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 adequately empower them 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 (also 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 as shareholder watchdogs reflects the flawedstructure 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 isessential 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 disclosure that comprise normative transparency, much of what is needed in improved egulation, including the ability ofindependent directors to perform as effective shareholderwatchdogs, would be provided.The fourth reason why mutual fund independent directors are not effective shareholder watchdogs is that Federal courts have historically refused to hear shareholder petitions of excessive mutual fund advisory fees relative to the value of shareholder services. Since the precedents laid down in the 1982 Gartenberg case, courts have 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.These precedents may well fall if the Supreme Court in its fall 2009term rules adviser Harris Associates charged its Oakmark funds shareholders excessive advisory fees. Without this relief, mutual fund shareholders must continue to depend on inadequately empowered 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 that reduce shareholder assets and returns, but which are effectively hidden from shareholders,especially retail investors.