Law should require majority-independent boards


When Congress wrote the Investment Company Act of 1940, the framework for the regulation of mutual funds, it permitted as many as 60 percent of a fund's board of directors (or trustees) to be people affiliated with the fund or its investment adviser.

Although one objective of the act was to prevent self-dealing by insiders, members seem not to have been concerned about the potential conflicts of interest inherent in annual board votes on the continuance of funds' investment advisory contracts.

While many, if not most, fund complexes have chosen majorities of independent directors over the last 54 years, the act's requirement of a minimum of only 40 percent independents has been left intact.

That could change at last: 1994 may be the year when the law is revised to mandate majorities of independent directors and to enhance their powers as shareholders' watchdogs. It also may be the year when directors' responsibilities are significantly expanded and when their sometimes substantial compensation is subjected to greater scrutiny.

The impetus for the changes in the act is provided by a 1992 study by the Securities and Exchange Commission's Division of Investment Management.

Led by Matthew A. Chambers, associate director of the division, it proposed not only that the minimum proportion of independent directors be increased to a majority but also that they be given the authority to terminate advisory contracts and that they -- not fund sponsors -- nominate people to fill independent director vacancies.

In a talk last month at the annual Mutual Funds and Investment Management Conference, co-sponsored by the Federal Bar Association and CCH Inc. in Scottsdale, Ariz., SEC Chairman Arthur Levitt said he agreed with the recommendations. Given his support, they could be formally presented to the commission before long and, if approved, be incorporated in a legislative package for Congress' consideration.

At the same time, Levitt told the conference, maintaining public confidence in funds requires that directors give more attention to areas beyond their traditional roles to increase investor protection.

"The responsibilities of independent directors -- and the realities of today's markets -- go far beyond fee structures," he said, going on to focus on four issues:

* Derivatives.

Noting that derivatives (financial instruments such as options and futures) can be tools in managing risks and generating income, Levitt pointed out that they themselves "may present significant risks."

"Directors will have to satisfy themselves that portfolio managers have the expertise to handle them -- that their uses are in keeping with the fund's policies -- that appropriate limits are set and observed -- and that managers are not blinded to the risk," he said.

* Liquidity.

"Directors should be asking portfolio managers how liquidity determinations are made . . . what factors do they consider? Are those factors appropriate? . . . How often are they revised?"

* Shareholder activism.

Directors should look at how a fund management plays its role as shareholder of the companies whose securities the fund holds: under what circumstances -- such as fights for control -- should it be active and how active should it be?

* Personal trading.

Avoiding "any definitive comment" pending completion of an SEC study of personal trading by portfolio managers, Levitt suggested directors "start asking hard and sometimes impolite questions" about fund policies, including codes of ethics.

". . . [W]e can ill afford even the perception of conflict," he said.

As Levitt was challenging directors to do more, the SEC staff was studying public comments on a proposal to amend the proxy rules for funds by requiring more disclosure, including how much directors -- primarily independents -- get in compensation and retirement benefits. A rule is likely to be proposed by this summer.

If adopted, the statement of additional information would tell you annually -- and a proxy statement, occasionally -- not only how much directors are paid by a fund that you own but also the aggregate they receive from a fund complex if they serve on more than one board.

The figures may surprise you. According to Lipper Analytical Services, directors' annual compensation ranges from $500 at a small fund to $300,000 at one of the biggest complexes, where directors may serve on more than 75 boards that hold monthly meetings. Of the top 20 fund groups, 13 pay directors $100,000 or more, Lipper reports.

When Levitt chaired the commission meeting at which the proposal was discussed prior to voting to request public comment, he asked Barry Barbash, director of the Division of Investment Management, whether he felt there is any correlation between a fund director's compensation and his independence "once it passes a given level" -- a question that has come up occasionally over the years.

"There has to be a certain level where independence is questioned," Barbash replied. "The problem is really determining where independence has been compromised due to the amount of compensation. I'm not sure where to draw the line."

Commissioner J. Carter Beese Jr., however, expressed "serious concerns" about implications of such a link.

"The solution isn't to keep them down below their independence level," he said. "Directors are very important watchdogs, and we hope people are going to pay for performance of that watchdog function."

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