The purpose of this writing is to propose a refocused lens through which to view the critical work of the independent directors to a mutual fund. While many of my views reflect my role as a fund board steward for over a decade of service, much of what follows is not new. My hope is that this thought piece will help re-frame the role of the fund board and act as a guide to the regulator in future rulemakings as to the appropriate use of the fund board for purposes of guarding shareholder interests. I have a few observations based on my close work with fund directors that I think could enhance the effectiveness of fund boards and re-focus the Securities and Exchange Commission on what is important with respect to the work boards do that could assist the SEC in its mandate.
I represented the management company at many fund board meetings at a very reputable fund management firm with a strong reputation for business integrity and putting shareholder interests first. I did not work for a firm that challenged or pushed the envelope with the fund board in terms of questionable business practices or lack of transparency. Anything we did was looked at through the prism of the interests of our clients, front and center, which led to a healthy and productive relationship with the fund board.
My basic point is that over time, through business and technological developments, increased regulatory obligations, and best practices for litigation defense, the work of the fund board has evolved to more of an oversight of fund compliance and operational processes which, while important, has detracted from more meaningful work that would be beneficial to funds and their shareholders. In looking at the role of the board through a refocused lens, the SEC should consider what is critical and important to investors: investment performance, shareholder service, good stewardship, and fees and expenses (the “Four Pillars”). Any future rulemakings or regulatory guidance should view the role of the board through this refocused lens.
As I said to the funds’ independent directors in my retirement speech, fund board work is a profound obligation that is quite different from the work of a typical corporate board. The role of a fund board, even in the best of times when things are running smoothly, is challenging and requires continual education. There is sometimes an inherent tension between the oversight role they play and the detailed information they are provided in that role. Due to the regulatory complexity in the mutual fund ecosystem, discussions of the manager’s corporate strategy generally take a backseat to fund compliance and regulatory requirements that must be overseen by the board. Fund directors receive an abundance of information on fund processes and investment activities. This information overload, if left unchecked, can turn a normal process or operational issue or an outcome in a fund’s daily operations into potential subject-matter at a board meeting and even decision points for the directors.
Good board members provide “constructive abrasion”; they have to be thoughtful advocates for fund shareholders, asking probing questions and seeking responses in order to get comfortable with their decisions. In their decision making, they need to ferret out and consider possible conflicts of interest involving the fund and its manager. But they also are informed of and may consider the business interests of the manager. The collective goal should be a healthy fund manager that is a good steward for fund shareholders that can attract and retain investment talent to perform well for fund shareholders. In this regard, I have found that in a well-functioning relationship, the board and the fund manager often have aligned interests.
Competition in the asset management space is fierce. There is a fine line between reasonable fees and expenses under the Gartenberg standard versus being the lowest cost provider. The SEC’s requirement of disclosure of board considerations in connection with the approval of advisory contracts, while well-intentioned, has not, in my opinion, had the desired effect of providing meaningful information to fund shareholders or improving the contract renewal process. In my experience, this disclosure appears to get little attention from fund investors and commentators other than from lawyers seeking to attack the process.
There have been reviews over the years by the SEC staff of the board function, including interviews with independent directors and their counsel. Yet, little seems to come from this activity other than tinkering around the edges and incremental reform (see 2018 SEC no-action letter issued to Independent Directors Council). We expect the fund board to play an oversight role of a fund’s operations and act as an independent check upon fund management. Yet, the amount of operational detail, compliance reviews, and fund processes and procedures thrown at the fund board has blurred the line between supervision and day-to-day management. The SEC in its fund rulemaking and guidance pronouncements over the last 10 years (liquidity risk management and sub-accounting guidance) has added more detailed work to the board agenda.
Challenges and Opportunities
- Regulation and complexity lead to the need for additional board expertise. We ask our fund directors to oversee complex areas such as valuation, derivatives, cybersecurity, and business continuity and resiliency without having intimate, substantive knowledge of these areas. Directors are more than capable of digging into the adviser’s processes and procedures and asking probing questions about them, but is this the best and highest use of their time in areas outside of the Four Pillars?
- The SEC seems to incorporate some element of board reporting as part of every new rule proposal, yet not much ever comes off the board’s agenda. As a consequence, we have years of reporting buildup or board “agenda creep.”
- There is an impact to in-house resources to support the reporting. Fund groups may need to dedicate more resources, both people and technology, to the effort. This would likely be at shareholder expense.
