Despite Plan to Fortify Independent Directors, Shareholders Must Be Their Own Watchdogs

A month ago, at a Securities and Exchange Commission round-table discussion on mutual fund fees and governance, John Markese asked for a show of hands.

“How many of you know who your funds’ independent directors are?” asked the president of the American Assn. of Individual Investors, turning to an audience of industry officials and observers.

“I don’t recall seeing a single hand,” Markese said.

And these were the so-called experts.

How many of us can name even one of the independent directors who sit on our mutual fund boards? How many of us even know that our funds have boards of directors to begin with?

The truth is, probably not many. Which underscores the challenge facing SEC Chairman Arthur Levitt.

Last week, Levitt unveiled a plan to make mutual funds more responsive to the needs of their shareholders by strengthening the role of independent directors.

Independent directors are folks who sit on fund boards but don’t have ties to the fund company, the investment advisor or the underwriter--ties that could lead to potential conflicts of interest. So they’re free to serve our interests.

In theory, anyway.

The reality is that independent directors, along with the rest of the board, often just rubber-stamp management’s decisions.

“Whether shareholders realize it or not, how directors fulfill their responsibilities directly affects them every day,” Levitt said. “From negotiating and overseeing fund fees, to monitoring performance, to policing potential conflicts of interest, fund directors should be on the front lines in defense of the shareholder interest.”

The Directors’ Dirty Little Secret

If directors haven’t been doing as much on our behalf as they could--for instance, by lowering fund management fees more--Levitt hopes to remedy this by increasing the number of independent directors on fund boards.

Currently, the SEC requires that at least 40% of a fund’s board be made up of independent directors. Levitt wants that upped to at least a majority.

There’s nothing wrong with this idea. In fact, it’s commendable. But if the goal is to have independent directors lead a charge to lower fund fees, the dirty little secret is that they already can--even without majority status.

Under current SEC rules, if a majority of the independent directors on a board don’t approve of a management contract--which includes fund expenses--then the contract can’t be adopted, no matter what the rest of the board says.

This means that adding more independent directors to a fund probably won’t improve our odds. The real problem must lie with the directors themselves.

The real problem is this: Mutual fund investors don’t know (and couldn’t care less about) their board of directors, and independent directors have no meaningful relationship with the shareholders they’re supposed to serve.

Until this is addressed, nothing will change.

In recent years, there have been two high-profile cases in which independent directors tried to remove their fund managers.

In both cases--one involving money manager Louis Navellier, the other Don Yacktman--the fund managers easily prevailed when the matter was put to a shareholder vote.

Shareholders Not Paying Attention

Does it come as any surprise? After all, how can you expect shareholders to trust people they don’t know?

“When an investor puts money in a fund, the contract he’s making is with the manager,” Yacktman argues. In other words, investors implicitly trust their fund managers.

At the same time, most of us couldn’t tell who our directors are even if they were standing right next to us with name tags on.

John Brennan, chairman of Vanguard Group and Investment Company Institute, lauds the job that the majority of fund directors have been doing, yet concedes this point.

“I’m not sure people do pay enough attention at this stage to who their directors are,” he said.

This is no small problem. After all, how can independent directors legitimately challenge popular fund managers if they’re politically impotent?

So what’s the bottom line?

If you want to safeguard your portfolio against egregious expenses and fees, don’t hold your breath for mutual fund reform. Just go with a fund with low expenses and fees to begin with. It’s that simple.

“In the end, it’s your responsibility,” said financial planner Harold Evensky of Coral Gables, Fla. “We can put in place a lot of protections, but a fool and his money are easily parted.”

Oh, by the way. It also can’t hurt to get to know your directors.

Times staff writer Paul J. Lim can be reached by e-mail at paul.lim@latimes.com.