Why Have Mutual Fund Independent Directors Failed as ‘Shareholder Watchdogs’?

Abstract

There are four basic reasons why mutual fund independent directors have failed in their roles as “shareholder watchdogs” under the Investment Company Act of 1940. The first reason is the Act’s flawed regulatory structure that insufficiently empowers independent directors to meet their fiduciary responsibilities under the Act. The Act in fact “outsources” oversight of fund advisers to independent directors, but fails to empower them adequately through direct SEC adviser oversight.

The SEC thus relies on independent directors to oversee fund advisers and protect shareholder interests. But, the lack of effective adviser oversight (including director acquiescence and ignorance) has led to numerous improper practices that conflict with fund shareholder interests.

The second reason mutual fund independent directors have failed to be effective shareholder watchdogs reflects the often flawed structure of fund boards. The 40Act gives independent directors a specified set of responsibilities, of which approval of fund advisory fee contracts and those with other service providers are primary. Research has shown significant relationships between size of fund advisory fees and number of independent directors, the number of independent directors relative to the total number of fund directors, and percentage of adviser’s fund and other fund assets subject to director oversight.

The third reason for failure of mutual fund independent directors to act as shareholder watchdogs is the failure of the 40Act and the SEC to provide for normative transparency of disclosure of adviser practices. Normative disclosure is essential to directors and certainly shareholders being able to monitor adviser practices. This is a very important issue as there are numerous generally hidden adviser conflicts of interest that reduce shareholder assets and returns. If Congress and the SEC were to require wide-ranging and detailed normative transparency of disclosure, much of what is needed in improved regulation, including the ability of independent directors to perform as effective shareholder watchdogs, would be provided.

The fourth reason why mutual fund independent directors are not effective shareholder watchdogs is that until 2009 no Circuit Court of Appeals has ruled for fund shareholder plaintiffs in cases of excessive advisory fees. In 1982, the Second Circuit Court in Gartenberg left effective oversight of excess advisory fees to assumed [incorrectly so] “arms length” negotiations between advisers and independent directors based on the assumption [incorrectly so] that fund markets are price competitive with rational investors.

The 2008 Seventh Circuit’s decision in Jones et. al v. Harris Associates rejected the legal foundation in the Gartenberg decision, but it also made it more difficult for mutual fund shareholders to petition courts successfully in cases of excessive advisory fees. However, the differing circuit court decisions plus a vociferous dissent by a leading judge in Jones apparently led the Supreme Court to accept this case in its Fall 2009 term.

Mutual fund investors will be greatly and properly served if the Supreme Court finds adviser Harris Associates charged its Oakmark mutual funds shareholders excessive advisory fees. The Court will also have a 2009 Eighth Circuit decision to consider –  the first to find for fund shareholders in a petition of excessive advisory fees.

Without relief from the Supreme Court, mutual fund shareholders must continue to depend on inadequately empowered, motivated, and informed independent directors to do what they can as shareholder watchdogs. This would be a sad commentary given the “laundry list” of self-serving adviser practices, such as excessive advisory fees, that reduce shareholder assets and returns.

Keywords: mutual funds, shareholder watchdogs, 40Act's flawed regulatory structure, flawed structure of fund boards, failure of 40Act to provide normative transparency of disclosure, court failures to find excessive advisory fees, Gartenberg decision

JEL Classification: G2, G23, G28