every aspect of the business -- looking for cracks in the system that enabled abusive trading strategies to proceed unchecked. While the internal investigations under way at the nation's mutual fund firms are highly unlikely to turn up any malfeasance on the boards, the ability -- or inability -- of boards of directors to safeguard the interests of fund investors looms as an increasingly important question in the effort to right the industry.