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Thursday, January 08, 2004

Six Steps Fund Directors Must Take

by: Sean Hanna, Editor in Chief

Fund directors had better remember the critical role they play in the industry warned SEC chief William Donaldson Wednesday evening. The SEC Chairman made his remarks to attendees of the Mutual Fund Directors Forum. During the speech, he also warned directors that the SEC is taking a careful look at the role independent directors played in the scandals that have been uncovered since September and that if directors are found to have harmed shareholders they will be "aggressively" pursued.

"We are asking whether the directors were aware of these abuses, and whether there were red flags that were ignored," he said.

Donaldson reminded the gathered directors of their fiduciary role to protect shareholders and that they "must play a key role in helping to restore trust in the mutual fund industry." As part of that service, independent directors, in particular, should serve as "independent watchdogs" guarding investors' interests, he said.

"You are the investors' first line of defense in ensuring that their interests are being served, that conflicts of interest are appropriately managed and disclosed, and that investors' money is being managed responsibly. While the SEC shares this mission to protect investors, we cannot be in the boardroom when investors' interests may be compromised. Investors are depending on you to stand up for them."

"It is not enough that you follow the letter of the law and the rules that the Commission has adopted. It's not even enough that you follow the best practices that the Forum will outline in the coming weeks. To be truly effective, you must be forceful in requiring your funds and their service providers to establish new standards of integrity. Investors must be able to see for themselves that fund companies, and fund directors, are living up to their fiduciary obligations and the spirit underpinning all of our securities laws," added Donaldson.

He said that directors of implicated funds should be asking themselves "What could we have asked of management to surface these issues?" and "What kind of reporting or information could we have requested that would have indicated that there was a problem?"

Lessons for Directors

  • Directors should be monitoring of fund flow data. By looking at purchases and redemptions of fund shares directors might have been able to detect significant short-term trading in their funds and pursue whether there were abuses in this area, he said.

  • They should also possess a "healthy dose of vigilance and skepticism in carrying out their responsibilities," he added. Fund directors have a legal obligation to devote the appropriate effort and energy in carrying out their responsibilities.

  • They must recognize that management's interests are not always aligned with the shareholders of the fund. "The mutual fund regulatory framework and the nature of the mutual fund business should foster a healthy tension between a fund's management and the independent directors," said Donaldson.

  • They must be proactive and continually challenge and question fund management in other high-risk areas, such as portfolio management, pricing, sales of fund shares (including the use of fund assets to facilitate distribution), and the overall program of compliance and internal controls. In monitoring policies, procedures and internal controls of the fund and its service providers, you must regularly challenge whether they are effective.

  • They must test those who oversee the fund's operations. "You must demand accountability from those to whom you have delegated, ensuring that they understand that you can relieve them of their duties if they are not performing to your satisfaction. You have the power as fund directors to insist on a culture of compliance, and we are endeavoring to provide you new tools in this area. You must wield your power appropriately to ensure that the interests of your fund investors are protected and that their interests come first."

  • They must oversee the pricing of portfolio securities, fund fees and performance. Fund directors must "fair value" a fund's portfolio securities when there are no readily available market quotations or when market prices are stale or unreliable, said Donaldson, such as when there has been significant market events subsequent to the market close.

    Regulatory Reforms

    Donaldson also outlined steps that he expects the Commission to take to ensure better governance practices at funds. The components of the fund governance package will include:

  • Requiring an independent chairman of the fund's board of directors;

  • Increasing the percentage of independent directors under SEC rules from a majority to three-fourths;

  • Providing independent directors with the authority to retain staff as they deem necessary, so they are not obligated to rely on the fund's adviser for assistance; and

  • Requiring boards of directors to perform an annual self-evaluation of their effectiveness, including consideration of the number of funds they oversee and the board's committee structure. "All boards should regularly assess how well they are functioning, and all board members must also assess if they have the time and resources to fulfill their obligations as a director," he said.

  • A reexamination of Rule 12b-1 and the use of fund assets to facilitate distribution, the use of soft-dollar arrangements by investment managers and the scope of the safe harbor contained in Section 28(e) of the Exchange Act by the Commission staff.

    "I believe that increasing the percentage of independent directors on fund boards will strengthen the hand of independent directors when dealing with fund management and will better serve the needs of fund shareholders," explained Donaldson.

    He added that the he feels a boardroom culture conducive to decision-making and a focus on the long-term interests of fund shareholders is more likely to prevail when the chairman of the fund's board is completely independent of the fund's adviser.

    "A fund board can be more effective when negotiating with the fund adviser over matters such as the management fee, if it were not at the same time led by an executive of the adviser with whom the board is negotiating," he said.  

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