Speech by SEC Commissioner:
Remarks at the Fund Governance Forum
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
New York City
June 7, 2007
Thank you, Allan, for that kind introduction and for the opportunity to be with you here this morning. Before I go any further, I should tell you that the views that I express today are not necessarily those of the Securities and Exchange Commission or my fellow commissioners.
You all will be spending the day thinking about the responsibilities of mutual fund boards in a number of specific areas and about how those responsibilities are changing and expanding. The theme of this conference — "Adapting to Changing Expectations for Fund Directors" — encapsulates the challenge. That challenge certainly will come alive today as you discuss such issues as relationships with chief compliance officers, securities lending, derivatives, soft dollars, 12b-1 plans, and the latest enforcement cases.
On behalf of investors and those of us at the SEC, the investors' advocate, I thank you for your service. You take on a lot of responsibility and risk as a director — including putting your personal reputation on the line. Investors are better off for your efforts — your diligence; your attention to the business; your advice to management; and, yes, as the party at the scene, your help in providing a sense of accountability. These challenges have only increased in recent years.
In case you conclude that the challenges for fund boards are simply too large, you also will be considering the recently unveiled proposal by Peter Wallison of the American Enterprise Institute and Robert Litan of the Brookings Institute. They propose a new model of collective investment vehicle that strips away the fund board. You will hear directly from Peter later today, so I will refrain from stealing any more of his thunder. Suffice it to say, I find the model that they propose a very interesting one. At a minimum, it is time for us to explore the viability of options other than the board-centric model for mutual funds that dominates the industry today. I share Wallison's and Litan's eagerness to expand the array of collective investment models available to investors.
The question that I would like to consider this morning, however, is a less ambitious one. Before your conference begins in earnest, I will take a detour to consider the issue of board independence. Specifically, I question whether board independence ought to be an end in and of itself. Is it not better to focus on enabling investors to obtain the financial products and services that appropriately fit their investment objectives? Independence may or may not serve that end, but it should not be an end in itself. The topic of independence seems particularly appropriate today since it was on this date in 1776 that Richard Henry Lee introduced the resolution in the Continental Congress that eventually became the Declaration of Independence.
Independence of fund boards does not necessarily bring to mind the same feelings of pride and patriotism that are stirred up by the mere mention of the Declaration of Independence. Nevertheless, the supposed need for ever more independent fund boards has been the impassioned rallying cry of many, particularly over the past several years. Greater independence, proponents argue, will ensure that the interests of the shareholders are protected and that the actions of the advisor are monitored closely and with an arm's length degree of skepticism.
Are these rallying cries from putative "investor advocates" on the sidelines reflective of the true concerns of investors? I suspect not. More likely, the average mutual fund investor does not give much thought at all to the degree to which a fund board is independent of the advisor. Prospective investors have many other things to consider in deciding whether and, if so, which mutual fund to purchase.
A recent survey by the Investment Company Institute found that only fifteen percent of mutual fund investors even look at information about the board of directors before investing and only five percent consider this information "very important" to their final investment decision. By contrast, more than three-quarters of investors look at fund fees and expenses and nearly half consider fees and expenses to be a very important factor in their investment decision. Nearly a quarter considered information about the company offering the fund to be very important information to consider before investing. It seems then that investors are not particularly focused on fund boards.
One response to the apparent lack of investor interest in board independence might be that even though investors might not think much about the composition of fund boards, they enjoy the benefits of independence. They benefit more, this argument goes, if their boards are more independent. In some cases, this is true. It appears, however, that there is not empirical support for generalized conclusions about the benefits of greater independence.
At the end of last year, the SEC published studies by our Office of Economic Analysis that looked at what economic research has to say on the subject of board independence. The studies that our economists reviewed do not support the conclusion that more board independence is uniformly better for funds. As our economists explained, "Existing empirical studies of the effects of mutual fund governance have failed to consistently document a statistically significant relation between fund governance and performance, particularly with respect to board chair independence." Likewise, empirical studies do not establish a causal link between independence and lower fees or higher returns.
