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SEC Chairman Outlines Fund Governance Reforms, Details Key Focus Areas

The SEC is readying a mutual fund governance reform package designed to allow fund independent directors to better serve as an effective check on fund management. In remarks at a forum of mutual fund directors, Chairman William Donaldson said the proposal will require an independent chairman of the fund's board of directors and will increase the percentage of independent directors under SEC rules from a majority to three-fourths. The Commission would also authorize independent directors to retain their own staff, as well as mandate that fund directors perform an annual self-evaluation of their effectiveness, including consideration of the number of funds they oversee and the board's committee structure.

Also addressing the forum, Investment Management division director Paul Roye said that the proposals, taken together, reinforce the tenet that independent directors should control a fund's board rather than being passive observers. With an independent board chairman and with independent directors representing at least 75 percent of a fund's board, he continued, independent directors will dominate the boardroom by controlling both the agenda and the votes.

For his part, Chairman Donaldson believes that a boardroom culture conducive to focusing on the long-term interests of fund shareholders is more likely 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 adviser over matters such as the management fee, he reasoned, if it were not at the same time led by an executive of the adviser with whom the board is negotiating.

By authorizing fund directors to retain their own staff, said Mr. Roye, the Commission is emphasizing the importance of relying on experts outside of a fund's management to provide information to the board. A board can only be as effective as the quality of information it receives, he reasoned, and a board relying solely on a fund's adviser for its decisionmaking information may not be considering all the information it needs to make the best decisions on behalf of investors.

Chairman Donaldson also stressed the importance of self-evaluation of fund boards. In particular, board members should regularly assess if they have the time and resources to fulfill their obligations as directors. He emphasized that fund boards and the directors themselves must make the decision about the number of boards upon which individuals can sit. Different boards have different needs, he noted, and different directors have different capabilities and time constraints.

But this framework also demands that directors regularly take a hard look not only at the number of boards they are on, but also at whether they are performing well. Similarly, the chairman wants directors to determine if the board as a whole, as well as the committee structure, is effective. The SEC chairman emphasized that answering these questions honestly is fundamental to the mutual fund director's job.

The chairman also mentioned a number of key areas that fund directors should be currently focusing on, including the pricing of portfolio securities, fund fees and fund performance. Significant harm can be done to investors if fund shares are not accurately priced, he said. When market quotations are readily available, these quotes must be used in valuing a fund's portfolio securities.

Directors, however, must also fairly value a fund's portfolio securities when there are no readily available market quotations or when market prices are stale or unreliable, such as when there has been significant market events subsequent to the market close. If a fund misprices its shares by failing to use fair-value pricing when market quotations for its portfolio securities are unreliable, he warned, market timers might take advantage of the disparity.

On the issue of fund fees, the chairman emphasized that the SEC should not act as a rate-setter and determine how much mutual fund investors should pay for the services they receive from a particular fund. This is a decision better left to the free market and to informed investors who have the benefit of an independent fund board looking out for their interests.

Furthermore, the Commission will address the fees issue through rulemaking, said Mr. Donaldson, who emphasized that uniform rules for the entire industry are more desirable than fees set through enforcement actions that can fragment the marketplace, particularly in enforcement matters that have nothing to do with fees.

In this regard, the SEC has moved forward on several fronts to enhance disclosure of mutual fund fees, including exploring ways to impose segmented disclosure of transactions costs, improved disclosure of breakpoint opportunities, dollars and cents disclosure to investors of mutual fund costs, as well as additional disclosure regarding the payments and incentives brokers receive in recommending particular funds to investors.

Even more, the SEC will bolster the effectiveness of independent directors in monitoring fees through the proposals to improve fund governance. A key component of this package will include a proposal requiring boards to focus on and preserve documents and information that directors use to determine the reasonableness of fees relative to performance, quality of service and stated objectives.

Closely related to the appropriateness of a fund's fees is the performance of the fund, noted the chairman. This focus is on whether the fund is fulfilling its stated investment objectives and delivering value to fund investors.

Finally, Chairman Donaldson said he has directed the staff to explore several other complex issues, including a reexamination of Rule 12b-1 and the use of fund assets to facilitate distribution, as well as 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. Similarly, he told the staff to explore steps to provide greater insight into the operation of hedge funds, which he said have frequently been focal points in SEC investigations of abuses in the mutual fund area.