Most investors unfazed by SEC rules

WASHINGTON — With few exceptions, defined contribution plan executives and their consultants gave a collective shrug of the shoulders to new SEC rules mandating mutual fund board independence.

But experts predict finding mutual fund directors will become more difficult. And one consultant believes the Securities and Exchange Commission's move raises the governance hurdle.

Fund governance generally isn't a high priority among 401(k) plan executives and their consultants.

"Will this materially impact the decision-making process in choosing DC plan options? I would be very surprised to see that the board structure plays a very big role," said Robert Hunkeler, vice president and director of investments, International Paper Co., Stamford, Conn. Mr. Hunkeler oversees about $3.8 billion of defined contribution plan assets and is chairman of the defined contribution plan committee of the Committee on Investment of Employee Benefit Assets, Bethesda, Md"Most plan sponsors evaluate mutual funds by judging the investment management team. You make sure the people around them are managing the administration well and look at the organizational structure, but that review typically doesn't include the board of the mutual fund," Mr. Hunkeler said.

Consultant Russell LaBarge agreed. "Plan sponsors don't pay a lot of attention to the board of directors of mutual funds. Boards don't dictate investment policy," said Mr. LaBarge, a principal at Strategic Capital Advisors Inc., Oak Brook, Ill.

While Messrs. Hunkeler and LaBarge both support efforts to eliminate conflicts of interest, each is torn about the move to fund board independence.

"Where will you get people with the expertise to really clean up fund operations? The fund board has more to do with compliance issues than with (day-to-day) administration. How will independent directors do a better job than someone who knows the company really well? That the regulators think this will work doesn't mean it will," said Mr. LaBarge.

Added Mr. Hunkeler: "I think you'll find a split in position on this issue of independence. I'm split myself. On the one hand, independence is good. On the surface, the notion is that the board is setting the fees and the board is made up of people from the fund company that will benefit from the fees appears to be a conflict of interest.

"But on the other hand, you probably want management insight from people from the inside who know the company well. I can see both sides."

William F. Quinn, president of AMR Investment Services Inc., Fort Worth, Texas, said the new rules' impact will be negligible. That's because many mutual fund companies are setting up independent fund boards, prompted in part by the mutual fund trading scandals of the past 10 months.

"The new regulations give an appearance of substantive change, rather than offering real change," said Mr. Quinn, whose company overseesabout $13 billion in pension assets for American Airlines and manages about $11billion in mutual fund-of-funds assets.

"It will give the small investor more confidence about the integrity of mutual funds, but institutionally, it won't be a big issue because it's mandated. Everyone has to comply within 18 months. It's not like anyone can get a competitive advantage by building independent boards. If the SEC had gone the other way (to leave board independence to the discretion of the fund company), then it would be more of an issue," Mr. Quinn said.

About 80% of AMR's directors are independent, he said. By August, that will rise to 83%. Plus, the board already meets quarterly in executive sessions, as the SEC now is mandating, and the funds' lead director is independent.

"I don't think the new rules will result in many changes for us, beyond changing the lead director's title to chairman," said Mr. Quinn.

Some in the consulting community strongly support the SEC's efforts.

"Every plan sponsor was upset when they found that their mutual fund board directors did nothing to protect their participants from high mutual fund fees. Anything that makes participants feel more secure in their investments — especially for companies that are de-emphasizing their defined benefit plans and focusing on defined contribution plans — is a good thing," said consultant Ted Disabato, senior vice president, Clark Consulting Corp., North Barrington, Ill.

He warned that 401(k) plan officials probably won't hire "any fund that has bad governance. The hurdle rate on governance just got higher. Funds must leap over that hurdle or the plan sponsor will be quick to scratch them off the list of DC plan options."

Kunal Kapoor, director of fund analysis for Morningstar Inc., Chicago, agreed the SEC's new fund regulations probably will result in better fund management.

"Boards have been too inactive, rubber-stamping whatever the fund company proposed. Fund companies have been setting the agenda, but these new rules will turn everything around and give boards a better opportunity to take charge of the agenda," Mr. Kapoor said.

"The question nobody ever asks (fund companies) is why their fees aren't lower. What is the real cost of running these funds? Both Dodge & Cox and the American Funds introduced funds fairly recently with much lower fees. They've shown that you can do this," Mr. Kapoor said.

Defined contribution plan consultant Bill Schneider predicted the new SEC regulations will drive up mutual fund costs, "which were already egregious."