According to our Office of Economic Analysis, economic theory tells us that:
in well-functioning markets, shareholders will select a mix of both inside and outside directors that maximizes the value of the firm. That optimal mix will depend on the value to investors of the different contributions that insiders and outsiders make to the board of a particular firm. In markets where there are few impediments to selecting the optimal board composition, there may be differences in board composition across firms.
If the optimal board structure is not achieved, then investors will suffer consequences. In other words, one size does not fit all and it is important to allow funds the latitude to find the size that does fit.
Further, there does not appear to be a link between the degree of independence and compliance probity. In fact, some of the most egregious problems in the late-trading/market-timing scandals happened at funds with — yes — seventy-five percent independent directors and an independent chairman.
Certainly, some of the benefits associated with independence are difficult to measure. But, so too are some of the benefits associated with having on the board directors those who are associated with the advisor. Independent directors have stronger incentives to provide a check on management, but a board with more inside directors is likely to have better information about what is going on at the advisor. Further, when the advisor's CEO serves as chairman of the board, he owes a direct fiduciary duty to the fund.
Congress required that only forty percent of a fund's board be independent out of a concern that a greater percentage of independent directors could interfere unduly with the advisor's decision-making. Perhaps this is not a concern in the normal course for a fund that is managed by a large, established advisor. Entrepreneurs in the mutual fund industry, however, do worry that, after pouring great effort and resources into starting a new fund, they could see their innovative ideas derailed. In the words of one fund advisor, "Having an entrepreneurial interested chair can make all the difference in the world in terms of having the initiative to create products which are of value to investors." Mandating supermajorities and independent chairmen could act as a barrier to entry into the fund industry, which is already a costly one to enter.
As a result of a conviction that independence must necessarily be better, rules and exemptive applications are full of independence conditions. In many cases, upon closer examination, there does not appear to be a logical explanation of how the independence requirement will address any underlying concern. In some cases, the only justification for including an independence provision in an exemptive application is that it has been in every prior application for that exemption. Similarly, in some cases, when it comes time for the Commission to adopt a rule, the only justification for independence conditions in that particular rule is that they have been in all of the relevant exemptive orders. In that way, a condition that may have been included as an ancillary addition or embellishment by an early applicant for exemptive relief becomes the standard.
Given the lack of evidence that more independence is always better, the SEC should be cautious in imposing independence mandates. The D.C. Circuit Court of Appeals' two rejections of our fund governance rule should help to moderate the SEC's ambitions in this area. At present, it is up to boards of directors to consider what works best for their particular funds. They can decide whether to have an independent chairman and how high the percentage of independent directors should be. Some fund boards have decided that an independent chairman is necessary, but a supermajority of independent directors is not. Others have come to the opposite conclusion. Still others have decided that neither a supermajority of independent directors nor an independent chairman is necessary. The decision often turns on the personalities involved.
A fund board is best situated to do its own cost-benefit analysis. It can and must do this analysis in the context of its fiduciary duty to shareholders and its knowledge of its fund's business. Thus, one independent chairman wrote to us to say that having an independent chairman yielded greater benefits than it cost, while a 75 percent majority of independent directors would not materially boost fund performance or lower fees. By contrast, another fund board wrote to us to say that a 75 percent supermajority makes economic sense, but an independent chairman does not. As the independent directors of this fund observed: "allowing fund boards the latitude to determine what is best for their individual circumstances and for the shareholders whose interests they represent will most effectively 'promote efficiency, competition and capital formation.'"
Regardless of what type of fund governance structure is selected, it is important that the five percent of shareholders for whom independence is "very important" to their final investment decision be told what that structure is. Clear disclosure allows fund shareholders for whom governance is important to take it into account in selecting funds in which to invest. It also allows them to vote with their feet, although admittedly there are costs to doing so.
