This year marks the 20th anniversary of a controversial SEC rule that was effective for less than two years, but changed registered fund governance forever.
During 2004 the mutual-fund industry was struggling with the public perception – accelerated by the mutual-fund timing scandal of the previous year – that fund directors were too cozy with fund managers to fulfil their responsibility of protecting the interests of shareholders even at the expense of those of the fund adviser, according to James McMonagle, who has been independent chair of the Selected Funds since 1997. That perception was not far wrong, he said.
“The insiders for a long period of time dominated everything,” McMonagle said. “They had the ability to just put their own folks and their close associates on the board themselves. Even though they might be technically independent, their alignment was closer to the adviser than it was with the ordinary shareholder.”
The SEC’s response to the timing scandal was rule IC-26323, the investment company governance rule, which was designed to enhance fund governance practices in several ways, the most contentious of which was requiring that all chairs be independent.
The proposal received pushback immediately from an industry in which only 43% of boards had independent chairs at the time, according to data from the Independent Directors Council (IDC).
The proposal’s public comment period in the spring of 2004 elicited letters from about 30 fund boards, the most of any SEC proposal until 33 boards weighed in on the open-end fund swing pricing proposal 19 years later.
The vast majority of board comments argued that the proposal should be withdrawn as inappropriate for fund boards that must be allowed to choose their own leadership structure
“From our perspective, there is no need to dictate by regulation a single approach when specific circumstances, tempered by the judgement of the independent trustees, may warrant a different approach,” read one comment signed by J. Lawrence Wilson, who was then lead independent trustee of the Vanguard Funds.
Unlike the 2023 swing pricing proposal, which was universally maligned by fund boards, the investment company governance rule did have some support among directors.
“Given the dollars involved in this conflict, the inherent dynamic of boards as social organisms and the realities of human nature (even when performing at its most noble levels), I can frankly see no good reason not to require independent chairpersons for mutual fund boards,” wrote John Hill, then-independent chair of the Putnam Funds in a comment supporting the move.
Undeterred by the negative feedback, the SEC adopted a rule in late 2004 requiring that fund boards be led by an independent chair and that 75% of directors must be independent of the adviser supporting the fund.
The rule was struck down in federal court two years later, but not before starting a wave of change among fund boards. Between 2004 and 2006, when the rule was struck down, the percentage of boards with independent chairs jumped from 43% to 56%, according to a contemporaneous IDC survey.
“That rule did have an impact, certainly, and you did see an increase around that time period for more boards moving towards having an independent board chair,” said Thomas Kim, managing director of the IDC.
“Although it was overturned, I think a lot of directors did realize the benefits for best practices of having a board chairman that would be independent from the adviser,” said Rachael Schwartz, a partner at Sullivan & Worcester who counsels fund boards.
The Supreme Court gave a boost to the idea that independent chairs lent credibility to the fund itself with the landmark 2010 Jones v. Harris decision, which enshrined board independence as one of the six “Gartenberg factors” that had to be considered when testing for excessive fund fees.
Jones v. Harris led to a wave of litigation by plaintiffs trying to catch funds charging excessive fees. None succeeded, but boards around the industry took note of the weight independent leadership could lend to courtroom arguments, and the assumption by courts that independent directors were more likely to be acting in the interest of shareholders than directors employed by the adviser, according to Hassell McClellan, independent chair of the John Hancock Funds.
“There’s been a great deal of — over the past decade or so — attention paid to the need for boards to act independently,” McClellan said. “In a situation where the question is whether or not you acted independently or ‘at an arm’s length,’ the more independence you can show, the better.”
Over time fund advisers also became more amenable to the idea of independent board leadership – after beginning to recognize how much easier it was to defend the decisions of an independent board under the scrutiny of a shareholder lawsuit or SEC examination, Schwartz observed.
“As time has gone on, I think a lot of investment advisers also see the benefits, that it can protect the fund company from certain governance issues if it’s seen that they have a very strong independent board structure,” Schwartz said. “So it can be beneficial to the adviser as well.”
Benefits of independence leadership
IDC surveys show that, by 2022, a record 70% of fund boards reported being led by independent chairs – an increase of 27 percentage points compared to 2004.
In an industry once dominated by interested chairs, many now argue that chair independence has become a clear and absolute best practice for fund boards.
“I do believe that independence creates a benefit. There’s sunshine,” said Nicole Crum, a partner at Sullivan & Worcester who counsels fund boards. “It’s less likely that there are going to be topics which are avoided, or information that’s crafted to emphasize some issues at the expense of others that’s driven by a conflict.”
