Statement by SEC Commissioner:
Regarding Investment Company Governance Proposal
by
Paul S. Atkins
Commissioner
U.S. Securities and Exchange Commission
Washington, D.C.
June 23, 2004
Thank you Mr. Chairman. When we first released these proposals for public comment in January, I was pleased to see that we were attempting to strengthen the governance function of mutual fund boards. Independence in appearance and fact is a laudable goal and one that I support. Unfortunately, although we are unanimous in wishing to strive towards that goal, I disagree with our approach. For these reasons, I must vote against this rule.
At the rule proposal stage, I was hopeful that we would consider seriously alternatives that were not as heavy-handed as those we originally proposed. We have not done this. I am uneasy about the SEC's will to mandate changes that are profound and costly, without serious consideration of the merits of those changes.
In an effort to try to determine whether or not I could support this rule, I have read many articles and studies on how to improve corporate governance. I came across a prophetic statement about corporate governance reform from our own Chairman. Back in 1999, as chairman of Aetna, he warned of a "growing cottage industry of superficial thought about corporate governance."1
Unfortunately, it appears as if the cottage industry has flourished and has now received taxpayer funding. Our actions today appear to be just the sort of problems that Chairman Donaldson wisely feared at the time. This package is billed as a simple, ready-made remedy to a complex problem that is inherent in our mutual fund regulatory structure. So, why would the SEC go down this path? The answer is simple: we have entered the age of atmospherics. We appear to be more concerned with "doing something" and going with "gut feelings," than we are concerned with making sure what we do is right.
I share my colleagues' profound disappointment with the recent revelations of late trading and market timing abuses. But, I do not subscribe to the contagious view that we must do something, lest we be accused of doing nothing. It is our responsibility to exercise disciplined restraint rather than to react in a manner that harms investors. I am saddened to see that we have chosen to follow the path of atmospherics and simplistic solutions, rather than taking the harder course and deferring action until we can determine what is right.
This agency is at a critical point. Should we sit here at this table, pat ourselves on the backs, and say that we are making meaningful reform that will benefit investors without anything to back us up other than a hope and a prayer?
We have decided what MIGHT have been helpful at some funds that have betrayed their shareholders MUST apply to all funds. No one suggests that we have any empirical evidence that this package will cure or even significantly affect the conflicts of interest inherent in our mutual fund regulatory structure. It is not the responsibility of regulated entities to demonstrate that this rule is not necessary (although some have provided evidence to this effect). The burden of proof is squarely on our shoulders, and we have not come close to fulfilling it. Instead of addressing this glaring deficiency through considered empirical inquiry, we march forward, boldly armed with anecdotal evidence and gut instincts. Anecdotal evidence cuts both ways. There is anecdotal evidence that rebuts this rule's basic underpinnings. Gut feelings, even if they are dressed-up as common sense and logic, are not a sufficient basis to reorganize the boardrooms of most of the mutual funds in this country.
This package requires profound changes that will affect thousands of funds. Almost 2,000 funds do not meet the 75% independent director requirement. We estimate that 80% or about 3,700 funds do not have a non-executive chairman. Forcing thousands of funds to recruit and hire new directors and a new chair is not an easy or an inexpensive task. Our proffered rationale for this is, and I quote from the release at page 25, "we believe [the benefits] are real" and theses changes "may increase investor confidence in fund management." Investors deserve more than this.
We completely ignore market power in this release. The best thing we can do is to empower investors themselves to act. Funds that betrayed investors have already been punished by the marketplace. Many investors walked and they put their money into other funds - funds that were not tainted with fraudulent conduct. Why should we punish the funds that investors have selected by imposing on them a one-size-fits-all solution?
As for those firms and individuals whose conduct was clearly reprehensible, we have demonstrated that our agency has the power to punish them. In the most egregious cases, we have permanently barred individuals from the industry. I applaud our enforcement efforts and believe that they will serve to deter future unethical, immoral, and illegal behavior.
However, as we discharge our regulatory responsibilities, we need to be mindful that morality and ethics cannot be legislated into existence, and criminal conduct cannot be legislated out of existence. Government controls alone will never be a solution if individuals and individual firms are not upholding their own end of simple business ethics through their own effective compliance. Unlike some, I have not lost my optimism that the overwhelming majority of people in the fund industry do try to do the right thing each and every day.