The SEC's agenda has been very full lately. This Spring has been marked by a series of roundtables and additional roundtable discussions are coming. Of greatest interest to all of you is probably the roundtable that we will be having two weeks from now on Rule 12b-1 fees.
Three years ago, in connection with the SEC's rulemaking to prohibit the use of brokerage commissions to finance distribution, we sought comment on whether we should propose additional changes to Rule 12b-1. We received a flood of comments that reflected strong passions around Rule 12b-1. At that time, we chose to defer additional changes to Rule 12b-1. I suspect that passions on the subject have not abated in the intervening years. I am expecting, therefore, that the roundtable will be an interesting event. I hope that it assists us as we contemplate possible reforms in this area.
In 2004, one of the approaches to reforming 12b-1 fees on which we specifically asked comment was an account-based approach. Under this alternative approach, distribution-related costs would be deducted from individual shareholder accounts rather than from fund assets. The SEC cited as one of the possible benefits of such an approach that fund directors' time would be freed to focus on other matters. It is true that 12b-1 plans are one of the many difficult areas into which directors must wade. If, as some charge, the purpose underlying Rule 12b-1 is no longer relevant, have fund boards been too liberal in approving Rule 12b-1 plans? Avoiding the subject altogether under such an alternative approach might be preferable for fund directors.
In fact, under 12b-1, the independent directors must approve the 12b-1 plans every year and vouch for their propriety. Rule 12b-1 is conditioned on approval by a majority of the independent directors. Thus, is it not especially ironic that some of the same people who so passionately support increasing the percentage of independent directors on the board are the same ones who say that 12b-1 plans are not in the best interests of shareholders? These plans are all today approved by independent directors as being in the best interests of shareholders.
Now, the issue of 12b-1 fees is rather complicated. I like to compare it to the wooden puzzle tower called Jenga that my children like to play — the whole thing collapses if you pull the wrong wooden piece out. 12b-1 fees are all part of the puzzle that makes the mutual fund world go around. Could they be labeled better? Certainly. What normal person knows what 12b-1 is anyway? Do the fees serve a purpose, especially for smaller funds? Certainly. Do shareholders get value for their money? I should hope so. Otherwise, I should hope that independent directors would not approve them. Are there abuses in this area? Perhaps. Is there a better way to accomplish this goal, or at least link the shareholder to the payment more directly? Perhaps. Is it time, after 25 years of experience and in a changed marketplace, to look at this subject again? Definitely.
Regardless of the changes that the SEC may make to Rule 12b-1, we should think about the implications of the growing list of responsibilities on fund boards. As another manifestation of the preoccupation with independence, it seems almost a knee-jerk reaction to involve directors, and particularly independent directors, in more and more issues. Independent directors are looked upon as an easy answer to every regulatory problem. Can independent directors fulfill all of these responsibilities adequately? On the bright side, there are many resources at hand to assist fund directors in serving their funds. The Mutual Fund Directors Forum and the Independent Directors Council are examples of the excellent help that is available.
Nevertheless, I think that the SEC needs to be cautious about imposing additional duties on fund directors. The mutual fund industry has asked that we be mindful of the onslaught of new rules. Last December, for example, the Investment Company Institute's Paul Schott Stevens requested "a period of reflection and review to weigh the effects, including the unintended consequences, of these seven years of plentiful new rules." If we expect directors to do their jobs well, we cannot overwhelm them with one new regulation after another.
The cost of director overload is one of the costs — but not the only cost — that we need to consider when we implement new rules. Regulatory actions should be shaped by a consideration of the anticipated direct and indirect costs of those actions along with an honest assessment of the expected benefits. During my tenure at the SEC, I have learned that even a small misstep by the SEC can be costly. Fixing a regulatory error can be time-consuming. In the meantime, firms may spend a great deal complying with the old rule. I have also seen that regulations can work well if they are carefully crafted.
