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Wednesday
Dec192012

The Duties of the Board of Directors of Mutual Funds and the SEC

Mutual funds have boards (of directors in the case of corporations; of trustees in the case of Massachusetts business trusts).  Most don't have employees.  Mutual funds are, therefore, managed by their investment advisor.  See Jennifer Taub, 34 Iowa J. Corp. L. 843, 849.  The advisor has a fiduciary obligation to shareholders.  15 USCS § 80a-35(b). 

Directors of funds have a variety of obligations under the securities laws.  As the ICI has noted, these include: 

  • Fair valuation determinations for certain securities held by the fund;
  • Voting of proxies for the fund’s portfolio securities;
  • The compliance function, which includes approving written policies and procedures and the hiring and compensation of the fund’s chief compliance officer; and
  • The process by which fund disclosure (including prospectuses) is prepared, reviewed, revised, and updated.

Under this structure, the most meaingful responsibility of the board is probably the approval of the agreement with the investment advisor.  See Statement by Mark Sargeant, 44 N.Y.L. Sch. L. Rev. 431 (2001) ("The principal unique duty is hiring and, theoretically, firing fund managers and other service providers.").  Moreover, approval must be by independent directors.  See 15 USCS § 80a-15(c).  Section 10(a) of the Investment Company Act of 1940 requires that the board must consist of at least 40% independent directors.  (Or, as the statute says, no more than 60% who are "interested persons").

Of course, there is some doubt whether this happens in a meaningful way.  See Comments by Eliot Spitzer, 11 Fordham J. Corp. & Fin. L. 1, 17 (2005) ("The boards of the mutual fund companies, who have a fiduciary duty to the investors. They are supposed to negotiate at arm's length with the management companies. Lo and behold, they never engaged in that negotiation. The management companies would come to them and say, "These are the fees we want," and they would say, "Fine." They did not get competitive bidding. They did not try to ratchet it down. Only in a few limited contexts where there was competitive bidding did they actually apply downward pressure."). 

The structure of mutual funds lends itself to the board placing inordinate reliance by the advisor with respect to fund activities.  Fair value determinations likely represent an example of this reality.  Section 2(a)(41) of the 1940 Act requires that assets of the fund be valued at "fair value."  Moreover, the definition explicitly provides that fair value in general must be based upon market quotations or, if not readily available, "as determined in good faith by the board of directors."  Id.  See also Fund Director's Guidebook, 52 Bus. Law. 229 (1996) ("Although directors are not directly responsible for the daily determination of the fund's net asset value, the board should approve the valuation methodologies that set forth the means by which management establishes the daily values of the fund's assets.").  While the board has to have some involvement, the actual valuation process is done by the advisor.  

That leaves unanswered the degree to which the board has to supervise the activities of the advisor with respect to asset valuations.  Some answers may arise out of the Commission's administrative proceeding filed against eight directors of a mutual fund. 

According to the allegations, the funds had a significant portion of their portfolio invested in "below-investment grade debt securities, some of which were backed by subprime mortgages where market quotations were not readily available."  For investments without a readily available market quotation, the obligation fell to the board to in good faith determine fair value. 

The SEC alleged that board failed in this responsibility.  Specifically, the SEC alleged that the board:

  • "did not specify a fair valuation methodology pursuant to which the securities were to be fair valued;"
  • did not "continuously review the appropriateness of the method to be used in valuing each issue of security in the company’s portfolio;" and
  • "made no meaningful effort to learn how fair values were actually being determined."

The allegations stated that the "failures were particularly egregious given that fair valued securities made up the majority—and in most cases upwards of 60%—of the Funds’ net asset values." 

The case is significant.  This is not one where the board was alleged to have failed to have done nothing.  According to the allegations, there were valuation policies in place.  See Investment Company Act No. 30300 (admin proc Dec. 10, 2012) (stating that the fund's Policy and Procedure Manual specified general factors that were to be considered "when making fair value determinations."). 

Instead, the SEC has essentially alleged a failure to continuously supervise the valuation process.  As the Complaint stated:

the Directors did not know and did not inquire what methodology was used by Fund Accounting and the Valuation Committee to fair value particular securities or types of securities. The information and reports provided to Directors at their board meetings did not provide sufficient information for the Directors to understand whatever methodology was being used by Fund Accounting to fair value securities. For example, at each quarterly board meeting the Directors received a list of the Funds’ portfolio securities that were required to be fair valued and the fair values assigned to each security. However, there was no way a Director could determine from the list the type of security, the basis for a particular assigned fair value, or whether that price had changed from prior quarters.

This case is in litigation and the statements in the complaint are only allegations.  The case, however, sends a significant message.  Directors on boards of mutual funds may well have to step up their involvement and their monitoring of fund activities or otherwise confront an enforcement proceeding.

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