Minimizing conflicts of interests in board decisions is the best way to ensure that shareholders’ interests always take priority over the adviser’s interest, according to Crum, who observed that all her fund board clients have independent chairs.
“It doesn’t make you a bad person to have a conflict, but it’s the idea that it can affect your decision-making and your perspective, when sometimes you don’t even realize that your perspective influences your decision-making in the way that it does,” she said.
“Not to say that you can’t have a board that’s dedicated to supporting shareholders without an independent chair,” Crum added. “I just think it’s helpful.”
A board chair can more easily tackle the delicate work of fund oversight when they don’t have to worry about being perceived as biased, according to McClellan.
“My sense is that having an independent chair helps both optically, and in reality, in sustaining the confidence of the board in the chair’s leadership on issues that may involve conflicting interests between the funds and the advisor,” he said.
Many boards can and do still provide effective oversight under the leadership of interested chairs, but the industry’s general embrace of independent chairs has not escaped their notice, according to Schwartz, who recalled how one of her board clients had historically had an interested chair but eventually decided to elect an independent chair to align with industry best practice.
“As we’ve seen, very high percentages now have independent chairs, and so I think the board took a look at that, noted it, discussed the benefits of having an interested person on the board, and determined those benefits could still be achieved with them serving as an interested director but not [as chair],” Schwartz said.
“They decided, ‘This is best practice, this is better governance for the fund company.’”
Enduring support for interested chairs
While some argue that every fund chair should be independent, others insist that the proliferation of modern governance practices – including the election of a lead independent director who shares the leadership spotlight with an interested chair — have allowed boards to develop strongly independent cultures even under the leadership of a chair who is not independent.
The same IDC survey showing that 70% of fund boards had independent chairs during 2022 also showed that 96% reported having either an independent chair or lead independent director – an increase from 61% in 2004 and from just 22% in 1996, the first year IDC took the survey.
“There’s a greater focus on ways to enhance governance within the fund board community,” Kim said. “Notions of good governance often emphasize the vital importance of independence, [which could include] having a leadership role on a board such as that of an independent board chair or — just as important — having a lead independent director.”
Even though more boards than ever are choosing chair independence, board leadership remains a nuanced topic with more than one right answer, he added.
“The unique circumstances facing a particular board and the funds they oversee, one can’t make a generalization about that,” Kim said. “It’ll vary from board to board.”
Independence is widely valued in board leadership, but many boards also benefit from the expertise and experience that an interested chair can bring, according to one board counsel who asked not to be named.
Just because a board chair happens to work for the adviser doesn’t mean they can’t be objective or critical about the adviser’s decisions, especially when guided by a lead independent director, the lawyer said.
“Some of the toughest chairs are the interested chairs, because they know where everything’s buried,” said the board counsel, who counsels boards with both independent and interested chairs. “They ask some of the most dead-on questions because they used to sit in that seat.”
Furthermore, fund boards can only approve advisory contracts by a vote of the independent board members, which empowers lead independent directors to push back against the interested chair if necessary.
“Really, the point is having an independent in some kind of leadership position,” they said.
Who’s ready to go nuclear?
While many safeguards may exist for a board under an interested chair, only an independent chair can ensure a board will stand up to management when necessary, McMonagle argued.
He speaks with unique perspective as a 33-year veteran of the Selected Funds board, which in 1993 became the only board in modern history to successfully use the so-called “nuclear option” when it fired fund adviser Kemper Corporation after a disagreement over Kemper’s plan to introduce sales fees to the no-load Selected Funds.
The board ended up replacing Kemper with Davis Advisors, which manages the Selected Funds to this day.
“We simply decided that we were not being well served, and that the holders of the funds were not being well served, and therefore we changed advisers,” McMonagle said of the board’s decision.
The Selected Funds board is still the only board that has successfully broken with its adviser, although the boards of the Navellier Funds and Yacktman Funds made high-profile, ill-fated attempts later in the ‘90s, both of which ended when shareholders voted against the boards’ proposals.
The nuclear option is the most powerful weapon in a board’s arsenal, even if it goes unused most of the time, according to long-time fund board consultant Meyrick Payne.
“Fund directors really do have a lot of power,” Payne said. “They don’t use it, but they do have it.”
For McMonagle, who joined the Selected Funds board in 1990 and has been chair since 1997, the Kemper incident stands as a lesson in how fiduciary duty ultimately depends on trustees’ willingness to disagree with management, including using their last resort.
“They’re very few and far between, but these moments in a boardroom are very, very important,” McMonagle said. “The board members themselves have to stand up and say ‘No, we’re taking the side of the people who are physically not here, and we’re going to represent their interest because we think this is the right thing to do.’”
