March 1, 2007
Thursday, March 1, 2007
Chairman Christopher Cox
Securities and Exchange Commission
100 F Street, N.E.
Washington, DC 20549
RE: Comments on File No. S7-03-04
Dear Chairman Cox,
I am writing to you on behalf of Morningstar, Inc. in support of a proposal that would require that mutual fund boards of directors be led by independent chairmen and be composed of 75% independent trustees. We think this is in shareholders' best interest because it would help mitigate conflicts of interest that occur when fund-company employees are prominent members of a fund's board. We think highly independent boards are more likely to oversee funds with lower fees and better performance.
First and foremost, we think requiring an independent chairman and a supermajority of independent directors would increase the effectiveness of the mutual fund board structure. By design, fund boards are in place to represent investors who have entrusted their savings to mutual funds. The board's responsibility is to ensure that funds charge a reasonable fee, are run with a sound investment process, and are managed by an appropriate advisor. This is the cornerstone of a fair and successful investor experience.
Without independent chairs and a supermajority of independent directors, we think the effectiveness of many boards is compromised by the inherent conflicts of interest between interested fund directors and fund advisors. Below, we describe some of these conflicts in more detail and explain why we think greater board independence would benefit shareholders.
Connection Between Board Independence and Low Fees, Better Performance
Fee negotiation is the key conflict of interest for interested directors. The board negotiates a fund's fee structure on behalf of investors, and lower fees are clearly more beneficial to shareholders, since fees reduce their total return. However, lower fees aren't likely to be in the best interest of the interested directors whose firms seek to maximize profits.
It makes logical sense that a fund board dominated by independent directors is apt to work harder to bring fund fees down than a board with a large complement of interested directors. That assertion has also been supported by a few academic studies, which found that independent fund boards have been more likely to oversee funds that charge less. For example, a 1997 study, Board Structure and Fee Setting in the U.S. Mutual Fund Industry, demonstrated that fees are lower when a higher percentage of directors are independent.
In turn, we think there's also a likely connection between independent boards and better fund performance. That's because Morningstar's own fund research shows a clear link between lower fees and better performance. In a February 2006 study outlined in the newsletter Morningstar FundInvestor, Russel Kinnel, Morningstar's director of mutual fund research, found that funds with the lowest expenses--the cheapest quartile of their investment-style peer groups--were most likely to outperform while assuming less risk. Since other studies have found that highly independent boards tend to oversee cheaper funds, we argue that those cheaper funds should yield better returns for shareholders.
We also want to point out flaws in a previous study that suggested funds run by independent chairmen have actually performed worse and cost more than some funds with interested chairmen. The independently chaired funds in that study hailed from just 14 fund companies--quite a small sample size. Moreover, most of the independently chaired funds in the study were managed by banks, whose primary business isn't running mutual funds. Thus, it's no surprise that these funds were lackluster performers.
Mitigating Other Conflicts
In addition to spurring lower fees and higher returns, requiring a greater degree of board independence would also help mitigate other conflicts of interest that can occur when interested directors oversee mutual funds. As you're well aware, fund boards approve many contracts related to fund management and administration. In many cases, the board must decide if an entity owned by the fund advisor should be hired to handle a particular function, such as transfer-agency, custody, and record-keeping services, or if those responsibilities should be delegated to an outside entity. In such situations, interested chairmen and directors cannot escape the appearance of conflict, and there have been examples in the industry where fund boards have made suboptimal decisions on behalf of shareholders. We'd point to a 2005 fine levied against Smith Barney Fund Management and its parent, Citigroup Global Markets, regarding that fund board's approval of a transfer-agency contract that benefited the fund family's corporate profits but didn't benefit shareholders. We don't think it's a coincidence that the Smith Barney fund board was chaired by an interested director.
Chairmanship Is a Full-Time Job
Finally, we question whether interested chairmen, some of whom have argued mightily to preserve the status quo, can give full attention to board service while fulfilling their responsibilities to the fund management company that employs them. After all, interested chairmen are not paid for their service on the mutual fund board, but insiders are paid for their roles at the fund advisor. Simply put, we question whether an interested board chairman has enough hours in a day to satisfactorily work for the fund advisor and run the board, particularly when that chairman isn't being paid for his or her board service.
In fact, independent board chairmen have told us that their service on the board is a full-time job, since they set the board's agenda, oversee board committees, and research complicated industry issues, including fee trends, best execution of securities trades, and so on. And in an August 2006 comment letter to the SEC supporting the independent-chairman rule, Henry E. Riggs, chairman of American Funds Growth Fund of America and Fundamental Investors, suggests that under his independent leadership, the funds' board has dug more deeply into important topics such as distribution, administrative costs, and economies of scale. We think it's reasonable to conclude that other boards run by independent chairmen would have similar experiences.
Another advantage to having an independent chairman is having a fund-company outsider fully up to speed on the issues facing the fund board. To be sure, independent directors are likely to be sufficiently engaged in the board's duties, but since the chairman sets the agenda and leads the board, we'd argue, based on our own observations of independent fund chairmen, that they often become just as familiar with fund-governance issues as fund-company insiders. We think this is an important check in the fund-oversight process.
In our view, the SEC has an opportunity to exhibit leadership here and do what's in the investor's best interest by requiring that fund boards be governed by an independent chairman and a supermajority of independent directors. The Commission has been charged with protecting shareholder interests, and we think it should do its best to empower a mutual fund board of directors to do the same. We urge the commissioners to act now and eliminate the glaring conflicts described above.
Laura Pavlenko Lutton
Senior Mutual Fund Analyst
Director of Morningstar Stewardship Grades for Mutual Funds