Continued from Part 1.

Lawyers With Only One Master

The new rules require that independent directors, before they hire a lawyer, must conclude that the lawyer's work for affiliates of the fund is "sufficiently limited that it is unlikely to adversely affect

the lawyer's professional judgment." This rule was needed because ethical rules for lawyers permit them to advise clients even when they have conflicting interests.

This proposal generated intense opposition, with the most strident resistance coming not from the fund industry, but from mutual fund lawyers. They argued that the

SEC

was regulating the practice of law, and even threatened to sue the SEC if the rule was adopted.

Fortunately, investors will no longer have to rely on "the vagaries of state or local bar enforcement" to ensure that independent directors receive independent advice, said SEC Commissioner Paul Carey in a recent speech.

"The structure of the fund industry -- where the adviser and funds are separate entities -- creates numerous opportunities for conflicts to arise," Carey argues. He believes this makes it imperative "to ensure that the independent directors receive independent legal advice in the more important conflict-of-interest situations, which come before fund boards at virtually every meeting."

Carey's view is borne out by an anecdote relayed to me by a senior partner at a major law firm who advises independent fund directors. After a board meeting in which the independent directors were particularly diligent in questioning the fund adviser's personnel, the lawyer was taken aside by an executive of the adviser. "Your job," said the executive, "is to make sure that doesn't happen. If it happens again, you're fired."

The independent counsel requirement has a major loophole, however. The rule applies when a lawyer represents the independent directors, but not when he represents the fund, even though a fund is, in fact, nothing more than its board of directors. Thus, independent directors who feel pressured to get their advice from the fund adviser's lawyer can simply redesignate the lawyer as counsel to the fund, without any real change in the nature of the legal advice provided or the persons relying on it. This loophole should have been plugged by requiring that all funds above a minimum asset size retain independent counsel.

Putting Their Money Alongside Yours

The new rules require that directors, independent and nonindependent alike, disclose within specified dollar ranges their investments in each fund on whose board they serve, and in the aggregate for the entire fund complex. This rule will let shareholders know whether their directors put their money where their mouths are.

A director should not serve unless he has confidence in the fund's adviser. If a fund is an appropriate investment for a director of the fund (e.g., a diversified U.S. stock fund for a middle-aged executive), then the director should have a significant investment in the fund. If the fund doesn't fit the director's investment needs, he should have a significant investment in another, more suitable fund elsewhere in the fund complex. What constitutes a "significant" investment depends on directors' total net worth, but knowing that at least some of their money is invested alongside yours is a good sign.

You'll have to hunt for the information, however, which will be provided only in the fund's Statement of Additional Information, or SAI. Funds aren't required to send this document to you, but you can get a copy by calling the number on the back of the fund's prospectus, or attempt to find it on the SEC's

Web site.

Binding Directors and Management

Another reason to familiarize yourself with the SAI is that the new rules require that it include new information about your fund directors' relationships with fund affiliates. Directors must disclose positions held with, and investments in, fund affiliates. They also must disclose transactions between directors and either the fund or its affiliates. The requirements also apply to directors' immediate family members.

Although the SEC says this new requirement is intended to reveal "circumstances that could affect the allegiance of fund directors to their shareholders," it is more accurately designed to reveal the allegiance of fund directors to

fund affiliates

.

Unfortunately, the rule comes too late to benefit shareholders of the

(HRSDX)

Heartland Short-Duration High Yield Municipal and

(HRHYX)

High Yield Municipal funds. These funds collapsed 44% and 70%, respectively, in a single day in October, apparently due to the directors' failure to ensure that the funds'

net asset values were accurate. (See my

Dec. 1, 2000 column for more on these funds.)

Heartland shareholders might have been interested to know that the real estate firm owned by independent director Jon Hammes developed and managed a 68,000-square-foot, half-vacant building of which the fund's adviser is the anchor tenant.

But the new rule might not even require disclosure of this blatant conflict of interest. The SEC established a $60,000 threshold for reporting conflicts, which means that unless the value of Hammes' real estate relationship exceeds $60,000, the fund will be able to keep it under wraps.

The SEC created the $60,000 threshold so industry lawyers would be spared having to make close calls about whether a director's relationship with a fund affiliate had to be disclosed. A nonlawyer might naively wonder why such close calls shouldn't be routinely decided in favor of disclosure, but as Chief Justice

Oliver Wendell Holmes

said, "The life of the law has never been logic."

The Big Picture

In the context of recent developments, these reforms represent an important step toward making independent directors more effective shareholder advocates.

Just a few years ago, no one gave fund directors a second thought. Since then, they've been the subject of countless articles criticizing their effectiveness and have increasingly been targets of SEC investigations and lawsuits. In early 1999, the SEC held a two-day conference dedicated to fund governance, to which the

Investment Company Institute

, the trade group for fund managers, responded a few months later with a report on recommended best practices for fund directors. The rules adopted last week were proposed in late 1999.

In early 2000, the

Mutual Fund Directors Education Council

, a brainchild of the SEC, was created, and it held its first conference in March. The council, which is headed by former SEC Chairman David Ruder, a

Northwestern University

law professor, held its second conference in Washington last week.

Chalk it up to the triumph of hope over experience, but one bright spot for the new year may be mutual funds managed more in the interests of their shareholders than management. With the stock market turning south, and

fund outflows setting records, more aggressive fund governance may be just what the industry needs to get back on track in 2001.

Mercer Bullard, a former assistant chief counsel at the Securities and Exchange Commission, is the founder and CEO of Fund Democracy, a mutual fund shareholder advocacy group in Chevy Chase, Md.