Berno, Gambal & Barbee, Inc.
March 10, 2004
The Honorable William H. Donaldson, Chairman
Re: Comments on Proposed Rule: Investment Company Governance Release No. IC-26323; File No. S7-03-04
Dear Chairman Donaldson:
We are an Arlington, Virginia-based investment advisor. Our advisory firm launched the Aegis Value Fund in May of 1998 in order to give the general investing public the opportunity to become clients of our firm, which is focused on deep value small-cap investing. We believed that we could provide solid absolute net-of-fee return to the investing public in a manner that we hoped would be very competitive against other mutual funds, both passive and active. While we had no industry connections of any note, and were not particularly talented at sales, we believed ourselves to be capable investment managers, and relished the opportunity to have our performance, net of fees, be compared side-by-side with the other managers in the mutual fund marketplace.
Our product was a success. At three years, we were ranked 5-stars by Morningstar and on July 7, 2003, were cited by the Wall Street Journal as holding the best 5-year record among all small-cap value funds, beating out our nearest competitor by nearly 2 percent annually. We are very proud of the fact that we have soundly beaten the indices and have generated strong absolute returns for our clients through a challenging market environment. The Aegis Value Fund now holds roughly $570 million in assets for approximately 20,000 individual investors.
While we were distressed with the recent illegal behavior by several of our large competitors and applaud the Commission's interest in promoting good corporate governance, we believe the policy prescriptions put forward in Proposed Rule Release IC-26323 are seriously flawed and if enacted, will limit choice and have the unintended consequence of damaging the investing public.
The proposed rule is predicated on the a priori belief that mutual fund shareholder interests are best served when mutual fund companies retain an independent chairman and a supermajority of independent directors on the board. We strongly disagree.
We do not believe there is any actual historical evidence such a board structure would be in the investing public's best interest. There is much evidence to the contrary, and we believe the SEC risks doing moral-hazard harm to the investing public by implying to investors that independently governed mutual funds are somehow more protective of their interests. Consider that Mark Hulbert, editor of the respected Hulbert Financial Digest, wrote in the New York Times "Almost all of the several dozen academic studies on board independence have found either it has no correlation with company performance or that companies generally perform worse when they have more outsiders on their boards." Enron Corporation had 11 independent directors out of 15, some of whom were individuals of high stature and yet Enron failed its investors miserably. On the other hand, Berkshire Hathaway provided tremendous investor returns for many years despite a very limited proportion of independent directors.
One drawback we see to independent directors for mutual funds is that they are not likely to be drawn from the money management industry. Unfortunately, conflicts of interest usually preclude the most knowledgeable and experienced industry professionals from serving on the board of another public and potentially competitive entity. The criteria for independence, therefore, effectively excludes the most knowledgeable candidates from active, decision-making independent director roles.
Well intentioned but ill-suited independent directors can wreak havoc on a Fund's investment operations as was the case with the Yacktman Funds in the late 1990s, when the independent directors sought to replace the manager with someone more willing to chase the "easy money" available in the high-flying technology sector. Fortunately for Yacktman's shareholders, he prevailed in a proxy fight, replacing the independent directors and sparing his investors from technology's ensuing collapse. Unfortunately, Yacktman and his shareholders were saddled with unnecessary time, effort, and legal expenses required to replace the errant independent directors.
We are very concerned that every investment decision that we make for our shareholders (who incidentally wish to have our firm manage their money, not a board of independent directors) has the potential to be overruled by, in Ned Johnson's words "a chairman with 40 years experience making carbonated beverages and who has just flown in for a two day meeting." We believe that money management by a committee of independent outsiders with little money management experience has the potential to be very harmful to mutual fund investors.
Certainly the large, venerable fund complexes will be able to work around these new regulations, either by paying-up for compliant independent directors or by hiring long-standing friends of the firm that just meet the narrow legal definition of "independence". The added legal fees, and higher regulatory costs are likely to be spread over a very large asset base. Portfolio managers at these firms will be shielded from independent board interference by a cadre of well paid consultants and legal staff. However, we fear the regulatory burden will be much more intense and time consuming for smaller firms such as ourselves who will not only have to interact directly with our customers, but also our own bureau of independent board members. Industry consolidation and a reduction in investor choice are likely to be fall-outs of this destabilizing cost-structure increase across the industry.
Should this rule be enacted, mutual fund managers with good records desiring to manage money for willing clients at a given rate of compensation without time-consuming interference by a bureau of independent directors will simply leave and start hedge funds for wealthy individuals and institutions, resulting in a deterioration of the talent available for the average mutual fund investor. We believe individual investors are best served when they have choices other than index and shadow index funds.
We urge the SEC to consider narrowing the focus of the proposed rule to apply only to entities where investors cannot leave freely without penalty. In open-ended, no-load mutual funds such as the Aegis Value Fund, should our client shareholders ever become unsatisfied with the investment returns our advisory firm generates or the fees we charge, these shareholders are free to liquidate their investment at the NAV without penalty the day they lose confidence in us. While a board of independent directors and their expensive, industry-connected consultants may reach a different conclusion, the only responsible conclusion that can be reached by any true fiduciary is that the remaining shareholders (those that stay with a no-load fund given the low cost of exit and the variety of other investment options in the market) wish to have their capital managed by the advisor.
Conversely, we would urge the SEC to examine further the corporate governance at closed-end funds that perpetually trade at discounts (and incidentally often do additional coercive stock offerings) and the scores of public companies trading on the exchanges at significant discounts to intrinsic value as a result of poor corporate governance. In these entities, investors face significantly higher penalties in extracting their investment than they do with no-load mutual funds.
With open-ended, no-load funds such as the Aegis Value Fund, we would urge the Commission to let the free market do its job. Please consider the words of former SEC Commissioner M.H. Wallman: "It may make sense to permit funds to structure themselves the way people actually think of them - as services bought based on performance and cost." It may even be time to revisit the mutual fund structure under the 1940 act altogether.
In the interim, we believe that the strong and just enforcement of existing laws, as opposed to additional burdensome and destabilizing new regulation is likely to be a better policy for the average mutual fund investor. We urge the commission to avoid this potential rule, which will hurt the investing public.
Scott L. Barbee
cc: Hon. Paul S. Atkins, Commissioner