New Rules for Independent Directors Will Give Funds More Above-Board Boards

With much fanfare, the Securities and Exchange Commission held a public meeting more than a year ago to propose rules designed to strengthen the role of independent mutual fund directors. In contrast, the SEC quietly adopted the rules last week, just barely completing its fund governance initiative before Chairman Arthur Levitt leaves office next month.

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On the whole, the SEC's proposals survived intense industry lobbying, and the result should be independent fund directors who are more effective advocates for shareholder interests.

The rules will increase in many cases the number of independent directors on fund boards and give them the authority to nominate new independent directors; require that counsel to independent directors also be independent; require disclosure of how much directors invest in the funds they oversee and of conflicts of interest between directors and fund shareholders.

While the reforms won't turn independent fund directors into zealous shareholder advocates overnight, increasing their number and authority will give them more leverage. More importantly, independent directors who are nothing more than cronies of fund affiliates will be exposed by new disclosure requirements, resulting in a more above-board board.

A Structure Fraught With Conflicts

An independent director is one who is not legally affiliated with the fund's investment adviser or other fund affiliates. Forty percent of a fund's board must be independent, a minimum Congress adopted to ensure the boards included directors whose allegiance would be to the fund, and not to the fund's investment adviser. Nonindependent directors usually are executives of the investment adviser.

The unique structure of mutual funds makes the role of independent fund directors critical to protecting shareholder interests. Mutual fund managers do not work for the fund. Rather, they contract with the fund to provide advisory and administrative services, and owe their primary loyalties to the adviser's -- not the fund's -- shareholders. As stated succinctly by the SEC, mutual funds are "organized and operated by people whose primary loyalty and pecuniary interest lie outside the enterprise."

For years, the SEC has sought legislation to strengthen fund boards by, for example, requiring them to have a majority of independent directors. The fund industry successfully stymied these efforts, so the SEC decided it would enact reforms on its own.

With admirable ingenuity, the staff found a way to legislate by rule. The SEC has adopted a number of exemptive rules without which funds could not engage in many common practices, such as charging 12b-1 marketing fees and offering different classes of shares with different sales charges (front-end loads, back-end loads, etc.). It simply made compliance with the new fund governance requirements a condition of relying on these rules, thereby requiring virtually all funds to comply with them as if they were law.

Give Independents the Upper Hand

The new rules require that fund boards have a majority of independent directors, an increase from the current 40% minimum. The vast majority of boards already have a majority of independent directors, and many are two-thirds independent.

For the minority of funds that have kept their independent directors in the minority, making them a majority will give them some added clout, but in some cases their authority may still be limited. Some state statutes and fund bylaws require greater-than-majority board approval to take certain actions. In those circumstances, the fund's adviser will be able to block independent director initiatives.

There really is no good reason for a fund not to have 100% independent directors. The fund industry has argued that fund boards need the expertise of executives of the fund's adviser. But their expertise is at the fund's beck and call, regardless of whether they serve as directors.

Independent Directors Choose Their Own

The new rules require that new independent directors be nominated by sitting independent directors. Again, most funds already are in compliance. This requirement will affect few funds. The vast majority of funds already have self-nominating independent directors because they are required to do so if any fund overseen by the directors charges 12b-1 marketing fees.

For the few funds that do not have self-nominating independent directors, the new rule will make it more difficult for the fund's adviser to install its candidates on the board. Nonetheless, there is no way to establish an impassable wall between fund directors and fund management, and management will still be able to "suggest" prospective independent directors.

Still, the new requirement may stiffen independent directors' resolve in disputes with the adviser. Previously, the adviser could nominate a slate of independent directors as replacements, and the only cost was that it could no longer collect 12b-1 fees. This happened to the (YACKX)Yacktman fund and the (YAFFX)Yacktman Focused fund in 1998 when Donald Yacktman, president of the fund's adviser, replaced the fund's independent directors with his own nominees.

A fund can continue to operate without collecting 12b-1 fees, but in many cases it cannot function without being able to rely on other rules to which the nomination requirement now applies. As noted above, one of these rules permits funds to offer multiple classes of shares with different commission structures. The new rule will deter advisers to such multi-class funds from deposing insurgent independent directors because nominating replacements would prevent the fund from selling shares.

See Part 2.

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