Mutual Funds

Board Structure

Investment companies, commonly called mutual funds, can be organized either as business trusts or as corporations. If a fund is organized as a business trust, it elects trustees rather than directors. While companies typically have annually elected or classified boards, many mutual funds have perpetual boards. Perpetual directors serve for the duration of the fund's existence or until the fund next considers the election of directors. Directors of funds with perpetual boards must stand for election only when fewer than two-thirds of a fund's directors at any time have not previously been elected by shareholders. This can occur if the fund proposes to add new nominees to the board or when the composition of the board has changed substantially (through retirement or dismissal).

In recent years, funds have been moving away from annually elected boards and toward the perpetual board structure. Some open-end funds have proposed a restatement of the Declaration of Trust, providing that current directors remain in office until they resign or are duly removed by an affirmative vote of two-thirds of the outstanding shares. Such a change makes it much more difficult for shareholders to alter the composition of the board.

Since company directors oversee management and represent shareholder interests on an ongoing basis, votes on directors are among the most important use of the shareholder franchise. Directors should be accountable to shareholders on an annual basis. However, because federal regulations strictly govern the permissible activities of the board and its advisors, and since funds generally allow shareholders more flexibility with respect to the transfer of their investment to another fund within the family, votes should not be withheld solely because the director nominees are to be elected for a potentially perpetual term. Such directors can be removed from office by shareholders at a special meeting called for such a purpose, or shareholders can choose to invest in a similar fund with a more frequently accountable board.

Director Independence and Qualifications

The Investment Company Act of 1940 provides that no more than 60 percent of the members of the board may be "interested persons" of the fund, although there is an exception for noload funds managed by an investment advisor, which are required to have only one "noninterested" director. (1940 Act, Section 10(a)). The term interested person, characterized by ISS as an inside director, is defined by the SEC to include:

• persons in a direct control relationship with the investment company or its advisor

• any broker-dealer or affiliate of a broker-dealer

• any person who has served as legal counsel to the fund within the past two years

• any member of the immediate family of an affiliated person

• any other person whom the SEC determines has a "material business or professional relationship" with the fund or its principal executive officer

In addition, some fund transactions, such as the amendment or renewal of an advisory contract, must be approved by a majority of the disinterested directors, who are under a duty to request "such information as may reasonably be necessary to evaluate the terms of [the] contract." (1940 Act, Section 15(c)). Furthermore, whereas a typical company may enter into a number of business relationships with suppliers, competitors, or customers (each of which could be represented on its board), mutual funds seldom have such varied and numerous business relationships. Therefore, notwithstanding the tight restrictions imposed by the SEC, affiliated outsiders are all but nonexistent on mutual fund boards, and any insiders will usually be employees of the fund's investment advisor. Thus, mutual funds have fewer affiliated outsiders and insiders on their boards (measured in percentage terms) than do typical corporations. However, certain directors who do not have an employee relationship but are tied to the manager in other ways can still be classified for legal purposes as independent.

Determining a director's independence is made more difficult by the fact that many directors serve on all of the boards within a fund family. Most fund companies maintain these umbrella boards because having several independent boards would entail prohibitive costs for the fund company. Some fund families operate clustered boards on which several groups of directors oversee selected funds based on factors such as investment objective or asset size. While such structures may cloud director independence, they also work to keep costs down. Though there have been some shareholder proposals requesting that the board take steps to provide that no nominee serve as a director on any other board, ISS does not necessarily agree that directors with such links are unable to effectively serve the fund investors. Indeed, directors of very large fund families are often retired industry executives whose board responsibilities are their primary employment.

Fund regulations not only play a role in stipulating director independence, but also impact director qualifications. The Investment Company Act of 1940 prohibits any person who has been involved in any bankruptcies or has been convicted of a felony within ten years from serving on the board of an investment fund (Section 9(a) 1940 Act). Additionally, Section 17(b) prohibits any provisions indemnifying directors or officers against liabilities to the company arising out of their willful misfeasance, bad faith, gross negligence, or reckless disregard of duty.

The Investment Company Institute (ICI) has weighed in on this topic with a 15point list of best practices for director independence. Increasing the number of independent directors on a board and limiting the number of funds on which any one independent director can serve are among the key issues that the ICI addresses (see Appendix A).

Attendance

ISS believes that directors should attend at least 75 percent of board and committee meetings to effectively carry out their fiduciary duties, and high absenteeism warrants withholding votes. Directors who fail to attend meetings are not able to adequately represent shareholder interests. Those who accept a nomination to serve as director should be prepared to make attendance at scheduled meetings a top priority. Attendance information is usually summarized in the fund's proxy statement, and inquiries should be made regarding any director who attends less than 75 percent of board and committee meetings.

When examining why a particular director failed to attend 75 percent of board and committee meetings, however, consider how many meetings the director actually missed. For example, if a board held two meetings during the year, and a particular director missed only one of them, the resulting 50percent attendance record does not necessarily warrant withholding votes unless it evidences a pattern of absenteeism. Unless there is a very good reason for missing meetings, consider absenteeism sufficient cause to withhold votes from that director.

Director Compensation

Fund directors are compensated on a yearly or quarterly basis and often receive an additional fee for each full board and committee meeting attended. Pensions are rare on fund boards, although larger fund families tend to grant these benefits more often than smaller, less demanding families. All noninterested directors will generally receive an annual retainer plus fees, and interested directors are often salaried employees of the fund or its advisor.

Although disclosure of director compensation is the norm, shareholders seldom have a voice in determining this compensation except through their votes on the management and advisory agreements. Because the interested directors are usually employees of fund's management company or of the advisor, the fees paid to the manager or the advisor are directly related to the salaries of those interested directors. These agreements generally do not spell out the compensation of each director, however, so they only indirectly control director compensation.

Because many directors sit on the boards of different funds within each family of funds, the reported compensation in one fund's proxy may not reflect the total compensation for that particular director. As each fund family could potentially consist of hundreds of funds, compensation can be underestimated. Directors say their responsibilities are complex and growing and that pay is an issue that they review carefully, but fund assets continue to grow, and neither fund expenses nor directors' salaries necessarily respond to economies of scale. Efficiency measures, such as a sliding scale in determining advisory fees and holding all fund meetings on one day, are issues to consider in compensation analysis.

Fund directors are usually compensated in cash and not in options in the fund, although ownership of shares among directors is prevalent and desirable. While some proxies will only disclose aggregate ownership in the family of funds, others will disclose a director's level of ownership in each individual fund. As long as a director owns shares of at least one of the funds in a family, ISS considers him a shareholder of the fund.