INDEPENDENT MUTUAL FUND DIRECTORS SEEK BACKING: HEY, SEC, WE CAN’T DO IT ALONE

Independent mutual fund directors have turned the tables on the Securities and Exchange Commission, arguing that if the agency wants them to be more aggressive watchdogs, it should do more to support them in battles with fund managers.

They spoke out late last month at the SEC’s two-day Washington round table on improving the effectiveness of independent directors.

Some of them chided the SEC for failing to back directors who tried in 1997 to replace Louis Navellier as manager of one of his namesake funds.

The feeling is that the commission redeemed itself somewhat when it sided with several independent directors in a dispute over legal fees in a proxy challenge brought by Chicago money manager Donald Yacktman — who succeeded in booting the directors from the board of his Yacktman Fund.

If independent directors can be removed by fund management through proxy fights like the one waged by Mr. Yacktman, they can hardly be expected to act in an “arm’s-length bargaining capacity” when negotiating fees and other issues with advisers, says Kenneth E. Scott, an independent director for American Century Funds and Dresdner RCM Capital funds.

sec taken to task

In the case of Navellier Funds, the SEC “discounted the credibility of the independent directors” and treated the battle as a “garden variety corporate struggle for control,” says Richard M. Phillips, a partner at Kirkpatrick & Lockhart LLP in Pittsburgh.

Paul F. Roye, director of the SEC’s division of investment management, says the agency “will vigorously pursue reports of violations (of federal law) and not sit by idly.”

“They need to establish a protocol to deal with the highly visible situation that happens very quickly,” said another speaker, David A. Sturms, a lawyer with Vedder Price Kaufman and Kammholz in Chicago who represents the Yacktman directors. “I hope that’s the biggest thing they got, even if they had to be hit in the nose to figure it out.”

The round table, held at SEC headquarters, is expected to lead to the development of “best practices” guidelines for the industry’s estimated 1,500 independent directors.

Under federal law, independent directors — those who are not affiliated with fund companies — are supposed to provide a check on managers, but increasingly they are under fire for failing to take action on issues ranging from fees to performance.

Chairman Arthur Levitt says the SEC will draft “far-reaching and concrete proposals” for improving fund governance, but it won’t push for specific legislation.

“I don’t think you get at this problem by rules and regulations,” says Mr. Levitt. “It is a question of whether (a practice) passes the smell test.”

One popular notion: having a majority of directors be independent, instead of the 40% required under federal law.

“For a board to have a chance to operate truly independently of its creator, the number (of independent directors to affiliated directors) should be at a minimum 2-to-1,” urges Aulana L. Peters, a Los Angeles lawyer and former independent director for the IDS Mutual Fund Group. She also calls for a mandatory retirement age of 70 for directors.

Panelists also believe that all boards should have nominating committees composed of independent directors that pick new independent directors — without input from fund managers. Currently, only funds with 12(b)1 distribution fees are required to have such nominating committees.

Directors and other experts clashed over what role independents should play, however.

Some say their job is to guard against conflicts of interest, while others say they act as bargaining agents for shareholders by contracting for fund services, including management.

“Independent directors have enormous influence in the disposal of the portfolio manager,” says Mr. Phillips, who argues that directors’ top priority should be investment performance.

Regardless of their role, directors admit that criticism of their compensation leads to questions as to whether pay compromises independence.

“We continue to be beaten with that stick,” acknowledges Gerald C. McDonough, an independent fund trustee at Fidelity, who was paid $264,500 in 1997, putting him among the industry’s highest-paid directors (InvestmentNews, Feb. 22).

Directors argue that they are not co-opted by advisers because they are paid by the funds they oversee.

“We may be overpaid but we set our own compensation and it’s paid by the fund,” says John R. Haire, an independent fund director at Morgan Stanley Dean Witter & Co. (He made over $400,000 in 1997, second-most in the InvestmentNews survey.)

“These (directors) are not people who are going to travel across the country three to four times for $40,000 a year and forgo bank directorships at the same time,” he adds.

Mr. Levitt seems to shrug off the pay issue, arguing that some directors who are paid relatively little are hardly active watchdogs, while others who are paid handsomely are very independent.

“I’m not sure you can pursue that analogy,” he says.

To the criticism that directors oversee too many funds, Mr. Haire responds: “If the CEO of an investment management company can supervise that many funds then so can I.”

Ms. Peters, a partner at Gibson Dunn & Crutcher LLP, worries aloud that any effort to develop “best practices” may result in overly broad standards that hamper, rather than help, directors.

Plus, she says, the SEC risks laying “the foundation for fostering cottage industries” when it heaps more responsibilities on directors, who may have to hire more outside help, such as lawyers and consultants, to effectively perform those duties.

Indeed, the experts agree, fund governance is probably weakest among small fund companies whose directors may not have the resources to hire independent legal help.

Ms. Peters suggests that the SEC pick and choose specific recommendations, such as requiring a greater percentage of boards to be independent.

“It would be a mistake to encourage activism for activism’s sake,” says John C. Coffee Jr., a law professor at Columbia University. “Some things the market does better than even the best independent board.”