JURIST >> OPINION >> Forum >> Rouge on a Corpse... 

Professor Mercer Bullard
University of Mississippi School of Law
JURIST Guest Columnist

In the wake of the biggest scandal in the history of the mutual fund industry, Columbia Law School痴 Jack Coffee noted that proposals to make mutual fund boards more independent was akin to putting 途ouge on a corpse. A bit of an exaggeration, but not by much.

The mutual fund scandal reflects a systemic failure of oversight by moribund fund boards. We can bring this corpse back to life, but only through a systemic solution. One solution would be to create a Mutual Fund Oversight Board, modeled on the Public Company Accounting Oversight Board (and endorsed by the PCAOB痴 first chairman, William McDonough), that would have inspection and enforcement authority over fund boards.

Enhancing the independence of fund directors will not be enough, although at the margins it will make fund boards more effective at protecting fund shareholders interests. Needed improvements include requiring a 75% independent board and an independent chairman, which the SEC has proposed, and narrowing the definition of independent director to exclude, for example, former directors and officers of the fund manager, which has been proposed in a number of bills in the U.S. Senate (see, e.g., Corzine-Dodd and Akaka-Fitzgerald-Lieberman bills).

The SEC has adopted rules requiring the appointment of a chief compliance officer who reports to the fund痴 board, and it interprets the up-the-chain reporting rules for legal counsel that were adopted last year to require ultimate disclosure to the board of the fund. A lawyer痴 duty to report up-the-chain applies even if he is employed by the fund manager, which usually is a separate legal entity from the fund.

These reforms are important steps in assuring that independent fund directors have the independence, authority and information needed to police fund managers. But they will be nothing more than 途ouge on a corpse if no steps are taken to make independent fund directors accountable for failing to protect fund shareholders.

The current scandals in the fund industry and the failures of fund boards to detect and prevent them cannot be blamed on independent directors lack of independence, authority or information. Rather, the pervasive and notorious nature of the scandals, as described below, reflect a more systemic problem.

In January 2003, the SEC, NASD and NYSE announced that investigations had revealed that in 32% of the transactions in which investors were entitled to discounts on commissions paid on mutual fund investments, they were overcharged.

In late 2003, the SEC preliminarily found (see testimony of SEC enforcement director Steve Cutler), in responses to queries sent to 88 of the largest fund complexes and 34 broker-dealers, a similarly striking level of illegal conduct. More than 25% of the brokers confirmed that they permitted orders to be submitted after the fund was priced, and 10% of the funds admitted some awareness of such late trading in their funds.

Almost half of the funds admitted having agreements with market timers, and almost 30% of brokers indicated that they assisted such market timers in some way. Over 30% of the funds selectively disclosed their portfolios in ways that may have disadvantaged the fund.

In January of this year, the SEC announced that examinations of 15 brokers revealed that 14 had accepted undisclosed payments directly from fund managers, and 10 accepted payments for selling fund shares in the form of brokerage commissions paid by the fund. Similar findings formed the basis of an SEC enforcement action against Morgan Stanley in late 2003, and charges against more firms are likely.

This pattern reflects a systemic breakdown in oversight at the fund board level. This is not to say that every instance of wrongdoing is an indictment of the system that permitted it. Rather, when wrongdoing is so pervasive and notorious, it must reflect a system that is designed to permit wrongdoing, principally by sanctioning conscious disregard of wrongdoing by the system痴 overseers.

This article does not permit a complete analysis of the indicators that were ignored by boards, but a few examples may suffice. The heart of the current scandal is the excessive trading of fund shares to exploit inaccurate prices. Excessive trading is easily detectable simply by reviewing public financial data on the amount of purchases and sales of fund shares. The problem of inaccurate prices was well-documented in both the academic literature and popular media.

The SEC had permitted funds to receive fund orders after the fund was priced only on the condition that the board take steps to ensure that orders were placed before the pricing time. The practice of making side payments to brokers was generally described in each fund痴 Statement of Additional Information (a document that shareholders do not receive) and it was widely known that brokers did not disclose these payments to their customers. The risks of portfolio disclosure had been loudly trumpeted by the fund industry for years in an attempt to prevent rules requiring more frequent public disclosure of portfolios.

These abuses were too pervasive and notorious to be attributed to the failings of individual directors or a few fund boards. We must explain why fund boards as a group, and presumably their counsel as well, so consistently ignored such open and notorious problems in the industry. When we find such consistently aberrant behavior across a large group, we must consider whether the behavior is, in fact, aberrant, or whether it actually reflects the expectations we hold for the members of the group.