Many others are likewise acknowledging the need to pay attention to the costs that the regulatory structure can impose and to look for better ways to regulate. Concern and suggestions for improvement are coming not only from the private sector, but also from politicians and regulators at the international, national, and state level. I am hopeful that with all of the current attention on the issue, we can move towards a smarter regulatory approach.
Treasury Secretary Paulson is providing valuable leadership on the issue. He has called for an assessment of "how the current system works and where it can be improved, with a particular eye toward more rigorous cost-benefit analysis of new regulation." He also has called for consideration of a more principles-based approach to regulation.
Not surprisingly, calls for reform have been particularly strong here in New York. New York Senator Schumer and New York City Mayor Bloomberg commissioned a report on the capital markets. They recommended "using a principles based approach to eliminate duplication and inefficiencies in our regulatory system." Even Governor Spitzer is planning to contribute to the debate about regulatory overload. Motivated by concerns about "burdensome and inconsistent state regulation, which drives up the cost of doing business, treats functionally equivalent business activities inconsistently, and fails to effectively protect the consumer," the Governor formed a panel last week "to identify ways for New York to retain and enhance its status as a world financial capital."
This focus on the effects of regulation in the marketplace is healthy. We need to be willing to question existing regulatory structures. When necessary, we need to be willing to replace them with new, more flexible and responsive regulatory approaches. I am happy to say that the SEC is looking again at our rules and at the costs inherent in those rules. These costs, of course, are ultimately borne by shareholders.
Buddy Donohue, head of our Division of Investment Management, has recently announced that he and his staff are embarking on a review of the regulations that have accumulated on our books to determine which to keep and which to eliminate. Among other things, we need to look at our disclosure rules. In some cases, this means more and better disclosure. We are working with the Department of Labor to improve the disclosure for investors in 401(k) plans. This is long overdue. We are also working on how to make mutual fund disclosure more targeted, streamlined, and meaningful. The short-form and profile prospectuses have never really gotten off the ground. That is for a myriad of reasons, including fears of litigation risk. With the huge technological advances of recent years, particularly web-based delivery and hyperlinking, I hope that we will be able to make progress in this area, which would be of so much help to investors who are burdened, distracted, and turned off by the overwhelming crush of information.
The costs of regulatory requirements — both out-of-pocket costs and the missed-opportunity costs from stifled innovation — fall entirely on investors and disproportionately on small funds. Small mutual funds struggle to attract enough investors to survive in the shadow of the well-known names that dominate the market. The highly regulated environment in which they seek to compete makes their struggle more difficult. Yet the SEC for the last few years has been distracted from this issue, especially because of the ill-fated fund governance rulemaking. In that rule context, of course, the court chastised us for not undertaking a real consideration — as mandated by Congress — of the effects on competition, efficiency, and capital formation. Costs go beyond out-of-pocket, direct costs — in that case, of paying independent directors. There are also the indirect costs on small advisors who have invested their time, money, and effort to start a fund based on an innovative, new approach. We ultimately deprive investors of opportunities and choices.
The thought of upending the regulatory structure that has grown up under the '40 Act might be unappealing. Your fears are certainly understandable given how integrated the regulatory structure is into the fabric of the fund industry and how integrated the industry is in the lives of American investors.
There are, however, steps that can be taken to achieve greater flexibility without unraveling the existing regulatory fabric. Allowing for experimentation along the lines suggested by Wallison and Litan is one possibility. Another related possibility is streamlining the process by which the SEC approves new products. In its current form, the process is a clumsy one. Inter-divisional coordination is lacking. The pace at which new product approvals move reflects an institutional disregard for the competitive importance of being the first to market with a new product.
I am confident that things are changing at the SEC. Some of this change may come with reluctance and nostalgia for a time when regulators went largely unnoticed, but all of us will be better off for the change.
Thank you all for your attention. Enjoy the rest of the conference. I would be happy to take some questions before your first session begins.