Solution to shareholder woes: Hire independent attorneys

A lot of things probably keep mutual fund cops awake at night, but the prospect of a nationwide shortage of lawyers isn’t one of them.

Robert Plaze, associate director of the Securities and Exchange Commission’s division of investment management, firmly believes mutual fund shareholders would be better served by a proposal that would largely prevent independent board counsel from also working for the fund adviser.

“The management company has its own interest,” he says. “It’s important that independent directors have their own counsel.”

Critics of the proposal, however, say it would force many law firms to choose between representing fund companies or outside directors.

Given that the big money is in standing up for fund companies, outside directors are likely to find themselves out in the cold when it comes to finding top-notch legal representation, they say.

“Nobody makes that much money representing the directors,” says Pamela Wilson, a mutual fund attorney at Hale & Dorr, a prominent law firm in Boston. “I’m afraid there could be a shortage of independent counsel if the SEC’s proposal is adopted.”

Fred “Chico” Lager, independent trustee of the Fenimore Asset Management Trust in Cobleskill, N.Y., agrees.

Any law firm willing to represent directors if the SEC’s proposal is adopted is likely to be less familiar with the rules governing the fund industry, he adds.

“We don’t want to deal with a law firm down the street that spends most of its days doing house closings,” says Mr. Lager, whose firm manages about $380 million in two mutual funds.

But Mr. Plaze, who is a lawyer himself, isn’t impressed with that line of thinking.

“It’s the old `there aren’t enough lawyers to go around argument’,” he scoffs. “I just don’t buy it. The demand for independent counsel will create the supply.”

So, the debate continues. It’s an important dialogue, the outcome of which could deepen the line between fund advisers and directors whose job it is to look out for the interests of shareholders. That line is particularly important when it comes to negotiating things like the fees.

If outside directors are too tight with advisers, or base their decisions solely on information coming to them from advisers, they may be at a disadvantage when it comes to negotiating the lowest fees for shareholders.

“Our focus is trying to flush out conflicts,” says Paul Roye, director of the SEC’s division of investment management. “There’s a recognition that independent directors play an integral role in overseeing fund operations.”

On the other hand, many outside directors have used the same law firms as their advisers for decades with nary a major problem resulting from a conflict of interest. Furthermore, the added cost of hiring another law firm is sure to be passed on to shareholders.

The SEC proposal was released in October and mirrors a best-practice recommendation made months earlier by the Washington-based Investment Company Institute. It’s part of the SEC’s latest efforts to beef up independent directors’ role on mutual fund boards.

Another proposal would require at least half of the fund board to be made up of independent directors.

The SEC is sifting through more than 150 comment letters it received regarding the proposals. Mr. Plaze declined to comment on when the commission is likely to issue a final version of the rules.

He did say, however, that the proposal involving outside directors and their use of independent counsel sparked considerable debate among directors, lawyers and others in the industry.

Among law firms that make a living by representing both independent trustees and advisers are heavyweights Ropes & Gray of Boston, Kirkpatrick & Lockhart in Pittsburgh and Dechert Price & Rhoads in Philadelphia.

The outcome of that debate is particularly crucial to small fund groups, which are more likely than large ones to share legal representation.

That’s because smaller fund groups tend to be under greater pressure to keep expenses low.

Some directors say that the need for separate representation does not justify the added costs.

“It’s not as if we are in an adversarial relationship with the adviser,” explains Mr. Lager, who as an independent trustee “shares” Dechert Price with Fenimore. “We also know that if at any point we feel the need to seek independent third-party counsel, we are free to do that.”

Charles Reaves, general counsel at Southeastern Asset Management in Memphis, which advises Longleaf Partners Funds, says if the SEC wants funds to have more independent directors and also outside legal counsel, it could ease the financial burden by allowing the outside counsel to be a member of the board.

In his comment to the SEC, Mr. Reaves argues that if outside directors earn $10,000 a year, for example, the combined counsel/director might be paid the $10,000, plus an additional $10,000 to $15,000 for acting as independent counsel.

“It would appear that it would be beneficial for smaller funds and their shareholders, who must bear these expenses, to allow these two roles to be combined in appropriate circumstances,” Mr. Reaves writes.

But Mr. Plaze says cost shouldn’t be the overriding factor in deciding whether independent directors should hire their own lawyers. “What is the cost of not having a proposal like this?” he asks. “If you are talking about negotiating advisory fees, what is the cost of not being a tough negotiator?”

That said, Mr. Plaze insists the SEC is sympathetic to the financial concerns of small fund boards.

It is also willing to accept that a link between a counsel and the directors and fund management may be too small to merit concern.

For example, a law partner who represents aa fund firm exec in a private real estate transaction may also represent a board’s outside directors.

It also stopped short of insisting that all outside directors retain separate counsel. Instead, the commission’s proposal would apply only to funds using an exemptive rule — rules that allow fund companies to do such things as set up a 12(b)1 fee plan, establish multiple share classes or make use affiliated brokers.

Since the vast majority of fund groups employ at least one exemptive rule, the SEC’s sympathy is anything but far reaching.

“Very few people are going to escape from this based on the fact that they don’t use one of the exemptions,” says Ms. Wilson at Hale & Dorr, which represents both advisers and independent trustees. “I can’t think of one of our clients that won’t be affected by this proposal. And we have several hundred clients.”