- Fund industry developments have contributed to this complexity through share class proliferation, new and complex products, and global expansion into new markets. We have not made it easier on our fund boards. Fund boards want to hear about business and industry trends, the “why” and not just “how” the manager does things. They need to understand how the manager invests for and services its fund shareholders, yet the regulatory initiatives are taking fund directors further and further into the weeds and away from their critical mission, which is to help ensure that advisers are delivering performance for shareholders at a competitive fee.
Roadmap for the SEC
In looking at the role of the board through a refocused lens, the regulator should consider how its existing or proposed regulatory requirement or guidance relates to the Four Pillars. Is it subject matter that is important to fund investment performance, service quality, good stewardship, and fees and expenses? If so, there is an opportunity for board involvement in that subject matter or area. Whenever possible, the board should be able to rely on the CCO and other “lines of defense” (internal audit, fund accountant, risk officers, chief technology officers) to police conflicts, compliance and business risks, and ensure that robust capabilities and policies and procedures are in place to address these areas.
The SEC should review every rule or regulatory pronouncement that requires board review as a condition/requirement for exemptive relief to assess whether, and the degree to which, board engagement is necessary and required to protect shareholder interests. There are some limits as to what the SEC can do on its own as certain functions are dictated by statute (i.e., fair valuation, approval of contracts, approval of auditors), but there is a host of limbs that could be trimmed.
For example, reviewing stress test results for money market funds under Rule 2a-7 at every board meeting may appear to have become a rote exercise that takes the board into a granular level of detail that is unnecessary in light of the board’s oversight role. Instead, this could be an annual review that focuses on the asset manager’s risk management processes and stress testing capabilities. “Close calls” and other adverse trends in the stress testing results can be discussed at the next board meeting or even in an ad hoc meeting when it is timely. The following are other examples where directors are asked to approve technical matters that are ripe for change by the SEC: approval of structural changes to share classes that don’t impact shareholder economics under Rule 18f-3; the outdated conditions for 12b-1 plan approvals; related “distribution in guise” issues where the onus is on the board to parse through the metaphysical concept of “what is distribution” for purposes Rule 12b-1 (i.e., when an intermediary is providing both distribution and non-distribution services to funds and their shareholders); and other affiliated transactions that the board ratifies or approves retroactively, such as affiliated redemptions or purchases in-kind.
38a1: Model for Board Engagement
Use Rule 38a-1 as a model for board engagement on subject matter outside the Four Pillars:
- Rule 38a-1 came out of the fund industry’s dark age and is a response to the market-timing scandals that rocked the industry back in the early 2000s.
- What isn’t always appreciated is that the industry actually lobbied for a compliance program rule about a decade earlier after the SEC was questioning whether the fund industry needed a self-regulatory body similar to FINRA.
- The SEC ultimately didn’t act on the proposal, but one wonders whether that rule could have changed the course of history in terms of the fund governance proposals that came later.
- Rule 38a-1 is now 15 years old, and most in the industry consider it a huge success. Why? It gives the board an ally in overseeing a fund’s activities and its management—acting as the “eyes and ears” of the board in an area that is not within the skillsets of most fund directors
- It is appropriately balanced in what the rule requires of the fund board—the fund directors approve the program, material changes to compliance policies and procedures, and receive periodic reports from the CCO on the operation of the program.
- It recognizes that boards are not experts in compliance and gives them access to an objective resource who can help them fulfill their fiduciary duties in this area.
- The SEC further enhanced the effectiveness of the rule by acknowledging that boards could rely on summary reports provided by the CCO in fulfilling their responsibilities and approving certain transactions under 1940 Act exemptive rules (see IDC no-action letter).
My proposed solution to simplify and re-focus the work of the board is to rely more heavily on the CCO, chief risk officer, fund treasurer and other senior leaders in line of defense positions as the eyes and ears of the board. Dealing with fund compliance programs and the fallout from missteps under complex mutual fund regulations are among the most tedious and challenging work assigned to the board. Most boards hear regularly from the CCO notwithstanding the requirement in Rule 38a-1 for annual meetings between the CCO and independent directors. For example, the SEC could condition CCO review and approval of certain fund compliance matters and exemptive rule conditions subject to board follow-up with streamlined information or CCO reporting. Consideration should be given to expanding the protocol outlined in then 2018 no-action letter issued to the IDC that allows boards to rely upon the CCO’s compliance representations for compliance with affiliated transaction rules under Sections 10(f), 17(a) and 17(e) under the 1940 Act.