"They will add layer upon layer of bureaucracy and make a steep rise in the cost of fiduciary insurance a certainty, for example. There will be a lot more friction in the cost area," said Mr. Schneider, a principal at Dimeo Schneider &Associates LLC, Chicago.

Mr. Schneider wonders how the mutual fund industry will identify independent director candidates, and how they'll persuade those they find to join the boards of approximately 11,000 mutual funds.

"Where are they going to be able to find these people?" he asked.

The answer, according to sources, is companies will have to sling their nets much wider and try new tactics.

For starters, mutual fund directors are likely to have far more varied backgrounds in the future than they have had in the past, said Peter Kindler, partner, Boardroom Consultants, Inc., New York. Mr. Kindler's firm specializes in recruiting directors for corporations of all kinds.

"Qualifications would depend on the needs of the different fund companies, of course. But candidates are likely to be people with financial expertise, knowledge of trading, markets, who are detail oriented, perhaps with accounting backgrounds," said Mr. Kindler.

In the past, many directors didn't have the financial and investment expertise to question the decisions and practices of mutual fund management, said Richard S. Lannamann, vice chairman, Spencer Stuart Associates, New York.

Mr. Kindler speculated mutual fund companies might decide to expand their board's responsibilities into such areas as marketing and strategic planning. "Now they focus mainly on oversight of trading activity, fees and manager selection. If they move into those other areas, they might want directors with those kinds of backgrounds."

Mutual fund consultant Geoffrey Bobroff, president, Bobroff Associates Inc., East Greenwich, Conn., predicted that mutual fund companies might try to find directors with a working knowledge of securities law, something that wasn't on their lists before. "They will want people who can bring value, as they need to address brokerage practices, management fees, 12b-1 rules," Mr. Bobroff said.

Finding board-worthy candidates with the right skill sets with time on their hands may not be that easy. The time commitment — attending at least four meetings a year, often two-day affairs — might deter well-qualified candidates with regular day jobs, he added.

Ex-government employees with financial experience and retirees with strong business and operational backgrounds might make good mutual fund board directors, said Mark Elzweig, president of Mark Elzweig Co. Ltd., New York. Mr. Elzweig's company specializes in mutual fund employee searches.

Another source of potential board talent might come from the pension fund community, Mr. Elzweig said. In the last month alone, Mr. Elzweig said former senior executives from large defined benefit pension funds have contacted him in search of mutual fund board directorships.

Their interest probably isn't surprising, given the pay scale: Directors are paid between $75,000 and $400,000 a year, Mr. Lannamann said.

It's uncertain who will set the new guidelines for independent board members, said Mr. Bobroff. Some experts believe it will be the SEC. Others speculated it could be the trustees at the fund companies.

Mr. Bobroff said: "There are no good guidelines for this, and I doubt that the SEC will help with them. They will leave it to independent consultants and counsels to the board to do it."

One way mutual fund boards can achieve a higher rate of independence is by reducing the size of the board. "If a board currently has 10 directors, where 50% are independent (and) 50% are insiders, if three insiders step down, 75% would be independent, so boards will shrink," said Mr. Bobroff.

Board structure also could change as independence is sought.

Mr. Kindler, for example, predicts directors will sit on fewer boards at one fund firm. Currently, directors sit on as many as 100 different boards at one company, he said.

Mr. Bobroff speculated that more boards might be consolidated or would use a committee structure.

He also predicts cottage industries will develop to serve boards. "There may be a need for other data we haven't figured out yet, and companies will create a template to provide it," Mr. Bobroff said.

While too big to qualify as a cottage industry, executive search firms with financial services expertise likely will be major beneficiaries of the SEC ruling.

"They will play a much larger role in finding board directors than they ever did," observed Mr. Lannamann. "Over the last 10 years, there were fewer than 12 searches done for independent board members" throughout the mutual fund industry, he said. "In the past year, our firm has done four of these searches, after doing none previously," he noted.

Recruiters stand to make a tidy bundle from increased mutual fund board recruitment. Mr. Lannamann said the going rate is between $75,000 to $150,000 for a director search, and recruiters expect their fees to remain static for now.

Not everyone agrees recruiters are the best choice to fill mutual fund boardrooms.

Mr. Bobroff believes most recruiters aren't good at finding the right people to be board directors. "These (mutual fund) boards have a culture all their own. It's difficult for a recruiter to bring someone into a setting where they may not have an affinity to the culture, philosophy and way it functions. How these boards are structured — with their own pecking orders — and how they work together is just different than at companies. Finding the right candidates who can fit in will be a challenge."

Reporter Vineeta Anand also contributed to this story.