Mutual fund cleanup: Washington's surprisingly slow-motion efforts at reform

International Economy, The, Wntr, 2004 by Roger M. Kubarych

Spitzer got involved because of the success of the New York attorney general's office in investigating and punishing investment banks that were corrupting the equity research process. Whistleblowers naturally turned to that office when they were unsure that the SEC would be responsive. But it is important to recognize that state laws are fundamental to the organization and governance of investment companies. As Paul Roye, director of the SEC's Division of Investment Management, has said: "Since investment companies, like other corporations, are organized pursuant to state law rather than federal law, the Investment Company Act is not the only source of authority for the management power of investment company directors." In other words, Spitzer and other state Attorneys General are not interlopers or merely "pushy politicians," as they have been described by their adversaries, but are at the center of the regulatory system for the mutual funds industry.

POOR CORPORATE GOVERNANCE CAUSES CORRUPTION

So far, in addition to Invesco, several mutual funds, hedge funds, and other institutions have been implicated in the scandal in one respect or another: Eddie Stern and Canary Funds, Strong, Janus, Pilgrim/Baxter, Putnam, Bank of America, Bank One, and Security Trust. For each story there appears to be a different set of facts, circumstances, and angles. But there are two common denominators. The first is that there was a rather pervasive indifference to the rules and to the basic sense of fiduciary duty. (It did not help that nobody seemed to be watching, either.)

But the second and more fundamental common denominator is an absence of internal oversight. Corporate governance of mutual funds has always been something of a charade. It defies common sense that the same individuals can simultaneously be independent directors of the boards of dozens of mutual funds within a fund complex. And this is a part-time activity for all of them. However worthy as individuals and accomplished in their own professions, independent directors can hardly perform even the most perfunctory of due diligence over what is going on in any of those funds, let alone dozens. However, the regulators have had a rather rarified notion of what independent mutual funds directors can do. They seem genuinely to believe that independent directors play a crucial role in ensuring shareholders' interests are protected.

The reality is that they do not and cannot play anything like that highly informed, necessarily intrusive, oversight role. Formally, they basically have two functions: hiring the investment manager and hiring the outside auditor. But these are formalities. No one can remember a case in which the board of a major mutual fund fired the fund manager for consistently poor performance or for a shareholder-unfriendly fee structure and shifted to another fund complex that might do better. As for exercising a duty of care, the independent directors have no way of accomplishing that. They have no staff, no independent legal or accounting advice, no ability to conduct independent due diligence, and no access to what actually goes on within the fund.