This is not the first time that we have tinkered with mutual fund board independence in an effort to make fund boards more effective. Just three years ago, the Commission took up this issue and required that independent directors constitute a majority of the fund's board. In contrast to our actions today, this change had a legitimate basis in the principles of corporate governance. It was designed to give independent directors the majority they needed to "control the fund's corporate machinery" and to take actions without the consent of the adviser from a "position of strength".2
Apparently, just three years later, we have decided that those changes failed miserably to achieve their purpose. The release that we have before us today suggests that independent directors are now powerless to effect change, despite the fact that independent directors constitute a majority of the board, which provides them with the power to elect officers of the fund, solicit proxies, and call meetings.
Does anyone really believe that having an additional independent director (or fewer directors so that the proportion of independent directors on the board is higher) -- or having a non-executive chairman -- would have prevented the scandals that are driving this rule change? If so, how can you explain the implication of Bank of America, Bank One, and Putnam, each of which had an independent chairman?
As we continue to focus on headcount of independent directors, I am concerned that we are digging for fool's gold. In only three years, we have moved from 50% to 75%. Why only 75%? Are we just saving room so that we have another opportunity, after more abuses come to light in the future, to increase, with great fanfare and the promise of a scandal-free future, the percentage? If we do so, I suggest the number 98.6. It works for body temperature; why not for mutual fund boards?
Far from being benign, the changes that we are adopting today might have a lasting, deleterious effect on the fiduciary obligations that are the cornerstone of our mutual fund regulatory structure. I am deeply concerned that all of the focus on independent directors is unintentionally shifting the focus away from the fiduciary obligations of the fund adviser and offloading this responsibility onto the fund's board of directors. If enforcement actions are driving this rule change, we should see the underlying violations for what they really are - they are violations of the adviser's fiduciary obligations, not necessarily failures of the fund boards. Instead of focusing greater attention on the critical fiduciary obligations, we appear to be watering them down. The fund board is there to police conflicts of interest, but the primary responsibility to see that investors' interests are protected lies with the adviser as fiduciary.
Reinforcing the importance of the adviser's fiduciary obligation is of utmost importance here and that important function is getting lost as we tinker and reengineer board independence. Take a look at our release: our only reference to the adviser's fiduciary duties is in the footnotes when we summarize the enforcement cases that arguably led to this package! What message are we sending regarding the adviser's fiduciary obligation? We are inadvertently creating a great moral hazard.
Independence is an important feature on mutual fund boards. Congress recognized this when it enacted the '40 Act. But, it is not the only important feature. Just as important, is that the each company has the flexibility to devise its own structure to accommodate the unique attributes of the company's corporate culture. Each firm is best suited to select its governance structure as long as the structure and any conflicts inherent in that structure are disclosed to investors. Investors are best situated to select the firm to which they will entrust their money. When this trust is betrayed, enforcement is appropriate and investors will react.
If we look at this through the lens of W. Edwards Deming's managerial philosophy known as total quality management, and the later variant Six Sigma, we can look at whether fraudulent activity by fund advisers derives from a common cause or something aberrant in a particular adviser's management process - that is, a special cause. If common causes are to blame for the fraudulent activity, then the system is flawed and redesign is necessary. The empirical data that we have found thus far does not point to the lack of an independent chairman as a common cause for the fraudulent activity by fund advisers. Rather, funds with independent chairmen seem proportionally implicated in this activity. Thus, a redesign of the fund governance system is not indicated by the data. To say otherwise suggests that we are mandating this redesign of fund governance based solely on well-meaning instincts and the perceived need to effect change. In other words, whim.
Although not a perfect solution, I could have supported one of the compromise proposals submitted during the comment period. A compromise that some of us considered would have provided, among other things, that independent directors would designate a Lead Independent Director and that all of the major board committees would be chaired by an independent director, who would have the authority to set the agenda of the committee. This proposal would address all of the problems that our release seeks to address without the excessive rigidity or cost that we are mandating today. Although this solution is far from perfect, at the very least it is less costly while producing the same amorphous and symbolic benefits that our rule will supposedly provide. I am disappointed that this alternative proposal was not on the agenda for a vote of the entire Commission today.
Please do not construe my vote or these remarks as criticism of the staff of Investment Management. I recognize that you have tried to do everything that you can to justify and defend this rule. I view you all as the lawyers who have been presented with an unwinnable case. You did the best you could with this impossible task. The blame for this change and the lack of any basis for mandating it falls squarely on the Commission's shoulders. That said, I thank you for your hard work and preparation today.
Endnotes
http://www.sec.gov/news/speech/spch062304psa.htm
