Thought Magazine

Board Governance—Ever Raising the Bar

It seems reasonable for boards to expect continued attention from regulators. As such, policies and procedures should be thoughtfully reviewed and validated regularly.

Board members at U.S. mutual fund companies may be feeling under pressure these days. With recent high-profile SEC enforcement actions and the resulting news headlines, fund directors have come under increasing scrutiny. There is interest from regulators for greater clarity on valuation, disclosure of fees, adherence to policies and procedures, and concerns about delegation of duties.

Aftermath of the financial crisis

Many retail investors in registered funds experienced significant losses during 2008 and 2009. In fact, some investors claimed they were not aware that their fund investments were so risky and subject to such large declines in value, given the types of securities in which they were invested and the strategies employed. Some of these claims have been investigated by regulators to see if investment firms, advisors or boards of directors were liable for breaches of law and fiduciary duties.

Fee disclosures

It appears to be a regulatory priority to improve and clarify the disclosure of all fees and/or expenses for the investing public. In addition, academic research has shown that investors, as a broad class, may be underperforming on an after-fees' basis, and that investors may not have all the information necessary to assess actual investment performance.

For example, in an article by Charles Ellis,1 the argument is made that there are no other services that charge such a high premium for the value of the service provided, particularly for actively managed funds. Explicit disclosure of section 12b-1 distribution fees—those fees paid by the fund out of fund assets to cover distribution expenses and sometimes shareholder service expenses—was made mandatory in 2010, and pressure continues to favor increasing clarity.

In addition, the investing public is aware that mutual funds charge higher fees to retail investors than to large institutions. In a 2012 study, authors Richard Evans and Rüdiger Falhenbrach found that retail funds with an "institutional twin" (where advisors offer multiple versions of a fund) underperform their institutional counterparts by 1.5 percent on a riskadjusted annual basis. In addition, these authors found that when a retail fund gains an institutional twin, the fund's expenses decrease and measures of managerial effort increase.

Lack of transparency on director pay

Investors do not appear to have a clear understanding of the work that directors perform on behalf of the fund, and how that ties to director compensation. This lack of clarity becomes even more concerning during periods of underperformance. In addition, many directors serve on multiple boards, particularly within the same fund complex. The investing public may not understand how a director can perform the appropriate level of due diligence for multiple funds. Providing insight into the responsibilities borne by directors and the actual burden of work may serve to put things in perspective.

SEC Exam Priorities

Last February, the SEC issued their examination priorities for 2013 for the National Exam Program's Office of Compliance Inspections and Examinations. This fourteen-page publication clearly documents some major issues of concern and highlights fund governance as a focus. The following is noted as an ongoing risk in the Investment Adviser/Investment Company Examination program:

Fund governance and assessing the "tone at the top" is a key component in assessing risk during any investment company examination. The staff will confirm that advisers are making full and accurate disclosures to fund boards and that fund directors are conducting reasonable reviews of such information in connection with contract approvals, oversight of service providers, valuation of fund assets, and assessment of expenses or viability.

A few best practices in board governance

Valuation—Against the backdrop of recent enforcement actions (see figure 1), valuation continues to be an area of focus for regulators. It seems clear that directors need to be actively involved with setting appropriate practices and policies. It is not sufficient to outsource this responsibility to others, although other professionals may be involved in the execution of these duties. Not only may funds be held responsible, but the board may be liable as well.

Conflicts of interest—One important policy to address regards conflicts of interest. Boards should put in place a solid and thoughtful process to identify and monitor potential and actual conflicts of interests. This review should not simply be a once-off occurrence but rather incorporated as part of an ongoing process. Boards should also ensure that these issues are then rigorously and regularly documented and disclosed.

Policies and procedures—Boards should have an oversight process in place that outlines the policies applicable to the fund, its managers and the board.

Delegation of duties—If a particular expertise is required that is not present in the board's composition, it can often be appropriate to engage with a subject-matter expert to assess, and even perform, some of the oversight work. However, while one may delegate the task, the board retains responsibility for the actual practices and their execution. As such, directors must be able to document the decision-making process, policies and procedures and also demonstrate that the appropriate level of oversight is performed. As noted in the Morgan Keegan case, figure 1, valuation remains a key function and a high priority to the SEC. Specifically, while boards may employ experts to perform the required valuations, they should possess or obtain the requisite knowledge in the subject area and demonstrate regular and reasonable oversight.