Two Recent Examples
A good example of where the SEC got it right was in the fund liquidity risk management rule. The original rule proposal would have required the board to approve a fund’s highly liquid investment minimum—that is, the board would have needed to weigh in on and approve each fund’s minimum level of assets that can be liquidated in three business days, including any changes to those highly liquid asset minimums which could occur as market or a fund’s conditions change. This is a dynamic, fact-intensive, and technical analysis of multiple factors requiring expertise on investments, markets, trading, and settlement—areas that require investment as opposed to business judgment.
After industry comment, the SEC recognized that this was not a good use of the board’s time. Commenters successfully made the case that the investment staff in conjunction with independent risk and/or compliance personnel, rather than the fund board, is most appropriate to make these determinations and that a fund’s board should primarily serve in an oversight role with respect to the process itself, as opposed to the specific outcomes of the process. The SEC listened and altered the final rule in accordance with commenter concerns.
Another example of how the SEC appropriately threaded the needle between board oversight and management of a fund’s processes and procedures was in the recent fair valuation rule. The guidance provided by the SEC in its adopting release is consistent with good board practice, recommending that the fund board evaluate the adviser’s valuation capabilities, inform itself of the adviser’s valuation processes and controls, and probe and ask questions to identify possible conflicts of interest and opportunities for potential improvement. The SEC further doubled down on the notion that the board does not need to approve outputs of an adviser’s or a fund’s processes, specifically stating in the adopting release that the board did not need to ratify fair value determinations made by the adviser. Finally, the SEC cut back on the prescriptive requirements in the proposed rule that would have required in-depth quarterly reporting on a litany of valuation matters, including material valuation risks, testing results, adequacy of the adviser’s resources, and material changes to and deviations from fair valuation methods. Instead, the final rule appropriately moved some of these items to an annual reporting cycle and empowered the board to determine which material fair value matters should be reported quarterly.
The Way Forward
The SEC should perform a wholesale regulatory review of the board process, using a clean slate approach that asks what are the most important functions for the fund board and how are these functions served or impeded by the current rule set? They should consider reorienting the board function by revising the appropriate regulations, SEC and staff guidance, and conditions for common exemptive relief so that more time and focus can be spent on the Four Pillars. As a general rule, for compliance, risk and other more technical processes, the board should oversee the process but not be asked to rule upon or approve specific outcomes of the process. With a wholesale focus of the appropriate role of the board that this lens provides, the work of the board would better serve what is of value to shareholders without losing the important protections that fund boards provide for shareholder interests.
Darrell N. Braman recently retired after 28 years of service with T. Rowe Price Associates, Inc. as a managing counsel in the legal department. The views expressed in this piece are those entirely of the author, who is no longer affiliated with T. Rowe Price.
 Competition from other types of investment vehicles (ETFs, private funds, collective trust funds, SMAs) along with evolutions in financial technology have provided an abundance of investor choice, which has put tremendous business pressure on mutual funds, particularly actively managed funds. Fallout from this business pressure can be seen in the M&A activity in the fund management space in the past several years, along with fee compression. Funds continue to be some of the most regulated and transparent investment vehicles in the financial services world. Regulatory arbitrage has contributed to a steady decline in fund industry assets and redirects cash flows into other less regulated vehicles.
 The problems with Section 36(b) of the 1940 Act are beyond the scope of this paper but should be looked at by Congress; competition, technological innovation on the service side, and the growth of passive investing have done more to lower fund fees and expenses than Section 36(b) could ever accomplish. Industry critics can point to the lack of court wins by plaintiffs’ firms as a failing of the statute, and the industry looks at it as a time-consuming and expensive cost of doing business.
 In this no-action letter, the SEC permitted funds to rely upon the chief compliance officer’s certification for compliance with affiliated transaction rules under Sections 10(f), 17(a) and 17(e) of the 1940 Act.
 See also a 2016 address by SEC Chair Mary Jo White at the Mutual Funds Directors Forum where she lays out her vision for fund board responsibilities while attempting to strike a balance between management and oversight.
 This assumes that the fund’s management agreement does not require the fund manager to bear this expense.
 This construct may be more difficult for smaller fund shops to implement as they may be more likely to outsource some or all of these fund stewardship functions. While fund boards to smaller fund complexes can adapt to the resource differences, accommodations may need to be made for such boards and small fund advisers.