SEC votes more independence at funds

In an important step toward cleaning up the scandal-tainted mutual fund industry, the Securities and Exchange Commission approved yesterday a proposal requiring funds to install independent chairmen and boards of directors.

The agency's five-member board voted 3 to 2 in favor of the regulation, which not only has been controversial within the $7.5 trillion industry but also has divided the SEC.


The regulation, which is to take effect in 18 months, requires that 75 percent of a mutual fund's directors be independent of the company. Directors will have the authority to retain staff to assist them in their duties, and hold meetings once a quarter without management present.

Advocates contend the reform will resolve a long-standing conflict: How can a chairman or director of a mutual fund board, who also is an employee of the mutual fund company, represent investors' interests fairly?


While consumer and investor advocates praised the vote, most agree more reforms are needed and predicted contentious fights as the SEC wrestles with the issues.

"The biggest battles are yet to come," said Mercer Bullard, a former SEC lawyer and president of Fund Democracy, a shareholder advocacy group. "Independent chairmen, it probably won't even make my top five list of reforms that I think are needed in the industry."

"The SEC is trying to put together a comprehensive reform package that is going to make legislation unnecessary," added Thomas R. Smith Jr., a corporate finance lawyer in New York.

Maryland Sen. Paul S. Sarbanes, the ranking Democrat on the Senate Committee on Banking, Housing and Urban Affairs, said it was too early to tell whether new legislation will be needed to impose mutual fund reforms.

He appeared hopeful that, given time, the SEC will require key reforms without legislative involvement.

"The SEC is still pushing the funds to improve their conduct, and examination and enforcement are taking place all of the time," Sarbanes said. "I think they have been responsive to the matters that have been raised with respect to the mutual funds. It was only last September that the issue first arose."

One issue pending before the SEC is whether to require brokerages to let investors know up front, or at the time of sale, if brokers are receiving additional commissions for selling certain mutual funds and whether the funds they are selling are the best deal for investors.

Consumer advocates are backing a proposal that would require disclosure of such arrangements. But the brokerage industry has complained that the costs of complying would reach $9 billion in the first year.


"We like more disclosure but we question whether these costs justify the results," said James D. Spellman, a spokesman for the Securities Industry Association, which represents broker dealers.

But James H. Bodurtha, an independent director with Merrill Lynch Funds, said that if a broker is being "paid to advise me to buy a fund, I ought to know that."

Details of expenses

Another reform proposal would require mutual fund companies to detail all expenses an investor will pay when buying a fund.

"We want a one-page description of all the expenses you are going to pay," Bullard said. "You put 10,000 bucks into a fund, you could easily spend $700 or $800.

"I think both of those rules [on disclosure at time of sale] are going to be under heavy assault."


Another bitterly disputed reform proposal would set a "hard" 4 p.m. trading deadline to stop late-trading abuses, which were at the center of some recent mutual fund scandals. Late trading allows favored investors to place trades after the 4 p.m. stock exchange closing bell, giving them an unfair advantage over others because they have extra time to react to late-breaking news.

"There has been a lot of lobbying going on, on that front," said Smith, the corporate lawyer.

He said 40l(k) plans, trustees and third parties that process large numbers of trades are complaining that they would have to enter their orders much earlier in the day to make the 4 p.m. close. "It certainly would favor those investors who place the orders directly," Smith said.

Barbara Roper, director of investor protection for the Consumer Federation of America, said the issue is one that the "SEC has basically acknowledged that, given the [industry] responses they have gotten, they have got to go back and look at it again."

Another reform that has not yet been debated would penalize market timers who buy and sell fund shares rapidly to achieve short-term gains. The practice typically generates lots of fund expenses, which can ultimately increase costs for other investors.

The SEC's proposal would hit these traders with a 2 percent fee on funds redeemed within five days of purchase. It would also require mutual funds to state in their prospectuses the risk market timers pose to other shareholders.


Roper sees a fight brewing on that issue. She worries that the proposed reform rule is not clearly written and could allow market timers to skirt the intended penalty.

Many experts view yesterday's vote requiring that 75 percent of directors be independent a key reform.

"How a management chair can serve both sets of constituencies is beyond me," said Christopher Traulsen, senior fund analyst at Morningstar Inc., a Chicago-based investment research firm. "I think they [SEC] are on the right path.

"Regulation isn't always the answer, but for so long the fund industry lobby has been so powerful nothing got done," Traulsen noted. "I think you are sort of seeing a backlash here."

Roper called the director regulation "extraordinarily important." She believes it will bring down mutual fund costs and make boards more aggressive.

"They [the SEC] have resisted considerable pressure to water down that proposal and that is to their credit," Roper said.


Two Republican members of the SEC board opposed the new rule yesterday, in part because of the requirement that fund chairmen be independent.

"I did not see any conclusive evidence that having an independent chair results in better performance for investors nor did it prevent market-timing abuses," said Commissioner Cynthia A. Glassman. "The ultimate goal for me is effective investor protection in substance, not just form." Paul S. Atkins is the other Republican who voted against the rule.

Several big mutual fund companies lobbied against the rule, saying they don't believe it would have made a difference in preventing scandals. Those companies included Fidelity Investments, Vanguard Group and Baltimore-based T. Rowe Price Group Inc.

"We are not against independent chairs, we just think the independent directors should choose their own chair," said James Riepe, vice chairman of T. Rowe Price Group.

Question of knowledge

Price has long had a 75 percent majority of independent directors on its mutual fund boards, but Riepe is chairman of 57 funds. He will have to step down in favor of a person who is independent of the company.


"It doesn't bother me personally at all; my job doesn't change," Riepe said.

His concern is that an independent chairman will not know as much about mutual funds as someone involved in the industry full-time.

"They are still a part-time overseer," Riepe said. "They will still be relying on the adviser for knowledge of the business."

Bodurtha, the independent director, said an independent board can force change at mutual funds. "I think there is a pretty intense negotiation that goes on over things like management fees, things like fund expenses," he said. "Legal fees are a major item for us."

He said that he and other independent directors at Merrill Lynch Funds talk with management each week.

Bullard, the investor advocate, believes more regulations are needed to prevent abuses, but he sees some progress.


"These are changes that were probably not even conceivable ... just a year ago," Bullard said. "Scandals are how things get done in Washington."