Boards should put in place a solid and thoughtful process to identify and monitor potential and actual conflicts of interests.

Board composition—Investors are seeking qualified, independent directors with minimal conflicts of interest. Boards are responsible for a broad range of functions, including the assessment of fund manager performance, review of manager contracts, oversight of manager adherence to fund registration and investment guidelines, and reviews of prospectus documentation, regulatory filings and compliance results. The composition of a board should be reviewed, and it should be considered if it is appropriate to enhance the diversity of experience represented in its composition.

Transparency of fees—Investors should be provided with access to simple, clear data regarding all fees for which they may be responsible. Investors also should feel confident that they are paying a reasonable fee for the benefits received in terms of investment returns. Ensure that fees are in keeping with current standards and are clearly communicated. Investors should be permitted to see the impact of these fees on their total absolute and relative returns to allow for fair comparisons. The pay structure should be disclosed for both board members and investment managers, demonstrating the performance-based components and/or incentives.

Three Recent SEC Cases Involving Valuation

Morgan Keegan:4
Eight former fund directors of Morgan Keegan were charged by the SEC on a number of valuationrelated charges in December 2012. It was alleged that the board delegated the responsibility for determining valuations without providing direction or retaining oversight. It was further alleged that the directors made no efforts to understand the fair value process and relied on a valuation committee and the firm's fund accountants.

Yorkville Advisors:5
In October 2012, hedge fund adviser Yorkville Advisors was charged with fraud related to suspicious fund performance. The regulator alleged that the hedge fund misrepresented the characteristics of the fund and its related valuation methodology and charged excessive fees based on over-inflated performance returns, among other charges.

On March 11, 2013, the SEC found that Oppenheimer provided misleading valuation and performance information. The actual valuation practices were not consistent with the stated policies, resulting in overstated performance results. The regulator also found that the policies and procedures were not reasonably designed to ensure valuations were presented as stated. The firm settled with the regulator for $2,800,000 and was similarly penalized by the Commonwealth of Massachusetts for approximately $130,000.

In conclusion, it seems reasonable for boards to expect continued attention from regulators. As such, policies and procedures should be thoughtfully reviewed and validated regularly. Diligent compliance practices should be visible in all parts of the organization and demonstrate a clear understanding of client needs. Regulators have clearly documented their priorities, and funds should be prepared to meet them.

1 Charles D. Ellis, CFA, Financial Analysts Journal, vol. 68, no.3, "Investment Management Fees Are (Much) Higher Than You Think," May/June 2012, www.cfainstitute.orgWeblinking practices.
2 Richard B. Evans and Rüdiger Fahlenbrach, CFA Digest, vol. 43, no. 2, "Institutional Investors and Mutual Fund Governance: Evidence from Retail–Institutional Fund Twins," May 2013, www.cfainstitute.orgWeblinking practices.
3 National Examination Program, Office of Compliance Inspections and Examinations, "Examination Priorities for 2013," February 21, 2013, page 4, www.sec.govWeblinking practices.
4 United States of America Before the Securities and Exchange Commission In the matter of J. Kenneth Alderman, CPA; Jack R. Blair; Albert C. Johnson, CPA; James Stillman R. McFadden; Allen B. Morgan Jr.; W. Randall Pittman, CPA; Mary S. Stone, CPA; and Archie W. Willis III, respondents, Release No. 30300/ December 10, 2012, www.sec.govWeblinking practices.
5 United States District Court Southern District of New York Securities and Exchange Commission, Plaintiff, against Yorkville Advisors, LLC, Mark Angelo, and Edward Schinik, www.sec.govWeblinking practices.
6 United States of America Before the Securities and Exchange Commission In the matter of Oppenheimer Asset Management and Oppenheimer Alternative Investment Management, respondents, March 11, 2013, www.sec.govWeblinking practices.

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Thought, 3Q 2013


Rachel Sykes

Rachel C. Sykes, CFA
Product Executive
Americas Fund Services


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