Unfortunately for fund shareholders, the expectations of fund directors as communicated by the SEC and the fund industry have been woefully inadequate. Neither the SEC nor the fund industry has set forth standards regarding the minimum steps that fund directors must take to fulfill their fiduciary duties to shareholders. Nor has the SEC痴 enforcement program demonstrated that directors will be held accountable for the gross disregard of their duties.

When SEC Chairman William Donaldson addressed the most recent meeting of the Mutual Fund Directors Forum in January of this year, he could have used the opportunity to remind fund directors of their responsibility for the current scandal, but the strongest reprimand he could summon was the charge that fund directors 杜ight have been able to prevent the fraud. When their chief regulator has low expectations for them, fund directors will live down to those expectations.

Just one month before Chairman Donaldson spoke to the Forum, the SEC had demonstrated in action what Donaldson implied in words: that the SEC will not hold fund directors accountable for gross negligence. The Commission settled charges against the independent directors of two bond funds in which shareholders had lost 70% and 44% of their investments, respectively, in a single day because of mispricing.

This case involved the worst instance of mutual fund mispricing in the history of the industry and led the funds into receivership. The fund痴 independent directors ignored numerous warning signs regarding the funds mispricing, which should have resulted in the directors paying significant monetary penalties and a life-time ban from serving on a fund board - a small price to pay considering that many shareholders lost a substantial part of their retirement savings.

The SEC saw things differently. Over three years after the mispricing occurred, the SEC agreed to settle for nothing more than an administrative cease and desist order. The directors did not admit to any charges or pay one penny in penalties or restitution, despite having been paid for board service during the three years that the SEC fumbled with the case. They were allowed to retain their compensation and serve on fund boards in the future, despite their having been at the helm during the largest fraud-related loss by a fund as a percentage of assets in the history of the industry.

SEC Commissioner Campos inventoried the inadequacy of the settlement in his withering dissent.

The insignificance of the penalty sends a message to fund boards and fund counsel that independent directors will not be held accountable for gross disregard of their duties. Imposing the minimum penalty in the SEC痴 arsenal - a no-admission-of-guilt, cease and desist order - in this case will make it difficult for the SEC to impose any penalty in cases involving lesser, but significant, violations of fiduciary duty.

The shareholder advocate cries out: This must change! But the practitioner and academic know there is no 杜ust about it. There is nothing inevitable about an effective response to the mutual fund scandal. Unless, through legislation or SEC rules, we cause systemic board failures to result in meaningful penalties, we should not expect independent fund directors to change their behavior.

This systemic problem of low expectations requires a systemic solution. This author has proposed (see 11/4/03 testimony) the formation of a Mutual Fund Oversight Board that would have inspection and oversight authority over mutual fund boards. The Board, a form of which Senator Kerry has proposed in S. 1958, would promulgate minimum fiduciary standards for fund directors and be authorized to take action against directors who fail to live up to these standards.

The life of a corporate board is nothing more than the public, enforceable expectations that we set for it. Unless we establish formal expectations and enforce them, fund directors will continue to be lifeless parodies of leaders, all dressed up with the requisite titles, independence, authority, and information, but without any directed purpose to their existence. We can revive mutual fund directors, but only when we begin to expect more from them.

© Mercer Bullard; All Rights Reserved

Mercer Bullard is an assistant professor of law at The University of Mississippi School of Law and the founder and president of Fund Democracy, a nonprofit membership organization that serves as an advocate and information source for mutual fund shareholders and their advisers.

March 15, 2004


JURIST Guest Columnist Mercer Bullard is an assistant professor of law at The University of Mississippi School of Law and the founder and president of Fund Democracy, a nonprofit membership organization that serves as an advocate and information source for mutual fund shareholders and their advisers.

Bullard is recognized as one of the nation's leading advocates for mutual fund shareholders. He has led numerous initiatives to improve mutual fund regulations for the benefit of America's investors, including successful efforts to prohibit the use of misleading fund names and to require disclosure of funds' proxy voting records. In 2001, Investment News named Bullard one of the most powerful voices in the financial services industry.

Bullard was formerly an assistant chief counsel at the Securities and Exchange Commission and practiced securities law in Washington, D.C. He holds a J.D. from the University of Virginia School of Law, an M.A. from Georgetown University, and a B.A. from Yale University.