Watchdog directors learn to bite

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The Independent Online
CLASS BEGAN promptly at 8:30am with a rousing welcome from leaders of the dollars 2-trillion US mutual funds industry. There we were, approximately 200 mostly male, mostly well-dressed veteran directors, new directors, and a few directors in training.

The point of the day-long exercises was to teach these representatives of Dreyfus, Kemper Financial, Oppenheimer, T Rowe Price, Fidelity Group and others their duties as outside directors. This was not meant to be fun and games. This was watchdog training.

Very quickly the tone was set by a top official of the US Securities & Exchange Commission. Speaking in reverential tones of the 1940 Act that was passed to clean up abuses in the industry, he began ticking off the statutory obligations of outside directors.

The points were not lost on one of my companions at table 3.'Are you a professional director?' he asked. 'If so, this guy makes perfectly clear that you are in for more than first-class air tickets and restaurant meals.' Indeed, it was in part to clarify the SEC's expectations that industry leaders decided to hold this first conference on the duties of outside directors. Arthur Levitt, the new SEC chairman, said he expected independent directors to display 'less ritual and more substance in the boardroom' - which he said meant 'not just active but pro-active involvement'.

He listed derivatives, portfolio liquidity, shareholder activism and personal trading by fund managers as areas demanding increased attention from independent directors.

Mr Levitt and other SEC officials sketched a profile of a much more aggressive 'ideal' director than the industry has come to expect. The 'ideal' director is not an affable, pin-striped City person but rather a pitbull - intent on protecting the shareholders' assets at every turn.

This means challenging management and advisory fees to make sure shareholders are getting the best deal; questioning 'unusual' trades involving derivatives, currencies and other volatile instruments; and even countermanding the decisions of portfolio managers if they are unable to explain them in plain English.

This does not mean, however, that independent directors should get into the business of 'micro-managing' funds. Or does it? Confusion abounds over whether they are obliged statutorily to ensure compliance with the 1940 Act, which would require micro-management, or whether they must more generally oversee funds as watchdogs.

The newly aggressive statements of SEC officials seem to be pushing directors over the line into more responsibility and, thus, more day-to-day involvement. Richard Breedon, Mr Levitt's predecessor as SEC chairman, had suggested an even broader role: that directors of mutuals, pension funds and other institutions exercise more aggressive rights as leading shareholders of big corporations.

The reason that SEC officials are displaying such anxiety over the role of directors is perfectly clear. Over the last decade, the mutual funds industry has recorded explosive growth, with assets that have climbed from dollars 133.3bn in 1980 to dollars 2,000bn in 1994. For the first time, mutual funds account for a larger percentage of the assets of small investors than do banks. This means that record numbers of small shareholders are at risk if something goes wrong, but few of them are aware of it.

Industry polls reveal that most small investors believe that their savings are as safe in funds as they would be in banks that benefit from deposit insurance. During a period when 93 per cent of the discretionary savings of US households is deposited in mutual funds, this is a frightening prospect to public officials. And so the onus of protection, in an already heavily regulated industry, falls unbidden on the independent directors.

The SEC is only reacting to Congress nerves in elevating these accountants, lawyers and investment managers as the last bulwark of shareholder protection. However, those who make up this bulwark are getting a little nervous. Most independent directors feel unqualified professionally to micro-manage funds and few either want the responsibility or think it desirable.

'What do I know about the risks of investing in a plant in China?' said an exasperated lawyer at table 7 who sits on the board of an international investment fund. As the veteran directors in the group observed, the mutual funds industry, despite huge growth, has emerged over decades almost scandal-free as a result of directors who acted as watchdogs, not micro-managers.

Now new-wave regulation is setting in. The fact that most small investors neither understand how their funds are managed nor comprehend the prospectuses that they read has raised the spectre of huge lawsuits. For example, directors were warned to expect a new breed of class action lawsuits on behalf of shareholders claiming to be ill-served by an inadequate prospectus.

Moral of the warning: independent directors had better become expert in the art of writing a prospectus. Moreover, it would be a good idea for directors to know intimately the laws and statutes that regulate the industry, as well as accounting procedures that determine how investment advisers allocate their fees among large and small funds.

Additionally, directors need to be up to snuff on the tactics used to sell their funds. And so we have the newly configured portrait of the independent mutual fund director. As one disgruntled participant at table 10 remarked, 'Who needs it?'