The Watchdog that Didn't Bark
New reforms are supposed to toughen up the independent directors who oversee mutual funds. Don't bet on it
(MONEY Magazine) – Ever since September 2003—when New York State attorney general Eliot Spitzer exposed chronic corruption in the mutual fund business—legislators, regulators and the media have been spewing out plans to fix the way that funds are run. In the latest move, this summer the Securities and Exchange Commission (the primary federal regulator of mutual funds) created new rules for the boards of directors who oversee the $7.6 trillion that Americans have entrusted to more than 8,000 funds. Will these reforms make your money safer?
In theory, the independent directors of a fund—those who aren't employees of the fund's management company—are your Dobermans: They can hire and fire a fund's managers at will, they ensure that your money is safe and they fight to keep your costs low. In practice, however, most outside directors have acted less like guard dogs and more like lapdogs on Prozac. Over the years, mutual fund boards have:
• Allowed costs to rise relentlessly • Failed to stop fund managers from taking excessive risk •Tolerated conflicts of interest that enriched insiders at the expense of investors • Ignored the rapid trading that hurt long-term shareholders • Looked the other way as funds grew too big to serve investors well
In short, outside fund directors are a living reminder of the ambiguity in the word oversight, which can refer either to the act of overseeing something or the act of overlooking it. No one can put a precise number on how much the wimpy behavior of fund directors has cost the investing public—but, by my reckoning, it runs into the billions.
Fund directors haven't fallen down on the job because they're lazy or stupid. Instead, they've failed because the job, as the law and government rules have defined it, is a joke.
To see why, here's a hypothetical scenario: I start Jason Fund Management and launch the Jason Funds, and I ask you to watch over them as one of my independent directors. You'll work a few weeks, max, per year, but I'll get you up to $200,000 in annual pay—plus, maybe, a pension and a few junkets to lavish resorts. You won't have to invest a dime in the fund or rub elbows with any of the fund's investors. Each year, you'll decide if I'm overpaid or should be fired. You're supposed to scrutinize me as objectively as if I had never done you any favors. After all, the law says I work for you, not vice versa, despite all appearances to the contrary. Of course, if you take too long deciding whether to fire me, we'll miss that golf game I've scheduled for us.
This is the nonsensical role that fund directors are asked to play: With no incentive to do so, they are supposed to bite the hand that feeds them. No wonder there's been a lot more licking than biting over the years.
Congress got us into this mess in 1940 by not making the independent directors fully answerable to fund investors. Since federal law does not give you the unconditional right to vote out board members who are derelict in their duty, independent directors feel no pressure from investors like you, so they rarely stand up to management. And this July, when the SEC stepped in with new rules, the best it could do was adopt well-intentioned but ultimately toothless reforms:
• The chairman of the board must be independent. No longer can the board be headed by an employee of the management company that runs the fund. • Seventy-five percent of the board (up from 60%) must be independent. • Outside directors must meet alone (without any management-company employees) at least quarterly, and they are entitled to their own support staff.
These measures, SEC chairman William Donaldson said earlier this year, will provide independent directors with "the tools, the access and the power to fulfill your legal duty and moral mandate as protectors of shareholder interests."
No, they won't.
First, the legal definition of independence is—let me put this as delicately as I can—idiotic. Let's go back to that hypothetical example of the Jason Funds. I could found the funds, be CEO of the company that operates them, then retire and just two years later become an "independent" director. How likely am I to tell my lifelong work buddies that they're now charging too much money or taking too much risk?
Congress should prohibit anyone who ever worked for the management company from serving as an independent director. That would hurt people like Joseph DiMartino, who earned $815,957 in fiscal 2003 for serving as the "independent" chairman of the Dreyfus Funds even though he was the president of the management company for 12 years. But it would help regular investors by reassuring them that independence means something.
Second, fund directors don't think and act like investors because they rarely are investors. MONEY recently conducted an exclusive survey of the 100 largest fund companies (see money .cnn.com/pf/features/fundguide/responses.html). At how many of the biggest fund families are directors obligated to own shares in the funds they oversee? Only eight. At how many of the top fund outfits are directors paid in fund shares rather than cash? A grand total of two (Armada and Brandywine).
If a director doesn't own any shares in a fund, how can he feel the pain of poor slobs like you and me who've had to suffer rising fees, unnecessary tax bills, inconsistent performance and uncontrolled asset growth? The SEC should require all fund directors to own shares, and it should encourage them to take their compensation in fund shares rather than cash.
Finally, while a fund's managers may be accountable to the directors, the directors are not accountable to you. Since 1995, state laws have systematically stripped fund investors of the right to vote against derelict directors. Delaware, where many funds are now incorporated, offers what Boston University law professor Tamar Frankel calls "a staggering degree of freedom" to restrict voting rights. Formerly, most directors had to be re-elected annually. Now many serve indefinite terms; the typical fund is like a banana republic run by directors-for-life.
Neither the SEC nor I have any solution to the ways excessive compensation and cushy perks can compromise the objectivity of "independent" directors. But you have the right (and you should be reminded that you have the right) to act against directors who act against your best interests. The SEC should mandate that every fund's prospectus feature a prominent statement of your rights as an owner, including:
• A reminder that federal law requires the management company to be replaced if a majority of shareholders vote for such a change • Details on what procedures investors must follow to demand a special meeting to vote against directors • The names of the directors, along with e-mail addresses or phone numbers where you can reach them directly
As the Mutual Fund Directors Forum, a group of independent trustees, recently advocated, funds should initiate annual election of board members. And as Benjamin Graham urged long ago, the directors should submit a separate annual report explaining why they retained the manager and how they determined the fairness of the fees you must pay.
In the first century A.D., the Roman satiric poet Juvenal asked, "sed quis custodiet ipsos custodes?"—"but who will watch the watchmen?" The answer today is the same as it was then: The only way to ensure your safety is to watch those who claim to be watching out for you.