If 2020 was unprecedented, 2021 wasn't far behind. Like all other businesses, mutual fund boards shifted gears, adopted new technologies, and what was previously unimaginable became the norm. So, what will stay and what will go as the pandemic eases its grip?
After 18 months of working under a variety of COVID-19 protocols, many boards were looking forward to going back to in-person or hybrid meetings in the fourth quarter of 2021 or first quarter of 2022. But with the emergence of new highly contagious variants and expected post-holiday surges, many boards have determined that it is best to take it quarter by quarter on deciding whether and when it will be the appropriate time to go back to in-person meetings.
All boards will likely take different approaches on these considerations depending on board members' individual risk profiles as well as on COVID-19 conditions and governmental mandates in the locations where meetings take place. While boards have been functioning well virtually and getting all of their work accomplished, with the pandemic entering its third year, the cohesion that board members gain by socializing in person may be taking a hit—particularly for boards where new members have been added during this unusual time. Additionally, "Zoom fatigue" is increasing, although many boards have shortened the meeting time per day and spread meetings out over a longer number of days in order to help ease this exhaustion.
ESG, Names Rule
With the rapid increase in mutual funds advertising that they are "ESG," and a corresponding increase in SEC comments for funds to disclose in registration statements the specifics of how the fund defines ESG and will meet those definitions, boards should be focused on this topic to ensure that there are proper oversight processes in place to make sure the fund is doing what it says. While this is always the case (funds must follow the investment strategies disclosed in their prospectus), there are extra layers of compliance involved with ESG funds.
There is now a proposed rule on the SEC's regulatory agenda associated with addressing matters relating to ESG factors, so there should be more concrete guidelines coming down the pike. Until the rule is proposed and then finalized, it is unknown what role boards will play, but it is clear that they will need to be laser focused on oversight of these types of products.
At the same time, the SEC is also intending to issue a proposed rule that would revise Rule 35d-1 (also known as the "names rule"), and this will likely require boards to be more cognizant of the name chosen for a fund to ensure that it matches the strategy and would not be misleading to an investor.
As fund names and niche strategies become more specific in an effort to differentiate funds from one another, it is a time for boards to ensure that the adviser has the proper resources in place to ensure that the fund is able to comply with all of its disclosures.
Derivatives, Fair Valuation
The clock is ticking toward the deadlines for which funds need to be in compliance with the new rules for derivatives and valuation, Rule 18f-4 and Rule 2a-5, respectively. As 2022 gets under way, boards will need to ensure that they are asking for regular updates on preparation for these rules to ensure that advisers and funds are creating the necessary policies and procedures to be able to meet compliance dates.
For derivatives, boards will need to understand which funds don't utilize derivatives at all or are limited users and which need a full derivatives risk management program (DRMP). For those boards that oversee funds that need a full DRMP, the board will need to approve the derivatives risk manager and be comfortable that the adviser has the proper personnel and resources to comply with all aspects of the rule. The board will also want to discuss with the adviser the format of reporting that the directors would like to receive as part of their oversight responsibility.
Regarding valuation, boards will need to appoint a valuation designee and approve any changes to valuation policies and procedures that are required to be in compliance with the rule. While boards will no longer need to ratify fair valuations, they still must oversee the valuation designee, and they should ensure they are comfortable with the reporting they will be receiving on a quarterly and annual basis. For both of these rules, as with any others, the reporting will likely be an evolving process.
Board Diversity
With the continuing attention on diversity and racial equity issues in society at large, boards will likely heighten their considerations of how to increase their diversity when looking to add a new member. While there are currently no regulations requiring fund boards to diversify, an increasing number of institutions are looking at board composition when making investment decisions, which also can include whether or not a fund's board is diverse. The diversity subcommittee of the SEC's asset management advisory committee has recommended to the SEC that additional disclosure requirements be adopted for investment advisers. What those disclosures may include and whether or not they impact the board or only the adviser remains to be seen, but boards will do themselves a disservice if they do not begin to include diversity as a topic when searching for new members.
Additionally, boards will also likely continue to increase their questioning on the adviser's diversity and inclusion efforts. More and more gatekeepers are requiring certain diversity and inclusion criteria be met in order to consider a fund for investment. Advisers and boards would not only be remiss to ignore this important issue but will also likely lose opportunities if they don't expand their pool of potential members.
Structural Changes
In 2021 we saw the first mutual fund-to-ETF conversions take place, and this will likely become a more common topic that boards will engage in with advisers to determine if a particular fund might be able to garner more assets and serve investors better in an ETF format. In some instances, an adviser may want to add the same investment strategy in an ETF format while continuing to keep the mutual fund format. Boards will be involved in these decisions, as well as discussions regarding the potential for cannibalization of the mutual fund and whether maintaining both formats could end up hurting investors in the original mutual fund.
Alongside these changes, boards will need to consider if they have the expertise to oversee both mutual funds and ETFs and if additional resources are needed to help them with these expanded responsibilities.
Adviser Resources
As the costs of regulatory burdens and the increase of fee compression continue to impact adviser profitability, boards should ensure that they question whether the adviser—particularly those smaller advisers—has the financial resources to fulfill its fiduciary duties to the funds under advisory. Additionally, with the "great resignation" we have recently seen in late 2021, boards should continue to inquire about whether the adviser, and particularly the chief compliance officer, has the staff and resources needed to ensure that the fund is in compliance with all regulations. Boards should also ask the adviser to confirm all material service providers are fulfilling their obligations, as many of the fund administrators and custodian banks are being impacted by this staff shortage.
Keeping Busy
This year is looking to be another year with new and/or changing regulations for investment companies. As mentioned already, there are plans to propose a new rule related to ESG and amendments to the names rule. Additionally, in December the SEC proposed amendments to the money market fund rule, which is likely to be finalized in 2022, and the SEC's recent publication of its regulatory agenda shows that it is working on proposing changes to the liquidity risk management rule and finalizing the rules related to modernization of shareholder disclosures.
Finally, on one of the last days of 2021, William Birdthistle was named as the new director of the Division of Investment Management at the SEC. A professor at Illinois Institute of Technology's Chicago-Kent College of Law, he has been an outspoken critic of the mutual fund industry, and his appointment may mean more strict regulations ahead. What these rules and changes will mean for directors remains to be seen, but rest assured you will be kept busy in 2022!
Rachael Schwartz is counsel at Sullivan & Worcester LLP in New York, where she focuses her practice on the Investment Company Act of 1940 and related securities and corporate laws. She counsels all types of registered investment companies, including mutual funds, closed-end funds, and exchange-traded funds. In addition to counseling registered investment companies, Schwartz also serves as independent counsel to directors of mutual funds and variable insurance trusts.